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Jul 26. 2009, Asia Times

It would appear that at last the US Congress has started to appreciate the extensive damage inflicted on the US economy by the Federal Reserve. This in large part because the Fed has a conflicting dual mandate of full employment and price stability and a structure that makes it vulnerable to the dictates of its chairman.

In pursuit of its full-employment mandate, using aggressive monetary policy since 2001, the Fed has driven nominal interest rates to record low levels, making real interest rates largely negative. Low interest rates, in turn have fueled speculation by reducing its cost, resulting in a number of assets bubbles, the most prominent in housing. This policy, in turn, has compromised the creditworthiness and soundness of the entire US banking and financial system.

The Fed’s reckless monetary policy has cost the US government trillions of dollars in bailouts for banks, the automobile industry, and homeowners. More precisely, on July 21, Neil Barofsky, the overseer of the Troubled Asset Relief Program (TARP), estimated in a prepared statement to a committee of the US House of Representatives that the total exposure of the US government to the financial crisis at US$23 trillion to $27 trillion. Fed policies set off commodity price inflation, most notably in oil prices, and exchange rates instability;  it aggravated external current account deficits; and it has already pushed unemployment to 9.5% in June 2009, with the expectation that it may reach around 11% before it is all done.

In the process, the Fed has created considerable distortions in the economy and has heightened economic uncertainty. The full extent of the damage and how long recession will last cannot be predicted today. There are in fact clear dangers that this unparalleled monetary expansion could be paving the ground for even bigger bubbles, more intense financial instability and larger bankruptcies in the future.

Yet the Fed has partially succeeded in blurring the diagnosis of the current crisis by blaming the financial crisis in part on excesses of the financial markets, on surplus countries, such as China and oil producers, and on regulatory failures.

The structure of the Fed and its recent policies should be a cause for national concern. While the dual mandate could theoretically allow the Fed to achieve acceptable level of inflation with low levels of unemployment, it could also create large cycles and severe recessions, with significant costs to the US economy. Which outcome prevails is an empirical question and depends on the policymakers at the Fed.

First, the Fed is dominated by one-man rule and its policy is largely influenced by the views of its chairman. In this respect, Alan Greenspan believed in financial deregulation, lax supervision, bailing out hedge funds, and rejecting calls to stave off housing bubbles or reinforcing bank regulations. His successor and present chairman Ben Bernanke believes in unorthodox monetary policy and that zero-interest rates and unlimited money were panacea for all problems, and he has ignored sound rules for sound central and commercial banking.

Second, the Fed has become a price-setter and is controlling interest rates at near zero, distorting the price structure of the broader economy. To maintain interest rates at such low levels, the Fed has to provide unlimited liquidity to banks and allow money supply and credit to rise at a fast rate, regardless of inflationary consequences, bubbles or financial stability. Such liquidity expansion has contributed to historically high current account deficits, and has pushed the credit-to-GDP (gross domestic product) ratio to an unsustainable level of 350%.

Recently two opposing views regarding the structure of the Fed have emerged: a group of academicians have circulated a petition that calls for preserving the Fed’s independence. The opposite view expressed by a group of US Congressmen calls for enacting central banking legislation and reining in the absolute powers of the Fed. Which is the best path for the US?

First, some background. The US Congress, on the heels of the 1907 financial crisis, established the Fed in 1913. The objective was to stabilize monetary policy and to prevent monetary crises that had taken place in the past when money supply had been uncontrolled and depended on the ability and willingness of banks to create money and provide credit. Notably, the banking system had experienced credit booms followed by credit contractions and waives of bank failures and long-lasting economic recessions and mass unemployment.

Ironically, the worst financial crisis and economic depression occurred only a few years following the Fed’s creation. At that time the Fed had failed its mandate for controlling money and credit creation and had instead instituted low interest rates that triggered speculation, massive purchase of gold by foreign central banks, and over-expansion of credit. The stock market crash and the collapse of the credit boom precipitated the Great Depression.
The notion of an independent Fed has all along precluded the enactment of central banking legislation and, therefore, has made the Fed dependent either on the doctrine and personality of its chairman, or on the pressure of interest groups, or both. It has constantly succumbed to Wall Street or political pressure for easy monetary policy.

The accord of 1951 between the US Treasury and the Fed illustrated such dependence. In particular, the accord ended a long period of very low interest rates imposed by the US Treasury as well as politicians and allowed the Fed some leeway to counter rapid inflation through reduced monetary expansion. Hence, purely discretionary powers together with no central banking legislation, in the name of independence, have subjected the Fed to various dependencies and turned it into a source of powerful financial and economic crises.

Quantity theory monetarists were proponents of money legislation and control of money and credit. Following financial crises and suspension of convertibility by the Bank of England in 1797, David Ricardo called for strict central banking legislation that would restrain central bank ability to create costless paper money. His views were implemented in Great Britain under the Pearl Act in 1844 through establishing two separate departments in the Bank of England, namely an issue department that issued currency based on gold and a banking department that performed banking operations for the state, commercial banks, and foreign operations.

The Pearl Act was an example of quantitative control of money and credit. In 1933, Henry Simons, Irving Fisher, and other authors of the Chicago Reform Plan called for filling the vacuum of central banking legislation and replacing discretionary and "dictatorial" powers that created considerable uncertainty and caused too much chaos and instability by a set of simple rules that would define a transparent and stable central banking. Quantitative control of the currency through a 100% reserve banking system and subordination of the money authorities to the fiscal authority were main elements of the 1933 Chicago Reform Plan.

The late Milton Friedman, a student of Simons, was a proponent of a fixed money rule consistent with a stable growth of money supply at about 2 to 5% a year. Harry Johnson, while sympathetic to fixed rule, repudiated discretionary rule and called for a democratic control of the Fed by bringing it under the control of elected officials both in the executive and legislative branches.

The proponents of a legislative framework for the central bank believed that they were not proposing a perfect solution, as no perfect solution exists; however, a legislative money framework would be far superior to arbitrary discretion, unaccountable central bankers, and over-using money policy for short-term stabilization. They strongly believed that money policy had to be conducted consonant with long-term goals of price and financial stability and to allow fiscal, competitiveness and price flexibility, trade policy, sectoral policies, and structural policies as instruments for short-term stabilization and for strengthening the private sector.

The US Fed is unlike a traditional central bank. Its main mandate was reformulated in 1946 under the full-employment act. It became possibly the only central bank in the world with a mandate to achieve full-employment and price stability. Accordingly, it became the most encompassing institution, with its powers extending to achieve the highest level of aggregate demand. Certainly politicians imposed the 1946 full-employment act, but paradoxically, the full employment mandate has been self-defeating.

Ensuing financial instability had pushed unemployment to 25% during the Great Depression and 12% during the 1970' stagflation. Today, Fed policies have pushed unemployment from 4.3% in 2007 to 9.5% in June 2009. Besides causing large-scale unemployment, the Fed has also failed to achieve price and exchange rate stability.

The US Treasury in June 2009 issued a regulatory plan for financial institutions. However, no regulatory framework has been considered for the Fed. Historical facts, including recent financial crisis, would indicate that in the absence of central banking legislation the current system would always expose the banking sector to future crises no matter how sound a banking regulatory and supervisory framework were in place.

Only a regulatory framework for the Fed can enhance its role, to make it accountable to legislative jurisdiction and to the electorate, and as a result enhance the stability of the financial system. Without legislative rules, it would be difficult to determine whether the central bank was conducting safe or unsafe central banking, or whether its mandate was limited to money and credit or was all encompassing.

Under the latter mandate, the central bank is conferred powers for enacting policies for achieving full employment of the labor force, irrespective of the safety of these policies; it fixes prices and dictates the allocation of resources in the economy at the expense of prudent money and bank stability. The control of banks, credit, and enforcement of prudent banking become somewhat contradictory when a central bank is mandated with full employment and price stability.

It would appear that the Fed sees no alternatives to monetary policy for promoting growth and employment. But zero-interest rates distort the price structure, erode the return to capital, discourage savings, investment, and depress growth and employment. They also fuel speculation and inflation.

Irrespective of millions of foreclosures originating from speculative housing prices and excessive property taxes, the Fed is injecting $1.5 trillion for mortgage loans in an attempt to re-inflate housing prices. In the same vein and despite record defaults on consumer loans and mounting toxic assets, the Fed is injecting $1 trillion in consumer loans destined to subprime borrowers.

Such unrestrained money policy can only worsen financial instability in the future. The Fed's monetary policy has made fiscal management very costly and difficult. The government has had to put in place bailout facilities, a toxic-asset purchase program, a housing bailout program, stimulus packages to revive economic activity. It has also had to run dangerously large deficits. The consequences could be compounding inflation, rising public debt and external deficits, and more financial instability. New liquidity injections could in part translate into toxic assets on the Fed’s balance sheet and fuel inflation.

The Fed's present strategy of inflating the economy to lessen the debt burden and to achieve employment, to be followed by monetary policy stabilization after the price level has been inflated high enough to cut real debt, is inequitable and has many associated risks, including aggravating fiscal costs, promoting moral hazards, and perpetuating a vicious circle of instability.

The recent debate regarding the role of the Fed is not new and reflects two opposing views of central banking requiring a public debate. A national debate of Fed policies and its possible reorganization has become a pressing matter for the United States.


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