R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 13 The Federal Reserve and Central Banking LEARNING OBJECTIVES After studying this chapter, you should be able to: 13.1 Explain why the Federal Reserve System is structured the way it is 13.2 Explain the key issues involved in the Fed’s operations 13.3 Discuss the issues involved with central bank independence outside the United States © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 13 The Federal Reserve and Central Banking IS THE FED THE GIANT OF THE FINANCIAL SYSTEM? •In May 2010, Congress took the unusual step of ordering an audit of the Fed’s emergency lending programs •The financial crisis highlighted the importance of the Fed and the strong influence its chairman has on the economy •But should the unelected head of the central bank have so much power? Economists and policymakers have debated this question for decades •An Inside Look at Policy on page 404 discusses how recent nominees to the Fed’s Board of Governors support the Fed’s expanded role in the financial system © 2012 Pearson Education, Inc Publishing as Prentice Hall Key Issue and Question Issue: Following the financial crisis, Congress debated reducing the independence of the Federal Reserve Question: Should Congress and the president be given greater authority over the Federal Reserve? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 43 13.1 Learning Objective Explain why the Federal Reserve System is structured the way it is © 2012 Pearson Education, Inc Publishing as Prentice Hall of 43 Creation of the Federal Reserve System • The Bank of the United States was created to function as a central bank, but the Bank rapidly accumulated enemies Local banks resented the Bank’s supervision of their operations • Congress granted the Bank a 20-year charter in 1791, but without enough Congressional support to renew its charter, the Bank ceased operations in 1811 • In 1816, Congress established the Second Bank of the United States, also under a 20-year charter The Second Bank encountered many of the same controversies as the First Bank and its charter expired in 1836 • Severe nationwide financial panics in 1873, 1884, 1893, and 1907—and accompanying economic downturns—raised fears in Congress that the U.S financial system was unstable without a central bank Finally, the Federal Reserve Act that created the Federal Reserve System became law in 1913 The Structure of the Federal Reserve System © 2012 Pearson Education, Inc Publishing as Prentice Hall of 43 Federal Reserve System The central bank of the United States • Economic power within the Federal Reserve System is divided in three ways: Among bankers and business interests Among states and regions Between government and the private sector • Four groups within the system were empowered to perform separate duties: The Federal Reserve Banks Private commercial member banks The Board of Governors The Federal Open Market Committee (FOMC) • All national banks—commercial banks with charters from the federal government—were required to join the system State banks—commercial banks with charters from state governments—were given the option to join The Structure of the Federal Reserve System © 2012 Pearson Education, Inc Publishing as Prentice Hall of 43 Federal Reserve Banks Federal Reserve Bank A district bank of the Federal Reserve system that, among other activities, conducts discount lending Figure 13.1 Federal Reserve Districts Division of the United States into 12 Federal Reserve districts was designed so that each district contained a mixture of urban and rural areas and manufacturing, agricultural, and service industries Note that Hawaii and Alaska are included in the Twelfth Federal Reserve District. â 2012 Pearson Education, Inc Publishing as Prentice Hall of 43 Making the Connection St Louis and Kansas City? What Explains the Locations of the District Banks? • When the Fed was created, district banks were intended to have much more independence than they have today • The Reserve Bank Organizing Committee was given the task of determining district boundaries, which remain unchanged since 1914 • Were the locations of Federal Reserve Banks influenced by politics? There was agreement about six of the cities: Boston, Chicago, New York, Philadelphia, St Louis, and San Francisco • A study about this controversy concluded that economic variables could correctly predict the cities chosen, while political factors could not So, while it may seem odd today for Missouri to have two Federal Reserve Banks, it appears to have made economic sense in 1914 The Structure of the Federal Reserve System © 2012 Pearson Education, Inc Publishing as Prentice Hall of 43 • Who owns the Federal Reserve banks? • When banks join the Federal Reserve System, they are required to buy stock in their District Bank So, in principle, the member banks own the District Bank • To prevent one constituency from exploiting the central bank’s economic power at the expense of another, Congress restricted the composition of the boards of directors of the District Banks • The directors represent the interests of three groups: Banks Businesses The general public • Member banks elect three bankers (Class A directors) and three leaders in industry, commerce, and agriculture (Class B directors) The Fed’s Board of Governors appoints three public interest directors (Class C directors) The Structure of the Federal Reserve System © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 43 The Principal–Agent View Principal–agent view A theory of central bank decision making that holds that officials maximize their personal well-being rather than that of the general public • This view predicts that the Fed acts to increase its power, influence, and prestige as an organization, subject to constraints placed on it by principals such as the president and Congress • If the principal–agent view holds, we would expect the Fed to fight to maintain its autonomy—which it does The Fed has frequently resisted congressional attempts to control its budget • The Fed successfully lobbied Congress to strip most of the provisions that would have reduced its independence from the final version of the Dodd-Frank Act How the Fed Operates © 2012 Pearson Education, Inc Publishing as Prentice Hall 29 of 43 • According to the principal–agent view, the Fed could manage monetary policy to assist the reelection efforts of presidential incumbents who are unlikely to limit its power • The result would be a political business cycle, in which the Fed would try to lower interest rates to stimulate economic activity before an election to earn favor with the incumbent party running for reelection • The facts for the United States don’t generally support the political business cycle theory Nevertheless, the president’s desires may subtly influence Fed policy • One study found a close correlation between changes in monetary policy and signals from the administration that they desired a policy change How the Fed Operates © 2012 Pearson Education, Inc Publishing as Prentice Hall 30 of 43 Fed Independence Arguments for Fed Independence • The main argument for Fed independence is that monetary policy—which affects inflation, interest rates, exchange rates, and economic growth—is too important and technical to be determined by politicians • Because of the frequency of elections, politicians may be shortsighted, concerned with short-term benefits without regard for potential long-term costs • The public may well prefer that the experts at the Fed, rather than politicians, make monetary policy decisions • Another argument for Fed independence is that complete control of the Fed by elected officials increases the likelihood of political business cycle fluctuations in the money supply How the Fed Operates © 2012 Pearson Education, Inc Publishing as Prentice Hall 31 of 43 Arguments against Fed Independence • The importance of monetary policy for the economy is also the main argument against central bank independence • In a democracy, elected officials should make public policy The public could hold elected officials responsible for perceived monetary policy problems • If the central bank was controlled by elected officials, monetary policy could be coordinated and integrated with government taxing and spending policies • Some critics note that the Fed failed to assist the banking system during the economic contraction of the early 1930s Also, Fed policies were too inflationary in the 1960s and 1970s Finally, some analysts believe that the Fed ignored the housing market bubble in the early 2000s and then moved too slowly to contain the effects on the financial system when the bubble finally burst in 2006 How the Fed Operates © 2012 Pearson Education, Inc Publishing as Prentice Hall 32 of 43 Making the Connection End the Fed? • The U.S Constitution does not explicitly give the federal government the authority to establish a central bank • Opponents of the First and Second Banks saw them as a means of unconstitutionally exerting federal power over the states • The standard argument in favor of the constitutionality of the Federal Reserve is that Article 1, Section of the U.S Constitution states that Congress has the power “To coin money [and] regulate the value thereof .” Congress delegated this power to the Federal Reserve under the Federal Reserve Act • Modern arguments against the Fed have been mostly based on whether an independent central bank is the best means of carrying out monetary policy During 2008, Congressman Ron Paul ran for the Republican nomination for president and argued forcefully that the Federal Reserve should be abolished • Given the Fed’s power and the fact that its officials are unelected, its role will remain a subject of debate among economists and policymakers How the Fed Operates © 2012 Pearson Education, Inc Publishing as Prentice Hall 33 of 43 13.3 Learning Objective Discuss the issues involved with central bank independence outside the United States © 2012 Pearson Education, Inc Publishing as Prentice Hall 34 of 43 • The degree of central bank independence varies greatly from country to country • In the United States, board members serve longer terms than in other countries, implying nominally greater independence In other countries, the head of the central bank serves a longer term than the chairman in the United States, implying somewhat greater political control in the United States • An independent central bank is free to pursue its goals without direct interference from government officials and legislators An independent central bank can more freely focus on keeping inflation low • The European Central Bank is, in principle, extremely independent, whereas the Bank of Japan and the Bank of England traditionally have been less independent By the late 1990s, both had become more independent and more focused on price stability Central Bank Independence outside the United States © 2012 Pearson Education, Inc Publishing as Prentice Hall 35 of 43 • The Bank of England, founded in 1694 and one of the world’s oldest central banks, obtained the power to set interest rates independently in 1997 • The Bank of Japan Law, in force since April 1998, gives the Policy Board more autonomy to pursue price stability • The Bank of Canada has an inflation target as a goal, which is set jointly by the Bank of Canada and the government While the government has the final responsibility for monetary policy, the Bank of Canada has generally controlled it • The push for central bank independence to pursue a goal of low inflation has increased in recent years Indeed, in most of the industrialized world, central bank independence from the political process is gaining ground as the way to organize monetary authorities Central Bank Independence outside the United States © 2012 Pearson Education, Inc Publishing as Prentice Hall 36 of 43 • What conclusions should we draw from differences in central bank structure? • Many analysts believe that an independent central bank improves the economy’s performance by lowering inflation without raising output or employment fluctuations • The most independent central banks had the lowest average rates of inflation during the 1970s and 1980s • The central bank also must be able to set goals for which it can be held accountable The leading example of such a goal is a target for inflation • Central banks in Canada, Finland, New Zealand, Sweden, and the United Kingdom have official inflation targets, as does the European Central Bank The U.S Fed has only an informal inflation target Central Bank Independence outside the United States © 2012 Pearson Education, Inc Publishing as Prentice Hall 37 of 43 The European Central Bank • The European Central Bank (ECB) is charged with conducting monetary policy for the 16 countries that participate in the European Monetary Union, or Eurosystem, and use the euro as their common currency • The ECB’s organization is similar to that of the U.S Fed The ECB’s executive board, chaired in 2010 by Jean-Claude Trichet who serves as president of the ECB, has six members who work exclusively for the bank • Board members are appointed by the heads of state and government, based on the recommendation of the Council of Ministers of Economics and Finance, after consulting the European Parliament and the Governing Council of the ECB • Executive board members serve nonrenewable eight-year terms The governors of each of the member national central banks serve a term of at least five years The long terms are designed to increase the political independence of the ECB Central Bank Independence outside the United States © 2012 Pearson Education, Inc Publishing as Prentice Hall 38 of 43 • In principle, the ECB has a high degree of overall independence, with a clear mandate to emphasize price stability, following the lead of the Bundesbank (Germany’s central bank) • Whether legal independence is enough to guarantee actual independence is another matter, however National central banks have considerable power in the ECB The governors of the European System of Central Banks (ESCB) hold a majority of votes in the ECB’s governing council • While the ECB statute emphasizes price stability, countries have argued over the merits of expansionary or contractionary monetary policy This conflict became particularly evident during the financial crisis of 2007–2009, when countries such as Greece, Spain, and Ireland urged that the ECB follow a more expansionary policy Countries such as Germany that had fared better during the financial crisis were reluctant to see the ECB abandon its inflation target Central Bank Independence outside the United States © 2012 Pearson Education, Inc Publishing as Prentice Hall 39 of 43 The European Central Bank and the 2010 Sovereign Debt Crisis • The 2007-2009 financial crisis affected the 16 countries of the European Union to differing extents, but the individual countries were not able to pursue independent policies in response • During the crisis, these countries also suffered from large government budget deficits To finance the deficits, they issued bonds, or sovereign debt A sovereign debt crisis ensued when the debt issued by Greece, Ireland, Spain, and Portugal came into question • On May 10, 2010, the ECB intervened by buying 165 billion worth of bonds ECB President Jean-Claude Trichet argued that the intervention was necessary to ensure that the affected governments would still be able to raise funds and to protect the solvency of European banks that had purchased large amounts of these government bonds Central Bank Independence outside the United States © 2012 Pearson Education, Inc Publishing as Prentice Hall 40 of 43 Answering the Key Question At the beginning of this chapter, we asked the question: “Should Congress and the president be given greater authority over the Federal Reserve?” Economists and policymakers have debated how independent the Fed should be from the rest of the government In 1913, the Federal Reserve Act placed the secretary of the Treasury and the comptroller of the currency—both presidential appointees—on the Federal Reserve Board In 1935, Congress removed these officials from the board to increase the Fed’s independence During the debate over financial reform in 2010, Congress gave serious consideration to allowing the president to appoint the presidents of the 12 reserve banks, although this proposal was dropped from the final version of the Dodd-Frank Act Given its importance in the financial system, it seems inevitable that economists and policymakers will continue to debate the merits of the Fed’s independence © 2012 Pearson Education, Inc Publishing as Prentice Hall 41 of 43 AN INSIDE LOOK AT POLICY U.S Senate Questions Three Nominees to Fed’s Board of Governors NEW YORK TIMES, Fed Nominees Support Expanded Duties Key Points in the Article • As the U.S Senate was nearing passage of a financial reform bill in 2010, the Senate Banking Committee heard testimony from three nominees to the Federal Reserve Board • In their testimonies, Janet Yellen stated that job creation would be a high priority for monetary policy; Sarah Bloom Raskin expressed concern for the social costs of joblessness; and Peter Diamond commented on the relevance of behavioral economics in interpreting complicated financial events • Christopher Dodd, chairman of the Banking Committee, said that the draft financial reform legislation called for removing much of the Fed’s authority in areas where it did not perform well during the financial crisis But in the end, the Senate supported retaining and strengthening the Fed’s supervisory role © 2012 Pearson Education, Inc Publishing as Prentice Hall 42 of 43 AN INSIDE LOOK AT POLICY In July 2010, when the Senate Banking Committee was drafting the reform bill to deal with the financial crisis, there were only four members of the Board of Governors, including the chairman, Ben Bernanke © 2012 Pearson Education, Inc Publishing as Prentice Hall 43 of 43 ... Prentice Hall CHAPTER 13 The Federal Reserve and Central Banking IS THE FED THE GIANT OF THE FINANCIAL SYSTEM? •In May 2010, Congress took the unusual step of ordering an audit of the Fed’s emergency... of 1 913 established the Federal Reserve System and incorporated a series of checks and balances into the system However, informal power within the Fed is more concentrated in the hands of the. . .CHAPTER 13 The Federal Reserve and Central Banking LEARNING OBJECTIVES After studying this chapter, you should be able to: 13. 1 Explain why the Federal Reserve System is structured the way