Election 2012

If The Federal Reserve Is Abolished, What Then?

Many critics of the Federal Reserve won't be satisfied until the central bank is shut down for good.

The Federal Reserve headquarters in Washington, DC.

But abolishing the Fed only raises the bigger issue: What would—or should—be in its place?

The debate is hardly new. Efforts to set a cohesive national monetary policy through a central bank in the U.S. have been many and turbulent.

However, pushing the Federal Reserve building into the Potomac River wouldn't be easy. Let's see how the process could play out.

What has to be done?

The first thing to do in getting rid of the Fed is for Congress to repeal the 1913 law—and the subsequent amendments—that set up the current Federal Reserve.

Born out of the 1907 depression and following 80 years without a Fed-like institution, the law was created to implement currency reform designed to stop financial panics and to provide an emergency reserve of money for the economy.

The Fed's mandate grew to include setting certain interest rates, controlling inflation, regulating banks, and "reaching full employment."

So what are the chances of a repeal? Even with the vocal criticism of Fed bashers like not much, says professor John Allan James from the Lubin School of Business at Pace University, who is critical of some Fed policies.

"It would take the two houses of Congress 10 to 20 years, in my opinion, to get the required votes to tear the system down or alter it in any major fashion," James explains.

If the law is repealed?

But suppose the law were taken off the books? The Fed's job—in simple terms—is to manage the nation's money supply and achieve the sometimes-conflicting tasks of full employment, stable prices while fighting inflation or deflation.

How would the U.S. economy then function? Something has to take its place, right?

Global markets would also need some sort of economic direction from the U.S. The Fed manages the dollar — and as the world's leading currency, a void left by a Fed-less America could throw those markets into chaos with uncertainty about who's managing U.S. interest rates and the American economy.

What about the gold standard?

Hold on, say naysayers like Paul, we don't need another system. We can return to the gold standard. The amount of money in the economy would then be entrusted to the supply of gold in the world and cut down on anyone's ability to increase U.S. dollars pumped into the economy— a major criticism of the Fed's policies since the 2008 recession.

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Tying the U.S. dollar's value to a fixed weight of gold has been done before—even with the Fed in place.

It was after decades of being on and off both gold and silver that America ended the gold standard in 1933, when President Franklin Roosevelt banned private ownership of the metal.

The tie to gold was completely broken in 1971 by President Richard Nixon.

What's left is called a system of 'fiat money' in which currencies are backed by the 'good faith' of their government rather than a metal like gold.

Reverting back to gold would do more harm than good, even in the Fed's worst days, says David Abuaf, CFA and CIO of Hefty Wealth Partners.

"The gold standard brought about some long-run price stability but it's also led to short-run volatility," Abuaf explains. "It acts as a limit on economic growth. The money supply would be based on the production of gold. The management of money is easier with a fiat currency."

And there may not be enough gold to go around to back up the dollar — it could be hostage to the whims of gold traders.

Can the Treasury step in?

If there were no return to the gold standard—and no Fed—what about the Treasury Department? It could be responsible for the amount of money being injected into the economy.

But that would create a political earthquake over who would be Treasury Secretary—as they are appointed by the President but must be approved by the Senate.

The Fed currently has legal independence from the White House and Congress—but must make frequent Congressional appearances—but if the decisions were made by the Treasury, that economic autonomy could easily disappear. The politicking over economic theories would be endless.

"Whatever replaces the Fed must be independent," says Abuaf. "If there isn't independence, it would be catastrophic. There needs to be a division of the government that does what the Fed does and be completely free of political interference."

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Maybe because of some political influence, the Fed has changed over the years. It's grown in power and created more critics along the way—but recently allowed a limited look inside its decision making. Some analysts believe it could do more.

"While it may be far from easy, if not impossible to rein in the Fed," says James, "making it much more transparent in what it does would reduce the need for abolishing it and at least reduce the rumbling from critics."

What's the answer?

If history is any guide, having some sort of central bank may have been better than none. Out of 100 years of Fed control, the country has had 22 recessional years, including one depression. The 100 years before the Fed saw 44 recessions and six depressions.

What's left is this: until someone thinks of a better idea than the gold standard or handing the economic keys to the Treasury Department, or just leaving a void, the Fed will probably have to stick around—flaws and all.

"I think most of the rhetoric is political blather and adds to a degree of uncertainty around the world, hurting all aspects of growth," says John Allan James. "It may make good media copy, but the chances of the Fed being dissolved are totally unrealistic."