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07/23/2009

Should the Fed be Audited?, by Arnold Kling

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 21st-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.


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