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On November 19, the House Financial Services Committee passed an amendment to its financial reform legislation that would authorize the General Accountability Office (GAO) to audit all aspects of the Federal Reserve's operations. The amendment—sponsored by Representative Ron Paul, the libertarian Texas Republican whose book "End the Fed" was published this year—would remove previous limitations covering GAO audits of Federal Reserve monetary policy, lending, and certain supervisory activities. The amendment was also sponsored by Paul Grayson, a Democrat from Florida.
The Federal Reserve policy has not been perfect over the one hundred years since it was established in 1913, or over the past several decades. But if this portion of the financial reform legislation becomes law, it will adversely affect the US economy and financial system. It will induce greater caution in decisions by the Federal Reserve and financial institutions. Economic and financial volatility will increase as a consequence. International confidence in US economic policies and our currency will be damaged.
The bill's sponsors say it is aimed at making the Fed more accountable, and indeed institutions in a democracy must be accountable for their policies. Transparency helps to ensure accountability. However, if policy actions are to be efficient and effective, accountability cannot always be instantaneous, and transparency cannot always be complete and continuous. The challenge is to strike the right balance.
The Federal Reserve, like all central banks, makes monetary policy decisions in an environment of uncertainty. In reaching its decisions, the Federal Open Market Committee (FOMC)—which comprises seven members of the Fed's board of governors, the president of the New York Fed, and the presidents of four other regional banks—can never be absolutely positive that economic growth will slow, requiring lower interest rates, or that inflation will rise, requiring higher interest rates.
If in the future members of the FOMC know that, at the request of one or more members of the Congress, the GAO may issue a report second-guessing their monetary policy judgment within a few months of a decision, the danger would lie in their hesitating to act preemptively, increasing the risk of a costly error. In cases where the US economy does plunge into recession, the recession would be deeper if the Federal Reserve delayed too long. In cases where the economy does enter an unsustainable boom, the inflation in asset and other prices would rise higher and the subsequent bust would be bigger if the Federal Reserve keeps monetary policy too easy for too long. The resulting increased volatility in the real economy, financial system, and price level would reduce the long-term growth rate of the US economy as consumers and investors—foreign and domestic—become more defensive in the face of greater uncertainty about the course of the US economy. The international attractiveness of assets denominated in US dollars would decline, further increasing the volatility of the US economy and financial markets.
Decisions by financial institutions to borrow from the Federal Reserve would be similarly affected by the proposed legislation. If their names and the details of their supervisory reports subsequently are revealed by the GAO, banks will be more cautious in their lending decisions. They would cut back sooner on their lending to farmers, consumers, and businesses if they risk the stigma of identification by the GAO as having had to borrow from the Federal Reserve in the face of a need for short-term liquidity. If their decisions to lend to individual borrowers, some of whom as a matter of course would default, would be subjected to ex post scrutiny by the GAO, banks would limit their lending to only the most creditworthy borrowers.
None of this is to say that the central bank should be above scrutiny or second-guessing. On the contrary. But the record shows that the Federal Reserve should and does learn from its mistakes. Federal Reserve policies should be open to criticism by the Congress and the general public. Perhaps, in fact, the Congress and other critics henceforth should be more consistent in their attention to Federal Reserve actions and policies.
Thoughtful critics around the world agree that historians will give the Federal Reserve high marks for its aggressive, proactive, and imaginative responses to the economic and financial crisis since its outbreak in August 2007. The irony is that the Paul-Grayson amendment to the financial reform legislation implies the opposite conclusion.
The majority on the House Financial Services Committee that voted for the Paul-Grayson amendment on November 19 wants greater accountability from the Federal Reserve, but in rushing to judgment about the Federal Reserve's decisions over the past 27 months, it got the accountability balance wrong. If this provision in the financial reform legislation becomes law, the nation and the world will suffer the negative consequences.
