Sunday, October 23, 2011

Free Bird

Below find a few excerpts from the unambiguously titled Independence + Accountability: Why the Fed Is a Well-Designed Central Bank (PDF) by Christopher J. Waller. I liked the paper. I have rearranged the excerpts to provide continuity in the shortened form presented here. I used the paper's conclusion as an intro, and the abstract as a conclusion :)

I have removed footnotes and references to sources. And I have broken up long paragraphs in to shorter ones, to better fit my attention span.

Hover over the first few words of each paragraph, and a note will pop up identifying the page number where it can be found in the PDF, which runs from page 293 to 301.

Note: the original PDF provides a "balanced" view that may be lacking from my post. Don't blame the Fed if my presentation is one-sided.

The PDF itself is 8 or 9 pages long. Not too much to read, even for me. If you were not already studying the economy before Robert Lucas got famous, I suggest that you read it to get some perspective.

Used with permission of the St. Louis Fed.

To the uninformed observer, the Fed’s structure is in many ways mind-boggling. In particular, it seems counterintuitive that, in a democracy, the central bank should have independence from Congress. Yet, this independence is the result of Congress trying to avoid making monetary policy mistakes for political gain.

Of course, accountability of public policymakers is a fundamental principle in a democracy. It is the tension between independence and accountability that led to the design of the Federal Reserve, and it has been an everpresent force in U.S. monetary policy for the past century.

The willingness of governments to force their central banks to print excessive amounts of money, or put in place policies that lead to higher inflation rates over time, has been termed the “inflation bias” of discretionary monetary policymaking. To minimize this bias, many governments have decided to give their central bank legal independence (CBI).

But do countries with independent central banks also have lower inflation? To answer this question properly, it’s necessary to calculate country-specific measures of central bank independence. Many economists have constructed measures of CBI from a variety of legal indicators, many of which are discussed in this article.

In a now famous article that was published in 1993, Alesina and Summers (1993) found that developed countries with high levels of central bank independence also experienced lower average levels of inflation for the period 1955-88. Figure 1 is derived from a figure in their paper, which clearly shows this negative relationship.

It has always been important that central bankers be independent of the political process to ensure that they cannot be manipulated by elected officials. However, having such great power means that central bankers have to be accountable to the electorate in some fashion, and accountability requires the central bank to behave in a transparent manner.

Over the years, there have been changes in the Fed’s structure to improve its independence, credibility, accountability, and transparency.

The tricky issue is that accountability means being subject to some political oversight, which weakens the perception that the central bank is independent.

The recent recession and financial crisis were, in many respects, the worst since the 1930s. In response, some economists and policymakers have begun to examine the Fed’s policies prior to and during the financial crisis to see whether its goals, responsibilities, or institutional structure should be changed to help prevent another financial calamity.

In response to the financial crisis and recession, some people argue that power should be further consolidated in Washington, D.C., to avoid another financial calamity. However, as St. Louis Fed president James Bullard and other Federal Reserve officials and private-sector economists have pointed out, moving the levers of monetary policy even closer to the hub of politics could lead to an erosion of the Fed’s independence ...

In 1913, Congress purposefully created the Federal Reserve as an independent central bank, which created a fundamental tension: how to ensure the Fed remains accountable to the electorate without losing its independence.

Over the years, there have been changes in the Fed’s structure to improve its independence, credibility, accountability, and transparency. These changes have led to a better institutional design that makes U.S. policy credible and based on sound economic reasoning, as opposed to politics.

In times of financial and economic crisis, there is an understandable tendency to reexamine the structure of the Federal Reserve System. A central bank’s independence, however, is the key tool to ensure a government will not misuse monetary policy for short-term political reasons.
Excerpts from Independence + Accountability: Why the Fed Is a Well-Designed Central Bank by Christopher J. Waller.
Federal Reserve Bank of St. Louis Review, September / October 2011


nanute said...

I read the entire PDF and I agree that it is probably a good thing to have an independent authority making monetary policy.(The Fed;never question the I think the problem that some critics have is that it seems that every time there is a serious shock to the system, that policy makers either don't see it coming, or worse yet, take the wrong prescriptive action. Part of this is a result of political pressure, and the other problem is that the independent bodies that make up the Fed are for the most part, bankers. Recent events show that the main objective by the Fed has been to stabilize the financial sector, while ignoring the dual mandate requirement that employment is part of the equation. Under current political conditions it is very apparent that one party, with the help of a few from the other party, is bent on cutting spending and shrinking the economy and most likely, increasing the level of unemployment. If the Fed can't see this, and does not implement policies that would offset this disaster, it will only give critics more fuel to throw on the "fire."
PS. Saw your response to the reserve requirement/sterilization point. Thanks

nanute said...

Upon further consideration, I think any attempt by the Fed to bring down unemployment would lead to Rick Perry calling for 2nd Amendment remedies. Free Bird? Lynyrd Skynrd? I heard the Tea Party members of Congress is forming a new group: ? Mark and The Austerians.