Problems with End the Fed

Our well-meaning friends in the Ron Paul camp have some incomplete ideas about economics and money. The genesis of this post was a post on a FreedomWorks blog, http://julieborowski.wordpress.com/2012/02/01/top-10-reasons-to-end-the-federal-reserve/. I believe this is a fair representative of the Ron Paul and his supporters supporters. As the Ron Paul movement gains influence, addressing the bad or unsubstantiated arguments will be very important. I have not answered all of the arguments in the post, but I addressed most of them and some are fairly similar to one another.

• The Federal Reserve Has Significantly Devalued Our Currency

"Since the Federal Reserve came into existence in 1913, the dollar has lost over 95 percent of its value. Today’s dollar is worth less than a nickel compared to the pre-1913 dollar."

This is true, but so what. This is a big problem if you kept cash under a mattress. 95% in value over a long period of time isn’t cause for concern, 95% in one year that could cause some problems. In any event, I do not keep large amounts of cash on hand. I put it into assets that earn a return over the rate of inflation.

• The Federal Reserve Hurts the Poor and Middle Class the Most

" But higher prices are actually a direct consequence of inflation since increasing the supply of money decreases the purchasing power of the dollar. Inflation hurts the poor most since they have less disposable income. Consumers with low disposable incomes will be negatively impacted by higher prices for food and clothing."

Simply not true. Inflation does not hurt the poor most. Inflation affects people who hold onto cash, and the poor tend to spend money that they earn in short order. The price of labor (wages) tend to rise with everything else so inflation does not erode the purchasing power of wages. An unexpected increase for inflation for a great many poor or middle class people would probably be beneficial. Take the example of a person with a fixed rate mortgage or student loans. If they owe $100,000, that amount stays the same if inflation increases from 2% to 10%.

Hyperinflation hurts the poor insomuch as it hurts everyone with the chaos brought on by unpredictable relationships between prices and in extreme cases money becoming useless as even a temporary store of value.
Inflation does have distributional effects and it does hurt some.

1. Receive a fixed interest rate over a long period of time and there is an unexpected increase in inflation.

2. Make illusory nominal gains through interest or capital gains. If inflation is at 10% and you receive 12% interest you’re outpacing inflation, except that you pay taxes on the 12% gain not the real gain.

3. Companies that are overtaxed because depreciation expense does not cover the replacement value of a capital good as it rises in price


Some countries with high rates of inflation have indexed their tax systems to inflation, so this need not be an ill effect of inflation.

• The Federal Reserve is Run By Unelected and Unaccountable Bureaucrats

"The Board of Governors at the Federal Reserve are not directly elected by the American people. This means that those who run the Federal Reserve are unaccountable to the people. The seven members of the Board ultimately decide the price or purchasing power of our money. That kind of central planning would never exist in a true free market economy."

If we have a central bank involved in money, it should be by unelected and unaccountable bureaucrats. There is a high correlation between the independence of central banks and a low, stable level of inflation over time. It’s the banks that are controlled by the treasury or ministry of finance that should have you more worried. I would be in favor of the central banks of the world using predictable targets such as nominal GDP (NDGP) rather than trying to outguess and out fool the economy.

• The Federal Reserve Has Made Our Economy Less Stable

"The Federal Reserve has brought us endless boom-and-bust cycles. The U.S. economy was much more stable before the Federal Reserve came into existence. It bears significant responsibility for every financial crisis over the past century including the Great Depression, the stagflation of the 1970s and recent economic meltdown. The Austrian Business Cycle Theory explains why we see such wide fluctuations in the economy. The theory states that a false boom occurs when the Federal Reserve lowers interest rates below the market rate which increases the supply of money. Artificially low credit cost sends out misleading economic signals to producers. They are inclined to respond by greatly expanding their production around the same time. In retrospect, these investment decisions calledmalinvestments are seen as a bad allocation of resources. Malinvestments will lead to wasted capital and economic losses. The expansion of credit cannot continue permanently which means that inevitable bust will follow a false boom created by the Federal Reserve."

I don’t think every business cycle or economic bubble post-1913 has been caused by the Fed. The temptation once you have a business cycle theory is to see it anywhere and everywhere. The Internet boom and bust, which was small by comparison but still significant was probably not an Austrian business cycle. It was not fueled by cheap credit. It was fueled by equity investors that were just wrong about valuation.

As for stability before the Fed -- 1819, 1837,1873,1901,1907.

GMU Economist Bryan Caplan wrote an excellent analysis of the problems with Austrian economics

• The Federal Reserve Has Far Too Much Power to Control Our Economy

"Federal Reserve Chairman Ben Bernanke has the power to dramatically impact our economy at a drop of the hat. The central bank completely controls and determines the money supply. It is permitted to create as much money as it wants out of thin air with no restrictions. This is the antithetical to the principles that America was founded on. Our Founding Fathers would be outraged that one centralized institution has unchecked and unprecedented power to control the economy and thus our lives."

• The Federal Reserve is Far Too Secretive

"The central bank severely lacks transparency. Throughout its 100-year history, it has always operated under a veil of secrecy. The Federal Reserve has never been fully audited by any outside source. Our elected representatives in Congress have very little oversight over the central bank. It has continually resisted any kind of congressional oversight claiming that it would endanger its “independence.” A comprehensive audit of the Federal Reserve would not harm its so-called independence. It would only expose how the Federal Reserve has been manipulating our currency behind closed doors. And Ben Bernanke surely doesn’t want that to happen."

If you like inflation, just wait until Congress controls monetary policy.

• The Federal Reserve Benefits Special Interests

"The policies of the Federal Reserve hurt the average American. It benefits the privileged few at the expense of the rest of us. The Federal Reserve erodes most Americans’ standard of living while enriching well-connected elites. The central bank serves big spending politicians, big bankers and their friends. Special interests receive access to money and credit before the harmful inflationary effects impact the entire economy. This is why high power lobbyists protect and defend the existence of the Federal Reserve."

I agree that any regulator is subject to regulatory capture and that benefits the incumbents in an industry. I don't see the evidence that the Fed erodes the standard of living. The inflation argument doesn't cut it.

• The Federal Reserve is Unconstitutional

"The Constitution makes no mention of a central bank. While there have been historical debates on the constitutionality of a central bank, I see no justification for the argument that the Federal Reserve is constitutional. The federal government only has about thirty enumerated powers delegated to it in the Constitution. The power to create a central bank is not explicitly granted to the federal government in our founding document. Due to my strict interpretation of the Constitution, I find the Federal Reserve to clearly violate the Constitution."

To be honest, I'm not sure. I believe it follows directly from the power to coin money. Congress can delegate authority to others provided it doesn't bind itself or future Congresses. Congress delegated this power and they could take it back at any time.

• The Federal Reserve Encourages Deficit Spending

"The Federal Reserve is largely responsible for the out-of-control spending by Congress. The federal government can only obtain money through taxation, printing or borrowing money. Printing money has become the federal government’s preferred method. This is also the most destructive method since the federal government is able to simply print more money as needed to finance its drunken spending spree. It has become a never-ending cycle of spending and printing more money. Voters can put pressure on their representatives to halt politically unpopular tax hikes and lenders could stop loaning money to the U.S. government. But it’s fast and easy for the Federal Reserve to print more money at a whim."

This argument starts with a truth about seigniorage or the profit that a government (or central bank) makes from printing money. This certainly has been significant in some places and times like in Zimbabwe, Argentina and Brazil during the 1980s. Seigniorage the US government makes from printing money is a couple percent of the federal budget.

• The Federal Reserve Routinely Bails Out Big Banks

"The Federal Reserve acts as the lender of last resort. The Federal Reserve was ordered through a Freedom of Information Act request to release 28,000 pages of documents in March 2011. The documents exposed that one of the largest recipients of the Federal Reserve’s money was foreign banks during the 2008 economic meltdown. The top foreign banks that received money were the Brussells and Paris based Dexia SA, the Dublin based Depfa Bank Plc, the Bank of China and Arab Banking Corp., according to Campaign for Liberty. In July 2011, due to a provision under the misguided Dodd-Frank financial overhaul law, the Government Accountability Office (GAO) conducted a one-time, watered-down audit of the Federal Reserve. The GAO investigators were not allowed to view most of the Federal Reserve’s monetary policy decisions including discount window lending, open-market operations and details on its transactions with foreign governments and banks. This first ever audit of the Federal Reserve revealed $16 trillion in secret bailouts to corporations and banks around the world in less than three years. These bailouts happened without a single vote taking place in any chamber of Congress."

The $16 trillion figure includes loans that were afforded on a daily basis. So if a bank borrowed $1 billion for 30 days, we would count this as $30 billion. Not to minimize the dollar amounts involved, but get the facts right first.


Comments welcome.

What to say

Lehman had its long slow, descent into bankruptcy. It makes you wonder why Bear and not Lehman. Part of it is that Bear failed first. The other is that Lehman's troubles were relatively well known for months and the market had time to absorb the news. If anybody else some better ideas, please comment.

We are seeing the 3 month treasury bond yield at near zero.
When the government can borrow for nearly free and a nominal basis and a negative real interest rate, it's not a good sign. You cannot help but think of Japan when you see the rates this low. There are some parallels, but the actions taken recently have been different than Japan in the 1990s. In Japan, bad banks were propped up by the government. At least the bailouts here seem to be designed so that the common stock holders do not receive much. I believe the goal of the recent bailouts is different than the bailouts in Japan. I hope the goal here is to assist an orderly liquidation of assets rather than to protect the older and established companies and to keep up appearances.

AIG received an $85 billion loan from the Fed in return for 80% of the equity. The Fed now has control over AIG. The effects of this are being felt by the financial markets today.
"Banks abruptly stopped lending to each other or charged exorbitantly high rates Tuesday, threatening to spread the troubles of American International Group Inc. and Lehman Brothers Holdings Inc. to a broad range of financial institutions and the global economy."

"The depth of the money-market problems became clear at lunchtime in London, when the British Bankers' Association published Tuesday's Libor borrowing costs. Every day, 16 banks report what it would cost them to borrow at certain maturities and currencies. Overnight dollar Libor soared to 6.4375% from 3.10625%, the largest jump on record. Three-month dollar Libor rose to 2.876% from 2.816%."

If you are relatively informed on the recent events, I'd enjoy having a conversation about it to see what you think.