Fed Independence: R.I.P.?

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania.  Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).


Fed Independence: R.I.P.?
October 29, 2009

It’s now official. The proposed legislation to reform America’s financial service supervision includes granting the Secretary of the Treasury a veto over Section 13(3) emergency action by the Federal Reserve Board of Governors. If this becomes law, it will be a sad day for the independence of America’s central bank.

The Secretary of the Treasury, a very senior cabinet position, is appointed by the President and meets with the President in the Oval Office weekly. The governors of the Federal Reserve Board are also appointed by the President. Both cabinet officers and Federal Reserve governors are confirmed by the US Senate. There are supposed to be seven governors; politics has purposefully limited this to five throughout the three-year financial crisis period.

The Federal Reserve governors are supposed to serve staggered 14-year terms with all seven seats filled. Instead, we have been governed by the present five member politically configured board.

The original seven governor construction was designed to insulate them from political pressure for very good reasons. Decades of monetary history throughout the world have disclosed what happens when political influence on a central bank intensifies. The Weimar Republic and Zimbabwe are evidence of the worst inflationary effects of politics. The Great Depression in the US and the nearly two decade deflationary recession in Japan demonstrate that monetary policy is not only inflation-prone. When central banks are under political influence you can get fire or you can get ice.

In Japan, the central bank contends with two members of the cabinet sitting in on its deliberations. There is no way to know how much of the last 15 years of deflation and recession is attributable to the inside political pressures placed on the governors of the Bank of Japan. But there is evidence to suggest political influence, especially when you observe how little the Bank of Japan has engaged in asset expansion during this crisis.

In the United Kingdom, the Bank of England now has to comply with procedures that involve the written reporting of monetary policy decisions to the Parliament. Previous politics empowered the Financial Services Authority whose purpose was to supervise financial institutions and prevent a crisis. One need only witness the current financial turmoil in the UK to ascertain how the introduction of politics has caused problems between the Bank of England and the Financial Services Authority.

Only one of the G-4 central banks avoids direct political influence. That is the European Central Bank, whose policymakers are protected by a treaty. The unanimous consent of 27 countries is required before the central bank’s independence can be threatened. Readers must note that 90% of the world’s $82 trillion of debt is denominated in one of these G-4 currencies. Three of the four are under some form of political hammer. That explains the euro’s ascendancy and also why there is increased pressure on the US dollar.

History shows that, over time, politics tends to favor easier monetary policy and lower interest rates than would otherwise be required. Thus inflation-prone tendencies are more likely to be the outcome of political intervention in monetary affairs of the US.

In the US we are experimenting with a massive issuance of federal debt. We now measure that additional debt in the trillions each and every year. And we are now trying to intensify and formalize the political intervention into the governing body responsible for the value of the US dollar. At the same time, this legislative initiative concentrates unprecedented power in the executive branch and in the hands of the Secretary of the Treasury.

If this becomes law, will global financial markets reprice the US currency to reflect this new asymmetrical policy threat? Will this risk premium result in higher interest rates, where deregulated markets can set them? Will there be a currency crisis? Will politics that create class warfare with “too big to fail” also, by implication, create an under class of “too small to survive?”

I do not want to personalize my criticism of this law to Treasury Secretary Geithner. His record in the New York Fed and since he became Treasury Secretary is controversial. But I ask one question. PPIP was his idea. It is an obvious failure. With a concentration of power in his hands, would it have been funded with a trillion dollars instead of falling victim to an independent market analysis of its flaws?

Memorializing executive power in the hands of one individual is fraught with danger. Think not only of Geithner. Would you have wanted to empower Paulson, Snow, O’Neill, Miller or Connally or others? Readers who want to take the time may wish to reflect on the evidence of history as it relates to our various Treasury Secretaries.

If any readers support this law change they may act accordingly with their Congressmen. In my case, I have already spoken personally to the Member of Congress I know well and asked him to oppose this destruction of the balance of power envisioned in our constitutional framework.

David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok@cumber.com


Copyright 2009, Cumberland Advisors. All rights reserved.

The preceding was provided by Cumberland Advisors, 614 Landis Ave, Vineland, NJ 08360 856-692-6690. This report has been derived from information considered reliable, but it cannot be guaranteed as to accuracy or completeness.

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