Founding the Fed

It has been at least a week since I mentioned central banks on this blog  – probably a first.   There are many areas of economics and public policy that interest me more, and which matter more.  But I have just finished reading Roger Lowenstein’s new book, America’s Bank: The Epic Struggle to Create the Federal Reserve.  The Federal Reserve opened for business on 16 November 1914, amidst  the global liquidity crisis, affecting the United States as much as the combatants, created by the outbreak of World War One.   There was, of course, little hint of what was to come when Woodrow Wilson had signed into law the new Federal Reserve Act into law on 23 December the previous year, one of the landmark pieces of legislation in Wilson’s first year in office.

(For anyone wanting to know more about the 1914 crisis, there are two worthwhile modern books; Saving the City  is a British-focused global story and When Washington Shut Down Wall Street is the American story.)

Lowenstein is a financial journalist (rather than an economic historian), with a number of books to his credit.  He is perhaps best-known for When Genius Failed: The Rise and Fall of LTCM.  His tale of the political and banking background to the passage of the Federal Reserve Act is a very readable account for anyone interested in the topic.   In places, it felt like an account of 1912 presidential election campaign – a particularly torrid affair as the Republican incumbent, Taft, was challenged at the general election both by the Democrat Wilson, and by Theodore Roosevelt, Taft’s predecessor and former friend and mentor.  I hadn’t realised how important William Jennings Bryan –  1896 Democratic nominee, and author of the famous Cross of Gold speech –  still was in the Democratic party’s own debates on a central bank.

By the early 20th century, the United States was relatively unusual , but hardly unique, in not having a central bank.  Britain, France, Japan, Germany and Italy all did, but then Canada, Australia, South Africa and New Zealand did not.  The US had had central banks previously –  the most recent had lost its position when Andrew Jackson vetoed the renewal of its charter in the 1830s.   But what marked out the United States in the 1900s was not the absence of a central bank but the presence of repeated severe financial crises –  the most recent in 1907, the effects of which –  while relatively short-lived-  were felt around the world.  As I’ve noted here previously, it is not as if the repeated financial crises seemed in any way to be derailing the longer-term  progress of the United States or the sustained lift in living standards.  At the time, the United States competed with places like New Zealand and Australia for having the highest material living standards in the world.

But in the short-run, the crises were enormously disruptive,  and even the seasonal pressures  – in an economy where farming still played a large role –  were large.  There were plenty of signs that something was broken, and some fix was needed.

The fix chosen turned out to be a central bank –  or rather, a system of regional central banks, loosely overseen and bound together by the Federal Reserve Board in Washington.

It needn’t have been.  Lowenstein tells the story as if the only sensible outcome was the founding of a central bank –  an outcome towards which all history was tending.  He tells his story vividly, and draws on a wide range of primary and secondary sources –  and the cover includes plaudits from former central bankers Ben Bernanke, Alan Blinder, and Paul Volcker.  But the book is weakened because the author shows no sign of having engaged with the alternative hypotheses about what had left the American system so prone to crises.    Many –  most recently Calomiris and Haber – have noted the contrast between the US system and that of Canada, which has been largely free of serious financial stresses before and after the founding of the central bank in 1935.  On a much smaller scale, but also in a heavily agricultural economy, one could include among the relative stable systems that of New Zealand.

If what rendered the US prone to crisis was the absence of a lender of last resort –  or even of external seasonal finance –  then the case for a central bank was much stronger. But a plausible case can be made that what left the US system prone to crises was the regulatory structure put in place over the previous few decades.  The United States system pre 1914 is often loosely characterised as “free banking”.  In fact, it was a highly regulated system.  The two most important regulations were the restrictions on branch banking and interstate banking, which made it very difficult for banks to effectively diversify risks, including liquidity risks, and the restrictions on the issuance of notes.  Physical currency was still a hugely important medium, and demand was highly seasonal.  State banks could not issues notes, and national banks were able to issue their own notes only to the extent that they held US government bonds to back them.  Bonds were relatively scarce, and expensive and, as noted, the demand for notes was highly seasonal.  The conversion of a deposit into a note did not change the nature of the credit risk the holder of the claim faced, but the ability of banks to do that readily, when customers wanted it, was constrained by law.  Perhaps the political economy would have made dealing with the restrictions on the geographic scope of banks impossible  at the time (it took many decades), but Lowenstein does not even deal with the question of whether, for example, amending the restrictions on the note issue might have largely dealt with the pressures –  for an ‘elastic currency’ – that, at the time, gave rise to the creation of the Fed.

Not doing so perhaps make the construction of his narrative easier, and more powerful.   But by not treating seriously those opposed to the creation of a central bank it does limit the insights he can offer.  Some perspectives from, say, the archives of the Bank of England of the Banque de France on what they made of the whole long process might also have been interesting.   Of course, the beauty of being a big country is that there are many other books and papers that deal with some of these issues.

I notice that George Selgin, from whom I’ve learned a great deal over the years, expresses similar views in his own comments on Lowenstein’s book and offers some richer comments on the weaknesses of the pre-1914 regulatory structures.  To repeat, Lowenstein’s book  is a good read, especially for anyone interested in the politics of it all, but just bear in mind the limitations

Our own central bank was not founded for another 20 years, opening for business on 1 August 1934.  There is a line commonly heard these days that central banks were largely created to deal with financial system stresses.  That was true in the United States –  although the most severe crises in US history have come since 1914 –  but it certainly wasn’t true here (or in Australia or Canada).  The Reserve Bank of New Zealand was created to allow independent macroeconomic management for New Zealand, especially to be distinct from Australia.    No one envisaged anything quite like modern discretionary central banking, with data reviews and potential policy adjustments ever six or eight weeks.  But it was about ensuring that New Zealand conditions –  export earnings and access to credit in London –  drove the behaviour of domestic credit in New Zealand, not those of the larger Australasian area.   New Zealand’s sovereign debt was extremely high around the time of the Great Depression, but nothing like as concerning to lenders as that of Australia.

Gary Hawke’s 1973 history of the Reserve Bank, Between Governments and Banks, remains the best account of the background to the founding of our central bank.    A more easily accessible perspective, by Matthew Wright –  a New Zealand historian on the Reserve Bank’s staff – is here.

Stan Fischer on central bank independence

Stan Fischer is one of the global elite of macroeconomic policy. Born in what is now Zambia, he has spent most of his adult life in the United States. He was Chief Economist of the World Bank, First Deputy Managing Director of the IMF, Governor of the (central) Bank of Israel, and is now Vice Chairman of the Board of Governors of the Federal Reserve.   He spent several years making a great deal of money at Citigroup in one of those door-opening roles senior officials and politicians often gravitate to.  Fortunately for his reputation, the next big job came up before Citi ran into its latest crisis over 2008/09.

In his time as an academic, Fischer, together with Guy Debelle, came up with the nice delineation between “instrument independence” and “goal independence” in analysing monetary policy arrangements.  In practice, the distinction is never as clean as all that, but one can think of our Reserve Bank having “instrument independence” in monetary policy (it can set the OCR wherever it likes from day to day) but as having relatively little “goal independence”.  The Minister of Finance takes the lead in setting the policy targets and although the Governor is a party to the PTA, the PTA has to be agreed before the Governor is formally appointed.  The Minister does not need to appoint someone who will not agree with his proposed policy targets. And, in principle, the Minister can have the Governor dismissed if the Minister is satisfied that “the performance of the Governor in ensuring that the Bank achieves the policy targets …has been inadequate”.

In many other modern central banks, there is no counterpart to the Policy Targets Agreement, and the statutory objectives for monetary policy are written sufficiently loosely that the central bank has a fairly high degree of goal independence too.   The Federal Reserve  –  where key policymakers rarely even quote the relevant section of the Federal Reserve Act[1] –  is a good example of the latter.

Stan Fischer gave a speech on central bank independence a couple of weeks ago, in which he discussed independence in respect of both monetary policy and (some aspects of) financial stability and regulatory policy.   I thought it was a slightly disappointing, rather complacent, speech.

Part of the context presumably is the simmering discontent with the Fed.  The 2016 Presidential race is getting underway and demand for changes to the Federal Reserve  legislation governing the Fed are being heard –  something that used to be common in New Zealand, but rarely seen elsewhere.

Two issues in particular have prompted legislative initiatives in the United States. One is to limit the Federal Reserve’s operational flexibility in response to financial crises, and the second is the ‘audit the Fed” movement.   I wanted to focus on the audit side.

At present, although the Federal Reserve is subject to regular financial audits, it is exempt from GAO reviews of “deliberations, decisions or actions on monetary policy matters”.   The purpose of the exemption is, supposedly, to protect the day-to-day operational independence of the Federal Reserve  –  the fear, in the words of a Wall St Journal piece, is “that aggressive members of Congress unhappy with a Fed interest-rate decision could dispatch the GAO repeatedly to investigate, essentially using the GAO as a way to pressure the Fed to change its policies.”

I don’t find this resistance overly persuasive.  After all, as Fischer points out, there is lots of external scrutiny and debate around the actions of the Federal Reserve.  Members of the FOMC need to have the fortitude and integrity to make the decisions they think are needed, in accordance with the law, regardless of the weight of external pressure.  If they can’t take the heat, there is always the option of finding another job.  It isn’t clear to me why GAO inquiries, no matter who prompts them, represent a more serious threat.  Either Congress can or can’t overrule the FOMC on specific decisions.  It can’t now, and wouldn’t be able to under any of the legislative initiatives that are around.  Anything else is scrutiny and steps towards effective accountability.

A similar fight is going on in the UK at present, where the Bank of England is fighting back (successfully it appears) against government plans to allow the National Audit Office to undertake value-for-money audits of Bank of England activities (the Court –  the equivalent of our Board –  will be able to block such audits).

Consider, by contrast, the situation in New Zealand.  Not only is the Reserve Bank Board paid to scrutinise and hold to account the Governor, in respect of all his responsibilities (including, quite explicitly, monetary policy), but in New Zealand the Auditor General is (in the Reserve Bank’s own words) “able to commission quite extensive investigations into the activities of the Bank”

And then there is section 167 of the Reserve Bank Act, which explicitly provides the Minister of Finance with powers to commission a performance audit of any or all aspects of the Bank’s responsibilities under the Reserve Bank Act [but not, it appears, those under the other Acts the Reserve Bank is responsible for?]

167 Performance audit

  • (1) The Minister may, from time to time, appoint 1 or more persons (whether as individuals or as members from time to time of any firm or firms) to carry out an assessment of the performance by the Bank of its functions and of the exercise by the Bank of its powers under this Act.

    (2) As soon as practicable after completing an assessment the person appointed shall submit a report to the Minister setting out the results of that assessment.

    (3) The report stands referred, by virtue of this section, to the House of Representatives.

    (4) A person appointed to conduct an assessment under this section, for the purpose of conducting that assessment,—

    • (a) shall have full access to all books and documents that are the property of or that are under the control of any person relating to the Bank or its affairs:

    • (b) may require any director, officer or employee of the Bank or any other person to answer any question relating to the Bank or its affairs:

    • (c) may, by notice in writing to any person, require that person to deliver any books or documents relating to the Bank or its affairs in the possession or under the control of that person and may take copies of them or extracts from them.

    (5) Nothing in subsection (4) limits or affects section 105.

    (6) The fees of the person appointed to carry out an assessment under this section shall be paid out of the funds of the Bank.


Of course, the section 167 powers have not been used in the 26 years since the Act was passed (although Lars Svensson’s inquiry into New Zealand monetary policy, commissioned by Michael Cullen, might be seen in that light)

And yet the best argument that Fischer can put up in response is that if such further audit or review powers were established

“the Fed would be subjected to the very sort of political pressure from which experience suggests central banks should be independent. Instead, a modern governance framework calls for the political system to give the central bank a mandate along with the operational freedom to pursue that mandate, supported by transparency and accountability”

Central banks are very keen to conflate the ideas of transparency and accountability – the Reserve Bank did it recently in their Bulletin on monetary policy accountability – but apply the parallel to an employee. Effective accountabiity for an employee rests on the simple fact that, after all the discussion and debate, if the employee does not work to the required standard he or she can be dismissed.

Members of the Federal Reserve Board cannot be removed from office for their policy choices, no matter how bad they might be. That is not uncommon for central bankers internationally, but it severely compromises the meaning of accountability. Central bankers don’t face re-election either. Reappointment is certainly one opportunity for effective discipline, but in principle members of the Federal Reserve Board of Governors are appointed for 14 year terms.

If Fischer is serious about maintaining a distinction between instrument independence and goal independence in the United States it is not clear why he would not support a move more towards a New Zealand system, where policymakers can be removed if they make bad policy. But if that can’t be practically be done – and perhaps it can’t in a US system, and perhaps it isn’t a practical option even here – it is far from clear why he (and his colleagues would continue to push back against measures that would provide for more official scrutiny of the choices and actions of the Federal Reserve. It is all very well to say that markets, the media, and think tanks scrutinise the Fed, but statutory provisions bring with them statutory powers, including access to relevant papers and information. I’m not suggesting that the Rand Paul “audit the Fed” bill has things precisely right,   But as Vincent Reinhart, a former very senior Fed monetary policy official, has argued, what possible threat could a twice-yearly “GAO audit of monetary policy:, a week before the Fed’s own semi-annual monetary policy report to Congress”, be?

Of course, one could reasonably counter “what good would it do”? But that is surely a matter for Congress, as the people’s representative, not for those who are being reviewed. Central banks are given very great power and it is up to us, as citizens, to find ways to effectively hold them to account. That has to include the ability to put pressure on them, even if the day to day decisions are finally theirs.

The New Zealand model has not worked particularly well in that regard – the Board is just too close to the Governor, and Parliament’s Finance and Expenditure Committee has too few resources and incentives. But equally, one can hardly say that the powers that do exist – which go well beyond those in the US – have threatened the operational independence of the Reserve Bank, on monetary policy or any of its other functions.

But surely the practical problem for citizens is the difficulty of securing effective accountability. There is plenty of debate about what central banks do – at least in the US – but accountability is more than debate, and has to include the ability to make a practical difference.

There is a price for operational independence. If legislatures do not think that those wielding the operationally independent powers are doing so appropriately, on  average over time, and yet cannot effectively hold decision-makers to account for their choices, operational independence itself will come under threat.  In a sense, that is what the Warren-Vitter legislative initiative (which the Fed is also fighting) seeks to do in the United States, in further restricting the Fed’s freedom of action in a crisis.   As I’ve noted previously, the US authorities (Treasury and the Fed) already have far less operational autonomy in a crisis that the New Zealand authorities do. In some respects, the New Zealand powers are disconcertingly wide –  the Public Finance Act appears to allow the Minister of Finance to bankrupt New Zealand with no parliamentary vote, and the Reserve Bank also has uncomfortably unconstrained powers in these areas. I suspect that something between the two models provides a better balance, but at least we have formal powers to review, and potentially dismiss, the Governor if he acts unwisely or inconsistently with his statutory mandate.  The US system has no such power.    If anything, it looks to me as though the Fed –  were it operating consistently with the goal vs operational independence model –  should be embracing as many reviews, and as much official scrutiny, as possible.

But perhaps that is the problem with global elites, in macro policy or other areas.  They often don’t really believe in effective accountability to citiznes, or in their potential for making mistakes.  They believe, too readily, in the rightness of their own judgements.  Institutional design has to operate with the limits of human knowledge and incentives. Humans –  even very able ones – and human institutions make mistakes.  And yet in the whole of Fischer’s speech, the words “error”, “mistake” and “misjudgement” don’t appear once.  Good models for governing powerful institutions have to built, and refined, starting from the proposition that people like Stanley Fischer, Ben Bernanke , and even Graeme Wheeler, will actually make mistakes.

[1]The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

Central banks blogging

The Bank of England has launched a new staff blog, and the fact of the blog –  rather than the initial content –  has attracted some attention.  The Bank of England summarises its aim this way:

Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England or its policy committees.

Tony Yates, a former BOE staffer, seems surprisingly optimistic.

There is a growing number of ex central bank bloggers, eminent (Bernanke) or otherwise, but central bank blogs are uncommon, if not entirely new.  The New York Fed has been running the Liberty Street Economics blog for a while, and Macroblog at the Atlanta Fed has been around for even longer.  At a supranational level, there is the iMFdirect blog.

But a blog is just a technology, one of many “communications channel” that central banks, as powerful public institutions can use.   The interesting point is the suggestion that the BOE blog will be a vehicle in which staff can “share views that challenge –  or support –  prevailing orthodoxies”.

That certainly would represent quite a change for most central banks.  But again, it is along a spectrum.  Many/most central banks have long published research and discussion paper series, which typically carry a disclaimer that the views were those of the authors and not necessarily those of the institution (at the Reserve Bank, we drew a strong distinction between Bulletin articles which carried no disclaimer, and thus could be taken as, in some sense, the views of the Bank, and other papers). Central bank analysts and researchers give conference papers, dealing with a variety of technical or policy issues, which carry similar disclaimers.  And not that many years ago, I heard Janet Yellen, then only vice-chair of the Fed, give a speech at a conference, and that speech also carried the standard disclaimer[1].

But the truth is that most central banks –  and I’m sure other government agencies, even those with operational independence, are no different –  typically have quite strict, but not always clear (to themselves or staff), limits to what staff are allowed to say in such documents or papers.   I’m still somewhat surprised, and impressed, that senior Fed researcher Robert Hetzel has been able to publish major books carefully (but critically) reviewing the Fed’s conduct of monetary policy.  Perhaps it is an advantage to be a very big but decentralised central banking system.

Tony Yates gives some of the flavour of this (historically quite tight) control in a BOE context, and I have also heard some BOE horror stories from people who used to work there.  It will be interesting to watch the BOE experiment, but I suspect it will end up being a channel primarily for the sorts of pieces on the blog today –  one on a topic not related to the Bank’s responsibilities at all, and one a nice, but anodyne, piece of analysis illuminating the rather obvious point that risks of deflation rise if shocks happen when conventional monetary policy has reached its limit.

And that is fine.  Openness and transparency in powerful public agencies are important, and there is far too little of both.  But the ability to have robust debate within an organisation in the formative stages of policy development is also important.   Great leaders can probably cope with challenge and scrutiny wherever it comes from, but on average we have to expect average leaders.  Often enough, they will feel threatened if someone down the organisation is being used by external critics to bash the organisation.  I’ve mentioned earlier how Graeme Wheeler got the Ombudsman to block release of a discussion note I had written, some time previously, on governance issues.    I think he was worried that the Green Party –  who have championed the cause of reform and greater transparency at the Reserve Bank –  would use my note to “politicise the issue” [aren’t institutional design and governance issues appropriately political choices?] and to undermine his own preferred approach to reform.

In many ways, a central bank blog is not much different than what we were trying to do at the Reserve Bank when we set up the Analytical Notes series a few years ago (a product I edited) –  or the Fed’s FEDS Notes series.  Our idea was that analytical pieces, that weren’t heading for journal publication, could be published, carrying a disclaimer that they were the views of individuals not the Bank.  Since any of this material would have been discoverable under the OIA, it was thought good for openness, and for staff themselves, to have a vehicle for putting such material in the public domain.  Sometimes it was actively used by the institution to get supporting material out for scrutiny.  There are quite a few interesting papers in this series, and I’ve already linked to several of them, but I’m pretty sure there was nothing in them that challenged current orthodoxies.  Prone to challenge orthodoxy as I was personally, I was pretty good at judging what could be got out the door, and phrasing things accordingly.

I’m not suggesting that the Reserve Bank has typically been a monolith in how staff participated in external events.  We hosted, with Treasury, an exchange rate policy forum a couple of years ago  –  to which a range of business and other people were invited.   All the papers were published with no “censorship” (at least for the Reserve Bank ones) and are still on official websites.  My paper involved a fairly critical perspective on New Zealand’s immigration policy and the potential adverse macroeconomic implications (not, of course, that the Reserve Bank is responsible for immigration policy).  I’ve given discussant comments at international central banking conferences casting doubt on the benefits of publishing extensive central bank forecasts, and have a chapter in a recent (fairly obscure) book suggesting, with all sorts of caveats, that we should not automatically think of inflation targeting as the ‘end of history’ (although this did prompt efforts at censorship by one new Deputy Governor).

But all that is different from whether staff should be able to question, in public, current policy preferences and frameworks.  Much as I think the Governor’s LVR policies are unnecessary, inappropriate and costly, I really don’t see that it is appropriate, or in the interests of good government processes, for staff to be saying so, even with all the qualifications in the world, in public fora.  And I’ve thought the Governor’s monetary policy decisions over the last few years were wrong, but no matter how carefully crafted the argument was, it wouldn’t have been appropriate to run that argument in public as a staff member.  In fact, I did a variety of speaking engagements in which I persuasively made the case for the Governor’s stance.  That was the external-facing bit of the job.  And rightly so.

Perhaps in some idealised world all debate could or should be open –  Tom Scott once ran a cartoon satirising Don Brash’s commitment to open comment and suggesting Don would have liked to broadcast all monetary policy deliberations live  –  but it isn’t the world we live in.  Organisations need to be able to have robust debate internally, without the sense of a simultaneous parallel track being pursued externally by people who happen to disagree on a particular issue.  And as I listen to accounts of people reluctant to comment on this or that issue because, for example, it might affect their future consulting opportunities, it is a reminder of why it is not a realistic alternative vision.

Now, I’m quite sure the Bank of England has no intention of allowing that level of dissent or openness either.  Perhaps pieces that “challenge current current orthodoxies” will be published when Mark Carney or Andy Haldane themselves want to challenge such “orthodoxies”, but it will be a surprise if we see pieces directly challenging views advanced by those senior managers.  The blog might also be used actively at times as a place for testing the waterr –  putting an idea or some analysis out, in a controlled way, but with some plausible deniability (‘it was just the author’s view”).

I’m not critical of that approach.  If I have a criticism, it is that perhaps the Bank of England is overselling what the blog can be.  If it can be a vehicle for some shorter and more informal pieces of analysis, or for translating into English some of the more technical working papers, it will probably serve a useful purpose.  And its existence is something of a “brand marker” –  the Bank’s current management wanting to mark itself out from the past.

In the end, there are always going to be judgements about the appropriate level of openness.  It will depend on the person, the issue, and even the specific external environment.  For some issues, treated in some ways, at some times, senior management will be comfortable with alternative perspectives (perhaps even quite critical, but well-argued, ones) from staff being published.  On other issues, the market or political sensitivities just make it unrealistic.

There are delicate balances to be struck.  For example, if central banks want to have and retain top-flight researchers there needs to be a reasonable commitment to a willingness to publish.  And a willingness to publish a range of views can help signal a general openness to challenge and the contest of ideas.  And engagement with alternative perspectives –  genuine engagement, not just an evangelisation exercise –  is important.  But robust internal debate –  with ex post scrutiny and document discovery –  remains far more important to well-functioning central banks.  Central banks, and those holding them to account, should be much more concerned to establish that those processes and cultures are in place.  In my observation and experience, that increasingly has not been the case at the Reserve Bank of New Zealand.

[1] It struck me at the time, because at much the same time the Reserve Bank Communications Department was trying to insist that we should not use the disclaimer in any presentation, on the grounds that when anyone was speaking anywhere they were speaking “for the Bank”.