Sunday, March 27, 2016

Congressional Attention to Monetary Policy over Time

The Federal Reserve describes itself as "an independent government agency but also one that is ultimately accountable to the public and the Congress...Congress also structured the Federal Reserve to ensure that its monetary policy decisions focus on achieving these long-run goals and do not become subject to political pressures that could lead to undesirable outcomes."

The independence of the Fed is by no means fixed or guaranteed. Rather, the Fed continually attempts to defend its independence. As Dincer and Eichengreen (2014) note, the movement of central banks toward greater transparency can be understood in part as an effort to protect independence by demonstrating accountability outside of the electoral process. They explain that "calls to audit the Federal Reserve have intensified as the central bank has come to rely more extensively on unconventional policies and expanded the range of its interventions in securities markets. The FOMC’s decision to make more information publicly available can thus be understood as an effort to reconcile the increased complexity of its operations with the desire to maintain and defend its independence."

The Fed derives its authority from Congress, and Congress can alter the Fed's responsibilities (and decrease its independence) by statute. Since the financial crisis, congressional calls for more oversight of the Fed or for less discretion by monetary policymakers abound. In National Affairs, Steve Stein writes:
"The independence of the Federal Reserve may well be more threatened in the coming years than at any time in the 100-year history of America's central bank. That independence could prove impossible to protect as long as the Fed continues to exchange its role as a defender of monetary stability for a new role as the ultimate overseer of the financial system. That new role is an inherently political one, and the Fed cannot expect to be permitted to perform it without interference from the democratically elected institutions of our political system."
It is difficult to measure the level of "threat" to Federal Reserve independence, but some indicators of Congressional attention to monetary policy are available. The Comparative Agendas Project tracks data on policy agendas, including hearings and bills, across several countries. Congress may use monetary policy-related hearings or bills as a form of signal to the Fed--an indirect form of political pressure or warning.

The figure below shows the number of bills in the U.S. Congress related to interest rates or monetary policy over time. Unsurprisingly, the 1970s and early 80s saw the largest number of such bills. The 1973-74 Congress considered 101 bills about interest rates and 55 about monetary policy. But the 2009-10 and 2011-12 Congress considered just 15 and 22 bills about monetary policy, respectively, which is low by historical standards.

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The next graph, below, shows the number of Congressional hearings on interest rates and monetary policy. These also peaked around the late 1970s. Since then, however, while hearings on interest rates have dwindled, hearings on monetary policy remain frequent--typically 10-20 per year. There is a mild upward trend from 2005 to 2012. Still, by neither metric of bills nor hearings is the Fed facing an unprecedented era of Congressional meddling.
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Monday, March 7, 2016

A Financial-Fiscal Trilemma

Financial crises and sovereign debt crises are, of course, not a new phenomenon. But the strong connection between fiscal crises and financial crises is relatively recent, primarily developing since the Great Depression and especially since the 1980s. In a new and ambitious NBER working paper, Michael Bordo and Chris Meissner survey the literature on financial and fiscal crises and their interconnections, providing both a history of thought and a catalog of open questions.

The key to the growing link between fiscal and financial crises, they explain, is the increased use of government guarantees of financial institutions. This means that banking crises are often followed by a rise in the debt-to-GDP ratio that can be partially attributed to costs of reconstructing the financial sector. Based on a synthesis of the research in this area and some preliminary empirical analysis, Bordo and Meissner posit that countries face a “financial/fiscal trilemma.” As they explain:
This financial/fiscal trilemma suggests 43 that countries have two of the following three choices: a large financial sector, a large bailout package, and a strong discretionary reaction to the downturn associated with financial crises. The logic is as follows by way of an example. Assume a country with a large financial sector faces a banking crisis. If so, then the government can provide a bailout package of a size that is commensurate with the size of the financial sector. If so it uses up its fiscal space. Otherwise it could lower the size of the bailout and devote its fiscal space to discretionary fiscal policy. With a smaller financial sector, and the same amount of fiscal space, since the size of the bailout would by definition be smaller, the size of the rise in debt due to expansionary policy could rise (p. 42-43). 
They use data from Laeven and Valencia (2012) on 19 systematic banking crises to estimate the equation:
Fiscal costs refer to the fiscal costs of bailouts in the three years following a crisis. Discretion is the change in debt not due to the fiscal costs of bailouts, also in the three years following a crisis. The estimation results, with standard errors in parentheses, are:

Notice that the estimated coefficients on the fiscal cost and discretion to GDP ratios sum to approximately 1, suggestive of a tradeoff. If the financial sector is smaller, or if the bailout package is smaller, then the change in fiscal costs to GDP ratio is likely to be smaller, which could allow a larger change in the discretion to GDP ratio, hence the "trilemma." The trilemma is illustrated by Figure 5, below. The discretion to GDP ratio is on the y-axis and the fiscal costs of bailout to GDP ratio is on the x-axis. For a given change in the debt to GDP ratio, the regression estimates imply an "iso-line" showing the fiscal costs of bailouts and discretion to GDP ratios that are possible.

Source: Bordo and Meissner (2015)

As further evidence of the trilemma, they present Figure 6, which illustrates that countries with a larger financial sector, as measured by the domestic credit to GDP ratio, tend to have a larger rise in the share of the debt to GDP ratio explained by bailouts.
Source: Bordo and Meissner (2015)
This evidence of a new "trilemma" certainly merits more rigorous empirical evaluation. As the authors note, however, empirical studies of financial and fiscal crises face the challenge of inconsistent classification and measurement. Alternative crisis chronologies lead to contradictory results. Bordo and Meissner thus propose the following:
If economists and policy makers truly believed that crises were an important phenomenon to understand and possibly avoid then it might be the case that an independent crisis dating committee could help set the standard in much the same way the NBER business cycle dating committee works. The advantage of following this model is that the NBER is a respected non-governmental, non-partisan organization. Other organizations such as the IMF are not sufficiently politically independent. If crises are becoming increasingly global and crisis fighting is a global public good, then the importance of such a reform should be obvious.