The Federal Reserve: Too Powerful?

By Douglas Rice | November 25, 2009 AAA
The Federal Reserve: Too Powerful?

It's all too obvious that financial reform is needed, but the details are in the hands of politicians with disparate agendas. Add to that lobbying of various interest groups and a soap opera on regulatory change ensues. The entity with the least political power, but the most economic influence is the Federal Reserve. So it's only natural that politicians are considering taking some of that power for themselves. (For background info, read our Federal Reserve Tutorial.)
Monetary Policy vs. Fiscal Policy
The Federal Reserve sets monetary policy for the United States. Monetary policy impacts the economy far more than fiscal policy which is controlled by Congress and the president. Monetary policy acts much faster, is more sweeping, and is larger in size than fiscal policy.

Also, monetary policy can be reversed fairly easily compared to fiscal policy. For example, once a spending bill has been signed, the money is spent. But the Fed can decrease the money supply as fast as it increases it. The fiscal policy that would slow the economy would likely be an increase in taxes. Not exactly a workable mechanism for politicians.

For evidence of the impact of monetary policy vs. fiscal policy just watch the financial markets when the Fed speaks vs. the Congress or the president. The markets parse every word of the Fed, looking for some change in policy or inclination there might be a future change. The president, Treasury secretary, and leaders in Congress can rail on about what they are going to do for the economy and the market barely pays attention. (For more, check out Formulating Monetary Policy.)

Recent Legislation
The Fed's dual mandate of high employment with stable prices would seem to be as bipartisan as anything ever could be. Who doesn't want high employment with stable prices? But because the Fed also is the lender of last resort, a role it played extensively in the recent crisis, the Fed is as independent as any government entity can be, and when economic conditions are less than perfect, this autonomy provides an opportunity for a power grab by the politicos.

This gives rise to the recent legislation that attempts to reduce the Fed's power and allow Congress to have more control. This is a catastrophic mistake.

The Fed's Important Independence
The importance of the independence of the Fed can't be overstated. Without it, we would never have become the country we are today. Why? Because politicians don't have the will to make the tough decisions in election years. And as every year seems to be an election year, they will put their own interest first and that means monetary policy will suffer.

For example, when inflation is rising, it's the Fed's job to reduce it. It does this by increasing interest rates and reducing money supply. This slows the economy. What politician running for election would ever be in favor of slowing the economy? When unemployment is still over 10%, it's likely the Fed will be raising interest rates to combat inflation. There will be cries from politicians that this isn't helping the job situation. They are right, but they are misguided. Inflation makes everyone poor, unemployment only impacts a small, but vocal, portion of the population. This leads to the old saying that it's the Fed's job to take away the punch bowl just as the party is getting started. Not exactly the way to get votes.

Other examples come from other countries where the separation of monetary policy and fiscal policy isn't as strong. Hyperinflation, a result of printing too much money to do things you can't afford, is strongly related to the lack of central bank independence. And even more regular rates of inflation are correlated as the less independence in the central bank, the higher the average inflation. Basically, politicians have difficulty with tough love, which is what stopping inflation is all about.

Bottom Line
While there are several proposals circulating on new financial regulations and there is plenty of time for cooler heads to prevail, it's unnerving to see leaders moving toward such obviously disastrous policy. In fact, what we should be doing is moving in the other direction. We should be limiting the politicians' role in the economy as they are the ones that allowed banks, investment firms and insurance companies to merge. They are the ones that regulated Fannie Mae and Freddie Mac. And, more importantly, they are the ones that are lobbied heavily by every special interest group and have to run for election using those groups' contributions.

Should the Fed's power be reduced? No, just the opposite.

For further reading, check out The Treasury And The Federal Reserve.

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