Fed ‘independence’ is a slippery slope

Published in American Banker, The Federalist Society, The American Conservative, and Live Trendy News.

Many observers, like Captain Renault in Casablanca, were “shocked, shocked!” at President Trump’s sharp criticism of the Federal Reserve and his attempt to influence it against raising interest rates, inquiring whether the president can fire the Fed chairman.

Yet many presidents and their administrations have pressured the Fed, going back to its earliest days, when the Woodrow Wilson administration urged it to finance bonds for the American participation in the First World War. The Fed compliantly did so, proving itself very useful to the U.S. Treasury.

That was not surprising, since the original Federal Reserve Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board, and the board met in the Treasury Department.

In the decades since then, lots of presidents have worked to influence the Fed’s actions. Their purpose was usually to prevent the Fed from raising interest rates, exactly like Trump. It was also often to cause the Fed to finance the U.S. Treasury and to keep down the cost of government debt, just as “quantitative easing” does now.
But has a president ever fired a Federal Reserve Board chairman?

Yes, in fact. President Truman effectively fired Fed Chairman Thomas McCabe in 1951. “McCabe was informed that his services were no longer satisfactory, and he quit,” Truman said. Being informed by the president that your performance is not satisfactory is being fired, I’d say. One might argue that McCabe didn’t have to resign, but he did.

The background to McCabe’s departure was a heated and very public dispute between the Truman administration, including Truman personally, and the Fed about interest rates and financing the Korean War. Truman had even summoned the entire Federal Reserve Open Market Committee to the White House, where he made plain what he wanted, which was straightforward. Since the Second World War, the Fed, as the servant of the Treasury, bought however many Treasury bonds it took to keep their interest rate steady at 2.5% — this was the “peg.” In the middle of the Korean War, Truman understandably wanted to continue it.

The Fed, on the other hand, was understandably worried about building inflation, and wanted to raise interest rates. As the two sides debated in January 1951, American military forces were going backwards down the Korean peninsula, in agonizing retreat before the onslaught of the Chinese army. Although financial historians always tell this story favoring the Fed, I have a lot of sympathy for Truman.

By now we have been endlessly instructed, especially by the Fed itself, that the Fed is and must be “independent,” and this has become an article of faith, especially for many economists. However, the opposite opinion has often been prominent, including when the Fed and the Treasury completely coordinated their actions during the financial crisis of 2007-2009 — as they should have.

What exactly does Fed “independence” mean? Allan Sproul, a long-time and influential president of the Federal Reserve Bank of New York, maintained that the Fed “is independent within the government.” That is masterfully ambiguous. It expresses a tension between the executive branch, Congress and the Fed, searching for an undefined political balance.

When McCabe resigned, Truman appointed, he thought, his own man, William McChesney Martin from the Treasury Department. Martin is often viewed as the hero of establishing Fed independence — correspondingly, Truman later considered him a “traitor.” But Martin’s understanding of what Fed “independence” means was complex: He “was always careful to frame his arguments in terms of independence from the executive branch, not from Congress,” a history of Fed leadership says.

“It is clear to me that it was intended the Federal Reserve should be independent and not responsible to the executive branch of the Government, but should be accountable to Congress,” Martin testified in 1951. “I like to think of a trustee relationship to see that the Treasury does not engage in the natural temptation to depreciate the currency.”

Seven decades later, how accountability to Congress should work is still not clear, and Martin would certainly be surprised that the current Fed has formally committed itself to the perpetual depreciation of the currency at 2% per year.

Martin stayed as Fed chairman until 1970, which allowed him to experience pressure from five different administrations. The most memorable instance was the personal pressure applied by President Johnson. In late 1965, the Fed raised interest rates with the war in Vietnam, domestic spending and government deficits expanding.

“Johnson summoned the Fed Chairman to his Texas ranch and physically shoved him around his living room, yelling in his face, ‘Boys are dying in Vietnam and Bill Martin doesn’t care!’” one history relates.

That’s quite a scene to imagine.

One may wonder whether Fed independence is a technical or a political question. It is political. The nature and behavior of money is always political, no matter how much technical effort at measuring and modeling economic factors there may be.

For example, the Fed over the last decade systematically took money away from savers and gave it to leveraged speculators by enforcing negative real interest rates. Taking money from some people to give it to others is a political act. That is why the Fed, like every other part of the government, should exist in a network of checks and balances and accountability.

There is also a fundamental problem of knowledge involved in the idea of independence. How much faith should one put in the judgments of the Fed, which are actually guesses? The answer is very little — about as much faith as in any other bunch of economic forecasts, given that the Fed’s record is as poor as everybody else’s. The Fed’s judgments are guesses by sophisticated, intelligent and serious people, but nonetheless guesses about an unknowable future.

Arthur Burns, the Fed chairman from 1970 to 1978, observed that among the reasons for “The Anguish of Central Banking” is that “in a rapidly changing world the opportunities for making mistakes are legion. Even facts about current conditions are often subject to misinterpretation.”

Very true — and moreover, the world is always changing.

In the light of the political reality of Federal Reserve history, a completely independent Fed looks impossible. In the light of the unknowable future, it looks undesirable.