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May 7, 2012

A Debate on the Federal Reserve

This week saw a viral video release of a debate between Representative Ron Paul and Professor Paul Krugman. Their debate was truly academic, in the Dick Vitale sense of the word, meaning it was entertaining but irrelevant. There is an important debate in there somewhere, and I am going to help dig it out.

Dr. Krugman and Dr. Paul debated the efficacy of the federal reserve system. Dr. Paul wants it abolished, and to see the nation return to the gold standard. Dr. Krugman wishes the Federal Reserve to exercise a more activist role. They are both wrong in the sense that either policy carries with it huge risks and uncertain benefits.

Dr. Krugman recognizes no doubt that the most recent recession was, at least in part, aided by the Federal Reserve keeping interest rates too low. So, when Dr. Paul criticizes the hubris of a federal reserve system having perfect knowledge of what interest rates ought to be, he is right. Dr. Krugman wants the Federal Reserve to be more active in expanding the money supply and increasing demand for goods and services. To do so, the Fed needs to actually fool consumers and businesses into believing that demand is real and not based simply on inflationary pressures. There are reasonable arguments for this, but they all have in common this need to fool some share of economic actors—I think that is a diminishing prospect in today’s economy. A more potent argument against the activist stance Dr. Krugman argues is that it is based on faulty legislation. The Employment Act of 1946 essentially required the Federal Reserve to do two mutually exclusive things: promote full employment and keep inflation low. Unsurprisingly, they haven’t been able to do both (but have on occasion, done neither) over the past half century. It is again time to think seriously about the role of the Federal Reserve.

Despite some really obvious concerns about the structure, mandate and performance of the Federal Reserve, Dr. Paul’s recommendations are wrongheaded in the sense that they won’t achieve what he thinks they might. Without the Federal Reserve, the monetary authority of the United States devolves wholly to the U.S. Treasury. This proposal has some way to go before it could be considered simply naïve. Imagine the world of monetary policy run by cabinet appointees? If you are pleased with the thoughtful, steady and reliable regulatory hand of the Environmental Protection Agency these past few years, Dr. Paul’s proposal to “End the Fed,” as his eponymous book argues, makes perfect sense. The gold standard argument is an equally splendid idea because gold is possessed of such intrinsic value (that’s a joke).

The real debate we now face is not over ending the Federal Reserve or extending its activist role. The relevant questions are:  (1) How much better does the Fed need to understand bubbles, (2) What steps can be done to identify, predict and prevent these bubbles and (3) What steps can the Federal Reserve take to limit their damage?  Dr. Paul and Dr. Krugman need not be part of that discussion.

Link to this commentary: https://commentaries.cberdata.org/622/a-debate-on-the-federal-reserve

Tags: law and public policy, budget and spending, federal reserve


About the Author

Michael Hicks cberdirector@bsu.edu

Michael J. Hicks, PhD, is the director of the Center for Business and Economic Research and the George and Frances Ball distinguished professor of economics in the Miller College of Business at Ball State University. Note: The views expressed here are solely those of the author, and do not represent those of funders, associations, any entity of Ball State University, or its governing body.

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