Motherhood, Apple Pie, and Central Bank Independence
Central bank independence is like motherhood and apple pie: Who can oppose it? We know from voluminous academic research that independent central banks tend to deliver better macroeconomic outcomes and in particular lower inflation. It is therefore unnerving that many members of Congress are calling for limits on the Fed's powers, and even for a more far-reaching reform of the Federal Reserve System. And in response to this threat, a group of 250 prominent economists have signed a petition in support of an independent Fed.
At first glance, this would seem to be a case of enlightened economists pitted against shortsighted politicians. The reality is more complicated, however, and the petitioners' call for independence overlooks three important subtleties.
First, defenders of independence (myself included) must concede that the Fed invited criticism with some of its more radical responses to the crisis, especially those that involved specific financial institutions: Bear Stearns, AIG, Lehman Brothers, Citibank, and Bank of America. A case can be made that the Fed has put taxpayer dollars at risk for the benefit of specific firms without the normal congressional oversight. And it certainly doesn't help that Goldman Sachs and JP Morgan turned out to be major beneficiaries of the Fed's bailouts. Granted, the Fed had little choice but to do what it did in these cases, as going through the proper channels would have been far too slow. The mistake was to take these steps without clear Treasury backing. (I don't like to say "I told you so," but I anticipated this in a report I wrote several months ago for the Committee on Capital Markets Regulation.) The Treasury did belatedly announce in March that it would assume ownership of some Maiden Lane assets, but by then the damage had been done.
Second, the near-term danger is not that political pressure will force the Fed to pursue an inflationary policy. Exactly the opposite is true: If the Fed were to unwind its positions and return to the status quo ante, as many would have it do, the result would be deflationary. The real threat is therefore that the Fed would end its expansionary policies too quickly. This may seem strange, but similar concerns were a factor in the Bank of Japan's reluctance to pursue aggressive expansionary policies in the 1990s. There, a misguided concern about a nonexistent inflationary threat, along with fears that its newly won independence would be jeopardized, led to a protracted policy paralysis.
Third, economists' well-intentioned calls for autonomy fail to recognize that independence is earned, not granted, and that with independence comes an expectation for accountability. This is why the achievement of independence has often been accompanied by the adoption of an explicit inflation target, making the central bank explicitly accountable for its macroeconomic outcomes. It is also worth recalling that the landmark Federal Reserve-Treasury Accord of 1951 was an accord, not a unilateral bequest. If the Fed is to be successful in fending off interference, it must be proactive in reaching an accord with the Treasury on a set of ground rules for dealing with the next financial crisis. Had it done so in March 2008 following the Bear Stearns failure, it wouldn't have found itself in the uncomfortable position of having to plead its case for independence.
Kenneth N. Kuttner, professor of economics at Williams College, was a visiting fellow at the Peterson Institute for International Economics in 2005–07. This was also posted on the blog Finance: Facts and Follies.