Monetary Policy As if Democracy Matters
Is it time to end central bank independence?
Central banks need to be independent. Otherwise, we risk monetary policy being used to influence elections and finance government debt. In the long-run, this will generate high inflation and economic instability. This idea seems to be one of the few beliefs that is almost universally held in finance and economics.
But is it correct?
Is it really healthy for a democracy to allocate so much power to a very small group of unelected central bankers? And do independent central banks really produce better economic outcomes? These questions are tackled in a provocative new book by Cambridge economist Leah Downey: Our Money: Monetary Policy as if Democracy Matters.
Use It Or Lose It
The U.S. Constitution gives Congress the power to create and regulate money. But Downey says the legislature - through an accumulation of small choices, or even non-choices - has gradually ceded that power. Like muscles that atrophy with disuse, power that is not exercised dissipates. Or slips into someone else’s hands. In the case of monetary policy, that power now rests with the 12-person, unelected Federal Open Market Committee.
Sure, Congress retains oversight and the Fed Chair must regularly appear before them to explain monetary decisions. There is some value to this - but honestly, not much. The Fed can justify virtually any action as fitting within its dual mandate of price stability and maximum employment1.
While it might seem surprising for politicians to have willingly ceded power, it gives them the ability to criticize economic outcomes without taking responsibility. The Fed in turn professes to be above politics by focusing on data-driven outcomes like inflation and unemployment rates. Both sides can thus claim that markets, not politics, drive monetary policy.
This fiction has become increasingly difficult to maintain since 2008. To fight the GFC, the Fed unleashed an array of tools that got it directly involved in allocating credit. Buying mortgage-backed securities benefits one class of citizens: homeowners. Buying government bonds lowered interest rates and turbocharged the stock market, benefitting another (and overlapping) class of citizens: equity owners. Lending money to foreign central banks helped rescue dollar-dependent institutions that sit outside the U.S.
The suddenness and heat of the battle justified the Fed’s actions in eyes of many. That may be correct, but it has since become impossible to claim its actions were politically neutral. Downey thinks it’s healthier - both for the economy and democracy - to stop pretending.
Know and Show
She wants Congress to move from being a backseat driver to steering the monetary policy bus. To be clear, she isn’t calling for the Fed to be eliminated. But she does want a new structure that gives Congress a clear way to both “know and show” its constitutional authority over money.
She likens the monetary system to a set of pipes delivering a flow of credit across the economy. Congress should establish a structure that allows it to specify where it would like credit to flow and why. It could choose to specify no preference, allowing credit to be allocated as it now. But it could also choose to express different priorities - say more credit to poorer regions, or manufacturing companies or small businesses. The Fed would then have to explain deviations from those outcomes.
Free market advocates would intensely dislike this type of credit guidance. But, we have credit guidance now, it’s just done in the shadows. Downey wants to shine a light on these decisions and then hand citizens, via their elected representatives, the tools to make different ones.
She also wants Congress to regularly reconsider the pipes themselves through a periodic Fed rechartering process. This would allow it to ask important questions like - should there be a pipe from every household directly to the Fed, why are there so many pipes leading from the US to other central banks around the world? Do we want a central bank digital currency? What should the role of regional reserve banks be? A re-chartering discussion held periodically would be a chance to debate and adapt the Fed’s mandate.
Stabilizing Uncertainty?
Her proposal would introduce a lot more uncertainty into policy making. Elections would bring new representatives with different ideas about where credit should flow and how it ought to be delivered and, with her structure in place, they would have an ability to see that through. Rechartering debates would have even greater potential to shift the financial landscape. To Downey’s mind this uncertainty is a feature, not a bug. To quote her:
From a democratic perspective uncertainty about the future is not a factor of the world we must cope with, it’s a normative requirement. To sustain a healthy democracy over time, the future must be uncertain.
She thinks it’s important we understand the difference between stability as protection of the status quo vs. stability as resilience. Our current system protects the status quo. To borrow a phrase from The Rise of Carry (sorry, couldn’t resist), volatility is “suppressed” until it bursts forth in a financial crash or seeps from financial markets to broader society, as is happening right now.
If more of the uncertainty that always exists was allowed to flow through into markets regularly, these destabilizing crises might be less frequent and less traumatic. Her aim is to introduce a structure that enables this to happen - that facilitates the voices of citizens regularly flowing through to economic policy. This is trading off short-term certainty for long-term resilience.
She admits her ideas are risky, but says risk is an essential, foundational element of democracy. Empowering the legislature might bring higher inflation. That’s a risk. It might bring wasteful credit allocation. That’s a risk, too. But it could also create a legislature that takes itself more seriously, that brings back power over money to the people it represents.
A risk worth considering.
Listen to my Ideas Lab podcast interview with Leah Downey:
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Downey points out that the Federal Reserve Act actually tasks the Fed with three goals: maximum employment, price stability and moderate long-term interest rates. The Fed simply ignores the third goals as being redundant. She argues that, in practice, the maximum employment objective is also redundant as most FOMC members believe it can only be achieved with price stability. There is a striking citation in her book where one Reserve Bank president admits to ignoring the maximum employment part of the mandate because “Congress had gotten it wrong.”
asking Congress to manage anything effectively is a risk in itself