Rand Paul joined Glenn Beck today to discuss the Fed and some of the attacks on his “audit the Fed” bill (see here for the transcript and the video). This is a good learning experience so bear with me for a few minutes as I explain some of my thinking here and why I’ve been critical of Paul’s rationale for the audit.
Paul sounds shocked around the 1 minute mark when he says that the Fed “just creates money” to buy assets. He seems to think that money is something that isn’t just created from thin air. Of course, anyone who understands modern banking knows that almost all of the money in our monetary system is created from thin air by banks when they expand their balance sheets. You can think of a bank loan as the bank buying your loan in exchange for a deposit. The bank does this by creating the deposit from thin air. That’s all it is. A money center bank expands its balance sheet in the same way that the Federal Reserve does. It just creates money from thin air. This happens millions of times a day when banks extend credit to consumers and businesses. Paul sounds a bit confused about how money is typically created in a fiat monetary system.
At the 2 minute mark Paul says the Fed has purchased $4.5T in assets and that we don’t know what they’re worth, what they are, who bought them or what they paid for them. This is all factually wrong. Section 1103 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires that the Federal Reserve release the details of their transactions, prices paid and the counterparties. You can go to the NY Fed website and download this data here. So Paul is making a factually incorrect point here.
You can also see exactly what’s on the Fed’s balance sheet and they’ve actually gone to excruciating levels to make sure you can understand every single line item in their balance sheet (see here). And the Fed marks its assets to face value because the Fed is only allowed to purchase government guaranteed assets. This actually makes a good deal of sense. Paul is worried that the Fed might incur mark to market losses, but this is inconsequential. If the Fed wants to hold all of its assets to maturity then it will simply do so. There is absolutely no reason for the Fed to incur a market loss on any of its holdings so Paul’s concern about marking to market is based on more misunderstanding.
Paul continues by asserting that the Fed is potentially buying assets at a mark up and from “their brother’s bank”. First, if you’re confused whether the Fed works to stabilize and help banks then please just stop being confused. The primary reason the Fed was created was to help stabilize the banks because a purely private system is inherently unstable at times (because they’re private risk taking entities who make mistakes at times just like any fallible capitalist entity). Banks are unique, however, because they operate the payment system that we all rely on to function daily. The Fed is the “lender of last resort” precisely because private banks can’t always be counted on to manage the payments system when a financial crisis hits. A public entity can continue to operate during a crisis by leveraging the strength of the aggregate private sector. This allows the payment system to continue operating without disruption as has been known to happen when private banks are the primary clearinghouses (this was a regular occurrence in the 1800’s before the Fed was created). So we should be very clear that the Fed exists to help the banks. But we don’t need to make silly assertions about potential corruption in the process of understanding this.
- Related: Who Owns the Federal Reserve?
- Related: Common Myths About the Federal Reserve
- Related: The Federal Reserve in the US Payments System
Paul goes on to say that people will be shocked if they were to realize that the Fed “makes a profit by creating money out of thin air”. Well, this is how money is created in a modern monetary system. Banks create assets and liabilities by expanding their balance sheets and they earn a profit on the spread. This shouldn’t be remotely shocking to anyone who understands the basics of banking and money. And it’s not necessarily a good/bad thing. Banks serve a necessary function in a modern monetary system by providing access to money on demand in a system that creates an elastic money supply. This is good when money is used for productive purposes and can be bad when money is used for unproductive purposes. But the outright rejection of this construct is misguided. In addition, Paul is contradicting himself because the Fed is earning profits on assets that they banks and the private sector would otherwise earn. In essence, the Fed is earning a profit for taxpayers because they remit all profits to the Treasury. So he should be thrilled that it’s the taxpayer making this money instead of the big bad banks. He doesn’t say this because it doesn’t fit his narrative, however.
Paul later touches on a related point about the inflationary potential of the Fed’s balance sheet expansion. This is something that Glenn Beck and Rand Paul have been warning about for years and years – the dreaded inflation or hyperinflation from QE. It was wrong then and it’s wrong now as I explained in real time many years ago and several times over the years.
I’m probably being a bit hard on Paul. He makes some relevant points. Specifically, we should expect strict oversight of the Federal Reserve. And we should all be tired of the fact that banks often make silly mistakes and we all foot the bill. But he has made some wildly inaccurate assertions in the course of trying to justify his “audit the Fed” bill that seriously undermine his rationale.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.