The insiders-only world of the Federal Reserve

The closeness between the Fed and the economics profession is reflected in several ways. One is straightforward hiring: using data from 2002, Lawrence H. White, a professor at the University of Missouri-St. Louis, calculated that “the Fed employs full-time about 27 percent more macro/money/banking economists than the top 50 U.S. academic economics departments put together.” The institution also hosts dozens more professors as visiting scholars, and provides key platforms for research through the many conferences it hosts annually. And economists with professional relationships with the Fed occupy important posts at academic journals: a 2009 story in The Huffington Post reported that 84 of the 190 editorial board members at seven leading journals were, or had been, affiliated with the central bank. “With regards to monetary economics, the Fed’s reach is nearly universal,” said Arpit Gupta, a research coordinator at Columbia University who focuses on consumer finance and banking.

The impact of this relationship on the Fed’s policy choices is debated: Ball sees professional economists as partly to blame for what he called the Fed’s preoccupation with inflation and its slowness in trying to address high unemployment, while other observers see academics as generally less tight-fisted than the bankers and businesspeople who are represented in the Fed system.

The flipside of that question — what is the impact of the Fed’s influence on the academic research agenda — is even thornier. But to critics, one consequence of the Fed’s outreach is to claim ownership of the debate, and to marginalize alternative views, both within and outside the institution. 

How might this play out? Tales of direct censorship of research by Fed economists are rare (though, as McClatchy’s Greg Gordon reported earlier this year, not unheard of). And while there are some instances of the bank’s supporters pushing back against high-profile challenges to its handling of the economy — for example, the cool response to a now celebrated paper by Raghuram Rajan, presented at the Fed’s showcase conference in 2005, warning that financial innovation had made the world riskier — “it’s not usually the case that what happens is somebody tells truth to power, and they get publicly rebuked,” said Waldman.

Rather, he said, the issue is which questions the Fed asks academic economists to answer, and which academic research the Fed decides to fund. “They’re most interested in stuff that will tell them how to do their jobs better,” said Waldman. And their jobs, of course, consist of overseeing, and preserving, the system that now exists. One result may be that the very real intellectual debate over the best strategies to achieve the Fed’s goals — in fact, recent months have been marked by public disagreements between top policy-makers — occurs only within well-defined parameters.

To illustrate the point, Waldman offered the example of “narrow banking.” Under the existing system, known as “fractional-reserve,” when you deposit money in a bank, the bank turns around and lends it out, while also making your money available to you on demand. This system expands the supply of money, facilitating investment and economic growth — but if everybody demands their money at the same time, bank runs or broader crises can ensue.

Government programs such as deposit insurance are designed to control the risk in the fractional-reserve system. In a narrow banking model, on the other hand, institutions defined as “banks” would simply be required to hold deposits in liquid or very safe assets such as government bonds, rather than reinvesting them as loans. These banks would offer very limited returns, but some commentators argue that creating such safe harbors would be an improvement on trying to devise fail-safe regulations that also allow banks to seek big profits. (In such a system, people could also place their money with other financial institutions that would be free to reinvest it, offering greater returns at greater risk.)

The case for the merits of narrow banking is contested. But either way, “I don’t think you’ll find the Fed funding that research,” Waldman said, because even modest steps toward that approach would represent a sea change from the current model. (Indeed, a search for the term “narrow banking” on the Fed’s website yields scant results.)

Some observers believe these concerns can be overstated: the Fed may take a selective approach, but the diversity of opinion within the central bank, and the presence of many economists outside it, provide useful checks. “The Fed has no ability to censor someone outside,” said Joe Peek, a professor at the University of Kentucky who worked for an extended period at the regional bank in Boston. Even the Fed’s control over access to data about banks — a key bit of leverage over skeptics — has loosened over the years (though not completely so, as its resistance to disclose information about the emergency lending program shows). But critics see the risk of self-censorship as real, if hard to quantify. An economist who is not employed by the Fed, but hopes to be one day, wrote White, “faces a subtle disincentive to do regime-challenging research.”

Balancing independence and accountability

But it would probably be a mistake to see the Fed’s close relationship with economists as operating primarily through pressure, intentional or otherwise. At least as important is the way that the Fed raises the esteem of the profession, and creates that rare opportunity: a way for academic research to directly affect public policy. The resulting dynamic may be self-reinforcing: an independent, technocratic central bank empowers economists, and empowered economists are persuasive in arguing for the necessity of an independent, technocratic central bank.

There are sound theoretical reasons why an autonomous central bank is desirable. The concern is that voters and incumbent politicians will usually have a bias toward stimulating the economy in the short-term, which can be destructive in the long run, so some degree of insulation from the political process is necessary. And this is not just an abstract argument: one interpretation of the damaging inflation of the 1970s is that the Fed, while nominally independent, did not at that point truly have the authority to check rising prices and wages in the face of political pressure. The “Great Moderation” that followed that episode — during which economists assumed a greater role within the Fed, and the Fed assumed a greater role in shaping policy — helped validate the technocratic approach.