Political independence of FED - Essay Example

Political independence of FED Political independence of FED It is apparent that financial sector plays a critical role in regulating financial matters in a country, particularly the Central Bank. However, political interference has been blamed for continued interference with how the financial regulators operate. This has been contributed by the fact that politicians like manipulating and controlling these institutions for their own gains. In his lectures, Bernanke (2012) argued that central bank should be allowed to make independent decisions without political interference in order to have sound decisions.

Studies have documented that political interference in the financial sector not only hinder how these institutions operate, but also interfere with how regulators enforce regulations. Financial regulators are, therefore, unable to take actions on banks that do not follow the laid down rules and regulations. When political interference is evident in the financial regulatory bodies, recognition of severity of crisis is delayed, intervention needed is also slowed and consequently raise the cost of the crisis to tax payers.

Shielding financial sector from political interference helps to improve the quality of regulation and supervision. This helps in preventing financial crisis. Financial regulators have two main purposes. First, they are mandated to protect the consumer. Second, they are also mandated to maintaining financial stability of financial institutions. When political interferences come in, these two roles of the regulator are abandoned. For instance, in 1997, political interference in the regulatory bodies of East Asia led to postponement of recognition of severity of crisis, which led to increased crisis.

In Korea for instance, banks were regulated by the ministry of finance and economy instead of the central bank. Due to the weak regulatory framework of the ministry, the 1997 crisis was realised. In Indonesia, politically connected banks led to poor enforcement of regulations. However, when crisis struck, the central bank overrode procedures of handling the crisis as per the directions direct from the president. According to Bernanke (2012), individuals in the financial regulatory institutions should focus on making long-term decisions rather than just focus on short-term political interests.

In addition, politically appointed individual to head or manage regulatory bodies would worsen the situation by being motivated by short-run electoral considerations in making decisions, something that would lead to financial crisis. Studies have documented that countries where elected officials interfere with monetary policies the results are excessive inflation. However, countries with central banks that are independent, average rates of inflations are noted. Nevertheless, heated debate has for long been on the role of the government in appointing and dismissing individuals to run central bank.

In order to have such matters cleared, several legal policies have been put in place in order to allow central bank operate independently. For instance, the Federal Reserve’s goals are set in its legal charter, but it has been argued that these goals are described in a vague manner and terms. All in all, since it’s the Fed that sets the goals without any political interference, the level of performance is believed to be better than goals set by the government for the central bank in some countries.

The level of independence of the financial institutions is determined by several factors. First, the chief executive office of a bank should be appointed by the central bank board instead of the finance minister. Secondly, central bank is considered to be independent if its charter states that price stability is solely the mandate of the central bank. Lastly, the independence of the central bank is noted higher when a set of limitations are put in place to limit government ability to borrow from the central bank.

However, it is apparent that a country where the rule of law is not strong, central bank is actually and highly embedded in the political culture than on the laws governing the institution. In light of this, it is critical for governments to set up mechanisms of allowing central banks to operate independently. Conversely, the central bank should instill measures that ensure that its objectives take account of the government’s objectives in order to strike a balance on the best policies to put in place in order to avoid crisis.

Conclusion Although many countries allow banks to run independently, they tend to interfere with the operations of the central bank. However, the overall independence of financial institutions should begin with the independence of the central bank. In this regard, reforms should be prioritized in order to ensure that accountability in the financial regulatory bodies prevails. This would ensure that financial crisis is avoided. In addition, governments should guarantee the independence of the financial regulatory bodies in order to allow them offer long-term decision for the country.

Reference: Bernanke, B. (2012). Political independence of FED. Retrieved on 18th Oct 2013 from: http://www.federalreserve.gov/mediacenter/media.htm