The Institutions of Federal Reserve Independence

On December 23, 2013, the Federal Reserve System celebrated its centennial. Over the course of that century, the Fed has become one of the most important governmental agencies in the history of the American republic, a transformation one scholar has labeled “the most remarkable bureaucratic metamorphosis in American history.” Its policies influence nearly every aspect of public and private life. Given this importance and influence, “[n]o one can afford to ignore the Fed.”

At the core of that “remarkable bureaucratic metamorphosis” is a much-invoked but as often misunderstood set of institutional arrangements that constitute the Fed’s unique independence. In the standard popular and academic account, law is at the center of that independence: indeed, it is the statute itself, under this view, that defines that independence. Economists and political scientists interested in central bank independence—having written enough on the phenomenon to give it an acronym (CBI)—take as given that law defines central bank independence. And legal academics, in the exceptional event that they have taken note of the Fed, have analyzed its independence within the context of administrative law and agency independence generally. Again, unsurprisingly, statutes are at the center of that analysis, too.

But the idea that Fed independence is determined by the Federal Reserve Act is wrong. In some cases, the statute does not say what people have assumed it says. But more often, the statute has created a system that subsequent practices have changed, strengthened, or undermined so completely as to render them dead letter. The law as written becomes displaced by law as implemented. The result is that reading the Federal Reserve Act tells us very little about the way this unique government agency exercises its extraordinary power.

Drawing on the language, structure, and history of the Federal Reserve Act of 1913 (especially as amended in 1935), other legislative materials, memoirs and biographies of Fed Chairs and other insiders, and other archival resources, the article—part of a broader project that includes the book, The Structure of Federal Reserve Independence, forthcoming from Princeton University Press—provides a more comprehensive account of the legal context of Fed independence and its evolution.

The article’s contributions are descriptive, prescriptive, and theoretical. Descriptively, the article explains the context and historical change of the many mechanisms of Fed independence, providing for the first time an explanation of how the Fed’s funding, appointments, and removability protections have evolved since they were first installed in the key legislative enactments of the Federal Reserve Act of 1913 and the Fed’s reformulation in the Bank Act of 1935. Specifically, the article discusses three features. First, how removability protections do not exist for the Fed Chair, but exist to unconstitutional (and probably non-justiciable) form for the presidents of the Reserve Banks. This is true despite the equivalence in administrative law of agency independence with removability protection for the agency head. Second, how the fourteen-year non-renewable term of the Fed Governors (meant to enhance Fed independence) and the four-year renewable term for the Fed Chair (meant to enhance accountability) have become precisely the opposite: filling Governor vacancies has made the Fed more dependent on the President, filling Chair vacancies has made it less. And third, the Fed’s extraordinary budgetary independence—its ability to create the money with which it funds itself—is not authorized by statute, and indeed was at the core of one of the central fights in the framing of the Fed.

Prescriptively, I argue that structural legal reforms to the Fed and its governance must seek to balance the idea of independence—the separateness that allows the Fed to make monetary policy in a way not subject to constant political pressures—against democratic legitimacy. In the context of the rules discussed here, proposals include limiting Chair tenure to two five-year terms, decreasing the size of the Board of Governors from seven to five (and decreasing their terms correspondingly to ten-years rather than fourteen), rendering the presidents of the Reserve Banks presidential appointments (or, at the very least, appointed by the Board of Governors), and clarifying the nature of the Fed’s budgetary independence.

Theoretically, the Federal Reserve Act demonstrates how statutory law gets displaced by its implementation. This is not simply a case of informal constraints or conventions shaping behavior, although the Fed provides examples of these, too. Instead, the laws of Federal Reserve independence demonstrate that subsequent developments—inside and outside the Fed, in monetary policy and in judicial interpretations of law—come to matter more than the law as written. Indeed, in some cases, the law as implemented cancels out the intention of the law as written. In this sense, the “institutions” of the article’s title follow but extend Douglass North and others in the New Institutional Economics literatures. The relationship between statutory law and the changes of context and implementation are institutional in that they are part of a broader array of “humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights).” But it is more than this: some of these changes do not reach the level of informal constraints, but are instead the changing contexts that provide avenues of behavior not sanctioned by the statute, but at the core of its statutory implementation.

The theoretical argument, then, is not just about the chasm between law on the books and law on the ground, but is a statement in favor of analyzing the history and evolution of the interaction between them: the institutional development of Fed independence relies on statutory authorization, statutory implementation, and the subtle but steady drip of change exerted by individual personalities, outside forces, and the role of chance.

The full article is available for download here.