The year 1913 is consequential in American history. Two seminal institutional changes occurred. The first was the introduction of the income tax and the second was the creation of the nation’s central bank, the Federal Reserve System. Both acts of Congress, the first requiring the high bar of the 16th Amendment to the United States Constitution and the second requiring the creation of a new institution, sum to the one motive of raising more money to run the government.
The Fed’s independence from the Department of the Treasury did not occur until the Federal Reserve-Treasury accord of 1951, initiated by Marriner Eccles and consummated by McChesney Martin, the two giants after whom two buildings of the Federal Reserve are named, across from each other on C Street, North West in Washington, DC (Eccles was a high-school graduate banker and a Mormon from Salt Lake City, Utah. Ben Bernanke and about 200 from among the brightest economics PhDs sit in the building on Constitution Avenue named after him).
Since 1951, the Federal Reserve is among the earliest of the world’s central banks to institute central bank independence. The consistency of monetary policy mostly as a reaction to the changes in economic conditions over time, independent of political pressures, to supply more or less money is the academic and practical significance of the Fed’s independence from the rest of the government of which it is a part. It is structured as a public, government entity in Washington and as 12 private banks in 12 regions around the country. As a whole, it is a government institution whose primary purpose at the time of its creation was to come to the rescue of the commercial banks in the event of bank runs, besides, of course, to supply money.
After 1951, the focus of the Federal Reserve shifted largely to a mandate consisting of three things: maximum employment, stable prices and moderate long term interest rates through money supply, even as it maintained its function of serving as a safety net to commercial banks in distress or to some firms capable of influencing the economy as a whole during periods of grave economic downturns. The pros and cons of these decisions are periodically reviewed by the Congress (though the Congress cannot instruct the Fed on future policy decisions), at will or as required by the Federal Reserve Act provisions of reporting to the United States Congress.
At issue in the debate over the future of the Fed in the aftermath of this financial crisis is if the Fed’s independence is being politically abused under the cover of monetary policy independence. Why a separate institution if what is parsimoniously necessary, in the interest of the tax payer and in keeping with the definition of fiat money (as a costless holder of value and facilitator of transactions), is a law guaranteeing functional independence to money supply while making it a part of the Department of the Treasury?
Shedding some light on the political dynamic of the engagement of the Fed with the rest of Washington can help in answering this question. It can be persuasively argued that the close, explicit ties of the Fed to the Congress and the Executive until 1951 from its inception in 1913 only went under cover after 1951 under the guise of central bank independence.
The power of the Fed is the power to control the purse strings of the US economy, because it is well known since Hume’s quantity theory of money in the 17th century that the growth of money grows the economic output, the frequency of money changing hands (or velocity) and the overall (or aggregate) price level being derivatives of the monetary base and the economic output.
The United States Congress had delegated this power the framers had granted it in Article I of the Constitution to the Federal Reserve when it created the Fed in 1913 because the Fed buys and sells government debt to inject or withdraw money. Government debt is both necessary to create money (to seed the Federal Reserve’s asset-side of the central bank’s balance sheet) and to finance the government’s budget deficits.
In reality, therefore, what truly matters from the standpoint of the government’s budget discipline is fiscal discipline as Alexander Hamilton and George Washington well understood after the Revolutionary War, money supply variation being always ancillary to cumulative government spending over time (government savings or debt; the current cumulative government debt is about $14 trillion), whatever be the operational mechanisms of supplying money, either through the daily bank reserves also known as the Federal funds market (as is currently the case) or by directly manipulating the quantity of money in the money market as Paul Volcker had done (another mechanism is directly regulating the bank reserve requirement with the central bank as the Chinese do).
When the Federal Reserve sells government debt to the financial institutions it does not regulate (or no one in the US government really regulates besides nominal oversight until today), the interest rates individuals and corporations pay to borrow money rises because of the rise in the scarcity of liquidity in the money market (or vice-versa). When this happens, the economy slows down (or grows) because it becomes more expensive (or less expensive) to invest in machinery and to hire people. Economic slowdowns (or expansions) always have political repercussions for elected officials who have delegated this responsibility to the Fed through the Federal Reserve Act.
A seminal example of an untimely economic slowdown occurred in 1992, entirely brought upon by domestic economic policy because the Greenspan Fed had preemptively raised interest rates by contracting money supply at the height of the popularity of former president George H.W. Bush after the extraordinarily successful Gulf War I, in which the United States benefited financially, on net, including on war spending, largely due to the stewardship of James A. Baker III, the Secretary of State during the war, and earlier, the Secretary of the Treasury for Ronald Reagan. A sitting president had lost his reelection, a rare occurrence, to an up and coming young Democrat politician named Bill Clinton who had, as coincidence would have it, campaigned on the economy by painting the incumbent as a foreign policy New England blue blood who was out of touch with the main street grocery store check out counter.
If not for this “Sliding Doors” phenomenon of the “Comeback Kid,” American history would have been very different: Iraq, including the ouster of Saddam Hussein and the ordering of the post-Cold War world would have been on a sound footing sooner and there would have not have been the necessity to go to war in the post-Soviet Afghanistan, especially because of the timely advice of former president Richard Nixon to George H.W. Bush in 1992, on the eve of his reelection, on how to approach the newly forming post-Cold War Commonwealth of Independent States (CIS) in the former Soviet sphere of influence. Most importantly, there would have been no financial crises caused by the rush to balance the Reagan-Bush budget deficits by Bill Clinton because of the hue and cry from the left-leaning American Economic Association (AEA) during the Reagan administration, but for the usual economic ups and downs of the business cycle as is typical of conservative and restrained economic governance. Clinton’s act of budget balancing has turned out to be a Pyrrhic victory. The Clinton administration had benefited significantly from the Reagan recovery since 1983 and sought “rent” from the markets to maintain its pro-government policies.
Nixon had wanted a “Marshall Plan” for the emerging CIS, similar to that for post-War Germany and Europe, wise counsel to the Republicans who were scratching their heads about how to deal with Mikhail Gorbachev, not the total economic collapse of the former Soviet States before they could get any help from the NATO West as president Bill Clinton together with his chief CIS adviser and long time Rhodes Scholar friend Strobe Talbott had accomplished much to the chagrin of Russia (Talbott’s long tome on Clinton’s Russia policy is a rambler relative to his sweet and short scholarly analysis titled “The Russians and Reagan”).
The current president Barack Obama has picked up US Russia policy, together with Indiana Senator Richard Lugar, where Nixon and Bush 41 had left off in 1992, though Russia is still awaiting its accession to the World Trade Organization (WTO) in deference to the large trade imbalances between China and the United States which are the principal source of global economic instability today. One word thus describes the failure of the Clinton economic agenda: imbalances.
The Alan Greenspan Fed, well known not to be on the best of terms with the Bush 41 White House, had made a mistake of historical proportions in its ambition to gain ground in the flux that is the Washington pecking order, perhaps to keep its beloved Chairman who was known to be favoring Bill Clinton − the Fed, as a bureaucratic institution, being historically more aligned with the Wilsonian Democratic party of big government social conservatives (or Blue dogs or the Reagan Democrats of 1980) and its euro-centric one world ideology (The League of Nations) than with the small government socially conservative Rockefeller Bush Republicans (from whom former Secretary of State Henry A. Kissinger had parted company by 1989) who are more closely aligned in ideology with America’s founders.
The mistake of the Eccles Fed in contracting money supply for a second time just before the reelection of FDR for his second term in 1936 is the staple of economics literature on monetary policy. Alan Greenspan’s Federal Reserve had made a far more serious mistake by preemptively tightening monetary policy at the beginning of the Bush 41 term inducing the 1990-1991 recession, with the economy recovering just after the 1992 election of Bill Clinton.
People indeed make mistakes because “[i]t’s the economy, stupid!” in 2011. It is indeed an age of turbulence for only its makers know why it is so.
The elites, therefore, always matter and so does their perspective on national interest.