REFORMING THE FED: ITS INDEPENDENCE AND LESSONS FROM HUMPHREY-HAWKINS

REFORMING THE FED: ITS INDEPENDENCE AND LESSONS FROM HUMPHREY-HAWKINS

ANTHONY BARRElT*

The last session of Congress witnessed renewed calls for reforming the Federal Reserve System so as to better coordinate monetay and j sca l policies. This paper examines how the current institutional structure, established by the Humphrey-Haw- kins Act of 1978, performed when the supply-side tax cuts were implemented during 1981 and 1982. "he findings reveal that authorities barely discussed the necessary policy coordination at the Humphrey-Hawkins hearings. Further, the record reveals that Fed Chairman Volcker refised to utilize the Fed's independence to publicly oppose the supply-side tax cuts.

I . INTRODUCTION

Recent sessions of Congress have witnessed a series of proposals to alter the institutional structure of the Federal Re- serve System. The range of proposals is broad, but the legislation has two basic objectives: (i) to remove the shroud of secrecy surrounding the Fed's actions and deliberations, and (ii) to better coordinate monetary and fiscal policies. However, the implicit and unquestioned assumption underlying the proposed legislation is that the Fed is in fact an independent agency that must be brought under greater congressional control.

One can gain insight into the merits and possible consequences of the proposed legislative changes by examining the resulting impacts of the last time authorities changed the institutional environment of the Fed. Public Law 95-523, the Full Em- ployment and Balanced Growth Act (bet-

*Associate Professor of Economics, College of St. Scholastica, Duluth, Minn. This is a revised version of a paper presented at the Western Economic Associa- tion International 65th Annual Conference, San Diego, June 30, 3990. The author thanks Gary Evans, David Eagle, and two anonymous referees for their comments.

Contemporary Policy Issues Vol. IX, July 1991

ter known as the Humphrey-Hawkins Act), was enacted in 1978. Among its many provisions was requiring that, twice a year, the Fed must report to Congress its monetary targets for the upcoming year and reconcile those targets with the administration's economic projections for the year. Clearly, the purpose of the Hum- phrey-Hawkins legislation paralleled that of much of 1990's crop of legislative proposals-i.e., to shed greater public light on the Fed's actions and to better coordinate monetary and fiscal policies.

The Humphrey-Hawkins Act provisions were put to the test in 1981, when President Reagan proposed his supply- side tax cuts. This paper examines the so-called Humphrey-Hawkins hearings (H-H hearings) of the House of Repre- sentatives' Committee on Banking, Fin- ance, and Urban Affairs, at which Fed Chairman Paul Volcker testified. The paper examines two critical issues. First, did authorities achieve policy coordination? The second issue, a byproduct of examining policy coordination, is whether the Fed is independent in practice. This paper reaches the somewhat paradoxical conclusion that while authorities did not achieve conscious policy coordination-

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resulting in the high interest rates and severe recession during the early 1980s- the Fed failed to exercise much of its independence.

11. THE SETTING AND THE HEARINGS

Three new factors combined to put in a unique position the 97th Congress, which convened in January 1981. First, congressional monetary policy oversight hearings still were in their infancy. Such hearings had existed for only six years. Further, am- biguities in the earlier laws (e.g., House Resolution 133 of 1975) regarding exactly what-and in what form-the Fed needed to report undermined the usefulness of the initial hearings. The H-H Act contained provisions correcting many of the weak- nesses. The second factor was that the Fed- eral Reserve, under the leadership of Chairman Volcker, was following the new policy of emphasizing the monetary aggregates and de-emphasizing the level of interest rates. The third unique factor was a new president who was proposing an economic policy dramatically different from the fiscal policies of the previous two decades .

The combination of substantially different monetary and fiscal policies created a situation crying out for careful review and coordination. The H-H hearings, in theory, provided an ideal forum for such a review. This paper examines the two hearings of the House of Representatives’ Committee on Banking, Finance, and Urban Affairs in 1981. The first hearing, on February 26, occurred shortly after President Reagan had submitted his economic plan containing the supply-side tax cuts. The second hearing, on July 21, occurred two weeks before the scheduled vote on the tax cuts.

The importance of an appropriate monetary policy was clear to all participants. Obviously, differences of opinion exist as to the specific appropriate policy, but no participants seemed to disregard the sig- nificance of the money supply. Further, the whole Committee on Banking conducted

the hearings, whereas the Subcommittee on Domestic Monetary Policy had conducted the bulk of hearings since 1979.

111. POLICY COORDINATION

Effectively coordinating monetary and fiscal policies requires three steps. First, one needs an analysis of the impact of the monetary policy goals, as stated by the Fed in its report to Congress. The Fed‘s report reaches the representatives shortly before the hearings, but representatives or their staff have sufficient time to review the report. Second, one needs an analysis of the impact of the president’s proposed fiscal policy. Again, the law requires the president to submit to Congress an annual report containing the administration’s proposals and economic forecast. The third step is reconciling the two policies.

The above layout is deceptively simple. In actuality, pitfalls abound. Economic forecasting is an imprecise art. Even in theory, the impact of a particular monetary or fiscal policy action can arouse intense debate. Still, effectively coordinating monetary and fiscal policies remains possible within a broad range of parameters.

In 1981, however, such coordination was made more difficult by the experi- mental nature of supply-side economics, making the optimal monetary policy a matter of considerable theoretical debate. However, supply-side supporters within the administration were unified. They maintained the appropriate monetary policy was a tight one. Paul Craig Roberts (1981), then Assistant Secretary of the Treasury for Economic Policy, observed:

A tax cut without a spending cut can result in a budget deficit, but a deficit is not inflationary unless the Fed mon- etizes i t ... but since the Reagan administration is not cutting taxes in order to stimulate demand, it will apply no pressure on the Fed to mon- etize debt.

Therefore, when the House held its hearings in 1981, much uncertainty sur-

78 CONTEMPORARY POLICY ISSUES

rounded the issue of coordinating monetary and fiscal policies. Remarkably, reviewing the transcripts of the two 1981 hearings reveals that the interplay of the supply-side tax cuts and monetary policy received relatively little attention. Only six exchanges between congressmen and Chairman Volcker dealt with the impact of the tax cuts given the Federal Reserve’s stated monetary policy goal. Of the 250 pages of testimony, only nine pages dealt with the subject.

This absence of review is difficult to ex- plain. One explanation is that the bulk of the testimony focused on past Fed actions or technical matters such as defining the various monetary aggregates. Such a focus is consistent with one stated goal of the oversight legislation: removing the shroud of secrecy surrounding the Fed so as to increase its accountability. Given the time constraint on questions, if a representative was concerned primarily with the Fed’s new operating procedures and other technical points, then this would limit the re- maining time for questions concerning policy coordination.

A second possible explanation for fail- ing to examine a critical economic issue is that the congressmen simply were eco- nomically illiterate and could not fathom the intricacies of monetary policy. In this case, however, no doubt exists that the committee was aware of the potential danger that would result from the supply-side tax cuts with a tight monetary policy and rising budget deficits. Representative Ste- phen Neal (D-N.C.) presented the issues clearly at both 1981 hearings. During the February hearing, he foresaw the possibility of a $100 billion deficit in the following year. He never used the words ”interest rates” but expressed concern over such a large deficit coexisting with the tight monetary policy (US. House of Representa- tives, 1981a, p. 122). During the July hearing, Neal was much more explicit. He laid out his ”most likely scenario,” which turned out to be a prescient job of eco-

nomic forecasting. Neal predicted that if lawmakers enacted all of President Reagan’s spending and tax changes, then a $110 billion deficit would result. He con- cluded what many economists were con- cluding at the time: Interest rates would rise. Interestingly, as the following exchange shows, he could not persuade Chairman Volcker to agree:

Mr. Neal: Somewhere, then, you would agree we would have these very high interest rates?

Mr. Volcker: We will have high deficits and that will be a factor on interest rates. How high interest rates will be, I think, depend [sic] on two other factors, apart from the deficit: How much progress have we made on inflation, and what is the current strength of the economy? (U.S. House of Representa- tives, 1981b, p. 222)

The Neal-Volcker exchange reveals that at least one committee member was aware of the potential danger to the economy. Neal was the only person at these hearings to explicitly raise the issue and attempt to persuade Chairman Volcker to discuss the implications of enacting the supply-side tax cuts with a tight monetary policy. Of the other four exchanges dealing with the supply-side tax cuts, two focused on whether signing into law the third year of cuts was advisable given the uncertainty inherent in such a commitment. The other two exchanges were brief questions about the incentive nature of the tax cuts.

Another possible explanation for the absence of discussion is that after Repre- sentative Neal raised the issue, the other representatives passed up the opportunity so as to avoid being repetitious. One can reject this explanation on two grounds. First, Neal’s questions came approxi- mately two-thirds of the way through the July 21 hearing. Second, the representatives displayed no reluctance about being redundant on other issues. During that same hearing, for example, six different representatives asked essentially the same questions concerning the impact of NOW

BARRETT: REFORMING THE FED 79

accounts and money market mutual funds on calculating the various monetary aggregates. Representatives exhibited sim- ilar repetition on the issues of lines of credit to finance mergers and impending trouble in the savings and loan industry.

In sum, the policy coordination goal of congressional oversight clearly failed during the critical period in recent U.S. economic history. Regardless as to why members of the House Committee on Banking, Finance, and Urban Affairs gave little attention to coordinating monetary and fiscal policies, the fact remains that they barely discussed the issue. Certainly, this episode should shed some light on the issue of imposing further oversight legislation. This conclusion is not meant to imply that policy coordination did not occur. Simply put, the Federal Reserve implemented the monetary policy that the administration supported but did so for reasons other than congressional oversight.

IV. INDEPENDENCE

The Federal Reserve, as an institution, seemingly is an independent agency of the government in the sense that the Fed can determine its policies free from the influence of partisan politics. Since the Fed’s origin with the Federal Reserve Act of 1913, Congress has made clear its desire to keep control of the nation’s money supply isolated from the political process. Few can argue that, in theory, the Fed‘s budg- etary freedom from Congress’s annual ap- propriations process, the Governors’ stag- gered 14-year terms, and the Board of Governors’ appointing the regional Fed- eral Reserve presidents all combine to give the Fed a greater degree of independence than that enjoyed by most other government agencies.

Currently, the political interest groups affected by the Fed are marshaling their forces so as to influence the fate of the proposed legislation. Critics of the legisla-

tion base their arguments on the grounds that one should consider the Fed’s independence as sacred. Chairman Greenspan (1989), while testifying in the House of Representatives, said the cumulative impact of the legislation would subject the Fed to ”a more intensely political perspec- tive ... [and] could risk bending monetary policy away from long-term strategic goals.” Herbert Stein leaves no doubt where he stands on the issue. He titled a recent essay, “How to Worsen the Fed‘s Problem” (Stein, 1989).

The Fed’s independence almost certainly is desirable, but whether the Fed is de fucto independent is debatable. Several economists have pointed out that the Fed still is subject to intense political pressure (e.g., see Kane, 1974, 1980, 1982; Meltzer, 1982). Public policy theory shows how a theoretically independent agency such as the Fed may sacrifice some of its independence so as to keep its critics at bay. Wooley (1982) observed: ”No prudent political actor can ignore the possibility that reactions to his policy decisions might damage the future ability of his organiza- tion to achieve policy goals.”

Fully reviewing the nature of independence and the Federal Reserve System is beyond the scope of this paper. However, one aspect of the Fed’s independence is its ability to speak out-in a voice different from that of the administration-on economic issues. This aspect of the concept of independence clearly is relevant when one examines policy coordination. Reviewing Chairman Volcker’s testimony reveals that the Fed was not willing to exercise its independence.

In 1984, Representative St Germain (D- R.I.), chairman of the committee, looked back on the 1981 hearings and put issue in stark terms:

These hearings do offer the Federal Reserve a great opportunity to dem- onstrate its vaunted and oft-pro- claimed independence. A chance to give the American people a clear pic-

the

80 CONTEMPORARY POLICY ISSUES

ture, drawn in plain everyday terms, of its opinion of economic policy-un- concerned about whether its numbers and analysis were in the same ball- park with the actions of the Presi- dent’s political appointees.

. . . The Federal Reserve-thanks to this committee’s initiative-was given repeated opportunities to provide a strong independent analysis of what was happening-to give warnings. If these signals were given-if there were stark differences with the administration’s headlong rush toward record unemployment and record deficits or major differences with the projections-most of the nation missed them. (U.S. House of Representatives, 1984, p. 2)

St Germain’s comments put the issue in stark terms, though one could argue that he is benefiting from hindsight. However, Chairman Volcker’s failure to speak out was noted during the July 1981 committee meeting, which preceded by two weeks the vote on the supply-side tax cut. Rep- resentative Fauntroy (D-D.C.) stated explicitly: ”What puzzles me ... is that as an independent agency . . . you have not exer- cised the authority of the independence that you have in judging administration and congressional actions that are pend- ing” (U.S. House of Representatives, 1981b, p. 218). Representative Reuss (D- Wis.), commenting on the Fed’s silence, in- cluded a veiled threat:

Yet, so far as I know, there hasn’t been one ounce of criticism or even analysis of the administration’s deficit-prone program.

Those who are given independence and don’t use it, may not deserve it. (U.S. House of Representatives, 1981b, p. 207)

Various representatives pressed Volcker for his position on the advisability of the supply-side tax cuts, but Volcker was ad- amant in maintaining his silence. During the February hearing, Volcker stated his position clearly: ”I do not concede that it is my function or responsibility or, really,

that it is appropriate for me to advise the Congress on the details of tax programs” (U.S. House of Representatives, 1981a, p. 149). Representative D’Amours (D- N.H.) explicitly asked Volcker for his opinion on conditioning the third year of the tax cuts on the economy’s performance. Volcker replied: ”I am not going to answer that question for you. I think you have to answer it yourself.” (U.S. House of Repre- sentatives, 1981b, p. 232) After an exchange of comments, D’Amours con- cluded by stating:

You are not speaking out on [the issues of the tax cut and the deficits]. You are pretending to speak out on it. We are looking to you for leadership. People like what Paul Volcker is saying, they look toward him for leadership. They think he is tough and independent.

You keep saying you are speaking out, but frankly, I know the issues fairly well, because I work with them every day and I can‘t hear what you are saying because you are saying a little bit for everybody. You are not enunciating a clear policy in terms of what we ought to be doing. (U.S. House of Representatives, 1981b, p. 233)

Clearly, the Fed, under Volcker’s leadership, chose not to exercise an aspect of its independence: speaking out on administration economic policy. The reasons the Fed made this decision lie in the realm of public choice theory. Fully examining the issues involved must be the subject of another paper. However, simply put, the Fed may have elected to sacrifice its freedom to comment independently on the administration’s fiscal policy so as to maintain its freedom in other areas or to maintain friendly relations with the relatively new Reagan administration.

V. CONCLUSION

Currently, substantial public debate exists over possible changes in the institutional setting of the Federal Reserve. The

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changes aim (i) to open to greater scrutiny the operations of the Fed and (ii) to better coordinate monetary and fiscal policies. Any proposal to change the Fed centers on the nature of the agency's independence.

This paper has examined two issues. First, if policy coordination is the purpose of some proposed legislation, then does congressional oversight hold out the promise of greater coordination? Examin- ing the exercise of such oversight during a recent critical period reveals that the House committee clearly failed. Some members made efforts, but the committee as a whole ignored the issue of policy coordination.

Second, examining congressional oversight reveals an interesting aspect of the nature of the Fed's independence. Clearly, independence allows members of the Fed to speak out on economic issues and to express opinions concerning the administration's policies. Chairman Volcker's testimony reveals that, under his leadership, the Federal Reserve was willing to abdicate that element of its independence.

REFERENCES

Friedman, B. M., "Public Disclosure and Domestic Monetary Policy," in R. Erb, ed., Federal Reserve Policies and Public Disclosure, American Enterprise Institute, Washington, D.C., 1978, 15-40.

Greenspan, A., Quoted in "Ending Inflation Would Have Cost," Wall Street Journal, October 26,1989, A2.

Kane, E. I., "The Re-Politization of the Fed," Iournal of Financial and Quantitative Analysis, November 1974, 343-352.

, "Politics and Fed Policymaking: The More Things Change, the More They Remain the Same," Journal ofMonetary Economics, April 1980, 199-211.

, "External Pressure and the Operations of the Fed," in R. E. Lombra and W. Witte, eds., Political Economy of International and Domestic Monetary Policy, Iowa State University Press, Ames, 1984, 211-232.

McElravy, J. N., "Communication and the Humphrey- Hawkins Process," Economic Commenta y , Federal Reserve Bank of Cleveland, April 1989.

Meltzer, A,, "Politics and Economics at the Federal Re- serve," in R. E. Lombra and W. Witte, eds., Polit- ical E c o n o m y of In te rna t iona l a n d D o m e s t i c Monetary Policy, Iowa State University Press, Ames, 1984, 223-225.

Peterson, S. B., A Historical Review of the Independence of the Federal Reserve System and an Analysis of Re- cent Policy Decisions, dissertation, University of Utah, 1985.

Pierce, J. L., "The Myth of Congressional Supervision of Monetary Policy," Journal of Moneta y Econom- ics, Vol. 4, 1978, 363-370.

Public Law 95-523, "Full Employment and Balanced Growth Act," Ninety-Fifth Congress, October 27, 1978.

Roberts, P. C., "The Keynesian Attack of Mr. Reagan's Plan," Wall Street Journal, March 19, 1981, A22.

Stein, H., "How to Worsen the Fed's Problem," Wall Street Journal, October 19, 1989, A20.

U.S. House of Representatives, Committee on Bank- ing, Finance, and Urban Affairs, Humphrey-Haw- kins Monetary Policy Oversight Hearings, Ninety- Seventh Congress, February 26, 1981, Govern- ment Printing Office, Washington, D.C., 1981(a).

, Humphrey-Hawkins Monetary Policy Over- sight Hearings, Ninety-Seventh Congress, July 21, 1981, Government Printing Office, Washington, D.C., 1981(b).

, Humphrey-Hawkins Moneta y Policy Over- sight Hearings, Ninety-Eighth Congress, February 7,1984, Government Printing Office, Washington, D.C., 1984.

Weintraub, R. E.. "Conprressionaf SuDervision of Mon- etary Policy," JGmal of Monetary Economics, Vol. 4, 1978, 341-362.

Wooley, J. T., "It's All Proximate," in R. E. Lombra and W. Witte, eds, Political Economy of International and Domestic Moneta y Policy, Iowa State University Press, Ames, 1984, 199-202.

REFORMING THE FED: ITS INDEPENDENCE AND LESSONS FROM HUMPHREY-HAWKINS

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