Defending the Indefensible

Bob Murphy of Austrian economics fame has a post up defending Rand Paul’s comments about auditing the Fed. Murphy highlights some of the errors Paul made and then makes a series of claims based on erroneous blog comments and his own misunderstandings. Let’s explore this in more detail.  If you haven’t already read my original pieces on Paul’s thinking then please see here and here.

• First, Murphy is a longtime believer in much of the nonsense that Rand Paul has been advocating over the last 5 years. The most vocal position was the idea that QE was “money printing” which would cause high inflation. Murphy actually guaranteed that inflation would be over 10% by January of 2013. He based this thinking on the idea that the excess reserves in the banking system created a risk of high inflation when the reserves were “lent out” by the banks. Of course, this is a totally erroneous description of the relationship between banks and their reserve holdings (see here). Banks lend first and find reserves later. The quantity of excess reserves they hold has no meaningful impact on the quantity of loans they make. So, given his past misunderstandings I think we have to take Mr. Murphy’s Central Banking commentary with a hefty grain of salt.
• Mr. Murphy spends considerable time defending Paul’s views by focusing on errors that Noah Smith made in a Bloomberg View piece. Murphy is right that Smith made many of his own accounting and typographical errors, however, this does not discredit the criticism of Paul.  It just means that Smith made some of his own errors. That has nothing to do with the fact that Paul misunderstood the difference between assets and capital and misconstrued the discussion about solvency by leaving out the Fed’s required profit remittance to the US Treasury.
• Murphy unfairly criticizes Matt O’Brien in a later section. First, he says that O’Brien is proving Paul’s point on leverage when he does no such thing. O’Brien pointed out that the Fed remits its profits to the US Treasury every year. If it were not required to do so its leverage ratio would be substantially lower. Second, the idea that the Fed might become technically insolvent is largely due to the remittance issue. If the government taxed 95% of every entity’s earnings (which is essentially what the remittance requirement is) then most firms would become technically insolvent. If, for some reason, the Fed were to become technically insolvent then it would be the fault of Congress, not the fault of its own “reckless” behavior.  Lastly, printing money is not what makes the Fed solvent. The Fed has earned over $500B in profits over the last 10 years because it earns interest on its holdings. And the only reason it hasn’t retained those earnings is because of the remittance requirement.  Murphy intentionally ignores the remittance issue because it debunks all of Rand Paul’s thinking.
• Murphy concludes with his own series of further misunderstandings:

“Central banks around the world have loaded up on assets, particularly central government debt, in an unprecedented fashion. If and when they decide to raise interest rates, among other things such action could instantly render the major central banks insolvent. Not only would this possibly cause a worldwide financial crash, but it would also limit the central banks’ ability to reduce the quantities of fiat money.”

• This is simply wrong at an operational level.  If the Fed were to raise interest rates its holdings could experience some mark-to-market volatility, however, the Fed values its holdings of US government bonds at face value. Further, it can and likely will hold most of these bonds to maturity at which point it will receive its principal back. There is absolutely no reason why the Fed should incur losses on its balance sheet given that its assets are government guaranteed. Murphy misunderstands several basic accounting and financial facts here.
• Raising interest rates would most certainly not alter the Central Banks ability to reduce the quantity of the broad money supply (or the quantity of reserves). The reason being that the Central Bank doesn’t control the quantity of broad money in the first place. Just like QE didn’t cause the high inflation that Murphy expected years ago, reducing QE will not impact its ability to control the money supply and reduce inflation going forward.
• Murphy does make a good point about the Fed’s oversight in general. Yes, it makes perfect sense to audit the Fed. We should expect further oversight. I am not even against an audit the Fed bill necessarily. I am against an audit the Fed bill that is motivated by sheer misunderstandings and ideological thinking.

These sort of ideologically driven misunderstandings have driven a stake through the heart of Austrian Economics over the last 5 years. Repeated misunderstandings and poor predictions have, in my opinion, discredited the school and Murphy’s most recent commentary does not help.