The Federal Reserve's Death Rattle?

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Last week I testified before the House Financial Services Committee in support of HR 1207, the Federal Reserve Transparency Act of 2009. Speaking on behalf of HR 1207 is particularly tricky because (1) what the Fed might be up to is entirely speculative, and thus can hardly be admitted into testimony; and (2) the bill is not opposed to the Fed per se, so arguments about the Fed’s performance as an economic stabilizer are also out of bounds (unless a congressman happens to raise them). Thus when the opposition argues that the Fed needs to maintain its secrecy in order to be able to keep up the super job it’s been doing, it would be considered “political” to argue that the Fed’s record has in fact been terrible. I eventually had to do so anyway, since there was no other way to answer some of the congressmen’s questions. But you see how delicate it is.

The most contentious moment for me came right at the beginning, when Congressman Mel Watt (D-NC) demanded to know if I supported a “policy audit” or a “numbers audit.” I was caught off guard because I couldn’t tell if he was asking for my personal opinion of what would be better or if he was seeking clarification of the meaning of HR 1207, which was presumably the point of the hearing. If the latter, I didn’t understand why he couldn’t simply have asked Dr. Paul this question sometime over the past seven months, the bill having been introduced on February 26. What I was trying to say, and I think at least the first part came through before being cut off multiple times, was this: because the Fed, unlike other entities subject to audit, is a creation of Congress exercising a government-granted monopoly privilege, an audit of such an institution will need to disclose more information than we would need (or have a right to) from a normal firm. But although we would like to see documentation of Fed meetings made available more promptly, and it would be nice to know the rationales for some of the Fed’s more inscrutable decisions, the purpose of the audit would not be to substitute the judgment of Congress for that of the Fed in the execution of monetary policy.

I don’t see how that could be summed up in a two-word answer. And any two-word answer I did give, I could tell from Congressman Watt’s demeanor, would be followed by a harangue that would use up the rest of his time. (The witness does not have a separate allotment of time in which to answer; the congressman has five minutes, and any answer the witness is permitted to give is included in that five minutes.) Congressman Watt chose to take my preface as an evasion, and then dismissed me for giving too “philosophical” an answer.

Congressman Ron Paul then asked me about whether secrecy or transparency was better for the markets. A good question. The Fed is trying to argue that transparency would spook the markets and create debilitating uncertainty. But isn’t the opposite in fact the case? The more people know what the Fed is doing, the better foundation they have for making sound decisions. Secrecy, on the other hand, encourages potentially damaging rumors and speculation as people try to figure out what’s really going on.

Dr. Paul further asked about the historical significance of the hearing, to which I replied that the hearing was indeed historic, given how successful the Fed has been since 1913 in keeping itself out of the spotlight. Congressmen in the past who ranked higher on the committee than Dr. Paul had tried numerous times without success to bring similar bills to a hearing.

In my opening remarks I added to my written statement, which I wasn’t strictly reading, a phrase for which Barney Frank (D-MA) would take me to task. In my written statement, I noted that the Fed is indeed independent in the sense that it can make trillions of dollars available to unknown friends on unknown terms. I then wrote that I couldn’t imagine any self-respecting American hesitating for a moment to challenge that kind of independence. In my oral remarks, after “self-respecting American” I added the words “who isn’t bought and paid for.”

Note that I wasn’t saying that anyone who opposes HR 1207 is necessarily in the pay of anyone. I was suggesting that people who thought it was just fine for the Fed to have such extraordinary discretionary powers might have a material interest at stake in the question.

As surely true as those words are, whether I should have said them is obviously debatable. But Barney Frank’s shocked and indignant reply was still a bit over the top. Who is bought and paid for, he demanded to know. Well, how about the firms on the receiving end of Fed largesse, for one? How many of those oppose this kind of Fed independence (and how many support 1207)? I didn’t want to get into this particular subject, but I mentioned the work of Professor Lawrence H. White of George Mason University, who has shown the economics profession to be completely in thrall to the Fed — what with millions of dollars in research grants (one of the points I made to Congressman Frank) and countless other levers of influence. (See his [.pdf] article “The Federal Reserve’s Influence on Research in Monetary Economics.” You might also note the more recent article on the Huffington Post, “Priceless: How the Federal Reserve Bought the Economics Profession,” making the same point.) When we read about monetary economists urging the maintenance of Fed “independence,” therefore, surely it’s not unreasonable to bear these factors in mind. Yet Congressman Watt dutifully inserted into the record their absurd warnings about inflation fears if 1207 should pass.

Now I’m told a few people are concerned about these semi-hostile exchanges (initiated by the congressmen, not by me) with a couple members of the committee. Naturally one wants to avoid hostile exchanges when possible, and I do not claim infallibility in my choice of words. But it is delusional to think the point of these hearings is to persuade congressmen. Everyone knows the hearings are of symbolic significance only. Their political effect has nothing to do with persuading congressmen, who have already made up their minds and are obviously not going to change them because of one person’s six-word turn of phrase at a hearing. If they have any political effect at all, it involves persuading the general public, if indeed the general public sees footage from the hearing. I hardly think it a stretch for me to suggest that the people who most wish to preserve the Fed’s “independence” to shovel money to well-placed firms would be those who stand to lose the most if that power were curtailed. And I rather doubt the American public would be quite as shocked and offended by this common-sense observation as Barney Frank claimed to be.

Another thing is that I can’t answer questions I’m not asked. A critic might say I should have stuck more closely to the pure question of the audit. Well, that’s exactly what my opening statement was about. My opening statement had nothing to do with whether the Fed was doing a good or a poor job. But after that point, all I can do is answer questions I’m asked. If I’m asked about whether I think the Fed is contributing to our economic problems, a question I got several times, I have to answer even though the question does not directly pertain to the audit. Likewise, it would have been nice to make the point that we want HR 1207 to be a stand-alone bill, rather than being absorbed into a larger regulatory reform package. For pedagogical reasons alone, it would be good for the country to see the Fed being discussed as a separate issue, and it would be good to know which congressmen favor Fed transparency and which do not. But none of the congressmen gave me the opportunity to address that issue, and there is extremely limited time to answer questions as it is. Moreover, it’s not even clear that such a clearly political question is an appropriate one for a witness to address.

The rest of the hearing was entirely friendly. Congressman Ed Royce (R-CA), who introduced himself to me afterward, mentioned Ludwig von Mises and the Austrian theory of the business cycle, which he had also done during his questioning of the Fed’s general counsel. Again, that is partly off topic, but going a bit off topic is not exactly unheard of in the history of congressional hearings. He was concerned that the Fed was both contributing to the moral hazard problem, which it obviously is, and setting interest rates too low and thereby feeding into asset bubbles. I in turn elaborated on these points, noting that although we hear a great deal about the need for higher capital requirements, no one asks the more fundamental question: why are equity ratios so low in the financial sector? Why do we not have this problem elsewhere? And the answer, of course, is that the very existence of the Fed encourages the financial sector to rely on the central bank for its liquidity problems. Even the International Monetary Fund noted (in an April 2008 report I cited in the hearing) that financial firms had become “more complacent about their liquidity risk management systems and u2018underinsure[d]’ against an adverse liquidity event, depending more heavily on central bank intervention for their liquidity problems.”

Michele Bachmann (R-MN) graciously held up a copy of my book Meltdown, which she said she was reading and enjoying very much. She was likewise concerned about the extent of the Fed’s discretionary powers, and the extent to which the taxpayer winds up on the hook for things he doesn’t even know about. I took the opportunity to clarify a point she already understood, but which is sometimes obscured in the shorthand we use: the impact on the taxpayer is really an impact on him in his capacity as a holder of dollars. If the Fed’s arrangements with private firms leave the central bank with lower-quality assets than before, then its ability to carry out its policies while preventing price inflation from getting out of hand is impaired. The Fed’s ability to sterilize its injections — i.e., taking dollars out of one sector of the economy as it injects them into another — is compromised when there is a decline in the quality of the assets it intends to sell to withdraw the dollars. In other words, it can still inject dollars, but it’s now harder to remove them (since its assets no longer fetch as many dollars).

The hearing was symbolically very significant. It was an extremely unusual thing to see so many members of Congress critical of the Fed, and generally for the right reasons. Barney Frank opened the hearing with an exceedingly gracious statement about Ron Paul and his persistent efforts over the years to bring about legislation of this kind. The whole thing was gratifying to observe, both for Ron Paul and, I dare say, for America.

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