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Episode 8 - Independence, Part II

Why political independence is so crucial to a well functioning central bank. Also, an explanation behind the Audit the Fed movement. 

Intro

This is The Bankster Podcast, and I am Alexander Bagehot. This is Episode 8 - Independence, Part II. Every episode I dive into the intricate world of central banking! I use one or two pieces of news from the Federal Reserve or monetary policy from around the world to summarize, translate, and explain a few points from the Centralverse. The Centralverse is the deep, the fascinating, the ever changing, and the incredibly consequential world of central bankers and the economies they attempt to support.

On Episode 7 - Independence, Part I we learned about the incredible story of how the Federal Reserve gained true political independence from the executive branch of government. If you didn't get a chance to listen to that one, don't worry. In today's episode we’ll talk about why independence even matters. By the end you'll understand why it's important and then you can go back and listen to Episode 7 to figure out how it was fought for and won.

But before we get going I have a few exciting announcements that I hinted at in the last episode. First of all, I was thrilled to see that Episode 3 - The Committee, Part I, about the creation of the federal open market committee, which is arguably the most important committee in the entire world, has been featured on the Federal Reserve’s official history website. You can find a link to the article where it's featured on the show notes or directly on my website www.thebanksterpodcast.com.

But wait, you ask, what are show notes? Well, good question observant listener. This leads to my second exciting announcement. Starting today you can sign up on my website to receive the show notes to each episode emailed directly to you. Through this email channel I will also provide occasional extra features from The Bankster Podcast and Centralverse bonuses.

One example of the bonus material you can look forward to if you sign up is a monthly book recommendation. There are hundreds of volumes that have been written about the Centralverse, and I've read a good number of them. Each month I'll recommend one that stands above the rest. Sign up before the next episode and you can look forward to the first installment of the book review. There’s also a new page on the website called Their Words where I will feature the books from the book recommended bonus email, as well as I’ll feature pictures of my growing collection of rare and valuable Centralverse books.

Here in the United States last week, we celebrated Independence Day at beaches and parks, enjoying hot dogs and fireworks, and inevitably forgot to reapply the sunscreen and ended the day with sunburns. So now let’s turn our attention to what independence looks like in the Centralverse and why it's so important.

News

To start off we are going to use the news section of today’s episode to address one of the loudest, most frequent, and highly misunderstood complaints about the Federal Reserve System. This complaint drills down to the fundamental principle of central banking independence. It comes up every couple of months and gained special attention last month when congressman Ron Paul introduced a bill in the House of Representatives with the slogan of the complaint. This happens to be the very same slogan that I heard on my first day as an intern in a big, new city. I walked right past a group of protesters chanting, “Audit the Fed! Audit the Fed!”

Now, doing this podcast has given me the opportunity to talk a lot about the Federal Reserve and central banking. The people I’ve spoken with span the gamut of understanding of the Centralverse, from employees at the Securities and Exchange Commision to middle school students. And this question about central bank audits comes up over and over and over again. The Federal Reserve itself gets this question so frequently that it has placed a permanent, big link on their homepage with the title, “Does the Fed get audited?” So let’s start with what the Fed’s PR group has to say about the issue, and then we’ll look a little deeper into what the issue is really about.

When you follow the link on the homepage you are taken to a bulleted list of ways in which both the office in Washington DC where the Governors work and the 12 Federal Reserve Banks are audited and reviewed. The list includes audits and reviews by two government agencies: (1) the Government Accountability Office, which is the, “independent, nonpartisan agency that works for the US Congress”, and (2) the Office of the Inspector General which provides, “independent and objective oversight” of the Federal Reserve and Consumer Financial Protection Bureau. Both of these audits and reviews are published in an annual report from the Board of Governors. This annual report, as well as a historical file of past year’s audit reports, can be found on the Board of Governor’s website. So we have two watch dogs under the government’s wing keeping tabs on the workings of the central bank. But is there anybody else?

Well, yes there is. The next bullet from the Fed’s list says that every year all of the financial statements of the Federal Reserve System are audited by an independent accounting firm. The 2015 financial year end audit was completed by KPMG and the previous few years before that it was Deloitte. These are both Big 4 accounting firms.

Now, after reviewing and researching this bulleted list of audits, reviews, and we haven’t even mentioned the congressional hearings that members of the Board of Governors are required to attend, one might ask, “Hold on. If the Fed is so thoroughly audited, what is the big deal about the protests to Audit the Fed? What do those people want?” If that’s what you’ve wondered as I’ve described the Fed’s answer to the audit question then you are on the right track. Because there is something that is exempt from an official government or outside audit or review. Something that the Fed didn't mention on their list. And that is the monetary policy setting committee. Remember them? We talked about them in great detail in Episodes 3 and 5, in the United States the committee is called the FOMC.

This group and the decisions that they make in regards to interest rates are not subject to political oversight. And this is what we are talking about when we talk about central bank independence.

Now when you hear politicians, radio hosts, or your friends talking about Auditing the Fed, you will know what they are and are not referring to (whether they know the difference themselves is a completely different question). But the most important thing will be that you recognize what aspects of central banks are reviewed namely - the financial statements. And the aspect that is not reviewed - the monetary policy committee. So now that we have that established. We can move on from the news section and talk about why an independent monetary policy committee is so important. But before we do that we need to set the stage. We are going to wind the clocks back to 18th century America.

Why It Matters

The preamble to the Constitution of the United States, which begins We The People (which by the way, I always hear the School House Rock Preamble song whenever I hear the words “we the people”. If you haven’t heard of School House Rock, you need to check them out and you can find a link on my website). Anyways, the Constitution is the principal legal document upon which the United States was formed, and the Preamble is the introduction. Therein it says that one of the goals of the government will be to, quote,  “promote the general Welfare”.

Over a hundred years later the government decided that the best way to promote the general welfare of the citizens and businesses within the country would be to establish an independent central bank. If you remember back in Episode 1, I mentioned that the Federal Reserve Act was passed in 1913 largely due to the failure of the government to respond to a financial crisis that had arisen because of one bank’s failed business. The government was unable to help, not because they didn’t want to, but because they couldn’t. But if the bankers and speculators had lost their money or even lost their jobs and that was the end of it, the government would have been fine. The constitution mentions nothing about promoting the welfare of New York banks or even Texas oil or Florida oranges or Silicon Valley technology companies. However, unfortunately, financial panics ignite with a small spark, spread like wildfire, and cause widespread and lasting damage to the general welfare of individuals, families, and businesses across the country.

The government decided that they needed to do something about this inability to respond to economic crises of this nature. See, politics have always struggled with two major issues: (1) it is slow moving and (2) the incentive structure is often short term. Let me explain. In order for the government to spend any kind of significant amount of money on stemming a financial panic, the Treasury Department needs support from Congress, who controls the budget. Both the House and Senate of Congress have to debate how much money to give and under what conditions. Then upon agreeing on the terms the president has to sign the bill authorizing the Treasury Department to spend the money to stymie the panic. If you want to watch another great School House Rock song about the challenges of passing a law, check out the song called I’m Just a Bill. As you watch the video imagine that the little paper bill is the authorization for emergency measures to be taken to stop a financial melt down. It’s slow. The process is complicated and drawn out.

The second issue is one that has plagued politics for a long time - the incentive structure. Economists, especially traditional economists, love to talk about incentives. In most situations incentives influence our decision making process. Imagine your least favorite food. Do you have it? Now, would you eat it if I gave you $1? How about $10? How about $1,000? $100,000? The money is the incentive and it would influence your decision about whether or not you’d eat the yucky food. Not every decision we make is purely based on emotionless personal benefit maximizing decisions. Behavioral economics has shed a lot of light on this for us; however, it doesn’t change the fact that many, if not most, of our decisions are highly influenced by the incentives that surround us.

So let’s think about the basic incentives for politicians. We can take the members of the House of Representatives as an example. They are up for reelection every 2 years. Which means they have to go back before their constituents, meaning the people in their district, every 2 years. So their incentives are to make decisions that will keep their constituents happy for the next 2 years. It’s hard, and against basic incentives, for a politician in the House of Representatives to make a tough choice that will hurt for a few years but be better in the long term.

After many debates and internal inspection the Congress of 1913 recognized that these issues were keeping them from promoting and maintaining the general welfare of the people during times of economic crisis. They decided to create a central bank. And in this new central bank they would take away those two issues that politics face: (1) slowed to act by procedures and sheer number of people and (2) short term incentives. They created the Federal Reserve and gave it the freedom (although not fully recognized for many decades later as we learned on Episode 7) to act swiftly and decisively; unhindered by congressional committees or the president’s opinion polls or anything else. They also made the terms length of the terms the governors would serve be 14 years long and limited them to just one term to avoid the short sighted incentives problem.

Two simple, real examples from the modern Federal Reserve illustrate the importance of central banking independence. In the Fall of 2007 and into 2008 financial industries around the world began to falter and quickly collapsed. The employment market would follow the financial markets and shed jobs dangerously fast. Not far from the wildfire example I mentioned earlier. The Fed responded in a number of different ways which we’ll talk about in depth on later episodes, but one significant thing that they did is lower the base interest rate. They were able to do this almost immediately. They cut rates incredibly rapidly and quickly brought them all the way to zero. This began in September of 2007. The Federal Reserve Bank of St Louis has an incredible timeline of the Financial Crisis that you can find a link to on my website or in the show notes for today’s episode if you sign up for the emails.

As a counter example on the politics side, it would take until October of 2008 (over a year later) before the Federal Government was able to pass TARP (which was basically the legal authorization I mentioned earlier for the Treasury Department to spend money to help in the rescue efforts). Now I don’t mean to demean or belittle the importance of democracy, or the Federal Government in maintaining a healthy economy. They play a huge roll and they must work in concert with the central bank to maximize prosperity. However, the government is slow and it helps to have the central bank’s agility to act quickly and decisively.

For the other example, the incentive scheme, we’ll dial back a few decades and revisit the inflation crisis of the 70’s. Inflation was running out of control and it was only the determination of the Chairman of the Federal Reserve, Paul Volcker, that finally reigned in the inflation. Looking back it’s easy for us to say, “Good job Mr Volcker, exactly what I would have done!” But it was not an easy decision. In fact the previous chairmen, Arthur Burns and William Miller, had done just the opposite. They had let the money supply grow and grow and inflation run steep.

When Volcker raised the rates the economy fell into a recession. It was a short recession but it still cost jobs in the short run. This is the kind of decision that congress wanted the Federal Reserve to have the power to make. To be able to make challenging decisions that have negative, short term consequences, but even greater long term benefits. Central banks are able to focus on the long term employment situation and the long term stability of prices. These are two goals that the government has mandated that the Federal Reserve work towards. These goals fit under the bigger goal of providing for the general welfare.

We’ll keep exploring how central banks are asked to, sometimes fail to, and other times succeed in accomplishing this goal. But no matter the outcome, one of the principle foundations of central banking is being able to make monetary policy decisions independently from the political arena. Every sector of the Federal Reserve is audited, except the monetary policy committee, and after this episode I hope you can see why bankers, businessmen, and citizens encouraged their government over a hundred years ago to ensure that the central bank would be granted political independence. If you missed it, go back and check out Episode 7 to learn about the incredible story behind how this independence was finally solidified in the 1950’s.

Conclusion

If you have comments, recommendations, or questions about the The Bankster Podcast or the Centralverse in general, you can email me, alexander@thebanksterpodcast.com. At my website you can find a transcript of today’s episode with links to all of the sources I used in creating the content, including a link to the financial crisis timeline. And I encourage everyone to go to the website, scroll to the bottom of the home page and sign up to receive each episode’s show notes and the bonus book suggestions.

One complaint I've heard from listeners, and it's a complaint that is not unique to this podcast, is how to share it with others when you don't know how they listen to podcasts, or if they even know what a podcast is. Well, I've created a simple solution. Another new page on The Bankster Podcast’s website is called Listen, and whenever you'd like to share the podcast you can simply post on social media or share directly the following link: www.thebanksterpodcast.com/listen. It's as simple as that. From that webpage anyone can select from a list of mobile applications and websites the way they do it. If you check it out and find another way that I haven't accounted for send me an email and I'll make sure to add it to the list. Thanks so much to all of you for listening. This has been an incredible learning experience and The Bankster Podcast will only grow and expand as the months go on!

I’d like to thank those of you that wrote a review last week. FrighteningMountainLionAttack said, “I am impressed with the stories told from the history of the central bank”. Keep sharing the podcast and sending in your reviews via whatever podcast app you use.

Today’s episode was written, edited, and produced by me, Alexander Bagehot. I dedicate this episode to Jackie and Heather. Who contribute to making each episode coherent. They also drove my stuff clear across the country to help me follow a dream I’d worked towards for years. And to all of you, thanks for listening. I’m Alexander Bagehot, and I’ll see you next time on The Bankster Podcast!

 

Episode 9 - Say What?

Episode 9 - Say What?

Episode 7 - Independence, Part I

Episode 7 - Independence, Part I