Central Bank Autonomy

The Federal Reserve System in American Politics

Kevin Corder

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781135675295
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

First Published in 1998. The Federal Reserve System, the nation's central bank, is directed by statute to maintain maximum employment, stable prices, and moderate long-term interest rates. This volume explores the Central Bank Autonomy, looking at preferences of central bankers, reserve requirements, open market transactions, credit control, macroeconomic outcomes, policies and capital market flows.

Central Bank Autonomy

CHAPTER 1

The Puzzle of Central Bank Autonomy

The Federal Reserve System, the nation’s central bank, is directed by statute to maintain maximum employment, stable prices, and moderate long-term interest rates. Top decision makers in the Federal Reserve System (the Fed) enjoy long terms of office and have considerable discretion over both policy choices and agency expenditures. This combination of extraordinary discretion and extraordinary control over economic outcomes has generated considerable controversy among observers of American politics and among economists. Some observers of the American political economy lament the formal subordination of representative democracy to the demands of owners of capital (Greider 1987). Conservative economists have persistently complained that political control of the money supply undermines economic stability and performance (Friedman 1962). The development of the contemporary Fed that motivates these criticisms is in many ways an incredible story. As recently as 1949 the Fed was simply an administrative agent for the Department of the Treasury and, as a result, under the strict political control of the president and his cabinet. Thirty years later, the Chairman of the Board of Governors of the Federal Reserve System, Paul Volcker, committed the central bank to a series of monetary policy choices that produced a serious recession. How does a federal agency undergo such a transformation, from subordinate to autonomous, in less than thirty years? Why does the United States’ central bank enjoy such a high level of autonomy?

The central claim of this book is that choices by two sets of actors explain central bank autonomy. Key decision makers at the Fed systematically update monetary policy institutions to remove critical elements of monetary policy choices from representative control. Members of Congress tolerate these developments because they benefit from central bank autonomy in two important ways. First, presidents are severely handicapped by central bank autonomy. Second, members of Congress can independently develop new federal credit institutions to protect narrow segments of financial markets from Fed choices. Central bank autonomy is a joint product of the strategic actions of Fed decision makers and the desire of members of Congress to frustrate executive control over monetary policy outcomes.

It is tempting to appeal to formal rules that define the Fed to explain the autonomy of the central bank: the Fed is exempt from the appropriations process and opportunities for appointment of key Fed actors is rare. These formal rules applied to the Fed in the late 1940s, when the Fed was subordinated to the Treasury, and the rules have not changed as the Fed has become more powerful. Remarkably, the statutes that created the contemporary Fed have not been substantially amended since the end of World War II. The structure of the Fed and statutory language describing the instruments of monetary policy are quite similar to language incorporated into the Federal Reserve Act in 1935. This is somewhat surprising given radical changes in the global mobility of capital and structural changes to the American economy that have occurred over time. Absent instructions from Congress, decision makers in the Fed have adopted new technology and new economic expertise to inform monetary policy decisions in an increasingly complex financial and economic environment. Presidents and members of Congress have rarely formally intervened to direct central bankers to adopt particular monetary policy instruments or particular strategies for managing the money supply.

Technological change and economic innovation have compelled decision makers in the Fed to rehabilitate the institutions that structure monetary policy choices. These institutional changes explain the transformation of the Fed from agent of the executive to a remarkably autonomous agency. The institutions of monetary policy are the source of central bank independence. Lombra (1988) labels the several sets of administrative rules and assumptions that are used to implement monetary policy after World War II as distinct “monetary regimes.” This label is somewhat misleading, since regime types imply stable sets of rules and patterns of interactions that persist over time. Instead, administrative rules used to implement monetary policy are never fixed for long periods of time. The rules are quite variable. Members of the Board of Governors of the Federal Reserve System routinely update bank regulatory rules, rules defining bank reserves, and rules governing the purchase and sale of government securities by the central bank. These administrative changes have enabled central bankers to redefine monetary policy as capital markets have become more complex and economic innovations have created new challenges for monetary policy. The functions and operating procedure of the central bank have varied enormously despite the persistence of the statutory instructions from Congress.

The scope of the administrative discretion that is given the central bank to implement monetary policy creates unique opportunities for central bankers to behave strategically. Central bank decision makers can use procedural rules to increase central bank autonomy. The technical uncertainty and change that motivates elected officials to grant substantial discretion to central bankers also undermines efforts to exert political control.

INSTITUTIONAL CHANGE AND OPPORTUNITY FOR STRATEGIC ACTION

Decision makers in the Fed have substantial discretion over the types of rules that are used to implement monetary policy. Recent work on institutions and institutional change (particularly Knight 1992 and North 1990) has identified a number of conditions where social actors can benefit from changes in the rules of the game that govern interaction. North (1990) claims that institutional change can have profound impacts on the long-term economic performance of nations. Institutions can affect the relative price of the courses of action that are available to social actors. Long run effects of these changes in relative prices can produce extraordinary divergence in outcomes over time. Knight (1992) claims that social actors may endorse institutional changes that reinforce existing distributions of power, rather than bring about socially optimal outcomes. Strategic motivations may dominate efficiency considerations in a variety of contexts. Since specification of the rules that define the scope and economic impact of monetary policy are left to the discretion of monetary policy decision makers, there is substantial opportunity for strategic action in the process of changing or updating rules. New rules may reflect the strategic choices of central bank decision makers, rather than the unambiguous pursuit of socially optimal control over the supply of money. Over time, institutions that structure monetary policy choices in the central bank may produce outcomes that diverge substantially from the interests of social actors with a stake in central bank performance.

This description of change in central bank institutions is informed by a larger literature on institutions and institutional change that emphasizes gradualism (Ostrom 1995, Knight 1992, North 1990, Thelen and Steinmo 1992). The gradualist perspective on institutional change is quite different than the punctuated equilibrium described by Krasner (1984) and applied to American institutions and outcomes in Skowronek (1982) and Baumgartner and Jones (1991). Punctuated equilibrium implies long periods of institutional stasis followed by short bursts of tremendous change, typically precipitated by internal crises or external shocks. Institutional change is rare, likely to involve conflict, and coincident with visible and important changes in outcomes. Theories of gradual change instead emphasize the persistence and durability of informal institutions (North 1990, Thelen and Steinmo 1992) and the costs of changing formal institutions (Knight 1992). Given the high costs and risks associated with updating statutory institutions of monetary policy, continuous and gradual changes in central bank operating practices are essential for central bank decision makers to respond to unforeseen innovations and shocks. Consistent with the gradualist perspective, informal change in operating procedures, not formal change in statutes, describes the evolution and transformation of the Fed.

Thelen and Steinmo (1992) and Grafstein (1992) emphasize that institutions can be perceived as immutable constraints by some actors at some times and (less often) as objects of contested choice by some actors at some times. Monetary policy institutions that are reflected in the statutory language of the Federal Reserve Act are extremely difficulty to change. These monetary policy institutions, subject to change by elected officials, are ultimately constraints on the behavior of central bankers, on organized groups interested in affecting monetary policy outcomes, and on elected officials. Other monetary policy institutions, subject to change by central bankers, are exclusively constraints on elected officials and other social actors. These rules are only weak constraints on central bank decision makers since administrative authority to update rules is fairly broad. This second set of monetary policy institutions, under the exclusive control of central bankers, is the focus of the book.

WHO GOVERNS UNDER THE NEW (AND CHANGING) RULES?

The policy outcomes produced by the Fed have motivated both economists and political scientists to investigate the relationship between elected officials and Fed policy choices. The study of American monetary policy offers two perspectives on political control of monetary policy. One set of research affirms the subordinate status of the Fed. It has become conventional wisdom among some political economists that the president “gets what he wants” from the Fed (See, for example, Alesina and Sachs 1988). In this context the Fed is best understood as an agent of the executive branch. Monetary policy would be expected to vary as the party identity of the president changes and may be expected to respond to the proximity of elections. Empirical tests of executive influence by Woolley (1988) and Beck (1984) suggest that presidents do in fact influence the behavior of the central bank. Other recent contributions have reinforced the subordinate perspective. Havrilesky (1987) claims that redistributive campaign promises lead elected officials to seek increases in the money supply. Aggressively redistributive Democratic administrations demand large increases; modestly redistributive Republicans demand smaller increases. He concludes that the Fed is ultimately responsive to the demands of elected officials (especially the White House).

A second set of observers of central bank activity conclude that central bank is somewhat autonomous. In some cases this autonomy frees central bankers to pursue policies consistent with social welfare (Rogoff 1985, Alesina and Gatti 1995). In other cases, autonomous central bankers will oversupply inflation in order to enrich their agency (Toma and Toma 1985). From this “bureaucratic autonomy” perspective, political constraints on central bank activity are weak. There is compelling evidence to support the bureaucratic autonomy perspective. First, economists observing legislative activity in the late 1970s concluded that congressional oversight was disorganized and ineffective (Pierce 1978, Roberts 1978). Central bank policy makers exploited technical sophistication and other information asymmetries to foreclose meaningful political oversight. Second, high and persistent inflation in the United States in the 1970s was taken as confirmation of the propensity of the central bank to oversupply money in order to satisfy narrow organizational objectives. Since central bank revenue is directly related to expansion of the money supply, budget-maximizing behavior by Fed decision makers would result in unexpectedly high inflation (Toma and Toma 1986).

An autonomous central bank may be perceived by the various social actors to be a long-run optimal solution to democratic governance of the economy (Rogoff 1985). Recent work (Alesina and Gatti 1995) uses the low inflation experiences of the 1990s to highlight the salutary effects of delegation to conservative (and autonomous) monetary authority. Schaling (1995) and others reveal a direct link between low levels of inflation and formal independence of central bank leaders. In a comprehensive examination of the literature and data on central bank independence, Cukierman (1992) investigates the incentives for monetary expansion and the consequences of central bank independence. It is ultimately the preferences of elected officials (constrained by either high public debt or a large disaggregated financial sector or both) that determine how much independence is conferred on central banks (Cukierman 1992, 450–1). Elected officials confer sufficient independence to optimize the trade-off between potential revenue from inflation and efficient financial market intermediation (potentially disrupted by unanticipated inflation).

THE FAILURE OF CONGRESS: A MENU OF EXPLANATIONS

What about Congress? The two perspectives described above—bureaucratic autonomy and executive dominance—are obviously mutually exclusive. Either the autonomy of the Fed is exaggerated or the influence of the president is exaggerated. The two perspectives do share one assumption: Congress does not matter. Neither perspective can accommodate positive evidence of congressional influence over monetary policy. If Congress influences monetary policy outcomes, then the Fed cannot be described as autonomous and the president cannot engineer partisan or electoral monetary expansions. The conspicuous absence of congressional influence over monetary policy outcomes is necessary for either perspective to be plausible. With few exceptions (Grier 1991), scholarship on the Fed takes the absence of effective congressional supervision of monetary policy as a matter of fact. Why might this be the case? A number of explanations have been offered: the goals and capacity of Congress are limited, central bank preferences are more consistent with administration objectives, or members of Congress have more direct instruments to influence macroeconomic and capital market outcomes.

Goals of Members of Congress and Presidents Differ

The political goals of presidents and members of Congress may be so different that benefits of central bank activity accrue strictly to the executive. Many observers of policymaking in the United States adopt a typology that distinguishes redistributive policy from distributive policy (Ripley and Franklin 1991, Lowi 1964, Spitzer 1983). Distributive policy choices involve the distribution of benefits to narrow groups or geographic areas with costs diffused over large groups of taxpayers or consumers. Redistributive policy choices involve allocation of policy gains and losses across large groups. We expect to observe members of Congress highly engaged in distributive and pork-barrel projects, but relatively disengaged and ineffectual in addressing redistributive policy (Ripley and Franklin 1991). Members of Congress are likely to eschew lawmaking altogether (Fiorina 1989) and likely to devote scarce lawmaking resources to affecting distributive policy outcomes. In this context, broad macroeconomic objectives, especially price stability, have little significance for members of Congress. If we adopt this conventional description of policy objectives and outcomes, then we should not be surprised to observe members of Congress cede control over price stability and monetary policy to the president.

Ability of Each Actor to Influence the Fed

The lack of attention to monetary policy oversight in Congress has been linked to a variety of specific features of monetary policy. Bewildering technical details are at the core of central bank policy deliberations. Legislators have inherited formal constraints on political control of the central bank: exemption from the appropriations process and long terms for political appointees. Roberts (1978) argues that legislators simply lack any effective mechanisms to influence central bank activity. The president enjoys the power to appoint members of the Board of Governors and has discretion in the choice of the Chairman of the Board of Governors (appointed for a four year term). These tools, although limited, offer a control over administrative agencies that is integral to presidential performance (Nathan 1983). Communication of administration objectives is also important. The president enjoys a direct, informal channel of communication with the Chairman of the Board of Governors (Kettl 1986). Formal administration signals to the Fed (mediated by the Wall Street Journal) systematically affect monetary policy outcomes (Harvilesky 1992). The political skills and resources of presidents and members of Congress may be so different that political control of the central bank is relatively easy for presidents.

Central Bankers Prefer Executive Control

If the president dominates monetary policy choices, it would appear that decision makers in the Fed must prefer this arrangement over shared control or direct congressional control. Policy makers in the Fed must believe that congressional apathy or incompetence, each a sufficient condition for exclusive executive influence over monetary policy outcomes, somehow benefits the Fed. Under these conditions we would expect to observe Fed choices that reinforce executive control and rarely observe administration complaints about monetary policy outcomes. Political business cycle theories assumes that presidents determine monetary policy outcomes fairly directly (representative is Alesina, Londregan & Rosenthal 1993). The optimal control variable in these formal models is the inflation rate. The political business cycle describes manipulation of inflation to generate higher than expected economic output in the quarter before elections. The implicit claim is that monetary policy institutions do not constrain executive actions to bring about preferred macroeconomic outcomes. In other contexts, it is argued rather unequivocally that presidential demands are simply accommodated by the Fed. This view is shared by monetarist economists who blame political control of monetary policy for the inflation problems of the 1970s. Representative is Newton (1983):

The Fed was instructed to participate in the inflationary process initiated by Johnson. The Fed cooperated pliantly with the Johnson demand for increased money supplies, including the provision of a sharply accelerated money growth in the 1968 Presidential election (Newton, 1983, 201).

The implication of this perspective is that when the preferences of members of Congress diverge from preferences of the president, the monetary authority will invariably follow the White House.

Scope of Alternatives

Since fiscal policy instruments require congressional deliberation and disposition, presidents are compelled to rely on monetary policy as a flexible tool for macroeconomic management (Kettl 1986, Woolley 1984). Congress has a choice of instruments to affect macroeconomic or credit market outcomes. The president does not. If this is true we would expect presidents to devote substantially more time and resources to influence monetary policy outcomes. Woolley (1984) argues that this type of relationship between the Fed and the president is mutually coercive. The president controls the political resources that guarantee the survival and vitality of the Fed. The Fed controls some of the economic instruments that can preserve an administration. From this perspective, members of Congress are neither constrained by nor particularly relevant to monetary policy choices. Members of Congress can use other agencies and other tools to influence credit market and macroeconomic outcomes. Since there are no strong incentives for members of Congress to affect monetary policy choices, they are relatively weak monitors.

REASSESSING THE IMPACT OF CONGRESS

It seems somewhat incredible to claim that members of Congress do not attend to monetary policy outcomes. Despite the variety of plausible and quite general explanations for congressional inaction, it is difficult to explain unambiguous and controversial long-term changes in American politics—like the growth of the autonomous Fed—without introducing members of Congress. In the period of increasingly independent central bank activity between the end of World War II and the 1981 recession, Congress began to assert more and more control over the activities of other e...

Table of contents

• Cover
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Tables and Figures
• Acknowledgments
• Abbreviations
• 1. The Puzzle of Central Bank Autonomy
• 2. Central Bank Autonomy and the Preferences of Central Bankers
• 3. Reserve Requirements and the Distribution of Monetary Restraint
• 4. Open Market Transactions: the Scope and Frequency of Capital Market Intervention
• 5. Selective Credit Controls and Credit Allocation
• 6. Macroeconomic Outcomes and Monetary Policy Institutions
• 7. Capital Market Flows and Federal Credit Institutions
• 8. Representative Control of Monetary Policy
• References
• Index