Friday, September 18, 2009
I know some readers will take up the "where in the Constitution does it say" charge. It's a legitimate point, but not likely to be very effective as an argument. And there is the reasonable point that the Federal Reserve does not do compensation studies and has no specific knowledge that makes it more able to do this than, say, the Department of Labor.
Under the proposal, the Fed could reject any compensation policies it believes encourage bank employees -- from chief executives, to traders, to loan officers -- to take too much risk. Bureaucrats wouldn't set the pay of individuals, but would review and, if necessary, amend each bank's salary and bonus policies to make sure they don't create harmful incentives.
A final proposal is still a few weeks from completion and could be revised along the way, according to people familiar with the matter. It requires a vote by the central bank's board, but no congressional approval.
The U.S.'s largest banks, about 25 in number, would get especially close scrutiny. The central bank intends to compare these banks as a group to see if any practices stand out as unusually dangerous to their firms.
Let me set those points aside.
The Federal Reserve is supposed to have independent status. As Dallas Fed president Richard Fisher pointed out a couple of years ago, at times the Fed has been less independent and at other times more so. Less in the 1960s, more in the 1980s and 1990s. Which Fed gave this country better performance? Not versus an ideal, mind you, just better. I don't think you would find many economists who thought the William McChesney Martin Fed performed better than the Paul Volcker Fed. For all the mistakes Greenspan made, his performance was better than Arthur Burns'.
Why? Is its independence part of the reason? Fisher writes:
Under Chairmen Alan Greenspan and Ben Bernanke, the Federal Reserve has been left alone to conduct monetary policy. We are a truly independent central bank. Policy is set by the Federal Open Market Committee. The 17 current participants in the FOMC deliberations consist of five governors, including the chairman, who are appointed by the president of the United States and confirmed by the Senate, and 12 presidents of the Fed�s regional Banks, each of whom serves at the pleasure of his or her Bank�s board of directors. All 17 participate in honest and vigorous discussion of the economy and each offers his or her individual policy prescription at FOMC meetings convened and presided over by the chairman. At the end of these meetings, the chairman calls for a vote.And where does that independence come from? Not the Constitution; monetary policy is the purview of the Congress, and the Fed is an agency delegated powers by the Congress. The question is what powers can you delegate to the Fed and still call it independent?
I think executive pay compensation is a particularly dangerous delegation to the Fed's ability to conduct monetary policy. Money is created not only by the Fed but by bank lending; if a central bank can control pay, it can influence bank lending. This makes the Fed less transparent when most everyone seems to agree that more transparency is needed.
I have the same fears regarding the Fed as a super-regulator. I would point out this wise advice from the Indian economist Ajay Shah last week:
[I]ndependence goes with a narrowing of the functions of the central bank. There is no economic case for having independence from politicians for functions such as running the payments system, regulating or supervising financial markets or banks, running a bond exchange and depository, manning a system of capital controls, etc. The rationale for independence is limited to one specific problem: that of setting the short-term interest rate of the economy. Hence, giving RBI [Reserve Bank of India --kb] independence requires narrowing down its functions to the core where economic logic suggests independence. All other functions need to be placed in conventional agencies, with control in the hands of accountable politicians.There's some places to quibble there -- why short-term interest rates, for example, and not the exchange rate or the stock of money? -- but in general Shah makes an excellent point. You might want another agency that regulates financial firms to be independent of political control. But the best central banks seem to be those that, to use Willem Buiter's words, stick to their knitting and avoid commenting on everything other than interest rate or exchange rate policy.
This proposed U.S. policy goes in exactly the opposite direction. It is a danger to our monetary system, and should be opposed immediately.