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Reining in the U.S. Fed

Congress created America’s current central bank the Federal Reserve System in 1913. As with all central banks its role ultimately is determined by the political process.

The Fed is tasked with more than simply issuing and maintaining the value of the dollar: the world’s reserve currency. Under the 1978 the Humphrey-Hawkins Full Employment and Balanced Growth Act it Fed must promote price stability and maximum employment. It also regulates banks, polices against systematic risk in the financial system and provides services to banks including check, ACH and wire transfer processing.

When men control the money supply there is a danger they will run the printing presses, creating more money to meet the political and economic exigencies of the moment.

Money matters enormously. It serves as a medium of exchange, a store of value and a unit of account. When central banks debase money they undermine each of its functions.

Since 1971 when President Nixon severed the final link between the dollar and gold, the U.S. hasn’t had even a fig leaf of having more than a fiat currency.

Fed Chairman Ben Bernanke is obsessed with the possibility of deflation. In a 2002 speech “Deflation: Making Sure “It” Doesn’t Happen Here” citing Milton Friedman’s famous “helicopter drop” of money, he vowed to rain money on the economy in the event of a liquidity freeze, earning the sobriquet “Helicopter” Ben.

President Obama too favors easy credit and a weaker dollar. His Fed appointments have been doves. He reappointed Chairman Bernanke, and appointed San Francisco Fed president Janet Yellen as Bernanke’s number two and regulator Sarah Raskin to the Fed board.

Under Bernanke the Fed is attempting to revive a stagnant economy, rather than simply being the guardian of the dollar.

The Fed’s balance sheet mushroomed from $939 billion to $2.375 trillion Since August, 2008. Creating $1.4 trillion diminishes the value of existing dollars, punishing saving and creditors, foreign and domestic.

The Fed has pursued a policy of “quantitative easing” meaning it prints money to buy assets. In Bernanke’s first round of “quantitative easing” (QE1), the Fed purchased debt from Fannie Mae and Freddie Mac, U.S. Treasurys and mortgage-backed securities.

Attempting to stimulate a still moribund economy, the Fed is embarked on a second round of “quantitative easing” buying $600 billion in U.S. Treasurys, creating money and monetizing government debt, which is a stealth tax on everyone holding dollars.

The central bank has kept the Fed funds rate – the interest rate at which banks loan deposits at the Fed to other banks, between 0 and .25%, meaning the real interest rate is negative, since January, 2008.

Printing dollars and suppressing short-term interest rates weakens the dollar. Since January, 2009 the St. Louis Fed’s trade-weighted dollar-value index against a broad group of U.S. trading partners declined 10%. Against gold the dollar depreciated 54%.

Lo, China is buying gold instead of US Treasurys. It imported 209.7 metric tons of gold in the first 10 months of 2010, a 500% yoy increase.

The ability to debase the world’s reserve currency at will makes Bernanke one of the most dangerous men on earth.

An overvalued dollar and insufficient liquidity are not what ail the US and global economies. Notwithstanding easy Fed credit and more than a trillion in unused bank reserves, the U.S. economy continues to languish in the doldrums. In November the headline unemployment rate was 9.8%. The U-6 rate was 17%. The best measure however of the employment situation is the employment-to-civilian-population ratio which hit a 25 year low at 58.2%. It’s been in free fall since 2008.

Another binge of printing dollars is not the answer. The Fed should stick to maintaining a strong dollar.

Fiscal policy is the problem. Cutting marginal tax rates, ideally eliminating the capital gains and corporate taxes, rolling back punitive regulation, vigorously promoting cheap and reliable energy, championing free trade, promoting free labor markets rather than unionization, and steadfastly upholding the rule of law rather than the politicization of law enforcement, would trigger robust economic growth. President Obama has been on the growth-suppressing side of every one of these issues.

Bernanke is mulling yet another round of quantitative easing (QE3). The Fed could buy more mortgage-backed securities, US Treasurys or even state bonds. All would further debase the dollar. Buying state bonds however would be uncharted territory, and profoundly dangerous.

Many U.S. states are de facto bankrupt. Total unfunded pension liabilities are over $3 trillion and $574 billion respectively for state and local governments. On top of the current year gimmicked $6 billion budget hole, California faces a projected $19.3 billion gap for the 2011-12 fiscal year, according to the Legislative Analyst’s Office, meaning the looming deficit is probably at least $25 billion. With $500 billion in unfunded pension liabilities and $88 billion outstanding debt the erstwhile Golden State is on the brink of fiscal Armageddon.

In 2011 it’s likely California and perhaps Illinois and New York will go to Washington hat in hand. While Obama might be inclined to bail out profligate blue states, it is unlikely Congress would go along. The Fed however is another matter.

California’s $1.85 trillion economy is the world’s 8th largest. The central bank could decide the largest state in the union’s woes posed a systematic risk and buy its bonds.

If the Fed bailed out improvident spendthrift California, it would create a nationwide nuclear moral hazard. Fiscal discipline, such as it is, at the state level, would be gutted.

Bankruptcy is the only thing that will jolt California to reform. University of Pennsylvania law professor David Skeel argues Congress should enact of new bankruptcy chapter for states. California’s principal creditors are its bondholders and unionized employees. Bankruptcy would force California to scale back its bloated government and public-sector employees’ rich compensation and pension packages. The state’s bondholders took a risk. They should take a haircut.

The political discourse on monetary policy is changing.

World Bank president Robert Zoellick weighed in in favor of a new international monetary regime compassing the dollar, euro, pound, yen and renminbi, and, importantly, considering gold as a reference point.

Populist conservative Sarah Palin channeling economist Larry Kudlow sounded a clarion alarm over Bernanke’s “QE2.”

Former Fed Chairman Alan Greenspan criticized Bernanke noting “(Gold is) the canary in the coal mine to keep an eye on. It is a signal there is a problem with respect currency markets globally.” Gold has appreciated a whopping 391% against the dollar since January, 2000.

St. Louis Fed president James Bullard said he would be “okay” with Congress eliminating the Fed’s dual mandate

The Fed’s underpricing credit from 2001 to 2005 was a principal cause of the housing bubble, overextension of credit and subsequent crash. Bernanke’s prescription of more easy credit and dollar creation are sowing the seeds of another crisis. It is high time Congress reined in the Fed.

On November 16th Congressman Mike Pence introduced H.R. 6406 which would strip the Fed of its mandate to promote maximum employment, restricting it to maintaining price stability. Senator Bob Corker promises a companion bill in the Senate.

Congress should also prohibit the Fed from bailing out state and local governments and link the dollar to gold or, at a minimum, mandate the Fed use gold and perhaps other commodities as an inflation reference.

President Obama is a soft-money man. Whether Obama would sign legislation circumscribing the Fed’s role is doubtful. Nonetheless, it’s worth a fight.

A sound dollar and market interest rates are vital to sustainable growth and the health of the US and global economies.

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