Fed’s Independence Vital for a Stable Economy
CBS’s moneywatch.com site recently released an article by Mark Thoma on the independence of the Federal Reserve, and those very real political conditions that threaten it. This situation is dangerously close to a Catch-22 scenario. Here’s the problem: When politicians get involved with monetary policy, manipulating it in their favor in order to be reelected, inflation usually results, along with a cycle of debt perpetuated in the economy. If the Fed resists such manipulation, asserting their independence, politicians could in turn place legislative restrictions on its independence — penalizing the Fed’s independence by taking it away. If that’s not a Catch-22, I don’t know what is.
Thoma’s article mentions that this very problem is currently becoming manifest in the U.S. Congress. Two pending bills are circulating in Congress, one that seeks to eliminate much of the Fed’s regulatory authority and the other to allow its monetary policy to be audited. These bills were developed as a safeguard against the Fed putting the brakes on the political business cycle, during which monetary policy plays out quicker with regard to output and unemployment than it does with regard to inflation.
So, if an incumbent politician wants to increase his chances of getting reelected, he may want output to peak right around the time of the election. To do this, he increases the money supply months before the election to reap the benefits of increased output; however, the consequent inflation will not hit until months after output peaks. This politician has begun a cycle of manipulation. It would be a wise next step to tighten monetary policy after the election to avoid inflation, but more often than not this step is not taken, because cutting the money supply will decrease output, and output is already in a state of decline after having peaked. So, rather than being perceived as responsible for a decline in output, in order to to avoid inflation, the politician lets inflation take the lead.
In addition to this sort of scenario, there is the added problem of government debt. Of the three ways to finance government purchases — increasing taxes, issuing government debt, and increasing the money supply — the most beneficial choice from a politician’s perspective would be to increase the money supply, because its drawbacks aren’t as easily seen by constituents. This also results in inflation, and can be referred to as monetizing the debt. Luckily for the politician, the blame for this inflation can be readily placed on increased prices for oil and other commodities.
As health care costs rise, and the public debt becomes more of a problem, worried politicians are resorting to the application of pressure to the Fed to act in ways that will make their political skills seem more attractive to their constituents. Consequently, it is a real possibility that the price for Fed independence — which is vital to upholding a healthy economy from the yo-yo effect of political whims — may, in the end, be that very independence.