The Myth of the Independent Fed
The Fed May Be the Worst Government Monopoly of Them All
APRIL 01, 1997 by THOMAS J. DILORENZO
Dr. DiLorenzo is a professor of economics at Loyola College in Maryland.
Ever since its founding in 1913, the Fed has described itself as an independent agency operated by selfless public servants striving to fine-tune the economy through monetary policy. In reality, however, a non-political governmental institution is as likely as a barking cat. Yet, the myth of an independent Fed persists. One reason this myth persists is that statist textbooks have helped perpetuate it for decades.
From 1948 until about 1980 Paul Samuelson’s Economics was the best-selling introductory economics text. Generations of students were introduced to economics by Samuelson. Although not as popular as it once was, Samuelson’s text (now co-authored with William Nordhaus) is still widely used. According to the 1989 edition:
The Federal Reserve’s goals are steady growth in national output and low unemployment. Its sworn enemy is inflation. If aggregate demand is excessive, so that prices are being bid up, the Federal Reserve Board may want to slow the growth of the money supply, thereby slowing aggregate demand and output growth. If unemployment is high and business languishing, the Fed may consider increasing the money supply, thereby raising aggregate demand and augmenting output growth. In a nutshell, this is the function of central banking, which is an essential part of macroeconomic management in all mixed economies.
For about the past fifteen years the top-selling economics text has been Campbell McConnell’s Economics, which echoes Samuelson and Nordhaus’s idealistic statism:
Because it is a public body, the decisions of the Board of Governors are made in what it perceives to be the public interest . . . the Federal Reserve Banks are not guided by the profit motive, but rather, they pursue those measures which the Board of Governors recommends. . . . The fundamental objective of monetary policy is to assist the economy in achieving a full employment, noninflationary level of total output.
These are mere wishes, not statements of facts, for there is voluminous evidence that the Fed—like all other governmental institutions—has always been manipulated by politicians.
The Fed as a Political Tool
When the Fed was founded, it was controlled by two groups, the Governors’ Conference, composed of the twelve regional bank presidents, and the seven-member Federal Reserve Board in Washington. In 1935 the Fed was reorganized to concentrate nearly all power in Washington. Franklin Roosevelt packed the Fed just as he later filled the U.S. Supreme Court with political sycophants. Roosevelt appointed Marriner Eccles, a strong supporter of deficit spending and inflationary finance, as Fed Chairman, although Eccles had no financial background and lacked even an undergraduate degree. In those years the Fed was really run by Eccles’s political mentor, Treasury Secretary Henry Morgenthau, Jr., and thus ultimately Roosevelt.
Later presidents were no less willing to influence supposedly independent Fed policy. According to the late Robert Weintraub, the Federal Reserve fundamentally shifted its monetary policy course in 1953, 1961, 1969, 1974, and 1977—all years in which the presidency changed. Fed policy almost always changes to accommodate varying presidential preferences.
For example, President Eisenhower wanted slower money growth. The money supply grew by 1.73 percent during his administration—the slowest rate in a decade. President Kennedy desired somewhat faster money creation. From January 1961 to November 1963, the basic money supply grew by 2.31 percent. Lyndon Johnson required rapid money creation to finance his expansion of the welfare/warfare state. Money-supply growth more than doubled to 5 percent. These varying rates of monetary growth all occurred under the same Fed chairman, William McChesney Martin, who obviously was more interested in pleasing his political master than in implementing an independent monetary policy.
Martin’s successor, Arthur Burns, was such a staunch supporter of Richard Nixon that he lost all professional credibility by enthusiastically endorsing Nixon’s disastrous wage and price controls. Even though his staff informed him in the fall of 1972 that the money supply was forecast to grow by an extremely robust 10.5 percent in the third quarter, Burns advocated ever faster growth before the election. The growth rate in the money supply in 1972 was the fastest for any one year since the end of World War II and helped re-elect Richard Nixon.
However, President Ford called for slower monetary growth as part of his Whip Inflation Now program, and the Fed complied with a 4.7 percent growth rate. But when Jimmy Carter was elected, Burns again complied with presidential wishes by stepping up the growth rate to 8.5 percent. Carter did not reappoint Burns, but the latter’s successors were equally cooperative. The money supply increased at an annual rate of 16.2 percent in the five months preceding the 1980 election—a post-World War II record.
In 1981 Donald Regan, Ronald Reagan’s Treasury Secretary, advocated, and got, more rapid monetary growth. A year later the President himself met with Fed Chairman Paul Volcker to lobby for slower growth, which was dutifully produced by the Fed. More recently, Alan Greenspan has reportedly been most accommodating to President Clinton.
Both Sides Benefit
The Fed is obviously influenced by the executive branch. But the relationship between the Fed and administrations runs far deeper. As Robert Weintraub observed, such contact has been and continues to be fostered by cross planting of high level personnel in both directions. Officials have also met weekly for decades. But personal contact is not necessary for the Fed to allow itself to be used as a political tool. The administration’s policy views are generally well known. Economist Thomas Havrilesky has even developed an index of executive branch signaling, based on newspaper accounts of the administration’s monetary policy preferences as reported in the Wall Street Journal. And as Weintraub concluded, a Chairman of the Federal Reserve Board who ignores the wishes of the President does so at his peril.
The Fed and presidents alike benefit from this arrangement. Economist Edward Kane has argued persuasively that the Fed’s ultimate political function is to serve as a political scapegoat when things go wrong. Writes Kane: Whenever monetary policies are popular, incumbents can claim that their influence was crucial in their adaptation. On the other hand, when monetary policies prove unpopular, they can blame everything on a stubborn Federal Reserve and claim further that things would have been worse if they had not pressed Fed officials at every opportunity. In return for this favor, the Fed is allowed to amass a huge slush fund (discussed below) by earning interest income from the government securities it purchases through its open market operations.
A Demand for Inflation?
It is also well established that politicians use the Fed as a tool of money creation to advance their own re-election. As Robert J. Gordon wrote in the Journal of Law and Economics more than 20 years ago: Accelerations in money and prices are not thrust upon society by a capricious or self-serving government, but rather represent the vote-maximizing response of government to the political pressure exerted by potential beneficiaries of inflation.
Gordon is wrong in denying that government is inherently capricious and self-serving, but he’s got a good point: Politicians are naturally inclined to finance government handouts to special-interest groups with the hidden tax of inflation, which hides the true costs of government from the taxpaying public. Joining with election-minded officials in favor of expansive monetary policies is a low-interest-rate lobby, led, argues Edward Kane, by builders and construction unions and by financial institutions that earn their living by borrowing short to lend long.
The Fed underwrites an enormous volume of research, some of which is very good. But, as Business Week magazine once observed: There is disturbing evidence that the research effort of the bank’s 500-odd Ph.D. economists is being forced into a mold whose shape is politically determined by the staff of the Federal Reserve Chairman. Some Fed economists admit that political expedience is the rule. Says former Fed economist Robert Auerbach, the practice at the Bank where I worked was to clear research through the Board of Governors and to ‘persuade’ economists to delete material that the Board or the Bank officials did not like.
Thus, all Fed research should be taken with a grain of salt. However, one recent study in particular deserves special attention. In 1992 Boston Fed research director Alicia Munnel published a report claiming to find persistent mortgage loan discrimination against minorities in Boston. The study, used to justify racial quotas for bank loans, was fatally flawed. The data were hopelessly jumbled. Equally important, the report failed to control for creditworthiness—credit ratings, job history, income, and so on. When confronted with these facts by Peter Brimelow and Leslie Spencer of Forbes magazine, Munnel admitted: I do not have evidence . . . no one has evidence of lending bias.
The Fed also uses its privileged position—and especially its multi-billion dollar slush fund generated by interest income on open market purchases—to lobby. Its preferred method is to pressure member banks, which it regulates, to lobby for it. It also recruits a small army of academic researchers, who benefit from Fed research grants, visiting appointments, and invitations to conferences at exotic locations, to testify on its behalf at Congressional hearings.
For instance, in the late 1970s Representative Henry Reuss introduced a bill authorizing the General Accounting Office to audit the Federal Reserve system. It was defeated because, as Reuss later explained, with the Federal Reserve Board in Washington serving as the command center, a well-orchestrated lobbying campaign was mounted, using the members of the boards of directors [of the regional banks] as the point men. In a speech to the American Bankers Association after the GAO bill was defeated, the Richmond Fed’s chairman, Robert W. Lawson, congratulated the assembled commercial bankers for their success: The bankers in our district and elsewhere did a tremendous job in helping to defeat the General Accounting Office bill. It shows what can be done when the bankers of the country get together. Academics conducted themselves in an equally disgraceful way, warning of potential abuses and assuring Congress that the Fed could be trusted to behave responsibly.
For decades, believers in the public interest theory of Fed behavior blamed the Fed’s failures to ensure price stability on the agency’s incomplete knowledge and difficulty fine-tuning the economy. But research suggests that the Fed’s abysmal record in controlling inflation reflects not mere incompetence, but the way in which the Fed is organized.
Until the Fed’s creation, there was no overall upward trend in the price level. Inflation occurred during wars, but prices then gradually declined to their former levels. Since the establishment of the Fed, however, there has been a continuous upward surge in prices. Public choice scholars believe that an important reason why the Fed has caused so much inflation is that it benefits from inflation. Since the entire operation has been funded since 1933 from revenue acquired through interest payments on government security holdings, the Fed has an incentive to purchase securities (thereby expanding the money supply) more than it has an incentive to sell them. Purchasing government securities is a source of income to the Fed, whose income is earned by the interest paid on the securities. Selling securities, on the other hand, causes a loss of income.
The Fed is constrained to return excess revenues to the Treasury, but enjoys great discretion over its budget and managed to spend over $2 billion on itself in 1996. Fed officials live quite well on their revenues. As a recent General Accounting Office report revealed: The Fed has 25,000 employees, runs its own air force of 47 Learjets and small cargo planes, and has fleets of vehicles, including personal cars for 59 Fed bank managers. . . . A full-time curator oversees its collection of paintings and sculpture. The Fed held $451 billion in accumulated assets as of 1996, when it was engaged in building for itself several expensive new office buildings. The number of Fed employees earning more than $125,000 per year more than doubled (from 35 to 72) from 1993 to 1996; even the head janitor (known as the support services director) is paid $163,800 in annual salary plus benefits. Money is lavishly spent on professional memberships, entertainment, and travel.
Economist Mark Toma has studied the Fed’s spending habits and believes that the Fed does in fact conduct monetary policy with an eye toward how its managers and employees can themselves profit from it. That means instituting a bias toward bond purchases and money creation. Similarly, William Shughart and Robert Tollison contend that the Fed behaves exactly like many other government bureaucracies, padding its operating expenditures by increasing the number of employees on its payroll.
That is, the Fed uses staff expansion to reduce the amount it must return to the Treasury. Thus, when engaging in expansionary policies, write Shughart and Tollison, the Fed can both increase the supply of money and increase the size of its bureaucracy because the two goals are served by open market purchases of securities. Contractionary policies, on the other hand, force the Fed to lower its profits and staff. Because of this unique financing mechanism, argue Shughart and Tollison, the Fed has been more successful in enlarging its employee staff over time than the federal government as a whole. This employment effect, moreover, may partially explain why the Fed has apparently been more willing to engage in expansionary than in contractionary monetary policies.
Regulation as a Political Tool
The Fed also uses its vast regulatory powers for political purposes, rather than to promote the public interest. The Fed’s authority is vast, but is most abused through enforcement of the Community Reinvestment Act of 1977. Under the CRA, the Fed must assess a bank’s record of meeting community needs before allowing a bank to merge or open a new branch or even an automatic teller machine. An entire industry of nonprofit political activists routinely files protests with the Fed, which must be evaluated before the bank can win Fed approval. The activists typically threaten to stall mergers or branch expansions unless banks give them—not the poor in their communities—money, a practice that many bankers consider pure blackmail.
For example, the Chicago-based National Training and Information Center threatened to delay a merger by a Chicago bank unless it received $30,000 to renovate its office. The bank agreed, and also gave $500,000 to other leftist organizations. In Boston, left-wing activist Bruce Marks, the head of the Union Neighborhood Assistance Corporation, filed complaint after complaint with the Fed over Fleet Financial Group’s community lending record until Fleet agreed to give $140 million to his organization and to make $8 billion in loans to individuals and businesses favored by Mr. Marks. We are urban terrorists, Marks explained to the Wall Street Journal.
The CRA is frequently used as a means of racial extortion. For example, the Fed, under the direction of former Governor Lawrence Lindsey, found statistical disparities in lending, i.e., the percentage of loans granted by the Shawmut Services Corporation to blacks and Hispanics did not match the groups’ proportion in the population. Yet no individuals complained of discrimination and the Fed did not claim to have found any victims. In fact, between 1990 and 1992, when the discrimination allegedly occurred, Shawmut’s mortgage loans to blacks and Hispanics more than doubled, and the mortgage rejection rate fell by 45 percent and 26 percent, respectively. However, the Fed employed 150 people to go out and find people who claimed to have been discriminated against by Shawmut and to offer them $15,000 each, effectively robbing the company of $1 million.
Any government monopoly will be corrupt and inefficient, but the Fed may be the worst government monopoly of all. Not only does it operate for its own advantage in the name of promoting the public interest, and offer government officials political cover for their self-interested policies, the Fed also allows no escape. One can at least refuse to do business with, say, the government school monopoly by homeschooling or by sending one’s children to private schools. But one cannot avoid the effects of the Fed’s monetary monopoly. It is time to depoliticize and denationalize our money.
1. Robert Weintraub, Congressional Supervision of Monetary Policy, Journal of Monetary Economics, April 1978, pp. 341-362.