There was perhaps no human shortcoming they perceived as more dangerous to the political order than groupthink. They worried that masses of people, though ordinarily even-minded, could be so swept up in political movements that the liberty of minority groups might be threatened. James Madison wrote in Federalist No. 10
: “A common passion or interest will be felt by a majority, and there is nothing to check the inducements to sacrifice the weaker party.”
This propensity to follow the herd is at the root of financial instability. In the most recent crisis, homeowners, investors and, notably, the Fed so succumbed to groupthink that we were almost unanimously blind to the risks of rising housing prices and bank leverage. So, how to create a Fed that guides its governors to be skeptical of crowd-induced financial excess?
To protect against passions of the crowd in the political arena, the Founders did two important things.
First, they established an independent Supreme Court. Justices receive lifetime appointments so they can make unpopular decisions without fearing for their jobs.
Second, the Founders explicitly made the court counter-majoritarian. The Bill of Rights protects certain rights even in the face of a passionate crowd that wishes to threaten them.
Like the judiciary, Fed governors benefit from political independence. They are appointed for 14-year terms. Unlike the court, however, the Fed is not charged with stopping a herd. The Fed’s mandate is to pursue price stability and maximum employment. When this mandate runs against the majority, the Fed can be counter-majoritarian, as when Paul Volcker raised interest rates in the face of inflation and widespread dissent.
Yet when financial excesses are building and not accompanied by inflation or unemployment, the Fed is unlikely to act. We need not accept this inaction. Fed governor Jeremy Stein, who has been writing on bubbles, said this summer that deflating a bubble would be consistent with the goal of promoting full employment because a bursting bubble affects employment.
In the abstract, Stein is right. The problem is that he almost surely expects too much of Fed governors. During a buildup of financial imbalances, most people view the excess as a rational function of some new development. In the early 2000s, the efficiency of the Internet justified unsustainable valuations that formed a bubble. Leading up to 2008, Alan Greenspan pointed to new credit derivatives as one reason risk would be controlled at banks. Simply including financial stability within a reconstruction of the Fed’s present mandate relies on Fed governors to discern excesses when other economic participants do not. But our Founders understood that organizations must be built to account for the fallibility of those in power, not assuming policymakers have greater wisdom than the country as a whole.