The Fed is a controversial institution on both the Left and the Right. Indeed, from the founding of the United States of America to the present day, there have been many influential figures who have opposed a national bank. Andrew Jackson opposed a precursor to the Fed – the Second Bank of the United States – because he felt that it stood for coastal elites and cronyism, and today people like Ron Paul oppose the Fed because they pine for the good old days of the gold standard. Much of this angst is fueled by the relatively undemocratic nature of the Fed. While the president and Congress have some oversight abilities and are able to appoint high level officials to the Fed, Fed decision-making and policy implementation is largely autonomous from the elected bodies of the United States government. This may be undemocratic, but it is ultimately in the best interest of the United States.
Before discussing the many advantages of an independent central bank, I first want to explain the basic role and duties of central banks. In short, central banks control the monetary policy of a country (or in the case of the EU, a supranational bloc). This means that interest rate policies and money printing are both controlled by the Fed. Central banks often have other duties as well. For example, they are sometimes tasked with financing the government’s budget deficits through buying securities and and making loans from their reserves, and they are sometimes also tasked with regulating and supervising commercial banks. Through buying and selling bonds and shifting interest rates, the Fed is able to indirectly control U.S. monetary policy, and this grants the Fed immense power over the direction of the nation’s economy.
Despite the immense power held by the Fed, voters do not have direct control over the nation’s monetary policy. While the Fed is certainly receptive to input from elected policymakers, it is under no obligation to comply with specific demands put forth by the President or Congress. Fortunately, this is actually not as bad as it sounds because the Fed still tries to generally align its policy with the actions of the Treasury – an agency that controls U.S. fiscal policy. For example, when the government pursued fiscal stimulus to respond to the 2008 Crisis, the Fed followed suit, implementing monetary stimulus measures to compliment and amplify the stimulus package passed by Congress. The Fed’s power is also checked by its charter, which mandates that the Fed work to control inflation and prevent large-scale unemployment. Thus, the Fed is legally bound to pursue the general interest of the American economy, preventing it from pursuing excessively crazy or misguided policies.
At this point you may still be unconvinced. After all, I might be correct in arguing that the Fed is still a relatively benign institution even without direct democratic oversight, but why not just make it fully subservient to Congress? If it is good now, wouldn’t making it directly accountable to the American people result in an even better institution? No, it would not. The reason for this is simple: politicians are myopic and election cycles are much shorter than economic cycles. If the Fed was subject to the whims of Congress, it would simply become a politicized tool to win elections. Incumbent politicians would demand ill-advised monetary measures to artificially inflate the economy before elections in an effort to boost their poll numbers. While this would help the economy in the short-run, it would create tremendous distortions down the road, potentially triggering frequent and devastating market contractions. For example, politicians might mandate excessively low interest rates to boost investment and grow the economy in the two or three quarters before the election. While this would certainly boost economic growth, it would also generate over-heating as firms engaged in riskier and riskier investments (a la the housing crisis). Ultimately, there is a reason we have a mixed government in which there exist both directly accountable legislators and shielded, disinterested technocrats. Full democracy is dangerous because uninformed voters and politicians could end up ruining the country. Full technocracy is also a poor choice because it prevents stake-holders and interest groups effected by government policy from weighing in and having their concerns addressed. By having a mixed system in which the fiscal side is controlled by directly elected representatives and the monetary side is controlled by a more autonomous (but still supervised) central bank, we create an imperfect, but more balanced system.
The central bank’s independence is controversial in part due to the importance of the economy. Many people probably wouldn’t mind if a relatively minor agency was autonomous, but the central bank – because of its significant influence on the economy – is a much more important and politically controversial institution. Really, though, central banks should not be that controversial. Indeed, the concept of a semi-autonomous central bank is similar in some regards to the arguments for federalism. Both center around the idea of granting smaller political and economic institutions some degree of autonomy and decision-making power due to their better understanding of certain issues. States understand their populace’s needs better than the federal government, and central bankers understand their economy’s needs better than elected politicians with no training in or understanding of macroeconomics. The similar justifications for federal systems and independent central banks are probably why Arend Lijphart finds a strong correlation between levels of federalism and central bank independence. Countries with a high degree of federalism like the U.S. and Germany have fairly independent central banks while unitary countries like New Zealand and Italy possess fairly weak central banks.
Yes, the Fed is fairly undemocratic. No, this is not all that bad. It is still subject to oversight from Congress and its charter has fairly strict demands that prevent the bank from disregarding the public’s desire for high levels of employment and price stability. Moreover, given how ineffective and dysfunctional the current Congress is, I’m none too distressed that they don’t have direct control over my currency.