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 21^st-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.

In his comment on my previous post about auditing the Fed, Bob Murphy stated that he shared my concerns about the audit movement because he, like me, distrusts Congress. He criticized my view, though, that the Fed is actually more transparent than run-of-the-mill federal bureaucracies, writing:

However, I think you're wrong about the level of secrecy. If Congress asks the head of the EPA to tell them where they are spending billions of dollars, can the head of EPA just say, "No, I feel that telling you that would be counterproductive to our goal of protecting the environment"? Because that's what Bernanke told Congress last December.

In the comment section, I granted that I might have overstated, but now I'm not sure. The specific information that Bernanke has refused to give Congress is which banks have gotten money from the Fed and how much. The amount that AIG receives is readily available, as is the total amount loaned out through various facilities. For the Social Security Administration to have the same amount of accountability that Bob is asking from the Fed, it would have to state who gets social security checks and how much; or ditto with government-provided student loans, government-provided mortgage guarantees, etc. Whether we favor that level of disclosure or not, the point is that they don't disclose that.

Moreover, would an audit even reveal the information Bernanke is refusing to provide? The auditors would have access to it, but would it appear in their report? I don't know.

The Treasury Department issues monthly reports on debt issued, and in which denominations. The Fed, however, reports changes in its balance sheet on a weekly basis. Are there any other federal agencies whose operations you can track anywhere near as closely?

I hasten to add that I never would sign the petition defending the Fed's independence that many of my colleagues at other universities, including my mentor, Harold Demsetz, signed. I favor the Fed's independence. But the economists' statement went much further. The most egregious line:

The democratic legitimacy of the Federal Reserve System is well established by its legal mandate and by the existing appointments process.

I think the Fed is illegitimate.

Four of us give our reactions:

Robert Litan
Lawrence J. White
Richard Posner
and yours truly.

I offer eight "audit findings" on the report, including

1. The Report does not offer a comprehensive analysis of the causes of the financial crisis.

2. The Report ignores the role played by housing policy in creating the financial excesses that preceded the crisis.

3. The Report ignores the role played by regulatory capital arbitrage in creating an unstable financial system.

4. The Report calls for a systemic risk regulator notwithstanding the probability that such an agency would be subject to the groupthink that caused the Federal Reserve, the International Monetary Fund, and other government agencies to misconstrue financial innovations as improving the distribution of risk in the financial system.

At various times in my life I have been in all 5 quintiles of family income distribution, and yet I have always felt like I was in the same "class," and I have never felt like my happiness had anything to do with how much income I was making.

Surprisingly, most marketers have no idea how well the Central Six can predict consumer behavior.  The typical consumer behavior textbook includes a large section devoted to individual differences, but no discussion of general intelligence and the Big Five factors.  Rather, the focus is on diverse "factors" that may influence consumer decision making: wealth, time, knowledge, attitudes, values, self-concepts, and motivations.  The fact that the Central Six efficiently predict individual variation across all these factors remains unknown or ignored... Marketers likewise pay attention to "demographic variables" - age, sex, ethnicity, socioeconomic status - without taking into account their correlations with the Central Six.

So, most current research on marketing and consumer behavior relies on a chaotic grab bag of outdated theories and unreliable findings.  The potent effects of general intelligence are hidden behind its causal effects, empirical correlates, and politically correct euphemisms: education, class, socioeconomic status, consumer knowledge, "cognitive resources," and "cultural capital." Often, marketers think they are studying the effects of class, race, or religion on consumer decision making when they are actually studying the effects of intelligence, which shows different average scores, for whatever reasons, across different classes, races, and religions.  The potent effects of the Big Five are likewise hidden behind their correlates and euphemisms: attitudes, motivations, self-concept, values, lifestyle, culture.  Here, marketers think they are studying the effects of sex, age, or political beliefs, when they are actually studying the effects of openness, agreeableness, stability, or extraversion, which also show different average scores across males and females, young and old, liberals and conservatives.

The Congressman I admire most, Ron Paul, is advocating that the Federal Reserve Bank be audited. Is this a good idea? I think there's one obvious plus and there are two less-obvious minuses.

The obvious plus is that an organization of bureaucrats that is used to not giving much information to Congress and to Americans in general would be required to open its books. Whenever a bureaucrat is humbled, all other things equal, that's a good thing.

Now, to the minuses. The first minus flows directly from the one plus. Much as some of us might enjoy seeing unelected bureaucrats squirm, the purpose seems to be, and the likely result would be, to make the Fed less independent. But a lot of research in the last 15 years or so, including work done by Alberto Alesina and Larry Summers [pdf.], finds that the more independent a central bank is, the lower is its inflation rate. So an ironic effect of auditing the Fed and reducing its independence could well be to raise the inflation rate.

The second minus is related to the first. The whole idea of a having one federal agency audit another typically excites mainly inside-the-Beltway people. Remember that Ron Paul will not be conducting the audit and that the "consumers" of the audit, Congress, are not 534 Ron Paul clones. It could not only lead to the first minus above, but could distract from discussion of more serious reforms such as ending the Fed.

One final point that is neither a plus nor a minus. The Fed, for all its secretiveness, is by no means the most secret government agency in Washington. I'm not talking about the obvious deep-cover organizations like the CIA or the National Security Agency. I'm talking about rank-and-file agencies like the Treasury Department, the EPA, the Department of Energy. Are they required to provide less information about their activities than the Fed is now required to provide? It's not obvious to me that they are.

Postscript: I enjoyed the interview that an anonymous (of course) interviewer with The Economist did with Ron Paul. My favorite line comes at the 10:24 point when they are discussing a world without the Fed.

The Economist: But who would control interest rates?
Ron Paul: The market. What's so strange about that?

From the Boston Globe.

The 10-member commission, which includes key legislators and members of Governor Deval Patrick's administration, voted unanimously to largely scrap the current system, in which insurers typically pay doctors and hospitals a negotiated fee for each individual procedure or visit. That arrangement is widely seen as leading to unneeded tests and procedures.

Instead, the group wants private insurers and the state and federal Medicaid program to pay providers a set payment for each patient that covers all that person's care for an entire year and to make the radical shift within five years. Providers would have to work within a predetermined budget, forcing them to better coordinate patients' care, which could improve quality and reduce costs.

Maybe the commission's proposal is a step in the right direction. Even if it is, I would suggest that perhaps no expert knows how to design the health care system. We may need a lot of trial and error. Government takeover means that you try something new every few years...maybe. Your choices are limited because entrenched interests preclude many options.

With markets, trial and error takes place continuously. A lot more things get tried. Failure gets weeded out more ruthlessly.

Of course, no one on the Left believes that. The core belief there is that experts know best, and that experts are only thwarted by evil corporations and stupid conservatives. The notion that no expert knows very much, and that the evolution of market processes produces better outcomes, is too threatening to contemplate.

My crisis point came at a 1999 conference that I organized in London on the origin of people's economic preferences.  We psychologists thought that economists would enjoy hearing about our preference experiments, so that they could develop more accurate and sophisticated models of human economic behavior.  How wrong we were.  It became clear that economists still followed a "revealed preferences" doctrine, which holds that consumer preferences are psychological abstractions - hidden, hypothetical states that cannot be measured or explained apart from the purchases that they cause.  If preferences are revealed only through purchases, and not through questionnaires, interviews, or focus groups, then it is redundant to study preferences apart from actual consumer spending patterns, to speculate about the origin of preferences, or to conduct market research on preferences for hypothetical products... So the economists gradually drifted away from the conference, leaving the psychologists to nurse our bruised egos, in the company of some strange-looking folks we hadn't seen before.

These folks weren't like the academics at the conference... They were the marketers, and they were hot for psychology.  They actually cared about people's preferences - where they come from, how they worked, and how to profit from them.  I talked for hours with them, and a new world opened up.

Econlog is in the top 25 economics blogs, as chosen by the Wall Street Journal. I've waited for my co-bloggers to crow about this, since I'm the newcomer (I started in October 2008), but because they haven't, I will. Of course, we don't know where the Journal put us in the top 25 because their list is alphabetic. But thanks to Arnold and Bryan, and thanks to the thousands of commenters who have helped us get this far.