Why the Idea of an Independent Federal Reserve is a Myth

Last Updated May 11, 2010 6:50 PM EDT

Commenting on congressional plans to leash the Federal Reserve, economist Mark Thoma articulates the standard division of labor between lawmakers and the agency. Under this view, politicians do their thing, which mostly has to do with mollifying voters, while Fed officials do theirs, which involves directing the U.S. economy. And never the twain shall meet.

The only problem with that is it's a myth. He writes:

The Fed is supposed to do things that politicians cannot do themselves because of the voter outrage it would cause. The idea is that politicians have very short-run horizons. Their goal is to get reelected, and they will generally do whatever it takes to try to ensure that outcome. Thus, policies that are best for the nation in the long-run but have short-run costs that would interfere with reelection will not be implemented by politicians.
But the Fed can do these things -- Federal Reserve Board members have fourteen year, non-renewable appointments to help them to take the long-run rather than the short-run view.
That's not exactly wrong, but it's not right, either. This notion that the Fed makes policy independent of fleeting political considerations is one of those ideas that sounds swell in civics class, but falls down in the real world (I suspect Thoma, a keen observer of the economic and political scene, knows this, which is why he left himself an out by qualifying that this is how the Fed is "supposed" to operate.)

Take the emergency lending facilities the Fed established in 2007 and 2008 to prop up the financial system. Congress never would've been able to swiftly implement such controversial programs, Thoma says, noting lawmakers' propensity to hide behind a bush whenever it's time to make politically risky decisions.

Hard to argue with that. But that doesn't mean the Fed didn't take into account the "short-run costs" of failing to bail out the banking industry, including the likely political fallout. That decision was less a demonstration of the agency's separation from Washington than of its conjoined-twin connection to it. The Fed (and Treasury's) move to rescue large banks, first under Hank Paulson and later Ben Bernanke, wasn't strictly, or even chiefly, an economic choice -- it was a political one.

Or take the Fed's making loans to banks at minuscule interest rates. This policy, too, is overtly political. It reflects not only the White House's aims, but also those of lawmakers who continue to channel Wall Street's angst. Meanwhile, it obscures the other political choices the Fed could make. Those include pressing to raise rates on banks in concert with a government policy to lend to consumers directly (There's no law that lending has to happen through banks.)

Sometimes, the Fed calls the tune. Under Alan Greenspan, for example, the agency shot every financial regulation on sight and encouraged a housing bubble. Congress merrily danced along.

'Twas ever thus, and for good reason. As shown by the latest congressional dust-up over the Fed, the agency ultimately answers to Congress. If it does things lawmakers don't like (ie, that are against their political interests), they can bring it to heel by changing the law.

That's why the entire history of the Fed amounts to a careful pas de deux with Congress, sometimes moving in time, sometimes crushing each other's toes. Lawmakers side with or against the agency (along with other pols siding with or against the Fed) in service to their respective agendas. Former Fed chairman Paul Volcker was famously adept at this game, joining forces with such Hill powerhouses as Sen. William Proxmire and Rep. Henry Reuss, both of Wisconsin, as his needs required.

Thoma is certainly right in one respect -- Congress and the Fed frequently blame the other for the country's problems. Indeed, that perhaps best defines their relationship: co-dependency.

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    Alain Sherter covers business and economic affairs for CBSNews.com.