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The Paul Bill & The Fed’s Independence

November 10, 2009
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Anil Kashyap and Frederic Mishkin lay the smackdown on the bill introduced by Rep. Ron Paul (R) that would authorize GAO audits of the Federal Reserve. A well-written and measured argument that doesn’t even have to fall back on the significant evidence that exists showing how important independence is to a central bank’s ability to control inflation and, to a lesser extent, promote economic growth.

Perhaps their most interesting point:

The Fed’s independence is critical to its credibility. During the financial crisis, this credibility allowed the Fed to take extraordinary action to prevent a possible depression without triggering inflation.

In other words, contrary to what Paul and his supporters are arguing, the Fed’s actions during the financial crisis might have resulted in worse outcomes if they had been subject to political oversight.

Something to think about before making any drastic changes to an institutional arrangement that has worked well for so many years, including as part of the successful effort by President Reagan to turn the nation’s economy around after the catastrophe that was the Carter administration.

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6 Comments leave one →
  1. Ariosto permalink
    November 11, 2009 4:48 pm

    “Without triggering inflation”? Are you joking? Have you seen the price of the Dow lately? It ain’t going up on fundamentals! What if we have massive price inflation next year or the year after — which we will unless Bernanke can really “drain liquidity” (which he can’t) or raise rates and make our currency attractive. What then?

    Sure, Paul Volcker was a successful Fed chairman. But what success have we had since then? No Fed chairman has the courage to raise interest rates today. They are complete political patsies, as Greenspan was and Bernanke now is. Can you say “monetizing debt”? It is hardly credible to say the Fed is still independent anyway.

  2. cjm13 permalink
    November 11, 2009 5:01 pm

    When I think “inflation,” I think things like CPI, PCE, PPI, etc., not equities prices. Equities are often a leading indicator of broader economic recovery, so it makes perfect sense for them to be increasing in advance of economic fundamentals. In fact, you could certainly argue that the Dow, S&P, and other indices went well below what fundamentals would have suggested to begin with.

    I fail to see how Bernanke “can’t” drain liquidity. Perceptive Fed observers have noted that, among the liquidity facilities introduced by the Fed in the past year and a half, one that gets very little attention but will be very important for reducing liquidity is interest paid on required and excess reserves. This new tool will be particularly useful for reducing liquidity in a timely and effective manner by offering a new, previously-nonexistent incentive for primary dealers and other financial institutions to hold on to reserves rather than engage in potentially inflationary lending. And that’s leaving aside the wide range of exit strategies available to the Fed in the form of changes to the existing lending facilities (they can close down TAF any day they want, and most of the others have set lifespans that will expire in February of next year), not to mention asset sales and the Fed Funds rate itself.

    And the contention that “no Fed Chairman has the courage to raise interest rates today” is rather thoroughly debunked by Greenspan’s ratcheting up of the Fed Funds rate at the end of his tenure to 525 basis points even as personal income growth remained stagnant. Hardly a “patsy” move if you ask me.

  3. Ariosto permalink
    November 13, 2009 5:04 pm

    Greenspan is your example! 525 basis points was not enough to make up for all the malinvestment caused by his (and Bush’s) reckless refusal to accept the recession of 2001. We are still a country totally dependent on cheap credit. Do you actually think Bernanke will have the courage to pop his own bubble recovery now? Are you kidding me?

    No Fed chairman has ever inflated and then managed to “drain excess liquidity” at precisely the right time. In fact, no central bank and no government that I have ever heard of has even suggested the possibility of doing such a thing. The tools you describe have never been used. It would require perfectly timing the moment at which the American economy is on its feet again (as if that’s going to happen anyway). You mention asset sales as a necessary part of the Fed’s cleaning up its balance sheet. How’s that going to work out for you? Do you think all those toxic bonds won’t be toxic any more? They would kill the markets if they were dumped back in. And how about the bonds that the Treasury would have to sell in this scenario? Who would buy them if interest rates weren’t high enough to be attractive? Actually, I don’t even think Bernanke believes he can pull it off. But if he admitted that, we’d already be screwed.

    As for equities prices, in the first place they aren’t rising in real terms (i.e., in terms of gold, not paper). In fact, they pretty much haven’t gone anywhere in about the last fifteen years. Priced in gold, the Dow is still high compared to how far it fell in the early 1980s. “Perceptive observers” (i.e., ones not beguiled by Keynesianism) suggest that the Dow has a lot farther to go, as it’s about 9 : 1 in gold now, and fell to 1 : 1 in the early ’80s. At any rate, money is going into U.S. equities because of the lack of anywhere else to put it, and the growing sense that the U.S. dollar is on its way down.

    Actually, what inflation we’ll get (and which you’ll miss by looking at the CPI) is likelier to be a currency-level event and not demand-pull inflation, so it’s unlikely any tool would stop a crashing dollar. Any tool that would be used would thrust us even more deeply into a depression.

  4. cjm13 permalink
    November 14, 2009 5:38 am

    And I’m guessing by your equities-priced-in-gold statistics that you’d prefer we move to the gold standard. Because having our currency value dictated by the vagaries of international financial markets (i.e. gold discoveries in Botswana) would be so self-evidently preferable to our own, independent, American monetary policy. Come on. We’d still have inflation if we went to the gold standard, it would just happen whenever new precious metal was dug up in Africa rather than as an at least partly-educated stab at trying to prevent deflation and liquidity crises.

    And I’m not in any way arguing that 525 basis points was enough; just that your claim that “no Fed chief has ever had the courage to raise rates” was self-evidently false. It’s true that the Fed was a contributing factor in the bubble, but you’re also forgetting the other big cause: the declaration of low-income home ownership as a political goal by the Clinton administration and the rejection of sensible regulation on underwriting standards rejected by Barney Frank and his Democratic ilk in the House. If it was entirely the Fed’s fault, asset prices across the economy should have been overinflated; instead, we saw primarily an unsustainable boom in home prices, which not coincidentally is where the failures of pro-home ownership Democrats and Republicans alike are concentrated.

    The timing of the exit may not be perfectly timed, but I have more faith in the Fed than you do. The “toxic assets” you mention were largely perceived as such because of the liquidity crunch; many of the assets on the Fed’s balance sheets (commercial paper, for example) are actually quite healthy, but were simply difficult to sell during the height of the financial crisis for cash-strapped firms. The Fed’s asset-purchase programs and liquidity facilities were not designed to, and did not, suck up uniformly “toxic” assets – some of the assets they hold might end up souring, but the majority are likely to be able to be sold or held to maturity and paid in full.

    Your comment about the lack of high interest rates on these assets as precluding their sale suggests to me you have a bit yet to learn about financial markets. The rates charged to the debtors that underlie the securities and assets the Fed holds have almost no relation to the level of the Fed Funds rate; even though the FFR is between 0 and 25 basis points, many of the “toxic” assets you mention charge underlying rates of 500 basis points or more, and obviously greater the greater the “toxicity” or underlying risk. What a company who issued these “toxic” securities charged to the person whose debt backs the security is a choice of private markets, not of the Fed. In other words, many of these “toxic” assets will be attractive to investors, precisely because they charge higher interest rates than are available almost anywhere else in the market.

    Lastly, I fail to see how additional GAO audits of the Fed would help at all in terms of Bernanke’s “courage” to “pop his own bubble.” In fact, injecting more politics into the Fed would only make it LESS likely that Bernanke will have the fortitude to raise rates – if he’s more “accountable” to misguided lawmakers like Nancy Pelosi, he’ll only feel more pressure to keep rates low, not less. So if you’re worried about a Fed Chairman’s ability to make the difficult decision to raise rates, you should be opposing the Paul bill, not supporting it.

  5. Ariosto permalink
    November 14, 2009 1:19 pm

    You misread me on two points.

    First, I referred to the interest rate on _T-bonds_, not on toxic assets, so you can excuse me of financial ignorance, if you’d like. I asked 1) whether the toxic assets would not be toxic any more and 2) how the Treasury would sell bonds without a higher interest rate. The toxic assets are bonds from subprime loans, credit card debt, auto loans, student loans, etc. And re 2), if you watched the bond market in the last year, you know what to expect from the so-called vigilantes.

    Second, I simply did not say that no Fed chairman has “ever” had the courage to raise rates. I said no Fed chairmain has the courage to do so _today_. Volcker did, and I said that. Greenspan’s fame is not from raising rates. He did so, but not courageously.

    Now to your errors. (Note that I don’t suggest you have more to learn “about financial markets.”) Botswana gold discoveries and gold discoveries in general are few and getting fewer, and wouldn’t cause significant inflation. It is ludicrous for you to speak of vagaries in the gold market and to omit the vagaries due to the Fed. The only vagary would be in shifting to it. But consider the vagary called “the housing bubble.” There’s another called “the Great Depression.” These would not monetarily have happened on a gold standard.

    Consider that the dollar has lost 95 percent of its purchasing power since the inception of the Fed, and that America actually enjoyed a small minor price deflation between its founding and 1913, till the Fed came along. Central banks exist _only_ to inflate in the long term. I suppose the economics department does not teach this.

    Another error. Central bank-induced asset bubbles often focus on particular sectors, like the tulip bubble in the Netherlands in the 1600s. (What, they don’t teach that, either?) These occur due to malinvestment in higher-order stages of economic production, of which housing is a good example. Only the Austrians explain this, which is why you’re utterly oblivious to it. To some extent all asset prices were inflated, but not as much as in the housing sector. Clinton and Frank certainly deserve some of the blame, but what they insisted on simply could not have happened without cheap money. You cannot simply create a bubble through political will.

    The point of the audit would be to end the secrecy which lends legitimacy to the Fed. The institution should be exposed and shamed. What would emerge is their pandering to liberal political goals. It would hardly be the beginning of a Pelosi-controlled Fed.

    Good luck with your faith in the Fed. It’s put your country in the horrible situation it’s in, and it’s only going to get worse.

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