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On May 18, in a victory over the Republican establishment, Rand Paul, son of the Federal Reserve's chief opponent in the U.S. Congress [Ron Paul], won the Republican Senatorial primary in Kentucky. He and his father object to the important roles being played by the Federal Reserve in the American economy.

It's time for the Federal Reserve to clean up its act. The Federal Reserve under Greenspan and Bernanke has been blowing it big time. The United States is mired in economic stagnation due to the loss of a large part of its manufacturing sector from 1998 through the present. Even worse, the solution endorsed and enacted by the Federal Reserve has been a corrupt bailout of the big banks.

The Pauls want to take the United States back to Andrew Jackson's closing of the Federal Reserve's predecessor which, when combined with a return to a strict gold standard, caused such a constriction in the U.S. money supply that a depression ensued which lasted from 1837 to 1844. The Pauls would throw the baby out with the bathwater. The Federal Reserve has important roles to play:

1. Closing Insolvent Banks. When banks go insolvent they need to be closed before they run up enormous debts.

2. Insuring Liquidity. An economy needs a money supply that is sufficient to finance transactions, inventory and payrolls. The Federal Reserve, under Ben Bernanke, performed this function admirably in October 2008, when, following the Lehman bankruptcy, liquidity dried up because banks were afraid to lend to each other.

3. Balancing Trade. These central banks have an important role to play in maintaining an exchange rate that balances trade. If that exchange rate gets too high, the country's industries lose market share in their competition in international markets. Greenspan did a terrible job with this function, letting the Asian Tigers currencies collapse in 1997 without offering their central banks the currency swaps that Bernanke offered when the dollar rose in October 2008. Then, after 1997, Greenspan ignored the Asian Central Bank excessive build-ups of dollar reserves which helped their industries steal market share from our industries. Bernanke continues to do nothing about his fellow central banks' dollar reserve build-ups to this day.

With these are important roles to play that are vital to stable prosperity, it is a shame to see these central banks entering into their new corrupt role of taking bad debts off the hands of their buddies in the private banking sector. In Europe, the European Central Bank is now buying Greek government junk-bonds at higher-than-their value from their buddies in private German and French banks.

Meanwhile, the Federal Reserve's balance sheet from May 13, 2010 shows $26.8 billion of credit extended to AIG (AIG), $67.4 billion of net portfolio holdings of Maiden Lane, $25.4 billion of AIA Aurora and Alico Holdings, and a whopping $1,098 billion of mortgage-backed securities. All of these questionable long-term loans were granted in order to bail out private sector banks.

The Federal Reserve has an important role to play in the American economy. It jeopardizes that role when it bails out its buddies in the private banking sector with long-term loans. The Federal Reserve should be prohibited from offering long-term loans to anyone, period.

The latest expansion of global government is to institutionalize bail-outs of "too big to fail" banks through a global TARP-like slush fund to be paid for through an international tax on banks. A much better solution would be to let big banks go bankrupt, while the central banks maintain liquidity, just as Bernanke did successfully following the Lehman collapse.

As Nouriel Roubini recently pointed out, if a bank is "too big to fail" it is "too big to save." If governments truly believe that some banks are "too big to fail," then break them up now, don't promise to bail them out afterwards.

Let's not lose sight of the fact that the Great Recession was not caused by the bankruptcy of Lehman Brothers. Both the Great Recession and the bankruptcy of Lehman Brothers were caused by the popping of a U.S. housing bubble. That bubble, in turn, had been largely caused by inflows of credit from Asian Central Banks.

The popping of the housing bubble in the United States resulted in a drop in consumption, because American consumers could no longer afford to keep borrowing on their homes to buy consumer goods. The contagion affected the entire world because American consumers could no longer buy as many imports. When trade is balanced, consumers get income from exports to buy imports. When it is out-of-balance, they must go into debt to buy them.

An international system built upon imbalanced trade cannot last. The trade-deficit countries must go deeper and deeper into debt to finance their imports. Eventually, they go bankrupt. The financial crisis that began in the United States in 2008 and spread to Southern Europe in 2010, still has a ways to run. The solution is not to transfer debt from the private sector to the public sector. That only works until the public sector goes bankrupt. The solution is balanced trade.

Disclosure: No positions

Source: Rand Paul's Victory Puts the Fed on Notice