When Larry Summers was still a candidate for Fed Chair, and the econoblogosphere was still debating whether or not he ought to be nominated, it became oddly fashionable to argue that it would be a good thing if Summers were to be confirmed and subsequently was not politically independent.
See, for example, Matt Yglesias: “If Summers’ close ties to Barack Obama and his team make people expect that monetary policy will err on the side of looseness and inflation overshooting, that'll be good for the economy.”
This seems to me to be dangerously short-term thinking. Fed independence has been a hard won achievement, and is not something that should be tossed aside lightly. To demonstrate this, I want to walk through two episodes of Federal Reserve history.
The Treasury-Fed Accord of 1951
The extent of Fed subservience to the Treasury during and immediately after World War II is pretty staggering. Robert Hetzel has a good narrative summary of the events leading up to the Accord, the so-called “Treasury-Fed War”.
Starting in 1942, the Fed pegged the interest rates on Treasury securities. The interest rates on T-bills (Treasuries with maturities of less than one year) were never allowed to rise above .375%, and the rates on Treasury bonds (longer term bonds) were pegged at no more than 2.5%.
How did the Fed keep interest rates low on Treasuries? By printing money to purchase them. Such large purchases were required that the Fed ended up owning basically the entire outstanding quantity of T-bills (though the public still held Treasury bonds).
This expansion in the money supply – truly, a monetization of the debt – led to high inflation as soon as the war was over and price controls were ended. Inflation in mid-1947 was 17.6%, and had only dropped to 9.5% a year later despite a looming recession.
By the second half of 1950, the FOMC was becoming severely antsy about all the inflation that it was creating (and recognized it was creating) as well as its loss of independence. In 1948, Chairman Marriner Eccles had not been reappointed by President Truman in order to demonstrate “who’s boss”, according to a Truman staff member. Starting in August 1950, the FOMC began raising the pegged rate very slightly and very slowly.
By February 1951, however, the Fed had had enough and declared that it was no longer willing to peg Treasuries. This came after six months of very public battles between the Federal Reserve and the Treasury, involving inaccurate media leaks, considerable political pressure, and what seemed often to be simply lies from the Treasury and White House.
The Truman administration finally relented, and the Accord was agreed upon, making the Fed independent and ending Treasury pegging after a very brief transition period. However, it seems that the White House may have not truly given up, as Fed Chairman William McCabe was forced out less than two weeks after the agreement was released on March 4, 1951.
William McChesney Martin, who had been an Assistant Secretary of the Treasury, was appointed as McCabe’s replacement. He was considered an ally of Truman, but once in office at the Fed, strongly supported its independence, creating the relationship between the Fed and Treasury that we see today. According to one Truman administration official, several years later Truman ran into Martin in New York. The former president only said one word – “traitor” – before continuing away.
Thus, it should be clear that Federal Reserve independence from the Treasury was something that had to be fought for.
Nixon pressures Burns
The Federal Reserve again came under political pressure during the Nixon administration. This time, instead of keeping the cost of debt down, President Nixon sought to ensure his reelection. Evidence comes from the Nixon Tapes and from members of the Nixon administration.
Nixon had felt burned after his loss in the 1960 presidential election, for which he blamed a weakening of the economy as November 1960 approached. He was concerned enough that, as soon as Martin’s term expired during his presidency (Martin had managed to remain as chair until then), he appointed Arthur Burns. Burns was considered a serious economist, but also a strong supporter of the Republican Party.
When Burns was first nominated, Nixon reportedly told him: “My relations with the Fed will be different than they were with Bill Martin there. He was always six months too late doing anything. I’m counting on you, Arthur, to keep us out of a recession… I know there’s this myth of the autonomous Fed [barked a quick laugh].”
Another Nixon administration member states that Nixon was responsible for anonymous leaks that were used to pressure Burns into loosening policy. One floated a proposal to expand the size of the Board of Governors, so that Nixon could pack it in a fashion similar to FDR’s court packing attempt; another proposed giving the White House more direct control over the FOMC; and a third falsely stated that Burns requested a pay raise when, in fact, he requested a cut.
The Nixon Tapes present the most irrefutable evidence. Nixon can be heard talking with his Secretary of the Treasury about Burns, stating, “War is going to be declared if he [Burns] doesn’t come around some.”
There are also tapes of Nixon and Burns, where Nixon says that “I don’t want to go out of town [Washington] too fast,” and, “This will be the last conservative administration in Washington.” He also declares the contemporaneous “liquidity problem” – that is, one of too much liquidity causing inflation – “just bullshit.”
Meanwhile, this appeared to have some effect on Burns. FOMC minutes indicate dissension among other members, but money supply growth increased, the federal funds rate dropped, and the discount rate was lowered.
This is the danger of having a Fed chair that is too close to the presidential administration: his or her sound economic judgment will be overridden by political beliefs.
This discussion is not quite as timely now that Summers has pulled his name from the race, though, there have been whispers about Tim Geithner being named. Nevertheless, it never a bad time to reiterate the importance of central bank independence.
Of course, independence should never be an excuse for lack of accountability. This, then, is just one more point on the long list of reasons why the Fed should stick to an explicit monetary policy rule that would ensure its insulation from political pressure and allow the public to judge it for any deviations from target.
(…not to mention, if this policy rule has a smart target and uses a smart instrument, then it will lead to economic prosperity.)
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