What If Ron Paul Really Killed the Fed?

BOSTON ( MainStreet) -- The most radical proposals to surface during this year's presidential primaries are Congressman Ron Paul's dual efforts to abolish the Federal Reserve and return the Unites states to a monetary standard backed by gold.

Should he prevail in November, and make good on his mission, how would that feat be accomplished and, perhaps more importantly, how would it affect average Americans?
Congressman Ron Paul wants to abolish the Federal Reserve and return the Unites states to a monetary standard backed by gold. The outcomes of those actions are in doubt.

It depends on whom you ask.

Economists -- many freely admit it -- have a spotty record when it comes to prognostication. There are diverse schools of thought within economics, and it is hardly an exact science despite the seeming precision of its mathematical formulas.

Abolishing the Federal Reserve is to take less than a year during a Ron Paul presidency. It would start with an audit of the Fed and end with the Treasury Department assuming its duties, overseeing a monetary supply backed by gold. (Silver has been touted as a potential secondary monetary commodity).

Paul is not the only high-profile figure who has championed an end to the Fed.

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The late Nobel Prize-winning economist Milton Friedman proposed, for instance, that the Federal Reserve could be eliminated and replaced by a computer control the nation's money supply without the interference of politics and emotion and at a shrewd and steady rate.

Across the political aisle from Paul -- though perhaps so far to the left it completes a full circle back to his libertarian brand of conservatism -- Ohio Democrat Dennis Kucinich (recently defeated in his home state's primary election) has floated his own such plan. A bill he filed in September, the National Emergency Defense Act, sees the termination of the Fed and its policies as a move necessary to improve employment, restore homeownership as a "safe harbor for savings," ensure the affordability of higher education and spark national infrastructure projects.

"A debt-based monetary system, where money comes into existence primarily through private bank lending, can neither create, nor sustain, a stable economic environment, but has proven to be a source of chronic financial instability and frequent crisis, as evidenced by the near collapse of the financial system in 2008," the bill says.

The Kucinich legislation promises that abolishing private money creation "can be achieved with minimal disruption to current banking operations, regulation and supervision." The plan would create a Monetary Authority, through the Treasury Department, based on "a governing principal that the supply of money should not become inflationary or deflationary in and of itself." Its policy goals should be "maximum employment, stable prices and moderate long-term interest rates."

The following is a look at how abolishing the Federal Reserve might succeed, or fail in four areas:

Inflation

Best-case scenario: Inflation is among the most damaging impacts of Fed policy, Paul says. Since "more money equals less value" -- Paul also blames "steadily eroding purchasing power" on Fed inflationary policies and calls it "a real, if hidden, tax imposed on the American people" -- returning the rise and fall of prices to free-market forces, rather than artificial manipulation, is a cornerstone of his economic plan. The Fed should have only one mandate, in his view: price stability.

"There is only one possible solution to the inflation problem: Stop creating money out of thin air," he says in campaign literature. "But we're already in such a mess that the only way to have a real impact on the money supply is to increase interest rates so that people pay back their loans and borrow less money from the banks, which decreases the amount of money in circulation."

But since "higher interest rates might very well crash the economy," he says, "the Fed's current 'solution' to overcoming inflation is creating even more of it."

Worst-case scenario: Americans could face the flip side of inflation, rampant deflation. That, in turn, would decrease wages over time.

Paul and his supporters assert that things would even out and that wages and prices would be in concert with each other, causing no actual loss of buying power -- but the strength of the dollar would likely increase buying power. For American's stuck with debt on homes, cars and other big-ticket items, these commitments could become very difficult to pay down barring a complex revaluation process that would need to take place nationwide.

In the early stages of the transition, consumers may react to shrinking wages by pulling back on spending, even if their actual dollars are worth more.

Political influence

Best-case scenario: Political influence on the Fed, in particular by the presidential administration appointing its chairman, would be removed. A stable currency and sound monetary policy via a Monetary Authority would prevail over political maneuvers that may prove damaging in the long run, even if popular with the electorate in the short term.

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"The exercise of nonpolitical control by the United States government over the money system has provided greater moderation in the supply of money and promoting the general welfare," the Kucinich bill reads. Therefore it mandates that no more than four members of the Monetary Authority it creates can be of the same political party.

Worst-case scenario: Putting monetary policy in the hands of the government leads to even more political influence. Legislators find loopholes, chip away at existing legislation, manipulate policy to their liking.

The Fed in its current state, at least officially, is independent. Shifting its duties to the Treasury Department would likely lead to rancorous politicking over who serves as secretary of the Treasury. Greater transparency, although noble, could lead to damaging, reactionary moves by corporations and stock market investors.

Perhaps more damaging to the security of the nation, the move to a gold standard once again could open the door to manipulation by foreign governments. China, already adept at manipulating its own currency to the detriment of the U.S., could also leverage its stockpile of gold to manipulate the U.S dollar or maneuver bond repayment to further bolster its own gold holdings, as could other nations with sizable, and growing, reserves of gold -- Russia and India. The gold-rich mines of African nations could lead to even more political upheaval on that continent.

Interest rates and credit

Best-case scenario: The Fed's low interest rates encourage borrowing, rather than saving, Paul says, with current low rates benefiting companies far more than consumers (with many companies still not dipping into cash reserves for spending or to spark hiring, despite that).

While Americans may benefit from lower interest rates for big-ticket items -- cars and houses -- the current environment has been destructive for fixed-income investors, in particular retirees on fixed budgets. Low interest rates also encourage long-term borrowing that, as evidenced by the housing market collapse, can be untenable.

In general, interest rates that are low through manipulation encourage the cyclical nature of "booms," bubbles and subsequent "busts" that hurt the economy, Paul says.

The Kucinich legislation provides for interest-rate ceilings. The annual percentage rate applicable to any loan could not exceed 8% on unpaid balances, inclusive of all charges.

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Worst-case scenario: Especially during the transitional, post-Fed period, there would be less liquidity and money available for institutions to lend. The impact on banking balance sheets could dry up credit lines, especially for the average consumer lacking the prioritized clout of corporations.

Even Paul admits there would be less credit under his plan, although he counter it would still be adequate and offset by steady economic growth.

A counterargument, however, is that taking away the ability of the Fed to cut short-term interest rates to spark borrowing could lead to sluggish economic growth.

"I think the Fed's actions by avoiding deflation, outright falling prices, is actually going to make people climbing out of their debt burdens over the next five to 10 years easier," said Josh Bivens, acting research and policy director of the Economic Policy Institute, at a Congressional hearing last February debating how monetary policy and job creation. "If you have a mortgage that is fixed at $150,000, and every other price in the economy starts plummeting around it, then all of a sudden your mortgage payment has just gotten a lot more onerous for you."

"By increasing the value of debt, again, you have a $150,000 fixed mortgage and all of a sudden your wage is 10% lower, all of a sudden you are more constrained by your nominal debt payments," he added. "And that will make the economy worse ... wage-cutting is absolutely not the way to get out of a recession."

Household finances

Best-case scenario: Without the Fed pulling the strings, job growth would be paced and steady, good news for households struggling amid high unemployment and layoffs.

"The history of the Fed has been that it has created boom-and-bust cycles in the economy ever since it began its existence," Thomas Diliorenzo, a professor of economics at the Loyola University's Sellinger School of Business, said during his testimony at the Congressional hearing. "And so, during the boom period, of course, it does create jobs, but the jobs that it creates, many of them are unsustainable jobs. I can recall hearing that Home Depot ( HD), when they laid off 7,000 people in one day, these were jobs that people had invested in, they invested their lives, their careers, and then the rug was pulled out from under them. That is the sort of thing that happens with what we call the artificial boom and bust created by the Fed's monetary policies."

In terms of personal finance, inflation is a killer for anyone trying to save for retirement. Portfolios need to assume, and beat, at least a 4% rate of inflation. Paul's assertion that inflation is created by our current monetary policy could mean that a wholesale change will make it easier to save and invest for long-term objectives.

Worst-case scenario: Without the guiding hand of the Federal Reserve, one that adapts to market conditions, a worsening of overall economic conditions would hurt average Americans far more than the temporary pain its policies might inflict.

During a speech in Westport, Conn., on March 1, Sarah Bloom Raskin, a Federal Reserve governor, defended Fed policy as it relates to savers and consumers.

"Critics of the Federal Reserve's accommodative monetary policy are correct that the low level of interest rates represents a strain on households who rely on income from interest-bearing assets; indeed, the flow of interest income that households earn on their savings has declined about one-fourth since the recession began," she said. But there's also a bright side: "Purchases of motor vehicles and other household durables can be financed more cheaply, and in many cases, households have been able to refinance their mortgages into lower-rate loans, freeing up income for other uses."

Raskin also made the case that "interest-bearing assets represent only a modest portion of overall household assets."

According to the Federal Reserve's Survey of Consumer Finances, less than 7% of total household assets are held directly in transaction accounts, certificates of deposit, savings bonds and bonds The bulk of household wealth is held in stocks, retirement accounts, business equity and real estate.

"For these other types of assets, rates of return depend primarily on the strength of the economy and how fast the economy is growing," she said. "Thus, these returns should be supported, over time, by the accommodative monetary policy that we have in place. Moreover, the Federal Reserve aims to keep inflation low and stable over time, which limits the risk to investors that high inflation will undermine the value of their savings."

Raskin doesn't believe that the extended period of low interest rates will discourage households from saving and, as a result, diminish the longer-run economic growth prospects of the U.S. economy.

"Households have a number of reasons to save in addition to their desire to earn interest," she said. "They need to be prepared for unexpected expenses and to rebuild the retirement nest eggs that were depleted by losses in equity and housing wealth during the recession. In fact, the portion of disposable income that households are saving has risen considerably since the recession began."

-- Written by Joe Mont in Boston.

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