Bob Murphy on Fed “Independence”

Writing in the Fiscal Times, leading Austrian economist Bob Murphy looks at whether the Fed is truly independent from political sway. (Spoiler alert: it isn’t.)

Professor Murphy highlights a 1975 study by Yale University professor William Nordhaus that showed the existence of a Fed-created “political business cycle”:

For most countries that he analyzed, Nordhaus found no smoking gun proving political interference with the central-bank policymaking, but he concluded that it appeared the United States had a very politicized business cycle.

Nordhaus looked at 10 “before and after” election periods covering five U.S. election cycles. For nine of those 10 periods, the unemployment rate matched his model’s prediction: Joblessness fell before the election and rose afterward. This pattern is exactly what one would expect if elected officials exercised discretion over the timing of the economy’s booms and busts. If the economic fluctuations were due to random chance, the probability that they would coincide with the observed pattern would be very small, only slightly above 1 percent.

Although intuitive, the simple predictions of a “political business cycle” model didn’t perform as well in the two decades following Nordhaus’ seminal work. One refinement was to assume politicians only lean on the central bank to loosen up before an election if it seemed they would otherwise be likely to lose; an incumbent who was confident of reelection wouldn’t take the risk of goosing the economy for short-term gain but having to paying a political price for it during the next term. (For details, see Kenneth Schultz’s 1995 article in the British Journal of Political Science.)

Fortunately, hyper-refined economic models aren’t always necessary for showing that political factors influence central bank policy. Indeed, ordinary narrative history can reveal even scandals of the opposite kind: central banks aggressively asserting their political independence at great cost to the economy. Nicholas Biddle was chief of the Second Bank of the United States — the Fed’s predecessor — who decided to fight moves by President Andrew Jackson to veto the renewal of the bank’s charter and withdraw Treasury deposits from the bank. A champion of hard money, Jackson said the central bank was a political tool that served the monied elites at the expense of ordinary people.

Biddle, however, had many cards to play during his battle against the populist Democrat. Not only did he have luminaries such as Daniel Webster and newspaper editors literally on his payroll, but he exercised his power to call in bank loans and tighten credit, thereby causing bank failures and a financial panic. “This worthy President,” Biddle wrote, “thinks that because he has scalped Indians and imprisoned judges, he is to have his way with the Bank. He is mistaken.”

Biddle’s callous disregard for the economic destruction he wrought shows the naivete in thinking that fallible men (and now women) could be in charge of the nation’s money machine and not succumb to temptations of power. No one should be deemed above the fray.

When Alan Greenspan took the helm at the Federal Reserve in 1987, he had a reputation as a hard-money man opposed to fiat money and government economic intervention. In 1966, he wrote an essay praising the gold standard that Ayn Rand would include in her book on capitalism, but you wouldn’t have known this had you only followed Greenspan’s actions at the Fed. Indeed, the excess creation of fiat money and credit during his tenure inflated the real estate bubble whose bust precipitated the financial crisis in 2008.

Less blatantly, Greenspan’s successor, Ben Bernanke, veered from the monetary strategy he outlined in his earlier academic work, leaving many economists puzzled as to why Bernanke as Fed chair seemed more interested in bailing out banks than in helping unemployed workers.

The above stories notwithstanding, the root problem with the Federal Reserve isn’t one of especially weak leadership caving to political pressure. Rather, the entire premise of “Fed independence” is absurd: The central bank cannot help but be political. It was created by an act of Congress in 1913. Under its current structure, the seven members of the Fed’s Board of Governors (from whom the chair is also selected) are nominated by the president of the United States and confirmed by the Senate. If the president and Senate were to pick the Board of Directors and CEO of Exxon — and this group then had regular meetings to announce its targets for the price of crude oil — nobody in the financial press would dream of calling Exxon’s decisions “independent” of politics. It would clearly be a state-run company, utterly subservient to Washington.

Trump committed a faux pas with his public complaints about the Fed. But his actual “mistake” was in letting the American people in on a dirty secret: The central bank is by its very nature a political institution that exists to serve the nation’s rich and powerful class, not the average Joe.

So by all means, let’s champion Fed independence from political interference, and start by taking away its government-granted power to create legal tender. If the Fed were a private bank like any other, we could be sure the president would no longer micromanage its policies.

Read the whole article here.

And help Campaign for Liberty expose the political influences behind Fed decision making by signing the petition to Senator Mitch McConnell asking him to schedule a vote on Audit the Fed. Sign here.