Evaluating the Configuration of the Federal. Reserve System in the Twenty-First Century. Swati Joshi

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1 Evaluating the Configuration of the Federal Reserve System in the Twenty-First Century Swati Joshi

2 Since its inception in 1913 under the Federal Reserve Act, the Federal Reserve system has evolved in order to keep up with the times. Originally created by Congress in order to maintain a stable monetary and financial system, the evolution of macroeconomic theory and monetary policy tools have led to an expanded role. Today the Fed works to achieve the dual mandate of stable prices and low unemployment, found in the 1977 amendment to the act. In addition, it supervises and regulates financial institutions in order to protect consumers, maintains the stability of the financial system, and plays a large role in operating and overseeing the nation s payment system. However, the organizational structure of the Fed as well as the geographic locations of its twelve regional banks has remained the same for the last hundred years. This leads to the question of whether the configuration of Federal Reserve System meets the needs of a country that has experienced significant change since the Federal Reserve Act was passed. In this paper, I will examine this question with regards to geography, organizational structure, and political factors. The original locations of the reserve banks and their district lines were determined in part by politics of the past: Missouri has both the Kansas City Fed and the St Louis Fed because of an influential vote needed for the Federal Reserve Bill to pass in the Senate, and Richmond has a bank because the architect of the Bill in the House was from Virginia. In addition, more reserve banks were placed in the eastern half of the nation because eastern cities received votes from national banks, and the minimum capitalization requirements paid by member banks meant that districts had to be larger in the west. One of the idiosyncrasies that has resulted is that district lines divide many states- one Louisiana bank is regulated by the Atlanta Fed, but a bank in the next county is regulated by the Dallas Fed. More importantly, the districts are no longer

3 representative of the population. For example, in the San Francisco Fed served 19 percent of the country s population in 2000, while the Minneapolis Fed served just 3 percent. Charlotte, home of Bank of America, a major bank, doesn t have a regional bank, but Richmond does. A more perfect map would be one where each district would have around the same population, and reserve banks would be in cities that were major banking hubs. Regional diversity represents the idea that the system should be responsive to the varied economic conditions in a country as diverse and large as the United States. Equal representation is a vital part of our country s framework, and that s not something the Fed should be exempt from. According to the Minneapolis Fed, the regional structure ensures the representation of varied regional interests in economic research and policy formulation, as well as directly on the FOMC. In addition to executing banking and consumer protection laws, perhaps the most important function of regional banks is publishing research and economic forecasts that those in their district may find useful, and bringing those local issues into the national arena when necessary. Redrawing the lines would help ensure that those regional voices are better heard. While a perfect map is highly unlikely due to the political nature of the issue, a modern map would almost certainly allow for better representation of our population. But do the current geographic locations of the banks meet the needs of the United States? While population epicenters have shifted, the rapid communication allowed by technology mean that proximity to a reserve bank is no longer as important. The involvement of regional banks in policymaking (established in the 1935 amendment to the Federal Reserve Bill, which created the FOMC) is crucial, but a recent study published by the ECB shows that the influence of regional bias on national policy is limited at best. This is corroborated by another study by Chappel et al.

4 (2008), which shows that compared to the nationwide unemployment rate, district unemployment rate only has a small impact on the interest rate preferences of members. Furthermore, the rotation system implemented by the Fed has effectively limited the potential for regional influence on policy-making. In other words, while a regional bank has the obligation to represent the people in its district, redrawing the lines would most likely have no visible effect on the monetary policy of the nation. Like the geographical locations of reserve banks, the organizational structure of the Fed has more or less remained the same since the formation of the FOMC, despite significant changes in its responsibilities. There has been an increased reliance on monetary policy as a means of assuring national economic health, which means that the question of organizational structure is intrinsically linked to questions related to the independence of the Fed. As MacLaury 1977 argues, the definition of Federal Reserve independence is better thought of as the Fed s insulated structure which enables monetary policymakers to look beyond the short term pressures in order to pursue long-term goals for sustainable growth. And while critics argue that this independence diminishes the accountability of the Fed, in truth the Federal Reserve system is accountable to both Congress and the public. The Fed s relationship with Wall Street is contentious; in Why the Federal Reserve Needs an Overhaul, Greider argues that the Federal Reserve has always been a glaring contradiction of democratic values...the monetary debate proceeds in the sanitized language of economic abstractions and is limited to a small group of elites. When private financial institutions have a misstep like the 2008 recession, it s public money that comes to the aid. Each member bank owns nominal stock in its regional bank, after all, and the member banks are responsible for electing six of the nine directors of each regional

5 Fed bank. On a basic level, this makes sense because the regional Fed banks work with member banks in order to provide financial services. However, the boards of Federal Reserve banks are inevitably representative of banking, financial, and business interests, and to some extent ignore the interests of the consumer or minority groups. Having broader representation among district leaders would allow for fuller discussion of consumer and minority issues on the local level, which could in turn influence policy on the national level. But completely eliminating bank membership would be disastrous- most bank deposits must be subject to Fed control in order for reserve mechanisms to work. Membership allows for equity and efficiency between competing banks. The Fed s bank supervision and regulatory functions are structurally accountable to the board, rather than the region bank board, which serves as a safeguard. A close relationship between central banks and the Federal Reserve is not only necessary but inevitable, and the Federal Reserve act reflects the concern that monetary policy not be dominated by banking interests. And as for communication, Kliesen et al shows that central bank communications have increased post-financial crisis, in part due to the Fed s shift towards forward guidance. While the current organizational structure undoubtedly has its flaws, it hasn t prevented effective national monetary policy, and that s ultimately what the Fed has been created for. Lastly, the political factors surrounding the Fed must also be considered in any discussion about its effectiveness. Returning to the definition of independence presented earlier, the Federal Reserve was created as an institution that could withstand the short-term economic goals of a president or Congress in order to look towards more sustainable, long term growth. This has led to some criticism surrounding the fact that the country s monetary policy sometimes contradicts

6 its fiscal policy, leading both impotent. More frequent reports to Congress are a worthy reform, but the contradicting policy is inevitable- the Fed should be able to withstand political pressures to follow an economic path that may not be in the country s best interest. A larger issue is the high turnover rate of the Federal Reserve Board; the composition of the board and its fourteen year term was intended to withstand political influences, ensuring that presidents could not easily exert their influence over the Board through their appointees. However, in recent years, presidents have been able to appoint the majority of their Board. Shortening the length of the term would perhaps allow for more political independence because turnover would be more predictable. As Conti-Brown argued at a recent economic forum at the University of Pennsylvania, discussions about reforming the Federal Reserve should stress personal reform over Congressional reform. While the political process and the selection of central bankers may be linked, politics should not be injected into those central bankers after their selection. And as previously mentioned, the Fed is accountable to both the public and Congress. In conclusion, the Federal Reserve system has endured over the last hundred years for good reason. While some reforms need to be considered, for the most part the configuration of the Fed is effective in creating monetary policy that benefits the nation in terms of geographical locations, organizational structure, and political factors.

7 Works Cited Annual Reports. Federal Reserve Bank of Minneapolis, pendence-a-changing-structure-for-changing-times. Greider, William. Why the Federal Reserve Needs an Overhaul. The Nation, 7 July 2015, Irwin, Neil. The Federal Reserve System Is Nuts. Here's How We Could Remake It. The Washington Post, WP Company, 9 Aug. 2013, The Enduring Structure of the Federal Reserve System: Is It Time To. Seven Things I Learned about the Transition from Communism VOX, CEPR Policy Portal, voxeu.org/article/enduring-structure-federal-reserve-system-it-time-redraw-map. wpcomimportuser1. Why Is the Federal Reserve Board Made up Entirely of Bush Appointees? Because Fed Governors Don't Serve out Their Terms. Time, Time, 20 Mar. 2008, business.time.com/2008/03/20/why_is_the_federal_reserve_boa/.

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