What Jekyll Island Built Into the System

The Federal Reserve Act of 1913 created an institution that was neither fully public nor fully private. Its twelve regional Reserve Banks were owned by member commercial banks, which held stock and received dividends. Its Board of Governors in Washington was a public body, with members appointed by the president. Policy decisions emerged from a hybrid process in which private bankers had substantial, if not decisive, influence. This design was not accidental -- it reflected the political constraints of creating any central bank in the American context and the institutional preferences of the men who drafted the legislation.

Three structural assumptions, embedded at the institution's founding, have shaped monetary policy for a century. The first is that the health of the financial system and the health of the broader economy are substantially identical -- that what is good for banks is, with some lag, good for everyone. This assumption explains why, in every major crisis, the Federal Reserve has moved first and fastest to protect the financial system, and why the costs of those rescues have been borne broadly while the benefits have accrued narrowly.

The second assumption is that price stability -- preventing inflation -- is a more important policy objective than full employment. The Jekyll Island architects, who were creditors by profession, had strong reasons to prefer price stability: inflation erodes the real value of loans, while deflation increases it. This preference was institutionalized in the Fed's mandate, which listed "maximum employment" alongside "stable prices" but in practice has generally treated inflation control as the primary objective. The consequences for workers -- who benefit from full employment -- versus creditors -- who benefit from price stability -- are distributional, not merely technical.

The Federal Reserve was designed to be independent from democratic accountability. What it was not designed to be independent from was the banking system that created it, funded it, and has dominated its governance ever since.Adapted from Simon Johnson, 'The Quiet Coup,' The Atlantic (2009)

The third assumption is that the Federal Reserve's independence from elected government is an unqualified good -- a protection against the temptation of politicians to inflate the currency for short-term electoral benefit. This argument has genuine force, but it also serves to insulate monetary policy from democratic accountability. The Fed sets interest rates -- which determine the cost of mortgages, business loans, and consumer credit for every American -- without direct democratic oversight. The political insulation that protects it from inflationary pressure also protects it from pressure to prioritize employment, wages, and distributional equity.

Benjamin Strong, the first governor of the Federal Reserve Bank of New York and arguably the most powerful Fed official of the 1920s, illustrated the consequences of these embedded assumptions. His low-interest-rate policy in the mid-1920s -- intended partly to help Britain restore the gold standard -- contributed to the asset price inflation and speculative excess that ended in the crash of 1929. Strong died in 1928, before the consequences became clear. Milton Friedman and Anna Schwartz (1963) later argued that the Fed's subsequent policy of allowing the money supply to contract by one-third was the decisive factor in turning the crash into the Depression -- a verdict that has shaped Federal Reserve thinking, including its response to the 2008 crisis, ever since.