Independence?

Chapter 8

Would Stimulus without Debt Undermine the Fed’s Independence?

Would stimulus without debt undermine the current degree of independence of the Federal Reserve from Congress and from the president? I contend that the answer is no for two reasons: (1) The Fed would decide when and whether to transfer funds to the Treasury for fiscal stimulus, and if so, how much; (2) the Fed would decide whether and how much to adjust its monetary policy instruments, taking into account its transfer (if any) to the Treasury, the fiscal stimulus enacted by Congress, its mandate from Congress to pursue high employment and low inflation, and everything else (for example, whether there is a financial crisis). Thus, stimulus without debt does not require the Fed to make the transfer to the Treasury for fiscal stimulus in a severe recession, or specify how large the transfer must be; nor does it tell the Fed how much to adjust its monetary policy instruments. Stimulus without debt would therefore preserve the current degree of independence of the Federal Reserve.

In this chapter I don’t address the important question: What is the socially optimal degree of independence of the Fed from Congress and from the president? This is a book about stimulus

without debt, not Fed independence. Consequently, in this chapter I focus on whether stimulus without debt would change the current degree of independence of the Fed, not whether the current degree of independence is socially optimal.

The Current Degree of Fed Independence

The US Constitution assigns to Congress the power to create money, but Congress has delegated this task to the Federal Reserve, which Congress created. The Fed is governed by congressional legislation—the Federal Reserve Act. Consequently the Fed is certainly not independent of Congress. Also, the president nominates the members of the Board of Governors of the Federal Reserve, including the chairman, and the Senate must approve the nominations. So the Fed is not independent of the president either. But once appointed, members cannot be removed because of their policies—just as Supreme Court justices can’t be removed for their written opinions.

In contrast to other government agencies, the Fed has its own source of funding: the interest earnings from its holding of securities (bonds) and from its loans to banks. After using a small portion to cover its expenses, the Fed returns most of its earnings to the Treasury. As a consequence, the Fed does not have to seek appropriations from Congress. Stimulus without debt would not affect this source of Fed independence.

The Fed is governed by congressional legislation: the Federal Reserve Act as amended over the years. In a 1977 amendment to the Federal Reserve Act, Congress assigned to the Fed a dual mandate: it specified that the Fed must pursue both high employment and low inflation. In 2008 the Fed was therefore expected to lower interest rates to try to induce borrowing and spending on goods and services to combat the deepening recession and

rising unemployment. In fact, in 2008 the Fed did lower interest rates for this purpose. By contrast, the European Central Bank has been given a single mandate: to pursue low inflation. If Congress had given the Fed the same single mandate prior to 2008, the Fed would have been unable to lower interest rates in 2008 to try to combat the fall in employment.

Stimulus without debt would permit, not require, the Fed to make a transfer to the Treasury for fiscal stimulus. This permission would not affect the Fed’s current degree of independence because the Fed would be free not to take this action.

But wouldn’t Congress exert great pressure on the Fed to make a large transfer for fiscal stimulus to the Treasury so that Congress’s fiscal stimulus didn’t raise the deficit or debt? Congress might. Wouldn’t Fed decision-makers feel they had to make a transfer as large as Congress wants? No, they would not. Speeches given by current and past members of the board of governors and current and past Fed regional bank presidents (who are also on the Federal Open Market Committee) make clear that most Fed decision-makers have always believed that the Fed should counter excessive fiscal stimulus in order to prevent inflation.

A Biased Definition of Fed Independence

In 1977 Congress enacted as an amendment to the Federal Reserve Act that gave the Fed a dual mandate: to pursue both high employment and low inflation. Thus, in 2008 the Fed explained its reduction of interest rates as an attempt to prevent a fall in employment. Some critics believe the Fed should pursue only low inflation, not high employment; they believe pursuing high employment is likely to lead to high inflation. These critics usually view Congress as likely to pursue high employment more

than low inflation, and that the Fed must be independent so that it can counter Congress by pursing only low inflation. These critics contend that the Fed is not really independent unless it pursues only low inflation.

One such prominent Fed critic was the late Allan Meltzer, a professor of economics at Carnegie-Mellon and author of a detailed history of the Federal Reserve. In an article entitled “Federal Reserve Independence,” Melzer (2014) said that the Fed’s quadrupling of its balance sheet without oversight during the Great Recession in less than five years at first glance seems to indicate its independence. He contended, however, that much of the balance-sheet expansion was undertaken to finance the outsized budget deficits during the recession, asserting that independent central banks do not finance budget deficits.

Thus, Meltzer asserted that “independent” means avoiding a specific action that Meltzer opposes: Fed financing of “outsized” budget deficits. The severe recession of 2008 caused an automatic drop in federal tax revenue well below federal spending, causing the Treasury to borrow the large difference, and in 2009 Congress enacted and the president signed a large fiscal stimulus to combat the recession that further widened the federal deficit, causing the Treasury to borrow more from the public. There was no direct transfer of funds from the Fed to the Treasury. Meltzer clearly disapproves of the budget deficits, the fiscal stimulus, and the Fed’s purchase of Treasury bonds in the open market during the severe recession. But his disapproval does not mean the Fed sacrificed its independence. The Fed bought a large amount of Treasury bonds in the open market because, in the Fed’s judgment (expressed in speeches, op-eds, and congressional testimony by Fed chairman Bernanke), such action would pursue high employment without sacrificing low inflation.

As the author of a history of the Fed, Meltzer contended that the original Federal Reserve Act in 1913 did not permit any

Federal Reserve support of the Treasury and that the founders wanted the Fed to follow the gold standard and adhere to a rule that prohibited financing the Treasury and the budget. Those two rules, Meltzer argued, supported an independent Federal Reserve during the 1920s.

Whenever the Fed followed a rule or took actions that Meltzer approved of—for example, monetary tightening that reduces inflation while ignoring the short-term negative impact on employment—Meltzer called the Fed “independent.” Consider Meltzer’s comments on Fed chairman (1979–1987) Volcker. Meltzer said Volcker was a relatively independent chairman because he was committed to a policy of reducing inflation. Volcker shared Meltzer’s view that the Fed should reduce money growth to lower inflation. Meltzer, a monetarist, called Volcker a “pragmatic monetarist” who shared Meltzer’s belief in what Meltzer called an “anti-Phillips curve,” which implied that the way to reduce the unemployment rate was to lower expected inflation and actual inflation.

Volcker reduced inflation in the early 1980s by cutting Fed money injections (via Treasury bond purchases) into the economy, which caused a sharp rise in interest rates and fall in consumer and business borrowing and spending, which threw the economy into a severe recession with high unemployment; it was this high unemployment and weak product demand that brought down wage increases, cost increases, and price increases.

Now consider Meltzer’s comments on Fed chairman (1987–2006) Greenspan’s independence. Meltzer said Greenspan, who succeeded Volcker, further reduced inflation and was a “relatively independent chairman” who resisted “open criticism” from the George H. W. Bush administration of Greenspan’s anti-inflation policy during the 1992 election year. In my view, the criticism from the Bush administration and others in 1992 was warranted because the unemployment rate rose from 5.6% in 1990 to 7.5%

in 1992, and yet the Fed did not cut the federal funds rate below 3.0% due to its primary focus on preventing inflation. Meltzer said Greenspan rightly followed a Taylor rule instead of erratic discretion, moving interest rates in response largely to inflation with only minor responses to unemployment, and Greenspan’s implementation of the Taylor rule produced a long period of growth, short and mild recessions, accompanied by low inflation, a period now called “the great moderation.” Greenspan was able to maintain Federal Reserve independence because his policy maintained popular support. Following the Taylor rule preserved Fed independence. Endorsing the Taylor rule is quite a concession for Meltzer because the Taylor rule, with the specific numerical weights advocated by Taylor, calls for at least some response to high unemployment. The Taylor rule response, however, is much milder than the response implemented by the Fed under Bernanke in the 2008 recession.

Finally, Meltzer turned to the 2008 recession. He gave credit to the Fed for preventing a financial collapse. But then his view of the Bernanke Fed’s actions turned negative. He pointed out that the Federal Reserve pursued the most expansive policy in its history and that idle excess reserves in banks rose from less than $800 billion to more than $2.5 trillion. Meltzer emphasized that this policy financed massive government budget deficits at very low interest rates, which is “the very opposite of what an independent central bank does.” He said he did not know of any example, anywhere, in which base money creation to finance large budget deficits avoided higher inflation. He was disappointed that the Fed had not revealed a credible policy to prevent inflation when the idle reserves were no longer idle, and worried about a possible “tsunami of idle reserves” that would spill over the domestic and international economy.

Meltzer made no mention of fiscal stimulus. In my view, fiscal stimulus is much more effective than standard monetary

stimulus in a severe recession; the Fed would have been much more effective if it had made a large transfer to the Treasury to finance a large fiscal stimulus instead of buying bonds. Thus, in a severe recession the Fed should finance a large fiscal stimulus. Meltzer refers to “massive budget deficits” without acknowledging that the recession itself caused large budget deficits. I agree with Meltzer, however, that the Fed must be prepared to raise interest rates once the economy enters a strong recovery and excessive demand threatens to generate inflation; I discussed how the Fed could do this in chapter 6.

Finally, Meltzer defines Fed “independence” as the Fed not financing fiscal stimulus and focusing mainly on inflation. But Fed independence is the Fed having the choice of whether to finance fiscal stimulus. Under stimulus without debt, the Fed is permitted, not required, to finance fiscal stimulus. The Fed’s degree of independence is the same whether Congress has prescribed a single or a dual mandate. Thus, Meltzer’s definition of “independence” is biased toward the monetary policy he prefers.

Summary

Stimulus without debt would not undermine the current degree of independence of the Federal Reserve from Congress and from the president because the Fed would decide whether to transfer funds to the Treasury and how much, and whether and how much to adjust its monetary policy instruments. Stimulus without debt does not require the Fed to make the transfer to the Treasury in a severe recession, or specify how large the transfer must be; nor does it tell the Fed how much to adjust its monetary policy instruments.