It's time to revamp the Federal Reserve
By Hossein Askari and Noureddine Krichene
It would appear that at last the US Congress has started to appreciate the
extensive damage inflicted on the US economy by the Federal Reserve. This in
large part because the Fed has a conflicting dual mandate of full employment
and price stability and a structure that makes it vulnerable to the dictates of
its chairman.
In pursuit of its full-employment mandate, using aggressive monetary policy
since 2001, the Fed has driven nominal interest rates to record low levels,
making real interest rates largely negative. Low interest rates, in turn have
fueled speculation by reducing its cost, resulting in a number of assets
bubbles, the most prominent in housing. This policy, in turn, has compromised
the creditworthiness and soundness of the entire US banking and financial
system.
The Fed’s reckless monetary policy has cost the US government
trillions of dollars in bailouts for banks, the automobile industry, and
homeowners. More precisely, on July 21, Neil Barofsky, the overseer of the
Troubled Asset Relief Program (TARP), estimated in a prepared statement to a
committee of the US House of Representatives that the total exposure of the US
government to the financial crisis at US$23 trillion to $27 trillion. Fed
policies set off commodity price inflation, most notably in oil prices, and
exchange rates instability; it aggravated external current account deficits;
and it has already pushed unemployment to 9.5% in June 2009, with the
expectation that it may reach around 11% before it is all done.
In the process, the Fed has created considerable distortions in the economy and
has heightened economic uncertainty. The full extent of the damage and how long
recession will last cannot be predicted today. There are in fact clear dangers
that this unparalleled monetary expansion could be paving the ground for even
bigger bubbles, more intense financial instability and larger bankruptcies in
the future.
Yet the Fed has partially succeeded in blurring the diagnosis of the current
crisis by blaming the financial crisis in part on excesses of the financial
markets, on surplus countries, such as China and oil producers, and on
regulatory failures.
The structure of the Fed and its recent policies should be a cause for national
concern. While the dual mandate could theoretically allow the Fed to achieve
acceptable level of inflation with low levels of unemployment, it could also
create large cycles and severe recessions, with significant costs to the US
economy. Which outcome prevails is an empirical question and depends on the
policymakers at the Fed.
First, the Fed is dominated by one-man rule and its policy is largely
influenced by the views of its chairman. In this respect, Alan Greenspan
believed in financial deregulation, lax supervision, bailing out hedge funds,
and rejecting calls to stave off housing bubbles or reinforcing bank
regulations. His successor and present chairman Ben Bernanke believes in
unorthodox monetary policy and that zero-interest rates and unlimited money
were panacea for all problems, and he has ignored sound rules for sound central
and commercial banking.
Second, the Fed has become a price-setter and is controlling interest rates at
near zero, distorting the price structure of the broader economy. To maintain
interest rates at such low levels, the Fed has to provide unlimited liquidity
to banks and allow money supply and credit to rise at a fast rate, regardless
of inflationary consequences, bubbles or financial stability. Such liquidity
expansion has contributed to historically high current account deficits, and
has pushed the credit-to-GDP (gross domestic product) ratio to an unsustainable
level of 350%.
Recently two opposing views regarding the structure of the Fed have emerged: a
group of academicians have circulated a petition that calls for preserving the
Fed’s independence. The opposite view expressed by a group of US Congressmen
calls for enacting central banking legislation and reining in the absolute
powers of the Fed. Which is the best path for the US?
First, some background. The US Congress, on the heels of the 1907 financial
crisis, established the Fed in 1913. The objective was to stabilize monetary
policy and to prevent monetary crises that had taken place in the past when
money supply had been uncontrolled and depended on the ability and willingness
of banks to create money and provide credit. Notably, the banking system had
experienced credit booms followed by credit contractions and waives of bank
failures and long-lasting economic recessions and mass unemployment.
Ironically, the worst financial crisis and economic depression occurred only a
few years following the Fed’s creation. At that time the Fed had failed its
mandate for controlling money and credit creation and had instead instituted
low interest rates that triggered speculation, massive purchase of gold by
foreign central banks, and over-expansion of credit. The stock market crash and
the collapse of the credit boom precipitated the Great Depression.
The notion of an independent Fed has all along precluded the enactment of
central banking legislation and, therefore, has made the Fed dependent either
on the doctrine and personality of its chairman, or on the pressure of interest
groups, or both. It has constantly succumbed to Wall Street or political
pressure for easy monetary policy.
The accord of 1951 between the US Treasury and the Fed illustrated such
dependence. In particular, the accord ended a long period of very low interest
rates imposed by the US Treasury as well as politicians and allowed the Fed
some leeway to counter rapid inflation through reduced monetary expansion.
Hence, purely discretionary powers together with no central banking
legislation, in the name of independence, have subjected the Fed to various
dependencies and turned it into a source of powerful financial and economic
crises.
Quantity theory monetarists were proponents of money legislation and control of
money and credit. Following financial crises and suspension of convertibility
by the Bank of England in 1797, David Ricardo called for strict central banking
legislation that would restrain central bank ability to create costless paper
money. His views were implemented in Great Britain under the Pearl Act in 1844
through establishing two separate departments in the Bank of England, namely an
issue department that issued currency based on gold and a banking department
that performed banking operations for the state, commercial banks, and foreign
operations.
The Pearl Act was an example of quantitative control of money and credit. In
1933, Henry Simons, Irving Fisher, and other authors of the Chicago Reform Plan
called for filling the vacuum of central banking legislation and replacing
discretionary and "dictatorial" powers that created considerable uncertainty
and caused too much chaos and instability by a set of simple rules that would
define a transparent and stable central banking. Quantitative control of the
currency through a 100% reserve banking system and subordination of the money
authorities to the fiscal authority were main elements of the 1933 Chicago
Reform Plan.
The late Milton Friedman, a student of Simons, was a proponent of a fixed money
rule consistent with a stable growth of money supply at about 2 to 5% a year.
Harry Johnson, while sympathetic to fixed rule, repudiated discretionary rule
and called for a democratic control of the Fed by bringing it under the control
of elected officials both in the executive and legislative branches.
The proponents of a legislative framework for the central bank believed that
they were not proposing a perfect solution, as no perfect solution exists;
however, a legislative money framework would be far superior to arbitrary
discretion, unaccountable central bankers, and over-using money policy for
short-term stabilization. They strongly believed that money policy had to be
conducted consonant with long-term goals of price and financial stability and
to allow fiscal, competitiveness and price flexibility, trade policy, sectoral
policies, and structural policies as instruments for short-term stabilization
and for strengthening the private sector.
The US Fed is unlike a traditional central bank. Its main mandate was
reformulated in 1946 under the full-employment act. It became possibly the only
central bank in the world with a mandate to achieve full-employment and price
stability. Accordingly, it became the most encompassing institution, with its
powers extending to achieve the highest level of aggregate demand. Certainly
politicians imposed the 1946 full-employment act, but paradoxically, the full
employment mandate has been self-defeating.
Ensuing financial instability had pushed unemployment to 25% during the Great
Depression and 12% during the 1970' stagflation. Today, Fed policies have
pushed unemployment from 4.3% in 2007 to 9.5% in June 2009. Besides causing
large-scale unemployment, the Fed has also failed to achieve price and exchange
rate stability.
The US Treasury in June 2009 issued a regulatory plan for financial
institutions. However, no regulatory framework has been considered for the Fed.
Historical facts, including recent financial crisis, would indicate that in the
absence of central banking legislation the current system would always expose
the banking sector to future crises no matter how sound a banking regulatory
and supervisory framework were in place.
Only a regulatory framework for the Fed can enhance its role, to make it
accountable to legislative jurisdiction and to the electorate, and as a result
enhance the stability of the financial system. Without legislative rules, it
would be difficult to determine whether the central bank was conducting safe or
unsafe central banking, or whether its mandate was limited to money and credit
or was all encompassing.
Under the latter mandate, the central bank is conferred powers for enacting
policies for achieving full employment of the labor force, irrespective of the
safety of these policies; it fixes prices and dictates the allocation of
resources in the economy at the expense of prudent money and bank stability.
The control of banks, credit, and enforcement of prudent banking become
somewhat contradictory when a central bank is mandated with full employment and
price stability.
It would appear that the Fed sees no alternatives to monetary policy for
promoting growth and employment. But zero-interest rates distort the price
structure, erode the return to capital, discourage savings, investment, and
depress growth and employment. They also fuel speculation and inflation.
Irrespective of millions of foreclosures originating from speculative housing
prices and excessive property taxes, the Fed is injecting $1.5 trillion for
mortgage loans in an attempt to re-inflate housing prices. In the same vein and
despite record defaults on consumer loans and mounting toxic assets, the Fed is
injecting $1 trillion in consumer loans destined to subprime borrowers.
Such unrestrained money policy can only worsen financial instability in the
future. The Fed's monetary policy has made fiscal management very costly and
difficult. The government has had to put in place bailout facilities, a
toxic-asset purchase program, a housing bailout program, stimulus packages to
revive economic activity. It has also had to run dangerously large deficits.
The consequences could be compounding inflation, rising public debt and
external deficits, and more financial instability. New liquidity injections
could in part translate into toxic assets on the Fed’s balance sheet and fuel
inflation.
The Fed's present strategy of inflating the economy to lessen the debt burden
and to achieve employment, to be followed by monetary policy stabilization
after the price level has been inflated high enough to cut real debt, is
inequitable and has many associated risks, including aggravating fiscal costs,
promoting moral hazards, and perpetuating a vicious circle of instability.
The recent debate regarding the role of the Fed is not new and reflects two
opposing views of central banking requiring a public debate. A national debate
of Fed policies and its possible reorganization has become a pressing matter
for the United States.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist at the International Monetary Fund and a former advisor, Islamic
Development Bank, Jeddah.
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