Elastic Currency, With a Vengeance

December 13, 2011

The tension between central banks and democracy is fundamental, because independent central banks are just that: independent.  It may be argued that this is a good idea -- most economists find it so -- but it is inherently non-democratic.  Thus, the underlying tension between central banks and their government sponsors is simply a weighing mechanism: the independence necessary to implement the correct policies versus the public oversight necessary to guarantee ethical practice, says Alex J. Pollock, a resident fellow at the American Enterprise Institute.

The argument in favor of a relatively independent bank espouses a belief in elite institutions, such that those who know more about a given subject (such as economists on the economy) should be granted relative freedom to work in their area of expertise.  However, while this principle seems attractive in that one assumes an economist knows best when discussing the economy, the experiences of the past decade do not support this assumption.  Central bankers failed to learn from their mistakes after the financial crisis of the late 1990s, and also failed to predict (much less prevent) the recent recession.  Such failures call into question the level of expertise located within central banks, thereby undermining their claimed right to policy autonomy.

The opposite of this situation (that is, greater cooperation and oversight with public officials such as the secretary of the Treasury) also has its pitfalls.  In the United States, the recent complication has been the gradual development of an extraordinary policy triangle between the Treasury Department, the Fed, and government-sponsored enterprises such as Fannie Mae and Freddie Mac.

  • The Federal Reserve buys $1 trillion of the debt and mortgage securities of Fannie and Freddie.
  • But Fannie and Freddie are completely broke.
  • So the Treasury buys $180 billion of Fannie and Freddie stock to support their obligations to the Fed and others.
  • But the Federal Reserve is also lending $1.7 trillion to the Treasury (by buying Treasury debt).

While this current triangle accomplishes the Federal Reserve's goal of creating an elastic currency that adapts to contemporary economic circumstances, the fact that roughly 10 percent of all U.S. residential mortgage loans on the bank's balance sheets represents a significant break with precedent and should be a cause for alarm.

Source: Alex J. Pollock, "Elastic Currency, With a Vengeance," The American, November 29, 2011.

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