Politics & Policy

Mend the Fed

From the June 7, 2010, issue of NR.

Last month, delegates to Maine’s state Republican convention junked the party’s proposed platform in favor of one promoted by tea-party activists. While a majority of its planks are unremarkable conservative proposals, the platform garnered some national attention for its more extreme elements, particularly a flat assertion that global warming is a myth and that its proponents should be investigated for illegal collusion.

But one troubling component of the platform that has mostly escaped notice is its position on the Federal Reserve. The platform supports an audit of the Fed, a mostly uncontroversial proposition that recently passed the Senate 96–0, “as the first step in Ending the Fed.” It is now the official position of the Maine Republican party that the United States should abolish its central bank.

There are real concerns about the Fed’s actions in the last two years, including a move into financial-asset markets far larger and more opaque than the one the Treasury Department has undertaken through TARP. The Fed has loaned out more than $2 trillion, and we don’t know to whom or on what terms. This is why the Fed should be audited and, if necessary, subjected to new restrictions on its activities. It does not follow, however, that we can do without a central bank or that we should return to the gold standard. Indeed, these moves would expose the United States to sharper business cycles and more frequent banking panics — all to solve an inflation problem that doesn’t exist.

For the first 130 years of American history, central-banking policy was a flashpoint in political debates. The period featured repeated establishments and disestablishments of central banks, a contest finally resolved with the creation of the Federal Reserve in 1913. In the ensuing 100 years, keeping the Fed has been largely uncontroversial. Since the early 1980s, its low inflation targets and its use of nonmetallic currency have been equally uncontroversial. No significant contingent within either political party has talked seriously about ending central banking for decades.

One outlier is Rep. Ron Paul (R., Texas), who has a bill before Congress to abolish the Fed — co-sponsored by none of his colleagues. How did his fringe position end up on a state Republican party’s platform? Three developments in the last two years have generated new enthusiasm for abolishing the Fed in certain Republican activist circles.

First, Ron Paul’s supporters have gained strength and influence within conservative ranks. Paul’s long-shot libertarian bid for the Republican presidential nomination in 2008 won him no primaries, but he nonetheless managed to win this year’s CPAC straw poll by a healthy margin. Many of his supporters are active in the tea-party movement and share his zeal for abolishing the Federal Reserve.

Other planks that Paul’s supporters might seek to insert in Republican platforms — an end to the drug war, a call for non-interventionist foreign policy — would draw strenuous objections from traditional Republicans, but few of them, and very few Americans in general, have a strong emotional investment in monetary policy. It’s not surprising that a call for radical change in that policy would be met with a shrug of acceptance.

Second, various overreaches of the federal government, including massive expansions of entitlements under the Bush and Obama administrations, have energized conservatives against intrusive federal agencies. Paul’s argument that the Fed is not only unwise but unconstitutional dovetails nicely with conservatives’ claims that Obamacare is unconstitutional. The timing is favorable for anti-Fed sentiment to catch on among conservatives.

But most important, the Fed’s activities have changed over the last two years in significant and worrisome ways. Since the financial crisis of 2008, the Fed has intervened in the market by purchasing not only government debt, which is normal, but also huge quantities of private debt, especially commercial paper (the short-term debt of large companies, financial and otherwise) and mortgage-backed securities.

The Fed also increased its lending with the creation of special credit facilities open to non-bank financial institutions not ordinarily eligible to borrow from the Federal Reserve. In short, the Fed has been freelancing under its existing authority and without congressional oversight, engaging in activities similar to those that Treasury has undertaken under TARP.

The practical effect of these moves has been to lower mortgage rates and to keep credit markets more liquid. But the Fed’s actions also expose American taxpayers to credit risk on top of what we already bear through Federal Housing Administration–insured mortgages, our guarantee of Fannie Mae and Freddie Mac, and other explicit and implicit guarantees to financial institutions.

We can’t say exactly what the risks are, because the Fed does not disclose exactly what assets it has purchased and to whom it has loaned (or is lending) money. All it discloses is the aggregate amount of lending it has done — which peaked at more than $2 trillion at the height of the crisis, dwarfing the $700 billion authorized under TARP.

Given these massive and opaque actions, why would anybody oppose auditing the Fed? One objection is that disclosing the details of the Fed’s lending to firms could undermine market confidence — for example, an investment bank that is known to be getting emergency loans from the Fed could face a run. This is true in the short run: Announcing “Bear Stearns almost ran out of cash today!” would not foster stability in the financial markets. But as Dean Baker of the Center for Economic and Policy Research points out, this is not a justification for withholding such information indefinitely: “The Fed is not in the business of covering up banks’ bad financial shape,” he writes. “The Fed should be making the banks’ condition more transparent, not helping them conceal it, as they did with Lehman for many months.”

Ben Bernanke made another case against an audit to Congress last year, arguing that it could undermine the Fed’s independence in its traditional roles — regulating the money supply and acting as a lender of last resort to banks. Indeed, it would be undesirable for Congress to start inserting itself in decisions about interest rates and the money supply: As we learned in the early 1980s, actions necessary to tame inflation can produce long-term economic benefits but drive the economy into recession in the short run, and this process is politically possible only because Congress can deflect blame toward the independent Fed.

But because the audit provision that the Senate recently attached to the financial-reform bill is limited to a one-time review of the Fed’s past activities, it’s hard to understand how this would enable Congress to interfere in future Fed actions. Since the results of the view would be made public only at a later date, it would not cause a panic about individual financial institutions. But it will allow us to know whom we loaned money to and on what terms — and what risks we were and are exposed to. And, as the Cato Institute’s Arnold Kling notes, “one could argue that the larger threat to Fed independence comes from its departure from standard operating procedures” — that if the Fed would stick to its traditional activities, then there would be no groundswell for greater oversight.

The case for an audit is compelling, which is why support for it grew beyond the odd coalition of far-left and far-right backers (Ron Paul teamed up with left-wing Florida Democrat Rep. Alan Grayson to sponsor the bill) to achieve unanimous support in the Senate. But should this audit really be a first step to “ending the Fed,” as the Maine GOP proposes?

Ron Paul’s 2009 anti-Fed polemic (aptly titled “End the Fed”) goes well beyond criticizing the Fed for using taxpayer dollars to stabilize teetering financial firms. In the book, Paul says “the entire operation of the Fed is based on an immoral principle” — that the government should have a monopoly on money and the power to inflate. He wants to abolish the Federal Reserve, end the issuance of fiat money (government currency not backed by precious metals), and return America to the gold standard.

Paul even finds Biblical justification for the gold standard, in Leviticus 19:35–36. He argues that the admonition to use “just weights and measures” requires the use of a precious-metal standard and renders fiat money “an abomination to the Lord.” (No word on whether Paul ever wears clothing weaved of two different materials, which is proscribed by Leviticus 19:19.) Of course, Paul’s anti-Fed case isn’t solely (or even principally) religious. He contends the Fed’s “inflationary policies” led to the recent financial crisis and recession. This is, he argues, because they have encouraged people to consume and borrow rather than save and invest.

You might be asking yourself, “What inflationary policies?” Good question. Since Paul Volcker was Fed chair in the early 1980s, inflation in the United States has been low and stable. Consumer Price Index increases since 1983 have averaged just 2.9 percent per year. What inflation exists at present does not discourage investment, because the normal, expected level of inflation is built into asset prices. Today, core inflation — the measure of consumer prices that excludes goods subject to non-monetary price shocks, such as food and fuel — is at its lowest level since the 1960s, less than 1 percent. This despite a vast increase in the money supply overseen by the Fed in the last two years.

When the economy picks up, the Fed will need to contract the money supply in order to prevent a resurgence in inflation, and that could be politically unpopular, as it may cause unemployment to spike. So there is a case to be made that inflation is likely to be higher in the future. But we can measure market expectations of future inflation by comparing the interest paid on indexed bonds (which compensate bondholders for loss of value due to inflation) with interest on normal government bonds. This measure, the “TIPS spread,” is under 2 percent for ten-year bonds, meaning the markets expect less than 2 percent average inflation over the next ten years. In other words, the markets believe that the Fed will suck excess liquidity out of the system when necessary, and that the dollar will remain stable. America hasn’t had an inflation problem since the Carter era and isn’t expected to have one in the future.

If whipping inflation is not critical at this moment, Paul sees many further benefits in abolishing the Fed. According to his book, it would take away the funding for “endless wars,” “curb the government’s attacks on civil liberties,” and “arrest . . . massive expansions of the welfare state.” All of which is nonsense. The Fed’s activities are not an important source of government financing. In 2009, the Fed set a record by posting a $45 billion profit, while the federal government collected more than $2 trillion in taxes and floated more than $1 trillion in net debt. As Megan McArdle of The Atlantic put it, “The federal government gets the money for the ‘welfare-warfare’ state just where it says it does: by taxing the bejeesus out of your wages.”

Governments sometimes try to finance themselves through inflation, with Zimbabwe providing an extreme example. It’s unsustainable and ultimately undermines your currency. But in America, seignorage (the government’s profit from issuing currency and inflating the money supply) pays for only a trivial portion of federal spending. Ending the Fed would not significantly crimp the government’s ability to create new health-care entitlements or conduct wars.

The promised benefits from ending the Fed would prove illusory, but the costs would be very real. The Fed’s main purpose is to take counter-cyclical monetary actions: interest-rate cuts in slow economies to encourage consumption, rate increases to discourage bubbles when the economy is strong. If we “end the Fed,” we must give up these practices.

Purist libertarians will cry that this is state management of the economy, but the overall track record of the Fed is good: Recessions over the last 70 years have been shorter and less severe than previously in American history, including those that occurred during the free-banking era. Paul claims that the Fed is the source of bubbles and panics, but bubbles and panics have been around much longer than the Fed and would endure in its absence.

It is also important to consider the alternatives to the Federal Reserve. When the economy enters recession, a chorus descends upon Washington demanding that lawmakers “do something” to fix it. Ordinarily, they can point to the Fed and say that it is easing interest rates to perk up the economy.

But in the current recession, we have seen what happens when room runs out for expansionary monetary policy, as short-term interest rates approach zero and the Fed consequently loses its ability to provide more monetary easing. Then attention shifts to Keynesian fiscal stimulus, with the government striving to spend money as quickly as possible, in ways wise and unwise, to try to create jobs. In other words, you get the stimulus package.

If we abolish the Fed, the government will lose its ability to manipulate the money supply, but not the political impulse to intervene in recessions. One of two outcomes is likely — either the government will go off the gold standard, so that it can increase the money supply, or it will substitute fiscal responses for monetary ones. Neither outcome is congenial for libertarians.

Finally, some of the benefits that Paul touts for the gold standard — notably, more stable price levels for exporters — would be realized only if other countries also adopted the gold standard. Since all industrialized countries use fiat currencies, America’s currency would still move relative to others, and exporters could not count on stable prices. Given the recent instability in gold prices, they would likely see increased price volatility.

To say that the Fed is necessary is not to say that it is perfect. Until the Volcker-Greenspan era, the Federal Reserve long had a bias toward being too expansionary, which led to the persistent inflation of the 1970s. More recently, the Fed appears to have erred by keeping interest rates too low for too long in the middle of the last decade, fueling a devastating housing bubble. And we don’t yet know what costs (or profits) taxpayers will see from the Fed’s recent financial-market activities.

If we abolished the Navy, we wouldn’t have any more scandals like Tailhook. But we keep the Navy because, whatever its flaws, we’d be worse off without it. The same is true of the central bank. To the extent we find problems with the Fed, we can reform it, being careful to maintain its independence in core monetary functions.

Reform will be easier once we have information from the audit. But the problems at the Fed that have spawned the calls for an audit — opacity and mission creep — are ones that Congress can tackle by imposing new restrictions. They do not relate to inflation, and they do not require that we “end the Fed.”

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute. His research is focused on state and local fiscal policy. This article originally appeared in the June 7, 2010, issue of National Review.

Josh Barro — Mr. Barro is the Walter B. Wriston fellow at the Manhattan Institute. His research is focused on state and local fiscal policy.


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