Wednesday, August 24, 2011

The Fed Is Political

. Wednesday, August 24, 2011

I meant to write about Rick Perry's idiotic "treasonous" comment but was occupied with other things. In any case, what Karl Smith said.

Perry's comments aren't completely out of the blue. Over the past few years we've increasingly seen how politicized the Federal Reserve is and how that can affect macroeconomic and regulatory policy. In mid-2009, polls showed the Fed was the least-popular major US agency, below even the IRS. Late last year a majority of Americans wanted the Fed audited or abolished.

Among elites, Fed-bashing is practically a cottage industry on both sides of the ideological spectrum. Obviously Ron Paul and the anti-inflationistas hit the Fed hard from the right for debasing/devaluing/inflating or something, while progressives like Yglesias and others advocate a Fed more dedicated to fighting unemployment. Part of this politicization comes from the Fed's dual mandate and the classic Phillips-curve inflation/unemployment tradeoff that tends to separate the right from the left*.

The Fed has also come under fire from both right and left over its role as regulator. The left finds the Fed completely derelict in its duty during the housing and derivates booms of the 2000s. The right accuses the Fed of regulating the banking system too much and favors various versions of free (or freer) banking. The left attacks Greenspan and Bernanke for being to laissez-faire. The right attacks Bernanke (a Republican and Bush appointee) for being too activist and trying to get Obama re-elected. International regulatory requirements such as the new Basel accord may not be fully implemented as pressures on American and European banks persist. Now Bank of America may be going down again.

These political battles have arguably hamstrung the institution. Peter Diamond, a Nobel Prize-winning economist, withdrew his nomination to the Fed when it became clear that he wouldn't receive approval in the Senate because he prioritized unemployment in his academic work. Obama has responded to the political climate by simply refusing to nominate anyone to fill key seats on the Board of Governors, despite the fact that the Fed is under greater pressures now than at any point in the past 30 or more years at least. Some on the right (eg Sumner) and left (eg Krugman) believe that Bernanke's prior academic work suggests that he would pursue a much different monetary policy were it not for opposite from the Board of Governors and, possibly, politicians.

Not all of these politics are clearly partisan. Both the far right and the far left strongly oppose the bank bailouts that heavily involved the Fed, and we found out yesterday that they were larger than previously thought. (Typical response: "[T]he Fed's secret bailout comes out to the same amount U.S. homeowners currently owe on 6.5 million delinquent and foreclosed mortgages. The progressive take on this story will be that the Fed has preferenced Wall Street over Main Street by using its exceptional authority to extend trillions in loans to banks without offering similar guarantees to underwater home owners.") Even worse for populists on both sides of the aisle is the fact that the Fed offered plenty of funds to non-American firms.

And yet we hear all the time about how the Fed is a technocratic institution, supposedly insulated from politics so it can set perfect policy from a dispassionate distance, thus correcting time inconsistency problems associated with the democratic election calendar. We hear it from academics who do empirical work on macroeconomics and politics, from government officials, and from our textbooks. We hear it from centrists who want to believe that it's true.

But it's not. The Fed is not only politicized; it is political. Every action taken benefits some group in society, often at the expense of another. Every policy choice has distributional consequences. Since the Fed is ultimately responsible for the health and well-being of the financial system, we can generally assume that the Fed will prioritize actions that benefit financial firms over other goals. And then they do. And then we claim to not understand what they're thinking. But that's the job that they've been given.

All of this is even more true of the European Central Bank.

*There's lots of work in political science and economics on this. See, eg, the classic Nordhaus (1975) article, Hibbs (1977), Alesina (1988), Milton Friedman's 1976 Nobel lecture, and plenty of others. There are some problems with this literature, but as a crude first-cut at monetary politics it's a good starting place.


The Fed Is Political
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