Power, Independence, and Guessing

The Power and Independence of the Federal Reserve is an informative and provocative history of the Fed and its remarkable evolution over a hundred years’ time: a complex institution, in a complex and changing environment.

Very importantly, author Peter Conti-Brown has included the Fed’s intellectual evolution, or the shifting of the ideas that shape its actions as these ideas go in and out of central banking fashion. This account makes readers wonder what new ideas and theories the leaders of the Fed will adopt, reinforce by groupthink with their fellow central bankers, and try out on us in future years.

As for the power wielded by the Fed, it has obviously come a very long way since its beginnings, when it was, as Conti-Brown describes it, “an obscure backwater government agency.” That is hard for today’s Americans to imagine. To illustrate the change, Conti-Brown relates the memorable story of when the new Federal Reserve Board went to President Wilson’s Secretary of the Treasury, William McAdoo, to complain that at a state function the board members were not given sufficient prominence in order of seating. McAdoo took the problem to Wilson. “Well, they might come right after the fire department,” replied the irritated President.

Little could he know that the Fed would become, in time, the global financial fire department, as part of being central bank to a world in which its fiat dollars were the dominant currency.

Of course the Fed has made, and doubtless will continue to make, great mistakes. Its enormous power, combined with its unavoidable human fallibility, renders it without question the most dangerous financial institution in the world—far and away the greatest potential creator of systemic financial risk there is.

Put that together with the other idea in Conti-Brown’s title: independence. He considers many factors affecting the independence the Fed so much wants and so energetically defends. He rightly emphasizes something as crucial as it is little-discussed: the Fed’s budgetary independence. The Fed, as Conti-Brown points out, is entirely free from the “power of the purse” normally exercised by Congress. Instead, it is able to spend whatever it wants out of the very large profits it automatically makes by issuing money, both the printed and the bookkeeping varieties. On the money-issuing and the spending, there is no constraint except its own decisions.

The more independent the Fed is, combined with its power and the huge riskiness of its actions, the bigger an institutional puzzle it represents in a government that was built on the principle of checks and balances.

In the famous conclusion of The General Theory of Employment, Interest, and Money (1936), John Maynard Keynes tells us that “soon or late, it is ideas . . . which are dangerous for good or evil.”  This is true in general in human affairs, but it is especially true of the ideas that come, from time to time, to dominate the minds of central bankers—and most importantly, the central bankers who run the Fed. Conti-Brown’s tracing of the ideas of the Fed’s dominant personalities over time is key to understanding the institution.

For example, take the idea of fiat money. This was clearly not what the Fed would be about, in the minds of the authors of the Federal Reserve Act, like then-Chairman of the House Banking Committee, Carter Glass (D-Va.). Conti-Brown writes: “The claim that the new Federal Reserve Notes would represent ‘fiat money’ were fighting words.” He quotes Glass’s defense on the floor of the House of Representatives against the charge: “Fiat money! Why, sir, never since the world began was there such a perversion of terms.” But now the Fed is known by all to be the center and font of the worldwide fiat money system.

Or take inflation. Conti-Brown nicely summarizes the view of William McChesney Martin, Chairman of the Fed for 19 years and under five U.S. Presidents in the 1950s and 1960s: “The keeper of the currency is the one who has to enforce the commitment not to steal money through inflation.” But now the Fed has decided to commit itself to perpetual inflation and has for seven years been stealing money from savers through negative real interest rates—all for the greater good as embodied in its current theories and beliefs.

As Conti-Brown says, it is not the case that there are “objectively correct answers to problems of monetary policy . . . in a democracy.” That is why the Money Question, as impassioned historical debates called it, is always political and not merely technical. Central banking is, he writes, “plagued by uncertainty, model failures, imperfect data, and even central banker ideology.” (He should have left out that “even.”)

Conti-Brown views central bankers as “adjudicating between conflicting views of that uncertainty, those failures, these ideologies.” Quite right, except that he has a more optimistic view of the process than I do. In place of “adjudicating” among uncertainties, a more accurate term would be “guessing.”

This recalls a marvelous letter to the Financial Times of several years ago suggesting that “in mathematics, one answer is right; in literature, all answers are right; and in economics, no answers are right.” Conti-Brown says “it is tempting to throw out the entire enterprise of central banking as politics by another name.” But as he also says, this would not be right, either.

The key fact is that in central banking the uncertainty is high and, therefore, guessing is required. But the cost of mistakes can be enormous. This causes responsible minds to tend to cluster around common ideas and to reinforce each other by saying the same things. The book discusses this clustering in terms of “cognitive capture,” but I think a better description would be “cognitive herding.” This affects central bankers as it does everybody else when confronted with the need to decide and act in the face of ineluctable uncertainty.

In making decisions subject to uncertainty, metaphors are helpful, and Conti-Brown is fond of what he calls “the poetry of central banking”—that is, powerful figures of speech. The most famous such metaphor is that of Chairman Martin, who characterized the Fed as the “chaperone who has ordered the punch bowl removed just when the party was really warming up.” Martin (who studied English and Latin at Yale) “changed the language of central banking,” says Conti-Brown, and therefore its ideas. One can only imagine how surprised Martin would be that, in recent years, the chaperone has been the one pouring bottles of rum into the punch bowl to liven up the party.

Finally, on the subject of the Fed’s independence, Conti-Brown quotes Fed Chairman Ben Bernanke telling his successor, Janet Yellen, that “Congress is our boss.” But does the Fed as an institution really accept that as it insistently defends and pursues its independence? The more the Fed achieves practical independence from Congress, the more intriguingly alien to our fundamental Constitutional order it is.