The insiders-only world of the Federal Reserve

December 14, 2010 — Few institutions in the country today are less loved than the Federal Reserve. At a time when disillusionment with Washington and Wall Street is rife, the Fed — which is quite literally a hybrid of the government and the banking sector — has come under widespread attack. And while there are important differences between the critiques offered by the right and the left, there are common threads, too. Vermont Senator Bernie Sanders, blasting the “veil of secrecy” surrounding the Fed’s emergency lending program at the height of the financial crisis, struck a tone sounded by many Fed critics: the institution is unaccountable, opaque, and unduly responsive to entrenched interests.

To the extent that there’s merit to this complaint, why might it be so? What elements of the Fed’s formal and informal institutional design contribute to this situation?

There’s more to the story than raw political power. Talk to people who have spent time thinking about the Federal Reserve — from the inside or the outside, and from either a sympathetic or critical perspective — and a picture emerges of a system that prides itself, with justification, on being rigorously technocratic and free of partisan disputes. But it’s also one that has historically been shielded from public scrutiny not just by its formal independence, but by its connections to other elites.

“Everybody in the Federal Reserve system is an insider,” says Steve Randy Waldman, a Ph.D. candidate in finance at the University of Kentucky and the author of the blog Interfluidity. But at the same time, Waldman notes, “it’s a system that’s designed to bring a lot of people to the inside” — a fact that may help to explain the political resilience of, and continued intellectual support for, a complex, oft-criticized institution.

‘A system that’s not designed to make room for outsiders’

What does it mean to say that the Fed is, in Waldman’s words, “a system that’s not designed at all to make room for outsiders”? At the most basic level, it means that there is no way for ordinary members of the public to agitate for change or express a preference through the most common democratic mechanism: an open election.

The Federal Reserve system is divided into two main parts: the twelve regional reserve banks, and a Board of Governors based in Washington, D.C. Each of the regional banks is overseen by a nine-member Board of Directors, whose chief responsibility is to hire a bank president. Six of those people are appointed by the executives of local member banks; three of those six are the executives of member banks. That’s about as “inside” as you can get.

Say you’re a consumer advocate or a supporter of alternative banking models, and you think you could bring a unique perspective to your regional Fed board. But because of your views, you suspect you may not catch the eye of your local bankers. What’s your strategy? Angling for an appointment from the national Board of Governors, which selects the last three members of each regional Board of Directors. And how do you get to be on the Board of Governors? You get appointed by the President, and confirmed by the Senate. Again, few outsiders need apply.

Meanwhile, once these appointees are in place, they are given a wide berth by the rest of the government. While the Chairman of the Board of Governors testifies before Congress several times a year, the bank’s policy decisions are not reviewable by other entities. The staggered 14-year terms given to members of the Board of Governors are also intended to protect the bank’s independence.

The closed nature of the system does not mean that concerns about the public good are ignored by the Fed’s design. The President, whose power to appoint the Chairman of the Board of Governors is substantial, is, after all, publicly elected. And one way to understand the system is as an attempt to balance political pressure for looser money in times of crisis — which should, theoretically, be reflected in the choices of the politically appointed Board of Governors — with creditors’ preoccupation with fighting inflation.

But it does mean that representations of the public interest are attenuated, and there is no ready-made channel for challenges to the prevailing model. Timothy Canova, a professor at the Chapman University School of Law and a critic of the modern Fed, pins some of the blame on the belief in technocratic expertise that prevailed during the Progressive period of the early 20th century, when the bank was founded. “It’s supposed to send a signal to citizens that [the central bank’s responsibilities are] too complicated for them, and they should just be happy with the delegation,” he said.

That, of course, leaves an important question: to whom are we delegating? While the Fed is the product of the government and the banks, there is one class of people who have been taken comfortably into its embrace, and who exert increasing influence over the institution’s policy choices: academic economists.

Forging closer relationships with economists

It might seem obvious that the country’s most powerful economic institution would have a close relationship with people who hold formal training in monetary policy, banking, and its other areas of responsibility. But the extent to which the Fed is run by academics — and the extent to which the institution exerts influence in the academy — is a comparatively recent development. It wasn’t until the 1970s that some of the regional reserve banks began to cultivate unique identities based on their research output, just as elite graduate programs develop distinctive reputations. Even after that period, many top policy-makers, even if they held Ph.D.’s, came from backgrounds in business or elsewhere in government. Laurence Ball, an economist at Johns Hopkins University who has held several positions within the Fed system, said an academic pedigree became increasingly important in the 1990s — and the shift has continued even within the past decade, as regional banks select presidents whose credentials measure up to the members of the Board of Governors.