“There is an old saw that the Fed chair is the second most powerful person in government. In the aftermath of the financial crisis, that may actually be an understatement.” Nicholas Lemann, The New Yorker:

America has a long and conflicted relationship with central banking. The controversial actions taken by the Federal Reserve during and since the 2007-2009 financial crisis reignited longstanding concerns about vesting so much authority in the hands of a few unelected officials. The Fed’s creative and aggressive use of its authority likely helped to reduce the size of the financial crisis and the magnitude of the recession that it triggered. Yet those actions also had significant distributional effects. They have benefitted some segments of the population at the expense of others and bestowed a particularly great largesse on the nation’s largest banks. This has led some to call for an end to the Fed and even more moderate observers are calling for a fundamental reassessment of whether the Fed should remain as powerful and as independent as it currently is. In a new article, forthcoming in the Journal of Law and Contemporary Problems and available here, I shed valuable new light on just how independent the Fed actually is and the types of tools that can best be used to balance the sometimes conflicting desires for a central bank that is both effective and accountable.

There are no easy answers when it comes to central bank independence. A large body of theoretical and empirical literature supports shielding central banks from direct accountability to elected officials. A primary reason is that the types of monetary policies most likely to achieve the long-term objective of stable prices can impose short-term economic pains. As reflected in the history of the Federal Reserve, a central bank that is overly responsive to the interests of elected officials is unlikely to pursue optimal long-term policies. Similarly, giving elected officials greater influence over how the Fed exercises its lender-of-last-resort increases the probability of politically motivated and socially costly bailouts. These and other considerations help to explain why the tools typically used to hold agencies politically accountable, like enabling the President to remove the head of the agency head at will or requiring an agency to go to Congress to fund its operations, have not been employed to make the Fed more politically accountable. Nonetheless, given the importance and contestability of the decisions the Federal Reserve is authorized to make, the renewed concerns about vesting such authority in the hands of unelected and formally quite independent officials cannot be easily dismissed.

My new article, The Federal Reserve: A Study in Soft Constraints, suggests that before we seek to solve the problem of Federal Reserve independence, we need to understand it. The article demonstrates that the Federal Reserve is not nearly as unconstrained as it appears if one looks solely on the formal mechanisms available for holding it accountable. Using case studies from the history of the Federal Reserve, it illustrates the existence of powerful “soft constraints” that shape Fed decisionmaking and otherwise enhance the capacity of the public and elected officials to hold Fed policymakers accountable for the their decisions. These constraints do not resolve the fundamental tension, but they do reduce the magnitude of the problem. Moreover, given the drawbacks of using more traditional tools to make the Fed more accountable, robust soft constraints might play a critical role in achieving the optimal balance among conflicting aims.

The article demonstrates the power of soft constraints by examining the influence of two such constraints on the Federal Reserve. One powerful set of constraints are principled norms, that is, principles that are generally accepted by experts and policymakers and that dictate how the Fed ought to act in a given set of circumstances. Using the real bills doctrine, Bagehot’s dictum, and the Taylor rule as examples, the analysis suggests that even when the Fed has no legally enforceable obligation to act in accord with a principled norm, the existence of the norm shapes Fed action and discussions about the same. As a result, principled norms can both substitute for and enhance the efficacy of formal constraints.

Another soft constraint, the reputation of the Fed Chairperson, similarly alters the actions that the Fed takes in socially beneficial ways and can promote the type of discourse that facilitates accountability. Fed Chairs often serve for exceptionally long periods, exercise significant influence while in office, and are held accountable, by politicians, the press and academics, for actions the Fed takes while they are in office. Fed Chairs thus have the incentive and means to influence the Fed’s actions to enhance their individual reputations. Based on these analyses, the article suggests that soft constraints play a meaningful and underappreciated role shaping Fed action and facilitating transparency and oversight. It further suggests that soft constraints merit more attention in the debates about agency independence more generally.

The preceding post comes to us from Kathryn Judge, Associate Professor of Law and Milton Handler Fellow at Columbia Law School, and is based on her paper entitled “The Federal Reserve: A Study in Soft Constraints”, which is available here.