It’s High Time to ‘Audit’ the Federal Reserve

The calls in Washington to “audit” the Federal Reserve are not for a narrow, bean-counting review of the institution’s financial statements. The audit’s goal is more fundamental: to assure that the checks and balances in a democratic government also apply to central bankers. It means figuring out how our elected representatives can effectively oversee unelected monetary “experts.”

History shows that these so-called experts are prone to destructive inflationary and deflationary blunders, and that the Fed’s actions over the last century represent the greatest systemic risk of any financial organization in the world. These actions include the runaway inflation after World War I and the overreaction leading to the depression of 1921; the failure to liquefy the banking crisis of the 1930s; setting off the internationally disastrous great inflation of the 1970s; and more recently stoking a housing bubble while failing to recognize that it was a bubble.

The Federal Reserve, established in 1913, was a prime example of the dream-world that President Woodrow Wilson imported from the theorists of the German Empire—the notion of government based on the superior knowledge of independent experts that bypasses the messy and undisciplined world of democratic politics. The fatal flaw? The Fed has no superior economic knowledge. It has only forecasts as unreliable as everybody else’s, and theories as debatable. Hence its many mistakes.

Since the Great Recession ended the Fed has been in overdrive. It is running an unprecedented, giant monetary experiment. This experiment includes years of negative real interest rates, the creation of a huge asset-price inflation, and the monetization of real-estate mortgages and long-term bonds. Should the Fed, or anybody, be allowed to carry out such vast and very risky experiments without effective supervision? The correct answer is: no.

Opponents say an audit would threaten the Fed’s “independence.” That’s precisely why it’s necessary. The promoters of Fed independence, which of course include the Fed itself, must believe that the Fed is competent to have the unchecked power of manipulating money and credit, or in a grandiose variation, of “managing the economy.” They must believe that the Fed knows what the results of its manipulations will be, when manifestly it does not. The century-long record of the Fed provides no evidence that the Fed is competent to be entrusted with this enormous discretionary power.

The historical argument against letting Congress play a role in monetary issues is that elected politicians are always inflationist, and it takes an independent body to stand up for sound money. Yet now we have the reverse of the historical argument: a sound-money Congress confronted by an inflationist central bank—a Fed that endlessly repeats its commitment to perpetual inflation at its “target” rate of 2% a year. This means prices will quintuple in a normal lifetime. What then?

Here is the reality: The Fed is a creature of Congress, which created it and has since amended the legislation that authorizes its existence on numerous occasions. In the 1970s, Congress, with Democratic majorities, made two efforts to bring the Fed under more control. In the Humphrey-Hawkins Act of 1978, it required regular reports to Congress by the Fed. These hearings achieve nothing but the Kabuki theater of scripted presentations and sparring over questions and answers.

In the Federal Reserve Reform Act of 1977, Congress defined a triple mandate for the Fed to follow: stable prices, maximum employment and moderate long-term interest rates. The Fed has dropped any mention of one-third of its assignment—“moderate long-term interest rates”—and redefined “stable prices” to suit itself. It tells us in remarkable newspeak that “stable prices” really means prices that always go up.

How is Congress effectively to oversee its creation? Congress is too big and on average not sufficiently knowledgeable to do so directly—that’s why it has committees. But the House Financial Services Committee is also very large, with 60 members, and both congressional banking committees have numerous other difficult areas of jurisdiction, not least being the crisis-prone housing-finance sector.

So I propose that Congress should organize a new Joint Committee on the Federal Reserve. The Fed would be its sole but crucial jurisdiction. All Humphrey-Hawkins reports should be made to this joint committee, and it should have the power to audit whatever about the Fed it deems appropriate.

Such a committee should have a relatively small membership, made up of senators and congressmen who become very knowledgeable about the Fed, central banking, the international relations of central banks and related issues. Like the Senate Select Committee on Intelligence, it should include ex officio members from the leadership, but in this case, from both houses.

“The money question,” as fiery historical debates called it, profoundly affects everything else. It is far too important to be left to a fiefdom Fed.

Thanks for sharing:

GOLDSTEIN: Idle cash in the banks basically means the Fed created all this money out of thin air, bought bonds from the banks. The banks took that money and sat on it and basically didn’t do anything. And so it’s not creating inflation ’cause it’s just sitting there in the banks. But it’s likely that at some point, as the economy continues to improve, things really start humming again, banks will start lending more. That money will be out there more. And it will, you know, then potentially start driving up inflation. And that is what the Fed has to worry about. I mean, that’s always the Fed’s job.

SMITH: What does the Fed do about this? They have never had this much money out there before.

GOLDSTEIN: Right. And in a basic way, they’re facing the same challenge the Fed always faces, which is you want to put money out there to get the economy going. And then, once the economy really starts taking off, you want to pull some of that money back before inflation gets out of control. But there’s a couple reasons why it’s a much harder job this time, right. The first reason is the magnitude is just much larger. There’s a lot more money out there. And one of the things Blinder told me is that means even a small mistake by the Fed can have real, large consequences out in the economy. The other reason, which I think is actually even more interesting/kind of scary, is the Fed has never done this before. The Fed has never, ever done quantitative easing before. I talked to this other guy, an economist named David Blanchflower, who worked at the U.K.’s central bank, the Bank of England, during the financial crisis. And he said, look, during the financial crisis, the central banks – the Bank of England, the Fed – were making it up as they went along. They didn’t know what to do. They’d never seen this before. And Blanchflower is pro-quantitative easing. He thinks the Fed did the right thing. But he says, look, we were making it up during the crisis. And when it comes time to undo QE, to start taking that money out of the economy, the Fed is still going to be making it up.

DAVID BLANCHFLOWER: They don’t have a nice chapter in a textbook to tell them what they should do. They’ve never done it before. They – they’re struggling.

GOLDSTEIN: So the Fed doesn’t know was going to happen when they finally wind down QE?

BLANCHFLOWER: Absolutely not… Sorry.

http://www.npr.org/templates/transcript/transcript.php?storyId=394274484

VANEK SMITH: So basically, Guy told me right now, without government support, it would be really, really hard for most people to get mortgages. And those mortgages would probably be more expensive – higher interest rates, things like that – if the government weren’t guaranteeing that they would buy them up from banks. That, in turn, would push housing prices down. And I talked to Adam Levitin about this. He’s a professor of financial regulation at Georgetown University.

ADAM LEVITIN: The problem is that we’ve built a market – you know, home prices are based right now on an assumption of tremendous government support for the housing market. And that basically becomes like an entitlement for the middle class. Socially, politically and economically, withdrawing that entitlement would be disastrous. The housing market has become really a market that’s too big to fail.

VANEK SMITH: What would happen if the government got out of the mortgage business tomorrow?

LEVITIN: We would have great depression – not great recession, great depression.

SMITH: Now, I can understand, as someone who owns a house, I don’t want anyone passing some sort of legislation that’ll make my house worth less – 10, 20, 30 percent less, I would be quite upset. But at the same time, I mean, come on people. The whole point of going through a crisis is to learn that prices have to reflect reality. So is anybody just saying, like, look, we’ve got to bite the bullet? We can’t build another housing bubble.

Nice synopsis of the bigger issue of mortgage finance.