Ron “End the Fed” Paul:

If you want to be a strict constitutionalist, there’s a lot more defense of having Congress involved with defending the value of the currency than delivering this responsibility over to the Fed.

Me: Keep in mind that there are in folks in Congress, such as Barney Frank, who would like to depower the Fed bank presidents because they worry too much about inflation.  Mend it, don’t end it!

A classic from David Goldman:

The crystal-meth monetary policy at the Fed makes everyone feel better, until they don’t. The nonstop rise in the price of dollar hedges tells us that it can’t last forever. Large balance sheets attached to the Fed’s money pump can show profits, and the price of spread assets (as PIMCO’s Bill Gross keeps emphasizing) is stupid rich. But at the capillary level, through, the economy is dying and gangrene is setting in. … It isn’t just the 17.5% broad-measure unemployment number that we should worry about, but the massacre of smaller businesses, who are concentrated in the most vulnerable sectors: real estate, construction, and retail. Retail sales may get a temporary shot in the arm from cash for clunkers, and a combination of tax credits and (de facto) subsidized mortgage rates may hold up the bottom of the housing market for a short time. But today’s data show how fragile these matters are.

The great David Goldman. First on the US asset bubble:

BOTH bond and stock prices are driven by the dollar. 17.5% unemployment by the broad measure keeps wages down and keeps the CPI low, despite the surge in commodity prices, while the cheap dollar makes US assets a bargain. Well, not exactly: the enormous reserve growth on the part of Asian central banks means that the Treasury’s debt-buying program has been outsourced to America’s Asian trading partners! No-one dares pop the bubble. It’s like what Woody Allen said about death. He wasn’t afraid of it; he just didn’t want to be there when it happened.

Now on gold:

What’s the price of the last ticket on last train out of Paris on the night the Germans march in? Whoever is carrying the most cash will get it, and that will be the price.  … As I have tried to show in several recent articles, most recently this Sept. 15 essay at Asia Times, gold is a hedge against the collapse of America’s central role in world affairs.

What is the correct price? Central banks alone own about 4.8 million tons of gold. The world produces about 2,200 tons. Suppose that central banks wished to increase their gold holdings by 1 percent. That’s 48,000 tons or so, or more than 20 times annual mining production. What’s the price elasicity on that sort of thing?  How badly do you need that ticket out of Paris? … If the whole world, including the Asian central banks, man the bucket brigade–except with kerosene in the buckets rather water–the prices of real assets are going to rise. The best real assets to hold are the ones most sensitive to the degradation of the dollar.

Ed Yardeni votes for The Chairman, but now he thinks the Federal Reserve need to change course:

I believe that the Fed did in fact avert a financial meltdown and an economic depression by flooding the financial system with liquidity, and by lowering the federal funds rate to zero. I believe that all the efforts to deal with the financial crisis by the White House and Congress–including TARP, PPIP, and ARRA-were counterproductive and offset some of the effectiveness of the Fed’s responses. On PBS NewsHour last Friday, Sheila Bair, the level-headed head of the FDIC, said that TARP was a huge mistake: “I think at the time it sounded like the right thing to do…but I just see all the problems it’s created.” She implied that had she been consulted by Hank Paulson and Ben Bernanke, she would have tried to dissuade them from pursuing this approach.

I think that the Fed should raise the federal funds rate to 1.0% to demonstrate some confidence in the economic recovery. A zero rate was justified by the effort to avert a financial meltdown and a depression. Now it may be doing more harm than good.

I think Henry Kaufman (in the WSJ) accurately outlines the public policy choice when it comes to financial reform: heavily regulated monster banks vs. a more decentralized, somewhat less regulated financial system TBTF creates a need for heavy regulation and less economic efficiency.

From what I could gather from a speech given by Fed Chairman Ben Bernanke at a conference sponsored by the Federal Reserve Bank of Boston a few weeks ago, the Fed favors constraining giant institutions to the point where they would become, in effect, financial public utilities. They might be required to increase equity capital and to limit their activities in proprietary trading and other risky activities.

But under this arrangement, these large institutions nevertheless would still command a vast amount of private-sector credit. And when markets became unstable in the future, other financial institutions would merge in order to come under the government’s protective too-big-to-fail umbrella.

If an overwhelming proportion of our financial institutions are deemed too big to fail, monetary restraint would fall heavily on institutions that are not. Pressure would sharply intensify on smaller institutions that mainly service local communities. Further consolidation would result, which in turn would reduce credit-market competition. At the same time, with increasing financial concentration, market volatility would increase.

All of this would narrow the gap between the Federal Reserve and the political arena. Taken to its logical conclusion, our market-based system of credit allocation would be replaced by a socialized financial system, and the Federal Reserve would become part of it.

A much better approach would be to prohibit any financial institution from remaining or becoming too big to fail. This would require that regulators downsize large financial conglomerates. In this process, the prime targets for divestiture should be financial activities that pose risk to the stability of the deposit function as well as operations that pose conflicts of interest.

Our financial system is at a crossroads. We can either succumb to the forces that are shifting markets toward greater government back-stopping and socialization. Or we can create a structure in which no institution is too big to fail, and a financial system that is supervised effectively by a modernized central bank.

The instant analysis on Senator Christopher Dodd’s aggressive financial reform plan is that it’s more about getting him re-elected than getting a bill through the Senate.

And there’s some truth there. Dodd is in the fight of his political life to keep his U.S. Senate seat. A tough bill plays on populist outrage against Wall Street and mitigates the damaging public perception that he was AIG’s man in Washington.

The bill is also more ambitious than its counterpart in the House, at least in how it deals with systemic risk. (The Dodd version of a Consumer Financial Protection Agency may be slightly less powerful.)

Unlike the White House-blessed plan of House Financial Services Chairman Barney Frank, Dodd’s plan would create an Agency for Financial Stability to deal with too-big-too-fail firms. This new entity could write new regulations or subject such firms to enhanced supervision. Dodd would also combine existing financial regulators into a Financial Institutions Regulatory Administration.

Accomplishing this vast reorganization means clashing with myriad committee chairs and industry lobbyists. And the Richard Shelby-led Republicans on the Banking committee, while favoring limiting the Fed, have no use for the consumer piece or new limits on Sheila Bair’s FDIC.

So the politics are dicey. But an even tougher package might actually be more of a potential political winner by gaining grassroots support across America. Consider that the public seems to believe two big things about financial reform: The Fed should not be given more power, and too-big-to-fail is terrible policy.

The Dodd plan makes progress on the first but could go much stronger on the second. It could have, for instance, embraced Paul Volcker’s argument that banks should be prohibited from owning and trading risky securities (though not necessarily from underwriting stock and bond offerings).

Or Dodd could have incorporated the 225-word amendment of Senator Bernie Sanders, a self-described ‘democratic socialist’, which would require the actual break-up of too-big-to-fail institutions.

Spend a few minutes at a ‘tea party’ or listening to conservative talk radio and you’ll find plenty of appetite for Sanders’ so-called left-wing reforms. Today’s right has about as much use for Big Money as it does for Big Government.

As it is, financial reform is a 2010 issue. Plenty of time to makes its teeth even sharper.

When you’re a nation getting ready to borrow $10 trillion or more over the next decade, you don’t want markets questioning your central bank’s commitment to controlling inflation.

But Congress continues to risk just such a scenario, whether through aggressively questioning Federal Reserve Chairman Ben Bernanke or pushing a bill to audit Fed monetary policy.

Now Representative Barney Frank, the chairman of the House Financial Services Committee, has suggested curbing the authority of the 12 Fed regional bank presidents.

As Frank sees things, monetary policy should not be influenced by “inappropriately placed private businessmen — or women, occasionally — picked by other private businessmen, and occasionally women.”

Drill down a bit and it’s clear that what really bugs Frank is not so much that regional bank presidents are selected by a nine-person panel, six of whom are elected by bankers. He just thinks they’re too hawkish.

Frank even commissioned and publicized a study that found that 97 percent of the hawkish dissents at Federal Open Market Committee meetings during the past decade were from the regional bank presidents.

Of course, higher rates would have been a good thing, given that the Fed’s extraordinarily easy monetary policy was a huge contributor to the financial crisis. And going forward, the Fed will face the economically and politically challenging task of withdrawing monetary stimulus when economic growth may well be sluggish and unemployment high.

But such medicine may be necessary to prevent an inflation outbreak. Congressional threats and bullying will make a hard job even more arduous.

Moreover, one reason the Fed has a decentralized structure is because of historic concerns about monetary policy serving only Washington and Wall Street.

Yet citizen concerns about the concentration of financial power are as alive today as they were in 1913 at the Fed’s creation. Monetary policy set solely by a presidentially-appointed and Senate-confirmed Board of Governors should certainly set off alarm bells with bond vigilantes concerned that Washington may try to inflate its way out of its debt problems.

If Congress wants to look at how the Fed conducts its  business, better to focus on better ways to make monetary policy reflect forward-looking market gauges such as commodity prices rather than the unemployment rate or output.

Ultimately, though, the Fed’s problem isn’t too much influence from bankers in Kansas City or Atlanta or Chicago. It’s too much influence from politicians in Washington.

Here is Barney Frank at yesterday’s House Financial Services hearing:

I had a study done. Ninety percent of Federal Open Market Committee [dissents] are from regional bank presidents and 90 percent of the 90 percent are for higher interest rates.

Those are inappropriately placed private businessmen, or women, occasionally, picked by other private businessmen, and occasionally women, and they should not be setting public policy.

I don’t care that the Fed rejected what the Treasury said. That may be a nice discussion among gentlemen. The Fed will not reject it when we, I promise you, next year, take up legislatively the issue. And I think it’s very clear. You should not have private citizens like the presidents of the regional banks voting on policy. And I guarantee that will happen.

Me: Along with the Fed audit bill, it is clear Congress wants to have more influence over the Fed. This, right at the time when global financial markets will have to remain confident America will not inflate its way out of its debt.

Andy Xie paints a dire scenario:

Central banks around the world have released massive amounts of money in response to the current financial crisis … But the proposition that a weak economy means low inflation is false. The stagflation of the 1970s proves it.

This round of monetary growth has mainly fed speculation, not credit demand for consumption or investment. Speculation has reached a dangerous point with the oil price threatening to reach triple digits again. Its implications for inflation may spook the central banks to raise interest rates quickly and trigger another crash.The excess money supply has created a new liquidity bubble.

The resulting asset inflation (stocks and bonds in developed markets and everything in emerging markets) has stabilised the global economy. The current equilibrium is one on a pinhead. The hope for strong economic recovery led by emerging economies raises investor optimism – and asset prices. This eases pressure on corporate balance sheets, spurs property production and boosts consumption through the wealth effect, making the hope self-fulfilling in the short term.

A rising oil price threatens to derail this recovery. It can trigger a surge in inflation expectation and a major crash of bond markets. The resulting high bond yields may force the central banks to raise interest rates to cool inflation fears. Another major downturn in asset prices would reignite fears about the balance sheets of global financial institutions, leading to new chaos.

The most devastating part of the NYTimes piece on Paul Volcker’s lack of influence on WH economic policy comes into the very last sentence of the piece:

So Mr. Volcker scoffs at the reports that he is losing clout. “I did not have influence to start with,” he said.

Me: I can’t believe Volcker is also too thrilled with what’s been happening lately with King Dollar. Yet the focus of the story is how the WH is ignoring Volcker’s advice to separate banking from investing and trading, a de facto restoration of the 1933 Glass-Steagall Act.

Mr. Volcker’s proposal would roll back the nation’s commercial banks to an earlier era, when they were restricted to commercial banking and prohibited from engaging in risky Wall Street activities. … The only viable solution, in the Volcker view, is to break up the giants. JPMorgan Chase would have to give up the trading operations acquired from Bear Stearns. Bank of America and Merrill Lynch would go back to being separate companies. Goldman Sachs could no longer be a bank holding company. It’s a tall order, and to achieve it Congress would have to enact a modern-day version of the 1933 Glass-Steagall Act, which mandated separation.

Glass-Steagall was watered down over the years and finally revoked in 1999. In the Volcker resurrection, commercial banks would take deposits, manage the nation’s payments system, make standard loans and even trade securities for their customers — just not for themselves. The government, in return, would rescue banks that fail. On the other side of the wall, investment houses would be free to buy and sell securities for their own accounts, borrowing to leverage these trades and thus multiplying the profits, and the risks.

Being separated from banks, the investment houses would no longer have access to federally insured deposits to finance this trading. If one failed, the government would supervise an orderly liquidation. None would be too big to fail — a designation that could arise for a handful of institutions under the administration’s proposal.

Banking expert Bert Ely sees things differently:

Had Glass-Steagall never been enacted, had it been repealed much earlier than 1999 …  the Big Five investment banking firms … might not have become as focused as they did on buying, securitizing, and trading subprime, Alt-A, and option-ARM mortgages. While the large commercial banking companies also engaged in mortgage securitization and originating nonprime mortgages, they did not get as deeply involved in those activities as did the investment banks. Arguably, then, had the separate, distinct investment-banking industry been melded into mainstream commercial banking years ago, today’s mortgage and financial crisis would not be as severe as it is, or may not have occurred at all.