The Hutchins Center Explains: Audit the Fed

Q: Is the Fed audited?

A: Yes. The Fed’s financial statements are audited by Deloitte & Touche and have been subject to oversight by outside accountants for many years. The Dodd-Frank law requires the Fed to post a link on its website to these audits. The Fed has done so.

Q: What would the Audit the Fed bill change?

A: First a little history: Between 1933 and 1978, the General Accounting Office (since renamed the Government Accountability Office) was not allowed to audit the Fed at all, except for the Fed’s role in handling the U.S. Treasury’s cash. In 1978, Congress gave the GAO authority to audit the Fed’s regulatory duties and role in the payments system, but prohibited it from reviewing “deliberations, decisions or actions on monetary policy matters.” The Congressional Research Service has posted a good, short history of all this.

In 2009, Congress changed the law to allow GAO audits of loans made by the Fed to a single company, such as Bear Stearns or Citigroup, but only when the Fed invoked Section 13(3) of the Federal Reserve Act. (That’s the provision that allows the Fed to lend to almost anybody under circumstances it deems “unusual and exigent.”) The Dodd-Frank law of 2010 further widened the GAO’s authority, allowing it to review the Fed’s internal controls, policies on collateral, use of contractors and other activities—but the GAO is still blocked from reviewing or evaluating the Fed’s monetary-policy decisions.

The Audit the Fed bill would change the law again, and allow the GAO to examine and criticize all monetary policy decisions without restriction.

Q: Why is the GAO barred from auditing monetary policy decisions?

A: As is the case in nearly all other capitalist democracies, the elected leadership of the U.S. sets objectives for the central bank—in the U.S., maximum sustainable employment and price stability—and instructs it to do what’s needed to meet those objectives. The rationale for this is the observation, backed up by economic research, that giving politicians power over interest rates and the supply of credit hurts an economy over time because politicians tend to prefer a little more growth now even if that means too much inflation later. Insulating those who set interest rates from short-term political pressures is believed to lead to a better economy over time.

Prohibiting the GAO—an arm of Congress–from second-guessing the Fed’s monetary policy decisions is part of that insulation. Another part is that Congress doesn’t control the Fed’s budget, the way it controls the budget of, say, the Securities and Exchange Commission or the U.S. Treasury. The Fed prints its own money, and after paying its bills, turns its profits over to the Treasury.

To make the Fed accountable to democratically elected representatives, the members of the Federal Reserve Board (though not the presidents of the 12 regional Fed banks) are nominated by the president and confirmed by the Senate for fixed terms. The Fed is required to submit semiannual reports on monetary policy and the economy to Congress, and its chair fields questions on those reports at congressional hearings.

Q: What is the Fed afraid of?

A: Most (though not all) GAO reports are boring and conclude with recommendations that are the good-government equivalent of “always buckle your seatbelt,” such as a recent suggestions that regional Fed banks post their board of directors’ bylaws and other information on line. (They did.)

But the Fed isn’t afraid of the GAO. It’s afraid of Congress. Fed officials worry, with good reason, that aggressive members of Congress unhappy with a Fed interest-rate decision could dispatch the GAO repeatedly to investigate, essentially using the GAO as a way to pressure the Fed to change its policies. That could reduce the Fed’s ability to make monetary policy decisions independently. In the Fed’s most detailed attack on Audit the Fed and similar bills, Fed governor Jerome Powell said recently the bills “fail to anticipate the significant costs and risks of subjecting the Fed’s conduct of monetary policy to political pressure.”

A survey of big-name economists by the University of Chicago’s Booth Graduate School of Business found not one supported the proposition that GAO audits of monetary policy “would improve the Fed’s legitimacy without hurting its decision-making.”

Q: What information do Sen. Rand Paul (R., Ky.) and other backers of Audit the Fed want that they’re aren’t now getting?

A: That’s hard to know.

In a recent speech at an Audit the Fed rally in Iowa, Mr. Paul derided GAO audits because they tell us “what they spent on coffee…and doughnuts,” but nothing about “the 4.5 trillion in assets that the Fed owns, [of which] more than 2 trillion is said to be troubled.”

“Who knows what that’s worth?” Mr. Paul said. “If $2 trillion is distressed and not of value, what if it’s worth 10 cents, they’re 90% off. That would mean they’re insolvent, and we would have a terrible problem.”

Mr. Paul is wrong. I covered the Fed for more than 25 years and I can’t find any GAO report or Fed website that reveals what the Fed spends on coffee and doughnuts. (I did learn in a report by the Fed’s inspector general that at Fed-sponsored conferences, alcohol may be served only after 5:30 p.m. and for no more than 90 minutes.)

We do, however, know plenty about what’s in the Fed’s $4.5 trillion portfolio, down to the CUSIP number of each of its securities, as the New York Times’ Neil Irwin pointed out recently.

Pressure from Congress and the press has led the Fed, with some reluctance, to release more information in recent years, including–with a two-year lag–the identities of banks and other financial institutions that borrow at the Fed’s discount window.

The only sense I can make of Mr. Paul’s assertion that the Fed holds more than $2 trillion in troubled securities is that he is referring to the $1.7 trillion in mortgage-backed securities that the Fed owns. But those securities are guaranteed by Fannie Mae and Freddie Mac, and they are now backed by the U.S. government. If mortgages underlying the securities go bust, the Fed won’t be out any money (though Fannie and Freddie and, thus, U.S. taxpayers, might be).

The Fed posts quarterly (unaudited)  and annual (audited) reports on the market value of securities in its portfolio. For instance, it says it has about $20 billion in unrealized capital losses on that $1.7-trillion in mortgage-backed securities.

Q: What are the politics of “Audit the Fed”?

A: The Fed has been the target of congressional animosity before. This round was launched by Rand Paul’s father, former Rep. Ron Paul (R., Texas), who made his objectives clear with the title of his book: “End the Fed.” The elder Mr. Paul’s goals went beyond holding the Fed accountable: He favored a return to the gold standard.

Antipathy toward the Fed grew during the financial crisis, in part because of its highly visible role in various bailouts and in part because it got a lot of the blame for the prolonged period of very high unemployment. Attacking the Fed is popular with some voters, particularly at the far right and far left of the political spectrum.

Rand Paul’s political action committee has used the issue as a fundraising tactic. (“The Federal Reserve’s cronies launched a nasty smear campaign against me because they’re terrified of the momentum Audit the Fed is gaining in Congress. The attacks are personal–and they’re only going to intensify. That’s why RANDPAC is holding a “Stand with Rand Audit the Fed” Money Bomb.”) His stated goal was to raise $150,000. The website says he got $88,524 as of Feb. 15.

The House already has passed versions of Audit the Fed. The election of a Republican majority in the Senate raises the chances of passage, hence the Fed’s angst. The new chairman of the Senate Banking Committee, Richard Shelby (R., Ala.) has said he’ll hold hearings on Mr. Paul’s bill.

But liberal Senate Democrats who have been critical of the Fed–notably Elizabeth Warren (D., Mass.) and Sherrod Brown (D., Ohio)–have said they oppose the bill.  That strongly suggests there won’t be 60 votes in the Senate to get the bill to the president. If it did get to his desk, he’d almost surely veto it.

The Fed will remain a target of hostile politicians, and criticism may intensify when the Fed raises interest rates, but the chance that the Audit the Fed bill, as currently written, will become law is close to zero.

Q: Beyond all these technicalities and partisan posturing, is there some important underlying issue here?

A: Yes. In a democracy, the tradeoff for a central bank’s independence is accountability to the nation’s elected leadership. Congress is having a hard time fulfilling its responsibilities to hold the Fed accountable . Too few members of Congress know enough to ask good questions at hearings where the Fed chair testifies. Too many view hearings as a way to get themselves on TV or to score political points against the other party. The press does a much better job at the chair’s press conferences.

Congress turns to the Congressional Budget Office for analysis of the economy and the budget that is independent of the White House or any vested interest. There is no analog for advising Congress on monetary policy (in part because Congress doesn’t make monetary-policy decisions). A few other countries have formal outside reviews of their central banks, sometimes by foreigners. In Norway, for instance, a small group of independent economists, with funding from the finance ministry, evaluates the central bank’s monetary policy annually.

Most Fed officials see any further erosion of the limits on GAO audit as a step toward undermining the Fed’s ability to pursue monetary policy free of political interference. But a few years ago, Vincent Reinhart, a former top Fed staff economist who has been occasionally critical of the Fed since he left, suggested a compromise: Rewrite the law so the GAO can do a twice-a-year review of Fed monetary policy to be submitted a week before the chairwoman’s semiannual report to Congress so members of Congress are better prepared for the hearings. Limiting the GAO to twice-a-year reviews, he says, would eliminate the risk of an aggressive committee chairman, demanding frequent “audits” of the Fed to pressure policy makers while helping Congress fulfill its oversight responsibilities. Of course, much of that could be accomplished without allowing the GAO to interview Fed officials or review internal documents. And nothing is stopping Congress from making better use of the substantial amount of commentary on the Fed from private-sector economists.

The Fed has taken a “just say no” stance on all pending legislation. But Mr. Powell opened the door a crack to alternatives–presumably alternatives that don’t require legislation – that would strengthen Congress’ ability to hold the Fed accountable. “I would welcome discussions with the Congress about ways to aid its important oversight of monetary policy,” he said. “There may be differing views of how Congress can best carry out this responsibility, but there can be no disagreement about the purpose of such oversight, which is to help the Federal Reserve succeed in promoting a healthy economy and a strong and stable financial system.”