February 23, 1996
« More Economic Letters
FRBSF Weekly Letter
The President and Congress are directly responsible for fiscal policy, but Congress has chosen (through the Federal Reserve Act) to delegate authority for monetary policy to the Federal Reserve System. Furthermore, it has granted the Federal Reserve a substantial degree of independence. Decisions about monetary policy are made by the Federal Open Market Committee (FOMC), which consists of 7 Governors, who are appointed by the President and confirmed by Congress, and 12 regional bank Presidents, who are chosen jointly by the Federal Reserve Board and the boards of the regional banks. On a short-term basis, FOMC decisions are largely independent of direct input from the President or Congress. And since members of the FOMC serve long terms and do not stand for election, they are largely insulated from the political process.
Why did the founders of the Federal Reserve choose to insulate the central bank in this manner? One possibility is that they were concerned that there would be an inflationary bias if monetary policy were too strongly influenced by elected officials. The empirical evidence suggests that this concern is warranted: across countries, there appears to be an inverse relation between average inflation and the degree of central bank independence (for example, see Alesina 1988 and Grilli, Masciandaro, and Tabellini 1991). But what is it about the political process that tends to create an inflationary bias? A recent paper by Jon Faust (1996) provides an intriguing answer, and this Weekly Letter discusses his arguments.
In most circumstances, our system of government favors the rule of simple majorities as a way to decentralize political power, but this preference is far from universal. There are any number of examples in which governmental decisions are insulated to a greater or lesser extent from the rule of simple majorities. The best example is the U.S. Supreme Court. Like the Federal Reserve Board, Supreme Court Justices are nominated by the President and confirmed by Congress but do not stand for election. They serve life terms, and they can’t be fired for rendering unpopular decisions. Hence, in the short run, the Supreme Court is largely insulated from the will of the electorate.
The rationale for having an independent Supreme Court is a belief that majority rule may sometimes produce undesirable outcomes. For example, in times of crisis, a majority of voters might be persuaded to temporarily suspend certain fundamental rights, such as that of free speech or assembly. While such an action might appear to be expedient, it might prove to be difficult to reverse once the crisis has passed. Once rights are suspended, they may be difficult to restore. There is also a moral hazard problem: some factions in society might provoke a crisis in order to undermine public support for basic rights. An independent Supreme Court limits the power of transient majorities to alter certain fundamental aspects of our political system and thus contributes to its long-term stability.
In the language of Alexis de Tocqueville (1969), an independent Supreme Court helps to protect against the “tyranny of the majority.” Can the same be said for an independent central bank? Faust argues that it can.
The first step in his argument concerns the effects of unexpected inflation on the distribution of wealth. In the United States, most debt contracts are written in nominal terms. A creditor agrees to lend a sum of money at a given nominal interest rate for a given period of time, and the borrower agrees to repay the principal plus interest at maturity. The interest payment consists of two components. First, borrowers must pay something in order to persuade lenders to part with their capital for the term of the loan. Second, inflation erodes the real value of the principal during the term of the loan, and borrowers must compensate lenders for this loss. Since the nominal interest rate is typically set at the beginning of the loan, the compensation for the erosion of purchasing power must reflect expected inflation, rather than actual inflation. These two components are reflected in the Fisher equation, which states that the nominal interest rate is equal to the real interest rate (payment for use of capital) plus the expected inflation rate (compensation for the erosion of purchasing power).
If expectations turn out to be correct, then the inflation compensation that was agreed upon at the beginning of the loan exactly makes up for the erosion in purchasing power during the life of the contract. If actual inflation turns out to be higher than expected, the inflation compensation turns out too small. Since the creditor is only partially compensated for the erosion of purchasing power, the debtor gains at his expense. On the other hand, if actual inflation turns out to be lower than expected, the inflation compensation more than offsets the erosion of purchasing power, and the lender gains at the expense of the borrower. Thus, unexpected inflation transfers wealth between creditors and debtors. Debtors gain when inflation is unexpectedly high, and creditors gain when it is unexpectedly low.
Now imagine what would happen if monetary policy were set by majority vote. Once loans are made, creditors would have a short-term incentive to vote for policies which would deliver an inflation rate that is lower than the one implicit in the debt contract, because this would redistribute wealth in their favor. Similarly, debtors would have a short-term incentive to vote for policies which would generate an inflation rate that is higher than the one implicit in the debt contract, because this would redistribute wealth in their favor. If monetary policy were set by majority vote, the more numerous faction would prevail.
This raises the question, “are debtors or creditors more numerous?” Direct evidence on this question is hard to come by, but two observations suggest that debtors may be more numerous. One follows from typical life-cycle spending patterns and the fact that the population grows over time. Early in life, people tend to borrow to invest in education, to smooth consumption between low income periods in their youth and higher income periods later in life, and to buy houses and other durable consumption goods. As people age, they pay off these debts and accumulate wealth for retirement. Thus, younger people are more likely to be debtors and older people more likely to be creditors. With population growth, there are more young people than old, and this suggests that debtors may be more numerous.
This life-cycle consideration is reinforced by the form in which many people finance their housing purchases. When people take out a mortgage, they acquire a real asset (land and a house) and a nominal debt (the mortgage). Like other fixed income securities, a fixed-rate mortgage incorporates a premium for expected inflation. Since this debt is nominal, its real value falls if inflation turns out to be higher than expected. Adjustable rate mortgages also tend to fall in real value when there is an unexpected increase in inflation, because they usually contain annual and lifetime caps on the nominal mortgage rate. These caps become especially important when there are big changes in inflation. On the other side of the balance sheet, households hold land and houses. Since these are real assets, their real (or inflation-adjusted) value is much less sensitive to unexpected changes in inflation. Thus, households who hold nominal debts and real assets would also benefit from monetary policies which generate surprisingly high inflation.
If debtors are more numerous than creditors, a majority of voters would have a short-term incentive to vote for policies which generate an unexpected increase in inflation. But over a long period of time, inflation cannot be higher than expected on average. Creditors are not fools. They would build this knowledge of voting patterns into their inflation forecasts and mark up the Fisher premium accordingly. Inflation would sometimes turn out to be higher than expected and sometimes lower, but on average the majority faction would not be able to use monetary policy to redistribute wealth. Systematic attempts to do so would just raise the average rate of inflation.
Moreover, although the majority would prefer low average inflation, they would not be able to achieve it. When seeking new loans, borrowers would like to promise to vote for low inflation, but once the contract is signed they would be free to vote as they please and would again have a short-term incentive to vote for high inflation. Creditors would see through this and give their promise little weight. They would insist upon a big Fisher premium to compensate for high expected inflation, and borrowers would support a high inflation policy in order to reduce the real value of the nominal interest rate, thus confirming creditors’ expectations of high inflation. Setting monetary policy by majority vote generates an inflationary bias which makes everyone worse off. In particular, the majority is worse off because they suffer the costs of higher inflation without achieving any redistribution.
If everyone prefers low average inflation, why can’t the electorate or the legislature solve the problem by giving the central bank explicit instructions in the form of official low-inflation targets? Creditors and debtors both have a long-term incentive to support low inflation, so both groups would presumably support such a plan. But how would these targets be enforced? Once debt contracts are signed, borrowers would have a short-term incentive to support an “exception” to the low inflation target in order to redistribute wealth in their favor. Hence the majority’s support for low inflation would not be consistent over time. Their short-term interests for redistribution would undermine their long-term interests for low average inflation.
The majority needs to find a way to commit to a low-inflation policy. One way to do so is to delegate authority to an independent committee and then let them make decisions about monetary policy. In effect, this makes it more difficult for the majority to change its mind. To achieve this independence, it may be important to insulate the central bank from the electorate and their representatives, so that they cannot easily punish central bankers for rendering decisions that are unpopular in the short run.
While central bank independence is important, it is not sufficient to solve this inflationary bias. The composition of the committee is also important. For example, if this committee were simply a microcosm of the general population, then majority voting within the committee would just replicate the inflationary bias in the general population. Thus, it may also be important to choose committee members so as to balance the forces for and against inflation. To achieve this balance, it may be necessary for the anti-inflation forces to be overly represented relative to their proportion in the general population.
Unexpected inflation redistributes wealth from nominal creditors to nominal debtors. If debtors are more numerous than creditors, majorities may often favor monetary policy actions that generate unexpected inflation. But since monetary policy can’t systematically generate surprisingly high rates of inflation, attempts to use it to redistribute wealth would just raise the average inflation rate without achieving the intended redistribution. In the end, policy by majority may lead to outcomes that are inferior even for the majority, and insulating monetary policy makers from the electorate may produce superior outcomes.
Alesina, Alberto. 1988. “Macroeconomics and Politics.” In NBER Macroeconomics Annual, Stanley Fischer, ed. Cambridge, MA: MIT Press.
Faust, Jon. 1996. “Whom Can We Trust to Run the Fed? Theoretical Support for the Founders Views. Journal of Monetary Economics (forthcoming).
Grilli, Vittorio, Donato Masciandaro, and Guido Tabellini. 1991. “Political and Monetary Institutions and Public Financial Policies in the Industrial Countries.” Economic Policy 13, pp. 341-392.
Tocqueville, Alexis de. 1969. Democracy in America. Garden City, NY: Doubleday.
More Economic Letters
Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.
Please send editorial comments and requests for reprint permission to