Thursday, January 8, 2009

Reforming the Federal Reserve

The policy responses to the current crisis have exposed some bad governance problems with the Federal Reserve. Like most central banks, the Fed is fairly independent, and needs to be as otherwise there are massive incentives for electorally directed manipulation of the money supply. However, in the current crisis the Fed has used its independence to provide massive benefits to private interest, most notably with with Citibank bailout, ultimately from the pocketbook of the taxpayer.

Clearly it's totally unacceptable for any institution to effectively give hundred of billions of taxpayer money with no effective control. We'll pay for years covering the past year of thinly disguised giveaways. However, we don't want to put the Federal Reserve under the direct control of the President due to the need for independence.

To solve this dilemma, I have a simple proposal: the Federal Reserve will only be allowed to own debt explicitly guaranteed by the federal government. It will not be authorized to make any guarantees of any other assets, or to participate in any derivatives. It may make loans only when suitably collateralized by government-guaranteed debt. If the Fed needs to operate a discount window, it must first get guarantees from the political system, so it will no longer be able to effectively give away money without taxpayer control.

The Federal Reserve will still be able to control the money supply but it will only be able to use use its implicit call on taxpayer money to benefit government-guaranteed entities, which is restrictive enough. I think this proposal provides leeway for the Federal Reserve to perform its monetary function with adequate interference while ensure that benefits from government granted authority are controlled by Congress and the Executive branch.


Anonymous said...

I started following your blog because I liked your comment today at Yves Smith's shop: "Whether and when we get a dollar blowout is in the hands of the Asian Central Banks now..."

Re reforming the Fed, you yourself have observed that it isn't enough to make accurate predictions or to talk sense. The Bank of The Fed is indeed crowding out other lenders. Defacto nationalization is a terminal spiral.

I look forward to reading your future posts.

FairEconomist said...

Re reforming the Fed, you yourself have observed that it isn't enough to make accurate predictions or to talk sense.

Ow, blow out my momentary hopes of rationality, will you?

Yes of course you're right the implementation of decent ideas is more of a problem now than the generation of those ideas. I'm just more of an academic/economist than a political thinker so I'm focussing on what I can do.