The Serendipitous Independence of the Fed

By Mike Dorf

An NPR story yesterday morning more or less confirmed what most Keynesians and neo-Keynesians (including the WSJ reporter who was interviewed for the story) have been saying for some time: The current focus on deficit reduction in the U.S. and austerity in Europe are drags on the economy.  The reporters note that the latest data show that the U.S. economy has grown at a faster rate than Japan's, which, in turn, has lately grown at a faster rate than that of the EU zone economies, which are essentially stagnant.

Those data only roughly confirm Keynesianism because of the somewhat mixed picture of economic policy in the three regions.  Japan has lately been pursuing both monetary and fiscal stimulus; the U.S. has been pursuing monetary stimulus (via the Fed) and fiscal austerity (via Congress and the President); Europe has been pursuing monetary austerity (until an extremely recent announcement of credit relaxation by the ECB) and fiscal austerity (at least in the most troubled countries, such as Greece, Italy and Spain).   A robust confirmation of Keynesianism would have Japan in the lead, followed by the U.S., followed by Europe, rather than the U.S. ahead of Japan, but Austrian/Austerion policy clearly does badly here, since it would predict that Europe would be in the lead, followed by the U.S., then Japan.  In fact, a number of factors explain the better recent performance of the U.S. economy than that of Japan, including long-term economic and demographic trends in the two countries.

In any event, suppose that the NPR and WSJ reporters are correct (as I believe that they are) that, all things considered, loose credit and substantial deficit spending would have been better for the U.S. economy over the last five years than the policy we have had--loose credit combined with an initial burst of too-small deficit spending followed by a premature effort to lower the deficit.  If that supposition is correct, then it is owing almost entirely to a happy accident that the Fed has been able to use monetary policy to push back against some of the harmful effects of the political branches' fiscal policy.  What accident is that?  Why, Fed independence, of course.

To see the accidental nature of our better-than-it-could-have-been fortune over the last half-decade, consider why a polity might decide to make its central bank largely independent of political oversight. The standard reason is the fear that a politically accountable central bank will loosen the money supply in order to provide short-term stimulus so that incumbents can be re-elected, but that the medium-term effect will be inflation.  In this account, sober central bankers are insulated from political pressure so that they can make the painful but necessary decision to tighten credit before inflation gets out of hand.

And yet, since the 2008 financial crisis, the Fed has been very sensibly pushing easy credit to the chagrin of a fair number of misguided lawmakers--especially but not exclusively on the right--who would have preferred monetary tightening to complement their fiscal austerity.

Well so what?  Central bank independence may have been originally conceived as a means of ensuring we got tight monetary policy when needed, but it appears that it is also useful for ensuring loose monetary policy when that is what's needed.  No harm, no foul, right?

Wrong.  As a matter of institutional design, in a constitutional democracy, government institutions ought to be electorally accountable, at least absent some good reason for insulating them from politics.  Thus, we have an unelected (and thus largely unaccountable) judiciary because the judiciary has a special role to play in protecting the rights of minorities and in insisting upon decisions according to the rule of law rather than partisan interest.  Likewise, the traditional argument for an independent central bank relied on a special reason to depart from democratic accountability--namely, the risk, noted above, that politicians would manipulate the money supply for short-term advantage if given the opportunity.

In the current political climate, it's true that the Fed has been making economically sound decisions while the elected branches of the federal government have been foolishly pursuing deficit reduction, but there is no systematic, structural reason why elected officials can't be trusted to spend sufficient sums of public money to promote economic growth.  Put differently, Congress has been pursuing bad economic policy for the last several years, but it's also been pursuing bad policy in other areas as well.  The fact that I (or you) think the Fed has it right and Congress has it wrong is not a justification for a politically unaccountable Fed, any more than the fact that Congress has it wrong about environmental policy or agricultural policy is a justification for a politically unaccountable EPA or Dep't of Agriculture.

We are lucky that we have an independent Fed that's acting rationally, but it is luck that, in a deep sense, we don't deserve.