FEDERAL RESERVE

Money 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 govern- ment has long made policy regarding the nation’s money on behalf of the people through their elected representatives in Congress.1 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 manage- ment 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 down- turn 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 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 addi- tional ways. First, like any other public institution, the Federal Reserve responds to the potential for political oversight when faced with challenges.

2 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 stabil- ity—but less so in a crisis.3 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.4 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 employ- ment, stable prices, and moderate long-term interest rates.”5 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 innova- tions 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.6 Collec- tively, 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 involv- ing 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 and bank credit. In the 1970s, the Federal Reserve’s mission was amended to maintain macroeconomic stability following the abandonment of the gold standard.7 This included making the Federal Reserve responsible for maintaining full employment, stable prices, and long-term interest rates. Supporters of this more expansive mandate claim that monetary policy is needed to help the economy avoid or escape recessions. Hence, even if there is a built-in bias toward inflation, that bias is worth it to avoid the pain of economic stagnation. This accommodationist view is wrong. In fact, that same easy money causes the clustering of failures that can lead to a recession. In other words, the dual mandate may inadvertently contribute to recessions rather than fixing them.

Limit the Federal Reserve’s lender-of-last-resort function. To protect banks that over lend during easy money episodes, the Federal Reserve was assigned a “lender of last resort” (LOLR) function. This amounts to a standing bailout offer and encourages banks and nonbank financial institutions to engage in reckless lending or even speculation that both exacerbates the boom-and-bust cycle and can lead to financial crises such as those of 199210 and 200811 with ensuing bailouts.

This function should be limited so that banks and other financial institutions behave more prudently, returning to their traditional role as conservative lenders rather than taking risks that are too large and lead to still another taxpayer bailout. Such a reform should be given plenty of lead time so that banks can self-correct lending practices without disrupting a financial system that has grown accustomed to such activities.

Wind down the Federal Reserve’s balance sheet. Until the 2008 crisis, the Federal Reserve never held more than $1 trillion in assets, bought largely

A far less harmful alternative is to focus the Federal Reserve on protecting the dollar and restraining inflation. This can mitigate economic turmoil, perhaps in conjunction with government spending. Fiscal policy can be more effective if it is timely, targeted, and temporary.8 An example from the COVID-19 pandemic is the Paycheck Protection Program, which sustained businesses far more effectively than near-zero interest rates, which mainly aided asset markets and housing prices. It is also worth noting that the problem of the dual mandate may worsen with new pressure on the Federal Reserve to include environmental or redistributionist “equity” goals in its policymaking, which will likely enable additional federal spending.9 to influence monetary policy.12 Since then, these assets have exploded, and the Federal Reserve now owns nearly $9 trillion of mainly federal debt ($5.5 trillion)13 and mortgage-backed securities ($2.6 trillion).14 There is currently no government oversight of the types of assets that the Federal Reserve purchases.

These purchases have two main effects: They encourage federal deficits and support politically favored markets, which include housing and even corporate debt. Over half of COVID-era deficits were monetized in this way by the Federal Reserve’s purchase of Treasuries, and housing costs were driven to historic highs by the Federal Reserve’s purchase of mortgage securities. Together, this policy subsidizes government debt, starving business borrowing, while rewarding those who buy homes and certain corporations at the expense of the wider public.  Federal Reserve balance sheet purchases should be limited by Congress, and the Federal Reserve’s existing balance sheet should be wound down as quickly as is prudent to levels similar to what existed historically before the 2008 global financial crisis.15

Limit future balance sheet expansions to U.S. Treasuries. The Federal Reserve should be prohibited from picking winners and losers among asset classes. Above all, this means limiting Federal Reserve interventions in the mortgage-backed securities market. It also means eliminating Fed interventions in corporate and municipal debt markets. Restricting the Fed’s open market operations to Treasuries has strong economic support. The goal of monetary policy is to provide markets with needed liquidity without inducing resource misallocations caused by interfering with relative prices, including rates of return to securities. However, Fed intervention in longer-term government debt, mortgage- backed securities, and corporate and municipal debt can distort the pricing process. This more closely resembles credit allocation than liquidity provision.

The Fed’s mortgage-related activities are a paradigmatic case of what monetary policy should not do. Consider the effects of monetary policy on the housing market. Between February 2020 and August 2022, home prices increased 42 percent.16 Residential property prices in the United States adjusted for inflation are now 5.8 percent above the prior all-time record levels of 2006.17

The home-price-to-median-income ratio is now 7.68, far above the prior record high of 7.0 set in 2005.18 The mortgage-payment-to-income ratio hit 43.3 percent in August 2022—breaking the highs of the prior housing bubble in 2008.19 Mortgage payment on a median-priced home (with a 20 percent down payment) jumped to $2,408 in the autumn of 2022 vs. $1,404 just one year earlier as home prices continued to rise even as mortgage rates more than doubled. Renters have not been spared: Median apartment rental costs have jumped more than 24 percent since the start of 2021.20 Numerous cities experienced rent increases well in excess of 30 percent.

Stop paying interest on excess reserves. Under this policy, also started during the 2008 financial crisis, the Federal Reserve effectively prints money and then “borrows” it back from banks rather than those banks’ lending money to the public. This amounts to a transfer to Wall Street at the expense of the American public and has driven such excess reserves to $3.1 trillion, up seventyfold since 2007.22 The Federal Reserve should immediately end this practice and either sell off its balance sheet or simply stop paying interest so that banks instead lend the money. Congress should bring back the pre-2008 system, founded on open-market operations. This minimizes the Fed’s power to engage in preferential credit allocation.