Opinion and Federal Reserve Bank and Economic Analysis

HICKS: Debate rages on about role of Federal Reserve

May 5, 2012

This week saw a viral video release of a debate between U.S. Rep. Ron Paul and Princeton economics 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.

Krugman and Paul debated the efficacy of the Federal Reserve system. Paul wants it abolished and the nation returned to the gold standard. Krugman wants the Fed to exercise a more activist role. They are both wrong; both options carry huge risks and uncertain benefits.

No doubt, Krugman recognizes that the most recent recession was, at least in part, aided by the Federal Reserve’s keeping interest rates too low. So when Paul criticizes the hubris of the Fed’s having perfect knowledge of what interest rates ought to be, he is right.

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 the need to fool some share of economic actors—something I think is a diminishing prospect in today’s economy.

A more potent argument against the activist stance Krugman advocates 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.

To no surprise, it hasn’t been able to do both (but has 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 obvious concerns about the structure, mandate and performance of the Federal Reserve, Paul’s recommendations are wrongheaded in the sense that they won’t achieve what he thinks they might.

Without the Fed, 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. Can you 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, Paul’s proposal to “End the Fed,” as his eponymous book argues, makes perfect sense. And 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: How much better does the Fed need to understand bubbles? What steps can be taken to identify, predict and prevent these bubbles? And what steps can the Federal Reserve take to limit their damage?

Paul and Krugman need not be part of that discussion.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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