Audit the Federal Reserve?

Note:
This is a derivative and expanded version of my op ed article published on p. A35 of the October 22, 2009 New York Times.
That article focused on a different Senate audit bill introduced by Senator Jeff Merkley, Democrat of Oregon, and Senator Bob Corker, Republican of Tennessee.
Federal Reserve Chairman Ben Bernanke has spoken out against Congressional bills to audit the Federal Reserve.
But why?
Proponents argue that the purpose of the audits is to increase the transparency of Federal Reserve policy and assure the quality of data from the Federal Reserve.
Aren’t these both in the public interest?
A recent Rasmussen-reports survey found that 75% of Americans favor auditing the Federal Reserve and making the results available to the public, while only 9% oppose it, with 15% being unsure. Such surveys suggest that the Federal Reserve has not pursued a successful communication strategy.
As a previous New York Federal Reserve Bank President remarked, the Fed is independent within the federal government, not of the federal government.[1]
Isn’t, therefore, an audit in the interests of good government?
Since the Federal Reserve was created by Congress, the Fed is inherently accountable to Congress.

In 1978, Congress passed a bill mandating audits by the Government Accountability Office (GAO) (then, the General Accounting Office) for most government agencies.
That bill excluded from audit a vast sweep of the Federal Reserve System’s activities.
Operations of some Federal Reserve activities, including monetary policy, were addressed the same year in the Humphrey-Hawkins Act.
The following year, Chairman Paul Volcker made major policy changes to lower the growing inflation rate of the 1970s.
Bernanke has stated that the 1978 audit exclusions should be credited with Chairman Volcker’s ability to act decisively.
I disagree.
I was on the staff of the Federal Reserve Board in Washington, DC at that time.
Paul Volcker was a determined Chairman, whose actions were based upon his own strong convictions.
Since the GAO has no policy-making authority, the GAO could not have prevented him from implementing his chosen policy.
Certainly, the granting of increased audit authority raises the possibility that future audits could second-guess unpopular policy actions—but audit authority is hardly necessary to do so, as demonstrated by the actions of both past Congressmen and Presidents.

There are well-known examples of such pressures.
I was asked by Arthur Burns, following his term as Federal Reserve Chairman, to lunch with him at the American Enterprise Institute.
I asked him at lunch whether any of his decisions had ever been influenced by Congressional pressure.
He emphatically said no --- not ever.
But Milton Friedman, in an interview published in the book, Inside the Economist’s Mind, revealed that Burns was influenced by Nixon’s irresponsible White House politics.[2]
Similarly, Fed Chairman William M. Martin discussed pressures from President Lyndon Johnson.[3]
Chairman Martin emphasized that, in his views, the Congress and the President set the nation’s economic priorities, including spending, taxes, and borrowing.
The role of the Federal Reserve, in Martin’s view, was to assist in fulfilling those policies, including facilitating Treasury borrowing at reasonable interest rates.
In 1966, when he led a sharp contraction of monetary policy to offset aggregate demand pressures from President Johnson’s policies, Martin was sharply reprimanded by President Johnson.
Later, President Reagan’s support was important to the success of Chairman Volcker’s anti-inflation policy.
None of the above dramatic moves had anything to do with Federal Reserve accountability to Congress.
Perhaps the closest antecedent to current Congressional audit proposals was the 1975-8 upswell of monetarist sentiment in the Congress.
During 1974, the Fed had tightened policy sharply.
Later analysis revealed flaws in the published monetary aggregates data that had caused the FOMC to believe that money growth was extraordinarily high.
In response, two Congressional measures—House Concurrent Resolution 192 in 1975 and the Humphrey-Hawkins Act of 1978—required that the Fed chairman appear twice each year before Congress to report the FOMC’s target ranges for money growth (if any had been set).
The Federal Reserve bristled under such supervision.
Never before in the Fed’s history had the Congress imposed a reporting requirement on Fed policymakers—and a requirement far less invasive than a GAO audit.
The Humphrey-Hawkins Act reporting requirement came up for renewal in 2003, but quietly was allowed to expire.
Semi-annual reports to the Congress continue, but without the force of law.

In my opinion, informed by my research, Volcker’s disinflationary policy (similar to 1974-5) was overdone and produced an unnecessarily severe recession.
The reason was that poor monetary-aggregate data, having improperly weighted components, led Volcker inadvertently to decrease monetary growth to a rate that, appropriately measured, was half what he thought it was.[4] Volcker wrote to me years later that he “still is suffering from an allergic reaction” to my findings about the actual monetary growth rate during that period.
Suppose a GAO audit had investigated whether the data being published were best-practice among monetary economists concerned with measuring monetary aggregates, and concluded that it was not.
Would Volcker have selected a more gradual disinflationary policy?
Perhaps.
Without unbiased external reviews of Federal Reserve measurement practices, we can never know—nor can we avoid—possible future mistakes.

Focus, for a moment, on the Federal Reserve’s monetary published data.
Is its quality the best possible?
Are the items reported constructed appropriately to the task of operating and understanding the path of monetary policy?
Unfortunately, no.
Consider, for example, the important and widely monitored data on banks’ “nonborrowed reserves.”
Every analyst understands that banks hold reserves at the Federal Reserve to satisfy legal requirements and to settle interbank payments, such as wire transfers and check clearing. The total of such reserves may be partitioned into two parts:
the portion borrowed from the Federal Reserve and the portion that is not (nonborrowed).
Clearly (or so it would seem to most persons) the borrowed portion of reserves cannot exceed total reserves, so nonborrowed reserves cannot be negative.
Yet recent Federal-Reserve-reported values of nonborrowed reserves were minus 50 billion dollars!
How does such happen?
In its definitions, by purpose and not by accident, the Federal Reserve chose to omit from “total reserves” large amounts of funds borrowed from the Fed and included in published figures for borrowed reserves.
Those term auction borrowings should be included in both borrowed and total reserves or in neither, depending upon whether they are or are not held as reserves.
Such confusing (indeed, some might say incompetent) accounting practice likely would not survive scrutiny by an outside, highly informed audit.

According to Section 2a of the Federal Reserve Act, the Federal Reserve “shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential….”
Although Federal Reserve policymakers have stated clearly that monetary aggregates currently are unimportant to their decisions, external analysts and researchers continue to depend on monetary aggregate data to obtain an accurate picture of the stance of policy.
During the 30 years since the Congress excluded monetary policy from GAO audits and mandated reporting of money growth in the Humphrey-Hawkins Act, two of the then extant four published monetary aggregates have been discontinued:
M1 and M2 remain, but M3 and L do not.
In quiet times, perhaps this is of little importance—but these broad monetary aggregates and the underlying data detail have been greatly missed during the financial crisis.
Further, the M1 aggregate is severely biased downwards.
Since 1994, banks have been permitted by the Federal Reserve to reclassify, for purposes of calculating legal reserve requirements, certain checking account balances as if they were MMDA saving deposits; banks supply to the Federal Reserve only the post-sweeps checking account (demand deposit) data.
The resulting published data on checking deposits understates, by approximately half, the amount of such deposits held by the public at banks. Why doesn’t the Federal Reserve require banks to report the complete data?
Does such published data satisfy the requirement of the Federal Reserve Act?
It seems likely that such an omission would not survive an unconstrained audit.