New Paper on the Three Ways the Fed Is Failing Us

Binder argues that the Federal Reserve faces three major problems going forward: its institutional bias against full employment, its questionable ability to enforce regulations on the financial sector, and conflicts of interests built into its basic governance model. That last point is a take on “Audit the Fed” that is not designed to hamstring policy, as the current measures are, but is instead approaches the issue from the left. Binder’s paper develops each of these three points in detail – here’s a quick summary.

Full employment is important for long-term reduction of inequality. Periods of high unemployment not only do damage to workers who lose their jobs and see their skills atrophy, but also cause those who keep their jobs to experience weaker wage growth. This is especially hard on those with lower incomes, who see larger cuts in working hours during periods of high unemployment.

If full employment is so important, why has the Fed given it a lower priority than fears about “credibility” and inflation that is nowhere to be seen? Binder walks through the history of how we got here. It’s important to remember that the current approach isn’t based on the empirical literature. There is no evidence that allowing, for instance, higher inflation in the single-digit range is harmful to growth. As it looks like the economy will be weak, and interest rates low, for the foreseeable future, this is a problem that won’t go away on its own. And as she concludes, “excessive emphasis on low and stable inflation at the expense of a strong labor market is unwarranted. Privileging low inflation over maximum employment means that more people are likely to experience unemployment, underemployment, or stagnant wages.”

Beyond monetary policy, the Federal Reserve is the major player when it comes to bank supervision and financial regulatory reform. But there are genuine worries that as we get further away from the financial crisis, we’ll have more difficulty maintaining strict enforcement of regulations. Examining this function of the Fed is essential, as regulations will become an important macroeconomic tool going forward.

Binder points out that the Fed could, for instance, set capital and margin requirements countercyclically, deterring run-ups in leverage during booms and providing more leeway during recessions. More collateral requirements on lending during boom times would function like an automatic stabilizer for the business cycle. The Fed, which is currently implementing the baseline response demanded in Dodd-Frank, will need to address these issues. More broadly, “Macroprudential regulation should extend beyond banking and cover any institutions that could have systemic consequences, including shadow banks.”

But none of this can be done without changing the Fed’s governance, and here’s where Binder lays out a set of reforms that get at the concept of Audit the Fed without demanding permanent monetary austerity. She notes that many of the Fed’s board members own stock in or work for banks that the Fed supervises and regulates. Some suggestions include that the “Fed should follow such central banks in Australia, Canada, the U.K., and the European Union in requiring its directors to disclose potential conflicts of interest. Like the Bank of Canada, the Fed should also prohibit its directors from participation in any real, potential, or apparent conflicts of interest, from having affiliations with entities that perform clearing and settlement responsibilities in the financial services industry, and from dealing in government securities.” Reports like this one from the GAO offer a wide range of other suggestions.

Right now the focus is on how much the Federal Reserve will weaken the already lackluster recovery by raising interest rates. But in addition to this short-term issue, we also need to be looking at the long-term issues of governance, regulation, and full employment. Binder’s paper gives an excellent rundown of where we need to go.