Essay Sample on an Independent Federal Reserve

Introduction

The Federal Reserve System (or the Federal Reserve or the Fed) is the central bank of the United States (the U.S.). It comprises 12 regional reserve banks, approximately 2,000-member commercial banks, the Board of Governors of the Federal Reserve System, the Federal Open Market Committee (FOMC), and the Federal Advisory Council (Mishkin, 2016). Congress established it in 1913 when it enacted the Federal Reserve Act (Mishkin, 2016). The financial panic of 1907 largely influenced the Fed's creation (Mishkin, 2016). The U.S. Congress gave the Fed the mandate to maximize employment, stabilize prices, and moderate long-term interest rates by using monetary policies (The Fed, 2016). These duties have since expanded to include control over commercial banks (Dadkhah, 2009; The Fed, 2016).

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The responsibilities of the Fed are critical not only to the U.S. but also the entire globe. To enhance its efficiency and allow it handle the enormity of its responsibility efficiently, the Federal Reserve Act and its subsequent amendments (of 1935 and 1951) makes it, perhaps, the most independent government agency in the world (Conti-Brown, 2015). This independence, however, has been the source of intense debate among policymakers (Dadkhah, 2009). Some of them argue for while others argue against the autonomy of the Fed. Therefore, this paper evaluates the arguments of both sides and the literature on the effect of an independent central bank in relation to macroeconomics principles.

The Nature of the Fed's Independence

To effectively evaluates the merits or demerits of an independent Federal Reserve, it is crucial to understand the nature of its freedom first. Mishkin argues that the Fed enjoy both types of autonomy that Stanley Fischer proposes central banks typically have - the instrument and goal independence (p. 367). The instrument freedom is the ability of a central bank to formulate monetary policy, and the goal independence is the ability of the central bank to set the goals of the monetary policy (Mishkin, 2016). The two freedoms shields, the Federal Reserve from political pressures that handicap other government agencies (Mishkin, 2016). Additionally, the Fed Board of Governors enjoys the protection of tenure for they are appointed for 14 years and cannot be expelled from office (Mishkin, 2016). The tenures are, technically, non-renewable (Mishkin, 2016). These factors lessen the incentives for the members of the Board to perform their duties in favor of the president or Congress (Mishkin, 2016).

Additionally, the Fed is the only entirely self-directed budgetary entity in the US (Conti-Brown, 2015). The Fed pays for its expenses from the money it makes from the securities it holds and loans made to banks (Peter Conti-Brown, 2015; Mishkin, 2016). It then accounts for the expenses it incurs before remitting net to the Treasury. This budgetary freedom protects the Fed from the appropriations procedures of Congress (Mishkin, 2016). Also, its monetary policy or foreign exchange market transactions are not subject to the federal auditing agency (the General Accounting Office) (Mishkin, 2016). For true power to control usually arise from financial restrictions, the autonomy to manage own finances is the strongest pillar of the Fed's independence (Mishkin, 2016).

An Argument for Independence

One of the most critical roles of the Fed is to control inflation and maintain stable prices. To achieve this, the Fed increases interest rates to limit the supply of money in the economy (Moss,). High-interest rates make borrowing to be expensive, decrease the spending power, forcing a decrease in productivity in the short-term (Mankiw, 2008). As a result, unemployment rises. This monetary policy is thus painful to pursue and it may undercut incumbent politicians if it needs to be implemented during an election year (Moss, 2014; Mishkin, 2016). In a democratic nation, politicians are shortsighted by the desire to win elections. This desire thus persuades them to go for short-term solutions such as reducing unemployment and interest rates. The solutions (increase in employment and low-interest rates) cause an increase in the supply of money that rises consumers' purchasing power, resulting in inflation in the long-run. If the Fed was not independent of political pressure, it is likely to fall under the influence politicians seeking re-election, and ignore the macroeconomic principle that there is trade-off inflation and unemployment only exists on the short-run. Therefore, the Fed needs to be independent to avoid imparting an inflationary bias to the monetary policy (Mankiw, 2008). Also, an independent central bank is likely to be concerned with the policy's long-term goals and it is thus it is a credible defender of a sound dollar and stable prices (Mishkin, 2016). On the other hand, if the Fed was under the influence of the president or Congress, it is likely to pursue a high money growth policy without considering that that will cause inflation and even higher interest rates in the long-run (Mankiw, 2008; Mishkin, 2016).

Another version of the preceding argument suggests that there exists a political business cycle in the US due to the nation's political process (Mishkin, 2016). The cycle commences immediately before an election when expansionary policies are pursued to curb unemployment and interest rates. These flawed policies eventually lead to high inflation and high interest to control (Alesina, 1988; Mishkin, 2016). Once the election is over, the country needs contractionary policies that politicians anticipate the public will forget before the subsequent election (Alesina, 1988; Mishkin, 2016). Evidence support that placing the Fed under the control of the executive branch or Congress may aggravate the cycle (Mishkin, 2016).

An additional reason the Fed should be autonomous arises from the danger that placing it under the control of the Treasury or a governmental fiscal agent will make it answerable to the president (Mishkin, 2016). The regime may then misuse the Fed by forcing it to finance extensive budgetary deficits by purchasing the government's securities (Mishkin, 2016). The Fed will thus be under coercion by the government disguised as a call for rescue. This undue influence will leave the Fed without an option but to oblige if it lacks autonomous, leading to more inflation. However, an independent Fed will withstand such pressure from the government (Mishkin, 2016).

Additionally, the control of the monetary policy is extremely fundamental to the health of the economy to be left under the care of politicians, who typically exhibit a lack of expertise when it comes to making difficult calls (Mishkin, 2016). These decisions include reducing budgetary deficits or reforming the financial structure (Mishkin, 2016). Also, the government and the Fed are agents of the public, which result in the principal-agent problem (the Fed and politicians are under a moral hazard to act in their own interests as opposed to public ones due to existing incentives) (Mishkin, 2016). This problem is more pronounced among politicians as, compared to the Fed, they have fewer incentives to act in the public interest (Mishkin, 2016).

An Argument Against Independence

The main argument against an independent Federal Reserves is that monetary policies are so significant to the economy as they affect almost every person in the country. As such, it is undemocratic to leave it under the control of a few individuals who answer to no one. Further, unlike with politicians, there are no guidelines to remove members of the Fed form office if their performance is poor. Though proponents of a dependent central-bank appreciate the significance of the Fed to chase long-term monetary goals, they contend that Congress also has been vastly successful in voting for long-term matters such as foreign policy.

The other argument is that the public holds the government answerable for the economic welfare but has does not do the same to the Fed, though it has the most crucial mandate for influencing the wellbeing of the economy. Also, the fiscal (which is handled by politicians) and monetary policy (which is under the Fed) are disorganized. Therefore, there is a need for both of these policies to be under the control of politicians, which will create an opportunity for the two to coordinate to promote economic stability for they will work in concert and not at cross-purposes.

The opposition to the independence of the central bank further points to its historical failure to appropriately use its autonomy. For example, they argue the Fed implemented excessively expansionary monetary policy in the 60s and 70s, causing rapid inflation. Also, question marks remain over the Fed failures to apply its lender of last resort designation during the great depression. There is also a concern that the Fed is not insusceptible to political influence. There is thus some fear the Fed might use its autonomy to implement narrow, self-interest course of actions instead of those that are in public interest.

An Analysis of the Arguments for and Against an Independent Fed vis-a-vis Macroeconomic Principles

It is vital to pursue monetary policies in line with prevailing macroeconomic factors and not political whims. To control inflation and stabilize prices in an economy, the Fed largely depends on decreasing the growth of money. This decrease in the money supply relies on an increase in interest rate, moderating employment, and reduction in government spending. These interventions make borrowing expensive, cause output fluctuations, and eventually result in increased unemployment (Alesina, 1988; Mankiw, 2008; Mishkin, 2016). These outcomes may be painful to the public, and thus they are usually politically unpopular. Because rational people make decisions at the margins and only chose an option that has incentives (Mankiw, 2008), politicians will likely to use high money growth and employment to secure re-elections (Mishkin, 2016). These policies increase the supply of money and the purchasing power and ultimately lead to high inflation (Mankiw, 2008).

However, the Federal Reserves is run by economic experts who know that high money quantity in an economy causes inflation and that there is a short-term trade-off between inflation and unemployment (Mankiw, 2008). As a result, it is going to make the prudent decision of increasing interest rates to avoid paying a greater deal in the long-run (Mankiw, 2008). The Fed will, however, achieve that if it is free from political pressures. In sum, shielding the Fed from direct political pressure from the president and Congress will reduce the inflation bias, partisan variability in monetary policy, and pre-electoral manipulation of monetary policy (Alesina, 1988).

In essence, evidence from various countries indicates that the level of inflation is inversely proportional to the degree of independence of the central bank (Mishkin, 2016). However, it is not desirable to pursue low inflation rates at the expense of poorer real economic performance (Mishkin, 2016). Luckily, evidence points out that the independence of central banks does not necessarily imply high unemployment and output fluctuations (Mishkin, 2016). The financial crises of 2008 showed to us that monetary policy could have overwhelming effects on other real economic variables (Mishkin, 2016. Though trends show more countries are granting their central banks more independence with the expectation of maintaining low and stable inflation, there is always a lurking hazard that a self-regulating central bank will not be accountable (Mishkin, 2016). Therefore, delegating the authority to make far-reaching monetary policy to an independent agency requires guaranteeing its accountability (Mishkin, 2016). Alth...