5 Myths & 5 Ugly Truths About the Fed

by Jeff Reeves | May 8, 2011 8:10 pm

Misinformation about the Federal Reserve abounds these days. And that misinformation cuts both ways – for every conspiracy theorist who labels the central bank and its chairman Ben Bernanke as the root of all economic evils, there is a brainwashed Fed defender who asks for just a little more time or a little more understanding.

I don’t pretend to be impartial when it comes to the Federal Reserve – I have my list of personal gripes both with Fed policies, as with the vocal alarmists and apologists who fail to look holistically at the role of America’s central bank in the 21st century global economy. But as a trained journalist, I must admit that what disappoints me most is the lack of an honest debate about our nation’s fiscal policies and its caretakers.

So here is my humble attempt at clearing the air and starting an important conversation about our central bankers: a hard look at common myths and ugly truths about the Federal Reserve.

The only disclaimer I will add is that I’ve done my best to broadly cover the major points of contention with the intention of starting a conversation about the important issue of the Federal Reserve. It is by no means complete, but is hopefully a good place to start. Your questions and corrections will be the real value of this piece – so make sure you to comment, criticize or add to any of the points here as you see fit.

Here goes: 5 myths and 5 ugly truths about the Federal Reserve.

Myth #1: The Fed is evil!

 

ben bernanke is the devil button p145485366130904201t5sj 400 150x150 5 Myths & 5 Ugly Truths About the FedMany well respected economists lay much of the blame for the Great Depression at the feet of the Fed. Put simply by Nobel Prize-winning economist Milton Friedman, “We had repeated recessions over hundreds of years, but what converted [the 1929 recession] into a major depression was bad monetary policy.” Unlike previous bubbles where the Fed gets only partial blame or can reasonably defend its actions, it is accepted by many that the Fed royally screwed up almost a century ago. All that said, however, it is the height of hyperbole to claim the policy mistakes or inaction of the Fed is “evil.” In fact, most monetary experts say it was inaction of the Fed that caused the Depression – not active malice. Incompetent officials who fail to properly perform their roles managing the money supply may be rightly despised for their lack of foresight or outright stupidity, but their gaffes are not a sign of ill will.

But here’s an ugly truth about Fed mistakes…

Unfortunately, the Federal Reserve is a very powerful entity with very real clout. The reality is that good intentions do not minimize the impact of bad moves and incompetence at the Federal Reserve – no matter how impressive the resume, noble the motivation or well-intentioned the philosophy. It’s telling that Friedman also said of the Fed’s actions in the Great Depression, “There’s no other example I can think of, of a government measure which produced so clearly the opposite of the results that were intended.” In short, even if you are 100% willing to embrace the role and responsibility of the Federal Reserve, the reality is that the human beings who operate the institution are far from perfect and they cannot be left off the hook as if they forgot the dry-cleaning. When the Fed makes mistakes, we all suffer the very real and very serious consequences.

NEXT: Myths about the Fed audits — or lack thereof…[1]

Myth #2: The Fed isn’t accountable to anyone and has never been audited

piggy bank break 5 Myths & 5 Ugly Truths About the Fed[2]Many conspiracy theories about the Federal Reserve include a thought along the lines of “Whenever a Congressman has introduced legislation to audit the Fed, that bill is always defeated.” While many efforts targeting the Fed have died on the floor, in fact independent financial audits of the Federal Reserve banks are conducted by accounting firms each year – as well as inquiries requested by the Board of Governors. Consider a 1992 GAO audit that drew attention to the Fed’s sluggish compliance with regulatory reforms mandated by the Foreign Bank Supervision Act of 1991. A previous audit also criticized payment system activities under the Monetary Control Act of 1980 for unfairly competing with some private banks. These are just two examples, proving that the Fed is not a black box but subject to information requests and audits like a host of other governmental agencies.

But here’s an ugly truth about Fed audits …

Those selfsame audits that shed light on Fed shortfalls have also been one of the biggest motivators for reform, via frustration by the auditors themselves. In fact soon after the 1992 study mentioned above, GAO comptroller Charles Bowsher[3] went before the Committee on Banking, Finance and Urban Affairs to lament that his office could have done better work if they had been given broader access. Specifically, Bower defended the GAO’s right to audit daily government securities auctions and foreign currency interventions – and supported a bill that would allow greater access to Fed activities. One that, surprise surprise, eventually died on the House floor. Ron Paul supporters will notice Bowsher’s comments sound curiously like the Texas conservative’s own complaints in his plain-titled 2009 book, “End of the Fed.” The only difference is that the concerns were voiced nearly two decades ago. The duality of the public-private Fed has long been a complicated matter for auditors, since the central bank retains some governmental privileges but also some private sector protections from 100% transparency with the American people, and there is much about the Fed that even regular audits cannot shed light on.

Myth #3: The Fed has ruined the economy by devaluing the dollar and causing inflation

inflation ahead sign 150x150 5 Myths & 5 Ugly Truths About the Fed[4]Here we get to a very sticky subject – the concepts of a weaker dollar or moderate inflation sometimes being “good” things. If you recall events in the financial markets in late 2008 and early 2009, one of the biggest concerns on the minds of most economists was the threat of deflationary death spiral akin to the mess that created Japan’s “Lost Decade” of stagnant economic growth. But according to the International Monetary Fund[5], much-maligned “quantitative easing policies” undertaken by central banks worldwide helped sidestep deflation. It’s also worth noting that a weak dollar makes American goods and services less expensive in the global marketplace, and thus makes us more competitive. Think of it as kind of a way to put a “discount” on American goods abroad to encourage business. Those who advocate zero inflation and a strong dollar have to consider the very real consequences of such actions.

But here’s an ugly truth about inflation and the dollar  …

 

For all the weakening of the dollar, there hasn’t been a material change in the import-export disparity for the U.S. According to foreign trade data released April 11[6], the trade deficit remains a remarkable $45.8 billion. And most economists predict that number will tick up against as the U.S. trade balance is affected by oil prices. In short, the idea that a weak dollar boosts imports is a gross oversimplification and ignores other factors at play in the global economy. Furthermore, while a reasonable level of inflation helps support demand there comes a tipping point when hyperinflation – such as skyrocketing gasoline and food prices we are seeing now – outpaces wages at an alarming rate and wreaks havoc on household budgets. If wages can’t keep pace with inflation, as is clearly the case over the last 6 months[7], then the net result is that people see their money buying less and less with each passing day. So if a weak dollar isn’t juicing the economy as some claim it should and inflation is now doing more harm than good, who’s side is the Fed on?

NEXT: Myths about the Fed as a “government” enterprise…[8]

Myth #4: The Fed is a private enterprise not beholden to the government

uncle sam money 5 Myths & 5 Ugly Truths About the Fed[9]It’s true that the 12 Federal Reserve banks are organized like private corporations, and are designed to operate largely independently of the federal government. It’s also true that big financial firms like Citigroup (NYSE: C[10]) and Bank of America (NYSE: BAC[11]) own stock in the banks and are paid a fixed 6% dividend on their holdings in District Reserve Banks. However, private bankers do not “oversee” the Fed since that stock does not come with voting rights.  It is the seven members of the publicly appointed Board of Governors – of which Ben Bernanke is the chairman – who set national monetary policy and give marching orders to the District Reserve Banks that they oversee. Private banks have no direct role in that process.

But here’s an ugly truth about the Fed’s government ties…

Though the dividend-paying Fed stock doesn’t come with a vote on day-to-day affairs, it does give private member banks a say in the Reserve Bank board of directors. Member banks elect six of the nine members of Reserve Banks’ boards. And it’s almost a given that former Wall Street banking execs wind up running the major reserve banks in the system. Take the current president of the New York branch of the Fed, William Dudley, served almost 20 years at Goldman Sachs (NYSE: GS[12]). The fact is that since it is set up as a public-private venture in an effort to give free enterprise a stake on behalf of national businesses, there are inherent limits on the amount of control the government – and subsequently the American people – can exert.

Myth #5: We are better off without a central bank

money lock 150x150 5 Myths & 5 Ugly Truths About the Fed

It is folly to believe that a major economic power could exist without a central bank to manage monetary policy. Let’s look at some history: For nearly eighty years, the U.S. was without a central bank after the charter for the Second Bank of the United States was allowed to expire after policy missteps and accusations of corruption. Sound familiar? On the plus side, the American economy did not implode and we did not slip into the dark ages as a nation. But the economy was hardly a beacon of stability. The Depression of 1893 was one of the worst in American history, with the unemployment rate exceeding 10% for half a decade. What’s more, a series of financial crises persisted — culminating with the 1907 Bankers’ Panic due to an inelastic U.S. currency and a run on banks that prompted the Federal Reserve’s founding. Whether or not you are willing to admit a central bank would have prevented or mitigated the economic crises in the decades before the Federal Reserve act, clearly the absence of the Fed did not categorically stabilize the American economy.

But here’s an ugly truth about Fed’s role in the economy …

Fed defenders point to these historical events — or to Paul Volker’s deft moves to end U.S. stagflation in the 1970s — as proof the economy isn’t better off without a central bank.But critics have an equally damning list of disasters that occurred under the Federal Reserve’s watch. Many commentators blame former chairman Alan Greenspan for partially inflating the recent housing bubble with persistently low interest rates during his last few years at the Fed. Others criticize Greenspan for not raising rates fast enough during the Dot-Com bubble, or failing to use other tools at his disposal such as raised margin requirements. And while only time will tell whether Ben Bernanke’s massive “quantitative easing” policies will ultimately result in more harm than good, there are very legitimate concerns about the actions. In short, America may not have been free from economic disaster without the Federal Reserve’s stewardship, but the central bank doesn’t exactly have a stellar report card. And if the Fed can’t prove convincingly that it does more good than bad or that it prevents more crises than it overlooks, what the heck is the point?

Jeff Reeves is editor of InvestorPlace.com. As of this writing, he did not own a position in any of the stocks or funds named here. Follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook.

Endnotes:
  1. NEXT: Myths about the Fed audits — or lack thereof…: http://investorplace.com/39883/fed-myths-federal-reserve-bernanke-evil/2/
  2. [Image]: http://investorplace.com/wp-content/uploads/2010/10/piggy-bank-break.jpg
  3. GAO comptroller Charles Bowsher: http://archive.gao.gov/t2pbat5/150187.pdf
  4. [Image]: http://investorplace.com/wp-content/uploads/2010/11/inflation-ahead-sign.jpg
  5. according to the International Monetary Fund: http://www.imf.org/external/pubs/ft/spn/2009/spn0927.pdf
  6. foreign trade data released April 11: http://www.census.gov/indicator/www/ustrade.html
  7. as is clearly the case over the last 6 months: http://online.wsj.com/article/SB10001424052748704530204576237081117462892.html
  8. NEXT: Myths about the Fed as a “government” enterprise…: http://investorplace.com/39883/fed-myths-federal-reserve-bernanke-evil/3/
  9. [Image]: http://investorplace.com/wp-content/uploads/2011/05/uncle-sam-money.jpg
  10. C: http://studio-5.financialcontent.com/investplace/quote?Symbol=C
  11. BAC: http://studio-5.financialcontent.com/investplace/quote?Symbol=BAC
  12. GS: http://studio-5.financialcontent.com/investplace/quote?Symbol=GS

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