4.4.2022

The Power and Independence of the Federal Reserve • Skunk Works

Last Week

The Power and Independence of the Federal Reserve

By Peter Conti-Brown

One of the exclusive powers long attributed to states is their ability to create, control, and destroy money. The tight control of currency is one of the most guarded functions of the government—in the United States, the founding purpose of the Secret Service was not to protect the president, but rather to curtail counterfeits in the wake of the Civil War. The Federal Reserve System, or the "Fed," is now responsible for the maintenance of the national money supply and to a significant degree, the economy itself. But the Fed, despite being so fundamental, has barely been around for a century. Though it literally prints all of our money (dollar bills are properly called "Federal Reserve Notes"), the Fed's responsibilities and autonomy aren't well-publicized.

An ethics professor at Wharton, Conti-Brown's main goal in this book is to set the facts straight. Popular models of the Fed as an independent buffer against short-term politics are overly simplistic, he argues. Moreover, the Fed cannot be understood merely by examining the laws that regulate it—certain aspects of its governance structure may even render it unconstitutional. The Fed is also an imperfect institution. Its role as a central bank means that its policies end up determining the economic well-being of millions. Yet because of its flaws, it often fails to be independent and accountable. Therefore, Conti-Brown suggests a few reforms that can improve the agency while showing how certain existing ones are misguided.

Ulysses and the Punch Bowl

The prevailing perception of the Fed endows it with a sort of technocratic autonomy. Isolated from short-term political considerations—most prominently, inflation as a means of stimulating growth—the Fed is able to effectively manage the economy across longer periods. In this abstraction, the Federal Reserve acts like a "chaperone who has ordered the punch bowl removed just when the party was really warming up." Or to use a more formal metaphor, the Fed can be compared to Ulysses' crew, who stuffed their ears with beeswax as they rowed past sirens, their captain bound to a mast.

In Conti-Brown's view, this view rests upon a few faulty assumptions. It first supposes that the Fed is bound to independence as a matter of law, and it also reduces the Fed to a singular rational entity faced with a political audience. It also assumes that the purpose of an independent central bank is insulation from political pressures. And lastly, it assumes that the Fed is technocratic, requiring "special training but not the exercise of value judgments under uncertainty." All of these assumptions, Conti-Brown argues, can be dismantled.

The Federal Reserve is not reducible to the actions of a single entity; its governance has made it one of the most convoluted organizations since its founding. Many outside entities, in particular Congress and the President, have a major influence on the agency via mechanisms such as threatening legislation and the appointment of its members. Nor is the Fed's primary concern the maintenance of price stability.

Historically, the Fed can be seen as really having three foundings, for it has evolved considerably over the years. The popular narrative holds that the panic of 1907 forced Congress to realize that it could not count on people like J.P. Morgan to save the system, so it passed the Federal Reserve Act of 1913. But in reality, what happened was a heated debate that resulted in a "Wilsonian Compromise" by the administration that created a collection of Reserve Banks, each with a governor and board, that would be beholden to the Federal Reserve Board. Ideologically, this struck a balance between centralization and decentralization as well as private versus public governance. But because the law itself was open to interpretation, the bounds between the Board and the Reserve Banks were blurred. Reforms such as the Glass-Steagall Act of 1933 created the Federal Open Market Committee (FOMC)—which governs the trading of government securities—but left the basic structure of the organization intact.

In 1935, however, a "second founding" occurred when FDR attempted to convince Marriner S. Eccles, a successful banker, to accept a Governor position on the Federal Reserve Board. Eccles refused unless "fundamental changes" were made, and the result was the Banking Act of 1935. This act abolished the Federal Reserve Board, replacing it with the Board of Governors (still in use as an anachronism) and demoted the heads of the Reserve Banks from governors to presidents. Although these changes might appear to be mere shifts in names, they amounted to a dramatic shift from a system of private governance to a public one that could be called a central bank.

Later, WWII would bring the Fed under direct governmental control, but the post-war period would bring the agency's connections with the government into question. From the debate, a single sentence would establish a truce:

The Treasury and the Federal Reserve System have reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose to assure the successful financing of the Government’s requirements and, at the same time, to minimize monetization of the public debt.

Although the sentence is "almost completely devoid of content," it would form the basic idea that the Fed's monetary policy is fundamentally independent of those of the executive branch. With the performance of the economy so vital to a president's political fortunes, this accord is an extraordinary separation of responsibilities. Moreover, it is completely informal.

Unintended Consequences

The Federal Reserve is in many ways a textbook case of legislative intent gone awry.

The Fed's Board of Governors comprises seven members, each appointed by the president for fourteen-year terms with Senate confirmation. A new member is appointed every two years, and the chair of the board is appointed for a four-year term. The original intent of this structure was to establish political independence, as the fourteen-year terms would prevent a single president from having undue influence. But in reality, governors resign far before the end of their term, with the median term being a mere five years. Today, only four of the seven seats on the board are filled. Legally, governors are prohibited from joining member banks while they are in office and up to two years after departure. Though this restriction does not apply to those that serve the full term, the prospect of spending an entire fourteen years shielded from the rewards of the industry appears to be an especially unattractive option.

Paradoxically, the four-year term has ended up being a mechanism for independence rather than accountability. As a governor is allowed to serve out the remaining term of their predecessor, it is possible for a Fed chair to serve nearly twenty-eight years provided that they obtain reappointment every fourth year. In practice, the regular pattern of presidential appointments permits control in both directions. A Fed chair may choose to appease the administration, which the author believes happened with William McChesney Martin Jr. during the latter Johnson and Nixon administrations. But a chair can also choose to play the game themselves and prevent an incoming administration from firing them, as was the case with Paul Volcker with the Reagan administration, and by some reports, Ben Bernanke with the Obama administration. Conti-Brown claims that the latter case of control is far more common—of the eight chairs that had served at the time of publication, five had been reappointed by a subsequent president, of which four were of the opposing party.

The Fed is the only government organization that funds itself. And because part of its role in monetary policy lies in controlling the supply of money, it is able to create money out of thin air to fund itself. Among government agencies, this role is singular. More interestingly, it has never been directly authorized by Congress—the original intention was for the Federal Reserve to impose assessments upon its component reserve banks in a manner similar to how the Federal Deposit Insurance Corporation (FDIC) or the Office of Financial Research (OFR) fund themselves.

Historically, the absolute budgetary autonomy of the Fed began with the original autonomous Federal Reserve Banks terminated in the Banking Act of 1935, which transferred open-market operations of the component banks to the Board. During this period, the Board could not create money itself but relied upon the Reserve Banks themselves. Moreover, the Fed could not truly print money at the time because of the gold standard and the "real bills doctrine." The gold standard would die in 1973, but the real bills doctrine stayed for longer. This doctrine stated that the reserve would only lend against (discount) notes that arose from genuine commercial transactions rather than primarily financial ones. But because of the difficulty in defining a "real bill," the doctrine did not work well in practice. With both restrictions out of the way, the Fed now issues notes that are truly fiat.

Fed Club

Beyond the broad powers that the Fed has acquired beyond the intentions of its creators, Conti-Brown proposes that the constitutionality of the organization itself is questionable. Popular arguments against the Fed assert that the federal government has no right to create a central bank in the first place or find fault with its ties to the private sector. Conti-Brown's proposal is a bit more nuanced: the Fed is unconstitutional because it is entirely outside the framework.

In the original Constitution, "Officers of the United States" are appointed by the president with the advice and consent of the Senate. However, since the president can't be responsible for everyone the federal government hires, the Constitution delegates the appointment of "inferior Officers" to the heads of each department and other officials. The exact definition of an inferior officer was established in Morrison v. Olson as an official whose boss was presidentially appointed and Senate-confirmed. Moreover, separation of powers permits Congress the ability to insulate such officers from being fired for any or no reason.

The problematic part of the Fed is the FOMC, which includes seven members of the Board of Governors as well as five of the Reserve Bank presidents. The president has nothing to do with the appointments of the five Reserve Bank presidents, and the members of the FOMC are not beholden to any superior officers. Even if the Reserve Bank presidents were inferior officers, their appointment would be questionable because the organizations that appoint them—the boards of each Reserve Bank—are not government departments. The president likewise cannot remove a Reserve Bank president directly—to do so, he would have to message the entire Board of Governors, who would then turn to the board of the Reserve Bank, which would then have to fire the targeted individual.

It is precisely this kind of nesting of removal restrictions that the Supreme Court has held violates the Constitution. The president cannot remove bank president members of the FOMC without reaching through two explicit for-cause removal restrictions, on top of a third layer of at-will removability: from the U.S. president, to the Board of Governors (layer 1), to the Reserve Bank board of directors (layer 2), to the Reserve Bank president (layer 3). If the PCAOB (Public Company Accounting Oversight Board) was “Humphrey’s squared,” then the FOMC may be Humphrey’s cubed.

Better Governance

Overall, Conti-Brown reveals that the Fed is a pretty fascinating beast. It's really hard to strike a balance between autonomy and accountability, but there are several reforms that can be made. The Dodd-Frank Act enacted in the wake of the 2008 financial crisis made progress by creating a separate Consumer Financial Protection Bureau, entrusting it with a function that was ambiguously associated with the Fed. The Act also created the "Vice Chairman for Bank Supervision," a position that Conti-Brown argues “is the broadest grant of authority to an individual in the Federal Reserve Act—greater than even the explicit authority given to the Fed chair.”

But there is also more work to be done across reform, the author argues. As he has already pointed out, the fourteen-year term has fallen short of its intended purpose in insulating the Board of Governors. Filling the vacancies would be a good first step, and Conti-Brown blames both Senate Republicans for rejecting qualified candidates and the Obama Administration for failing to nominate enough people. Altering the structure of the Board by establishing a single ten-year term with no option to serve a predecessor's term would also help, as would reducing the size of the group itself. Limiting the term count of the chair would also go a long way.

Beyond the Board, there's also the tricky constitutionality of the FOMC that should be addressed. Here, Conti-Brown proposes that the Reserve Bank presidents serve at the pleasure of the Board, removing the multiple layers of protection that were the original cause. Given the lack of transparency surrounding the Fed, others—Rand Paul in particular—have supported legislation to "audit the Fed." Because Congress can already influence the Fed through appointments and threats of legislation, Conti-Brown thinks that these “represent a threat for more political control without corresponding benefits of accountability.” Forcing the Fed to explain its monetary policy against a standard, he argues, would have unintended consequences.

Monetary policy, institutional governance, and legal concerns tend to be pretty boring topics, and Conti-Brown does a pretty great job at making all of this more legible. Although I did fall asleep a few times while reading this one, it does a decent job at getting the major points across.

Skunk Works

By Ben R. Rich and Leo Janos

With few exceptions, the only instances in which mainstream firms have successfully established a timely position in a disruptive technology were those in which the firms’ managers set up an autonomous organization charged with building a new and independent business around the disruptive technology. Such organizations, free of the power of the customers of the mainstream company, ensconce themselves among a different set of customers—those who want the products of the disruptive technology.

Clayton M. Christensen, The Innovator's Dilemma

As they grow older and larger, companies inevitably become calcified and bureaucratic. For many firms, this aging only ends in a slow and painful death, as newer competitors disrupt the foundations of their business. But in some cases, organizations are able to compartmentalize concentrated talent in a way that avoids the stifling culture of the larger firm. The teams behind Gmail, the original Macintosh, and the IBM PC are regarded as examples of such groups. However, the pioneer of the archetype arose not in tech, but in defense—at Lockheed's "Skunk Works," which pushed the bounds of military aviation.

As the second director of the group, the author witnessed some of the group's best years. An immigrant from the Phillippines whose family fled just before the Japanese occupation, Rich is clearly a patriot whose love of his country is equaled only by his devotion to the engineering thrills of his work. Whereas the end uses of the technology he developed—first for the CIA during the Cold War and later for the military in Iraq—are morally questionable, Skunk Works Rich's primary focus is on the process. Especially within the military-industrial complex, the challenges of funding and politics are often more threatening than those of engineering. At the end of the day, Rich genuinely believed that the planes he built helped the US win the Cold War.

Secret Histories

Rich's time at the Skunk Works saw the development of three instrumental planes: the U-2, the SR-71 Blackbird, and the F-117 stealth fighter. The first two projects were built under the leadership of Kelly Johnson, Rich's predecessor and the founder of the group. Rich oversaw the making of the last plane, which he begins the story with.

The U-2 was a spy plane whose key advantage was simply flying at an absurd altitude—70,000 feet. At the time, this would have put it outside the range of Soviet fighters and missiles, rendering it essentially untouchable. As a result, the U-2 could fly over any part of the USSR unimpeded, which the government took advantage of to conduct flights over Moscow itself. The U-2's run ended, however, when Francis Gary Powers was shot down, coincidentally on the last planned overflight. The U-2 is still in use today.

Even years before the U-2's end, engineers on the team recognized that the USSR would eventually stop the overflights of the country. If flying higher was not enough, then another option was to build a plane capable of outrunning any missile, which would enable a more stable dominance of the sky. On top of that, the new aircraft would also fly a few miles higher. In the 1960s, the idea alone was outrageous. But the persistence of the team produced the SR-71 Blackbird, which to this date remains the fastest air-breathing piloted aircraft. Unlike typical fighters, which could fly for bursts on afterburners, the SR-71 would fly entire missions with the afterburners on. The high temperature and strength requirements resulted in the project producing the first titanium plane, which at the time was so scarce that the CIA ended up discreetly sourcing the metal from the Soviet Union itself.

At 80,000 feet, the outside air temperature was about minus 65 degrees F. As the inlet sucked in the air at Mach 3 through narrowed openings that compressed it, the air heated to 800 degrees. The bypass turbojet engines took the heated and high-pressure air (40 psi) and squeezed it further in a compressor, heating it to about 1,400 degrees F. At that point fuel was added to heat the air inside the burner to 2,300 degrees F. This supercharged air was then expanded through the turbine, before being fed into the roaring afterburners, superheating the combustible mix of gas and air to 3,400 degrees F, just 200 degrees below the maximum temperature for burning hydrocarbon fuels. The white-hot steel nozzle spit out its fiery plume in the form of diamond-shaped supersonic shock waves. Even in the frigid upper atmosphere, the air boiled at 200 degrees F for a thousand yards behind those booming engines. This unprecedented propulsive power sped the Blackbird at an unbelievable two-thirds of a mile a second.

Rich's pride and joy, which he chooses to open the book with, is the F-117—the first true stealth plane. At a time when computers were a millionth as powerful as they are today, the F-117's shape was computer-designed so as to minimize its radar signature to the size of a golf ball. The hard part came in making sure the plane would appear invisible while being able to take off in the first place. The aircraft was so stealthy that the canopy had to be given special consideration, as the pilot's head could appear larger than the plane itself. Beyond engineering concerns, Rich had to constantly deal with the reality of securing funds and time, through which he had to navigate a bureaucracy that looked upon his project with disbelief up until the very end.

Why only two dimensions and why only flat plates? Simply because, as Denys later noted, it was 1975 and computers weren’t yet sufficiently powerful in storage and memory capacity to allow for three-dimensional designs, or rounded shapes, which demanded enormous numbers of additional calculations. The new generation of supercomputers, which can compute a billion bits of information in a second, is the reason why the B-2 bomber, with its rounded surfaces, was designed entirely by computer computations.

Denys’s idea was to compute the radar cross section of an airplane by dividing it into a series of flat triangles. Each triangle had three separate points and required individual calculations for each point by utilizing Ufimtsev’s calculations. The result we called “faceting”—creating a three-dimensional airplane design out of a collection of flat sheets or panels, similar to cutting a diamond into sharp-edged slices.

Red Tape

The modern military-industrial complex is a poster child for overblown expenditures, bureaucratic inefficiency, and crony capitalism. Although things were a bit better in his day, Rich's stories are filled with accounts of the waste and ineptitude with which the government and its contractors operated. Against the outside world, the fiercely independent Skunk Works strikes a strong contrast.

We had a very strong and innovative design organization of about a dozen truly brilliant engineers, working at their drawing boards in a big barnlike room on the second floor of our headquarters building, who simply could not be conned or browbeaten into doing anything they knew would not work. One day, Kelly called upstairs for an engineer named Bob Allen. “Bob Allen there?” he asked. Whoever answered the phone replied, “Yeah, he is.” And hung up.

Rich recalls fourteen rules that the Skunk Works regarded with near-religious reverence, set out by his predecessor. A few are pretty specific to military contractors having to deal with inspections and cost reports, but the others offer a slice at how the organization saw itself:

1. The Skunk Works program manager must be delegated practically complete control of his program in all aspects. He should have the authority to make quick decisions regarding technical, financial, or operational matters.

1. The number of people having any connection with the project must be restricted in an almost vicious manner. Use a small number of good people.

1. Very simple drawing and drawing release system with great flexibility for making changes must be provided in order to make schedule recovery in the face of failures.

1. There must be a minimum number of reports required, but important work must be recorded thoroughly.

1. The contractor must be delegated the authority to test his final product in flight. He can and must test it in the initial stages.

1. The specifications applying to the hardware must be agreed to in advance of contracting.

2. Funding a program must be timely so that the contractor doesn’t have to keep running to the bank to support government projects.

1. Because only a few people will be used in engineering and most other areas, ways must be provided to reward good performance by pay not based on the number of personnel supervised.

Skunk Works isn't just Rich's story—it includes testimony from various generals, test pilots, and other defense officials that help to paint the full picture. The incredible secrecy with which the group operated makes you wonder how a book like this ever got published in the first place and all the stuff that's been left out. Rich is in many ways a natural storyteller, and his optimism for the American vision and technology makes for an incredible sense of confidence in his work. Few places have the same concentration of talent that Skunk Works did, and it is likely that we may never see another like it again.

We became the most successful advanced projects company in the world by hiring talented people, paying them top dollar, and motivating them into believing that they could produce a Mach 3 airplane like the Blackbird a generation or two ahead of anybody else. Our design engineers had the keen experience to conceive the whole airplane in their mind’s-eye, doing the trade-offs in their heads between aerodynamic needs and weapons requirements. We created a practical and open work environment for engineers and shop workers, forcing the guys behind the drawing boards onto the shop floor to see how their ideas were being translated into actual parts and to make any necessary changes on the spot. We made every shop worker who designed or handled a part responsible for quality control. Any worker—not just a supervisor or a manager—could send back a part that didn’t meet his or her standards. That way we reduced rework and scrap waste.

We encouraged our people to work imaginatively, to improvise and try unconventional approaches to problem solving, and then got out of their way. By applying the most commonsense methods to develop new technologies, we saved tremendous amounts of time and money, while operating in an atmosphere of trust and cooperation both with our government customers and between our white-collar and blue-collar employees. In the end, Lockheed’s Skunk Works demonstrated the awesome capabilities of American inventiveness when free to operate under near ideal working conditions. That may be our most enduring legacy as well as our source of lasting pride.

This Week

Order Without Design

By Alain Bertaud

According to UN estimates, 2007 marked the first time in history when a majority of humanity lived in cities. In designing these population centers, urban planners have an enormous number of decisions to make. In Order Without Design, Bertaud links the development of cities to their labor markets, arguing that city design can be improved through a synthesis of urban economics and urban planning.