The Federal Reserve Diet

LONDON – Markets around the world were relieved by the US Senate’s confirmation of Federal Reserve Board Chairman Ben Bernanke’s reappointment. It was the right decision from the perspective of financial stability; change at the top would have thrown in doubt the Fed’s determination to respond decisively to the crisis – and, indeed, its long-term commitment to low inflation.

Bernanke’s performance over the last two years has won high praise, and an extended political fight over control of US monetary policy was the last thing the world needed at what is still a very delicate moment for the global economy.

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Nevertheless, 30 senators voted against Bernanke. This may, in part, have just been partisan politics, but Bernanke was appointed by President George W. Bush, and there were other voices, both Democrat and independent, raised against his reappointment.

The case against Bernanke rested partly on his performance before the crisis. Was he not a hard-core member of the “Greenspan consensus,” which held that it was not the Fed’s responsibility to look out for bubbles, whether of asset prices or credit, and that it should limit itself to mopping up after the event?

Bernanke had also supported the low-interest-rate policy implemented after the dot-com collapse, which, in the view of many economists, was maintained for too long, fueling the boom and contributing to the bust. Indeed, just recently he defended that policy, whereas many other central bankers have tacitly or explicitly accepted that they need a new approach to credit and asset prices.

That was, I think, part of the reason for many commentators’ doubts about Bernanke’s continued suitability. But these arguments became tangled up in a broader critique of the Fed’s actions.

Should it have been allowed to rescue the insurance giant AIG so expensively, without approval by the US Congress? How is it that the Fed’s balance sheet can expand so dramatically, potentially committing large sums of taxpayer dollars, without Congress having a purchase on its decisions, except well after the event?

These questions have led to pressure for audits of the Fed’s actions, and for greater political control over its decision-making. Congressman Ron Paul has been leading the pack hunting the Fed, but he is by no means as isolated a voice as he was two years ago.

This is dangerous territory. Any suggestion that monetary-policy decisions would in future be subject to political override would, to use a non-technical term, spook the markets. Most developed countries have concluded that central-bank independence makes good sense. Politicians acknowledge, in their more rational moments (yes, they have them), that they can’t be trusted with the interest-rate weapon, especially as an election approaches. So they have handed it over to technocrats, in the hope that they make rational choices that benefit everyone.

I share this consensus view. But there is a problem, and the crisis has highlighted it. The arguments that apply strongly in the case of interest rates are less clear when it comes to other functions that central banks may carry.

If a central bank is committing public funds in support of individual firms, even with a systemic justification, do not different accountability considerations apply? And if it is a direct institutional supervisor, as well as being the lender of last resort, there are different considerations again. Supervisors make decisions that, in effect, have an impact on private financial returns and property rights. They must operate within tight legal constraints, and with rigorous accountability frameworks, involving the government and the legislature.

In its proposed reforms of the regulatory system, the Obama administration plans to give the Fed more of these powers. That has inevitably strengthened the hands of those who argue that more power requires more accountability.

The problem is how to establish two different types of accountability for two different functions. Is it possible to maintain a rigorously independent chairman when it comes to interest rates, and a tightly accountable chairman when he is making supervisory decisions? Only with great difficulty, is my answer. It is very hard to make legislators understand these delicate distinctions. There is bound to be some contagion from one function to another.

So the proposals to strengthen the Fed’s regulatory role carry great risks. It would be far better, in my view, to leave the Fed with an overall systemic role, which raises fewer new accountability issues. Below it, there is the opportunity to create a single banking supervisor, combining the functions of the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the regulatory functions of the regional Feds. In a perfect world, one would add in the state banking regulators, but I recognize that at this point I have begun to trample on cherished features of the US Constitution!

This regulatory architecture would leave the Fed free to speak openly about the development of the financial system as a whole, without worrying about the implications for individual institutions in its care. The crisis has demonstrated that we need this plain speaking. Moreover, such a solution would protect the Fed’s crucial independence in its monetary-policy role.

President Obama should not draw the conclusion that arguments about the Fed’s accountability have gone away with Bernanke’s confirmation. If he proceeds with plans to give it more functions, they will persist. To protect the Fed’s independence, which is a global public good of the highest importance, he should cut back the Fed’s authority to its core role.