Central Banking is too Important to be De-Politicized; on Lev Menand’s The Fed Unbound

After Stagflation during the 1970s, many markets were liberalized and, over time, central banks made a lot more independent in lots of places. In addition, some countries in Europe embraced the EURO (and founded the ECB), and barriers between regulated banking and shadow-banking (including by investment banks) were removed.

The intended aim, and in certain respects the successful effect, of central bank independence was to de-politicize central banks in three senses: first, to remove the temptation for politicians to use interest rates to benefit their own electoral prospects (which was thought to be the cause behind persistent inflation). Second, to prevent the use of central banks as a piggy bank for well-connected interest groups. Third, to turn monetary policy over to technocratic experts and, thereby, remove it as an electoral issue.

Over time one unintended effect of the third kind of de-politization is to dumb down our political class, which need not show any interest in monetary policy because it can always pass the buck to central bankers, and even delegate the execution of other policies to them. Arguably this state of affairs also made political debates more focused on cultural issues and less on the complex trade-offs involving monetary (and so-called fiscal) issues. In addition, as central banking was removed from the political arena, and so able to move with great rapidity, central bankers were actually nudged into taking on a whole range of crisis management tasks.

After many financial crashes, Greenspan puts, and bail outs later, this has generated a considerable mission creep for institutions that lack accountability and have deep enough pockets to make mistakes without having to learn from them. In recent times new tasks – like greening the financial system/economy – have been added to central bankers’ policy portfolio. And we probably narrowly avoided a bail out for crypto (largely because central bankers were slow to understand it).

The effect of this process is the development of a super-government-agency that tries to do too much without sufficient accountability and that undermines the legislative process. While there are important differences among the regulatory and governance frameworks of central banks worldwide, and they have different stature and influence, the previous paragraphs fit the situation of many central banks in the OECD.

One of the more insidious effects of the status quo we have arrived at is that where central bankers’ efforts “to conduct a more general economic policy are successful, they are likely to increase inequality given its available levers. Most obviously, backstopping shadow banking leads to more shadow banking, which likely entails more rent extraction as show banks privatize the gains from government-backed money creation.” (Lev Menand (2022) The Fed Unbound: Central Banking in a Time of Crisis, 134-135) That is to say, central bankers have de facto encouraged asset price inflation, upward redistribution, and incentivized a bubble (or financialized) economy.

Menand is a lawyer with a background in government service as a US Treasury official. His book is primarily about the development of the Federal Reserve and how it became a kind of super government agency today. It is written with careful precision and without rhetorical excess. Even if the historical material is somewhat familiar, Menand makes the material lively and calls attention to the significance of often overlooked rule changes.

For example, I always assumed that the rise of Eurodollars –“an arbitrage, a way for companies to issue dollar money instruments without complying with US banking laws” (p.113) —  was the effect of the Marshall plan and only became important with the oil embargo that enriched OPEC affiliated countries. But Menand shows that the development of Eurodollars (and the shadow banking system) was, in fact, encouraged by the “Martin-led Fed” in the late 1950s and 1960s. The FED, thereby, undermined the whole spirit of the post 1930s banking laws, and helped promote shadow banking. It did so in order to provide US banks a competitive advantage abroad (p.114). Perversely, the institution has been rewarded with more authority since even as leading US banks have had several rounds of bail outs during the last few decades (including the 1980s Brady Bonds).

Because asset price inflation so clearly helps the educated and well off in today’s political economy, one is often treated as a class traitor or an outright crank when one casts doubts on central bank independence (and one is treated to lectures about the 1970s). This despite the fact that balance sheet of the last few decades with an independent central bank regime is underwhelming: growth rates are subdued, we have had upwardly redistributive bail-outs, and even inflation has returned. (Obviously, the asset price inflation of property is not just a monetary phenomenon, but also effect of land/zoning and mortgage deduction policies. But central banks often allow member banks to treat mortgages as (near) risk free.)

Menand (Columbia University) also points to a governance problem: central banks make policy without sufficient scrutiny from stakeholders and accountability to the wider public. It is predictable that this leads and has led to sub-par policy outcomes. As Menand puts it “there is also a practical problem with the government relying on the Fed to backstop shadow banks, compensate for inadequate fiscal policy, and extend credit to the real economy. It isn’t well designed to perform these functions. Compared to most administrative agencies, its officials are highly insulated from political oversight, and its activities are not subject to rigorous procedural requirements or public scrutiny.” (130)

In fact, “many of the Fed’s activities are not subject to the same sort of judicial review as the activities of other government agencies, nor is its policymaking process structured with as much public participation and engagement. The Fed’s mission also requires a close relationship to the banking sector and a set of tools that are financial in nature. Given this, as well as the reliance the Fed has developed on the primary dealers to execute many of its policies, any efforts the Fed makes toward general economic policy are likely to disproportionally benefit financial firms.” (p.131) As Menand goes on to note, this also encourages rent-seeking by the well-connected.

Menand has a reformist sensibility. And in future posts I discuss some of his proposals. But as long as we leave the political discussion of central banking to conspiracy theorists and anti-establishment populists, we should not expect much reasoned discussion about reform. My own view is that this is a very dangerous state of affairs not just because of the distributional effects, but because once the conspiracy theorists and anti-establishment populists own an issue they will reap the rewards when the next big financial crash hits.