How Congress Should Reform the Fed

Alexander William Salter  – May 18, 2023 @ American Institute for Economic Research

It’s very difficult for elected officials to hold the Federal Reserve accountable. Is that a problem? 

There’s a strong counter-majoritarian tradition in American politics. The Constitution itself strictly limits what simple majorities, acting through their representatives, can accomplish. Contemporary central banking’s “democratic deficit” could be a feature, not a bug.

While we should always be wary of populist passions, the Fed’s insularity from the political process plausibly creates more problems than it solves. No less an economist than Milton Friedman thought that the Fed should be brought under the supervision of the Treasury or Congress. Friedman worried the central bank’s “independence” made it a law unto itself, sheltered from the consequences of its habitual mistakes. As the economy struggles with historic inflation and a wave of bank failures — both of which the Fed should have prevented — it’s worth considering alternatives.

Constitutionally, the Fed is a creature of Congress. The legislature created the Fed in 1913 not as a substitute for the gold standard and the National Banking System, but as a complement. The Fed was supposed to serve as a quasi-public clearinghouse to facilitate emergency liquidity transfers between banks to make the US system less panic-prone. But the onset of World War I spelled the end of this relatively limited mandate. The Fed began experimenting with monetary policy powers to support the market for government debt. Thus began a process of mission creep that resulted in the Fed becoming what its earliest proponents promised the public it never would: a central bank.

It’s time for the legislature to re-assert its control. The Fed’s recent dalliances with social and environmental policy have nothing to do with its legal grant of authority. Climate change and systemic inequality are valid policy areas for the United States Congress, but unless and until it says otherwise, not for the Fed. Hence Congress’s first order of business is passing legislation keeping the Fed within its legally prescribed lanes.

Second, Congress should separately crack down on the Fed’s experimentations with a central bank digital currency (CBDC). This is a dangerous technology that would give the government unprecedented access to and control over private financial transactions. CBDC would not meaningfully improve the operation of monetary policy or the pursuit of financial stability. All it would do is grant central bankers the power to redirect the flow of commerce by, for example, selectively processing payments, or debiting accounts to stimulate spending. Congress should pull the plug on the Fed’s pilot program and make it totally clear that CBDC is not permitted, absent enabling legislation.

It’s also time for the legislature to reconsider the dual mandate. There’s no need for the Fed to focus on full employment separately from price stability. In a fiat money economy, aggregate demand (nominal spending) stability is all a central bank can reasonably influence. And price stability is a consequence of aggregate demand stability. (Yes, the possibility of supply shocks complicates this. But such shocks are by nature temporary, and historically are much rarer than aggregate demand instability as a source of economic malaise.) Congress should accordingly narrow the Fed’s mandate to keeping the dollar’s purchasing power steady and predictable.

Finally, Congress needs to fix the Fed’s bank oversight and last-resort lending policies. The Fed is supposed to regulate banks and discount loans when the need arises. It’s very bad at both. Fed regulation has not made the banking system safer. If anything, it’s contributed to “too big to fail,” which results in recurrent crises. 

As for discounting, the Fed refuses to make any serious distinction between the illiquidity and insolvency of its counterparties. Making emergency funds available to the latter rewards the reckless bank behavior that gets us into trouble in the first place. Congress should narrow the Fed’s regulatory concerns to maintaining adequate bank capital. It should also consider abolishing the discount window entirely. Direct loans are unnecessary. Open-market operations can keep the financial system liquid.

Whether we like it or not, the Fed is one of the most important — if not the most important — economic institution in the country. It must be made to serve the public interest. The Fed should adhere to the rule of law. Right now, it only adheres to the rule of central bankers. A congressional course correction is long past due.

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Alexander William Salter

Alexander William Salter is the Georgie G. Snyder Associate Professor of Economics in the Rawls College of Business and the Comparative Economics Research Fellow with the Free Market Institute, both at Texas Tech University. He is a co-author of Money and the Rule of Law: Generality and Predictability in Monetary Institutions, published by Cambridge University Press. In addition to his numerous scholarly articles, he has published nearly 300 opinion pieces in leading national outlets such as the Wall Street Journal, National Review, Fox News Opinion, and The Hill.

Salter earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Occidental College. He was an AIER Summer Fellowship Program participant in 2011.

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Monetary Control: Central Banks Today

Alexander William Salter  – May 13, 2021 @ American Institute for Economic Research

Most wealthy countries today have central banks. And most of these central banks operate discretionarily. What this means is that monetary policymakers have significant latitude to determine the course of monetary policy. Although monetary policy is crafted using sophisticated economic tools, ultimately any policy decision in a discretionary regime is a judgment call.

Defining monetary policy is nontrivial. The definition I prefer is changing the money supply to affect macroeconomic variables, such as inflation or unemployment. The trouble is, as we’ll see shortly, on this definition it is unclear that much of what central banks have done since the 2008 financial crisis qualifies as monetary policy. Another definition might be whatever central banks do to affect macroeconomic variables. This would capture recent policy innovations, but in my view—and in the view of most practicing monetary economists before the 2008 crisis—this definition is too broad. It includes policies which are not truly monetary. 

From the 1980’s up through the end of the 2000’s, monetary policy in the United States was pretty straightforward. If the Federal Reserve were concerned by a looming recession, it would engage in expansionary policy. This means it would create new money and use it to purchase assets, usually short-term government bonds, in the secondary market. The investors who sold their bonds to the Fed now have credits on their bank accounts. This increases the total reserves in the banking system. The banking system responds by increasing financial intermediation: loaning out the new money. As it’s channeled into productive investments, the new money increases the demand for goods and services, which lessens the risks of recession. The result would be higher employment, but also higher inflation, as prices rise throughout the economy.

Contractionary policy worked the opposite way. The Fed would sell bonds, retiring the money it received from circulation. (This was almost always done digitally. Don’t think of destroying physical currency units; think instead of deleting balances from a bank account.) Bank reserves decrease; financial intermediation slows down. The Fed might enact contractionary policy if it were worried about overly high inflation. The slowdown in demand-side economic activity means prices would rise more slowly than before (disinflation, the usual result), or even fall (deflation, although this almost never happens in practice).

However, there’s been a big change in how the Fed conducts monetary policy since the 2008 crisis. Under the new system, the Fed does not attempt to change macroeconomic variables by changing the quantity of reserves in the banking system. Instead, the Fed has switched to using one of its administered interest rates—the rate paid on banks’ excess reserves held in their accounts at the Fed—to conduct monetary policy. The original idea behind the Fed was that it would be a quasi-clearinghouse, or bankers’ bank. It still retains some of these features. Member banks of the Federal Reserve System have their own bank accounts, which they keep at the Fed. The Fed can pay banks interest on their deposits, at the Fed’s discretion. 

In the aftermath of the turmoil that ripped through markets in 2008, the Fed asked and received from Congress permission to pay interest to banks who held greater deposits at the Fed than the statutorily required minimum. By changing this administered (meaning non-market) rate, the Fed can change the incentives for banks to engage in financial intermediation. In other words, there is no longer a direct link between the total quantity of bank reserves and overall economic activity, as well as the macroeconomic variables that serve as snapshots of that activity.

Under this new system, if the Fed wants to enact expansionary policy, it lowers the rate paid on excess reserves. This reduces the incentive for banks to hold reserves at the Fed (they are getting paid less), and increases the incentive to engage in financial intermediation (other things they can do with the money have a comparatively higher payoff). Correspondingly, if the Fed wants to enact contractionary policy, it raises the rate paid on excess reserves. This increases the incentive for banks to hold reserves at the Fed (they are getting paid more), and reduces the incentive to engage in financial intermediation (other things they can do with the money have a comparatively lower payoff).

How much does this change in the Fed’s operating framework matter? As it turns out, it’s a big deal. We need to remember the Fed’s awesome power: it has a monopoly on the production of base (alternatively, narrow) money, which is the economy’s most liquid asset. It can literally create money out of thin air. Anybody at all familiar with the logic of politics can see this power lends itself to abuse. Under the old monetary policy framework, however, there were immediate costs to misusing this power. If the Fed were to succumb to politicians’ influence, running the printing presses to satisfy a political interest group, the result would quickly be higher-than-desired inflation. The Fed would be forced to scale back. Now, however, the link between expansionary monetary policy and undesirable outcomes, such as higher inflation, is much weaker. The Fed can print money, purchase whatever assets it wants, and then prevent those purchases from having undesirable macroeconomic consequences by raising interest payments on excess reserves.

What this means is that the Fed now has a much higher degree of freedom to preferentially allocate credit. We saw this process start during the 2008 crisis. Rather than act as a responsible lender of last resort, the Fed tried to support the prices of specific assets, such as the now-infamous mortgage backed securities. It also made emergency loans to politically advantaged banks, which were not justified by the fundamental solvency of those banks. The Fed continued to abuse this power in responding to Covid-19. In the more recent case, the Fed made direct loans to non-financial organizations, including small- and medium-sized businesses, large corporations, and state and local governments. Although the magnitude of these policies is not yet large—these unconventional asset purchases are still a very small fraction of the Fed’s balance sheet—a dangerous precedent has been set. In the event of market turmoil, the Fed evidently feels comfortable not only being a liquidity provider, but also a credit allocator.

In other words, the Fed has stopped engaging solely in monetary policy. It is now doing fiscal policy as well. This mandate creep should trouble everyone who cares about the rule of law. When the Fed’s monopoly prerogative on money creation is used not for benign macroeconomic purposes, but in the service of fiscal politics, the economy will atrophy. Growth will slow down as scarce credit is allocated by politics, not profit. The Fed will become a less effective agent for fighting macroeconomic downturns. Again, the problem is that the Fed’s new operating framework presents too many opportunities for elected officials and bureaucrats to meddle in affairs beyond their competence. 

Now that the supply of reserves in the banking system can become arbitrarily large, it’s much easier to engage in fiscal policy masquerading as monetary policy. Charles Plosser, a respected macroeconomist and former president of the Federal Reserve Bank of Philadelphia, summarizes the problem: “Once the demand for reserves is satiated, there is no limit, in principle, to how big the [Fed’s] balance sheet or volume of reserves can be. A large balance sheet unconstrained by monetary policy is ripe for abuse. Congress and an administration would be tempted to look to the balance sheet for their own purposes, including credit policy and off-budget fiscal policy.”

This is why the definition of monetary policy matters. If monetary policy just means “whatever central banks do,” then the Fed’s activities over the past decade qualify. But if monetary policy is supposed to be liquidity-focused—if the Fed is supposed to provide markets a foundation for allocating resources, but not itself allocate those resources—then the Fed has crossed the Rubicon from monetary policy to fiscal policy. It’s supposed to be the people’s representatives, in Congress assembled, that conduct fiscal policy. The Fed engaging in this task is a major breach of established macroeconomic policy norms.

History shows we can’t trust central banks to stick to their mandates. Like all political organizations, they want to increase their power. Unfortunately, there’s no reason to think that an increasingly active central bank will better serve the public. As we’ve seen since 2008, the opposite is at least as likely. While this is true of all central banks, it is particularly evident in the case of the Fed. It is not simply that the Fed is getting worse at fighting recessions. It’s that the Fed’s operating framework systematically tends towards the abuse of life, liberty, and property. If we want to fix this, we need to take a much closer look at the relationship between money and freedom. Only if we understand this relationship, philosophically, economically, and historically, will we be in a position to fix what’s gone wrong with our monetary institutions.

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Alexander William Salter

Alexander William Salter is an Associate Professor of Economics in the Rawls College of Business and the Comparative Economics Research Fellow with the Free Market Institute, both at Texas Tech University. He has published articles in leading scholarly journals, such as the Journal of Money, Credit and Banking, the Journal of Economic Dynamics and Control, the Journal of Macroeconomics, and the American Political Science Review. His opinion pieces have appeared in The Hill, The American Conservative, US News and World Report, Quillette, and numerous other outlets.

Salter earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Occidental College. He was an AIER Summer Fellowship Program participant in 2011.

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