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The Elusive Promiseof Independent
Central Banking
Keynote Speech by Marvin Goodfriend

Independent central banking is reviewed as it emerged first under thegold standard and later with inconvertible paper money. Monetary andcredit policy are compared and contrasted as practiced by the 19th
century Bank of England and the Federal Reserve. The lesson is that wide
operational and financial independence given to monetary and credit
policy in the public interest subjects the central bank to incentives
detrimental for macroeconomic and financial stability. An independent
central bank needs the double discipline of a priority for price stability
and bounds on expansive credit initiatives to secure its promise forstabilization policy.
Keywords: Bank of England; Central bank independence; Credit turmoil
of 2007–08; Federal Reserve; Great Inflation; Lender of lastresort; Monetary policy
JEL Classification: E3, E4, E5, E6Professor of Economics, Tepper School of Business, Carnegie Mellon University and National
Bureau of Economic Research (E-mail: marvingd@andrew.cmu.edu).........................................................................................................................................................
The paper benefited from the comments of Michael Bordo, Barry Eichengreen, Kenneth Garbade,
Robert Hetzel, and Allan Meltzer, and presentations at the Bank of Korea 2012 International
Conference, Seoul, South Korea and the Institute for Financial Studies, Southwestern Universityof Finance and Economics, Chengdu, Sichuan, China. The research was supported by the Gailliot
Center for Public Policy at the Tepper School, Carnegie Mellon University. This paper was
prepared for the 2012 BOJ-IMES Conference, “Demographic Changes and Macroeconomic
Performance,” held by the Institute for Monetary and Economic Studies, Bank of Japan, in Tokyo
on May 30–31, 2012.

MONETARY AND ECONOMIC STUDIES/NOVEMBER 2012
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION

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I. Introduction
Established centuries ago largely to facilitate government finance, central banks undertook independent monetary and credit responsibilities only gradually. The 19th century
Bank of England (BOE) undertook last-resort lending during banking panics, butotherwise followed the rules of the classical gold standard. Established by the Federal
Reserve Act of 1913, the Fed employed its monetary and credit policy powers to help
finance World War I and thereafter to manage the money supply somewhat independently of gold to smooth short-term interest rates against liquidity disturbances. The
idea was that the Fed’s independent policy powers would improve on the rules of theclassical gold standard, rules that were seen as unduly restrictive.
The story is one in which wide operational and financial independence to pursue
monetary and credit policy in the public interest proved detrimental to macroeconomic
and financial stability.1 From the beginning, the Fed’s smoothing of interest rates
weakened the link between gold flows and the monetary system, and set the stage
for a highly unstable price level, including the deflation that precipitated the Great
Depression in the 1930s. Later, in line with public and political pressures, the Fed’s
inclination to prioritize low unemployment over low inflation produced go-stop monetary policy in the Great Inflation of the 1960s and 1970s. The Volcker Fed (1979–87)
asserted a priority for price stability in the early 1980s that eventually brought down
both inflation and unemployment. The Fed learned that eﬀective monetary policy
independence needs the discipline of a credible commitment to low inflation.
Independent central bank credit policy has undergone a parallel evolution. The 19th
century BOE followed Walter Bagehot’s (1873) dictum to stabilize financial markets
during a banking panic by lending freely at a high rate against good collateral. Bagehot’s
advice worked because the BOE operated as a private profit-maximizing institution
whose shareholders earned the profit and bore the losses; the BOE thus had an incentive
not to subsidize its last-resort lending or expose itself to unwarranted risks.
Bagehot’s rule is widely referenced as the rationale for central bank lending today.
Yet Bagehot’s rule has not been followed by the Fed. Early on and for decades thereafter, the Fed set its discount rate below market rates and subsidized lending todepositories by targeting borrowed reserves to obscure its routine management of shortterm interest rates. Fed lending supported insolvent depositories in the 1970s and 1980s.
The U.S. Congress in 1991 gave the Fed virtually unlimited power to lend beyond
depositories in a crisis. Unbridled credit policy independence in conjunction with its
financial independence drew the Fed into a massive expansion of credit in the 2007–08
crises, with the “implied promise of similar actions in times of future turmoil.”2 Just
as the priority for price stability was needed to discipline independent monetary......................................................................................
1. Economists have expressed a range of views on independent central banking. Friedman (1962a) is skepticalthat an independent central bank can deliver low inflation consistently. Prescott (2006, p. 209) argues that an
independent central bank will sustain low inflation consistently today because it will be punished for excessive
inflation. The “Petition for Fed Independence” signed by Roberto Caballero et al. (2009) contains nearly 200
signatures approving of virtually unconditional independent monetary and credit policy powers. McCallum(1995, 1997) identifies various caveats. Cukierman (1992) assesses independence empirically. Hetzel (2001),
Meltzer (2003, 2010), and Stein (1969) survey the ebbs and flows of Fed independence in practice.
2. Volcker (2008, p. 2).

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policy, tightly circumscribed boundaries are needed today to discipline independent
credit policy.
The above points are developed in detail as follows. Section II reviews the evolutionof independent monetary policy, covering in turn the 19th century BOE under theclassical gold standard, the Fed under the 20th century gold standard, and post–WorldWar II go-stop monetary policy. Section III reviews the evolution of independent credit
policy, covering in turn last-resort lending by the 19th century BOE, borrowed reservetargeting by the Fed, and emergency credit assistance by the Fed. Section IV contrasts
the fiscal finance and the monetary stability roles of central banking in the context of therule of law and government responsibilities more generally. Section V explains how the
double discipline of a priority for price stability and bounds on expansive credit policy
can enable an independent central bank to steer clear of unauthorized fiscal finance andsecure its promise for stabilization policy.

II. Independent Monetary Policy
Independent monetary policy had its origin in the 19th century with the occasional
relaxation of classical gold standard rules so that the BOE could undertake so-called“lender of last resort” responsibilities during banking crises. The Fed was established topursue monetary policy independently within the gold standard. The two central banks
pursued their independent monetary policy powers very diﬀerently as a result of theirgovernance structures.
A. Independent BOE Monetary Policy and the Classical Gold Standard
Under the classical gold standard rules of the Bank Charter Act of 1844, the BOE was
obliged to exchange its circulating bank notes and its deposit liabilities at 4.25 pounds
per ounce of gold. Except for a fixed fiduciary note issue, the BOE was ordinarily
required to hold a 100 percent gold reserve against its circulating bank notes.3 There
was little room for the BOE to engage in independent monetary policy. Short-term
interest rates and other financial variables were linked relatively tightly to gold flows.
When obliged to buy gold at the fixed pound price, the BOE would expand noteissuance and market interest rates would fall; when it was obliged to sell gold, thenote issuance contracted and market interest rates rose.
Normally, the BOE’s “Bank Rate,” the rate at which it would lend against designatedclasses of securities, was kept fixed slightly above market rates.4 The Bank Rate could
come into play in the event of a run on the banking system. Banks would sell assets inan eﬀort to acquire bank notes to pay out depositors. In so doing, asset prices would be
driven down and short-term interest rates driven up until they hit the Bank Rate ceiling.
Bagehot’s famous prescription—that the BOE should stand ready to lend freely at ahigh rate on good collateral—dictated that the BOE should accommodate the demand......................................................................................
3. Commercial bank balances held at the BOE became increasingly important during the 19th century. No gold
reserves were required against such bankers’ balances. Because the BOE was a profit-maximizing entity, theinterest opportunity cost of holding gold instead of securities limited its willingness to hold precautionary
gold reserves.
4. See Hawtrey (1938).

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for bank notes fully at Bank Rate against any good collateral it was oﬀered.5 The
U.K. Treasury suspended temporarily the gold reserve that it required the BOE tohold against its circulating bank notes during the panics of 1847, 1857, and 1866 toenable the BOE to supply the banking system temporarily with whatever currency wasdemanded at Bank Rate.
Bagehot’s rule worked well for the 19th century BOE for three reasons. First, it was
generally profitable for the BOE to hold fewer gold reserves against its bank notes than
the government required, so the BOE would expand lending if gold reserve requirements were suspended. Second, the BOE would profit from lending at a high Bank
Rate. Third, because its shareholders earned the profit and bore the risk of loss, the BOE
had an incentive to lend against collateral of impeccable creditworthiness. So there waslittle ex ante distortion due to credit allocation and little ex post credit subsidy.
This raises the question: if the BOE had the incentive to follow Bagehot’s ruleduring banking panics, why then did Bagehot need to promote the rule for the BOE tofollow? Perhaps the BOE needed Bagehot’s encouraging public policy rationale to act
as the “lender of last resort” to deflect charges of profiteering.
Ironically, the “lender of last resort” policy practiced by the BOE under Bagehot’srule is best thought of not as “credit policy” at all but as “monetary policy.” Lendingat Bank Rate did not require for its eﬀectiveness that the BOE take credit risk on its
balance sheet. Last-resort lending worked by satisfying temporarily the excess demandfor bank notes against riskless securities.6 Last-resort lending served its purpose well,because as monetary policy it could be disciplined eﬀectively by the BOE’s profitmaximizing incentive and by the government’s relaxation and reimposition of gold
reserve requirements during and following banking crises. The credibility of thenation’s commitment to defend the 4.25 pound per ounce price of gold, which wasmaintained throughout, guaranteed that private capital would be forthcoming to help
defend the gold value of the pound against a speculative attack that might develop as
the BOE followed Bagehot’s rule.
B. Independent Fed Monetary Policy under the Gold Standard
The Fed was founded just before World War I in the belief that its interest rate policy
would be guided by the rules of the classical gold standard. Initially, the Fed was
required to hold a 35 percent gold reserve against bankers’ balances and a 40 percent
gold reserve against Federal Reserve notes, and to stand ready to convert its deposit
and note liabilities into gold at US$20.67 per ounce. The Fed had a large cushion ofgold reserves when the war ended in November 1918. Its gold reserves declined sharply
after the gold export embargo was lifted in 1919 and gold flowed out of the country. To
defend its minimum gold reserve requirements, the Fed raised short-term interest rates
sharply from around 4 to 7 percent between October 1919 and June 1920 and kept rates
high through March 1921. The resulting recession from January 1920 to July 1921 was
sharp and deep. Unemployment rose from an average of 4 percent in 1920 to around
12 percent in 1921. The Fed’s index of industrial production fell from 39 in 1920 to 30......................................................................................
5. Bagehot (1873; reprinted 1927 edition, pp. 187–188).
6. See Goodfriend and King (1988, pp. 15–17).

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in 1921 and returned to 39 in 1922. The wholesale price index fell 37 percent during
the recession and stayed there during the recovery.7
The Fed’s interest rate actions geared to defending the gold standard partiallyreversed the rise in the price level that had occurred during the war. However, there
was little public support in the United States for the Fed’s deflationary, high interest rate
policy in the early 1920s, and the Fed was traumatized by its first use of interest rate
policy. Congress discussed legislation limiting the Fed’s power to raise interest rates
beyond a ceiling rate without congressional approval.8 The Fed did not raise interest
rates to this level again until the 1960s. Even then, the Fed raised rates reluctantly,
creating the go-stop inflationary problems discussed below.
To loosen the link between short-term interest rates and gold flows, the Fed shortly
thereafter began to build up a stock of “free gold,” gold reserves in excess of legallyrequired ratios. Targeting gold reserves far above required minimums allowed the Fed
to accommodate fluctuations in gold flows without immediately adjusting short-term
interest rates.9 By stockpiling gold, the Fed essentially divorced monetary policy fromthe constraints of the gold standard.10 The Fed let its gold stockpile run up and down toaccommodate fluctuations in demand at the fixed dollar price, sterilizing the monetaryeﬀects of gold flows with securities operations.
In so doing, the Fed pursued monetary policy with considerably more flexibility
than had the BOE.11 The Fed radically altered the character of short-term interest rate
movements, eliminating sharp fluctuations and introducing a high degree of persistence
into short rates unknown previously.12 However, by weakening the operational link
between gold flows and short-term interest rates, the Fed inadvertently set the stage
for a highly unstable price level, including the deflation of the 1930s and the inflationthat followed World War II.
The Fed was willing to stockpile gold, and forgo interest income from securities
it might have held otherwise, because it was not a profit-maximizing institution.
The Fed was set up and run “in the public interest.” The Fed was given “operational
independence” over its balance sheet, and “financial independence” to fund itself fromits net interest income, ostensibly to free its money-creating power from potentiallyinflationary budgetary politics. The U.S. Treasury was the recipient of net income after
expenses arising from the Fed’s monopoly on bank reserves and currency.
Thus, the Fed had the operational independence to acquire free gold instead ofinterest-earning securities and the financial independence to deprive the governmentof revenue by holding free gold instead of securities. One wonders whether Congress
would have been willing to authorize explicitly the “spending” of net interest income
from monetary policy operations to stockpile gold far above legally required minimums.
At any rate, the Fed’s pursuit of independent monetary policy stands in contrast tothat pursued by the BOE. Instead of coexisting with the rules of the gold standard, the......................................................................................
7. The descriptive data come from Meltzer (2003, pp. 109–119).
8. Meltzer (2003, p. 127).
9. Board of Governors of the Federal Reserve System (1976, table 93, pp. 346–350).
10. See Friedman (1961) and Goodfriend (1988).
11. See Hetzel (1985).
12. See Mankiw, Miron, and Weil (1987) and Goodfriend (1991, pp. 22–23).

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Fed’s monetary independence proved destructive of the discipline of the gold standard
and eventually supplanted the gold standard with an inconvertible paper money.
C. Go-Stop Monetary Policy
When the dollar price of gold was raised to US$35 an ounce in 1934, the price waswell above the world market price. Gold flowed into the Fed, tripling its gold stockin six years until it held about half of the world’s gold. By the early 1960s, the Fed’s
inflationary monetary policy had more than doubled the price level, and the Fed wasforced to sell gold to maintain the US$35 an ounce price.13 When inflationary money
creation eroded the Fed’s free gold in the mid-1960s, Congress eliminated the minimum
required gold reserve. The private dollar price of gold was allowed to float freely in1968 and the gold standard finally broke down definitively in 1973.
The flexibility of an inconvertible currency created increasingly destabilizing inflationary go-stop monetary policy. Acting in the public interest, the Fed was inclined tobe responsive to the shifting balance of the public’s concerns between unemployment
and inflation. The Fed would pursue monetary stimulus to drive the unemployment rate
down as long as the public was willing to risk higher inflation to stimulate additional
economic activity. Only when economic activity was strong and inflation moved above
the prevailing trend did inflation become the public’s predominant concern.
In keeping with the public interest, the Fed justified its periodic inflation-fighting
actions against an implicit objective for low unemployment. By the time the public
became suﬃciently concerned for the Fed to act against inflation, pricing decisions
had begun to embody higher inflation expectations. Restraint on inflation then required
an aggressive increase in short-term interest rates to create a recession to bring down
inflation. In any go-stop cycle, there was a relatively narrow window of broad public
support for the Fed to tighten monetary policy against inflation. The window opened
when rising inflation was widely judged to be a problem and closed after tighter monetary policy caused unemployment to rise. The Fed would settle for a higher trend rateof inflation with each policy cycle.
Deliberately expansionary monetary policy in the “go” phase of the policy cycles
came to be anticipated. The Fed became ever more expansive in its pursuit of low
unemployment, causing trend inflation and inflation expectations to move ever higher,
which in turn necessitated ever more contractionary recessions in the “stop” phaseof the policy cycle. Monetary policy became a source of instability and wound up
worsening both inflation and unemployment.14 Eventually, the Fed recognized that it
would be better to reverse its priorities—to justify its actions to stimulate employment
against a commitment to low inflation. The reversal of priorities during the Volcker
disinflation in the early 1980s enabled monetary policy subsequently to reduce bothinflation and unemployment.15......................................................................................
13. Friedman (1962b, pp. 58–60).
14. Friedman (1964) discusses go-stop policy. Taylor (1979) documents the ineﬃcient variability of inflation andunemployment during the Great Inflation period relative to the estimated eﬃcient policy frontier. See also
Romer and Romer (1989).
15. The Volcker disinflation is discussed in detail in Goodfriend and King (2005).

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The key to the Fed’s success is its preemptive interest rate policy actions against
inflation, the first in 1983–84 and the second in 1994. Both circumstances were marked
by a significant inflation scare in long-term bond rates. The 30-year Treasury bond raterose by 3 percentage points from the summer of 1983 to the summer of 1984. The
bond rate rose by 2 percentage points from the fall of 1993 to the fall of 1994. On bothoccasions, the Fed raised short-term interest rates by 3 percentage points to containthe inflation scare, even though actual inflation had not yet begun to rise. And on bothoccasions, the Fed’s preemptive interest rate policy actions prevented a subsequent
rise in inflation and reversed the inflation scare in bond rates without an increase in
unemployment. These preemptive interest rate actions against inflation set the stage fortwo of the longest business expansions in U.S. history.
A milestone was reached in January 2012, when the Bernanke Fed (2006–) formally
adopted an explicit 2 percent inflation target. In so doing, the Fed recognized explicitlythat independent monetary policy needs the discipline of a priority for price stability
to oﬀset the tendency to drift otherwise into destabilizing inflationary go-stop
policy cycles.16

III. Independent Credit Policy
Credit policy involves lending to private institutions (or acquiring non-Treasury securities) with freshly created bank reserves or the proceeds from the sale of gold or
Treasury securities. Operating in the public interest with financial independence, theFed has pursued independent credit policy very diﬀerently than did the private
profit-maximizing 19th century BOE.
A. BOE Credit Policy
The 19th century BOE engaged predominantly in two types of credit initiatives. Itpurchased bills of exchange (bankers’ acceptances) outright at a discount. And it purchased securities that the counterparty agreed to repurchase at a given price and datein the future. “Advances,” as the latter were known, were collateralized by the security
in the repurchase agreement. Advances were made on bills of exchange, U.K. Treasury
securities known as consols, or other eligible securities.17
Flandreau and Ugolini (2010) argue that the rise of the fully secured business ofinternational trade finance was instrumental in the BOE’s willingness to provide lastresort lending during banking panics. For instance, they document that foreign billsof exchange were the preponderant security purchased outright or advanced under
repurchase agreements by the BOE during May 1866, when the Overend Gurney panic
reached its peak. They point out:[I]t may not take a huge credit analysis talent to understand that a shipment
secured by the commodity, traveling in a British ship, boarded in a British entrepot, guaranteed by the importer, his banker, and the drawee in London has......................................................................................
16. See Goodfriend (2005).
17. The description above is from Flandreau and Ugolini (2010, p. 7).

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little scope for going bad. The boom in global trade in the 1850s and 1860s
and the supremacy British banks achieved in financing it, meant that there wasnow a large supply of wonderful collateral on which the Bank of England could
lend freely.18
In other words, the abundance of bills of exchange provided the BOE with collateral,
virtually free of credit risk, against which it could lend currency during a banking
panic. In fact, Flandreau and Ugolini (2010) point out that even though two of thelargest recipients of BOE advances in 1866 were banks that collapsed during the crisis,
the BOE was fully protected against losses in each case.19
Thus, to reiterate the point emphasized in Section II.A, independent credit policy
practiced by the 19th century BOE was more akin to monetary policy than credit
policy. Last-resort lending did not involve taking on credit risk. Nor did it involvea subsidy, since it was undertaken at a high Bank Rate. Moreover, last-resort lendingat Bank Rate put a ceiling on short-term interest by accommodating the demand for
currency. Furthermore, since currency was provided at Bank Rate via the purchaseof securities—either outright or under a repurchase agreement—last-resort lending
actually involved open market purchases of riskless private securities rather thanlending to particular institutions.
B. Fed Credit Policy
The Fed has practiced independent credit policy in two distinct ways. First, it has
utilized “borrowed reserve targeting” to manage short-term interest rates. Second, it
has provided “emergency credit assistance” to depositories and other entities infinancial distress.
1. Borrowed reserve targeting
In contrast to the 19th century BOE, which normally kept the Bank Rate above market
rates, the Fed kept its equivalent discount rate below market rates. The Fed helped
to finance World War I by allowing depositories to borrow heavily at its discountwindow against Treasury securities.20 In so doing, the Fed’s discount rate put a ceilingon riskless short-term rates. Other money market rates floated above the discount rate
at spreads commensurate with liquidity and credit risk. The public understood that thediscount rate anchored money market rates.
After the traumatic experience raising interest rates in the early 1920s discussed
previously, the Fed moved to manage short-term interest rates less visibly by targeting“borrowed reserves.” To do so, in 1923 the Fed put in place administrative prohibitions
against continuous borrowing by individual banks. Subsequently, even riskless shortterm money market rates floated above the discount rate. The Fed managed the spread
between riskless money market rates and the discount rate by varying the quantityof aggregate bank reserves that the Fed forced the banking system to borrow at thediscount window. Higher (lower) forced borrowing drove up (down) market rates
relative to the discount rate.
......................................................................................
18. Flandreau and Ugolini (2010, p. 21).
19. See Flandreau and Ugolini (2010, p. 21).
20. Garbade (2012).

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Borrowed reserve targeting enabled the Fed to create the illusion that money market
rates were determined by market forces. To raise rates, the Fed first quietly sold securities from its portfolio to drain reserves from the banking system. Market rates would
float higher relative to the fixed discount rate as the banking system was forced toborrow more reserves from the Fed. Then, the Fed reversed its open market sale tonormalize the spread as it raised the discount rate, and the discount rate would follow
market rates higher.21
Borrowed reserve targeting was employed again to implement interest rate policy
quietly and invisibly in the 1950s and 1960s, and finally in the 1980s, to obscure
the Fed’s unpopular interest rate actions against inflation. The Fed did not make its
interest rate policy actions fully transparent until February 1994, when it began toannounce its intended federal funds rate target immediately after each Federal Open
Market Committee meeting. In 2003 the Fed began to set the discount rate for routine
borrowing at a penalty rate above the federal funds rate, in part to eliminate the subsidy
that borrowing banks could obtain, and also because borrowed reserve targeting was
no longer needed to hide interest rate policy actions.
Selling securities paying market interest to force the banking system to borrow
reserves at the lower discount rate cost the Fed interest income. The financially independent Fed simply passed through the interest cost in reduced revenue to the fiscal
authorities. The lost income was relatively minor, since borrowed reserve targeting
was implemented with relatively little forced borrowing. Nevertheless, one wonders
whether Congress would have been willing to authorize explicitly the “spending” ofinterest income by the Fed to hide the Fed’s interest rate policy actions.
2. Fed emergency credit assistanceThe constraints on the Fed’s independent emergency credit policy powers wereloosened gradually over time.22 The original Federal Reserve Act of 1913 authorized
the Fed to extend credit only to member banks of the Federal Reserve System. Lending
to other entities was not permitted at all until 1932, when Section 13(3) of the Act
gave the Fed the authority to lend to “individuals, partnerships, and corporations” in“unusual and exigent circumstances” as determined by the vote of at least five membersof the Board of Governors. However, Fed credit extended to nonbanks in the 1930s was
relatively insignificant because collateral requirements in Section 13(3) were highly
restrictive even after being relaxed by a 1935 amendment, and because entities suchas the Reconstruction Finance Corporation were established with funding authorized
explicitly by Congress to allocate credit widely to nonbank entities.23 The idea seems
to have been that expansive credit policies should not be carried out by an independent
central bank because credit allocation is inherently political and has the potential todegrade the central bank’s independence.
The Fed made few loans under Section 13(3) after the 1935 amendment took eﬀect
in 1936 until long after the section was amended as a result of the Federal Deposit
Insurance Corporation Improvement Act (FDICIA) of 1991. Financial markets were......................................................................................
21. See Goodfriend (1991, pp. 19–22) for a more extensive discussion.
22. The discussion below draws in part from Clouse (1994) and Todd (1993); see also Hackley (1973).
23. See, for instance, Jones and Angly (1951).

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relatively stable until the 1980s. And the Monetary Control Act of 1980 gave all depositories access to the Fed discount window, whether or not they were members of theFederal Reserve System.
Following the 1987 stock market crash, policymakers began to discuss the potential
desirability of relaxing restrictions on Fed lending to nonbank financial firms. Section
473 of FDICIA amended the Federal Reserve Act so that the only collateral test remaining under Section 13(3) was “satisfactory security,” the same test that applied toborrowings of depository institutions.24 Alan Greenspan wrote in 1991:[A]t the urging of the Federal Reserve Board of Governors, Section 13-3 ofthe Federal Reserve Act was considered, and amended, by Congress. The section grant[ed] virtually unlimited authority to the Board to lend in “unusual andexigent circumstances.”25
In eﬀect, the 1991 amendment to Section 13(3) gave independent Fed credit policy thesame wide discretion that its independent monetary policy powers had attained withthe demise of the gold standard.
The Fed and the 19th century BOE pursued their independent credit policy powers
very diﬀerently as a result of their governance structures. When Bagehot urged the
BOE to lend in a crisis against good collateral at a penalty rate, he did not need to say
more. The problem was to encourage the BOE to lend freely in a banking crisis once
the U.K. Treasury suspended the gold reserve requirement against notes.26 Bagehot
could be sure that the BOE would lend primarily against foreign bills of exchange so
as not to take on credit risk. Likewise, he could be sure that the BOE would lend at a
profitable penalty rate, since the BOE’s own funds were at stake and the BOE was aprofit-maximizing institution. There was little chance that the BOE would subsidize its
lending and distort credit flows. There was no need, since it was the monetary featuresof last-resort lending (the elastic provision of currency) that mattered for stabilizing
market interest at the Bank Rate ceiling.
The problem with regard to Fed credit policy today is just the opposite—it is tolimit the Fed’s lending reach. The financially independent Fed is inclined to lend rather
than risk a panic by not lending, even if forced to take relatively poor collateral atinordinately low interest, because its own funds are not at stake. The fiscal authorities
are content for the Fed to take responsibility for denying or extending credit to troubled
financial markets because the Fed’s inclination to lend usually matches their own,
notwithstanding the potential cost to taxpayers. And the fiscal authorities have theoption to criticize Fed actions after the fact if that proves politically useful. Moreover,the Fed puts taxpayers at risk even if it protects itself by taking good collateral. If theentity to which the Fed lends fails with a Fed loan outstanding, the Fed takes collateralat the expense of taxpayers exposed to losses from backstopping the deposit insurance
fund, or from other financial guarantees that the government may have put in place.
The setup facilitates lending laxity and moral hazard.
......................................................................................
24. Todd (1993, p. 20).
25. Greenspan (2010, p. 17).
26. See, again, Bagehot (1873).

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For these reasons, the Fed exhibited a tendency to expand its lending to depositories
beyond short-term liquidity assistance long before FDICIA authorized lending to nonbanks in 1991. For instance, in 1970 depositories were encouraged to borrow fromthe Fed to support the commercial paper market in the wake of the Penn Central
bankruptcy. In 1974, Fed lending supported the insolvent Franklin National Bank until
it could be purchased by a group of investors. Similarly, Fed lending from May 1984 toFebruary 1985 supported the undeclared insolvency of Continental Illinois Bank until
it was resolved.27 Schwartz (1992, p. 68) observed:
By the 1980s hundreds of banks rated by regulators as having a high probability of failure in the near term and which ultimately failed were receiving
extended accommodation at the discount window . . . [t]he change in discountwindow practices, by delaying closure of failed institutions, increased the losses
the FDIC and ultimately taxpayers bore.28
FDICIA contained provisions intended to limit longer-term Fed credit policy supportof troubled depositories. Ultimately, however, the power that FDICIA gave the Fed to
expand its lending reach beyond depositories more than oﬀset the restrictive provisionsof the Act.
From the 1980s, regulatory permissiveness and technological innovation in the
United States led to a huge expansion of securitization and structured finance of longerterm illiquid cash flows for funding in money markets via shadow banking.29 By 2007,
money markets accounted for a share of financial intermediation that rivaled depository
intermediation in scale. Importantly, the potential expansion of Fed lending to support
liquidity in money markets was not accompanied by the supervision and regulationof money markets as it was for depositories with access to Fed credit. Worse, thefact that money markets could expect support from expansive Fed credit policy in acrisis directly, or indirectly via lending to depositories, probably encouraged the vast
expansion of money market finance.
In the 2007–08 credit turmoil, the Fed was put in an untenable position given its
wide powers to lend—disappoint expectations of accommodation and risk a systemic
financial collapse, or lend expansively and feed expectations of even more expansive
lending. Analogously to inflationary monetary policy, fully independent Fed credit
policy exhibited a tendency evident in the credit turmoil to expand its lending reachin scale, maturity, and eligible collateral.30
The problem confronting independent Fed credit policy is this: unbridled credit
policy has the capacity to create ever greater boom and bust credit cycles while simultaneously undermining the Fed’s independent legitimacy within government. The natureof the problem is explored and a solution is proposed below.

......................................................................................
27. Schwartz (1992, pp. 62–64).
28. The Fed’s lending to insolvent banks in the 1980s is discussed at length in Clouse (1994, pp. 972–977) and in
Schwartz (1992).
29. Goodfriend (2011b).
30. See Goodfriend and Lacker (1999, pp. 14–15).

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IV. Government, Rule of Law, and Independent Central Banking
Among the government’s primary responsibilities are the provision of external andinternal security, the enforcement of contracts, and the resolution of disputes. The
government also must have an agreed political mechanism for assessing taxes on the
public and determining the purposes to which public funds are allocated.
If government is to be eﬀective, it must be regarded as legitimate—conforming
to recognized principles or accepted rules and standards. Public confidence in government is indispensable. Political, regulatory, or judicial processes must follow laws
and procedures that are openly agreed, readily understandable, and thoroughly andfairly enforced. Clarity and simplicity about the rule of law are essential to promoteequal opportunity. Complexity and opacity give an advantage to insiders, undermine
legitimacy, and erode voluntary cooperation essential for eﬀective government.
Independent central banks have veered between two diﬀerent public policy purposes. The modern “monetary stability” purpose values independent central banks fortheir power to guarantee low inflation and financial stability to promote sustainable
employment and economic growth. Price stability is valued, in addition, for providing
financial security, an inflation-free environment within which ordinary citizens can savereliably for retirement.
The older “fiscal finance” purpose values independent central banks for the occasional emergency financing of government spending. Central banks were charteredoriginally with the profitable right to issue bank notes within the gold standard in
exchange for providing loans to the government. Likewise, the Fed employed its power
to create currency and bank reserves to help finance the U.S. government at low interest
during both world wars.
Since the credit turmoil of 2007–08, independent central banks have employed
expansive credit policy initiatives for fiscal finance purposes beyond boundaries ordinarily regarded as legitimate by the legislature and the public. Whether justified by
the need to act in a timely manner, or by the need to act in lieu of paralyzed fiscal
authorities, independent credit policy initiatives that reach beyond such boundaries
rightly draw scrutiny. Expansive credit initiatives undermine an independent central
bank’s legitimacy and potentially its capacity to pursue monetary stability eﬀectively.31
Expansive independent credit policy that bypasses the legislative process for whateverreason creates complexity and opacity that favors insiders and weakens the public’s
confidence in government overall.

V. Securing the Promise of Independent Central Banking32
Monetary policy disciplined by a priority for price stability is well suited for delegation
by Congress to the independent Fed. To secure the Fed’s credibility for low inflation,
Congress in its oversight capacity should accept the Fed’s announced 2 percent inflation
objective and hold the Fed accountable for achieving it on average over time. Congress......................................................................................
31. See Blinder (1996).
32. This section draws on themes developed extensively in Goodfriend (2011a).

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should insist that the Fed adhere to a “Treasuries only” asset acquisition policy, except
for occasional lending to depositories, to avoid credit risk on the Fed’s balance sheet.
The Fed would recycle all interest income on its Treasuries (net of operating expenses)
directly back to the fiscal authorities to allocate as they see fit. Operational monetary
policy independence with Treasuries only and a priority for price stability would work
well and steer the central bank clear of political entanglements.
Fed credit policy has considerable potential to create friction between the Fed, thepublic, and the fiscal authorities. Emergency credit policy works by interposing thegovernment’s unique creditworthiness—the power to borrow credibly against futuretaxes—between private borrowers and lenders to facilitate credit flows to distressedborrowers. Fed credit policy involves lending to private institutions (or acquiring nonTreasury securities) with freshly created bank reserves or the proceeds from the saleof Treasuries. To prevent future inflation, bank reserve creation eventually must be
reversed with sales of Treasuries, or else the Fed will have to pay a market interest
rate on the reserves. Either way, credit policy involves the lending of public funds toparticular borrowers financed by interest-bearing liabilities issued against future taxes.
The Fed returns the interest on its credit assets to the Treasury, but all such assets
carry credit risk and involve the Fed in potentially controversial disputes regarding
credit allocation.
Occasional Fed lending to solvent, supervised depositories in the short term against
good collateral is protected against ex post loss and ex ante distortion and deserves adegree of operational independence. However, credit initiatives that extend the Fed’s
credit reach in scale, maturity, and eligible collateral to unsupervised or potentiallyinsolvent institutions, or the purchase of non-Treasury securities, inevitably carry credit
risk, excite questions of fairness, and threaten the legitimacy of both the Fed and thefiscal authorities. Hence, Congress in its oversight role should clarify the boundaryof the Fed’s responsibilities for taking expansive credit actions and correspondingly
restrict its independence in doing so.
The 2010 Dodd-Frank Act recognizes the problem and requires Fed lending extended beyond depositories to be approved by the Treasury Secretary and to be partof a broad program not directed to any particular borrower. The Dodd-Frank requirements do not address the problem adequately, however, because the Administration
is no more authorized to commit taxpayer resources than the independent central
bank—only Congress can do so. And the Treasury is as likely as the Fed has been
to favor expansive credit policy in a financial crisis rather than risk an immediate
financial collapse.
To deal eﬀectively with the potential for an expanding and ultimately self-destructive
Fed lending reach, taxpayer representatives should be involved more prominently in
congressional oversight of expansive Fed credit policy. Expansive lending should be
authorized before the fact by Congress in its oversight role, and only as a “bridgeloan” accompanied by a “take out” arranged and guaranteed in advance by Congress.
The authorization process should include a clear, explicit, and public discussion of
the fiscal risks, alerting taxpayers in a clear and explicit way to the potential cost of
expansive Fed credit initiatives. An expectation of taxpayer reluctance to bear the costof expansive Fed credit policy could then credibly bend down market expectations of51

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the Fed’s lending reach so that banking and credit markets would better insure themselves against liquidity risk. Protecting the legitimacy of the Fed’s independence withstrong legislative action would defuse the implied promise of expansive Fed credit
policy actions in the future and help act against a repetition of the boom and bust cycle
in money market finance.

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