When it comes to monetary policy, the popular commentary discusses the Federal Reserve System as a monolithic interest rate machine, raising and lowering rates to stabilize (or destabilize) the macroeconomy. More observant Fed watchers think of its big players, recognizing conflict among the voting members of the Federal Open Market Committee (FOMC). In that framing, monetary policy comes down to a battle between hawks and doves.
But the Federal Reserve System is not a monolith, and it is much more than a few members sitting on the FOMC. As in any large organization, the decisions made by those on top are influenced by the spontaneous order of ideas that develops below. The structure of the organization helps determine whether that order is beneficial or harmful on net.
A recent NBER working paper by Michael Bordo and Edward Sampson Prescott digs into how ideas spread through the Federal Reserve System and, ultimately, influence monetary policy. The authors argue that the Fed was well-suited to generate and process ideas because of two features: the decentralized structure of the branches and the relative independence granted to those branches. Bordo and Prescott argue that “the Reserve Banks were an important entry point for new ideas into the Federal Reserve System, and that these ideas ultimately contributed to Federal Reserve policy making.” Most importantly, new ideas coming from the Reserve Banks helped stop the inflation of the 1970s and taught the Fed how to maintain inflation since then.
The Reserve Banks were not always so important. The Banking Act of 1935 concentrated power in the Board of Governors, which was then a part of the Treasury. It was only after 1951, when the Fed was separated from the Treasury and the new chairman, William McChesney Martin, formed an ad hoc subcommittee to review FOMC operations (which ultimately resulted in the FOMC meeting more often — seven times per year instead of four) that the Reserve Banks began to function like those we see today.
As the FOMC became more important, Bordo and Prescott argue, the Reserve Bank presidents — who sit on the FOMC — started to pay attention to monetary policy. With this new burden, the Reserve Banks needed to hire economists to help inform the voting members of macroeconomics. As they write, “The increased role of economists in the System and the Reserve Banks was important for several reasons. First, it allowed for an improved flow of information and ideas within the system and with economists outside the System. Second, the Reserve Banks, with their semi-independent corporate structure, allowed for new and sometimes dissenting views to develop and survive in the System without being viewed as an expression of disloyalty.”
Two famous examples help highlight the Reserve Banks’ ability to generate new information: monetarism and rational expectations.
Imagine yourself in the 1960s. The prevailing view among macroeconomists is Keynesianism. The view spread from academia to the Fed through appointments of governors and the hiring of new staff, fresh off their PhD coursework at MIT.
At the same time, however, a wildly different view about macroeconomics and monetary policy is developing at the Federal Reserve Bank of St. Louis: monetarism. The St. Louis Fed’s president, D.C. Johns, felt ignored throughout the Fed system; he responded by hiring Homer Jones (Milton Friedman’s teacher) in 1958 to serve as the Reserve Bank’s research director. Jones oversaw a department that nurtured monetarist ideas. Even though St. Louis’ monetarists did not win over the whole system right away, in the longer run, they laid the groundwork for ideas that, according to the authors, “culminated in Chairman Paul Volcker’s actions to stop inflation.”
Whereas the St. Louis Fed helped develop and propagate monetarism in the 1960s, the Minneapolis Fed in the 1970s and 1980s pushed for credible policies and models incorporating rational expectations. If anything, the Minneapolis Fed’s influence was even greater, since it involved a revolution of the whole macroeconomic profession. And the implications of rational expectations were huge: if the statistical Phillips curve cannot be thought to hold reliably once the central bank attempts to exploit it (because people anticipate policies), the case for Keynesian policies falls apart. Moreover, to end inflation, the economists at the Minneapolis Fed showed, the Fed couldn’t simply say it wanted to end inflation. It must, instead, credibly commit to some course of action consistent with ending inflation and convince people that it would remain committed to that course. Volker was able to do that.
Bordo and Prescott make a compelling case for regional Reserve Banks, on the grounds that they result in a more diverse set of opinions and, hence, better economic ideas over time than would prevail in their absence. Reserve Banks brought monetarism and rational expectations into the monetary policy discussion, and, more recently, they have fostered dissenting views on the Fed’s role as a lender of last resort and the effectiveness of quantitative easing. One should keep this in mind when considering proposals that would see the role of regional Reserve Banks reduced.
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