Paul versus Bernanke

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The fascinating
two-year "rumble" that has been threatening since the
November 2010 mid-term United States elections will unfold after
the new congress is seated this week. The feature bout on the card
will pit: in the right corner, Ron Paul, the Texas Republican congressman,
a graduate of Duke University Medical School, 1988 presidential
candidate and author of the best-selling 2009 book End
the Fed
; and in the left corner, Ben Bernanke, chairman
of the board of governors of the US Federal Reserve System, MIT
PhD economist, former chairman of the Council of Economic Advisors
and Fed governor.

This dream
prize fight should take place because the Republicans have "mischievously"
nominated Ron Paul as the chair of an important
sub-committee of the House Financial Services Committee, namely
the sub-committee on domestic monetary policy and technology, which
scrutinizes US monetary policy.

The two combatants,
Paul and Bernanke, have sharply opposite views in ideology and policy-making.

Paul, a well-known
libertarian, belongs to a school of thought that rejects Keynesian
economics, and abhors fiscal deficits and a government that polices
the world. He supports the market mechanism, including for interest
rate determination, supports bankruptcies, and dislikes bailouts
and moral hazards, advocates the gold standard and a safe and stable
dollar, and is critical of the law that banishes the use of gold
in domestic circulation.

approach to economic policy is well known and speaks for itself.
As a key policy-maker under the George W Bush and Barack Obama administrations,
he was the architect of extremely loose monetary policy that earned
him the alias "Ben the helicopter" and has provided the
foundation for recent financial developments in the United States,
resulting in financial turmoil with a severe recession, unprecedented
peacetime fiscal deficits and rising public debt. He is a strong
supporter of Keynesian economics and quite relaxed about the dangers
of inflation and inflationary expectations. His near-zero interest
rate policy has reduced income from savings and distorted prices.

Since the nomination
of Paul to chair the domestic monetary policy sub-committee, media
and academic circles have become intrigued as to how the relationship
between the congress and the Fed will evolve. In particular, to
what extent will he be able to implement the ideas that he has advocated
since the early 1970s, calling for sound money, a return to gold,
and culminating with the elimination of the Fed?

To say that
Paul faces great challenges is an understatement. If his tenure
as a head of the sub-committee ends with no change in US monetary
policy and at the Fed, then all of his ideas could be seen as rhetoric,
with his supporters becoming discouraged at discovering the gap
between his ideas and political realities.

If, however,
Paul succeeds in reforming US monetary policy and the Fed, he would
set an important historical precedent, with his supporters gaining
confidence in their ability to make hitherto difficult changes in
the US financial system.

Even before
round 1, Paul has started to dampen expectations. Although he has
re-emphasized his belief that the Fed should be abolished, he has
cautioned that turning ideas into reality takes time and effort.
He has noted that his first action on the job will be to "think
things through and not over-do things too soon." When asked
if he intends to get rid of the Fed, the congressman replied: "Not
right up front, but obviously that is the implication. Even in my
book about ending the Fed, I talk about not turning the keys and
locking the doors, I talk about a transition."

The congressman
spoke about how he would go about reining in the Fed and the reasons
he believes it is vital to do so. "I’ll have plans for hearings
to find out how much information we can get. Obviously it is very
popular with the American people to audit the Fed, to know what
they are doing. They can spend trillions of dollars and we don’t
know where it goes. They have a bigger budget, they spend more money
than the congress does, and yet we have no oversight. It was never
intended that a secret body like this could create money out of
thin air and spend it, take care of some banks and big business
and foreign banks while the American people struggle."

These statements
indicate that Paul has quickly become more pragmatic and has toned
down his plans for radical reforms, possibly handing the banner
of radical reform to future generations after Americans have suffered
even more from financial turmoil and chaos.

reforms to future generations could be a disappointing message to
Paul’s supporters. However, it may not be, as it appears that Paul’s
priority is to audit the Fed’s operations. This would be in line
with legislation he introduced, incorporated into the Dodd-Frank
Act of July 2010, enabling the Government Accountability Office
(GAO) to audit the accounts of the Fed.

For those who
are familiar with Paul’s ideas, this priority falls short of their
expectations. The urgency does not seem to lie in auditing the Fed’s
operation as much as to prevent further erosion of the value of
money and spreading economic malaise. The urgency for his supporters
is to stop the hemorrhage before washing away the blood.

Although a
physician by training, Paul has displayed detailed knowledge of
monetary economics and documented the adverse effects of the Fed’s
policies. He has pointed out that, contrary to its mandate to promote
price stability, the Fed has promoted price instability.

Looking at
the pre-Fed era, the US consumer price index (CPI) declined at an
annual average of 0.5% and real gross domestic product (GDP) grew
at an annual 4% during 1800–1912; this would have been labeled grave
deflation by Bernanke and would have been considered as a danger
to the economy.

During the
Fed era, the CPI rose at 3.5% per year and real GDP at 3.25% per
year during 1913–2009. Hence a dollar bought almost twice as much
goods in 1912 as it did in 1800; and in 2009 it bought less than
5% of the goods it bought in 1913.

Paul pointed
out that the Fed was a joint creation of the government and Wall
Street to provide an "elastic" monetary system, with the
real and hidden purpose being service to the interests of Wall Street.

In fact, there
may not have been a more opportune time to think about radical monetary
reforms than the present, with more Americans aware of the economic
and financial policies, the impact of Fed policies on the US economy
and in the face of a declining standard of living for the large
majority of Americans.

The standard
of living has been declining; impoverishment increasing, and the
era of "opulence" as described by the late Professor John
Kenneth Galbraith only a dim memory. A large number of Americans
are still living out the financial nightmares of 2007–2009, with
millions of foreclosures and general bankruptcies. It could be the
best time for popular support for Paul’s ideas.

Paul has been
an influential member of congress and has been member of the banking
committee; yet despite his strong views and statements and sharp
criticism of the Fed in the past few years, he was unable to initiate
reforms that would rein the Fed’s expansionary monetary policies.
Recently, some House Republican members wrote to Bernanke urging
him to renounce the new quantitative easing program, which will
inject $600 billion into the economy. Their letter was simply ignored
by the Fed.

This state
of affairs and the absolute power of the Fed to impose policies
regardless of strong policy disagreements illustrate the urgency
of hearings and reform. It is congress that created the Fed in 1913;
it is congress that has imposed mandates on the Fed, including the
reforms that set up the rate-setting Federal Open Market Committee
in 1933 or the mandate of full-employment in 1946. It is congress
that could legislate reforms on the Fed.

While Paul’s
long-time career in congress has been rich in ideas and prophetic
of the financial crisis, it has nonetheless been marked with very
few substantive initiatives for monetary reform.

Paul has clearly
stated that he does not intend to shut down the Fed, admitting that
doing so would require far-reaching reform. However, it is his intention
that the idea has to be nurtured over generations until new leaders
are elected with this goal in mind or until the Fed has caused such
economic and social damage that the electorate chooses leaders with
the explicit mandate of shutting down the Fed.

Hence, by stepping
backward from the cherished idea in his book, he may lead supporters
and politicians to consider his views as a form of utopia rather
than a position that can become operational in the near future.
Prior to Paul, the well-known University of Chicago and London School
of Economics professor Harry Johnson was critical of the existence
of the Fed as a policy-making body and proposed transforming it
to an agency within the US Treasury, but this idea was never pursued.

Short of shutting
down the Fed, which would require considerable campaigning within
the political establishment and proposing the details of the monetary
system that would emerge after such a closure, there are many less
revolutionary ideas proposed by reformists during the 1930s and
later, most recently by Paul and other critics of the Fed.

money supply to a fixed rule was emphasized much earlier by the
Currency School and translated in the United Kingdom into Sir Robert
Peel’s act in 1844 that separated the Bank of England into an issue
department and a banking department, with the issue of currency
tightly determined by the amount of gold in hand.

The advocates
of the fixed-money rule, such as economists Irving Fisher, Henry
Simons, and Milton Friedman, believed that the Fed should only control
monetary aggregates according to fixed increment rates between 2%
and 4%, ensure safety of the banking system, and renounce setting
interest rates or controlling the unemployment rate.

Besides versions
of the currency school theory, reformists during the 1930s proposed
the establishment of 100% reserve banking, which would eliminate
money creation and destruction by banks, thus making banking safe
and eliminating financial crises.

A less radical
reform advocated in the past as well as recently is to drop the
Fed’s mandate to achieve full employment as this mandate may be
inconsistent with the role of a central bank as a monetary agency
responsible for managing liquidity and ensuring banking safety;
this mandate may have led the Fed into printing money, resulting
in banking crises and inflation.

Paul has considered
gold as the pillar of the monetary system that he envisions and
supports. Ever since the collapse of the gold standard in 1914,
some authors have kept on advocating a return to gold. While the
metal has its supporters, it has more adversaries among professional
economists. Gold was the common currency that unified all other
currencies in a fixed exchange arrangement under the gold standard.
The president of the World Bank has also recently proposed a return
to a gold standard. Such a move would be much more difficult than
president Richard Nixon’s decision to abolish dollar convertibility
in 1971, in turn destroying the fixed exchange arrangement adopted
under the Bretton Woods system in 1944, which had afforded gold
a continuing role in the monetary system.

However, if
Paul manages to re-introduce a form of the gold standard or abolish
laws that forbid the circulation of gold, he would have accomplished
a great deal of the reform program that he has campaigned for since
the early 1970s. The menu of reforms for Paul as head of the domestic
monetary policy sub-committee is, therefore, not limited.

Paul doesn’t
appear to think that Bernanke is better or worse than the previous
Fed chairman, Alan Greenspan. It is, instead, the monetary system
that needs a radical overhaul. He has predicted that under the present
Fed-dominated system the economy will deteriorate, inflation will
become very high, and that the American people will become poorer.
He holds congress responsible for fiscal management, bailouts, re-inflation
of housing prices, and authorizing Fed policies.

He has noted
that foreign central banks have been buying gold and getting out
of the US dollar and that the dollar may loose its status as a reserve
currency. In such a scenario, he does not believe that the Special
Drawing Rights (or SDRs) issued by the International Monetary Fund
or any other currency could replace the dollar – only gold could.
As a representative of the American people, he believes that congress
may have to consider substantive monetary reforms that would restrain
excessive powers of the Fed.

As it turns
out, a large majority of congressmen are supportive of the Fed,
believe that printing money is the solution to end recessions and
high unemployment, and are critical of Paul’s ideas, claiming that
the overwhelming majority of Republican congressmen are not supportive
of his approach to economic and financial policy.

The 2010 November
elections may have already sent a clear message of what the electorate
thinks. As Americans pay higher prices on a daily basis for gas
and food, as more suffer the humiliation of unemployment and foreclosures
and are deprived because of economic inequities, more of the electorate
will support candidates with platforms calling for fiscal and financial

For Paul, the
US is on the verge of a currency crisis that may undermine the very
existence of the Fed: "What I really fear is that when the
Fed comes to an end it will not be by my planning but it will end
with a catastrophic financial dollar crisis. This crisis when it
comes, and I think we’re approaching it, affects everybody because
it’s such an important currency. I think we’re moving into very,
very dangerous times."

Let the rumble

with permission from Asia

5, 2011

Askari is Professor of International Business and International
Affairs at the George Washington University. Noureddine Krichene
is an economist with a PhD from UCLA.

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