An article in the WSJ by Ron Paul and Jim DeMint today discusses the issues of FED independence and transparency. They mention a “puzzling assertion made by the Fed and its supporters … that the Federal Reserve has some sort of independence from the government.” They continue to argue that the FED is not independent, but instead is a government run monopoly whose mandate to maintain stable prices has caused them to expand the money supply thereby causing an inflationary effect rather than, what they claim to be, the natural deflationary tendency caused by ever rising productivity. Indeed in their first paragraph they mention that in the past 96 years the US dollar has lost 95% of its purchasing power.

OK, but here’s what they haven’t mentioned. First, one problem with deflation, especially if it’s persistent, is that it can slow down the growth of economies. The reason is that expectations that prices will soon fall will make consumers and businesses hold off on purchases waiting until they can get the better deal. Anyone buying a computer in the past few decades knows how frustrating it can be to buy when you know that in 6 months the same expenditure will get you a faster computer with more features. Thus deflation can reduce the velocity of money, or the rate at which transactions are made. For this reason it makes some sense to maintain a low and steady inflation rate.

The second thing they fail to mention is the experience of many other countries that did not have semi-independent central banks. The problem that often arises is that legislatures are pressured to raise government spending and programs, thereby pleasing voters, but are reluctant to increase taxes to pay for these programs, which will clearly displease voters. Borrowing to finance a government deficit is always the next option, but sometimes this can be expensive especially if the government is running up large and potentially unsustainable deficits forcing them to raise interest rates to a high level to attract lenders. (currently the US has the large deficits, but not yet the very high interest rates). The other option, which seems relatively painless, is to force the central bank to “lend” the government the money it needs to finance its large deficit. Of course, central bank lending also means the printing of money, which if not counteracted by a drop in money elsewhere, is certain to have inflationary consequences.

Studies in the past have suggested that countries who have had severe hyperinflations in the past (e.g. Latin American countries in the 70s and 80s) are also those whose central bank was NOT semi-independent from its legislature. However, the countries whose central banks are more independent, like the US, have had a much lower inflationary path.

Thus, there are some good reasons to maintain FED independence that have been overlooked in this article. That’s my main point!