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Bernanke Responds to Incentives

Wednesday June 15th, 2011   •   Posted by Emily Skarbek at 9:59am PDT   •  

Bernanke urges for an increase in the debt ceiling, demonstrating the wisdom of James Buchanan and Richard Wagner. In Democracy in Deficit, Chapter 8, the authors set out to model Keynesian-oriented fiscal policy with the “the plausible hypothesis that monetary authorities are, like elected politicians, subjected to both direct and indirect political pressures, and that they need not be all-knowing” (8.8.4).

Where many see public choice playing out with regard to politicians serving special interests, the conventional and accepted view of the Federal Reserve is that the actions of central bankers are independent of political influence. People may accept that Keynesian fiscal policy creates budget deficits, promotes debt finance, and has a bias toward a growth in government and at the same time view the independence of the Fed as suggesting no direct link between deficits and inflation.

In evaluating the evidence over 1961-1974, Buchanan and Wagner find that the data:

“reinforces the thesis that budget deficits are positively related to changes in the stock of money. During this latter period, the average annual increase in the money stock was 4.9 percent, a full three percentage points above the annual average during the preceding interval. A closer examination of this historical record reveals that the Federal Reserve System has responded to budget deficits (surpluses) by increasing (decreasing) its holding of government securities. This pattern obtains for both the 1946-1960 and the 1961-1974 periods. The Federal Reserve, in other words, appears to be a major source for financing budget deficits….What is different is simply that the magnitude of budget deficits has become so immense, and with no offsetting periods of surplus. The “facts” suggest that the actions of the Federal Reserve Board have not been independent of the financing needs of the federal government.” (8.8.21)

Buchanan and Wagner hypothesize that “that political pressures also impinge on the decisions of monetary authorities, even if somewhat less directly than on elected politicians, and that the same biases toward demand-increasing policy steps will be present” (8.8.22).

In other words, what incentive does Bernanke have to be strictly neutral between demand-increasing and demand-decreasing actions? Public-choice theory tells us that Bernanke is just like the rest of us. He will be directly influenced by the reward-punishment structure he faces. “No monetary decision maker, no central banker, enjoys being hailed as the permanent villain” and certainly doesn’t want to be the one the public regards as responsible for budget cuts, unemployment and poor economic performance.

Bernanke—like you and me—responds to incentives. Political decision making, however, is biased against making the best choices for the well-being of everyday Americans.

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June 2011