jack kemp, becker and posner, and the federal reserve

First, I would like to start off with the sad news the former NFL quarterback, Congressman, and 1996 Vice-Presidential candidate Jack Kemp died over the weekend. Kemp was one of the few voices for truly free markets and limited government over the past half century. One of the biggest mistakes the Republican party has ever made was nominating George H. W. Bush for President in 1988 instead of Kemp.  The first Bush's anti-free trade and pro-tax growth policies undercut the Republican message and its legitimacy, leading directly to Bill Clinton's election in 1992.  Kemp also co-sponsored Reagan's 30% across the board tax cuts in the early 1980's, which were a major factor contributing the sustained economic growth of the United States during the 1980's and 1990's.  Today's WSJ had an excellent collection of partial op-eds written by Kemp over the past 30 years.  The link is here, and I highly recommend checking it out, as Kemp's consistent policies and dedication to free markets, show that he understood the problems facing the nation and how to address it.  If more of Kemp's ideas had been put into place, we may not be facing as serious economic problems as we are today.

Secondly, I recently stumbled upon a blog written by Gary Becker (a Nobel Prize winning economist at the University of Chicago) and Richard Posner (Judge on the 7th Circuit Court of Appeals, leading scholar on economics and the law, and probably the most cited Circuit Judge in United States history).  Located at http://www.becker-posner-blog.com/, the blog breaks down important issues in economic terms.  For instance, in their latest posts, the two independently analyze the economic consequences of a pandemic such as swine flu, the costs associated with preventing such an outbreak, and posit several viable options as the most economically efficient way to tackle such a problem.  I highly recommend it to anyone interested in economics and its application to real world political issues as well as policy in general.   Both Becker and Posner have great economic and analytical minds and are able to succinctly breakdown very complex issues, thereby making them understandable even to someone with only a modest economic background.  

In one of his more recent posts, Judge Posner addressed the Independence and fundamental role of the Federal Reserve system, which got me thinking.  It is unfortunate and extremely disheartening that so many Americans do not even understand what it is that the Fed actually does or what its role is in the American financial system.  Fundamentally, many Americans understand that the Fed adjusts interests rates, but they do not understand how they accomplish this goal, what the Fed's objectives actually are, and how it is responsible for the entire monetary policy of the United States.  Therefore I am going to briefly describe the Fed and its role in our financial system and address what I consider potentially devestating powers available to the Fed with regards to monetary policy.

The federal reserve was originally created in 1913 as a lender of last resort in order to prevent runs on banks that were common at that time.  After the Bretten Woods agreement collapsed in the 1970's when Nixon took the U.S. off the gold standard, the Fed gained increased influence by affecting monetary policy in order to attempt to maintain low inflation as well as maximum employment.  But how does the fed actually affect monetary policy?  In times of economic downturn, the money supply will become more scarce, as more people will save in an expectation that they will need it later during more tough times.  In order to keep the credit markets flowing and provide the capital necessary to spur investment, the fed will buy government securities/bonds (mostly short-term bonds), which pumps cash into the economy when the cash is deposited in bank accounts and then withdrawn and spent.  This increase in monetary supply held by banks will allow for more money to be lent, decreasing the demanded interest for such loans (i.e. lowering short term interest rates).  Long term interest rates will inevitably follow (at least to some degree) the short term rates, which will increasing lending, hopefully spurring economic growth and growing the economy.  Conversely, if the Fed wants to raise interest rates (probably to combat inflation) it will sell some of the government bonds it holds, thereby removing money from the financial system.  Presumably, it could then prevent that money from re-entering the system, which decreases the total amount available, thereby increasing the demand for the currency.  This increased demand will lead lenders to value their money higher, an charge an increased rate of interest on the money that they loan.

All of this sounds good, but missteps by the Fed over the past few decades have had extremely detrimental effects on the U.S. economy.  Additionally, the Fed's tremendous power as the sole decision maker with regards to the U.S. money supply (and effectively the entire world's money supply as many major currencies are fixed to the U.S. dollar) has the potential to have a devastating effect on the country's growth and the standard of living of all Americans.  Today, there is almost uniform agreement that the Fed's easy money policy of the late 1990's and early 2000's was a major contributing factor to the housing bubble that lead to the economic collapse we are currently facing.  In order to spur current economic growth, the Fed has increased the money supply by over $1 trillion this year alone.  If the Fed gets its job right, then it should increase the money supply as total U.S. output increase, thereby stabilizing prices relative to growth.  However, this rarely happens.  In order to prevent devastating deflation from occurring, the Fed must over estimate the amount of money to produce, thus increasing money supply relative to total economic output and causing inflation.  In fact, for the past three decades the fed has doubled the money supply every ten years.  This inflation is a hidden tax, which is in fact extremely regressive.  How is it that we allow a completely private, unelected board decide how much to tax the American consumer in the form of inflation?  It just doesn't make sense.  Unfortunately I do not have time to outline my solution here, but I will in a future post.