-Caveat Lector-

~~for educational purposes only~~
[Title 17 U.S.C. section 107]

The Myth of the 'Independent' Fed
by Thomas J.  DiLorenzo

Ever since its founding in 1913, the Fed has described
itself as an 'independent' agency operated by selfless
public servants striving to 'fine-tune' the economy
through monetary policy.  In reality, however, a
nonpolitical governmental institution is as likely as
a barking cat.  Yet, the myth of an 'independent' Fed
persists.  One reason this myth persists is that statist
textbooks have helped perpetuate it for decades.

 From 1948 until about 1980 Paul Samuelson's Economics
was the best-selling introductory economics text.
Generations of students were introduced to economics
by Samuelson.  Although not as popular as it once was,
Samuelson's text (now co-authored with William Nordhaus)
is still widely used.  According to the 1989 edition:

   The Federal Reserve's goals are steady growth in national
   output and low unemployment.  Its sworn enemy is inflation.
   If aggregate demand is excessive, so that prices are being
   bid up, the Federal Reserve Board may want to slow the growth
   of the money supply, thereby slowing aggregate demand and
   output growth.  If unemployment is high and business
   languishing, the Fed may consider increasing the money
   supply, thereby raising aggregate demand and augmenting
   output growth.  In a nutshell, this is the function of
   central banking, which is an essential part of macroeconomic
   management in all mixed economies.

For about the past fifteen years the top-selling economics text
has been Campbell McConnell's Economics, which echoes Samuelson
and Nordhaus's idealistic statism:

   Because it is a public body, the decisions of the Board
   of Governors are made in what it perceives to be the public
   interest ... the Federal Reserve Banks are not guided by
   the profit motive, but rather, they pursue those measures
   which the Board of Governors recommends ... The fundamental
   objective of monetary policy is to assist the economy in
   achieving a full employment, noninflationary level of total
   output.  These are mere wishes, not statements of facts, for
   there is voluminous evidence that the Fed -- like all other
   governmental institutions -- has always been manipulated by
   politicians.


The Fed as a Political Tool

When the Fed was founded, it was controlled by two groups, the
Governors' Conference, composed of the twelve regional bank
presidents, and the seven-member Federal Reserve Board in
Washington.  In 1935 the Fed was reorganized to concentrate
nearly all power in Washington.  Franklin Roosevelt 'packed'
the Fed just as he later filled the U.S. Supreme Court with
political sycophants.  Roosevelt appointed Martinet Eccles, a
strong supporter of deficit spending and inflationary finance,
as Fed Chairman, although Eccles had no financial background
and lacked even an undergraduate degree.  In those years the
Fed was really run by Eccles's political mentor, Treasury
Secretary Henry Morgenthau, Jr., and thus ultimately Roosevelt.

Later presidents were no less willing to influence supposedly
independent Fed policy.  According to the late Robert Weintraub,
the Federal Reserve fundamentally shifted its monetary policy
course in 1953, 1961, 1969, 1974, and 1977-all years in which
the presidency changed.  Fed policy almost always changes to
accommodate varying presidential preferences.

For example, President Eisenhower wanted slower money growth.
The money supply grew by 1.73 percent during his
administration -- the slowest rate in a decade.  President
Kennedy desired somewhat faster money creation.  From January
1961 to November 1963, the basic money supply grew by 2.31
percent.  Lyndon Johnson required rapid money creation to
finance his expansion of the welfare/warfare state.
Money-supply growth more than doubled to 5 percent.  These
varying rates of monetary growth all occurred under the same
Fed chairman, William McChesney Martin, who obviously was more
interested in pleasing his political master than in
implementing an independent monetary policy.

Martin's successor, Arthur Burns, was such a staunch supporter
of Richard Nixon that he lost all professional credibility by
enthusiastically endorsing Nixon's disastrous wage and price
controls.  Even though his staff informed him in the fall of
1972 that the money supply was forecast to grow by an extremely
robust 10.5 percent in the third quarter, Burns advocated ever
faster growth before the election.  The growth rate in the
money supply in 1972 was the fastest for any one year since
the end of World War II and helped re-elect Richard Nixon.

However, President Ford called for slower monetary growth as
part of his 'Whip Inflation Now' program, and the Fed complied
with a 4.7 percent growth rate.  But when Jimmy Carter was
elected, Burns again complied with presidential wishes by stepping
up the growth rate to 8.5 percent.  Carter did not reappoint Burns,
but the latter's successors were equally cooperative.  The money
supply increased at an annual rate of 16.2 percent in the five months
preceding the 1980 election -- a post-World War II record.

In 1981 Donald Regan, Ronald Reagan's Treasury Secretary, advocated,
and got, more rapid monetary growth.  A year later the President
himself met with Fed Chairman Paul Volcker to lobby for slower
growth, which was dutifully produced by the Fed.  More recently,
Alan Greenspan has reportedly been most 'accommodating' to
President Clinton.


Both Sides Benefit

The Fed is obviously influenced by the executive branch.  But the
relationship between the Fed and administrations runs far deeper.
As Robert Weintraub observed, such contact 'has been and continues
to be fostered by cross planting of high level personnel' in both
directions.  Officials have also met weekly for decades.  But personal
contact is not necessary for the Fed to allow itself to be used as
a political tool.  The administration's policy views are generally
well known.  Economist Thomas Havrilesky has even developed an index
of executive branch 'signaling', based on newspaper accounts of the
administration's monetary policy preferences as reported in the Wall
Street Journal.2    And as Weintraub concluded, 'a Chairman of the
Federal Reserve Board who ignores the wishes of the President does
so at his peril'.

The Fed and presidents alike benefit from this arrangement.
Economist Edward Kane has argued persuasively that the Fed's
ultimate political function is to serve as a political scapegoat when
things go wrong.  Writes Kane: "Whenever monetary policies are
popular, incumbents can claim that their influence was crucial in
their adaptation.  On the other hand, when monetary policies prove
unpopular, they can blame everything on a stubborn Federal Reserve
and claim further that things would have been worse if they had
not pressed Fed officials at every opportunity."3 In return for this
favor, the Fed is allowed to amass a huge slush fund (discussed below)
by earning interest income from the government securities it purchases
through its open market operations.


A Demand for Inflation?

It is also well established that politicians use the Fed as a tool
of money creation to advance their own re-election.  As Robert J.
Gordon wrote in the Journal of Law and Economics more than 20 years
ago: "Accelerations in money and prices are not thrust upon society
by a capricious or self-serving government, but rather represent the
vote-maximizing response of government to the political pressure
exerted by potential beneficiaries of inflation.

Gordon is wrong in denying that government is inherently capricious
and self-serving, but he's got a good point: Politicians are naturally
inclined to finance government handouts to special-interest groups
with the hidden tax of inflation, which hides the true costs of
government from the taxpaying public.  Joining with election-minded
officials in favor of expansive monetary policies is a 'low-interest-rate
lobby', led, argues Edward Kane, 'by builders and construction unions
and by financial institutions that earn their living by borrowing short
to lend long'.

The Fed underwrites an enormous volume of research, some of which
is very good.  But, as Business Week magazine once observed: 'There is
disturbing evidence that the research effort of the bank's 500-odd
Ph.D. economists is being forced into a mold whose shape is politically
determined by the staff of the Federal Reserve Chairman.' Some Fed
economists admit that political expedience is the rule.  Says former
Fed economist Robert Auerbach, 'the practice at the Bank where I worked
was to clear research through the Board of Governors and to 'persuade'
economists to delete material that the Board or the Bank officials did
not like. [Robert D. Auerbach, "Politics and the Federal Reserve,"]

Thus, all Fed research should be taken with a grain of salt.  However,
one recent study in particular deserves special attention.  In 1992
Boston Fed research director Alicia Munnel published a report claiming
to find persistent mortgage loan discrimination against minorities in
Boston.  The study, used to justify racial quotas for bank loans, was
fatally flawed.  The data were hopelessly jumbled.  Equally important,
the report failed to control for credit-worthiness credit ratings, job
history, income, and so on.  When confronted with these facts by Peter
Brimelow and Leslie Spencer of Forbes magazine, Munnel admitted: "I do
not have evidence ... no one has evidence of lending bias."


Taxpayer-Funded Lobbying

The Fed also uses its privileged position and especially its
multi-billion dollar slush fund generated by interest income
on open market purchases-to lobby.  Its preferred method is
to pressure member banks, which it regulates, to lobby for
it.  It also recruits a small army of academic researchers,
who benefit from Fed research grants, visiting appointments,
and invitations to conferences at exotic locations, to
testify on its behalf at Congressional hearings.

For instance, in the late 1970s Representative Henry Reuss
introduced a bill authorizing the General Accounting Office
to audit the Federal Reserve system.  It was defeated because,
as Reuss later explained, "with the Federal Reserve Board in
Washington serving as the command center, a well-orchestrated
lobbying campaign was mounted, using the members of the
boards of directors [of the regional banks] as the point
men." In a speech to the American Bankers Association after
the GAO bill was defeated, the Richmond Fed's chairman,
Robert W. Lawson, congratulated the assembled commercial
bankers for their success: "The bankers in our district
and elsewhere did a tremendous job in helping to defeat
the General Accounting Office bill.  It shows what can be
done when the bankers of the country get together."
Academics conducted themselves in an equally disgraceful
way warning of potential abuses and assuring Congress that
the Fed could be trusted to behave responsibly.

For decades, believers in the "public interest" theory
of Fed behavior blamed the Fed's failures to ensure price
stability on the agency's incomplete knowledge and
difficulty 'fine-tuning' the economy.  But research
suggests that the Fed's abysmal record in controlling
inflation reflects not mere incompetence, but the way in
which the Fed is organized.

Until the Fed's creation, there was no overall upward
trend in the price level.  Inflation occurred during wars,
but prices then gradually declined to their former levels.
Since the establishment of the Fed, however, there has
been a continuous upward surge in prices.  Public choice
scholars believe that an important reason why the Fed has
caused so much inflation is that it benefits from inflation.
Since the entire operation has been funded since 1933
from revenue acquired through interest payments on
government security holdings, the Fed has an incentive
to purchase securities (thereby expanding the money
supply) more than it has an incentive to sell them.
Purchasing government securities is a source of income
to the Fed, whose income is 'earned' by the interest paid
on the   securities.  Selling securities, on the other
hand, causes a loss of income.  The Fed is constrained to
return 'excess revenues' to the Treasury, but enjoys great
discretion over its budget and managed to spend over $2
billion on itself in 1996.  Fed officials live quite well
on their revenues.  As a recent General Accounting Office
report revealed: "The Fed has 25,000 employees,  runs
its own air force of 47 Learjets and small cargo planes,
and has fleets of vehicles, including personal cars for
59 Fed bank managers ... A full-time curator oversees its
collection of paintings and sculpture."7 The Fed held $451
billion in accumulated assets as of 1996, when it was
engaged in building for itself several expensive new
office buildings.  The number of Fed employees earning
more than $125,000 per year more than doubled (from 35 to
72) from 1993 to 1996; even the head janitor (known as
the 'support services director') is paid $163,800 in
annual salary plus benefits.  Money is lavishly spent
on professional memberships, entertainment, and travel.

Economist Mark Toma has studied the Fed's spending habits
and believes that the Fed does in fact conduct monetary
policy with an eye toward how its managers and employees
can themselves profit from it.  That means instituting
a bias toward bond purchases and money creations Similarly,
William Shughart and Robert Tollison contend that the Fed
behaves exactly like many other government bureaucracies,
padding 'its operating expenditures by increasing
the number of employees on its payroll."9

That is, the Fed uses staff expansion to reduce the amount
it must return to the Treasury.  Thus, "when engaging in
expansionary policies," write Shughart and Tollison, "the
Fed can both increase the supply of money and increase the
size of its bureaucracy because the two goals are served
by open market purchases of securities." Contractionary
policies, on the other hand, force the Fed to lower its
profits and staff.  Because of this unique financing
mechanism, argue Shughart and Tollison, "the Fed has been
more successful in enlarging its employee staff over time
than the federal government as a whole."  This employment
effect, moreover, "may partially explain why the Fed has
apparently been more willing to engage in expansionary
than in contractionary monetary policies."

Regulation as a Political Tool

The Fed also uses its vast regulatory powers for political
purposes, rather than to promote the 'public interest'.
The Fed's authority is vast, but is most abused through
enforcement of the Community Reinvestment Act of 1977.
Under the CRA, the Fed must assess a bank's record of
'meeting community needs' before allowing a bank to
merge or open a new branch or even an automatic teller
machine. An entire industry of nonprofit political
activists routinely files protests with the Fed, which
must be evaluated before the bank can win Fed approval.
The activists typically threaten to stall mergers or
branch expansions unless banks give them -- not the
poor in their communities -- money, a practice that many
bankers consider pure blackmail.  For example, the
Chicago-based National Training and Information Center
threatened to delay a merger by a Chicago bank unless
it received $30,000 to renovate its office.  The bank
agreed, and also gave $500,000 to other leftist
organizations.  In Boston, left-wing activist Bruce
Marks, the head of the Union Neighborhood Assistance
Corporation, filed complaint after complaint with the
Fed over Fleet Financial Group's community lending
record until Fleet agreed to give $140 million to his
organization and to make $8 billion in loans to
individuals and businesses favored by Mr. Marks.
"We are urban terrorists," Marks explained to the Wall
Street Joumal.  "'The CRA is frequently used as a means
of racial extortion.  For example, the Fed, under the
direction of former Governor Lawrence Lindsey, found
'statistical disparities' in lending, i.e., the
percentage of loans granted by the Shawmut Services
Corporation to blacks and Hispanics did not match the
groups'proportion in the population.  Yet no individuals
complained of discrimination and the Fed did not claim
to have found any victims." In fact, between 1990 and
1992, when the discrimination allegedly occurred,
Shawmut's mortgage loans to blacks and Hispanics more
than doubled, and the mortgage rejection rate fell
by 45 percent and 26 percent, respectively.  However,
the Fed employed 150 people to go out and find people
who claimed to have been 'discriminated against' by
Shawmut and to offer them $15,000 each, effectively
robbing the company of $1 million.

Conclusions

Any government monopoly will be corrupt and inefficient, but
the Fed may be the worst government monopoly of all.  Not only
does it operate for its own advantage in the name of promoting
the public interest, and offer government officials political
cover for their self-interested policies, the Fed also allows
no escape.  One can at least refuse to do business with, say,
the government school monopoly by homeschooling or by sending
one's children to private schools.  But one cannot avoid the
effects of the Fed's monetary monopoly.  It is time to
depoliticize and denationalize our money.



        1. Robert Weintraub, "Congressional Supervision of Mon-
  etary Policy," Journal of Monetary Economics, April 1978, pp.
  341-362.
        2. Thomas H,,ivrilesky.  "Monetary Policy Signaling from the
  Administration to the Federal Reserve," Joumal ofmoney, Credit
  atid Batikiiig, vol. 20, no. 1, February 1988.
        3. EdwardJ.Kanc,"PoliticsandFedPolicymaking,"Joumal
  of ivonetaty Ecoi?oitzics, vol. 6, 1980, P. 206.
        4. Robert J. Gordon, "The Demand for and Supply of
  Inflation," Jotii-rial of Law a@id Ec,otioinics, vol. 18, 1975, p. 808.
        5. Robert D. Auerbach, "Politics and the Federal Reserve,"
  C(@nteinpoi-a Polic Issues, Fall 1985, p. 52.
        6. Ibid., P. 53.
        7. John R. Wilke, "Fed's Huge Eriipire, Set Up Years Ago,
  Is Costlv and Inefficient," Wall StreetJ(@urnal, Sept. 12, 1996, P. 1.
        8. Mark Torna, "The Inflationary Bias of the Federal
  Reserve Svstem," Joumal ofvonetary Lconomicy, vol. 10, 1982,
  pp. 163-1 @0.
        9. William Sbughart and Robert Tollison, "Preliminary
  Evidence on the Use of Inputs by the Federal Reserve System,"
  Aniei-ican Ec-otiomic Review, June 1983, pp. 291-304.
      10. Susan Alexander Ryan and John Wilke, "Banking on
  Publicity, Mr. Marks Got Fleet to Lend Billions," Wall Street
  Journal.  Feb. 11, 1994, p- A-5.

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