Just as Congress and the president control fiscal policy, the Federal Reserve System dominates monetary policy, the control of the supply and cost of money. Since monetary policy affects everysector of the economy, the Fed has to be considered coequal with the president and Congress in macroeconomic decision making.
The Fed's Structure
The Federal Reserve system consists of a seven-member board of directors in Washington, D.C.,and 12 regional banks, each controlled by its own directors. These regional institutions, owned bycommercial banks within their jurisdictions, only do business with the Treasury and their memberbanks, not with the public at large. They do not lend money for automobiles or homes, and theirmain assets are U.S. government securities (such as Treasury bonds). The Federal Reserve banksalso perform a variety of services for other banks such as check processing and storing anddistributing cash. All national and state chartered banks are subject to Federal Reservesupervision and regulation.The Federal Reserve Board of Governors oversees the entire system. The president appoints sixof the governors (subject to Senate confirmation) to 14-year terms and the board's chair to a 4-yearterm. (The president's and chair's terms of office do not overlap, however.) Alan Greenspan is thecurrent chair.
The Fed's Operations
Even though the Constitution authorizes the government to "coin money," it would be impractical tocontrol its supply by speeding up or slowing down the printing presses. After all, if enough wereprinted it would soon be worthless. It is also impractical to tie the value of paper money toprecious commodities such as gold or silver, since the supply of these commodities does notalways keep pace with economic growth. Governments discovered that when these metals didn'tkeep pace with growth there was usually insufficient currency to finance investment andconsumption. Therefore, the Fed relies on its legal authority to manipulate "fiat money": papercurrency, coins, funds in checking and savings accounts, and other legally accepted forms ofexchange.The Federal Reserve System manages the money supply in three ways:
Reserve ratios. Banks are required to maintain a certain proportion of their deposits as a"reserve" against potential withdrawals. By varying this amount, called the reserve ratio, the Fedcontrols the quantity of money in circulation. Suppose, for example, it orders banks to hang on toan extra 1 percent of their deposits. They would then have 1 percent less to lend. One percent maynot sound like a lot, but it translates into billions of dollars that are siphoned out of the economy.
Discount rate. When banks temporarily overcommit themselves, they occasionally have to borrowfrom the Fed to secure the necessary funds to meet their reserve requirements. The interest ratecharged for these loans is the discount rate, and it too affects the money supply. If the Fed raisesthe discount rate, banks cannot afford to borrow as heavily as before and have to curtail theirlending and raise their own interest rates. That results in less money flowing into the economy.Conversely, if the Fed relaxes its discount rate, financial institutions have more dollars for theircustomers. Seen from this perspective, the discount rate has a snowball effect: Raising it meansthat other interest rates go up as well and, other things being equal, economic activity slows down;lowering it has the opposite effect.
Open-market operations. By far the most important of the Fed's activities are open-marketoperations, the buying and selling of government securities. After Congress approves an increasein the national debt, the Treasury Department prepares a mix of bonds, bills, and notes that itauctions to private dealers who are authorized to trade government securities. When it wants toinfluence economic activity, the Fed buys or sells these assets through its Federal Open MarketCommittee (FOMC) or open-market desk, as it is commonly known.
The process works this way: If the Fed decides to increase the money supply, its open-marketmanager buys back treasury securities from private dealers, paying for them by simply creditingtheir bank accounts. It does not transfer any actual cash. (This power distinguishes it from all otherfinancial institutions and gives it its clout.) The dealers' banks now have more money to lend, andthese loans ultimately find their way into more banks, which pass a portion of them on toadditional borrowers. The Fed's initial purchase thus has a multiplier effect as money ripplesthroughout the economy. Of course, the process is reversed when the Fed sells off some of itssecurities, because it in effect deducts the price from the purchasers' accounts, leaving their bankswith fewer deposits.
The main idea is that the Fed's accounting maneuvers, not switching the printing presses on and off,produce increases or decreases in the money supply.
The Fed and the Political System How one interprets the Fed in relation to various models ofwho governs, such as pluralism or the power elite, depends on how much independence frompolitical influence one thinks the system has. On paper the Federal Reserve System appears to berelatively autonomous, since it receives its operating revenues from its constituent banks, not fromcongressional appropriations, and since its governors, once in office, cannot be dismissed by thepresident. The governors' long terms mean that an occupant of the White House cannot expect topick a majority of the governors. The Fed, moreover, conducts its meetings in private and is underno legal obligation to report to the executive branch. Given these conditions, one might think itcould escape public accountability altogether.
Yet the Fed is also the creation of Congress, which takes a strong interest in its work and canalways amend its charter. Furthermore, as a practical matter, the Fed's officers have to interactdaily with senior executives in the Treasury Department, the OMB, and other agencies. The chairfrequently testifies before legislative committees and regularly consults with the president's staff.All members of the board of governors realize the value of maintaining support at both ends ofPennsylvania Avenue because they know determined political opposition can undercut theirpolicies. In short, the Federal Reserve's statutory independence does not immunize it from politicalpressures.
The ill-defined boundaries between the Fed and the rest of the Washington establishment leads toendless debates about its autonomy. Some observers emphasize the Fed's political nature, arguingthat it pays close attention to the desires of the White House. Presidents normally want the moneysupply to flow freely enough to keep the economy booming and will pressure the Fed to achievethat result. Members of the board do not want to antagonize the chief executive and, if pressed,often cave in.
Some political economists go even further: They detect a political monetary cycle (PMC), duringwhich the Fed relaxes monetary policy in the months before a presidential or congressionalelection, hoping that business will pick up and thus make the incumbent president's party shine inthe eyes of the electorate. As soon as the campaign ends, however, it tightens the screws again tohold down inflation. According to this interpretation, the Fed rhythmically starts and stops theeconomy for partisan purposes. If true, the existence of a PMC would suggest that the Fed is atleast indirectly accountable to the people, as democratic theorists hope.
Others, however, doubt the Fed's susceptibility to presidential influence and question the wholePMC concept. It seems unlikely, they claim, that the Fed would act so blatantly on anyone's behalfbecause such partisan behavior would tarnish its reputation in financial circles for competence andobjectivity. It is also doubtful whether the Fed has sufficient data and knowledge to fine-tune thesupply of money on short notice. Monetarism, in the last analysis, is a broadsword, not a scalpel,and cannot be wielded with the precision assumed by the PMC hypothesis. Finally, severalempirical studies dispute the existence of a political monetary cycle. One economist said that hecould not uncover a "single episode...in the Fed's history to suggest that [it] had bowed topresidential election pressures, and a lot of episodes to suggest that it resists them."
If the Federal Reserve System avoids the tugs of partisanship, what factors do affect its actions? Itcould be argued that it has many of the trappings of a power elite. In the first place, monetarypolicy is by any reasonable standard a trunk decision. The availability of money and magnitude ofinterest rates affect employment, prices, savings, investment, growth, and productivity and hencetouch the lives of everyone from the smallest consumer to the largest corporation. These policiesare developed and enforced by the Fed's board of governors and its operating arm, the FOMC, twotiny, nonelected groups of men and women with close connections to the banking and financialcommunities. Indeed, the background of the Fed's highest officers is one of its most distinguishingfeatures. Though many of them come from modest origins, they have spent the bulk of their careersin major banks and Wall Street investment firms and many, like former Fed Chairman Paul Volckerand the present chair, Alan Greenspan, have shuttled back and forth between jobs in these privatefinancial institutions and important positions in the U.S. government.
Spending one's life in banking, business, and commerce creates the sorts of loyalties the powerelite school predicts. One expert, who does not necessarily accept the power elite thesis,nonetheless lends it credibility when he writes that "Federal Reserve officials work in a milieuthat is significantly shaped by the interests and concerns of the commercial banks."
In brief, as much as fiscal policymaking seems to conform to the pluralist interpretation ofAmerican politics, monetary policy approximates the power elite model. Yet before acceptingeither of these theories, we need to see what influence the public as a whole exerts.
Go to Political Economy page
Go to Political Science 105 page
Go to H. T. Reynolds page
