Power of the Fed belongs to elected officials

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 such as the quantitative easing conducted by Bernanke’s Fed over the past five years?

There is, of course, a role for bold experimentation. But experience demonstrates that, when it comes to government institutions, unchecked audacity is almost never desirable — and, in some cases, can be highly destructive.

The US’s system of government imposes particularly strict constraints on officials’ actions, reflecting a deep-rooted scepticism of philosopher-kings. Its political institutions are based on a carefully calibrated system of checks and balances, which helps to control the misjudgments and self-dealing of those in power.

But checks and balances can also impede crucial reforms. Indeed, they are part of the reason the US did not establish a permanent central bank until the Federal Reserve Act of 1913 — long after the UK, France and Germany — and, even then, authorised 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.

The Fed’s seemingly unchecked authority undermines ordinary Americans’ faith in their government. A more decentralised monetary authority would align better with the US’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 overlend, stoking inflation and triggering economic collapse.

But centralised, one-size-fits-all monetary policies cannot counteract booms or busts reliably, and often have unintended consequences. 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.

A return to monetary decentralisation would require radical policy changes, including the implementation of 1930sstyle laws enabling regulators to monitor banks, ensure that deposit insurance is credible and comprehensive, and halt offbalance-sheet financial activities. The Fed and other regulators would have to provide resources and backing to examiners in the field.

Further, 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 crosscurrents that buffet prices and jobs.

There is a need for more creative economic thinking. 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 decentralisation would take time. In the meantime, congressional review of top-down monetary-policy gambits could be established.

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. 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 decentralisation and legislative review. And the European Central Bank, for example, faces unique challenges of governance and legitimacy. But central banking is too important to be left to technocrats.