The Need for an Independent Federal Reserve Bank

(Or a Perfect Federal Reserve Bank Cannot Be Taylor Made)

 

Patrick R. Wallace

Daniel P. Messmer

 

If you put the federal government in charge of the Sahara Desert, in five years there’d be a shortage of sand.

                                      -Milton Friedman

 

A Call to Regulate the FED

            There are two current and different calls for regulation of the Federal Reserve Bank.  One is that more oversight is required from Congress.  Senator Rand Paul is leading this charge.  Unfortunately for Senator Paul, the Supreme Court has already ruled that the Federal Reserve among other entities is independent.  So while having to answer with audits to show no wrong doing, fiscal responsibility, etc. the board of the FED will act as it sees fit to best handle the economy. 

Another movement is out there that the FED should be made to follow rules almost in a flow chart fashion; if this happens - then do that.  So, like Ohm’s Law which states that if voltage goes up, current goes down, the FED should abide by rules that govern the rates at the discount window, how much in bonds should be purchased and other like rules.   The business world in general and conservative punditry in particular constantly rail against the Government to quit vacillating on laws and tax rates that adversely affect business.  This would allow the planning which business needs to be able to invest in equipment, supplies and other long term expenditures. 

There is a Republican-sponsored bill currently up for discussion in the House of Representatives that would put this style of a rule into place.  It would allow the Federal Open Market Committee to change this only with congressional approval by the Government Accountability Office (Miller, 2014). 

 

            The Taylor Rule: A rule that suggests appropriate adjustments to interest rates, based on various economic factors such as inflation and employment rate.  The rule indicates that if inflation or unemployment rates are higher than desired, interest rates should be increased in response to these conditions, and the opposite actions should be taken under the opposite conditions (Taylor Rule, 2014).

 

            In his opinion piece for the Wall Street Journal, John Taylor claims that the economy does well when the Federal Reserve follows rules.  Mr. Taylor points out the booms of 1923 to 1928 and 1986 to 2002 as examples.  But he does not mention the Mellon tax cuts of 1921 or the Reagan tax cuts.  Nor does Mr. Taylor give too easy credit terms in the 1920’s or the ridiculous mortgage terms of the 2000’s their due in helping cause busts in the economy.  Taylor goes on to cite the National Industrial Recovery Act of the 1930’s as a change in FED policy instead of laying the blame for this economic travesty at the feet of FDR and the Congress du jour who passed it into law with the New Deal (Taylor, 2014). 

 

The Opposing Opinion

            After all, responses to The Roaring Twenties, the Great Depression, and the Housing Booms that followed the returning troops from World War II and during the Bush presidency, the economy after the Kennedy tax cuts, or the one after the Reagan cuts that helped President Clinton pay off the national debt varied each and every time.  Had the FED been following rules to respond to these swings in the economy some economists and politicians claim the highs and lows would not be so dramatic.  The country would have been better served if a flow chart with the correct responses would have been followed (Miller, Bloomberg.com, 2014).  In addition, using the Taylor formula would have driven the interest rate into negative numbers during the popping of the housing bubble in 2008. 

            An oversight of the Taylor Rule is that there are often outliers that are beyond the scope of Mr. Taylor’s formula.  The equation would have mistaken the extreme winter weather of 2013 to 2014 as harbinger of deep economic downturn instead of a temporary shock.  This would have dropped interest rates fifty basis points needlessly. 

            Another problem with a cause and effect solution to the FED is that the numbers used are often released to great fanfare claiming some political advantage only to be corrected and re-released late Friday after the media has gone home for the weekend.  NOT that anyone would accuse the government of misleading numbers, cooking the books, or using misdirection but these numbers are after the fact anyway.  TARP and other laws and policies are better used as the horse is trying to get out, not in the next quarter after it has escaped the barn, jumped the fence and galloped off to pastures unknown.   

            Two former Federal Reserve Chairmen, Ben Bernanke and Alan Greenspan warn against this idea.  While not opposed to looking to the Taylor rule, or rules like it, as a tool to make policy, these hard fast rules do not allow the type of flexibility needed when volatile events rattle the nation’s economy to its foundations (Miller, 2014). 

            A prime example of a situation that no one could have predicted, or no formula could have cured the problem, was the Dutch Tulip Craze.  In 1593, one hundred and one years before the Bank of England was chartered, tulips were introduced to Holland.  This novelty of a flower created a fad market for tulip bulbs and the price increased.  The bulb became scarce and the law of supply and demand kicked in.  Prices of tulip bulbs skyrocketed.  The laws of greed and stupidity quickly followed causing the prices to further escalate until the overpriced bulbs rose some twenty times in value in short order.  Needless to say the price collapsed, the Dutch were too heavily invested in a worthless product and the government attempted an influx of cash to the market but was too little too late (Beattie).  The tulip bubble was unforeseen, so economic rules could not be put in place.  Any attempt to fix the problem on the way down was purely reactive and too little too late.  And the most important fact in this case was investors as usual are an unpredictable lot.  Once started, nothing could have corrected this bubble or the depression that followed.  From the Tulip craze to the housing bubble and resulting credit crisis, each boom and bust cycle is different from its predecessor. 

            Did the FED’s stable policy cause the good times of the 1920’s and the Reagan expansion or did the good times result in the FED’s stable policy?  Does the rooster crow because the sun rises or in the case of those who think the FED omnipotent, does the sun rise because the rooster summoned it by crowing?

            Wishing the FED adopt a stable monetary policy is similar to the Japanese manufacturing paradigm of the last century.  Improvements could only be made incrementally and industry changing ideas where shunned.  Thus, Compaq, Intel, Microsoft, Dell, Apple and others threw a game changing monkey wrench into the very stable growth industries of Sony et al.  The FED does not possess the foresight to ward off the next housing bubble, war economy or Bernie Madoff.  There is always a John Law or Richard Fudd waiting in the wings to unintentionally shoot torpedoes at the SS Economy.  Much of what the FED does when plans go awry is reactionary.  Had anyone known with certainty what Bear Sterns, Lehman Brothers and the rest would be facing, the troubled businesses would have been put in order before the panics. 

            In his paper “The Design and Communication of Systematic Monetary Policy Strategies” Andrew Levin comments on the inadvisability of a permanently fixed rule. Conditions may arise that are not captured by any of the models used for the rule.  Secondly, conditions will evolve over time which will cause the need to change the rule.  Having a FED independent of such rules allows it to adjust on current events and conditions; not those of pre-World War 1913 (Levin, 2014).

            On what theory, proof, fact or documentation would those who wish to regulate the FED base their rules?  Given this is the 100th anniversary of the Federal Reserve Banks; is that history enough to have a set of rules that are known to work in all cases?  As Andrew Levin states, "Clarity and transparency of communications play a key role in enhancing the effectiveness of monetary policy and in sustaining the central bank’s operational independence over time.”  This is what the FED should be doing to accommodate business who needs to plan not lock itself into a formula, flowchart or other foundation that results in lumbering results instead of swift action should the need arise.  The 465 cooks in the house and senate should keep their collective hands out of the FED’s soup.  The Federal Reserve must remain independent.  It should use tools such as the Taylor Rule and others in determining the best course of action.  It should by no means be locked into a cause and effect situation.  Only by being free to do what is needed can the FED escape the mindless bureaucracy that infects so many government institutions thus permitting economic status quo when shock and awe are absolutely necessary. 

 

Beattie, A. (n.d.). Market Crashes: The Tulip and Bulb Craze. Retrieved June 30, 2014, from investopedia.com: http://www.investopedi.com/features/crashes/crashes2.asp

Levin, A. T. (2014). The Design and Communication of Systematic Monetary Policy Strategies.

Miller, R. (2014, Aug 5). Bloomberg.com. Retrieved Aug 5, 2014, from www.bloomberg.com: http://www.bloomberg.com/news/print/2014-08-05/bernanke-greenspan-voice-doublts-about-tying-to-policy-rule.html

Taylor Rule. (2014). Retrieved July 22, 2014, from Investorwords: http://www.investorwords.com/6945/Taylor_Rule.html

Taylor, J. B. (2014, June 26). The Fed Needs to Return to Monetary Rules. Retrieved June 30, 2014, from Wall Street Journal: http://online.wsj.com/articles/john-taylor-the-fed-needs-to-return-to-monetary-rules-1403823464

Wikipedia.org. (n.d.). Retrieved June 30, 2014, from Wikipedia.org: http://en.wikipedia.org/wiki/Income_tax_in_the_United_States