The Fed’s Remarkable ‘Independence’ Claim
Published in AIER’s The Daily Economy.
In the course of human events, the Federal Reserve is constantly declaring itself independent — that it both is and should be independent. The specific issue of whether this unelected body should be independent of the elected President has again been raised in the 2024 presidential campaign. The general issue of whether a central bank as part of the government can or should be independent is classic.
Given the foundations of American political philosophy, to say that the Federal Reserve should be independent is a remarkable claim. The Constitutional bedrock of the American government is that all its parts be subject to checks and balances from others. Should one immensely powerful part of the government, the Fed, be exempt from checks and balances? It seems to me that the answer is obvious: of course not.
Yet many people, especially economists and journalists, believe the Fed should somehow be independent. How can this be? That the Fed itself should unendingly promote this idea, and therefore its own power, is not a surprise. Every government bureaucracy yearns to be free of any meaningful oversight and discipline by the mere elected representatives of the People. But by what feat of public relations brilliance did the Fed manage to convince so many others of this hardly self-evident proposition?
The Fed’s Knowledge Problem
Put simply, the Fed is an ongoing attempt at central planning and price fixing. It is an unelected committee whose actions are based on debatable and changing theories applied to data which is already from the past by definition. The Fed fixes the price of money, performs various bailouts and lends to the government. (For all this, its preferred, more dignified name is “monetary policy.”)
The promoters of Fed independence share an unspoken and mistaken assumption: that the Fed is competent to have unchecked power of price fixing and manipulating money and credit–or in a more grandiose vision, of “managing the economy.” Although in fact neither the Fed nor anybody else can have the knowledge required to do this, it is assumed that the Fed knows what the results will be of, for example, monetizing $8 trillion of long-term bonds and mortgages. These unprecedented “quantitative easing” investments were accurately described by former-Fed Chairman Ben Bernanke as “a gamble.” The Fed cannot know what the results of its own actions will be — rather, it is flying by the seat of its pants.
An insightful old story compares the Fed’s monetary task to trying to land a 747 aircraft with the windshield painted over, and with instruments which tell it only approximately where the aircraft was and approximately how fast it was flying 15 minutes ago. The Fed’s problem is even harder than this, since financial actors are always anticipating what it may do, and therefore the airport it is trying to reach is in effect moving around. Moreover, the Fed has to be constantly busy trying to promote the crew’s credibility and assure the passengers on this 747 that there is nothing to worry about because it is in control.
Like all attempts at central planning, the Fed’s efforts are faced with recursive complexity and inescapable uncertainty. Although it will have some successes, it is also doomed to recurring failures. It cannot escape the problems of an unknowable economic and financial future and an insufficiently understood present. Even how to interpret the economic past always remains debatable. In short, the Fed inevitably suffers from the knowledge problem of all central planners demonstrated by Ludwig von Mises and Friedrich Hayek.
Neither the Fed nor anybody else can know, but only guess about, for example, what the celebrated “neutral rate of interest” is or was or will be. That this theoretical neutral rate is called “r-star” gave rise to the brilliant and honest aphorism of Fed Chairman Jerome Powell: “We are navigating by the stars under cloudy skies.”
How Should the Fed Fit into the Constitutional System of Checks and Balances?
While flying by the seat of your pants, gambling with many trillions of dollars, and navigating by the stars under cloudy skies, how independent should you be?
The Chairman of the House Committee on Banking and Currency in 1964 was Wright Patman, a populist Democrat from Texas and sharp critic of the Fed. He conducted hearings that year in which the Committee’s Domestic Finance Subcommittee reviewed in detail “The Federal Reserve After Fifty Years.” Here are some of their conclusions:
“An independent central bank is essentially undemocratic.”
“Americans have been against ideas and institutions which smack of government by philosopher kings.”
“Our democratic tradition alone will be enough to make many thoughtful people demand a politically accountable central bank.”
“To the extent that the [Federal Reserve] Board operates autonomously, it would seem to run contrary to another principle of our constitutional order — that of the accountability of power.
It seems to me that these conclusions of 60 years ago are all exactly correct (although I do not agree with other conclusions of the report).
If one agrees with Wright Patman that government by philosopher kings is contrary to American principles, that the Fed should not try to be a philosopher-king and should therefore be accountable and not independent, the question remains: to whom should the Fed be accountable and from whom independent?
My conclusion is that the Fed should be independent of the President and the Treasury, but it should be accountable to, not independent of, the Congress. The Congress is the possessor of the Constitutional Money Power (“To coin money [and] regulate the value thereof”) and the Taxing Power (“To lay and collect Taxes”). The Fed serves as a critical part of both. We must include taxation because the inflation the Fed creates is in fact a tax, which takes the People’s purchasing power and transfers it to the government.
The President and the Treasury
It is natural that the President and his Treasury Department should want to control the Fed, since this gives them the power to keep spending money when they are in deficit, by having the Fed print it up. Presidents of both parties have often wanted lower, or at least not higher, interest rates for political purposes and used their influence with the Fed accordingly.
The Treasury Department of course likes lower interest rates which reduce the cost of the debt it issues, and reduce the amount of new debt needed to pay the interest on the old debt. This natural connection was displayed in the original version of the Federal Reserve Act in 1913, which made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board (this provision was in force until 1935).
For extended times in Federal Reserve history, especially during major wars and emergencies — beginning with the American entry into World War I in 1917 when it was three years old — the Fed has been subservient to the Treasury Department. In these times, the Fed devoted itself to loyally financing the government’s deficit as needed. It did so again during the Covid financial and economic crisis and aftermath in 2020-21. Will the Fed repeat this performance in the future? Given a war or other emergency big enough, it will.
Historically, under the master politician Franklin Roosevelt, “the Treasury controlled most decisions” and “the Federal Reserve had a subsidiary role,” according to Allan Meltzer’s magisterial A History of the Federal Reserve. Also during this period, the Treasury took every ounce of the Federal Reserve’s gold. Meltzer summarizes this period as the Fed “in the backseat.”
The intense dispute between President Truman and his Treasury Department, on one side, and the Fed, on the other, in 1951 is notable in Fed history. Truman was in the middle of the Korean War, the American Army had retreated down the Korean peninsula under the Chinese onslaught, and the Treasury had to finance the war. They wanted the Fed to keep buying Treasury bonds at the rate pegged since World War II at 2.5 percent. But in this instance, the Fed thought interest rates should rise a little. Truman told the Fed Chairman, Thomas McCabe, “That is exactly what Mr. Stalin wants. He then in effect forced out McCabe and put in a new Chairman who he thought was his own man, William McChesney Martin of the Treasury Department. Martin, however, favored somewhat higher rates to control inflation and a Fed “independent within the government.” Truman called Martin to his face a “traitor.”
President Lyndon Johnson had a memorable dispute with the Fed, when the Fed raised interest rates to confront the rising inflation from Johnson’s Vietnam War and welfare expansion deficits. “How can I run the country and the government if… Bill Martin is going to run his own economy?” the furious President reportedly demanded. Martin (who as Fed Chairman was on his fourth President) traveled to Johnson’s Texas ranch to discuss the issue. Johnson called Martin’s action “despicable” and according to one report, physically pushed the proper Martin around the living room of the ranch, shouting at him. Quite a scene to picture.
We come to the interesting relationship between President Nixon and Fed Chairman Arthur Burns. Meltzer writes, “Ample evidence…supports the claim that President Nixon urged Burns to follow a very expansive policy and that Burns agreed to do it.” In Burns’ defense, Meltzer adds that at that time “many economists and politicians…wanted to reduce unemployment using highly expansive policies.” Wittily and cynically, Nixon said he hoped the independent Fed Chairman would independently decide to agree with the President.
Burns is said to have remarked with fine irony, “We dare not exercise our independence for fear of losing it.”
The Fed is always in a web of presidential and financial politics. President Trump’s pressure on Fed Chairman Jerome Powell to lower interest rates, while delivered in some characteristic language, repeated the historical precedents.
We can safely predict that this natural tension between the President, the Treasury and the Fed will continue into the future as far as we can imagine. Nonetheless, the Fed should be Constitutionally accountable to the Congress, not to the President and the Treasury.
The Congress
At all times, the Fed remains a creature of Congress, if the Congress exerts its authority. If Congress has the will and the political forces align, it can rewrite the Federal Reserve Act and in so doing, redirect, instruct, restructure, or even abolish the Fed. In addition, as the then-President of the New York Fed testified during the 1964 hearings, “Obviously, the Congress which set us up has the authority and should review our actions at any time they want to, and in any way they want to.” Should Congress audit the Fed? Of course, any time it wants to.
The definition of the kind of money the nation will have is an essential Congressional responsibility, not a prerogative of the Federal Reserve. Another Congressional responsibility is definition of the powers and organization of the Fed. The Congress in the past has often legislated on these central public questions, including:
The Gold Standard Act of 1900 — defining money.
The Federal Reserve Act of 1913 — creating the Fed.
The Gold Reserve Act of 1934 — taking away the Fed’s gold and taking the country off the gold standard into a fiat paper money standard.
The Banking Act of 1935 — reorganizing and centralizing the Fed.
The Bretton-Woods Agreement Act of 1945 — taking the United States into a new international monetary system. Central to it was the commitment to foreign governments that the US would redeem dollars for gold at the fixed rate of $35 per ounce (The dollar has since depreciated against gold by more than 98 percent). In 1971, under President Nixon, the US reneged on the Bretton-Woods Agreement, putting the world on a pure fiat money regime and enabling the Great Inflation of the 1970s.
The Federal Reserve Reform Act of 1977 — trying to make the Fed more accountable to Congress and assigning the Fed its so-called “dual mandate” of maximum employment and stable prices.
The Humphrey-Hawkins Act of 1978 — suggesting a long-term inflation goal of zero if consistent with the dual mandate.
Regarding the essential political goal of stable prices, in 2012 the Fed on its own authority, without the approval of Congress, redefined “stable prices” to mean perpetual inflation. It unilaterally proclaimed that the United States should have 2 percent inflation forever. At that rate, in a single lifetime of 80 years, average consumer prices will quintuple. Whether America wants that kind of constantly depreciating currency is a fundamental political question for the Congress.
How in the world did the Fed imagine that it had the authority all on its own to commit the nation to perpetual inflation and perpetual depreciation of the currency at some rate of its own choosing? It suggests a certain arrogance — something a philosopher-king could do, but not a government body subject to Constitutional checks and balances. The idea should have been submitted to the Congress for approval. It wasn’t.
Therefore I propose a Federal Reserve Reform Act of 2025, numbering among its provisions these:
Congress should cancel the 2 percent inflation target set unilaterally by the Fed until Congress has approved that or some other guidance. For better guidance, I suggest price stability. This would mean a long-run average inflation rate of approximately zero — or perhaps for political agreement, between zero and one percent. The Fed should be a key participant in this discussion, but not the decision-maker.
Congress should make it clear that the Fed in general does not have unilateral authority to decide on the nature of US money, which is an essential public question, and that any such decision requires review and approval by Congress.
Congress should seriously review the financial statements of the Fed. Since the Fed has now lost $200 billion over the last two years, it has burned through all its retained earnings and all its paid-in capital more than four times over. This massive loss means that the Fed’s real capital is now negative $156 billion. Any organization that claims independence, even if it doesn’t really have it, ought at least to be solvent. Congress should recapitalize the Fed.
Such reforms would constrain the Federal Reserve’s declarations of independence with Constitutional accountability.