Does the Federal Reserve know what it is doing? The answer is no. Furthermore, can the Federal Reserve know what it is doing? The answer is also no.
This is not because the officers of the Fed are not intelligent. They are indeed brilliant. It is because of the inherent unknowability at the heart of the Fed's decisions. The central bank cannot possibly make much more of a guess about the complex and recursive factors at play in the world's financial systems and economies.
That inherent inability to know what it is doing, combined with the central bank's vast power, make the Fed the most financially dangerous institution in the world. However good the central bank's intentions might be, its actions manipulate the world's dominant fiat currency based on the debatable theories and guesses of a committee of economists. That can create disastrous financial instability. Since that is true, how can anybody think the Fed should be an independent power? That is a puzzle indeed.
The real results of discretionary central banking are sharply different from the hopes expressed at the time of the Fed's founding in the early 1900s. William G. McAdoo, who was then secretary of the Treasury and also chairman of the Federal Reserve Board, proclaimed that the Federal Reserve banks "will give such stability to the banking business that the extreme fluctuations in interest rates and available credits which have characterized banking in the past will be destroyed permanently."
With the many inflations, booms, busts and panics since then, it is hardly necessary to say how different reality turned out to be. Yet after 101 years of experience to the contrary, unrealistic expectations of what the Fed can do, and the unrealistic belief in the Fed's knowledge and competence, are still prevalent.
Why the Fed disappoints these expectations and does not work as fondly hoped is simple. The Fed is a continuing effort at central planning and price fixing by committee. Like all such efforts, it is doomed to recurring failure by the inescapable Hayekian problem of insufficient knowledge. That is not constant failure, but recurring severe failure. The Fed, like all central planners, is faced with virtually infinite complexity and massive uncertainty, not only about the unknowable future, but also about what is really happening in the present.
So the Fed is equally bad at foreseeing the economic and financial future as everybody else is. As one observer recently pointed out, "the 1960s thought Keynesian economics had eliminated the business cycle only to be ridiculed by the 1969-70 and 1973-75 downturns. A generation later, enthusiasts of The Great Moderation [were] dumbfounded by the 2007-09 great recession."
Since the Fed does not operate on knowledge of the future – that being impossible – it relies on academic theories. Its theories and ideology change over time. They are waves in an ocean of guesses.
Fed officials and Fed believers endlessly stress that the Fed has to be "independent." These promoters of Fed independence share a mistaken central assumption: that the Fed is competent to have the unchecked power of manipulating money and credit, or in a more grandiose version, of "managing the economy." Neither the Fed nor anybody else has the knowledge to do this.
The independence promoters never consider how the Fed should be accountable, as every part of a democratic government should be accountable. No part of a democratic government, let alone one with such immense power and riskiness as the Fed, should be free of checks and balances and free of any serious accountability. To whom should the Fed be accountable? To its creator, the legislature. This is true no matter how much the Fed arrogantly thinks that the mere elected representatives of the people can never understand the mysteries of its high calling.
At various times in its history, especially during major wars, the Fed has been entirely subservient to the Treasury Department and devoted to loyally monetizing the government's deficit as directed. But at all times, the Fed is a creature of the Congress.
In 1965, the House Banking Committee – then controlled by the Democrats – held a series of hearings to examine the Fed and produced a report, "The Federal Reserve System After Fifty Years." The committee correctly concluded, "To the extent that the Board operates autonomously, it would seem to run contrary to another principle of our constitutional order—that of the accountability of power."
Alfred Hayes, who was then president of the Federal Reserve Bank of New York, told that committee: "Obviously, the Congress which set us up has the authority and should review our actions at any time they want to, and in any way they want to."
That was right then and still is. The Fed should give up its philosopher-king pretension.
Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991-2004.