The Government Accountability Office released a report Wednesday which studied conflicts of interest and diversity amongst Federal Reserve Officials. Though the 127 page GAO report didn't accuse the board of corruption, it does warn, "directors' affiliations with financial firms and former directors' business relationships with Reserve Banks continue to pose reputational risks to the Federal Reserve System."
The report points to the example of Stephen Friedman who was chairman of the New York Federal Reserve in 2008, when Goldman Sachs applied to become a bank holding company in order to receive cheap loans from the central bank. At the time, Friedman was a shareholder and board member of Goldman Sachs. The New York Federal Reserve sought a waiver to allow Friedman to remain president even though normal rules would have prevented this arrangement. The waiver was granted on the logic that finding and installing a replacement in the middle of a banking crisis would be difficult and potentially harmful to the economy. In January of 2009, an "automatic stock purchase program" triggered Friedman's purchase of additional stock in Goldman. The backlash from this forced his resignation.
The politics surrounding the Federal Reserve are tricky in the best of times. During crises, people get a bit more worked about about this institution, to say the least. Ironically, the Federal Reserve's main purpose is to steer the national economy through times of crisis.
Financial markets are basically a virtual crowd of people. And no matter how rational an individual human being is (and individuals' rationality is certainly up for debate), we all know that crowds are given to bouts of irrationality, especially when fear is involved. If everybody believes that credit is about to freeze up, nobody will be willing to lend any money. This becomes a self fulfilling prophecy.
English economist and journalist Walter Bagehot famously called the British central bank the "lender of last resort." This description has survived until today as a succinct description of a central banks role. When nobody else is willing to lend, The Federal Reserve, America's central bank, should continue to lend to institutions that are solvent. This, theoretically, will prevent unnecessary financial turmoil brought on by the vicissitudes of financial "crowds."
This is all well and good in theory, but in practice it can get kind of messy, as the past few years have shown. For a central bank to be effective in a democracy, it must be insulated from quickly shifting political winds. If representatives had direct control of the bank, they would be tempted to use the institution to goose the economy in the short term, sacrificing stability for gains that might help them electorally. In addition, central bank actions must be swift and decisive and avoid the gridlock of representative democracy.
However, when an institution is so insulated from popular oversight, there is plenty of room for actual or perceived corruption. The Federal Reserve is a fairly complex system made up of a board of governors and several regional banks each with its own boards. The Federal Reserve has 7 member Board of Governors appointed by the President and approved by the Senate. The regional banks have boards of governors themselves, 2/3s of which are elected by the member banks in their respective regions. There are three classes of boards of governors of the regional banks, one of which can be affiliated with financial institutions regulated by the fed, and two of which cannot. All are supposed to have knowledge of the economy and financial system, for obvious reasons.
The main issue here is that those who are most expert in financial system are those who have gained and stand to gain substantially from the financial system. The GAO report acknowledges this, and its solution is basically more transparency. Transparency can stem temptation to abuse the system by its officials, and it can assuage the fears of critics who believe the system is being abused. Reform will be a delicate process, but considering Washington isn't accomplishing much these days, it may be a while until we see any changes at all.
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