In the middle of our market economy sits an island of central planning, the Federal Reserve. No president or Congress dares challenge the power of its chairman, Ben Bernanke.
J. Bradford Delong | October 27, 2008
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Now go further back in history to 1844, and pick up the story that leads to Bernanke's current power and eminence. The place is London. The occasion is the debate in Britain's House of Commons over the terms on which the charter of the Bank of England -- the government's bank -- is to be renewed. The British government was then the largest economic institution the world had ever seen, and Britain, the fastest-growing economy ever seen: It was the age of the original Industrial Revolution, with the first large-scale automated factories, the first steamships, the first net of railroads, and the first time that any national economy had developed the chronic disease that we call the industrial business cycle.
Before the 19th century the causes of times of economic distress were obvious: war, famine, or disease, or a state bankruptcy -- a government that decided that it was simply not going to pay its debts. You could see what was going wrong and what had caused it.
The industrial business cycle was different -- and mysterious. Factories would be shut but not because of a lack of raw materials or of workers who wanted the jobs or of people who needed the products. Construction workers would be idle but not because the country had enough railroads or buildings or ports. People would be much poorer than they had been a couple of years before but not because an invading army had burned their cities or a plague of locusts had eaten their crops.
What seemed to be happening was that the flow of funds of individuals' savings into banks and then out to companies that wanted to expand or maintain operations somehow dried up. Sometimes the flow of money into the banks dried up first, and so the interest rate the banks had to pay to attract funds and deposits rose. As a result, the interest on the loans the banks had made was suddenly less than the interest they had to pay out on deposits. The banks then ran short of cash, couldn't pay their obligations, and crashed. This further dried up the flow of funds from savers: Why deposit your money in a bank that might crash next week? Sometimes the confidence of entrepreneurs in expanding their enterprises flagged and faltered, and the value that they paid each other for shares of ownership of factories and railroads and office buildings fell. Then they could no longer sell shares in their properties to pay back the banks from which they had borrowed -- and
the banks ran short of cash, couldn't pay their obligations, and crashed. This too dried up the flow of funds from savers. Before the Industrial Revolution, these things didn't happen. Ever since, they have happened roughly every five years, at varying levels of severity.
In reaction to these first contractions, the Bank of England developed a custom: In a panic, crash, or depression, when smaller banks were running short of cash, the Bank of England would print some up and lend it out to the other banks. Nobody thought that Bank of England notes were bad because nobody thought the Bank of England would crash: the British Empire would never let it fail. So the Bank of England lent to smaller banks that could not meet their obligations, expecting repayment only after the crisis had passed. This lending would keep smaller banks from crashing, lower interest rates, and raise asset prices. Indeed, the crises did pass. Savers reappeared, and the interest rates banks had to pay to attract deposits fell. Entrepreneurs returned from their rest cures, recovered their confidence, and asset prices rose again. And the Bank of England got repaid -- or at least got repaid enough of the time to keep the system going.
All of this was illegal. The notes the Bank of England printed were supposed to be backed by gold in its vaults. The 1844 parliamentary debate was about whether the Bank of England's charter should be amended to make legal what the bank was already doing. Prime Minister Robert Peel said no: If the Bank of England had the legal power to print extra notes to rescue banks in a crisis, he said, then the banks would get into more crises, taking more risks because they knew that the Bank of England would rescue them. But, Peel said, if the governor of the Bank of England decided, in a panic, to rescue banks or lend them money to prevent the panic from snowballing into a crisis and then into a depression -- then the government would not prosecute its bank for violating its own charter. As Charles Kindleberger puts it in his book Manias, Panics, and Crashes, the principle was that the central bank should always show up when it was really needed, but beforehand,
and in normal times, its appearance should always be in doubt.
As the 19th century passed, the Bank of England began to exercise its power to set the key price in the economy. There had always been a "bank rate" -- a rate at which other banks could borrow from the Bank of England. At the start, the Bank of England would periodically adjust the "bank rate" to follow the general price in the free money market in normal times, but it found that the other banks were waiting for it before they would change their own lending rates. By the end of the 19th century, the short-term interest rate in Britain was an administered rather than a market price all the time -- not just in the panics when the Bank of England lent money in emergency-rescue operations.
The United States in the 19th century did without a central bank and had the world's severest panics and deepest depressions -- in 1857, 1873, 1884, 1893, 1896, and 1907. In 1907, the financier J.P. Morgan said "enough" and constituted himself as a pick-up central bank because nobody doubted that his and his partners' fortunes were so large that their credit was good. In 1913 Congress created the Federal Reserve. The Federal Reserve did not acquit itself well during the Great Depression: Milton Friedman and Anna J. Schwartz always blamed that on the untimely death in 1928 -- just before the crash -- of the Fed's leader, New York Federal Reserve Bank President Benjamin Strong, and the lack of competent replacements. Other central banks also did not acquit themselves well during the Great Depression: They all seem to have decided that maintaining the gold standard was more important than rescuing banks, which is why we no longer have a gold standard.
After World War II, the Federal Reserve found its footing. Eight times a year, and in emergencies, the Federal Open Market Committee met to assess the levels of the federal funds rate and the Federal Reserve discount rate -- the American equivalents of Britain's "bank rate." The Reserve set its interest rates with an eye, first, to maintaining price stability (because inflation makes all other tasks much more difficult); second, to minimizing the danger of a future financial crisis; and, third, to keeping the economy's level of growth as high and unemployment as low as possible given the other two objectives.
In the first decades after World War II, the Federal Reserve came under heavy political pressure: Members of Congress would denounce the Fed for keeping interest rates too low and thus triggering inflation; other members of Congress would denounce the Federal Reserve for keeping interest rates too high and thus creating high unemployment and low real wages; presidents prodded the Reserve to lower interest rates to produce an economic boom at re-election times. But the 1970s taught members of Congress that criticizing the Federal Reserve is likely to backfire: If it takes your advice, you cannot then blame it for what has gone wrong in the economy. The 1980s taught presidents and their staffs that getting into a fight with the Fed is likely to shake business confidence and risk either higher inflation or higher unemployment or both. The memory of the 1970s and the 1980s created a culture inside the Federal Reserve of resistance to political pressure. Many
in the Fed believe that the root cause of our only post–World War II depression, in 1982, had been caused by then Federal Reserve Chair Arthur Burns' willingness to bow to pressure from his political patron Richard Nixon to create a booming economy for Nixon's re-election campaign in 1972.
The last even semiserious political effort to pressure the Federal Reserve came in 1991, when George H.W. Bush's White House delayed Alan Greenspan's reappointment as chair and threatened to find a replacement if Greenspan and his committee did not lower interest rates far and fast enough to suit the White House -- what then–White House counsel C. Boyden Gray told me were "counterproductive and pointless games." Since Paul Volcker's appointment as chair in 1979, the Reserve has been effectively independent from the rest of the government. And whenever it makes a decision, the word comes down to all executive-branch officials to stay on message, as we were told when I worked at the Treasury in the 1990s:
"Our role at the Treasury Department is to support the independent regulators. ... The Treasury Department supports the actions taken by the Federal Reserve Bank of New York and the Federal Reserve. We believe the actions taken were necessary and appropriate."
All this evolved not by design but by accident. The Bank of England did not start out thinking its job was to rescue the banking sector in crisis; it just found there was a crisis and thought it could do some good. Robert Peel did not set out to create a central bank, but prosecuting the Bank of England for charter violations seemed a mistake at the time. The Bank of England did not set out to supplant the market and turn the interest rate into a centrally planned and administered price, but monetary management in extraordinary times led to monetary management in unusual and then in ordinary times. The 1913 U.S. Congress did not set out to turn Ben Bernanke into a philosopher-prince, but the absence of an American central bank was blamed for the dire panics and depressions that struck between the Civil War and World War I. And post–World War II presidents and congresses did not set out to cede all effective powers of national macroeconomic management
to the philosopher-princes of the Federal Reserve; it just seemed like the least-bad idea at the time.
But just because central banking is independent of politics does not mean that politics is independent of central banking. "You may not be interested in the dialectic," Leon Trotsky once said, "but the dialectic is interested in you." That we now have independent central banks run by technocratic philosopher-princes like Ben Bernanke, and that we have these central banks because elected legislators and executive politicians do not want to challenge their authority or change their charters, has powerful implications for the freedom of action and choices that presidents and elected governments can make. Let me give three examples:
At the start of the Clinton administration in 1993, Alan Greenspan as Federal Reserve chair was firmly and genuinely convinced that the federal budget deficit, at its level at the time, was inflationary. Deficits raise debt. One of the things governments do to get from under the burden of a high national debt is inflate the currency. Greenspan was firmly convinced that if he wanted to maintain price stability -- and he wanted to maintain price stability -- then he had to offset the upward pressure on inflation coming from expectations that someday the government would start printing money to ease its debt. To offset inflation, he raised interest rates and so created a supply imbalance in the labor market: You can't have durable inflation without rising wages, and you can't have rising wages with an excess supply of workers looking for jobs in the labor market.
Thus, the debate about the economic policy of the Clinton administration carried out in the fall and winter of 1992–1993 -- how to find the proper balance among middle-class tax cuts, public-investment expenditure increases, upper-class tax increases, and deficit reduction -- was brought to a sharp and immediate halt by the Federal Reserve. Because Alan Greenspan was committed to keeping inflation low, any Clinton administration economic policy of benign neglect applied to the deficit would be very likely to produce a substantial recession. Greenspan, of course, said that he was not an unelected technocrat imposing his policy preferences on the elected president but merely an informant about the reality of the bond market -- which generated James Carville's crack about how he wanted to be reincarnated: "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter, but now I want to come back
as the bond market. You can intimidate everybody."
A similar process had the opposite effect between 1995 and 2000. Greenspan's belief -- over the objections of many if not most of the members of his committee -- in the "new economy" of the Internet revolution led the Fed chair to reduce interest rates below what standard Federal Reserve reactions found appropriate for the late-1990s levels of inflation and unemployment. This action generated the high-productivity, high-employment boom of the late 1990s that then turned into the dot-com bubble.
The current financial crisis has its roots in Greenspan's decision to keep interest rates very low in 2002 and 2003 to head off the danger of a deflation-induced double-dip recession, and his subsequent decision that the costs of cleaning up after a housing bubble were likely to be less than the costs of the high unemployment that would be generated by a preemptive attempt to pop a housing-speculation bubble. Two years ago, I would have said that Greenspan's judgment here was correct. Six months ago, I would have said that his judgment was probably correct. Today -- in the middle of the largest nationalizations in history -- I can no longer state that Greenspan made the right calls with respect to the level of interest rates and the housing bubble in the 2000s.
In all three of these episodes, the president and the Congress -- neither of them wishing to erode confidence by a public disagreement with the Federal Reserve -- had about as much power to set or influence policy as the Queen of England does in Britain: They had the power to talk to the decider -- Greenspan then and Bernanke today -- and nothing more.
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<http://www.prospect.org/cs/articles?article=republic_of_the_central_banker>
More history can be found in Wall Street:
<http://www.wallstreetthebook.com/>
Timely, as today is a day of national protest by goldbug conspiranoids:
Shane