When trying to understand the monetary policy function of the Fed, who better to talk to than the recently retired vice chairman of the Board of Governors and 40-year Fed veteran Donald Kohn? He now works as a Senior Fellow for the Brookings Institution. He believes that an independent central bank is the best way to control money supply to achieve price stability.
Of course, there are other ways in which monetary policy could be conducted. One option would be to put the government directly in charge of monetary policy. For example, the Treasury could do it, or Congress could directly vote on changes to interest rates or policy shifts.
"There tends to be an inflation bias to central banking when (monetary policy is) closely controlled in the political process," Kohn explains. He says history has shown that politicians worried about re-election tend to engage in short-term monetary policy easing to stimulate the economy, while ignoring long-term price stability. This can lead to excessive inflation.
"Periodic bank panics occurred under the gold standard; the Fed was founded to deal with those."
Another way to conduct monetary policy could be to peg currency to a commodity like gold. The U.S. used to take this approach through the gold standard. With this strategy, some think you don't need a Fed, because the quantity and value of the currency depend on the quantity of the commodity. Kohn says that this approach can be inflexible and dangerous:
Periodic bank panics occurred under the gold standard; the Fed was founded to deal with those. And you're at the mercy of the supply of gold in the world, and its distribution among countries. You get situations as had occurred in the 1920s, when some countries accumulated large volumes of gold and they put downward pressure on the price levels of other countries that didn't have those large quantities of gold. It wasn't until after the U.S. went off the gold standard that we were able to begin emerging from the (Great) Depression.
He believes central bankers can do a better job of achieving price stability and other objectives with more flexibility than a commodity standard that ties the money supply to rigid rules.
If Not the Fed, Then Who?
This is not meant to be an exhaustive argument proving that an independent central bank is utterly necessary. Instead, these are just a few reasons why those with first-hand Fed experience believe that having a central bank like the Fed is better than other alternatives. And remember, quibbling over what objectives at which a central bank should aim as a part of its monetary policy philosophy isn't an argument against Fed; it's argument for reform. If you were to get rid of the central bank entirely, then you would need to find other regulators and/or mechanisms to take over its essential responsibilities. And as the sources above explain, trying to do so could get sticky.
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