Is the US Federal Reserve Worthwile?

My wife asked yesterday if I agree with US presidential candidate Ron Paul's call for eliminating the Federal Reserve. I do not agree with Paul on this, however, I think it's very good for Paul to be putting the question out there for discussion.

We've had the Fed for so long most people never ask whether it's a good idea to have federal officials setting our monetary policy. The Federal government should be constantly evaluated on how good of a job it does on everything it's involved with.

The criticisms of the Fed

• The Fed has made bad decisions: Overly tight policy led to the Great Depression. Overly loose policy led to the stagflation of the 1970s. Critics have blamed Fed policy for the tech stock bubble.
  
• Unexpected inflation: Poor Fed policy could result in unexpected inflation. People making economic transactions have to factor this risk into their business deals. People making a long term lease contract need to be mindful that they don't know what the value of the dollar will be at the end of the year. People lending fixed-rate money need to charge extra (and consider protecting themselves with rate derivatives) to handle the risk of rising rates.
• Expected Inflation: Good Fed policy results in a normal condition of a few percent inflation. This costs people "menu costs" to update their price lists, "shoe leather costs" to take their money to the bank. It also discourages people from saving because when investments go up with inflation, it's taxable.
  

Why the Fed is a good idea

The Fed evens out the economic cycle by smoothing out the expansions and recessions. Even if the Fed has not done a perfect job, it's better than just leaving it to chance. The alternative Paul suggests is to peg the dollar to gold. Gold is used in products and is still being extracted. Its value could change with supply and demand for gold. We would be turning our monetary policy over to something random.

We see Fed critics on both sides.

• The Fed should provide more liquidity to help with the housing bust.
• The Fed created the tech and house bubbles and is risking creating inflation with too loose monetary policy.

It makes me suspect that Fed is doing a decent job balancing the pressures for tight and loose policy.

It does such a good job that I would like to see a similar board set up to set fiscal policy. (More on fiscal policy in a future post)