Concerns about the Fed’s New Balance Sheet

That’s the title of a chapter I contributed to a new book edited by John Ciorciari and John Taylor entitled The Road Ahead for the Fed. The book grew out of a conference held at Stanford University in March.

In my chapter (a draft of which can be obtained here), I review the mechanics of what the Fed has been doing with its balance sheet, and then raise three concerns. One of my concerns is that the Fed’s new balance sheet has compromised the independence of the central bank:

The decision of where public funds are best allocated is inherently political. Any risks on the Fed’s new balance sheet are ultimately borne by the taxpayers. The U.S. Constitution specifies that decisions of how public funds get spent shall be up to Congress, and with good reason. Citizens have a right to vote on which risks they choose to absorb. And of course there are powerful established interests with views on which sectors should receive an infusion of public capital. The Fed is simply being naive if it thinks it can become involved in those decisions on a weekly basis and yet still retain its independence from Congress and the President.

The reason I find that loss of Fed independence to be a source of alarm is the observation that every hyperinflation in history has had two ingredients. The first is a fiscal debt for which there was no politically feasible ability to pay with tax increases or spending cuts. The second is a central bank that was drawn into the task of creating money as the only way to meet the obligations that the fiscal authority could not. Every historical hyperinflation has ended when the fiscal problems got resolved and independence of the central bank was restored.

Surely it is not far-fetched to suggest that the U.S. faces a profound political challenge in using spending cuts or tax increases to meet its current and planned fiscal obligations. Here’s an observation that brought that reality home to me on a personal level: in fiscal year 2006, receipts collected by the U.S. federal government from personal income taxes totaled $1.06 trillion. Thus, to a first approximation of what an extra trillion dollars in taxes would mean for me personally, I just take the number I paid in 2006 and double it. And then I ask myself, how likely is it that Congress would actually do such a thing? With budget deficits in excess of a trillion dollars annually for the foreseeable future, it seems we are already well past the point at which the ability of the Treasury to fund the expanded liabilities through tax increases would reasonably be questioned.

Moreover, the detailed cooperation between the Fed and the Treasury in the various new credit measures seems to have arisen from precisely such pressures. Congress is, in fact, unwilling to accept explicitly the risks to which taxpayers are exposed as a result of the many new Fed-Treasury initiatives. If I were the chair of the Federal Reserve, I would want to be asking, “why was I invited to this party?” The answer unfortunately appears to be, “because you’re the one with the deep pockets.” That the Fed should find itself in a position where Congress and the White House are viewing its ability to print money as an asset to fund initiatives they otherwise couldn’t afford is something that should give pause to any self-respecting central banker.

The book also includes a chapter by Donald Kohn in which the Fed’s Vice-Chairman responded to some of these concerns. Here is what Kohn had to say about Fed independence:

Have we compromised our independence? No. Central banks all over the world and the legislatures that created them have recognized that considerable independence from short-run political influences is essential for the conduct of monetary policy that promotes economic growth and price stability. To be sure, in the process of combating financial instability, we have needed to cooperate in unprecedented ways with the Treasury. Our actions with the Treasury to support individual systemically important institutions have sparked intense public and legislative interest. As Chairman Bernanke has indicated, the absence of a regime for resolving systemically important nonbank financial institutions has been a serious deficiency in the current crisis, one that the Congress needs to remedy. Congress and the public, quite appropriately, want to know more about lending programs that have greatly increased the scope and size of the Federal Reserve’s interventions in financial markets, and we will give them that information. In addition, our country, like others, is undertaking a broad examination of what changes are needed in our financial regulatory system. This examination will consider the role of the Federal Reserve in the supervision and regulation of financial institutions and the advantages and disadvantages of establishing a systemic risk authority.

It is natural and appropriate for our unusual actions in combating financial instability and recession to come under intense scrutiny. However, increased attention to, and occasional criticism of, our activities should not lead to a fundamental change in our place within our democracy. And I believe it will not; the essential role for an independent monetary policy authority pursuing economic growth and price stability remains widely appreciated and the Federal Reserve has played that role well over the years. The recent joint statement of the Treasury and the Federal Reserve included an agreement to pursue further tools to control our balance sheet, indicating the Administration’s recognition of the importance of our ability to independently pursue our macroeconomic objectives.

My chapter also discusses two other concerns about the Fed’s new balance sheet. The first is whether, insofar as the goal is to allocate capital to particular targeted categories, the Fed and Treasury have formed the correct vision of what we really want capital markets to be doing at the moment. A second concern is that the Fed’s new balance sheet has handicapped the Fed’s ability to fulfill its primary mission of promoting price stability. Specifically, I worry that the Fed’s new actions have made it harder both to avoid deflation and to assure the public that the Fed will prevent a resurgence of inflation.

The book also includes contributions from a number of other prominent individuals. I particularly recommend the thoughtful analysis by Andrew Crockett (president of J.P. Morgan Chase International) on whether the Fed is the logical institution to be given broader regulatory functions given the desirability of maintaining central bank independence.

You can read my chapter here, or order the book from Amazon.

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