Ron Paul wants to “End the Fed,” but like other government agencies, it may just need some strong discipline.
The Republican presidential candidate visited Boise last month and reached out to potential voters with this and other proposals that he believes will improve our economy. While Paul’s arguments for the economic ills resulting from Federal Reserve policy may be justified, it doesn’t directly follow that eliminating the organization will solve anything.
Paul has called for a return to the gold standard. The basic argument for a gold standard is that it would control government — you can’t print more money if you don’t have the gold. While this is true, it rests on the assumption, and contains the implication, that people will always want gold, or always “treasure” its value.
At times, gold has been a good store of value, but this may not always be true, and gold is not an easy medium of exchange. Further, governments have debased their commodity-based currency for centuries. Even the Bretton Woods system (agreements set up in 1944 to manage financial relations among major industrial countries) was thrown out (in 1971) when it didn’t serve our needs.
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A better approach is the rule of law. Like all areas of government, the U.S. Federal Reserve system is more likely to help and perhaps more importantly less likely to harm our economy if it followed a known set of rules.
In 1913, the U.S. Congress established a central bank called the Federal Reserve System and charged its governing body, the Federal Reserve Board of Governors (the Fed), with maintaining a sound and stable financial system. Toward this goal, most U.S. banks are required to keep deposits, or reserves, with the Fed, creating a large pool of funds not being used in the economy.
When banks get into trouble, the Fed uses reserves to lend the troubled banks money until their cash flow improves. This lender-of-last-resort role for the Fed has worked well over the years and, by some accounts, protected the financial system in 2008 from an even worse fate.
Through the years the Fed quickly learned that it could affect banking activity, and therefore economic activity, by controlling the level of reserves. Since the 1940s, it has been part of the Fed’s mission to both encourage economic growth and protect against inflation.
Opponents of the Fed like Ron Paul say that discretionary policy is dangerous because policymakers know so little, may abuse their power and are likely to be inconsistent over time.
Again, this may all be true, but eliminating the Fed eliminates banking reserves. Without reserves, the banking system could be much more volatile. Stricter Fed rules would be better.
Economist John Taylor of Stanford University is well known for a simple policy rule whereby the Fed would set interest rates and thereby bank reserves based on current inflation readings and employment levels. The Taylor rule showed, for example, that the Fed was keeping interest rates too low prior to the financial crisis of 2008.
Had the Fed been following the rule, interest rates would have risen from the low levels that provided fuel for the crisis. Even if the crisis still occurred, the Fed could act as a lender-of-last-resort under Taylor’s or another similar policy rule.
Ending the Fed may eliminate some problems, but other problems from the past will just come back to haunt us.
PETER CRABB Professor of finance and economics at Northwest Nazarene University in Nampa