How the Fed got into a fight: The US Federal Reserve is 80 years old. James Forder argues it has not always been such a paragon in the war against inflation

Click to follow
The Independent Online
IT WAS 80 years ago today that the Federal Reserve came into existence as the central bank of the United States of America. Now the European Union has the goal of a single currency and a European 'Federal Reserve'.

Although before 1913 it was possible for the US to have a single currency without a central bank, today it is inconceivable that Europe should. What is more controversial is whether that Bank should be 'independent' of political control.

The advocates of independence often quote the Federal Reserve - along with Germany's Bundesbank - as a model of an independent central bank. But does 80 years of Federal Reserve history really suggest that central banking works best in the absence of political control?

The Fed is understandably proud of having been set up as an 'independent' bank, but today's idea of independence differs greatly from that which was current before the First World War. In modern Europe, it is said that wicked politicians must have their hands tied to stop them abusing economic policy for electoral gain.

But in 1913, the fear of America's farmers, led by William Jennings Bryan, was that the Federal Reserve, if created, would raise interest rates, benefiting the banking community at the cost of agrarian borrowers.

The Fed was 'independent', but this meant independent from Wall Street and the bankers. On the other hand, there were two representatives of the government on the board, including the Secretary of the Treasury. Putting the Chancellor of the Exchequer on the board of the Bank of England would not be thought to make it independent]

Nor was the Fed more independent when these representatives of the government were removed from the board in the 1930s. Far from being the champion of sound money and conservative economics, the chairman of the board, Marriner Eccles, was a confidant of President Roosevelt and more advanced than the president in his thinking on the possibilities for the New Deal.

The Fed only began to emerge as an independent player after the Second World War and three key dates stand out. The first was 1951, when it became impossible for the Fed to hold down the interest rate on government debt. The Treasury opposed a rate increase, as did President Truman, but the economic inevitability associated with the amount of government borrowing forced them to give in. After that, the Fed had at least limited discretion over interest rates.

The second landmark was associated with the presidential election of 1972, but the Fed can hardly score points for independence here. This was the year that Richard Nixon was re-elected and it was also the year of a monetary policy that was, conveniently for Nixon, far too loose. The American inflation that finally destroyed the Bretton Woods exchange rate system followed.

The circumstances of that inflation are all too suspicious. Arthur Burns was chairman of the Fed and an old friend of Nixon. They both believed that Nixon had lost the 1960 election to Kennedy because the Fed had not eased policy to get him elected. Then Sandford Rose in Fortune magazine openly accused Burns of threatening the Fed with presidential wrath if it failed to co- operate.

None of that, of course, is independent behaviour, but since the Rose accusation, the Fed has been unfailingly vigilant in asserting its independence and the public impression of its status has changed accordingly.

The third key event was the appointment of Paul Volcker as Fed chairman by a beleaguered Jimmy Carter in 1979. Volcker dominated world monetary politics during his time at the Fed with his determination in fighting inflation. With the election of Ronald Reagan he assumed an even more central role in economic policy-making.

But is the Volcker period an argument for determined, independent inflation-fighting by the central bank? How much did Volcker contribute to Carter's loss of the presidency? Would a less independent bank have done more to help Carter and less to fight inflation?

No, in fact it was Carter who was set on an inflation-fighting policy. Come the election he may have regretted the results, but it was his policy. Volcker was chosen by him to persuade Wall Street that inflation would be defeated. So in a sense it was Wall Street after all that ran the show. But it was Carter's policy, not the Fed's 'independence', that led to his downfall.

Two lessons for Europe stand out. Independence is an elusive quality. The Fed has been 'independent' for 80 years, but for whom? What does independence mean? Will it always mean what it means today?

Even on today's meaning - independence from those wicked politicians - what benefits come from this? None of us perhaps ever quite trusts politicians, but they can be voted out, as Carter was. Arthur Burns never lost an election.

The author is lecturer in the economics of European integration and Fellow of St Peter's College, Oxford.

(Photographs omitted)

Comments