Choosing Sides in the Fight for the Federal Reserve: Whom Should Wise Investors Align With?

By Martin Hutchinson
Contributing Editor
Money Morning

A debate over the future of the U.S. Federal Reserve is taking place in the halls of Congress. 

On one side is U.S. President Barack Obama and his plan to expand the authority of the Federal Reserve. In addition to its current powers, Obama plans to give the Fed regulatory authority over large financial institutions that are considered "too big to fail."

On the other side is U.S. Rep. Ron Paul, R-TX, who has gathered 250 signatures for a proposal to audit the Federal Reserve. This audit, by Paul's own admission is only a down payment towards his overriding goal of abolishing the central bank.

So who's right? Should the Federal Reserve have more authority or less? And what will the outcome mean for investors?

The call for greater Fed power comes, as might be expected, from those who think the Fed has done a good job managing the financial crisis. Their view is that the Fed – by swelling its balance sheet by about $1.4 trillion and more than doubling the monetary base in less than a year – prevented deflation from taking hold in the economy and saved the banking system, which was in dire danger of collapse.

To those with this mindset, it makes sense for the Fed to act as the primary regulator of banks and investment banks that pose a systemic risk to the U.S. financial sector.

But the problem with this plan is that any potential rescues would not be carried out on the Fed's dime, but on that of the Federal Deposit Insurance Corporation (FDIC). That means a collapse in the banking system would actually benefit the Fed by allowing the central bank to ramp up its balance sheet to replace all of the banks' losses and ensure that its chairman makes the nightly news every evening. 

Even for those who are not staunch believers in Nobel Prize-winner James Buchanan's public choice theory, the incentives seem to be wrong. It would make more sense to put banking system regulation firmly under the FDIC, which is responsible for paying up if anything goes wrong.

It's not likely that an empowered Fed would impose tight restrictions on the big banks. Instead, the central bank's governance would probably become a prime example of "regulatory capture," by which spineless regulators exist mainly to do the bidding of the very institutions they're supposed to be regulating.

Since the rest of us are dependent on the Fed's monetary policy to survive economically, and need bank regulation that will keep the biggest banks from picking our pockets every few years, we don't want the Fed to become a subsidiary of Goldman Sachs Group Inc. (NYSE: GS) – something that seems likely under the Obama proposal.

On the other hand, Paul's bill appeals to those like myself, who believe the Fed has consistently run an over-expansionary monetary policy since the mid-1990s.

The credibility of this theory has been undermined by the fact that inflation has been kept under wraps, but this month's consumer price index (CPI) and producer price index (PPI) figures – up 0.7% and 0.5% respectively – suggest that another surge in prices may not be far off.

As we go through the fall, the months of price declines in late 2008 that were caused by the collapse of energy and commodity prices will cause year-over-year inflation to trend higher. That, in turn, is likely to raise gold prices and Treasury interest rates, causing bond market panic and inevitably changing the public perception of the Fed's performance.

So if the Obama administration wants to give the Fed new powers and extend Chairman Ben Bernanke's term in office (which ends in January 2010) they had better do so quickly.

In any case, Paul's proposal to audit the Fed would bring central bank operations more under the control of politicians, who supposedly would be able to expose unpopular goings-on and unexpected losses in the Fed's operations. That's why it has attracted bipartisan support.

But rather than simply auditing the Fed or abolishing it, as Paul proposes, there is a much better case for giving the central bank a new mandate, whereby its obligation to maintain monetary stability is given precedence over all other obligations.

Under the Full Employment Act of 1978, it has a dual obligation to maintain employment and monetary stability. A new mandate that prioritized monetary stability would force the Fed to follow the policies of former Federal Reserve Chairman Paul Volcker. That would mean keeping interest rates well above the rate of inflation, thereby favoring savers over borrowers.

As investors, we should thus oppose the Obama administration's plans for the Fed, which seem likely to perpetuate the rent-seeking of Wall Street's biggest banks. We should also be suspicious of Paul's bill to audit the Fed, since that would bring it more closely under the control of elected politicians. History has shown that politicians cannot be trusted with the ability to create money out of thin air.

Instead, we should back plans to pass legislation that "Volckerizes" the Fed on a permanent basis, making monetary policy sound, eliminating the risk of inflation, and raising the rates we earn on all of our savings to a level that pays us adequately for providing banks and other borrowers with our money.

In the end, the ability to earn decent returns on savings and keep the result is the most important capitalist freedom of them all.

News and Related Story Links:

• Money Morning:
  Obama's Financial System Overhaul Would Give the Fed Broad Powers Over Wall Street

• Money Morning:
  Will Week of Controversy Undermine Financial System Overhaul?

• House.gov – Ron Paul's Speeches and Statements:
  Abolish the Federal Reserve

• Wikipedia:
  Regulatory Capture

• Wikipedia:
  Public Choice Theory

• Money Morning:
  With Inflation on the Horizon, Gold Prices are Ready to Rally