In case you didn't know, Ron Paul is a US Congressman who currently heads the House Financial Services Committee's subcommittee on monetary policy. I assume that this gives him some power to mobilize forces to implement his ideas. Paul is of course a vocal critic of the Fed. If there was good science backing up Ron Paul's ideas, and if the ideas were tight and well-reasoned, that would be great. Unfortunately, End the Fed which I take to be the best Paul can do in marshaling his thoughts, is for the most part bad science, consisting of flimsy arguments and some utter nonsense.
Now, to start, you should understand where I am coming from. I was not born in the United States, though I am currently a US citizen. For Canadians, coming to the United States and working here is relatively painless. For example, I look and sound like I could be from Minnesota, or the Upper Peninsula of Michigan (those people are essentially Canadian anyway - they even know how to hold hockey sticks). Sometimes I feel badly for some of my fellow immigrants, including the ones from Asia who have to struggle with the language, or those from Mexico who have to deal with this guy, but I digress. I got my first year-round job at the Bank of Canada in 1979, when I was 24. Since then I have worked full-time at the Minneapolis Fed (2 years), and have been a visiting academic at the Federal Reserve Banks of Richmond, Cleveland, Philadelphia, Kansas City, Atlanta, and New York. I currently spend an average of something less than one day per week at the St. Louis Fed, in my hometown, where my full-time job is at Washington University in St. Louis. My title at the St. Louis Fed is "Research Fellow," and I have an office over there (no window unfortunately) with my name on the door. I also know some powerful people. I went to graduate school with 2 Fed Presidents, know 4 Fed Presidents well (Narayana Kocherlakota is a rather aggressive poker player; Dean Corbae is not), and am an acquaintance of Ben Bernanke's from back in the day (e.g. we both belonged to Glenn Hubbard's NBER group for a time).
I'm not trying to boast here. As everyone knows, Canadians are trained not to do it (there are some exceptions - my friend Randy Wright has never been accused of excessive modesty). I may be slow at times, but surely after all this time hanging out with central bankers and working on the inside of their institutions I have some understanding of how central bankers think and how well they do their jobs. I also like to think of myself as an independent thinker. In this blog, I'll sometimes criticize people in the Fed when I think they need it. Some of that is in the spirit of this. Whether my ideas have any impact on how these people think about policy is a mystery to me.
Now, what is End the Fed about? The first paragraph of Chapter 10 (page 141) sums it up:
The Federal Reserve should be abolished because it is immoral, unconstitutional, impractical, promotes bad economics, and undermines liberty. It's destructive nature makes it a tool of tyrannical government.Now, I'm sure that to some of you this sounds like a rant, but let's give the poor guy a chance, and consider the pieces of his argument.
1. The Fed is immoral. The idea here has to do with what Paul calls "printing money out of thin air." We have a government, and the government is a tyrant. The tyrant must confiscate resources in order to keep itself alive. To confiscate the resources, the tyrant can tax, issue interest-bearing debt, and also issue money, through the tyrant's central bank. When the tyrant taxes us, we can see what is going on. The thief is taking our stuff, but he or she is being pretty up-front about the whole thing. If the government borrows in order to acquire resources, then this is more indirect. The government debt issued to finance the tyrant's spending could actually just be deferred taxation (the government taxes us in the future to pay off the debt), and maybe we can figure that out, which is what Ricardian equivalance is all about. But if the tyrant simply uses its monopoly over the printing press to issue money in order to acquire goods and services, then the theft is even more indirect. As private citizens we are deprived of resources by the tyrant because the extra money issued by the tyrant drives up prices and makes our money worth less in terms of goods and services. Now, instead of a thief with the gall to steal our stuff in broad daylight, we have an underhanded, conspiratorial thief who walks off with our stuff in the dead of night. Not only that, but the thief is in league with rich bankers. Even worse.
Is the Fed immoral? Ron Paul wants you to think that what the Fed is doing is mysterious, secretive, and underhanded. We have all been hoodwinked but, according to him, he has figured it out, and will proceed to enlighten us. You can forgive Paul somewhat for the "printing money out of thin air" idea, as this is part of what is conveyed in conventional money and banking undergraduate courses. Indeed, Paul's exposure to formal economics training appears to be confined to a single undergraduate course, in which he seems to have been exposed to the money multiplier, probably the most misleading idea propagated in monetary economics. As discussed here, a central bank is best viewed as just another financial intermediary, the unique characteristic of which is that it has a monopoly on the issue of some class of liabilities. The Fed creates liabilities out of "thin air" to purchase the assets in its portfolio. A bank creates deposit liabilities out of thin air to purchase the assets in its portfolio. General Motors can create equity claims out of thin air to finance the purchase of new plant and equipment. Further, the fact that the liabilities of the Fed do not represent specific claims to anything in the future is neither here nor there. In private markets, in which Paul puts much trust, we have developed arrangements by which private firms issue claims (stock) which are not specific promises to pay anything specific in the future (dividends are discretionary). Further, private firms make no commitments about their future plans to issue more stock, or to buy back stocks, decisions which will affect the value of stock held by existing shareholders, just as decisions by the Fed affect the value of the existing stock of money outstanding. Nothing mysterious here at all.
Now, Paul seems very focused on inflation, and the resources extracted from the private sector by way of the inflation tax. It would help here to do some back-of-the-envelope calculations to get an idea of the magnitude of resource extraction. From fourth-quarter 2010 NIPA numbers, GDP was about $14.9 trillion, and total expenditures (by all levels of government) were about $3 trillion, at annual rates (seasonally adjusted), so the tyrant was extracting about 20.1% of GDP (this is all levels of government). Now, inflation has been hovering around 1% per year recently, but suppose it were 2%, which is the Fed's stated inflation target (not officially, but Bernanke says as much in public). What is seignorage, i.e. the implicit revenue the government collects, through the Fed, from the inflation tax? To calculate this, we need to know what the tax base is. Let's think of the current stock of reserves as essentially T-bills, which the Fed plans to retire in good time (to take it at its word). Then, the remainder of outstanding Fed liabilities is essentially currency (which certainly corresponds to Paul's language) which is just short of $1 trillion, so let's call it $1 trillion just for argument's sake. Then, with 2% inflation, the revenue from the inflation tax is about $20 billion per year, or 0.7% of government spending, or 0.14% of GDP. Small potatoes, and certainly not enough to justify an armed mob outside the Fed in Washington screaming "end the fed," as Paul seems to envision.
What is missing from Paul's arguments is some statement of principles about what the government should be doing. The best we get is this, on page 192:
When government grows, liberty suffers. This happens no matter what justification is given for the government programs financed.Suppose I take this literally. Paul thinks liberty is good. More government means less liberty, therefore the optimal state of the world is one with zero government. But Paul also appears to be offended by theft, so surely he recognizes that there might be some problem in leaving policing to the private sector. Maybe he thinks that an army might be useful, if not for pursuing exploits abroad, then at least for defending us from invading Canadians. Once we recognize that there is some role for government, we are going to have to finance this government, and that will require contributions from all of us. There is then a whole branch of economics - public finance - that deals with the issue of how those contributions can and should be made, and the consequences of alternative means of resource extraction for the government. In primitive economies, where the costs of collecting taxes are high and financial markets undeveloped, it can be economically efficient for the government to generate much of its revenue with the inflation tax. In modern economies, we think not. We recognize that inflation is costly, and modern disciplined central banks keep inflation rates low.
2. The Fed is unconstitutional. I'm not a constitutional expert, by any means, but this argument seems to be coming from the same place as this, which does not quite say that the income tax is unconstitutional, but comes close. I know the idea is floating around. Get serious.
3. The Fed is impractical. Paul seems to think that the Fed is the wrong tool for getting the job done. What's the job that we want done? Apparently we want price stability, so let's take that as given. What is Paul's alternative to the Fed? He wants to go back to the good old days of the gold standard. So what's wrong with that? I discussed some of the issues here. Basically, if price stability is the goal, any commodity standard is incapable of delivering it. Here is what Paul appears to have in mind, though he is pretty vague about the whole arrangement. One of Paul's Austrian-economics heroes is Murray Rothbard, who wrote this. Rothbard thought the gold standard was a good idea, and also had a problem with fractional reserve banking. Basically, what Rothbard his in mind is some combination of the gold standard and Friedman's 100% reserve requirement on any transactions medium. Any liability used in transactions must be backed 100% by gold. Now, the key problem with this arrangement, aside from the usual difficulties with the fluctuating relative price of gold, is that there is not provision for "currency elasticity," a term written into the Federal Reserve Act of 1913. Currency elasticity is a concept you can teach to students in homework problems. Roughly, the demand for money will fluctuate due to fluctuations in various exogenous factors (time of day, day of the week, month of the year, productivity, transactions technologies, etc.). If the money supply does not accommodate these shocks, prices will fluctuate as well, and we will not have price stability. If all media of exchange are backed one-for-one with gold, then you get some elasticity due to the fact that gold can be diverted from other uses (and dug out of the ground) to use as backing for transactions media. But this necessarily implies that the relative price of gold is fluctuating and, by implication, there is no price stability. Further, restricting private financial intermediation with a 100% reserve requirement, while un-Libertarian and inconsistent with what Paul seems to stand for, is also economically inefficient - it works like a tax on financial intermediation. Theft, as it were.
4. The Fed promotes bad economics. How do you tell good economics from bad economics? Sometimes the profession gives prizes to people. There's the John Bates Clark Medal. There's the Nobel Prize. Two Nobel Prize winners were Ed Prescott and Robert Lucas, Jr. Prescott has had a long and fruitful relationship with the Minneapolis Fed, and Lucas has been a frequent visitor there. The collaboration between University of Minnesota economists and researchers working at the Minneapolis Fed produced some of the most important breakthroughs in 20th century macroeconomics. New Keynesian Economics was developed by people like Mike Woodford and Mark Gertler, who have ties to the New York Fed, and to other central banks in the world, including the ECB. Currently, there is first-rate research being done at all of the Federal Reserve Banks in the system, and at the Board of Governors in D.C., and some of those research groups would easily rank among the top 20 among working groups of macroeconomists in the world. Bad economics! What an insult! To do its job, the Fed needs to be on top of economic science, and I think it does a good job of that. A particular strength of the Federal Reserve System is its decentralization. A regional Fed President is appointed by the Board of Directors of the individual regional Fed (though the appointment must be approved by the Board of Governors), and regional Feds develop their own idiosyncratic views, with a healthy competition in ideas among the regional Feds, and between the regional Feds and the people in Washington D.C. No central bank in the world appears to be organized in a way that promotes this degree of diversity in ideas.
5. The Fed undermines liberty. What's that about? Summary:
Remember that the people who run the Fed are just regular people, as flawed as anyone else. The only difference is that they have massive power to break civilization. Any institution that can do this is by nature tyrannical and is specifically what the Constitution was trying to prevent.I'm sure that Ben Bernanke does not look in the mirror in the morning and think of the guy he sees as being capable of breaking civilization. Central bankers may be powerful, but there's no need to go overboard here.
I have sometimes contemplated, in published papers, what the world would look like without a central bank, and how private arrangements might substitute for what the central bank does. It is important to question the existence of central banks, to put central bankers on the hot seat about their methods, and to work to improve central banking practice. However, I am convinced that, given what we know, getting rid of the Fed would be foolhardy. The science of economics is no different from any other science. Our understanding of central banking is imperfect, just as our understanding of cancer and global warming are imperfect. We have a pretty good idea about the broad outlines of what a central bank is good for, but about the details we are not sure. My judgment is that the world would be a much more unstable place without the Federal Reserve System than with it. Instability is a threat to our freedom, as events of the last 10 years should make clear. While Ron Paul might be able to convince me that we should end the Fed, my best guess is that he is not up to it.