The Federal Reserve was established in 1914 as independent
of the president and Congress—and for good reason. The Fed's founders
understood that politicians had to be blocked from using monetary policy to
juice the economy before elections. Extensive research supports the wisdom of
the Fed's political independence; monetary policy works best when it is
insulated from the vagaries of election cycles. The problem is that while the
Fed is largely independent of politicians, it is intimately connected, and even
answerable, to the financial institutions that it is supposed to regulate.
Consider the board of directors of the Federal Reserve
Banks. Nine directors oversee each of the 12 Federal Reserve Banks. Private
banks choose six of the nine. The other three are typically the CEOs of major
corporations or executives at other financial institutions, such as
private-equity firms.
Fed presidents are also deeply tied to financial
institutions. For example, the current president of the New York Fed was at Goldman
Sachs before taking over the Fed. His predecessor is now president of the
private-equity firm Warburg Pincus.
A growing body of academic research indicates that the stock
market values these bank-Fed connections. A 2013National Bureau of Economic
Research paper, "The Value of Connections in Turbulent Times: Evidence
from the United States," provides a case in point. In November 2008, when
it was announced that then-New York Fed President Timothy Geithner would
be nominated for Treasury secretary, the stock prices of financial firms with
which he had close personal connections soared relative to those of other
financial firms. Those same stock prices plummeted when his nomination briefly
ran into problems over his taxes.
Markets might be right about the value of close relations
with the Fed. A paper recently presented at the NBER by titled "Stock
Returns over the FOMC Cycle"—finds evidence suggesting that the Fed has
been leaking information. Senior Fed officials regularly gather between their
highly publicized Federal Open Market Committee meetings to discuss monetary
policy. Although the information from these lesser-known meetings is not
released to the public until weeks later, the authors found that stock prices
respond immediately after the meetings, suggesting that people and financial
institutions are trading and possibly profiting on information contained in
those meetings.
The Fed's multibillion-dollar assistance to financial
institutions occurred without transparency. After Bloomberg News filed a
Freedom of Information Act request in 2008 regarding the Fed's actions,
Congress urged the Fed to comply. The Fed refused and fought all the way to the
Supreme Court—which in 2011 ordered it to release the records. When the Fed
finally complied, it provided thousands of pages in a non-searchable PDF
format, making it difficult to piece together the relevant facts.
What to do? A few
simple reforms would be helpful. First, the tight links between the Fed and the
financial-services industry could be weakened by reconsidering the number of
Fed directors appointed by banks. Second, Fed officials should be required to
agree to a waiting period—perhaps as long as five years—after leaving the Fed
to take a position at a financial-services firm.
Third, there should be greater transparency and oversight of
the Fed's role as a financial regulator. Congress should establish
mechanisms—including a group of experts with the authority to demand
information from the Fed and the capabilities to assess Fed performance.
Such reforms will not be a panacea: They will not address
the extensive reach of finance into the political process of drafting and
implementing financial regulations. But they represent principled first steps.
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