Politics and the Fed

Monday, March 1, 2010

Economics Working Paper WP10102

In the standard economic model of policy choice, choices are made by analyzing the social welfare implications to find welfare optimizing policy choices. In this paper, I argue that in a democratic government, and perhaps elsewhere, policy choices emerge from a political process. People vote; the voting process chooses elected representatives. With their appointees the representatives make policy choices. The appropriate model for policy analysis is a political economy model.

This conclusion is reinforced by my fifteen years of studying the history of the Federal Reserve. From the start, that study reflected the influence of James Buchanan and many others who followed him by analyzing policy choices made by individuals or committees motivated by considerations other than optimal welfare. Some of my prior work with Alex Cukierman and Scott Richard is fully in that tradition. (Meltzer, Cukierman and Richard, 1991)

Consider recent Federal Reserve policy. The Federal Reserve has more than doubled the size of its balance sheet. It has more than $1 trillion of excess reserves and more than $1 trillion of long-term, relatively illiquid mortgage-backed securities. No central bank in a developed country ever had so much long-term debt. In 1932, a much less informed Federal Reserve Board refused a request from Congress to support the mortgage market. Congress responded by creating the Home Loan Banks, a fiscal solution. The current Board undertook the fiscal operations. This is a political decision. Who would claim it is optimal policy?

Politics and the Fed