Independence + Accountability: Why the Fed Is a Well-Designed Central Bank

Article excerpt

In 1913, Congress purposefully created the Federal Reserve as an independent central bank, which created a fundamental tension: how to ensure the Fed remains accountable to the electorate without losing its independence. Over the years, there have been changes in the Fed's structure to improve its independence, credibility, accountability, and transparency. These changes have led to a better institutional design that makes U.S. policy credible and based on sound economic reasoning, as opposed to politics. In times of financial and economic crisis, there is an understandable tendency to reexamine the structure of the Federal Reserve System. A central bank's independence, however, is the key tool to ensure a government will not misuse monetary policy for short-term political reasons. (JEL E52, E58)

Federal Reserve Bank of St. Louis Review, September/October 2011, 93(5), pp. 293-301.

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The Federal Reserve has taken unprecedented actions in the financial markets since the advent of the financial crisis. Noteworthy examples include lending more than $1.5 trillion to financial institutions and buying $1.25 trillion of mortgage-backed securities to stabilize the economy. The large scale of these interventions has brought intense public scrutiny of the Federal Reserve's powers and institutional structure. In particular, many have questioned why the Fed has the freedom to engage in such actions without the explicit consent from Congress or the president. This freedom from political interference is commonly referred to as "central bank independence."

The focus of this article is to review why Congress made the Federal Reserve independent when it created it in 1913. The article also addresses the fundamental tension that comes with an independent central bank: how to ensure that these policymakers are accountable to the electorate without losing their independence. The key point to remember is that giving the central bank independence is the best method for governments to tie their own hands and prevent them from misusing monetary policy for short-term political reasons.

THE POWER OF MONEY

Money is obviously a vital part of an economy because it allows trade to occur more efficiently. Governments have a great power that no one else in the economy has--the ability to print money. Thus, the government can acquire more goods by printing more money, a process known as seigniorage. This power, however, brings with it a dangerous temptation. Imagine that you had this power; just think of what you could do with it! You could live a great life, feed the hungry, and house the homeless. And all of this could be achieved simply by printing more money. This sounds wonderful. How can it be dangerous?

If the government prints too much money, people who sell things for money raise their prices. (These prices can apply to goods, services, and labor.) This lowers the purchasing power and value of the money being printed. In fact, if the government prints too much money, the money becomes worthless. We have seen many governments give in to this temptation, and the result is a hyperinflation. Hyperinflations were observed in the 20th century in Germany (twice), Hungary, Ecuador, Bolivia, and Peru, with Zimbabwe as the most recent casualty. Such episodes of high inflation can greatly impair the functioning of the economy or collapse it altogether. Thus, having the power to print money brings with it great responsibility to respect that power.

It is important to remember that the temptation to print money is not restricted to less-developed countries. In fact, the United States has suffered from high inflation several times. In pre-revolutionary days, many colonies had the right to print money and fell prey to their own excesses. The Continental Congress did the same during the Revolutionary War. In 1775, it gave the colonies the authority to issue Continental dollars to finance the war. …