Wednesday, October 26, 2011

Ron Paul's Sensible Reminders of Central Bank Limits

Ron Paul, Texas Republican Representative and presidential candidate, wrote a well-reasoned editorial in Thursday's edition of the Wall Street Journal entitled Blame the Fed for the Financial Crisis.

Without getting into mind-numbing detail, let me focus on one key passage of his piece,

"The Federal Reserve has caused every single boom and bust that has occurred in this country since the bank's creation in 1913. It pumps new money into the financial system to lower interest rates and spur the economy. Adding new money increases the supply of money, making the price of money over time—the interest rate—lower than the market would make it. These lower interest rates affect the allocation of resources, causing capital to be malinvested throughout the economy. So certain projects and ventures that appear profitable when funded at artificially low interest rates are not in fact the best use of those resources.

The great contribution of the Austrian school of economics to economic theory was in its description of this business cycle: the process of booms and busts, and their origins in monetary intervention by the government in cooperation with the banking system. Yet policy makers at the Federal Reserve still fail to understand the causes of our most recent financial crisis. So they find themselves unable to come up with an adequate solution.

In many respects the governors of the Federal Reserve System and the members of the Federal Open Market Committee are like all other high-ranking powerful officials. Because they make decisions that profoundly affect the workings of the economy and because they have hundreds of bright economists working for them doing research and collecting data, they buy into the pretense of knowledge—the illusion that because they have all these resources at their fingertips they therefore have the ability to guide the economy as they see fit.

Nothing could be further from the truth. No attitude could be more destructive. ...the notion that the marketplace, where people freely decide what they need and want to pay for, is the only effective way to allocate resources—may be obvious to many ordinary Americans. But it has not influenced government leaders today, who do not seem to see the importance of prices to the functioning of a market economy.

The manner of thinking of the Federal Reserve now is no different than that of the former Soviet Union, which employed hundreds of thousands of people to perform research and provide calculations in an attempt to mimic the price system of the West's (relatively) free markets. Despite the obvious lesson to be drawn from the Soviet collapse, the U.S. still has not fully absorbed it.

The Fed has painted itself so far into a corner now that even if it wanted to raise interest rates, as a practical matter it might not be able to do so. But it will do something, we know, because the pressure to "just do something" often outweighs all other considerations.

If the Fed would stop intervening and distorting the market, and would allow the functioning of a truly free market that deals with profit and loss, our economy could recover. The continued existence of an organization that can create trillions of dollars out of thin air to purchase financial assets and prop up a fundamentally insolvent banking system is a black mark on an economy that professes to be free."

It's an instructive and, I believe, correct analysis of what the Fed has done to the US economy for nearly a century since it was created by Congress. In response to populist pressure for a dispersed federal authority, unlike the old First and Second Banks of the US, the regional organization of the Fed was designed to represent the interests more than simply the US financial sector.

Rather than trying to exercise more control over the monster which Congress created, it could, instead, follow the advice of the late Milton Friedman and replace the institution's monetary policy authority with a  rule-based approach to monetary base management. John Taylor has suggested a rule which assumes the existence of the Fed, but provides an interest rate-setting formula.

But what Congressman Paul so correctly emphasizes is that the Fed, having a staff and budget, has come to believe it can manipulate the money supply to some good effect, rather than simply adjust its growth to relevant factors involving population and GDP.

As with other governmental institutions, once chartered and funded, the Fed is unlikely to ever unilaterally relinquish its powers and/or admit it is mistaken in its ability to beneficially attempt to fine-tune monetary policy.

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