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Obama or McCain's Chance to Reshape the Fed

By Robert Robb

The influence the next president may have on appointments to the U.S. Supreme Court and thus the judicial policy of the country is well known and widely discussed. It is likely to be a big issue in the election.

That the next president may have an equally large opportunity to influence the monetary policy of the country, however, has gone virtually unnoticed.

There are currently two vacancies on the seven-member Federal Reserve Board of Governors. Another member is continuing to serve, as permitted under the law, even though Congress has not reconfirmed him. Another vacancy will occur this summer. And Ben Bernanke's term as chairman ends in 2010.

The Democratic Congress is sitting on President Bush's Fed nominees. If it continues to do so, the next president may have the chance to nominate a majority of the board. Regardless, the next president will get to nominate the chairman of the Fed, who historically has been a dominant leader on monetary policy.

This opportunity occurs when the Fed has been doing a lousy job and represents a threat to the American economy.

The primary job of the Fed is to maintain a stable currency. At this, it has failed miserably.

The value of the dollar compared to the euro, whose central bank has behaved more sensibly and steadily during these economically turbulent times, has dropped over 50 percent since 2000. It has dropped 28 percent just since Bernanke's appointment in February, 2006.

About a third of the price of crude oil imports can be attributed to the depreciation of the dollar. Inflation is running north of 4 percent and rising. The Fed says, not to worry. Core inflation, excluding energy and food, is lower.

The rationale for excluding energy and food in setting monetary policy is that their prices are volatile. And when they are, indeed, volatile - both rising and falling - that's a sensible approach. When they are consistently rising, however, excluding them simply understates the problem.

The Fed has neglected price stability to try to cushion the economic fallout from the housing bubble bursting.

However, even here, its actions are deeply troubling. The longer the perspective, and the more that is known, the worse the Bear Sterns bailout seems.

The Fed, in cahoots with Bush's Treasury Department, forced the sale of Bear Sterns rather than allowing it to go bankrupt. Treasury Secretary Henry Paulson even dictated the terms of the sale to J.P. Morgan Chase. The Fed facilitated the sale by assuming $29 billion of Bear Sterns' questionable securities. The Fed also opened its credit window to other investment banks.

Former Fed Chairman Paul Volcker, who tamed inflation in the 1980s, said that the Fed had gone to "the very edge of its lawful and implied powers, transcending certain long embedded central bank principles and practices."

Historically, the Fed had limited its lending to banks whose deposits are federally insured. Now, no one knows who the Fed is willing to lend to or under what circumstances.

Bailing out Bear Sterns and opening the credit window to investment banks were supposedly necessary to prevent a total collapse of the U.S. financial system. If the failure of a mid-sized investment bank can have that sort of consequence, then there is entirely too much risk and opacity in the system.

More regulation can only do so much to rein in excessive risk-taking and opacity. The system is just too big, and regulations too easy to skate in the world of international finance, for a cop-approach to work.

The only thing that will work is to make it clear that failure will be permitted.

The next president needs to go to Wall Street and say, you're on your own.

No bailouts on my watch.

Then the president needs to appoint a critic of the Bear Sterns rescue to replace Bernanke in 2010, to make clear that what the Fed imprudently opened has been closed. And appoint inflation hawks to the Board to the extent he has the opportunity.

Ordinarily, it is good if politicians ignore the Fed. The instincts of politicians regarding monetary policy are almost uniformly bad. That's why central banks need to have independence.

These, however, aren't ordinary times. Unfortunately, neither John McCain nor Barack Obama seems aware of either the opportunity or the need, or up to the task.

Robert Robb is a columnist for the Arizona Republic and a RealClearPolitics contributor. Reach him at robert.robb@arizonarepublic.com. Read more of his work at robertrobb.com.

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