March 7, 2011 Phone: 202.783.

3870
Fax: 202.942.7649

www.freedomworks.org

400 North Capitol Street, NW

Suite 765
Dear Senator, Washington, DC 20001

Attached is a memo written by Dr. Judy Shelton providing information and questions you may
want to consider when assessing Peter Diamond’s nomination to become a Member of the
Federal Reserve Board of Governors. Dr. Shelton is Senior Fellow and Director of Monetary
Policy at FreedomWorks, a grassroots group with over 1 million members nation-wide, and
author of A Guide to Sound Money (here: http://atlasnetwork.org/guidetosoundmoney/ if you are
looking for concise insight into monetary policy).

Dr. Shelton’s memo starts with an overview of what committee members should focus on when
considering a nominee for the Federal Reserve Board of Governors. She emphasizes the
importance of distinguishing a nominee’s current policy positions from his academic accolades
for prior work, noting that winning the Nobel Prize in economics, as Paul Krugman did, should
not be the deciding factor when considering a nominee.

Dr. Shelton then examines Diamond’s career, highlighting his support for Fannie Mae-like
entities and policies that rely on government intervention rather than on the private sector. She
warns that his policy positions are not congruent with creating the environment in which
economic growth is most likely to occur. She concludes with questions to draw out his views on
the role of government that will likely influence his decisions as a monetary policymaker.

Although beyond the scope of Dr. Shelton’s thoughtful memo, it is interesting to note the work
of the co-authors with whom Diamond published two of his best known papers. It is not known
how these co-authors influenced Diamond, but it is worth inquiring. First is "The Beveridge
Curve", co-authored with Olivier Blanchard, chief economist for the IMF. Blanchard in
“Rethinking Macroeconomic Policy” suggests central banks should aim for higher inflation; say
4%, sacrificing monetary integrity for policy maneuverability. Does Diamond Agree? The IMF’s
president recently called for a global currency. Does Diamond agree? Second is "Increases in
Risk and Risk Aversion," co-authored with Joseph Stiglitz, who chaired a UN panel on
reforming the international monetary system that recommended replacing the U.S. dollar as the
top reserve unit with one based on the IMF’s “Special Drawing Rights.” Does Diamond agree?

While such nominations usually pass without much fan-fare, we hope this one does not. Given
the importance of the position, and Diamond’s long record, we intend to shed as much sunlight
on this nomination as possible. We oppose this nomination and ask that you do, too.

Sincerely,

Max Pappas
Vice President, Public Policy

Lower Taxes – Less Government – More Freedom

 CONFIDENTIAL

March 7, 2011

MEMORANDUM

For: Members of Senate Committee on Banking, Housing & Urban Affairs

From: Dr. Judy Shelton, Senior Fellow and Director of Monetary Policy

Subject: Nomination Hearing for Peter A. Diamond to be a Member of the

Board of Governors of the Federal Reserve System

Overview

Peter Diamond, a professor at the Massachusetts Institute of Technology since 1966, was
awarded the Nobel Prize in economics this past October.

That is no small thing.

But then again, New York Times columnist Paul Krugman was also awarded the Nobel
Prize in economics in 2008. Does that mean the Senate Banking Committee should
automatically relinquish its right to question the economic judgment of Krugman if his
name were ever put forward as a nominee for the Federal Reserve Board?

Certainly, it would be inappropriate for members of the Committee to ignore the fact that
Krugman is a strong advocate of government fiscal and monetary stimulus, i.e., deficit
spending and printing money, as a cure for economic slackness. Notwithstanding the
charming manner in which Krugman expresses his views (he calls Rep. Paul Ryan a
“charlatan” and his Road Map for America plan a “fraud”), it is important to distinguish a
nominee’s current policy positions from academic accolades for prior work. Committee
members should be careful to focus on the monetary perspective a nominee is likely to
bring to the Federal Reserve Board; this is what will influence future decisions on
whether to suppress or elevate interest rates.

That is, does the candidate believe that monetary policy should be used to accommodate
government spending? Does the candidate favor using monetary stimulus in conjunction
with fiscal stimulus measures? Does the candidate take the view that the chief purpose of
money is to provide a useful measuring tool for private enterprise – or should it be seen
as an instrument of government economic policy?

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These fundamental questions should be probed if Committee members are to ascertain
the broad political philosophy of the candidate. These leanings regarding the role of
government in a free-market economy will come to bear on the interest rate policy
choices of any future Governor of the Federal Reserve System.

In Diamond’s case, we already have an inkling of his current beliefs in terms of the
government’s capacity to remedy the perceived shortcomings of the private sector. “The
quantitative easing is a help,” he told Bloomberg News on Nov. 30, “but it needs fiscal
backing. Given the other things happening, it’s not as powerful as we need.” A month
earlier, Diamond urged Congress to extend unemployment benefits and approve more aid
for state and local governments to help them keep teachers and other workers on the job.
During his interview with NPR News on Oct. 31, Diamond said: “The clearest, simplest
way to hold down unemployment is for the federal government to give more money to
the states so the states will stop laying off teachers, police, other workers.”

In addition to Diamond’s assertion that the federal government should employ stepped-up
fiscal measures and “powerful” monetary policy to stimulate the economy, it is also
evident that he has strong beliefs concerning tax policy. Specifically, Diamond does not
believe the Bush administration’s tax cuts should have been extended for all taxpayers.
On Nov. 30, Diamond recommended that taxes be raised on those earning more than
$250,000 based on his belief that “the amount of stimulus you get out of the tax cuts on
the highest income people is very small.” Such thinking runs counter to a supply-side
economic approach, which recognizes that private-sector job growth is negatively
affected by tax hikes aimed at high-end earners – as these are precisely the individuals
most likely to engage in entrepreneurial activity and create new businesses.

In short, recent pronouncements by Diamond suggest he would sooner rely on the

government’s ability to shape the economy through deliberate intervention than on the
innovative potential of the private sector to respond to market incentives. The key to
allowing free market mechanisms to function at optimal levels is to facilitate clear price
signals – i.e., to ensure that money provides an accurate and reliable unit of account so
that the real value of goods and services is conveyed with clarity. When price signals are
distorted through loose monetary policy, economic resources are misallocated and
financial capital is misdirected. Diamond’s predisposition for government-directed
solutions to private-sector challenges does not bode well for increasing the productive
output of America’s economy – and warns against the validity of his judgment as a
prospective Federal Reserve Board member. Genuine prosperity cannot be forged at the
expense of monetary integrity.

It would be easy to cite a number of proposals put forward by Diamond in other areas to
provide further evidence of his tendency toward sweeping government plans. In a 1991
New York Times op-ed entitled “Health Care for Everyone,” the MIT professor argued
that universal coverage could be achieved by having the government create groups for
health insurance purposes. Diamond suggested that risk could be managed in the same
way the Federal National Mortgage Association (Fannie Mae) operates by grouping
individual mortgages together into securities that are sold to private investors. “What if

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government simply assigned people to groups, ranging in size from 10,000 to 100,000,
based solely on where they live?” he posited. “Cross-subsidization of premiums can
equalize insurance payments between urban ghettoes, where health is relatively poor, and
more affluent neighborhoods in the same city or region.” Diamond’s proposal would thus
have the government bundle individuals into large groups for health-care insurance
purposes; he compares his approach to the way government bundles residential
mortgages to reduce the overall threat of default. “Colleagues have suggested calling the
plan “Fanny Medic” or “Healthy Mae,” he notes in his op-ed (clearly unaware it would
prove a most unfortunate comparison).

Or then there is Diamond’s proposal, co-developed with Peter Orszag, to reform the
Social Security system. The plan was submitted to the Congressional Budget Office for
evaluation in 2004; according to CBO documents, it was rigorously analyzed to
determine its potential impact “on the Social Security program, the federal budget, the
U.S. economy, and present and future beneficiaries.” The bottom-line conclusion of the
CBO’s analysis is encapsulated by the opening sentence of the Summary: “The proposal
would both increase taxes and reduce benefits relative to those scheduled under current
law.” For specifics, one can consult an array of charts and graphs, but one observation
within the lengthy text of the CBO assessment stands out in particular: “Workers with
higher earnings would be disproportionately affected by the proposal; relative to their
earnings, they would generally experience larger tax increases and larger benefit
reductions than workers with average or below-average earnings.” This aspect of
Diamond’s proposal would seem to provide further confirmation of his apparent bias
against high-end taxpayers.

Health care and social security, of course, are matters of fiscal policy. They do not fall in
the realm of monetary policy – at least, they should not. The fundamental duty of
monetary policymakers is to calibrate the supply of money and credit to the productive
needs of the real economy; they should not act to facilitate government intervention by
accommodating deficit spending. Which is why it is so vital that Committee members
attempt to glean the intentions of the nominee in this regard.

The seven appointed governors of the Federal Reserve Board automatically serve as
members of the Federal Open Market Committee. Together with the president of the New
York Fed and four of the eleven other Federal Reserve Bank presidents (on a rotating
basis) they constitute the 12-person committee that makes key decisions on interest rates
and the growth of the U.S. money supply. The ramifications of engaging in overly loose
monetary policy are hugely negative, affecting both domestic and global markets.
Members of the FOMC who are inclined to support activist government involvement in
the economy through strong fiscal measures may be sorely tempted to provide correlative
monetary stimulus.

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The Federal Reserve is charged with the dual mandate of achieving “maximum
employment” as well as “stable prices” through its conduct of monetary policy; thus,
some might argue that FOMC members must take major fiscal issues into consideration.
But this creates internal policy tension because government outlays for health care, for
social security, or for extended unemployment compensation (an area that touches on
Diamond’s background in labor economics) have significant budgetary consequences. To
the extent these programs exacerbate the mismatch between government expenditures
and government revenues, our nation will continue to run budget deficits annually. These
mounting deficits must be financed through the issuance of Treasury securities. If the
largest holder of Treasury securities is the Federal Reserve – and it is, since late January
– there exists a conflict of interest among government agencies that is both obvious and
disturbing.

In evaluating the suitability of this nominee, or any nominee, to serve as a member of the
Federal Reserve Board of Governors, it is important to keep in mind that a fixation on
government spending as an economic remedy poses a direct threat to monetary policy
prudence.

Questions

 Monetary policy is generally considered a highly complex and rather

sophisticated area of economics. Could you get back to basics and define for us
the three primary functions of money? The primary functions of money are: (1)
medium of exchange, (2) unit of account, (3) store of value.

 Which of these primary functions do you think the U.S. dollar fulfills best?
Medium of exchange; the dollar is widely accepted. Which of these functions do
you think the U.S. dollar performs worst? Store of value. The candidate should be
aware that the dollar has lost 95 percent of its value since 1913 – the year the
Federal Reserve was established. This figure is based on the CPI Inflation
Calculator available on the Bureau of Labor Statistics website:
http://data.bls.gov/cgi-bin/cpicalc.pl?cost1=100&year1=2011&year2=1913
Should the nominee choose to discuss the unit of account function, listen for
references to the dollar as a global currency that take note of the difficulties
posed by fluctuating exchange rates; this could be a helpful discussion.

 Given that the dollar’s purchasing power is reduced when there is inflation, could
you tell us at what level of inflation you would become concerned as a Fed Board
member? That is, how much inflation do you think is acceptable without violating
the Fed’s mandate to achieve “stable prices” – 2 percent? 3 percent? Nominee will
likely hedge from naming an actual percentage rate, though he may suggest 2
percent is acceptable (since Chairman Bernanke has indicated as much). If we
were to have, say, 3 percent inflation for several months in a row, as measured by
the CPI, would you vote to tighten monetary policy? It is important to ascertain
how vigilant this nominee will be with regard to inflation.

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 Do you believe the Federal Reserve’s preferred measure of core inflation – the
Personal Consumption Expenditures Price Index, or PCE – provides a meaningful
sense of the impact of rising prices for average Americans? He should
acknowledge that it does not include price changes for food and fuel; this is
because the Fed considers those prices to be “variable.” But you should probe to
see whether the nominee recognizes that rising food and fuel prices can reveal
important trends. Monetary policymakers need to take commodity pricing trends
into serious consideration.

 The inflationary effects of quantitative easing are being felt outside the United
States. Rising food prices have been linked to protests across the Middle East and
other areas of the world. Do you feel the Federal Reserve has any responsibility
for maintaining monetary stability beyond our borders? He may follow
Bernanke’s lead and suggest that the Fed is only responsible for domestic
monetary policy and that other countries should use their own tools to control
inflation. While this has been a convenient tactic to avoid further questioning, it
does not comport with Fed actions and the nominee should be drawn out on this
point. But isn’t it inconsistent to take such an isolationist position when the Fed
cooperates so generously with foreign banks when it comes to emergency loans or
currency swaps? Huge sums were loaned to foreign banks by the Federal Reserve
through the Term Auction Facility (TAF) and the Primary Dealer Credit Facility,
as well as the Fed’s commercial paper funding facility.

 Do you believe that being the issuer of the world’s most prominent reserve
currency is a privilege – or a burden? Could you give us your own cost-versus-
benefits assessment? The U.S. needs to face up to this issue as our economic
competitors endeavor to challenge the dollar’s key currency status. It’s an
important topic this nominee may well have to confront if he becomes a member
of the Federal Reserve Board.

 Can you tell us the approximate value of U.S. Treasury securities held by the Fed?
$1.1 trillion. How does this compare to the amount of U.S. Treasury securities
held by China or Japan, the two largest foreign holders? China holds $896 billion
and Japan holds $877 billion. Are you troubled that, since the Fed began buying
Treasury debt under QE2 and QE “lite” (reinvestment of principal payments from
its large mortgage debt holdings into Treasuries), other central banks have scaled
back their own purchases of U.S. debt obligations? He should be concerned that
the Fed has become the leading holder of U.S. Treasury securities even though it
has yet to reach the halfway mark in its latest round of quantitative easing. See
“Fed passes China in Treasury holdings”(Financial Times, Feb. 2)
http://www.ft.com/cms/s/0/120372fc-2e48-11e0-8733-
00144feabdc0.html#axzz1FtmE7byp

 Does it seem healthy to you that an agency of government – the Federal Reserve –
has become the chief financier to our nation’s Treasury department?