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I recently speculated that Mitt Romney might endorse Ron Paul's plan to audit the Fed and on August 20, he did just that. Governor Romney is attempting to shore up support amongst the conservative populists that had backed Congressman Paul. Unfortunately, the choice to audit the Fed could have enormous economic ramifications.

The Research

Although the proposed Fed audit plans attempt to avoid outright political influence by appointing the supposedly nonpartisan Government Accountability Office to audit the Fed, the GAO is actually highly influenced by Congress. Studies by Professors Steve Maser and Fred Thompson of Willamette University found that

the GAO appears to be highly responsive to congressional constituency interests. Its decisions appear to be biased in favor of… the constituents of pertinent congressional leaders in a way that the decisions of the courts are not.

So, the evidence indicates that the GAO is willing to sway decisions to favor the political interests of Congress.

Professor William Bernhard of University of Illinois has also demonstrated that independent central banks help alleviate pressures caused by conflicting political points of view about economic policy. We need only look to the fiscal policy sphere to understand his point. Since Republicans and Democrats can't compromise on a long-term deficit reduction plan, we continue to have disjointed, ad hoc policies that make long-term business planning a challenge. If this type of decision process was injected into monetary policy, the Fed could never make a credible commitment to a long-term policy.

World Bank economist Philip Keefer and NYU Professor David Stasavage take this point one step further when they demonstrate that the further removed central bankers are from politics, the more credible their policies are to the market. So, if anything, we should be making efforts to remove the Fed from politics in order to promote economic stability.

Market Response

Given that the proposed audit plan relies on the GAO and thereby involves Congress in monetary policy decisions, it would be extremely difficult for the Fed to control inflation by raising rates and inflicting pain when necessary. The result would be less faith in the U.S. dollar since our political leaders lack the will to make tough decisions (just look at the looming fiscal cliff). So, the dollar would diminish in value, businesses would not be able to make long-term plans, and markets would experience increased volatility. This sequence of events increases the odds of businesses moving offshore, thus further undermining the U.S. labor market.

Essentially, extending the Fed audit beyond its current version (the Fed has been subject to post-hoc oversight since legislation passed in 1977 and 1978) will increase market risk and uncertainty, thereby increasing the value of safe-havens like gold, while simultaneously diminishing the value of former safe-havens like U.S. Treasuries and the U.S. dollar. Equity investments would also be in turmoil as U.S. companies would decline in value while foreign markets rise in value, partially due to declining worth of the U.S. dollar.

Conclusion

By adopting Ron Paul's Fed audit plans, Mitt Romney has avoided an ugly conflict at the RNC convention, but he has stepped toward a policy that infringes on central bank independence and could have a profoundly negative impact on the U.S. dollar, U.S. Treasuries and U.S. equities. As the research indicates, the proposed audit would inject Congressional politics into Fed policymaking. Congress having this power could further destabilize the U.S. economy, create barriers to business planning and ultimately expel investors from U.S. equities, sending them to the safety of inflation hedged assets.

Source: Pandering To Populism: How Auditing The Fed Hurts The U.S. Economy