Whither the Fed?

The crisis of last year has exposed flaws in the Fed’s institutional arrangement, but criticism must be pointed.

The Federal Reserve System has gotten a bit of press in the Daily as of late. Last week a column was written in criticism of the Fed, using the language of the economic thought followed by libertarian Rep. Ron Paul, R-Texas. Known as the Austrian school, it is very pro-market and has little patience for the governmentâÄôs control of money, let alone the Fed. Indeed, as the current recession has shown, the role of the United StatesâÄô central bank needs reconsidering. But criticism must be pointed. The aforementioned article was far off base. While it is fair to deride the fiscal exuberance demonstrated by the government, blaming the Fed for the amount of debt raised by government spending fundamentally confuses the central bank for the Treasury Department, and abdicates congress for appropriating the money. The balance sheet of the U.S. government is not the same as that of the central bank. The Federal Reserve exists to smooth out the fluctuations in the economy by watching inflation and unemployment. It also is the lender of last resort in crisis situations. The real criticism to be had is over how well the Fed conforms to its mandate. Many have fingered Alan Greenspan for arrogantly basking in the light of the success of the stock market at the expense of the real economy. Paul Krugman, a Nobel laureate and prominent liberal voice, once cynically quipped, âÄúIf you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.âÄù Indeed, of all the actors that can be blamed for Wall StreetâÄôs explosion, the Fed is high up on the list. The low interest rates following the tech bubble crash earlier this decade made money cheap to borrow, finding its way into housing and more general credit lines. That such a great error could be made by supposed technocrats is disconcerting. Former Fed employees have worried that policymaking is done in a flawed manner. That is, it is assumed that the global economy moves lockstep with the U.S. It is true that the U.S. is the prime driver of the world economy, but factors such as foreign exchange and trade involve more complex analysis than what is currently used. Now that the economic pain has begun, the Fed has moved into new territory. Since the collapse of Lehman Brothers in September, it has created more than $1 trillion available for troubled financial institutions. This has many implications. It is basically now choosing winners and losers in the economy. Some worry that this is a massive power grab made by unelected technocrats who have little accountability. The debate over whether the Fed should be independent is not new. But if technocrats were having a hard time dealing with the crisis, politicians would find it harder. They have a horrible track record with making hard decisions and are prone to populism. Congress has been buying votes for two decades with promises of rising house values and stock markets. In essence, their time horizons are too short for stable economic policy. Truly, when the dust settles the Federal Reserve needs an official review. But making Fed officials electable would make the fundamental factor of the economy, the dollar, politicized. And for all the talk of the U.S. being a democracy, it is a constitutional republic. One that has checks and balances on, yes, even the people. St. JamesâÄô Street welcomes comments at [email protected]