Democracy Versus Bankers at the Fed

The Federal Reserve Board has provided the basis for thousands of conspiracy theories in its near 100-year existence. These conspiracies have some basis in reality as can be seen by the Fed's recent moves on monetary policy. In the last two meetings of the Fed's Open Market Committee (FOMC), the Fed's key decision-making body, the members appointed through the political process unanimously supported stronger measures to spur growth and create jobs. By contrast, three of the five voting members appointed by the banking industry opposed further action.

This extraordinary split has not received the attention it deserves. It suggests that the financial industry is using its power at the Fed to try to block the course preferred by the appointees of democratically elected officials of both parties.

The Fed is an enormously important if poorly understood institution. Its control of monetary policy (primarily short-term interest rates), gives it the ability to speed up or slow growth. It also has enormous regulatory power. Alan Greenspan could have used this authority to put a check on the junk loans that fueled the housing bubble in the years 2002-2006.

If the Fed wants to ensure that the economy does not grow too rapidly it can slow growth by pushing up interest rates. This was the cause of all the post-war recessions prior to the last two as the Fed raised interest rates in order to reduce growth and employment and, thereby, slow inflation.

The Fed can also boost growth by lowering interest rates. To counteract the current recession, the Fed lowered its short-term rate to zero. Since this is as low as interest rates can go – the Fed can't have negative interest rates – the Fed has tried to reduce long-term interest rates by measures such as the quantitative easing policies adopted in 2009 and 2010, and more recently the purchase of long-term bonds through “Operation Twist.”

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This is where the issues of control come in. The FOMC has 19 members. Seven of these members are governors of the Federal Reserve Board. These governors are appointed by the president and approved by Congress. They serve a 14-year term. The extraordinary length is intended to ensure their independence. They can use their best judgment without worrying that the current president or Congress will take away their job.

However, the other 12 members of the FOMC are not appointed by democratically elected officials. They are the 12 regional bank presidents. While the process of selecting the regional bank presidents is somewhat complicated, it is largely controlled by the banks within a region. This means that 12 of the 19 members of the FOMC are selected by the banks. At any point in time, only five of the 12 bank presidents have a vote. This gives the governors a 7-5 majority among the voting members, even though they are outnumbered 12-7 on the FOMC as a whole.

Most of the time, decisions by the FOMC are unanimous. The FOMC typically discusses the current economic situation for two to three hours and considers possible actions. By the time a vote is called, everyone has expressed their opinion so the outcome is already known. In the interest of showing support for the Fed, most members agree to support the majority decision to make it unanimous. Occasionally, one member will make a point of dissenting to show that he or she felt strongly about the issue being considered.

The last two meetings of the FOMC were extraordinary in that they featured not one, but three dissents. Furthermore, it was striking that all three dissents came from the bank presidents who were appointed by the banking industry.

The immediate issue at hand is whether the Fed should be trying to do more to boost growth and create jobs. The five governors (there are two vacancies) appointed through the democratic process all felt that it was important to do more to generate jobs. This was a bipartisan sentiment. Three of these members were appointed by President Obama, one was appointed by President Bush and one (Chairman Bernanke) was appointed by both.

However of the five people appointed by the banking industry, three voted against stronger measures. The likely explanation is that bankers don't care much about unemployment. After all, they have jobs, as do most of their friends. On the other hand, inflation is really bad news for banks. It directly reduces the value of their assets.

This means that when the Fed debates a policy that risks somewhat higher inflation in order to reduce unemployment, the bankers' answer is to screw the unemployed. The outrageous part of this story is that the bankers don't have to push their agenda as an outside interest group; they actually have seats directly given to them on the FOMC.

This would be like letting Pfizer or Merck pick two of the five commissioners for the Food and Drug Administration, or letting Comcast and Disney pick members of the Federal Communications Commission. All regulatory agencies are susceptible to inappropriate influence by the affected industry groups, but in the case of the Fed, the country's most important regulatory body, the industry group is already on the inside.

An overhaul of the Fed is long overdue. It should be turned into a body that directly answers to Congress just like every other regulatory agency. And the bankers must go. This would be a great way to mark the Fed's 100th anniversary in 2013. We can make it an institution that is consistent with democracy.