Arnold Kling  

Should the Fed be Audited?

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I want to make a few comments on this issue, which David has touched on

On balance, I think I would support auditing the Fed.

1. The conservative case against auditing the Fed is that it will reduce the Fed's independence and hence lead to inflation. That one strikes me as weak. In a democratic society, if the people want inflation, then they will have it. The reason that we have not had much inflation over the past 25 years is that Gerald Ford and Jimmy Carter did not get re-elected while Ronald Reagan did. Politicians learned something about popular preferences from those results.

However, keep in mind that I am a non-monetarist. I tend to see inflation as a fiscal phenomenon. That is, the pressure to inflate comes from deficits. So I could see the U.S. running into inflation troubles in the next decade, even if the Fed remains "independent."

2. I tend to see the assumption that experts know best as the core belief of those who champion the state over individual liberty. (In some sense, this is my basic take-away from Sowell's A Conflict of Visions.) It would fit with this core belief to build up a myth of the Fed as a set of experts so wise and so important that they must be kept insulated from question or scrutiny. Those who instead are inclined toward a Hayekian view, that expert knowledge is trivial compared to the wisdom embedded in local knowledge and tradition, will be reluctant to swallow the myth of the Fed's precious expertise.

3. I perceive signs of what Danny Kaufmann calls "cognitive capture" of the Fed by the banks that it regulates. That is, the Fed sees the world through the eyes of the executives at large banks.

For example, here I summarize the financial crisis as a combination of bad bets, excessive leverage, domino effects, and 21st-century bank runs. The bad bets and excessive leverage represent bad decisions made by banks, with the full knowledge and support of regulators. The other two effects represent loss of confidence.

Everything that the Treasury and the Fed have done in the aftermath of the crisis has focused on the "loss of confidence" aspect, rather than on the "bad decisions" aspect. The decision to prop up the banks reflects a view that once confidence is restored they will be just fine. The regulatory reform proposals ignore the fundamental causes of bad bets and the various incentives to build up excessive leverage. Instead, they envision a systemic risk regulator that somehow notices when confidence might become fragile.

This emphasis on "loss of confidence" is suspicious. I myself emphasize bad bets and excessive leverage, although I think the other factors did play a role. I also keep in mind that every businessman who has ever failed has blamed his failure on loss of confidence. Show me a busted oil wildcatter who doesn't think that the banks cut him off just before he was about to strike it rich. Show me a start-up founder who burned through his stake who doesn't think that his investors lost their nerve in spite of all the progress he was making. Show me a retailer or real estate developer who doesn't think he could have hung in there if the banks had been more reasonable about stretching out his loans.

They all think they failed because investors lost confidence. Bankers are no different. The audit that I would like to see is one that examines how the Fed determined that the financial crisis should have been treated as consisting largely of an extraordinary loss of confidence, rather than consisting of mostly bad bets with excessive leverage.



COMMENTS (15 to date)
pushmedia1 writes:

Could you explain the economics behind your statement, "So I could see the U.S. running into inflation troubles in the next decade, even if the Fed remains 'independent'."?


isaac writes:

On point 2, this Christina Romer paper shows that in fact the Fed does--or at least used to--have better information about the future state of the economy than private actors.

Superheater writes:

I am in favor of auditing the fed, simply because I don't believe secrecy and unaccountability serve a free society. That having been said, an audit is not a magic bullet.

How are we to audit the fed? Are you in favor of a financial statement audit, which will produce nothing other than the an opinion on the effectiveness of the fed's internal controls (explicitly if we use Sarbanes-Oxley standards and only implicitly if we don't follow those standards) and the fairness of its financial statement assertions? How about a performance audit using GAO "yellow book" standards? The latter allows for estimates of the effectiveness and efficiency of how the fed meets its objectives.

An audit cannot answer the two questions people need answered most: should there be a fed and if so-what should be its mission and the powers given it to achieve that mission.

Gamut writes:

isaac:

All I see in that paper is the obvious -- the fed knows better what it's actions will be down the line -- and the rest of us have to sit around and wait to see what it decides. The market cannot reliably predict inflation because it cannot reliably predict fed policy. After all, deficits or no deficits, it still makes a difference who the decisions will be made by, and who they're beholden to. This sort of information is probably available, but not reliable enough to use when placing bets on the table.

Ms. Romer ignores that fact that the fed is acting on behalf of a small number of people of whom each has a disproportionately large influence on the outcome in mind. The martket is a massive number of people, most of whom have absolutely no influence on the outcome. Seems strange to compare the actions of the two. Like comparing the performance of fed and public predictions of government contract recipients.

Marcus writes:

"However, keep in mind that I am a non-monetarist. I tend to see inflation as a fiscal phenomenon. That is, the pressure to inflate comes from deficits."

Isn't that just two different sides of the same coin? (no pun intended)

Amaturus writes:

One of the central issues I see is that a lack of real education about the Fed has enabled quite a bit of dishonesty from the pro-audit crowd. You don't have to look far to find someone to claim that the Fed has never been audited, despite the fact that Fed operations are audited by a private accounting firm in accordance with Section 11B of the Federal Reserve Act. The GAO also has auditing authority over the Fed in many circumstances. Of course, operational transparency isn't Paul's point, he wants sunshine on monetary policy decisions. It's certainly legitimate for the public to want to know how such major policy decisions are made, but the problem is that we already know. The FOMC publishes its meeting minutes online pursuant to FOIA. This is transparency. What the 'Audit the Fed' bill seeks is control. For as much criticism as we should have for Bernanke, I think he has a legitimate concern when he suggests that the Rep. Paul's bill "would effectively be a take-over of monetary policy by the Congress [and] a repudiation of the independence of the Federal Reserve, which would be highly destructive to the stability of the financial system, the dollar and our national economic situation." I foresee no good outcome from more political intervention.

8 writes:

The Fed itself is "highly destructive to the stability of the financial system, the dollar and our national economic situation." Would Barney Frank do worse? Undoubtedly. But thus far no one wants Barney Frank in charge, they just want full transparency.

Right now the Fed is similar to the post-WWII CIA. It has a budget and operations, but what it does with the money and material, or more specifically, who it does it to, is unknown.

q writes:

denying the fed secrecy denies them the ability to act in an informationally sensitive manner.

i think we should have this transparency: open the books to everyone to see but with a one year lag.

i think we should insist on this for any tbtf banks as well.

S Andrews writes:

Barney Frank is for maintaining the secrecy of the Fed.

"Fed Independece" is the biggest load of BS I have seen in recent memory.

Justin P writes:
Those who instead are inclined toward a Hayekian view, that expert knowledge is trivial compared to the wisdom embedded in local knowledge and tradition, will be reluctant to swallow the myth of the Fed's precious expertise.


Count me with they Hayekians. The so called "experts" failed to see the road we were heading towards, they failed to see the housing bubble and they failed to see the long term implications of their fiscal and monetary policies. What credibility do they have left? How long and how much misery do the "experts" have to inflict on the people, before people will start to see them for what they really are?

Not as a slight to you Dr. Kling, but most of the people that keep on advocating "believe the experts" are those that are the "experts" or hope to be one.

As Gamut said above, (paraphrasing) why should we believe in the prognostication powers of the so called experts when they are in a position to make their prognostications come true, at all costs. If they Fed see's inflation coming, by God they will see it, even if they have to do it themselves.

The whole idea of a independent Fed is ludicrous. Watch Bernanke dance his little jig for Obama when it comes time to renew his chairmanship, that should blow away all notions of "independence" of the Fed.

Justin P writes:


mostly bad bets with excessive leverage.

Who made those bets?

10 points if you said: experts.

Don Lloyd writes:

I'm curious as to how we can see comments posted yesterday in response to an article that won't be published until Wednesday, according to the header.

Regards, Don

Hi, Don.

I have revised the date to today.

One possibility that Arnold hand-typed the date in anticipation of publishing it on Wednesday, but then decided to publish it earlier. The hand-typed date overrode the actual publication date. There is a comment that looks like it was posted beforehand, but that's just 'cause I don't know the actual time of publication yesterday.

There are probably other possibilities; but anyway, it's fixed now. Sorry for the temporary confusion.

Lauren

Ivan writes:

Arnold, if you are inclined toward Hayekian view, and doubt experts' ability to centrally manage economy in all, including monetary area, wouldn't be in that case abolishing Fed altogether an appropriate policy from your point of view? If people themselves really better coordinate their business than experts, that obviously would mean that gold standard is vastly superior than central bank regime. If you think it is not, then I cannot see the real substance behind your critique of expert-governed monetary system.

In that regard, it is relatively minor point whether Fed policy is driven by secretive group of gurus-experts, or by more open and non- secretive group of gurus-experts, some of them auditing the others. It is the nature of the task (political governance in the monetary field) and not the group that carry out the task what is the main problem. Your main point seems to be that monetary policy was bad, and should be improved. But, that is only a variation on the theme - you think that better use of expert knowledge is needed for better results in monetary policy, what is far cry from "Hayekian" idea against expert knowledge in general, you cited in the beginning.

Monte writes:

We should either swallow the FED or spit it out. Congressional oversight would improve transparency while subjecting it to further political influence.

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