Central Banks, should they exist, should be able to do what is right for monetary policy, which includes regulation of credit.? In a fiat money world, where credit exists as electronic entries, credit is money.

But wait, what if central bank independence is compromised from within?? What if voluntarily becomes the lap dog of the President, Treasury, or Congress?

It takes a bold man to stand up to the powers that be, and the Fed has had its share of them.? Marriner Eccles opposed Truman.? William McChesney Martin, Jr. stood up to Presidents and Congress for his long term as Chairman.? Paul Volcker blew cigar smoke at representatives and Senators as he restored sound money to the US amid screams of pain in the economy.

Central bank independence doesn’t mean squat unless the central bank uses it!

In the name of independence, for fear that the President or Congress would restrict the central bank, many Fed Chairmen have given in to the powers that be:

• Ben Bernanke, rescued entities that he should not have rescued, and established lending programs that use the national credit to benefit a minority of participants.? These actions should have been taken by Congress, if done at all, so that the voters could decide whether it was right to do it or not.? Bernanke validates the idea that the government keeps the Fed around to do what it cannot do constitutionally.
• Alan Greenspan threw liquidity at every little and big problem, and was slow to withdraw liquidity, pushing the US slowly but surely into a liquidity trap, which Ben Bernanke was saddled with.
• G. William Miller and Arthur F. Burns, who facilitated the inflation of the ’70s, at the behest of Nixon and Carter.
• Daniel R. Crissinger and Roy A. Young, who facilitated the loose monetary policy of the ’20s.

Central bank independence means risking your own tenure for the good of the institution.? Marriner Eccles and Paul Volcker did not get reappointed because they offended the President.??? Central bank independence does not mean compromising in order to protect against micromanagement.? Independence means being a man, and telling the President and congressmen that you will do what is right to preserve sound money, regardless of the consequences.

The Fed as Systemic Risk Regulator

I have suggested in the past that the Fed should regulate systemic risk as an aspect of its mandate only because they are the biggest creator of systemic risk through loose monetary policy.? I am not suggesting this on the basis of competence — that is ridiculous.? But on the basis of modifying the behavior of the Fed to make it more resistant to loosening rates early because of systemic risk concerns — that makes sense, because it will increase the emphasis on a sound currency.

Now, many economists are pleading with Congress to be gentle on the Fed because an independent Fed is critical to sound economic policy.? That would be true if the Fed were willing to take politically unpopular actions that were in the best interests of the economy.? Sadly, that is not true of the present Fed.? They do what the politicians want, and give the politicians cover, because the politicians can point at the Fed as the actor, via the rubric of “Central Bank independence.”

I say that the Fed needs more accountability and transparency to Congress, and ultimately to the American.? The quasi-public, quasi-private nature of the Fed needs to be changed to public or private.? Section 13.3 of the Federal Reserve Act, which allowed for the most egregious bailout actions, should be repealed. If bailouts need to be done, let Congress do them, and let them take the heat for their actions.

Not only should the Fed be audited as any large public or private organization, but if they are a public organization they should respond to the FOIA requests from major news organizations (Bloomberg, Fox Business, etc.) without hiding behind technicalities of protecting business secrets.? The insurance industry regularly reveals detailed data on their operating companies, with little seeming harm.? The banks can afford to do the same.

Power without accountability should be foreign to our republican form of government.? Control of our currency rightfully belongs to Congress, and Congress should tighten controls on the Fed so that its degree of independence is limited to the ordinary matters pertaining to a central bank — preserving the soundness of the currency.? Its competence there has been limited; but hey, at least focus on the basics would restore confidence in an institution that no longer has the confidence of the American people.

“Central Bank independence” is a nice phrase, but to the economists who petitioned Congress to preserve the status quo, I would simply ask this: How and from what should the central bank be independent?? To whom and in what ways should it be accountable?

I’ve written before about the Fed’s de facto triple mandate:

1. Low goods-price inflation.
2. Low labor unemployment.
3. Protect the financial system in a crisis.

Number 3 is the implicit obligation of the Fed, for several reasons:

• The Fed carries out monetary policy (in ordinary times) through the banks.
• Banks in the Federal Reserve System have close ties to the regional Federal Reserve Banks.
• Bankers and those sympathetic to bankers comprise a large portion of the leadership and staff of the Federal Reserve.
• Regulating banks gives jobs to many at the Fed.

Stepping back, let me tell you a story.? In the mid-90s, I became worried about inflation going out of control again, given the degree of monetary growth that I saw.? I’m not sure where I got the idea, but eventually it struck me that in the ’70s, when inflation was running hot, we had a lot of spenders and few savers.? In the ’90s, more savers and fewer spenders.? (You have to add in agents of the baby boomers, including the defined benefit plans, and the growth in 401(k)s, and products like them.)? Goods weren’t inflating from excess money, assets were being inflated as the baby boomers were socking away funds for retirement.

(Note to stock investors: be wary when market P/Es rise dramatically — there are limits to what is reasonable in P/Es for any level of corporate bond yields.? This applies to price-to-book and -sales ratios as well.)

As one more example of how monetary policy affects the asset markets, consider how the Fed temporarily flooded the banks with liquidity to avert problems regarding Y2K, and the stock markets reacted to the excess liquidity with a two month lag.? The Fed helped put in the top of the tech bubble.? I don’t know how the money leaked out of the banks to the stock market, but excess reserves under good conditions will produce loans.

Thus, I came to the conclusion that the Fed ought to look at asset inflation as well as goods inflation somewhere in the late ’90s.? But doesn’t the implicit third mandate cover that?? Alas, no, the third mandate is reactive, not proactive.? It kicks in after a crisis hits — Greenspan then floods the market with liquidity, and only steps back when things are running hot again.

A proactive policy would limit the degree of easing that the FOMC could do — once the spread of ten-year Treasuries over two-year Treasuries exceeds 1%, all easing would stop.? The banks can easily make money with a yield curve that steep… not much money, but enough to keep them alive (the financial sector would shrink under these rules).? There would be a second rule that when he spread of ten-year Treasuries over two-year Treasuries is less than 0%, all tightening would stop.? During times of extreme inflation or unemployment, these rules could be waived by Congress for a year at a time.? But that lays the policy back at the door of Congress, which represents the people and the states, where the decision belongs.

A policy like this eliminates the risk that the Fed can steepen the yield curve dramatically, leading to bubble creation — the excess credit has to go somewhere.? Another limit on the Fed could be a limit on total leverage in the economy — above a certain limit, such as 2x GDP, the Fed raises the Fed funds rate, regardless of the unemployment situation, until indebtedness falls.

Bubbles are financing phenomena.? Controlling bubbles can be done by controlling credit, and that is what the Fed tries to do — control credit, which is money in our era.? (Until we go back to something better, and get the government out of the money business — some sort of commodity standard.)

The present Fed holding action inflates assets not goods.? By offering financing to asset markets that are in disarray, it supports asset prices.? For now, none of that balance sheet expansion leaks out to the general public, and thus, little goods inflation.? But also, little true stimulus.

In short, the Fed should limit its powers to reliquefy the economy, because sloppy efforts in the past 25 years produced the popped bubbles that we are now dealing with.? Better to leave policy tight longer, and not loosen so much in troubles.? Don’t worry, we might have to wait longer for recovery, but the recoveries will be sounder when they come.

Parting Shots

• Can the Federal Reserve spot bubbles?? I think so, but it cuts against their unemployment mandate.? They would need to keep policy much tighter in good times.
• Would it threaten Fed independence?? What Fed independence?? I don’t see the Fed opposing politicians as it did in the ’50s and ’60s.
• Mishkin is too optimistic about the competency of the Fed, given its past failures that created bubbles.
• Finally, the chief economist at the Bank of International Settlements gets proven right, as he predicted the bubble that we got into.
• My view is, since the Fed is the major creator of the bubbles, let them be the systemic risk regulator, and then limit their powers of easing monetary policy.? (It would be better to move to a commodity standard, but that’s not on the table now.)? Make the third policy goal of the Fed explicit, and ask them to preserve the banks solvency in the long run, though not necessarily the short run.

Often when we talk about the Fed, we talk about a dual mandate — low inflation, and low labor unemployment.? But as I suggested at RealMoney many times, there is a hidden third mandate: protect the integrity of the banking system.

Often,? a tightening cycle would end with a bang, with some credit starved entity (Residential Housing, Nasdaq, LTCM, Lesser-developed Asia, Mexico, etc.) dying.? The Federal Reserve would then spring into action and say, “We must fight the threat of unemployment.”? Would they?? No, they would invoke protecting the financial system, which protects the banks.? After all, monetary policy does not work when banks are compromised, as they are today.? No wonder there is Credit Easing.

So when I hear the Fed proposed to be the systemic risk regulator, I have two thoughts:

1) You did a bad job with monetary policy and bank supervision, but you are nice guys, because you do for the US Government all of the things the Treasury Department can’t Constitutionally do.? Now let’s see if you can do better with controlling systemic risk, even though we haven’t granted you control over all the levers necessary to do so.

2)? Maybe this will make them better with monetary policy; it makes the triple mandate explicit.

My view is that the Fed is one of the major creators of systemic risk in our economy through the use of monetary policy to stimulate our way out of bad times.? The temptation that Greenspan succumbed to was to throw liquidity at problems too early, which avoided liquidation of marginal debts, and the debt levels built up.

If the? Fed has to minimize systemic risk in the economy, maybe it becomes less willing to loosen policy profligately.? I would hope it would work that way.

That said, given the lack of success for the Fed on its goals, I suspect that if it were given the task of reining in systemic risk, it would fall prey to political pressure, and fail at that as well.

I go back to my earlier proposal — the Fed would have to keep the US economy under a limit of private debts being less than 2x GDP.? But can you imagine the Fed tightening during a boom to avoid systemic risk, or raising margin requirements?? I can’t, so even though ideally the Fed would be the right player to manage systemic risk, in practice, systemic risk is unmanageable, because there are too many interests that benefit from boom times.? That’s why I don’t expect much from the proposals to manage systemic risk, regardless of who gets the power to do so.