Defend Fed independence—you might need it
Federal Reserve independence is on trial in Washington again.
President Donald Trump’s top economic adviser, Larry Kudlow, broke with decades of economic orthodoxy on Tuesday when he agreed with the prominent supply-sider Arthur Laffer that Fed independence is undemocratic and that monetary policy should be handled by the Treasury Department or Congress.
Then on Wednesday, Maxine Waters, Chair of the House Financial Services Committee, urged Fed Chairman Jerome Powell to resist efforts by the White House to compromise his institution’s autonomy.
Like most economists, I consider Fed independence to be a valuable tool. At the same time, the conservative Laffer raised important concerns, many of which are echoed on the left by adherents of modern monetary theory.
Supply-side theory emerged in the 1970s, and argued that a combination of tax cuts and relatively low interest rates could bring down inflation and grow the economy. Supply-siders waved away concerns about deficits.
Modern monetary theory argues that government spending should be used to sustain growth and that any resulting deficits should be financed by monetary policy. MMT waves away concerns about inflation.
Most of the commentary around these theories focuses on their lack of concern about deficits. That lack of concern, however, is a product of their rejection of central bank independence. With the central bank at its disposal, the White House could always control the high interest rates that deficits encourage.
Both supply-siders and MMT adherents justify this stance by arguing that monetary policy is a tool of public policy that should not be controlled by a technocratic committee of economists any more than foreign policy should be controlled by generals.
This is an unorthodox stance but it deserves to be taken seriously.
The first is democratic accountability. The reason for creating an independent Fed is to reduce the influence of democracy on monetary policy. The thinking is that democratic bodies and the public are likely to be shortsighted, ignoring long-term risks like inflation that could follow politically popular tax cuts or spending increases. Instead, monetary policy should be run by experts trained to recognize those risks and address them.
When the Fed meets to discuss interest-rate changes only seven—the chair and six governors—out of a total of 19 decision makers are appointed by the president and approved by the Senate. The other 12 are regional Fed presidents who are appointed by their respective boards. The Fed’s unusual voting structure requires seven of the 12 presidents to sit out each vote, theoretically giving the White House appointees a majority.
Currently, however, two governorships are vacant, meaning that the regional presidents have as much voting power as the federally appointed chair and governors. Nor is this situation unusual. When Trump came into office, two of the governorships were vacant and two more governors resigned soon after.
This structure implies that despite Trump’s efforts to pressure the Fed to raise interest rates, neither the White House nor Congress has much power to compel the Fed to do anything.
The Fed was set up this way so that it could take a long-term view without being influenced by the next election or the whims of the party in power.
As Laffer pointed out in a CNBC interview on Monday, however, it also removes a powerful tool that governments have for making policy. As a supply-sider, Laffer believes that the Fed should lower interest rates to accelerate economic growth, encourage investment and make the most of the recently passed tax cuts.
I generally agree. The Fed’s rapid pace of interest-rate increases combined with the Trump’s haphazard trade policy have increased uncertainty and caused businesses to pull back on investment at precisely the moment when it’s most advantageous for them to plow ahead. As a result, the U.S. economy won’t get a clean test of the power of tax cuts to spur long-term growth.
Unlike Laffer, however, I am willing to swallow this bitter pill because the same institutional structure that prevents supply-side economics from being fully implemented also constrains MMT.
If a Democratic president embraces MMT, it will be crucial for an independent Fed to make sure that the potential costs of those policies are transparent, not papered over and left for future generations.