Thursday, August 27, 2009

Auditing the Federal Reserve is Economic Suicide

Given the potentially fatal repercussions, auditing the Federal Reserve is one of the most underreported stories by the media today. Investors today should be fearful of this development. It is shocking to see three out of four Americans supporting a bill that could lead to economic catastrophe. The passing of Ron Paul’s H.R. 1207 bill may bring serious and unintended inflationary consequences that can destroy investors’ wealth.

While it may not be the intent of the lawmakers, Ron Paul’s bill, a.k.a. Federal Reserve Transparency Act, will enable the congress to influence the outcomes of monetary policy through an audit of the Federal Reserve’s day-to-day operations, thus severely compromising the independence of the U.S. central bank from political influences.

The free market understands that auditing the fed is a very dangerous line to cross. If crossed, U.S. inflation will likely skyrocket over the next decade to unseen levels. The U.S. economy will tank under a hyperinflationary environment. Bond investors lose money as interest rates rise. Stock investors earn negative real return as equity risk premium rises and aggregate PE ratio nose dives. The US Dollar erodes due to higher domestic inflation relative to foreign inflation. Gold and commodity prices rise.

How Does Auditing the Fed Cause Inflation?

Inflation is caused by a central bank that loses control of its money supply. There are two ways that a politically compromised central bank can lose control of its money supply.

Road to Inflation #1: Repeating the Political Cycle

When the central bank is not independent, politicians have historically pumped up the money supply (for temporary economic boost) shortly before an election to buy votes with lower unemployment rate. After the election, the effects wear off, returning the economy to its natural rate of unemployment but at a higher inflation rate than before. Because it is hard to fight off inflation quickly, by the time the next election rolls around the economy has not been squeezed back to its original inflation rate. Politicians pump up the money supply again, this time from a higher base inflation. As this cycle repeats itself, the central bank loses control of the money supply.

Road to Inflation #2: Financing Government Spending

A central bank that lacks independence from politicians makes it tempting for the government to finance an inappropriately large portion of its spending through printing money. A central bank that promises to finance too much government spending also loses control of the money supply.

Will the Bill Pass?

Although Obama and his economic team oppose this bill, it may not matter much. The risk of the bill passing is increasing every day. Ron Paul is using the recent economic recession as an opportunity to sway angry politicians to advance his personal agenda of ending the fed. The table below shows that government officials are embracing the Federal Reserve audit. In fact, support is so overwhelming that we are dangerously close to reaching the veto-proof status. Once reached, the President will have little say in the outcome. Deadline for voting of this bill has been set to December 2010.

In sum, auditing the Fed’s daily operations will cause it to succumb to political pressure, lose control of the money supply, and create sticky inflation that could be much worse than the 1970’s. America is an angry nation right now. When it comes time to vote on the bill, it remains to be seen if cooler heads will prevail or if America will swallow the economic suicide pill.

*Related links: Reactions from 6 economists, Bernanke, Bernanke (2), Geithner, Washington Post, and general public.

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