Reforming the Rules That Govern the Fed

Chairman Barr, Ranking Member Moore, subcommittee members, it is a pleasure to be with you today to share my thoughts on how to improve the governance structure of the Federal Reserve System.

As historians of the Fed such as Allan Meltzer (2003, 2009a, 2009b, 2014) frequently note, the Fed has failed to achieve its central objectives – price stability and financial stability – during about three-quarters of its one hundred years of operation. Although the Fed was founded primarily to stabilize the panic-plagued U.S. banking system, since the Fed’s founding the U.S. has continued to suffer an unusually high frequency of severe banking crises, including during the 1920s, the 1930s, the 1980s, and the 2000s. Unfortunately, research shows that the Fed has played an active role in producing most of those crises, and its failure to maintain financial stability has often been related to its failure to maintain price stability. The Fed-engineered deflation of the 1930s was the primary cause of the banking crises of that era. The Fed’s lax monetary policy produced the Great Inflation of the 1960s and 1970s, which was at the heart of the interest rate spikes and losses in real estate, agricultural, and energy loans during the 1980s, which produced the banking crisis of that period. A combination of accommodative monetary policy from 2002 to 2005, alongside Fed complicity with the debasement of mortgage underwriting standards during the mortgage boom of the 2000s, and Fed failures to enforce adequate prudential regulatory standards, produced the crisis of 2007-2009 (Calomiris and Haber 2014, Chapters 6-8).

It is worth emphasizing that the U.S. experience with financial crises is not the global norm; according to the IMF’s database on severe banking crises, the two major U.S. banking crises since 1980 place our country within the top quintile of risky banking systems in the world – a distinction it shares with countries such as Argentina, Chad, and the Democratic Republic of Congo (Laeven and Valencia 2013, Calomiris and Haber 2014).

In his review of Fed history, Allan Meltzer (2003, 2009a, 2009b, 2014) points to two types of deficiencies that have been primarily responsible for the Fed’s falling short of its objectives: adherence to bad ideas (especially its susceptibility to intellectual fads); and politicization, which has led it to purposely stray from proper objectives. Failures to achieve price stability and financial stability reflected a combination of those two deficiencies.

Unfortunately, the failures of the Fed are not merely a matter of history. Since the crisis of 2007- 2009, a feckless Fed has displayed an opaque and discretionary approach to monetary policy in which its stated objectives are redefined without reference to any systematic framework that could explain those changes, has utilized untested and questionable policy tools with uncertain effect, has been willing to pursue protracted fiscal (as distinct from monetary) policy actions, has grown and maintains an unprecedentedly large balance sheet that now includes a substantial fraction of the U.S. mortgage market, has been making highly inaccurate near-term economic growth forecasts for many years, and has become more subject to political influence than it has been at any time since the 1970s. The same problems that Meltzer pointed to – bad ideas and politicization – now, as before, are driving Fed policy errors. I am very concerned that these Fed errors may result, once again, in departures from price stability and financial stability (Calomiris 2017a, 2017b, 2017c). 2

In my testimony I show that the continuing susceptibility of the Fed to bad thinking and politicization reflects deeper structural problems that need to be addressed. Reforms are needed in the Fed’s internal governance, in its process for formulating and communicating its policies, and in delineating the range of activities in which it is involved. My testimony will focus on three types of reforms that address those problems: (1) internal governance reforms that focus on the structure and operation of the Fed (which would decentralize power within the Fed and promote diversity of thinking), (2) policy process reforms that narrow the Fed’s primary mandate to price stability and that require the Fed to adopt and to disclose a systematic approach to monetary policy (which would promote transparency and accountability of the Fed, thereby making its actions wiser, clearer, and more independent), and (3) other reforms that would constrain Fed asset holdings and activities to avoid Fed involvement in actions that conflict with its monetary policy mission (which would improve monetary policy and preserve Fed independence).

Together these three sets of reforms would address the two most important recurring threats to monetary policy – short-term political pressures and susceptibility to bad ideas – and thereby improve the Fed’s ability to achieve its ultimate long-run goals of price stability and financial stability, which are crucial to promoting full employment and economic growth. Table 1 summarizes the reforms proposed here, and Figure 1 outlines the primary channels through which reforms would improve monetary policy.

To read the full report, click here. 

Photo: thomaguery / iStock / Getty Images Plus