May 18, 2023

How Congress Should Reform the Fed

It’s very difficult for elected officials to hold the Federal Reserve accountable. Is that a problem? 

There’s a strong counter-majoritarian tradition in American politics. The Constitution itself strictly limits what simple majorities, acting through their representatives, can accomplish. Contemporary central banking’s “democratic deficit” could be a feature, not a bug.

While we should always be wary of populist passions, the Fed’s insularity from the political process plausibly creates more problems than it solves. No less an economist than Milton Friedman thought that the Fed should be brought under the supervision of the Treasury or Congress. Friedman worried the central bank’s “independence” made it a law unto itself, sheltered from the consequences of its habitual mistakes. As the economy struggles with historic inflation and a wave of bank failures — both of which the Fed should have prevented — it’s worth considering alternatives.

Constitutionally, the Fed is a creature of Congress. The legislature created the Fed in 1913 not as a substitute for the gold standard and the National Banking System, but as a complement. The Fed was supposed to serve as a quasi-public clearinghouse to facilitate emergency liquidity transfers between banks to make the US system less panic-prone. But the onset of World War I spelled the end of this relatively limited mandate. The Fed began experimenting with monetary policy powers to support the market for government debt. Thus began a process of mission creep that resulted in the Fed becoming what its earliest proponents promised the public it never would: a central bank.

It’s time for the legislature to re-assert its control. The Fed’s recent dalliances with social and environmental policy have nothing to do with its legal grant of authority. Climate change and systemic inequality are valid policy areas for the United States Congress, but unless and until it says otherwise, not for the Fed. Hence Congress’s first order of business is passing legislation keeping the Fed within its legally prescribed lanes.

Second, Congress should separately crack down on the Fed’s experimentations with a central bank digital currency (CBDC). This is a dangerous technology that would give the government unprecedented access to and control over private financial transactions. CBDC would not meaningfully improve the operation of monetary policy or the pursuit of financial stability. All it would do is grant central bankers the power to redirect the flow of commerce by, for example, selectively processing payments, or debiting accounts to stimulate spending. Congress should pull the plug on the Fed’s pilot program and make it totally clear that CBDC is not permitted, absent enabling legislation.

It’s also time for the legislature to reconsider the dual mandate. There’s no need for the Fed to focus on full employment separately from price stability. In a fiat money economy, aggregate demand (nominal spending) stability is all a central bank can reasonably influence. And price stability is a consequence of aggregate demand stability. (Yes, the possibility of supply shocks complicates this. But such shocks are by nature temporary, and historically are much rarer than aggregate demand instability as a source of economic malaise.) Congress should accordingly narrow the Fed’s mandate to keeping the dollar’s purchasing power steady and predictable.

Finally, Congress needs to fix the Fed’s bank oversight and last-resort lending policies. The Fed is supposed to regulate banks and discount loans when the need arises. It’s very bad at both. Fed regulation has not made the banking system safer. If anything, it’s contributed to “too big to fail,” which results in recurrent crises. 

As for discounting, the Fed refuses to make any serious distinction between the illiquidity and insolvency of its counterparties. Making emergency funds available to the latter rewards the reckless bank behavior that gets us into trouble in the first place. Congress should narrow the Fed’s regulatory concerns to maintaining adequate bank capital. It should also consider abolishing the discount window entirely. Direct loans are unnecessary. Open-market operations can keep the financial system liquid.

Whether we like it or not, the Fed is one of the most important — if not the most important — economic institution in the country. It must be made to serve the public interest. The Fed should adhere to the rule of law. Right now, it only adheres to the rule of central bankers. A congressional course correction is long past due.