The Federal Reserve: fourth branch of government?

January 20, 2008

In previous commentaries I have scolded the Federal Reserve’s indecision and the Federal Government’s spending habits. Recently in the article Bernanke fiddles while Wall Street burns I solicited rational explanations for their behavior. The response has not been overwhelming, but today I came across the following document from the Federal Reserve Bank of St. Louis that peaked my curiosity.

The paper was written in the summer of 2006 by Laurence J. Kotlikoff, who is a professor of economics at Boston University. Even though I generally agree with his conclusions, I probably wouldn’t have given the paper a second thought if it weren’t published on the website of a Federal Reserve Bank that is known to be hawkish, in contrast to public statements issued by Ben Bernanke. Below is Kotlikoff’s summary.

Is the United States bankrupt? Many would scoff at this notion. Others would argue that financial implosion is just around the corner. This paper explores these views from both partial and general equilibrium perspectives. It concludes that countries can go broke, that the United States is going broke, that remaining open to foreign investment can help stave off bankruptcy, but that radical reform of U.S. fiscal institutions is essential to secure the nation’s economic future. The paper offers three policies to eliminate the nation’s enormous fiscal gap and avert bankruptcy: a retail sales tax, personalized Social Security, and a globally budgeted universal healthcare system.

If the conclusions expressed in this paper are consistent with the position of the Federal Reserve Bank of St. Louis, it’s not unlikely it is consistent with the positions of other central bankers as well. More specifically, the Federal Reserve Bank of Dallas is also known to be quite hawkish. But if the cause of inaction is genuine deadlock, why would Ben Bernanke be so dovish in public?

The answer may come down to the primary antagonist in the good professor’s rant above — the Federal Government. They complain about the negative effects of irresponsible fiscal policy, oblivious to their own misjudgments, but that’s not the point. We happen to find ourselves in the middle of a somewhat rare presidential election in which no incumbents are running. This happens to be a perfect opportunity to shape political discourse without hurting too badly the individuals currently in power. Everybody knows that investors hate uncertainty, is the Federal Reserve trying to raise awareness among the political elite by causing panic among the electorate?

Paul O’Neil was the first Treasury Secretary in George W. Bush’s administration; in his tell-all book “The Price of Loyalty” published after he was fired there is an odd conversation described in which then Federal Reserve Chairman Alan Greenspan issues a warning about the remarkably non-conservative fiscal positions held by this new breed of Republican, people we now refer to as neo-conservatives. It’s difficult to know if O’Neil was simply trying to disassociate himself from a failing Presidency or if they were both genuinely concerned about the fiscal policies of the new government, but we know for sure that ever since Bush took office politicians have been roundly ignoring economists and preaching ridiculous notions like “deficits don’t matter”.

Is the Fed fighting back? Is it actually possible we are witnessing the Federal Reserve trying to assert influence over a hopelessly ignorant and irresponsible political class? Has the Federal Reserve emerged as a 4th branch of government doing the work Congress failed to accomplish?