The late, great economist and historian of the Federal Reserve, Allan Meltzer – whose three-volume history of the Fed stands alone as a magisterial, meticulous analysis of Fed decision making – frequently testified before Congress about the failings of the Fed and how to fix them. Meltzer would point out that, over its first century, the Fed’s policy record can only be regarded as successful less than a third of the time (which includes most of the 1920s, the years from about 1991 to about 2001, and a few more years here and there). The rest of the time the results were bad by any imaginable standard.
The Fed caused the Great Depression through persistent monetary contraction (1929-1933), was forced by that failure to cede control over the money supply to the U.S. Treasury (1934-1951), accommodated huge deficits to produce an unprecedented U.S. inflation in the 1960s, presided over stagflation in the 1970s, caused a major recession followed by numerous banking crises in the 1980s, from 2002 to 2006 it helped to engineer the housing bubble that produced the subprime crisis, and it created a new surge of inflation when it accommodated the fiscal binge of 2020-2021 by delaying its response to that surge by a full year.
Meltzer’s analysis concluded that there were two main contributors to Fed failures: bad thinking about the economy (the Fed often misunderstood the effects of its own policies), and interference by the Executive Branch that caused inflationary accommodation of deficits. Underlying those failures has been a deeper institutional failure to make the Fed accountable for its errors. Mistaken thinking goes uncorrected, and politicization is routinely denied, and therefore, never addressed. This is not properly understood as a Fed shortcoming; our government has failed to create the institutional framework that ensures Fed accountability.
Regular hearings where the Fed Chair explains Fed actions to Congress have little effect. Committee members point to bad outcomes and ask wide-ranging questions, but given the many qualitative (and often conflicting) objectives established by Congress for the Fed (price stability, full employment, interest rate stability, and financial stability), there is no clear bottom-line measure to apply when grading Fed actions. Fed Chairs find it easy to run out the clock, noting that they have had some successes, explaining the challenges of forecasting, expressing sympathy for the viewpoints expressed by critics, and providing vague assurances that they will take everything into account.
With respect to the problem of Executive interference in Fed policy, it is important to see the current attacks by President Trump from a broader historical perspective. Ironically, despite his bluster, Trump has not been, and is unlikely to become, the President most successful at manipulating the Fed. It’s just that other Presidents have been quieter about it, while often exerting more influence. Over most of its history, Fed independence from the Executive has been an aspiration rather than a reality. Fixing the Fed will require more than defeating Trump’s attempts to force resignations or install his cronies as Fed leaders; only deep governance reform will make it likely for the Fed to enjoy a helpful increase in its independence from the Executive going forward.
The failure to establish effective governance over the Fed reflects a deeper truth about U.S. monetary history. The governance structure for monetary policy is the result of reactive, myopic legislative responses to particular historical events rather than a thoughtful attempt to create a reliable and constitutionally grounded structure to ensure accountability.
That failure began with the Constitution itself. Article I, Section 8 of the Constitution gives Congress the power to “coin Money, [and] regulate the Value thereof.” But what does that mean? The American Revolution was funded (like the wars fought by the Colonists against the French and Indians) in large part by printing the Continental dollars issued under the Articles of Confederation, which were redeemed eventually at 1/100th of their face value. The huge “inflation tax” produced by depreciated Continental dollars left Americans jaded about paper money’s potential benefits.
At the Constitutional Convention, our founders failed to reach agreement about what monetary powers the federal government should have. They understood that the Executive should not be given the awesome authority of the printing press. And States were prohibited from issuing paper money or making it a legal tender. But Congress was not specifically granted those authorities under Article I, Section 8. Some favored granting those powers explicitly, while others favored prohibiting paper legal tender, and still others (who won the day) noted the important role paper money had played in funding the Revolution and argued that leaving the federal power vague would ensure that it would be used only in extremis.
That winning view was tested during the War of 1812, when government finances faced a crisis, and the path of least resistance was to issue bills of credit (which were receivable for taxes, but not made a legal tender for private debts). After the War, the bills were withdrawn and the government reverted to issuing only bonds to fund its needs. The founders smiled from heaven.
But then came the Civil War. Large funding needs were met initially by selling government debt to a consortium of banks. The Union’s prospects deteriorated in the fall of 1861, and the Treasury announced it would rely almost entirely on debt rather than taxes to fund what was likely to be a protracted war, causing bond prices to plummet. The solvency of the banking system came into doubt and the banks suspended convertibility. The government issued legal tender notes (later called Greenbacks) as a way to bail out the banks, as Bray Hammond and others have explained, because a depreciated dollar caused banks’ deposits to fall in value alongside their assets.
By 1870, it appeared that the Supreme Court would find the issuance of paper legal tender unconstitutional. To prevent the chaotic unwinding of the previous decade of financial transactions, President Grant packed the court with two Justices who he knew would find in favor of the government’s authority to declare paper money a legal tender, making that a permanent federal power. After 1871, not all the founders were still smiling about U.S. monetary history.
At the time the Federal Reserve was established, the dollar had been defined as a certain amount of gold (under the Act of 1900). Importantly, the Fed was not permitted to deviate from the gold standard. It bears emphasis: the Fed was not created to determine the value of the dollar because Federal Reserve Notes were not intended to be a fiat currency!
The Fed was created in 1913 mainly to reduce seasonality in the cost of credit, which resulted from the seasonality of the activities of planting and harvesting crops, which created seasonal peaks in credit demand in the spring and fall. Spikes in the seasonality of credit costs were also seen as contributors to banking instability (widespread suspensions of convertibility happened in 1873, 1893 and 1907). The Fed’s operations succeeded in smoothing seasonal cycles through its supply of discounts and advances (which funded bank credit demand spikes in the spring and fall), and that success was reflected in reduced seasonality in interest rates and reduced seasonal stock price volatility.
Under the Federal Reserve Act, the Fed was not a “central bank,” a fact which one of its architects, Senator Carter Glass, insisted upon. It was divided into twelve regional Reserve Banks, owned by commercial banks in their respective regions, and the Reserve Banks operated largely independently of one another in setting discount rates and deciding on credit policy. The Fed Board sitting in Washington D.C. had limited authority over credit policy initially.
Although Fed Board members working in D.C. were nominated by the President, the fact that the value of the dollar was set by Congress (under the gold standard), combined with the fact that the Board had little power over credit supply, meant that the President – through the power to nominate members of the Board – had virtually no influence on the value of the dollar.
All that changed in the Great Depression. In March 1933, the U.S. abandoned the gold standard. Now the dollar would be determined by the supply of fiat currency, such as Federal Reserve notes. Just as important, in 1935, the structure and governance of the Federal Reserve System was changed to centralize power over policy decisions and give greater power within the System to the (newly formed) “Board of Governors.” Prior to 1935, Presidential appointees in Washington had played an advisory role to the Reserve Banks. In 1935, the Board of Governors was given majority control over the centralized policy making body, the Federal Open Market Committee. Furthermore, only President Roosevelt’s appointments to the prior Board were allowed to serve on the new Board of Governors.
The combination of an end to gold convertibility and an increase in the power of the Board of Governors meant, de facto, that the President had – for the first time in U.S. history – substantial indirect power in the determination of monetary policy. Strictly speaking, one could say that was not consistent with Article I, Section 8, of the Constitution, but 1935 was not a time for strict speaking about the Constitution.
More importantly, the Executive’s monetary power in 1935 was not only indirect (through its nomination authority of Governors). Secretary Henry Morgenthau had pushed through legislation in 1934 establishing two important new conduits of fiat money creation (via the Exchange Stabilization Fund and the power to purchase silver with Treasury currency). These gave the Executive the power to create a large amount of fiat money. The Fed still had the power to control the supply of its notes, but Morgenthau noted that his authority to create notes was larger in magnitude than the Fed System’s existing supply. That meant that if the Fed tried to shrink the money supply, he could offset any such shrinkage. He chortled in his diary that the new funds he had pushed to create put him in charge of the overall supply of dollars and the value of the dollar, which was his intent:
…the way the Federal Reserve Board is set up now they can suggest but have very little power to enforce their will. . . . [The Treasury’s] power has been the Stabilization Fund plus the many other funds that I have at my disposal and this power has kept the open market committee in line and afraid of me.
Through its new monetary authorities, the Treasury had the power to intimidate the Federal Reserve into carrying out the administration’s policies. For example, when Fed Chair Eccles and Morgenthau clashed over the extent of money creation related to gold flows in 1936, Eccles was forced to back down when it became clear that the Treasury had the means and the political capital to conduct policy as it saw fit. This allocation of power was antithetical to the allocation envisioned by the Constitution.
The Treasury’s control over monetary policy lasted until the so-called Fed-Treasury Accord of 1951, under which the Treasury agreed to cede control over the supply of money back to the Fed. Underlying that agreement was an important fact: the monetization of Treasury debt during World War II had produced a major increase in the amount of Fed currency, while the Treasury’s powers to create money had not grown; the Fed was now able to shrink or expand the aggregate supply of money, and would be able to offset any changes produced by the Treasury if it wished to do so.
Although the Accord returned power over monetary policy to the Fed, the Executive continued to be able to exert authority indirectly through its appointment power, a permanent intrusion of the Executive into that Constitutionally established Congressional authority. As if to emphasize that fact, one month after the Accord was signed, President Truman appointed one of his cronies, Assistant Secretary of the Treasury, William McChesney Martin, as Fed Chair, after ousting the existing Fed Chairman, Thomas McCabe.
Ever since the Accord, the discussion of “Fed independence” recognizes the potential threat from Executive interference to promote myopically expanding the money supply to make the current Administration more popular. Presidents can choose to wield that power by appointing cronies to Fed positions, if they wish to do so. In practice, the record has been mixed, but it is typically the case that Presidents have been willing to try to undermine Fed independence when it suited their short-term interests to do so.
Under Presidents Eisenhower and Kennedy, inflation was low and economic growth was steady. There was little reason to try to influence the Fed, and both Presidents seem to have been content to allow Chair Martin to serve with little interference. Under President Johnson, the stakes were raised by accelerating inflation, and the Administration and the Fed sparred over policy (it was even reported that President Johnson shoved Chair Martin during an argument at his Texas ranch). It is hard to point to specific actions by the Fed that reflected Administration interference and Martin is often viewed as a paragon of Fed independence who emphasized the Fed’s accountability to Congress rather than the President. And yet, actions may speak louder than words: Although some Fed decisions displeased the Johnson Administration, overall, the Fed accommodated the spending binge of the Vietnam War and the Great Society, which drove the great inflationary surge of that time.
President Nixon had been a sharp critic of Chair Martin’s support of Fed tightening (which he blamed for his electoral loss to President Kennedy). Nixon appointed his Counselor to the President, Arthur Burns, as Fed Chair, and Burns served in that role from 1970 to 1978. Burns conferred closely with Nixon and was regarded as a Nixon loyalist. His refusal to address the stagflation of the 1970s – which would have required monetary tightening and a short-term contraction of economic activity – even brought him to argue that the Fed was helpless to end inflation, despite its control over the supply of money.
President Carter eventually appointed Paul Volcker as Fed Chair, someone who had privately confided to Carter that he would fight inflation even it meant causing a large recession. Carter appointed the staunchly independent inflation-fighting Volcker knowing that this outcome was likely. One explanation is that Carter realized that inflation had become a major political liability to his Administration; allowing it to persist arguably would have been even worse for him politically.
President Reagan’s election was due in part to the recession caused by the first Volcker tightening in 1979. Nevertheless, he too supported Volcker’s anti-inflation battle, and reappointed him, although the deep recession in 1982 almost cost Reagan reelection in 1984.
President George H.W. Bush (via his Treasury Secretary, Nicholas Brady) tried to control Fed policy under Chair Alan Greenspan. According to Brady – who invited me to his office in the 1990s specifically to tell me this story – he and Greenspan had agreed that Bush’s willingness to tighten fiscal policy (the abandonment of his “read my lips” promise not to raise taxes) would be worthwhile but should be offset by a Fed monetary expansion. Brady felt betrayed when Greenspan allegedly failed to follow through on his promise, which he believed cost Bush reelection in 1992.
There is little evidence I am aware of that either Presidents Bill Clinton or George W. Bush tried to influence Fed policy (at least prior to the 2008 crisis). But given the high growth and low inflation of that era, there was little policy advantage to be gained by them from interfering in Fed policy.
Presidents Biden and Obama followed the Truman and Nixon model in appointing many cronies to Fed leadership roles (most obviously, Governor Tarullo and Governor Brainard). For President Obama, crony Fed appointments mainly mattered through their influence on regulatory policy – especially through the actions of Governor Tarullo, who had substantial authority at the Fed over regulatory policy.
In the Biden era, the most important Presidential influence on the Fed likely resulted from the long-delayed reappointment of Chair Powell, which seems to have succeeded in getting the Fed to delay tightening for a year in response to accelerating inflation. The reappointment, announced in November 2021, with less than three months remaining before his term expired, was one of the most delayed reappointments in Fed history. It likely influenced the Chair to delay tightening both before the nomination and afterward. After accepting the Administration argument that inflation was a transitory problem that did not require tightening, it would have been unseemly to change policy advocacy too quickly after the reappointment. In contrast to President Trump, President Biden seems to have used his appointment power without publicly pressuring the Fed, which likely made the pressure more effective.
Another recent development at the Fed that has increased the power of the Executive over the Fed has been the abuse of the Board’s approval power with respect to the appointment of Reserve Bank Presidents. Fed Presidents, appointed by each regional Federal Reserve Bank’s Board, traditionally had been a source of independence from politics within the Fed. Recent Fed Presidents such as Charles Plosser, Thomas Hoenig, Esther George, Jeffrey Lacker, James Bullard, and Loretta Mester, often were sources of dissent from the views of the Chair at Federal Open Market Committee (FOMC) meetings.
Chair Janet Yellen reportedly set the precedent of using the Board’s veto power to push hard for the Atlanta Fed to appoint Rafael Bostic as its President (which made him the first African-American Reserve Bank President), in response to pressure she received from Ranking Member Maxine Waters. Reportedly, this practice has now become routine under Chair Powell, as the Board reportedly uses its veto power to effectively force Reserve Banks to appoint his favored candidates. This has increased the power of the Board by reducing the potential for dissent, and therefore, indirectly has increased the power of the Executive over FOMC decision making. Currently, in a sharp departure from the past, there are virtually no Reserve Bank Presidents known for playing the role of outspoken dissenter at FOMC meeting.
President Trump’s attacks on Chair Powell and Governor Lisa Cook are consistent with his tendency to openly and shamelessly make use of any lever of power within reach to further his plans. And Governor Miran (who retains his Administration position as Chair of the Council of Economic Advisers while serving at the Fed) is clearly a Trump crony who has committed in advance, and through his FOMC statements about the path of interest rates, to back maximum monetary loosening. But the above review of Fed history shows that Trump’s actions reflect more a new style than a new policy.
It is high time to fix Fed governance with a view to making it both successful and consistent with the Constitution’s Article I, Section 8 allocation of power. As Meltzer and many others have argued for decades, that isn’t as hard as you might think.
There are lots of good ideas being floated to improve the structure of the Fed and its independence. Several academics have proposed to foster diversity of thought and independence from the Executive by increasing the voting power of Reserve Bank Presidents at FOMC meetings to allow all Presidents to vote at each meeting. Currently only a subset of them vote at each voting. I support that proposal, but it would be much more effective if Congress also eliminated the (now abused) veto power of the Fed Board over Reserve Bank President appointments.
There is another proposed reform that would foster Fed independence more than any other: requiring the FOMC to announce a systematic policy framework.
That idea would require Congress to pass legislation requiring the FOMC to choose and announce an algebraic policy rule (which it could change over time) that would indicate how Fed interest rate changes should react to macroeconomic news. There are several versions of this proposal being discussed. Most economists who advocate this approach, like me, believe that for practical reasons the Fed should be able to construct the rule, not Congress, and the FOMC should be able to deviate from the reactions indicated by its rule in unusual circumstances. But having the rule in place would create a benchmark, and discretionary deviation from that benchmark would require explanations in Congressional hearings.
Without a statutory mandate, the Fed will never choose to constrain its own discretion by adopting a publicly disclosed benchmark rule for policy. Requiring the FOMC to agree on a rule would itself provide clarity to the market, as well as a basis for robust and germane questioning from Congress. Perhaps most importantly, having a benchmark in place would limit the abuse of discretion, and it would thereby insulate Fed leaders from Presidential pressures to abuse their discretion. If such a rule was in place in 2021, Chair Powell could have relied on it to explain the need to increase interest rates in response to inflation, and President Biden may have seen little point in delaying his reappointment.
