A Queer Duck or a Duckbill Platypus?
Dallas Business Review
Summer 1994

The late populist Texas Congressman Wright Patman once wrote, "Constitutionally, the Federal Reserve is a pretty queer duck." Martin Mayer, author of the The Bankers and other excellent books on finance, followed that up with the observation that "the Federal Reserve would be a queer duck even without any Constitution, for a more awkward and complicated mixture of private and public, executive and legislative, national and regional could not possibly be imagined."

I wouldn't have put it quite that way, but they had a point. The structure of the Federal Reserve is rather complicated: the Fed is a decentralized central bank, an independent government agency with private sector participation and a strong local presence. Congress designed it that way on purpose, and the design has stood the test of time. The intent was to protect the integrity of the institution charged with protecting the integrity of the dollar by establishing checks and balances that would prevent a concentration of power, and prevent political control or interference.

Rather than a queer duck, a more appropriate metaphor for the Fed might be a duckbill platypus—an egg-laying mammal that is a marvel of evolution, with the bill of a duck, webbed feet, and the tail of a beaver. The Fed, like the platypus, may lay an occasional egg, but it, too, is well adapted for its task and has performed well in recent years.

The Dallas Federal Reserve has somewhat of a split personality— part of a governmental body with the responsibility to regulate our monetary system. It is also a business that services our financial institutions and must turn a profit. The Dallas Fed—one of 12 Federal Reserve Banks—is part of the Federal Reserve System, just as the economy of the Southwest is part of the national and global economies. We can't have a separate monetary or regulatory policy for the Southwest, but we can and do involve local citizens in the process and make sure that local conditions and concerns are represented in national policy forums.

Central Bank Independence and Inflation Control
While we have many roles, it is our responsibility for monetary policy that makes insulation from political influence imperative. The U.S. Constitution gave to Congress, rather than the Executive Branch, the power to "coin money and regulate the value thereof." Congress, in effect, delegated that responsibility to the Federal Reserve in 1913. Subsequent legislation has spelled out our monetary role in more detail.

The fundamental responsibility of a central bank is to protect the value of the nation's money. The need for central bank independence is based on the premise that there is an inherent conflict between this responsibility and the political process. This conflict is based on the short-term time horizon inherent in the political arena, where the temptation is to go for short-term gains at the expense of the long-term health of the economy. Just as the girls get prettier at closing time, shorter term priorities look better at election time. Protecting the internal and external value of the dollar implies inflation control, a long-term task. Since the value of money varies inversely with the general price level, the conflict might be cast in terms of price level stability versus other national priorities.

Professional economists generally agree, however, that there is no long-term conflict between price stability and the goals of economic growth and high employment levels. In fact, most would argue that except perhaps in the transition to it, price stability establishes a favorable environment for maximum sustainable growth. In economists' terminology, the long-term Phillips curve is vertical, meaning that in the long term you can't buy higher employment levels by accepting greater inflation.

On the other hand, some economists and virtually all politicians facing election believe that there is some temporary trade-off. In this view, you can buy somewhat faster growth and lower unemployment levels by running the economy hotter that its long-term sustainable, non-inflationary pace—especially if the inflationary policies are unexpected by market participants. Any employment or growth gains, however, can only be temporary, and the resulting inflation will undermine the favorable employment climate. The usual result is a boom-bust cycle in which the average growth rate is worse than the growth generated by a steady non-inflationary pace. You wind up with permanently higher prices and, at most, only temporarily higher employment.

Research also supports the view that a country's long-term success in achieving price-level stability is positively related to the degree of independence of its central bank. (For more information, see the Dallas Fed 1990 annual report.) Many countries around the world are recognizing this relationship and giving their central banks greater independence from the government, as well as a mandate to focus on price stability as their primary goal. The point is to avoid the temptation to pursue elusive and contradictory short-term goals to the detriment of the long-term health of the economy.

Unfortunately, the consensus among economists about long-term relationships is not easily embraced by politicians with short time horizons. The closer the next election, the more tempting it is to press for short-term stimulus, regardless of the longer term consequences. The task of resisting that pressure is most often a thankless one.

Popular support for price stability is necessary in a democratic society, but it is difficult to come by until inflation seems to be out of control, as it was in the late '70s and early '80s. One important obstacle to public understanding and support for inflation fighting involves the fallacy of composition, a fallacy of generalizing from personal experience. Inflation results when spending in the total economy exceeds the capacity of the economy to produce real goods and services. It is usually associated with money growth that exceeds the real growth potential of the economy. Money growth, in turn, results from excessive loans and investments made by banks and other financial institutions whose deposits are used as money.

The fallacy of composition comes in because individual borrowers at banks never see any capacity constraints. They have good uses in mind for their borrowed money. Business loans, for example, are always expected to add more to total product than would be needed to repay the loan. However, the sum of these loans, and the total amount of money created by them, may well exceed the real resource constraints of the economy.

Scarce real resources in the economy are invisible at the level of the business firm or the individual borrower because they can always get all the resources they need by bidding and paying for them in the marketplace. But in a full-employment or near-full-employment environment, the resources going to one sector will be leaving another. The spending and competition for scarce resources may increase output in one area but will shrink it in others. Inflation will result, but the cause of inflation will not be obvious to all the participants. The paradox is that the sum of activities that appear "non-inflationary" when viewed separately are inflationary when viewed collectively.

The real scarcities and constraints in the economy will be visible to the individual players only as money becomes harder and more expensive to borrow.

"Tight money" is a necessary rationing device if inflation is to be avoided or minimized, but it will always appear unnecessary and arbitrary to the borrowers. It is the job of the central bank to allow the real capacity constraints in the economy to be reflected in financial markets to keep money as scarce as the goods that can be bought with it. But that is usually a thankless task.

Ironically, it is more appreciated by the public after inflation has gotten out of hand and consequently the correction is more painful, than it is when central bank action is more timely and the correction less painful. Nobody at the party wants the punch bowl taken away, except perhaps the next morning.

Checks and Balances and Local Involvement
Sound economic policies depend on public understanding and support. That is why economic education is a priority of the Dallas Fed. As noted earlier, Congress built several features into the Fed's structure to protect it from partisan political influence while keeping it in touch with the business community: long and staggered terms for members of the Board of Governors, geographical dispersion, private-sector ownership of Reserve Banks, private-sector boards of directors, joint appointments of Reserve Bank presidents by the local boards and the national Board, self-financing of Reserve Bank operations rather than tax appropriations. This design keeps the Fed free from political influences.

This does not mean that the Fed is unresponsive to the needs of the community. The Fed is a decentralized central bank with deep local roots. The Dallas Fed cannot conduct local monetary policy, but we can and do bring local citizens into the process, making sure that national policies take our local conditions and concerns into account. The credit crunch, NAFTA and the changing oil business are but three recent examples of local issues with national significance. As the central bank of the Southwest, we also try to reflect and promote the local ethic of entrepreneurial capitalism in our research, speeches and conferences.

Local participation in the monetary policy process occurs largely through the input of local boards of directors and advisory councils. These diverse groups are drawn from the private sector of our local communities. Our current Dallas board, for example, includes two community bankers, a farmer, a labor leader, an independent oil operator, and a small-business person. Our deputy chairman heads a major oil producing and refining company headquartered in San Antonio, and our current chairman is a venture capitalist from Dallas. We have similar boards in our Houston, San Antonio and El Paso Branches, as well as advisory councils for small business, agriculture and financial services. Our region, the Eleventh Federal Reserve District, includes northern Louisiana and southern New Mexico, as well as all of Texas.

Grass roots information percolates up from local sources in various ways. By law the local Reserve Bank boards make recommendations to the Board of Governors on the discount rate, the interest rate banks pay to borrow money from the Fed, every 14 days. This requirement necessitates a continuing dialogue about local economic and financial conditions. As president of the Dallas Fed, I have the advantage of this dialogue while serving on the Fed's principal monetary policy-making committee, the Federal Open Market Committee (FOMC). I also use our local research staff, and try to stay in touch with local economic and financial conditions through direct contacts and formal surveys.

In addition to determining monetary policy and filtering local information, the Fed is a profit-making business. We operate on our own income, without funds appropriated by Congress, which helps keep us independent.

Reserve banks not only operate with their own earnings but also return the excess, roughly 90 percent, to the Treasury. The bulk of the earnings are a by-product of open market operations, which involve the sale or purchase of government securities. A gradually growing money supply requires the Fed over time to be a net buyer of government securities. A tiny amount of earnings comes from interest charged to banks borrowing at the discount window—tiny because banks borrow very little these days.

In addition to traditional central bank functions, Reserve Banks also provide financial services to commercial banks and other financial institutions. Since 1980, we have been required to price these services and fully recover their costs, including implicit costs that are not actually incurred but would be incurred if we were not a central bank. These "priced" services include check collection, the electronic transfer of funds and securities, automated clearinghouse (ACH) operations, and the like. We also distribute coin and currency to the public through the banking system as a non-priced service. In addition, we provided services on behalf of the U.S. Treasury as the fiscal agent of the government. We also have a role in banking supervision, examining state-chartered member banks and bank holding companies.

The pricing of our services and the requirement of full cost recovery is a feature of our organization that has significant implications for our attitude and culture. It means that we are a quasi-governmental agency subject to market discipline. We must show a profit, even though we don't get to keep it. We have the same pressures on us as a private-sector firm to remain efficient and competitive. Our participation in the financial services marketplace helps to distinguish us further from a government agency run exclusively from Washington.

However, our messy organization chart tempts tinkerers. But any effort to change it in order to make the Fed more politically responsive or accountable should be made with extreme caution. The choice may well be between a funny organization chart and funny money. Whether a queer duck or a duckbill platypus, in its current form the Fed provides a model for government that combines national and local accountability, self-funding, and the responsibility for a sound monetary system.

And it works.

The Fed and the Platypus: A Story That Needs to Be Told  The platypus may look a bit strange and it may not be readily understandable or understood, but it has served nature's purpose and has survived in the process of evolution. The same could be said about the Federal Reserve: it has served the purposes of Congress in1913 when it passed the Federal Reserve Act, and it has adapted and evolved through changing economic times. The platypus has been more than a simple freak or curiosity. At one time it was widely hunted for its luxurious fur; one use for the pelt was to make a purse (maybe a link to monetary policy). It may look funny or exotic, but it works. It's functional. It makes the most of its environment in Australian streambeds. It looks strange in a picture. To see it out of its element, you would think of it as clumsy, ungainly, half-slithering, half-plodding along its too short legs and webbed feet. But in its own element, the streams, it moves efficiently through the water. People need to see the Federal Reserve in its own element, too, as it sifts through the muddied waters of monetary policy, supervision of member banks and regulation and large-scale payments systems. Not to make too much of the comparison. The platypus is a protected species. Only Mother Nature may understand why the platypus is still around. The Federal Reserve performs functions vital to the U.S. economy and to the balances necessary in international finance. But better compared to the scientifically dignified platypus than a "queer duck."

About the Author Bob McTeer is president and CEO at the Federal Reserve Bank of Dallas.