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FEDERAL RESERVE

Paul Winfree

oney is the essential unit of measure for the voluntary exchanges that

constitute the market economy. Stable money allows people to work

freely, helps businesses grow, facilitates investment, supports saving for retirement, and ultimately provides for economic growth. The federal government has long made policy regarding the nation’s money on behalf of the people through their elected representatives in Congress.’ Over time, however, Congress has delegated that responsibility first to the Department of the Treasury and now to the quasi-public Federal Reserve System.

The Federal Reserve was created by Congress in 1913 when most Americans lived in rural areas and the largest industry was agriculture. The impetus was a series of financial crises caused both by irresponsible banks and other financial institutions that overextended credit and by poor regulations. The architects of the Federal Reserve believed that a quasi-public clearinghouse acting as lender of last resort would reduce financial instability and end severe recessions. However, the Great Depression of the 1930s was needlessly prolonged in part because of the Federal Reserve's inept management of the money supply. More recessions followed in the post-World War II years.

In the decades since the Federal Reserve was created, there has been a downturn roughly every five years. This monetary dysfunction is related in part to the impossibility of fine-tuning the money supply in real time, as well as to the moral hazard inherent in a political system that has demonstrated a history of bailing out private firms when they engage in excess speculation.

Public control of money creation through the Federal Reserve System has another major problem: Government can abuse this authority for its own advantage

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by printing money to finance its operations. This necessitated the original Federal Reserve’s decentralization and political independence. Not long after the central bank’s creation, however, monetary decision-making power was transferred away from regional member banks and consolidated in the Board of Governors.

The Federal Reserve’s independence is presumably supported by its mandate to maintain stable prices. Yet central bank independence is challenged in two additional ways. First, like any other public institution, the Federal Reserve responds to the potential for political oversight when faced with challenges.? Consequently, its independence in conducting monetary policy is more assured when the economy is experiencing sustained growth and when there is low unemployment and price stability—but less so in a crisis.’ Additionally, political pressure has led the Federal Reserve to use its power to regulate banks as a way to promote politically favorable initiatives including those aligned with environmental, social, and governance (ESG) objectives.*

Even formal grants of power by Congress have not markedly improved Federal Reserve actions. Congress gave the Federal Reserve greater regulatory authority over banks after the stock market crash of 1929. During the Great Depression, the Federal Reserve was given the power to set reserve requirements on banks and to regulate loans for the purchase of securities. During the stagflation of the 1970s, Congress expanded the Federal Reserve’s mandate to include “maximum employment, stable prices, and moderate long-term interest rates.”° In the wake of the 2008 global financial crisis, the Federal Reserve’s banking and financial regulatory authorities were broadened even further. The Great Recession also led to innovations by the central bank such as additional large-scale asset purchases.

Together, these expansions have created significant risks associated with “too big to fail” financial institutions and have facilitated government debt creation.° Collectively, such developments have eroded the Federal Reserve’s economic neutrality.

In essence, because of its vastly expanded discretionary powers with respect to monetary and regulatory policy, the Fed lacks both operational effectiveness and political independence. To protect the Federal Reserve’s independence and to improve monetary policy outcomes, Congress should limit its mandate to the sole objective of stable money.

This chapter provides a number of options aimed at achieving these goals along with the costs and benefits of each policy recommendation. These recommended reforms are divided into two parts: broad institutional changes and changes involving the Federal Reserve’s management of the money supply.

BROAD RECOMMENDATIONS • Eliminate the “dual mandate.” The Federal Reserve was originally

created to “furnish an elastic currency” and rediscount commercial paper so that the supply of credit could increase along with the demand for money