Ron Paul Wants to End the Fed

As explained in Central Bank Design, a central bank needs independence from politicians, because they can wreak havoc on the economy by manipulating the money supply for their own expediency, as has happened so often in the past.

There are always politicians who want to meddle with the central bank. One such politician is Ron Paul, a libertarian serving as a Republican, who wrote a book called End the Fed that was published in 2009, in which he advocated, among other things, the gold standard so that money cannot be created out of "thin air". He believes that the Fed was responsible for the recent credit crisis, for keeping interest rates artificially low, and even for the government's bailout of banks and other businesses.

Ron Paul will, in 2011, become the chairman of the Subcommittee on Domestic Monetary Policy and Technology on the Financial Services, which oversees the Federal Reserve, the U.S. Mint, and interacts with other financial organizations such as the World Bank.

On February 26, 2009, Ron Paul introduced HR 1207, the bill to audit the Federal Reserve: “I rise to introduce the Federal Reserve Transparency Act. Throughout its nearly 100-year history, the Federal Reserve has presided over the near-complete destruction of the United States dollar. Since 1913 the dollar has lost over 95% of its purchasing power, aided and abetted by the Federal Reserve's loose monetary policy. How long will we as a Congress stand idly by while hard-working Americans see their savings eaten away by inflation? Only big-spending politicians and politically favored bankers benefit from inflation.” http://www.ronpaul.com/legislation/audit-the-federal-reserve-hr-1207/

However, all modern economies must be able to create and destroy money when it is necessary and this is one of the main purposes of the central bank.

An economy can only run efficiently with an optimal supply of money — no more or less. If an economy would rely on the gold standard, then it would depend critically on the amount of gold that it has. To see what happens when a country cannot control its own money supply, one only has to look at the European countries of Greece, Ireland, Portugal, and Spain. Although these countries cannot print money out of thin air, they, nonetheless, got deeply into debt, and because they cannot manage their own money supply, they will have to both raise taxes and cut spending for the foreseeable future, which will have a devastating effect on their economies.

Gold also has the disadvantage of being heavy and not easily transported. But maybe Ron Paul thought that the currency should be backed by gold. But then someone would have to monitor the printing of currency to assure that there was enough gold to back the currency. After all, this was a common cause of financial panics and busts in the 18th and 19th centuries in America. Banks would print more money than they had specie (gold and silver coins) for, but the public didn't find out until it started withdrawing their money from the bank and found that they did not have enough.

What about electronic payments? While one may argue that electronic money could be based on gold, who would make sure that there was a one-to-one correspondence?

And what caused the credit crisis? Not the Fed. The credit crisis began as a flaw of financial engineering — specifically, the creation of mortgage-backed securities (MBSs) that allowed the loan originators to pass on their credit default risk to investors of the securities. The loan originators earned loan origination fees and servicing fees for their loans, and hence, made more money by originating more loans. Eventually, to keep their profits coming, they started to extend loans to people who could not really afford them. Although the loan originators were in the best position to assess the creditworthiness of the borrowers, they were unconcerned about their credit risk because they were making their money from the loan origination fees and the servicing fees — the buyers of the mortgage-backed securities would suffer from any defaults, which initially didn't worry them because they thought real estate prices would always go up and the securities had the blessings of the credit rating agencies.

Inexplicably, banks bought most of these MBSs. When it became evident that they were not as financially sound is assumed, they started to buy protection in the form of credit default swaps. As more and more borrowers defaulted, banks stopped lending money to other banks because they did not know how much of these deteriorating MBSs that other banks held. Hence, the money supply severely contracted, banks stopped lending to anyone including businesses, to protect what they had. And because the money supply had contracted, many people were losing their jobs. Hence, banks stopped lending to people, who also held onto whatever they had, which greatly decreased consumption, and further contracted the economy.

The Federal Reserve had nothing to do with this scenario — it was allowing loan originators to pass on the credit default risk to investors. When loan originators are forced to assume some of the credit default risk, they are much more careful in selecting their borrowers. In Europe, there were securities similar to MBSs called covered bonds, none of which, unlike the MBSs, went bad. Of course, better regulation of the financial industry would go a long way to prevent these problems, but, alas, the Republicans are against regulating the financial industry, and Ron Paul happens to be one of them.

Furthermore, it was the Republicans, under President Bush, that initiated the bailouts. Again, the Federal Reserve had nothing to do with it.

Ron Paul laments that since 1913, when the Fed was created, the dollar has lost 96% of its value. "The Federal Reserve is the chief culprit behind the economic crisis its unchecked power to create endless amounts of money out of thin air brought us the boom and bust cycle and causes one financial bubble after another." (http://www.ronpaul.com/legislation/audit-the-federal-reserve-hr-1207/)

Some inflation is necessary because the money supply has to grow with the economy, otherwise it will be stifled by deflation, but it is impossible to know exactly how much money to create, so it is better to overestimate the amount of money needed, which will stimulate the economy, rather than underestimating the amount which would cause a contraction of the economy. The inflation rate is measured by the Consumers Price Index, which allows the Fed to adjust the money supply to keep inflation low. The federal government also benefits from inflation which helps to keep taxes lower.

The fact is, every country in the world has a central bank, and none of them are on the gold standard, nor will they ever be. Being able to control the money supply is a critical factor to an efficient economy. A gold standard would not have prevented the credit crisis, but it would almost certainly prevent the economy from recovering in a reasonable time. In his book, Ron Paul predicted that the credit crisis would continue on and on, but even now, as I write this on December 14, 2010, the economy is getting stronger by the day. While the central bank can easily create money, it can also easily destroy it, and so a central bank is needed to provide the optimal amount of money for the economy.

It is true that the regulation of the money supply has to be carefully controlled, which is why the central bank has to be independent, transparent, accountable, and run by economists and bankers who know how the economy works, not by politicians seeking the limelight or trying to manipulate the money supply for their own political expediency. Not that Ron Paul wanted to do this, but plenty of politicians would certainly like to do so.

Central banks are absolutely necessary to today's economies, which is why there will be no end to the Fed.