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A Case for Monetary Reform
B y J a m e s L. P i e r c e *

rotating schedule vote on decisions that arc
crucial to the nation's well-being."
“ Furthermore, with regard to monetary
policy they arc not accountable to the Board
of Directors of their Reserve banks. Those
Boards are excluded from monetary policy
discussions connected with the OMC. Thus,
in my view the Reserve Bank presidents are
not responsible to anyone for their votes. The
accountability of the Reserve Bank presidents
should be established if they are to continue to
have a say in monetary policy."
The Federal Open Market Committee
(FOMC). or OM C as Mr. Lilly calls it, is the
primary vehicle for monetary policy in the
United States. It makes all the decisions
concerning the execution of open-market
operations. These operations in turn are
directed toward afTccting the growth of
money and credit, the level of interest rates
and. ultimately, the level of economic activity
in the United States. Changes in resenre
requirements and in the discount rate, which
arc determined by the Federal Reserve Board,
are distinctly secondary to open market oper­
ations in the conduct of (J.S. monetary poli­
cy.
The FOMC has twelve voting members: the
seven governors of the Federal Reserve, the
president of the Federal Reserve Bank of New
York, and four presidents of the remaining
eleven Reserve Banks; these four presidents
serve on a complcx rotating basis. All twelve
Reserve Bank presidents take part in FOMC
meetings but only five vote on policy. Of the
twelve votes on the FOM C only the seven
from the Board of Governors arc cast by
individuals who receive presidential appoint­
ments and Senate confirmations. Reserve
Bank presidents arc not appointed by any
public official. Rather, they arc appointed by
the private directors of their Reserve Banks
with the appointment confirmed by »>e
Federal Reserve Board. The Bank directors
arc private citizens; one third of w h o m are
bankers, one third arc individuals selected by

Any paper on U.S. monetary reform must
consider reform of the Federal Reserve
System. This paper considers reforms of the
Federal Reserve that should enhance the
quality of monetary policy. Two kinds of
reforms are considered: 1) changes in the
internal institutional structure of the Federal
Reserve that should enhance the quality of its
monetary policy decisions; 2) changes in the
powers of the Federal Reserve to impose
reserve requirements that should enhance the
efficacy of the policies themselves.

I. Internal Reorganization
On July 17, 1978, Senator William Proxmire released, during hearings of the Senate
Banking Committee, the contents of a letter
written to him in March by David M. Lilly, a
former member of the Board of Governors. In
that letter, Mr. Lilly described four specific
areas in which he thought the Fed should be
reorganized. The contents of the letter
provide an excellent vehicle for discussing
organizational reform of the Fed. In fact, to
have the Lilly letter made public is an impor­
tant reform itself; former governors of the Fed
have been remarkably silent about flaws in
that institution. Mr. Lilly’s observations will
be quoted, and then I shall offer my own
comments on those observations.
1) Organization o f the Open M arket Com­
mittee
“ I think that the presidents of the Federal
Reserve banks should have the same ac­
countability that applies to members of the
Board as regards the Open Market Commit­
tee. The Reserve Bank presidents are neither
appointed by the President of the United
States nor by the Board of Governors,—yet
they serve on the Open Market Committee
and have input into monetary policy and on a
’ University of Califomia-Bcrkcley.




246

VOL 69 iVO ’

ISSUES OF MONETARY POUCY

bankers, and one third are sclectcd by the
Federal Reserve Board.
Mr. Lilly observes that Federal Reserve
Bank presidents arc accountable to their
boards of directors, but these directors are not
privy to monetary policy discussions or deci­
sions. Thus, because the directors arc not
aware of what the bank president said in
FOMC meetings and only learn of his vote
after a significant time delay, the Reserve
Bank presidents actually arc accountable to
no one. He argues that their accountability
should be established. I agree, but changing
the nature of appointment is not sufficient to
establish accountability.
Many proposals have been made over the
years to increase the accountability of the Fed
and the FOMC. There arc two elements in
this accountability: who appoints the decision
makers and to whom must they explain their
actions oncc appointed. Mr. Lilly only
addresses the first element. It will be
discussed briefly here before turning to the
second clement.
The question of who appoints the members
of the FOMC is the less important of the two
elements. Nevertheless, most observers would
agree that the private directors of Reserve
Banks have no business appointing members
of the FOMC. Many proposals have been
made over the years to rcctify the situation.
Some would restrict the FOM C to Federal
Reserve Board members, others would retain
the participation of Bank presidents on the
FOMC but require cither presidential or
Federal Reserve Board appointment of the
presidents with Senate confirmation in either
case. Sincc 1 prefer restricting the FOM C to
Federal Reserve Board members, I should
like to point out some of the difficulties
involved in having Reserve Bank presidents
sit on the FOMC.
The Federal Reserve Board currently can
exert a powerful influence over selection of
Reserve Bank presidents by confirming or
rejecting names supplied to it by the bank
directors. Further, and perhaps more impor­
tant, the Federal Reserve Board approves the
budgets of the Reserve Banks. The Board
and/or its chairman can make life very
unpleasant for a Bank president who causes




247

too much trouble at FOM C meetings. Thus,
even if Bank presidents were appointed by the
president of the United States and confirmed
by the Senate, they would not be free agents
so long as the Board controls their budgets.
There arc Bank presidents who act indepen­
dently of the Board, but by-and-large,
Reserve Bank presidents go along with the
Board.
It is difficult to overstate the power that the
Board of Governors, and particularly its
chairman, has in the FOMC. Perhaps a few
examples will make the point. The Board
controls (or at least it did under the previous
chairman) all staff material presented at the
FOMC, and only Board staff members make
verbal presentations at FOMC meetings.
Reserve Bank presidents usually seek Board
approval prior to agreeing to testify before
Congress. Reserve Bank presidents typically
have their testimony reviewed by Board staff
and the Board itself prior to delivery. Board
members do not check their testimony with
Bank presidents prior to delivery. Finally,
Bank presidents do not form coalitions within
the FOM C but the Board often represents
such a coalition. It is unlikely that a presiden­
tial appointment would make Reserve Bank
presidents much more willing to buck the
Board and its chairman.
There appear to be two solutions to the
nonindcpcndcncc of Reserve Bank presidents.
The first would simply accept the reality of
the situation and cxcludc Reserve Bank pres­
idents from the FOMC and monetary policy
decisions. This solution would have the virtue
of fixing responsibility directly with the Board
of Governors. It would have the deficiency of
depriving monetary policy deliberations of
regional influences and knowledge. The
second solution would retain the Bank presi­
dents on the FOMC, require presidential
appointments with Senate confirmation and
take the budget control over the Banks away
from the Federal Reserve Board. About the
only feasible way that budget control can be
taken from the Board is to change the entire
budgetary treatment of the Federal Reserve
System, including the Board. This could be
accomplished by placing all Fed expenditures
within the federal budget. Such a change

248

AMERICAN ECONOMIC ASSOCIATION

would entail congressional authorization for
Federal Reserve expenditures, both of the
Board and the twelve district Banks.
Reform of appointment of members of the
FOMC would enhance the accountability of
that body. The most important improvement
in accountability, however, must come from
greater disclosure of decisions by the FOMC.
Disclosure was not mentioned in Mr. Lilly's
letter, but it is the key to accountability. The
Fed cannot be held accountable until it is
forced to announce what its policies arc, how
it selected them rather than others, what
effects it expects to have with the policies and
how it will modify them if events do not
materialize as expected. In accountability, it
is crucial to distinguish objectives and the
methods selected to achieve them from honest
policy mistakes that result from an uncertain
environment. Disclosure is the only method of
making this distinction. Some progress has
been made to increase disclosure, first in the
form of House Concurrent Resolution 133
and later in an amendment to the Federal
Reserve Act which made most of the elements
of the Resolution permanent. The Fed does
announce its money growth targets, but it
refuses to name objectives for the economy
and to divulge its forecasts and policy altcrnatives. True accountability will occur only
when these factors are disclosed.
2) Board o f Directors o f the Reserve Banks
“Only the three Class C directors arc
chosen by the Board of Governors. The Class
A and B directors are chosen by the member
banks. This ostensibly gives the member
banks a larger voice in the running of the
Reserve banks than the Board of Governors.
In light of the reforms made with regard to
the interests to be represented by members of
Board of Directors made by Public Law
95-188,1 believe it would be desirable to have
both Class B and Class C directors selected by
the Board of Governors in Washington.”
Currently, two-thirds of the directors of
Reserve Banks are chosen by member banks
in the district and one-third are selected by
the Federal Reserve Board. Recent changes in
the law (P.L. 95-188) impose antidiscrimina­
tion standards on selection of directors and




MAY 1979

liberalize slightly the standards for selection.
Despite these minor changes, the majority of
Reserve Bank directors is still selected by
member banks in the district. Mr. Lilly would
like to have all directors chosen by the Board
of Governors in Washington.
It is easy to make too much of the issue of
Reserve Bank directors. They really exert no
influence on monetary policy; their primary
function is to advise the Bank president on
internal operations and to provide community
involvement with the Federal Reserve. Bank
directors might appear to have a policy role
because requests for changes in the discount
rate must come from Reserve Banks, but the
Board of Governors is free to ignore these
requests and usually docs. The discount rate
function docs lead to economic briefings of
the board of directors so that possible submis­
sions of discount rate changes can be consid­
ered. Because the Board in Washington must
approve these requests and because most
requests arc not even considered, the role of
the bank directors is not important. The
Board almost always has a menu of previously
proposed changcs in the discount rate avail­
able, should it wish to change the rate. If
there is nothing on the menu that the Board
likes, a phone call solves the problem.
Central banking is a governmental function
and it is inappropriate to have private individ­
uals serving as directors of Reserve Banks.
Central banking functions are no more impor­
tant to bankers than to anyone else, yet the
selection of directors is dominated by bankers.
Mr. Lilly would like to have the bank direc­
tors selected by the Board in Washington; I
would like to see them eliminated altogether.
If a Reserve Bank president wants help with
internal operations, then let him appoint an
advisory group.
3) Deferral o f Open Market Committee
Directive
“ I see no reason why the release of the
policy directive of the OMC needs to be
delayed. Everyone should have the same
access to the decisions made by the OMC.
Currently, only those brokers and dealers
with large staffs monitoring Federal Reserve
policy on a daily, and in some cases hourI)»

VOL 69 s o . :

ISSUES OF MONETARY POLICY

basis can know whai monetary policies the
OMC is pursuing. This is discriminatory and
gives brokers and dealers an advantage over
the ordinary citizen/*
The deferral of release of the FCM/C direc­
tive has been a holly debated issue for some­
time. Some people, many of whom arc in the
Fed, argue that speedy release of the directive
would be harmful because it would encourage
speculation. It is difficult to find merit in this
argument. Insiders such as government secu­
rity dealers know very quickly when the Fed
has changed policy. After all, the Fed exe­
cutes policy through open market operations
with these dealers. Other large operators in
the money market employ Fed watchers who
have become very good at divining when the
Fed has changed policy. It is difficult to
understand why the rest of the public must
wait thirty days to learn of Fed policy.
There appears to be a belief within the
Federal Reserve that secrecy and confusion
about current policy enhances the effective­
ness of that policy. I know of no basis for this
belief. The sooner the public knows what
monetary policy is. the better. The public
cannot decide what to do with information
until it has it.
I believe that the real reason the Fed defers
release of the directive is its penchant for
secrecy, which in turn is a desire to avoid
accountability. If the Fed truly had its way, I
doubt that it would ever release the directive,
it would usually produce only platitudinous
statements about the “ thrust** of policy.
Speedy release of the directive is clearly
called for. While I think it is helpful to have
policy debates in private in order to invite free
interchange of ideas, once decisions are made
they should be announced immediately.
4) Monetary Policy Responsibilities o f the
Board o f Governors
“ I accepted the position on the Board
because I viewed, and still do, the Board's
monetary policy responsibility to be of utmost
importance to the nation. Unfortunately,
there are many other m atters that come
before the Board that are lime consuming,
and these detract from this major rcsponsibil-




249

Contrary to popular opinion, the Federal
Reserve Board and Reserve Bank presidents
spend most of their time on matters other
than monetary policy. The Federal Reserve
Board spends most of its time on bank and
holding company regulation. The Reserve
Bank presidents are concerned not only with
regulation but also check clearing, funds
transfer, and other operating activities. It
seems reasonable to assert that monetary
policy is a full-time job and policymakers
should not be distracted by other matters.
The Federal Reserve is on both sides of this
issue. On the one hand, many Board members
have felt the frustration indicated by Mr.
Lilly over the relatively small amounts of time
available for monetary policy. On the other
hand, the Board has resisted efforts to reduce
its regulatory burdens. When faced with the
prospect of seeing its regulatory functions go
to other agencies, the Fed evidences a strong
desire to protect its turf.
The Fed has argued strenuously that it
needs regulatory functions in order to help it
execute monetary policy. I know of no case in
which monetary policy was helped by having
the Fed in the regulatory business. I know of
many cases in which regulatory responsibili­
ties got in the way of monetary policy. The
Federal Reserve needs data on what is
happening with respect to banks and in finan­
cial markets in general. It does not need to
regulate in order to obtain these data. I
believe monetary policy would be signifi­
cantly improved if the Fed ceased being a
regulator.

II. Some Further Considerations
Mr. Lilly’s complaints seem well founded.
They all spring from the same institutional
source. The basic problem lies with viewing
the Federal Reserve as a banking agency. A
central bank is not a private bank; it plays its
role by affecting the nation's monetary base.
The current structure of the Fed has its
roots in history, not in good economics. It was
history that produced Reserve Banks that
were set up like private banks with stockhold­
ers (member banks) and boards of directors.

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AMERICAN ECONOMIC ASSOCIATION

The stock of the Reserve Banks should be
retired (purchased from member banks) and
the boards of directors eliminated. Reserve
Banks should become purely governmental
entities.
It was also history that made membership
and regulations by the Fed come with reserve
requirements. It is important to divorce
reserve requirements from Fed membership
and regulation. Required reserves held at the
Fed are helpful to monetary policy. Reserve
requirements should have nothing to do with
the type of charter an institution has or with
who regulates it. If reserve requirements
should be imposed on a particular kind of
liability for purposes of monetary policy, then
they should be imposed on any institution that
accepts that liability: member bank, nonmember bank, savings and loan, mutual
savings bank, or credit union.
The Federal Reserve has found itself with
declining membership primarily because
many banks have found required reserves
onerous. It has used all sorts of schemes to
attract members. The Fed doesn't need
members, it needs authority to impose reserve




MAY 1979

requirements.
While there is no evidence that declining
membership has injured monetary policy,
there is evidence that the Fed's Rube Gold­
berg graduated reserve scheme has harmed
monetary control. There is also reason to
believe that with autom atic transfer accounts
starting in November, and with nationwide
N O W accounts (or their equivalent) waiting
in the wings, there could be explosive growth
in transactions accounts offered by institu­
tions that do not have reserve requirements
imposed against them. If this explosion
occurs, the Fed could find its monetary policy
control slipping. The solution appears to lie
with imposing reserve requirements against
all transactions accounts and allowing all
institutions that ofTcr them to have full access
to Fed services including the discount
window. The answer docs not lie with forcing
these institutions to be members of the Fed. If
all institutions have access to Fed services,
there will be no incentive to be members and
the Fed's regulatory burdens should die a
natural death. This reform would solve many
of Mr. Lilly's problems.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102