There are many reasons for disliking the Federal Reserve, and readers often encounter a wide variety of these reasons in articles and commentary by financial writers and economists. It is often the case, however, that many critics of the Fed attack the Fed for the wrong reasons.
For example, one will often see Fed critics attacking the Fed for not lowering interest rates enough or soon enough. This is just one variation of the idea that the Fed is not doing things “correctly.”
Another criticism is that the Fed is not acting “independently” enough or that the Fed has abandoned its old way of doing things in some imagined golden age of central banking.
These sorts of criticisms, however, are generally premised on the idea that the Federal Reserve would be a benign or beneficial institution if only the Fed did “its job”—whatever that means—in a way the critic finds to be satisfactory.
This misguided and fanciful view of the Fed tends to center around three Fed myths. They are:
- The Fed would do a good job if it were more independent.
- The Fed can help restrain the central government’s bad fiscal policy.
- The Fed can properly plan the economy if the Fed avoids a “policy error.”
In practice, the Fed, by its very nature, won’t do any of this. And it never has. The Fed has never been a brake on federal profligacy, and the Fed has never been independent of political concerns or institutions. Moreover, the Fed cannot plan the economy, abolish business cycles, or otherwise guide the US economy to better outcomes than the market can.
Myth One: Fed “Independence”
The first myth is well entrenched among Fed observers, especially among professional academic economists. Beginning in freshman year, economics students are inculcated with the false notion that the Federal Reserve has “independence,” and thus pursues monetary policy based strictly on economic data and dispassionate concern for optimal economic performance. In this fantasy, central bankers disregard pressure to craft policy in a way that benefits the elected government and its interest groups. In the real world, of course, this myth is obviously untrue and thousands of pages written by historians and political scientists have shown that the Fed is a profoundly political institution which is very sensitive to political pressure from the White House and other institutions. (For examples, see here, here, and here.)
Yet, today we still see Fed critics—including those who self-identify as favoring free markets—embrace the myth and some will complain that “the Fed is losing its independence!” Or they might say that “the Fed used to be independent but now it’s not, and that’s why Bad Thing X is happening.”
This attitude is based on a version of good-ol’-days history in which the Fed was somehow doing things “right” because it was apolitical. Well, those days never existed. In fact, the Fed has always been an enthusiastic participant in helping the central government pursue political goals.
Myth Two: The Fed Helps Restrain Federal Fiscal Policy
The US federal government and the Fed often engage in a joint dog and pony show in which some reporters ask a Federal Reserve official about the current state of US fiscal policy. The Fed official then says something about how federal deficits and federal debt are a problem. The implication is that the Fed official disapproves of Federal deficit spending, and is somehow above the fray.
Some politically naïve observers fall for this ruse and take it to mean that the Fed is somehow working behind the scenes to restrain federal spending, deficits, and debt. There is zero evidence that this happens. In fact, the evidence all points to the opposite. As I note here, the Fed has always explicitly made itself available to help push down borrowing costs for the federal government, and to “accommodate” federal spending:
Fed Chairman William McChesney Martin is known for supposedly “taking away the punch bowl” during times of economic boom in order to tamp down price inflation. That may have been Martin’s preference, but as federal spending accelerated during the 1960s, the Treasury increasingly called upon the Fed to enable larger deficits without allowing Treasury yields to rise. The “guns and butter” policies of the Great Society and the Vietnam War meant the Fed would have to work closely with the Treasury to get the executive branch the deficit funding it wanted. This policy came to be called “coordination.” As [Allan] Meltzer puts it, Martin “agreed that the Federal Reserve should assist in financing the deficit because Congress approved it. Thus, he accepted ‘coordination.’”
Things have hardly improved since then, and federal deficits have exploded over the past 45 years. It is simply not the case that the Fed traditionally worked to rein in federal spending during some legendary time of the past.
Fostering more federal spending is what the Fed does, and we can’t say that things would be different if the Fed only got better leadership and did things “right.” There’s no fixing this because enabling federal profligacy is baked into what the Fed is.
Myth Three: The Fed Can Smooth Out Business Cycles
This is probably the most common myth repeated by Fed critics of a wide variety of backgrounds. Monetarists like this one, and will often criticize the Fed for inflating the money supply too much or not enough. (Friedmanites, after all, still stick to the debunked idea that the Great Depression was caused by too little monetary inflation.)
The assumption here is that it’s perfectly fine for the central bank to centrally plan the economy, just so long as the bank picks the “correct” policy. By “correct” policy, it is meant that the Fed will raise the target interest rate at just the right time and then lower it against at just the right time. The thinking is that the Fed’s central planners will minimize the effects of the business cycle and perhaps even avoid recessions entirely.
On the other hand, if the Fed is “late” in lowering interest rates, or raises the target rate “too high” then the Fed—according to this theory—has committed a “policy error.”
Of course, in this way of thinking, the problem with the Fed isn’t that it is manipulating markets and centrally planning the economy. No, the only problem is that the Fed isn’t doing it properly. If one buys into this idea, the answer isn’t to abolish the Fed or greatly limit its powers. No, the “solution” is just to put a different group of central bankers in charge. The new group, it is assumed, will then implement the “correct” monetary policy.
This is all based on false hopes as well since it is impossible for a Fed technocrat—or anyone else—to know how far the central bank should adjust the target policy rate up or down. The real problem is that there is an institution—i.e., the Fed—that has the power to engage in this type of central planning and market manipulation.
The Fed cannot smooth the business cycle or make recessions go away. In fact, the real life history of the Fed shows that the Fed has never prevented a recession or “smoothed” the business cycle. As Murray Rothbard has shown, the Fed has been propagating the causes of economic depressions its entire existence.
All the Fed can do—and indeed, all it does do—is expand the money supply to drive up asset prices, create bubbles, and hope that price inflation doesn’t get “too bad.”
Once we have a solid understanding of why central planning by central banks doesn’t work, we see that “policy error” is never that the Fed allows short-term rates to rise “too high for too long.” The real policy error is the central bank’s creation of business cycles by artificially expanding credit and the money supply.
The Fed critics who believe that the Fed need only manipulate the economy “correctly” are living in a fantasy in which the Fed will do the exact opposite of what it was created to do. The Fed exists to expand the money supply because that siphons off wealth to the benefit of the central government. This helps fund regime wars and augment the regime’s financial power. It’s not a coincidence that central banks are erected by the ruling classes who control national governments. The ruling classes don’t do this for the good of ordinary people. The ruling classes create central banks because central banks are good for the ruling class.
Dreams about “sound management” and “a return to fiscal responsibility” do little more than propagate the idea that central banks will do a good job so long as the right people are in charge.
