Fed Independence and Comparative Institutional Analysis

13 November 2009 at 3:58 pm 3 comments

| Peter Klein |

I’ve written before on Fed “independence” and why I don’t support it. The vast majority of economists, especially the more prominent ones, are strongly in favor of independence and against Congressional attempts to limit the Fed’s discretion in monetary and regulatory policy. The standard argument is that a “politicized” — i.e., accountable — central bank will be more expansionary than an unaccountable central bank, assuming that credit expansion affects output first and prices (inflation) second. Last week’s piece by Kashyap and Mishkin follows this script. On the face of it, this seems absurd, as — to take only the most obvious example — the Greenspan-Bernanke “independent” Fed has been the most expansionist in modern history, with a ballooning money supply throughout the 2000s and near-zero interest rates and injections of giggledysquillions of dollars into the banking sector in the last 18 months. The independence crowd cites cross-country studies finding a negative correlation between central-bank independence and inflation, but these studies are controversial (many problems with reverse causation, omitted variables, sample size, etc.).

My question today is different: Where, in those arguments, is the comparative institutional analysis? After all, in policy analysis, we are always comparing imperfect alternatives. We try to avoid the Nirvana fallacy. Craig does this in his post below, asking if a centralized financial regulator would be less bad than the competing regulatory bodies we have today.

But the macroeconomists entirely ignore this problem. Consider Mark Thoma’s defense of independence:

The hope is that an independent Fed can overcome the temptation to use monetary policy to influence elections, and also overcome the temptation to  monetize the debt, and that it will do what’s best for the economy in the long-run rather than adopting the policy that maximizes the chances of politicians being reelected.

This naive wish is simply that, a hope. Where is the argument or evidence that a wholly unaccountable Fed would, in fact, “do what’s best for the economy in the long-run”? What are the Fed officials’ incentives to do that? What monitoring and governance mechanisms assure that Fed officials will pursue the public interest? What if they have private interests? Maybe they’re motivated by ideology. Suppose they make systematic errors. Maybe they’ve been captured by special-interest groups like, oh, I don’t know, the banking industry (duh). To make a case for independence, it is not enough to demonstrate the potential hazards of political oversight. You have to show that these hazards exceed the hazards of an unaccountable, unrestricted, ungoverned central bank. The mainstream economists totally ignore this question, choosing to put a naive faith in the wisdom of central bankers to do what’s right. Guys, have you never heard of public-choice theory?

Entry filed under: - Klein -, Bailout / Financial Crisis, Financial Markets, Myths and Realities, Public Policy / Political Economy.

Just So Stories: Financial Regulation Edition The Amazing Krugman

3 Comments Add your own

  • 1. Jesper Wittrup  |  14 November 2009 at 2:44 am

    Good point! But I am baffled by the outgoing question”: Guys, have you never heard of public-choice theory?” It appears to me that much of the literature on central bank independence indeed explicitly claims to be based upon public choice theory. Apparently it is possible, however, to be well versed in public choice theory and observe with distaste the rent-seeking behavior of the political world, and at the same time believe that independent central bankers can only act based upon professional norms and in the public interest.

    This peculiar bias is not something new, though. Notice for instance how Buchanan, one of the founders of the public choice school, seems to perceive the independent judge as a proud defender of a Status Quo interpretation of the “Rules of the game”, and portrays him as a neutral umpire who is clearly “above” the foul world of politics (see e.g. his 1988 American Economic Review Article on constitutional political economy).

    In contrast to Peter Klein I tend to believe that in the end a good case might be made for the relative independence of both central bankers and judges, but Peter clearly has a point: How can it be that Public Choice theory is (with a few exceptions) so blind to the possible incentives these “political” actors may have?

  • 2. Peter Klein  |  14 November 2009 at 10:02 am

    Jesper, you’re quite right, my last sentence is misleading. As you say, the puzzle is why economists readily accept that legislators, regulators in energy and manufacturing, and local officials can be captured, but think that Fed chairmen, governors, Treasury secretaries, and most jurists are immune.

  • 3. Jesper Wittrup  |  14 November 2009 at 1:57 pm

    And the fact that economists – and people in general – hold central bankers in such high regard is also the most persuasive argument for central bank independence. Given the wide-spread belief in the professionalism and prudence of central bankers, rational governments should aim at increasing their credibility by creating and maintaining independent central banks. Recent events may have weakened this logic, though: http://www.voxeu.org/index.php?q=node/3943

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