AIG, Wall Street Bailouts: Is the Federal Reserve’s Independence at Risk?

The Federal Reserve was created 95 years ago to prevent banking crises as an independent agency whose Washington-based governors are appointed by the president of the United States and confirmed by the Senate. Its officials usually steer clear of the most heated political debates in a bid to protect their freedom to make the tough decisions required to keep inflation under control. There’s a good reason for giving the Federal Reserve so much independence. Decisions about the stability of the financial system often require quick decisions in times of crisis.

Ever since the credit crisis started in August 2007, the Federal Reserve has been engaged in a few political actions involving tax payer risks: asking Congress to approve Treasury Secretary Hank Paulson’s $700 billion bailout plan, agreeing to lend $85 billion to American International Group, taking on $30 billion in illiquid Bear Stearns assets to facilitate its take over by J.P.Morgan Chase, and helping engineer the federal takeover of Freddie Mac and Fannie Mae, which could cost the Treasury over $200 billion.

The political role being played by the Federal Reserve is setting a dangerous precedent: unelected officials deciding, without congressional votes, which companies and industries should be aided by its nearly $1 trillion balance sheet and which should be left hanging. The Federal Reserve is committing so much taxpayer money on its own rather than having Congress or the executive branch commit it. Its new roles of overseeing Wall Street investment banks and the AIG loan portfolio, among them, may bring it into conflict with the job of managing monetary policy.

The Federal Reserve has been using government funds and its credibility in its attempts to end the credit crisis. This increasing political role of the Federal Reserve could put its hard won independence at risk. Its independence is crucial to setting the interest rates that guide the economy.

The Federal Reserve probably did not want to be seen in a political role, but it had no choice – charged with maintaining the stability of the financial system and the economy, it had little choice but to take aggressive action in the face of a potentially devastating crisis. It was watching a falling knife and had to grab it before it landed on somebody’s chest.

Any proposals to change the Federal Reserve’s role would face fierce opposition. Because of the actions it has taken so far in trying to save Wall Street firms, if it comes under attack, Wall Street will be among its main supporters. It will also have the support of an army of loyal bankers around the country.

Everything depends on how the economy emerges from the present credit crisis. If it stages a steady recovery, it will increase the credibility of the Federal Reserve and there will be less concern about its political role.

1 comment to AIG, Wall Street Bailouts: Is the Federal Reserve’s Independence at Risk?

  • Raymond

    There is intense political pressure on the Fed to be seen as doing what is right to manage the crisis (that originated right at their doorstep.)

    There is exposure and then there is Being Exposed.

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