BOSTON – Financial circles are buzzing about Janet Yellen’s nomination to succeed Ben Bernanke as Chair of the US Federal Reserve. But they are largely ignoring another, much more fundamental question: How much discretion should the Fed – indeed, any central bank – be given to conduct daring monetary-policy experiments like the vast quantitative easing conducted by Bernanke’s Fed over the last five years?
There is, of course, a role for bold experimentation. Many of life’s most important decisions are ultimately blind leaps, and accepted solutions often turn out to be wrong. For example, alcohol is now considered an inefficient method for cleaning wounds, because it kills infection-fighting white blood cells. In fact, venturesome trial and frequent error have driven human development.
But experience has repeatedly demonstrated that, when it comes to government institutions, unchecked audacity is almost never desirable – and, in some cases, can be highly destructive. Mao Zedong’s rash decree in 1958 to eliminate China’s “pestilent” sparrows led to the proliferation of grain-eating locusts, diminishing yields and contributing to a famine that led to more than 20 million deaths.
America’s system of government imposes particularly strict constraints on officials’ actions, reflecting a deep-rooted skepticism of philosopher-kings. Its political institutions are based on a carefully calibrated system of checks and balances, which, by enhancing accountability, helps to control the misjudgments and self-dealing of those in power. Where beliefs and interests diverge, America’s system favors open debate that accommodates a wide range of views. After all, people are more willing to consent if their dissent has been heard.
But checks and balances can also impede crucial reforms. Indeed, they are part of the reason why the United States did not establish a permanent central bank until the Federal Reserve Act of 1913 – long after the United Kingdom, France, and Germany – and, even then, authorized it only to prevent financial panic and monetary collapse. The fact that the Federal Reserve System comprises 12 regional reserve-holding banks reflects the fear at its founding that Wall Street financiers would otherwise capture monetary policy.
How things have changed. Today, enormous power is concentrated in the hands of the 12-member Federal Open Market Committee, which sets interest rates and regulates the money supply behind closed doors – decisions that are not subject to review or challenge. Retirees can sue if their homes are seized for urban renewal, but not if the Fed’s financial suppression deprives them of a return on their savings.
The Fed’s seemingly unchecked authority, like the National Security Agency’s warrantless surveillance, undermines ordinary Americans’ faith in their government. Tea Partiers and Occupy Wall Streeters alike now scorn the Fed – whose legitimacy is based on abstract theories that assume away winners and losers, rather than on democratic accountability – for serving the interests of major banks.
A more decentralized monetary authority would align better with America’s democratic traditions and economic reality.
As it happens, governments directly provide only a thin “base” layer of money; most money is created by banks extending credit. Such a “loan-by-loan” process usually allocates money and credit effectively; however, it can over-lend, stoking inflation and even triggering economic collapse.
But centralized, one-size-fits-all monetary policies cannot counteract booms or busts reliably, and often have unintended consequences. For example, while raising interest rates may help to curb inflation and possibly even avert a credit bubble, doing so curtails both sound and unsound lending alike.
A better approach would be to regulate individual banks, branches, and even loans, while limiting the Fed’s interventions to those that serve its original purpose of ensuring an adequate monetary base and acting as lender of last resort during panics, like the 2008 financial crisis.
A return to monetary decentralization would require radical policy changes, including the implementation of 1930’s-style laws enabling regulators to monitor banks, ensure that deposit insurance is credible and comprehensive, and halt off-balance-sheet financial activities. The Fed and other regulators would have to provide resources and backing to examiners in the field.
Furthermore, Congress would have to relieve the Fed of unrealistic mandates for ensuring low unemployment and controlling inflation. While the Fed should be responsible for forestalling the monetary instability that can trigger intolerable inflation or mass unemployment, its policies cannot account for the many cross-currents that buffet prices and jobs. In the rapids, it is best to concentrate on keeping the canoe from capsizing, rather than worrying about maintaining a straight course.
More generally, there is a need for more creative economic thinking. Economists, beginning with Milton Friedman, have long emphasized top-down monetary policies; but they have failed to reach any useful consensus on the most effective strategy. Amid heated debates over whether monetary policy is too tight or too loose, a more grounded approach based on the “do no harm” principle has received little attention.
Of course, achieving such radical decentralization would take time. In the meantime, congressional review of top-down monetary-policy gambits could be established.
As it stands, US lawmakers routinely delegate technical issues to experts; but, given the hazards of these experts’ often-unwarranted certitude and insulation from popular opinion, lawmakers wisely retain authority over important decisions. Indeed, the US Constitution gives Congress far-reaching powers, including to declare war and appropriate funds for military campaigns.
Against this background, major changes in Fed policy – such as the decision to purchase trillions of dollars’ worth of securities or push interest rates to zero – could easily be subjected to legislative approval (except in times of emergency). While such a system would reduce the Fed’s independence, it would put the onus of difficult political decisions where it belongs: on the democratically elected members of Congress.
Countries with smaller, more homogenous economies and undivided, powerful governments might not benefit from more decentralization and legislative review. And the European Central Bank, for example, faces unique challenges of governance and legitimacy. But, regardless of the circumstances, central banking is too important to be left to technocrats.