U.S. Monetary Policy Essay, Research Paper
U.S. Monetary Policy
Economic policy dictates the lives of many people. Economic regulation affects everyone, if the economy falters then people lose money, inflation runs rampant, and unemployment rates rise. Controlling U.S. monetary policy, or at least having some influence, ranks high on the agenda of many political actors from the president and Congress, to the private sector like the credit industry.
At the heart of U.S. monetary policy is the Federal Reserve System. The Federal Reserve controls the money supply to member banks, and the interest rates that money can be lent and borrowed at. They also can control the money supply through open market sales on a much smaller level, but interest rates and reserve requirements are the big tools that the Federal Reserve uses to control the economy.
A basic explanation of the functions of the monetary policy tools is necessary at this point so the positions of the actors and political ideologies can be understood. This purposes of these tools can best be explained by Paul Peretz:
Monetary policies determine the amount of money and credit that is available in a society. When the amount of money and credit is reduced, the price the borrowers have to pay for money (the interest rate) goes up. When the money supply is increased, the interest rate is driven down. People borrow more when the interest rate is lower; they use the borrowed money to purchase goods, such as cars and houses, and invest in machinery and factories. Thus, increasing the money supply stimulates the economy. Of course, beyond some point the economy can be overstimulated. With more money in their pockets, people bid up the prices of goods and the result is inflation. Reducing the amount of money available to borrowers tends to depress the economy and slow inflation (Peretz, 267).
This explanation, however basic, does not account for the minute margin of error involved in controlling the economy. That is why the Federal Reserve only acts when it feels incredibly compelled to redirect the economy.
The Federal Reserve acts as an independent agency. Its members serve comparatively long terms and are politically insulated to a certain degree. My previous paper touched upon the debate over whether something so important as economic stabilization should be controlled by a body that is so independent. This can be related to the ideological differences between the parties and their beliefs on monetary policy.
The Democratic Party typically wants lower interest rates. They are willing to risk inflation for economic growth. This is most historically prevalent during the Great Depression. Massive government spending to stimulate the economy and lower astronomical unemployment rates came under Franklin Roosevelt, a Democratic president.
On the other hand, Republicans want higher interest rates because they focus on controlling inflation. Most Republicans think that through mildly depressing the economy, the end result is a steadier growth and a more stable economy. The above descriptions of basic party philosophies tend to be a little misleading; neither party wants to destroy the economy. They are both on the same page, however they polarize that page with the separation in views. Remember stimulating the economy through interest rates is a powerful resource for the Federal Reserve, and a small change can produce a gigantic outcome in the economy.
The president could quite possible be the most visible actor in the struggle for control of the economy. To most Americans, the president is the one who controls the government, which is true to a certain extent since we have moved from and era of Congressional government to Executive Branch leadership. The president is very powerful, but with this power comes accountability. When the economy is poor, then voters hold the president responsible. Anyone with any knowledge in political science knows that to the average voter, the economy is the largest determinant of voting.
This is the reason behind Edward R. Tufte s theory on political control of the economy. Tufte thinks that Presidents try to pump up the economy before elections, especially incumbents. The purpose of this is to gain electoral support going into the polls. Both parties have different methods for achieving their goals. Republicans typically depress the economy prior to the election then take the brakes off. Democrats try to stimulate the economy previous to the election. Both ways have the same goal, to increase the amount of disposable income.
Many people ask why the President would attempt to control the economy when it is such a risky task. Well, the reward is glorious. Strong electoral support is the prize for the party who masters control over the economy. The phenomenon of presidential influence over monetary policy is known as the political-business cycle (Tufte, 1994). However, the amount of influence the president can exercise is questionable. He has no direct influence other than through his appointments, and the only one he can appoint with certainty is the Chair of the Federal Reserve Board (appointed every four years). The Chair, the most powerful member of the Federal Reserve, meets with the president on a regular basis, and a certain amount of loyalty can be assured. The president has the best of both worlds: first he can probably exercise influence where he should not be able to because the Federal Reserve is an independent agency. Second, he can reap the benefits when he is successful, yet blame the Federal Reserve when the economy stumbles, political insulation acts as the scapegoat.
Federal Reserve Board Chairman Alan Greenspan touches upon the risks of the political-business cycle. Most economists fear the politicization of the Federal Reserve. Greenspan cements his views:
The lure of short-term gains from gunning the economy can loom large in the context of an election cycle, but the process of reaching for such gains can have costly consequences for the nation s economic performance and the standards of living over the long term. The temptation is to step on the monetary accelerator, or to at least avoid the monetary brake, until after the next election. Giving in to such temptation is likely to impart an inflationary bias to the economy and could lead to instability, recession, and economic stagnation (Greenspan 290).
This represents the compromise that political actors have to make when struggling for control of the economy.
Congress wants its piece of the economic policy pie as well. Voters are not as punitive with Congressman and the economy, because the accountability of Congress is dispersed. The rule of a good economy equaling re-election for incumbents still applies. The way Congress becomes involved is first the approval of presidential appointees. Second, come the oversight committees, they hold hearing and the Chair of the Federal Reserve reports to them on the economy and monetary policy. The oversight committee in the House is the Committee on Banking and Financial Services. Under Rule X, controlling committee referral for legislation in the House, the committee gets any legislation pertaining to management and reform of the Federal Reserve System, particularly the subcommittee on Domestic and International Monetary Policy. The committee s oversight plan for the 106th Congress includes:
The Committee will hold hearings on the Federal Reserve Board s semi-annual reports on the conduct of the nation s monetary policy. . .. No Committee has a greater oversight obligation than the Banking Committee with its jurisdiction over the Federal Reserve Board and its conduct of monetary policy. In this regard, the combination of a more disciplined fiscal policy promulgated by Congress and the continued prudential stewardship of monetary policy by Chairman Greenspan has produced the longest peacetime growth in modern times. Given many economic and financial difficulties globally, however, it is important to understand how these problems could affect the U.S. domestic economy and how monetary policy simultaneously interacts with both domestic and international objectives (Committee s Oversight Plan, 1999).
Congress uses the committee system to control the Bureaucracy as part of our system of checks and balances. This is how the House plays a role in the development of monetary policy.
The Senate has an oversight committee as well, the Senate Banking Committee. Much like the House Committee on Banking and Financial Services, the Senate Banking Committee reviews legislation pertaining to banks and banking, economic stabilization, and Federal monetary policy, including the Federal Reserve System (Senate Banking Committee Information, 1999).
Other federal agencies play a role in economic policy because it affects their policy initiatives and implementation. Two examples are the FFIEC (The Federal Financial Institutions Examinations Council) and the FDIC (Federal Deposit Insurance Corporation). The FFIEC as a specific mission, The Council is a formal interagency body empowered to prescribe uniform principles, standards, and report forms for the federal examination of financial institutions (FFEIC, 1999). The FFIEC is responsible for supervising and regulating the actions of banks. The success of the Federal Reserve depends upon the performance of banks. If they act irresponsibly, then the Federal Reserve can have problems stabilizing the economy. The Federal Reserve Board National Information Center provides comprehensive information on banks and other institutions for which the Federal Reserve has a supervisory, regulatory, or research interest including both domestic and foreign banking organizations operating in the U.S. (National Information Center Website, 1999).
The FDIC is a federal agency that insures personal deposits in banks. The purpose of the FDIC is to maintain a high level of savings in banks. The FDIC desires to influence economic policy because when the Federal Reserve alters the reserve requirements for banks, the level of FDIC activity corresponds. There are many agencies that have an interest in monetary policy other then the FFEIC and the FDIC. Some of these are the National Credit Union Administration (NCUA) who regulates credit unions, and the U.S. Department of the Treasury whose mission is also to promote stable American and world economies and controls the physical money supply through coinage.
The private sector also engages in controlling economic policy. Two of most prominent actors in the private sector are those whose livelihoods rely upon interest rates. When looking at the top five contributors to members of the House Banking and Financial Services Committee, the picture becomes much more clear. The top five contributors are: 1. National Association of Realtors, 2. American Bankers Association, 3. National Association of Home Builders, 4. Bank of America, and 5. Bank One Corporation (Center for Responsible Politics Committee Profile: Banking and Financial Services, 1999).
1. The National Association of Realtors is easy to comprehend. When interest rates are low, people borrow money to buy houses and other property. Realtors make their commission off of buying and selling property, so they want low interest rates.
2. The American Bankers Association is also simple to understand. They desire interest rates that increase bank activity, so they can profit. Another route of influence is through the twelve Federal Reserve member banks. Each of the member banks elects members to the main body; these representatives come from their Board of Directors which in turn comes from commercial banks. Bankers socialize with other bankers, so commercial banks and bankers can influence monetary policy.
3. The National Association of Home Builders naturally wants to build homes. Most people need to borrow money to build homes, so low interest rates are the objective of this group.
4. Both 4 & 5 represent commercial banks. Much like the American Bankers Association, commercial banks need to profit through lending, mainly through credit cards. Interest rates play the main role in how the banks profit.
Economic policy affects many people, and many people battle to control it. Actors in both the private and public sector have much to gain from influence economic policy. What is interesting is why so many actors attempt to control the actions of an independent agency. Maybe it is not so independent and politically insulated as the public is lead to believe.
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