Any Federal reserve bank may make advances for periods not exceeding 15 days to its member banks on their promissory notes secured by the deposit or pledge of bonds, notes, certificates of indebtedness, or Treasury bills of the United States … at rates to be established by such Federal reserve banks, such rates to be subject to the review and determination of the Board of Governors of the Federal Reserve System. Federal Reserve Act, Sec. 13(8)

As a student, I did not know where the term “discount window” came from. Why not “discount facility”? When I joined the staff of the Federal Reserve Bank of Boston in 1973, the mystery was solved. The bank was still housed in its old building, which had a grand banking lobby. And in the lobby was a teller's window with the word “Discount” above. It used to be that bankers would bring their collateral to the window and arrange their loans. The Boston Fed's new building does not have a teller's discount window, but the facility survives.

President Wilson signed the Federal Reserve Act into law on December 23, 1913, “to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes” (preamble, Federal Reserve Act). In 1913 the discount rate was the principal policy instrument, and the gold standard was taken for granted. Open-market operations had been invented, but not yet discovered.

This chapter is concerned with the economics of organization and management, a relatively new area of study that seeks to analyze the internal structure and workings of economic organizations, the division of activity among these organizations, and the management of relations between them through markets or other higher-level, encompassing organizations.

The dominant approach to this subject is transaction-cost economics, as introduced by Coase (1937, 1960) and developed by several others since, most notably Williamson (1975, 1985). The main tenet of Coase's theory is that economic activities tend to be organized efficiently – that is, so as to maximize the expected total wealth of the parties affected. In this context, two sorts of costs are customarily identified – those of physical production and distribution and those of carrying out necessary exchanges. Because these are typically treated as distinct and separable, the efficiency hypothesis becomes one of transaction-cost minimization: The division of activities among firms and between a firm and the market is determined by whether a particular transaction is most efficiently conducted in a market setting or under centralized authority within a firm.

This approach has two conceptual problems. First, the total costs a firm incurs cannot generally be expressed as the sum of production costs – depending only on the technology and the inputs used – and transaction costs – depending only on the way transactions are organized. In general, these two kinds of costs must be considered together; efficient organization is not simply a matter of minimizing transaction costs.

The main purpose of this chapter is to develop and test a theory that predicts the voting of individual Federal Open Market Committee (FOMC) members who dissent, on the side of either tightness or ease, from the Committee's regular monetary policy directives. It is initially assumed that such a directive reflects the monetary policy desired by a majority of the Committee and that the Committee controls monetary policy. It is further assumed that the central government, specifically the administration, has a strong influence on monetary policy (Havrilesky 1987, 1988) through ongoing communication with the Committee (or its chair) and through FOMC appointments (Havrilesky and Gildea 1989).

The theory predicts individual dissenting votes as a function of the difference between each of the dissenter's “characteristics” and the mean value for that characteristic for all FOMC members. Each characteristic is a measure of the member's “career proximity” to the central government. The desired monetary stabilization policy of the central government is assumed to have a time-consistent inflationary bias. Presidential appointments of 7 of the 12 members of the FOMC are assumed to reflect several objectives. These objectives include attaining politically optimal stabilization policy, paying political debts, building antiinflationary credibility, and satisfying the representational demands of constituents (Woolley 1984; Havrilesky and Gildea 1989). Because of these multiple objectives, the FOMC as a whole will have a lesser inflationary bias than will the central government. Therefore, members whose career-proximity characteristics are closer to the central government than are the FOMC means for those characteristics will tend to dissent on the side of ease.

The study of developing societies as a distinct field of contemporary political science began in the 1950s. Cambridge, Mass., provided the birthplace for important traditions in the field, whose content was shaped by the intellectual interests of the scholars who were its parents. Early researchers focused on the modernization of traditional societies and in particular on the political significance of mass communications and of human culture.

As did so many of my generation, I made my way to Cambridge to train with the pioneers of development studies. In my early work, I essentially adopted their definition of the field. But later I changed. The seeds of doubt had been planted early on, and they propelled me toward a perspective based on political economy.

INTERESTS AND OPTIMIZING BEHAVIOR

My dissertation focused on the roles of the Mineworkers' Union and of the United National Independence Party in implementing the government's labor policy in postindependence Zambia. Adopting the social-psychological approach that had dominated my graduate training, I attempted to explain that policy's failure in terms of the inability of the union and the governing party to communicate the foundations for the government's labor policy effectively. That policy consisted of a wide national perspective, specific development objectives, and the appropriation of an investable surplus from the mining industry. The fact that the union and political party provided poor communication between the government and the labor force, I argued, helped to explain the continued militancy of the laborers.

The controversy over the effectiveness of monetary policy has raged on for decades despite the fact that the first link in the monetary policy chain has been virtually ignored – the link between the individuals who compose the FOMC and the resulting open-market policy directive. The sixth edition of The Federal Reserve System: Purposes and Functions (1974, p. 57) describes FOMC members as first having to “individually interpret the available statistical and qualitative macroeconomic data in order to evaluate the state of the economy.” Second, “each attending FOMC member is asked to give his or her own policy recommendation.” Finally, “committee members have to deliberate in order to reach a consensus of their individual viewpoints.” The purpose of this chapter is to incorporate this discretionary behavior into an analysis of the voting records of individual FOMC members. The hypothesis to be tested is that FOMC members attempt to implement their personal preferences subject to certain imposed constraints. Career and social-background variables will reflect preferences, whereas relevant political and economic variables will enter as effective constraints.

Preferences: political voting theory

Political scientists have long tried to explain the voting behavior of Supreme Court justices. The question they have tried to answer is this: Why do various Supreme Court justices vote differently when confronted by the same facts and the same history of legal precedents? That question is strikingly similar to the question of interest in this chapter: Why do FOMC members vote differently when confronted by the same economic data and the same economic history?

“The Fed is a creature of Congress.” So Senator Paul Douglas told William McChesney Martin during his confirmation hearings. Senator Douglas went so far as to suggest that Martin paste that slogan on his mirror so that he would see it every morning while shaving. The slogan has some merit. The Federal Reserve was created by a simple act of Congress in 1913. The act has had at least one major set of amendments (during the New Deal), as well as numerous more minor changes. Congress debated, in 1975, the possibility of making major structural changes in Fed-Congress relationships. At any time, by a simple act of Congress, the Fed could be radically changed, or even disbanded. Careful observers (Pierce 1978; Roberts 1978; Weintraub 1978; Woolley 1984) have noted, however, that Congress gives the Fed an unusually free rein.

These observers noted that at least through the 1970s, Congress appeared to play no role in the making of short-run monetary policy. The Fed's legislative mandate appears to be to “make monetary policy in the public interest.” The reforms of 1975 simply mandate that the Fed tell Congress what it did and what it is doing, and why it did not do what it said it would do. Congress gives the Fed a similar free rein in regulating the banking industry. The amendments to the Bank Holding Company Act of 1970 and 1976 give the Fed tremendous latitude to pass on bankholding- company mergers and acquisitions, as well as to determine the legitimate scope of the activities of banks and bank holding companies.

There is growing awareness that political considerations play an important part in determining the Federal Reserve's monetary policy and regulatory actions. As a result, economists and political scientists are becoming increasingly interested in the Fed's political role. This chapter is concerned with how the Federal Reserve uses its regulatory functions, its role as lender of last resort, and other means to amass political power. It is argued that when these sources of political strength interact with the tremendous influence derived from being the agency of monetary policy, the Federal Reserve emerges as a formidable source of political power within the U.S. government. The Federal Reserve's position concerning expanded powers for banks is an example of how it works to increase its political power.

The Federal Reserve's political role

Studies of the Federal Reserve's political role are slowly accumulating, but the work is still at a rudimentary stage. Several chapters in this volume contribute to that literature, and they provide references to earlier studies. Some studies have attempted to show that the Federal Reserve's independence of Congress or the president is more apparent than real. For example, Kane, in this volume and elsewhere (Kane 1980, 1982), argues that Congress makes the Fed appear more independent than it really is by using the central bank as a scapegoat or whipping boy: Congress engages in “Fed-bashing” when it is politically desirable to do so. Other studies have documented instances in which the Federal Reserve's monetary policies were influenced by presidents or powerful members of Congress. Still others have pointed to principal-agent considerations to explain why the Fed at times can act independently of Congress.

There are two classic definitions of economics: Alfred Marshall's “a study of mankind in the ordinary business of life” (Marshall 1947, p. 1), and Lionell Robbins's “the allocation of scarce resources among competing ends” (Robbins 1935, pp. 12-15) Marshall focused on the questions that economists try to answer, whereas Robbins focused on the tools they have available. For better or for worse, Robbins's definition won out. But this book is Marshallian. It stresses the practical problems that demand answers, rather than those problems that can readily be resolved by the economist's tools. Although the authors of the various chapters in this book – most of whom are economists – use the maximizing model of economic analysis, their focus is on understanding Fed behavior, rather than on refining the tools of economic analysis. They are very much aware that these tools are means to an end, rather than ends in themselves. Hence, they refuse to bypass important economic problems simply because the applicable tools lack elegance and cannot provide rigorously derived answers. Such a problem-oriented focus is now a minority approach among academic economists and hence needs justification.

The problems that fall under the rubric of monetary policy are diverse. Some are problems of economic theory or econometrics, such as the optimal inflation rate or the controllability of the monetary growth rate. These problems rightly receive much discussion in the professional journals, discussion that obviously is necessary to formulate a correct monetary policy. But though such discussion is necessary, it is not sufficient. To gain a complete picture of any government policy, one must also consider the political milieu in which the policy is carried out.

Introduction

In these two final chapters of the book, we are concerned with the economic logic of social institutions, particularly those formal and informal rules, norms, and customs of a community that affect economic behavior, the organization of production, and economic outcomes. Chapter 9 looks at stateless societies and international property rights, and Chapter 10 deals both with autocratic states and with the political institutions of democracy. The approach is the same as in Chapters 6 and 7, where we examined the logic of various organizations in input and output markets, such as the firm, sharecropping, or warranties. As we see it, exchange in the political arena interacts with the environment (i.e., exogenous variables such as information technology, resource endowments, or geographical location) and gives rise to contractual arrangements – that is, social institutions. Again, in the political field, both the outcomes of contractual relationships and the structure of the contracts themselves are shaped by transaction costs. It is important to note that the NIE approach to social institutions does not require that the environmental (exogenous) variables be the same from one study or model to another. For example, depending on circumstances we may want to treat population growth or technological change as either endogenous or exogenous variables. Laws, norms, and custom can be modeled either as endogenous variables or as a part of the environment (a constraint).

Property rights and their dimensions

Most goods can be useful, or otherwise give satisfaction to individuals, in several ways. A walking stick can be used for support when walking or to beat an unpleasant neighbor. Potatoes can be eaten baked or used for making alcohol in a basement distillery. A gun can be used for hunting or holding up banks. A site can be used for the construction of a home or a small factory. We refer to the rights of individuals to use resources as property rights. A system of property rights is “a method of assigning to particular individuals the ‘authority’ to select, for specific goods, any use from an unprohibited class of uses.” The concept of property rights, as used in NIE, is a broad concept. In terms of law, it is wider than the legal concept of property rights, and it also includes social norms, as Alchian (1977) has emphasized: