Tags

[Chapter 2 of End the Fed by Ron Paul (Grand Central Publishing, 2009), pp. 12–31. The publisher controls reprint permissions for this chapter, and has given permission to Mises.org to run this. Unlike most everything else on Mises.org that is published under Creative Commons, it cannot be reposted or republished, but blogs and sites are welcome to link here.]

Most Americans haven't thought much about the strange entity that controls the nation's money. They simply accept it as though it has always been there, which is far from the case. Visitors to Washington can see the Fed's palatial headquarters in Washington, D.C., which opened its doors in 1937. Tourists observe its intimidating appearance and forbidding structure, the monetary parallel to the Supreme Court or the Capitol of the United States.

People know that this institution has an important job to do in managing the nation's money supply, and they hear the head of the Fed testify to Congress, citing complex data, making predictions, and attempting to intimidate anyone who would take issue with them. One would never suspect from their words that there is any mismanagement taking place. The head of the Fed always postures as master of the universe, someone completely knowledgeable and completely in control.

But how much do we really know about what goes on inside the Fed? With the newest round of bailouts, even journalists have a difficult time running down precisely where the money is coming from and where it is headed. From its founding in 1913, secrecy and inside deals have been part of the way the Fed works.

Part of the public-relations game played by the chairman of the Fed is designed to suggest that the Fed is an essential part of our system, one we cannot do without. In fact, the Fed came about during a period of the nation's history called the Progressive Era, when the income tax and many new government institutions were created. It was a time in which business in general became infatuated with the idea of forming cartels as a way of protecting their profits and socializing their losses.

The largest banks were no exception. They were very unhappy that there was no national lender of last resort that they could depend on to bail them out in a time of crisis. With no bailout mechanism in place, they had to sink or swim on their own merits. What was more, following the Civil War, American presidents actually worked to implement and defend the gold standard, which put a brake on the ability of the largest banks to expand credit without limit. The gold standard worked like a regulator in this way. Ultimately, banks had to function like every other business. They could expand and make risky loans up to a point, but when faced with bankruptcy, they had nowhere they could turn. They would have to contract loans and deal with extreme financial pressures. Risk bearing is a wonderful mechanism for regulating human decision making. This created a culture of lending discipline.

In the jargon of the day, the system lacked "elasticity." That's another way of saying that banks couldn't expand money and credit as much as they wanted. They couldn't inflate without limit and count on a centralized institution to bail them out. This agenda fit well with a growing political movement at the turn of the 20th century that favored inflation (sometimes summed up in the slogan "Free Silver") as a means of relieving the debt burden of farmers. The cause took on certain populist overtones, and many people began to believe that an elastic money supply would help the common man. They identified the gold standard as a system favored by large banks to keep credit tight. Even today, many writers on the Fed mistakenly believe that the central bank and the largest banks are working to keep credit tight in their own interest.

Even the Fed itself claims that part of its job is to keep inflation in check. This is something like the tobacco industry claiming that it is trying to stop smoking or the automobile industry claiming that it is trying to control road congestion. The Fed is in the business of generating inflation. It might attempt to stop the effects of inflation, namely rising prices. But under the old definition of inflation — an artificial increase in the supply of money and credit — the entire reason for Fed's existence is to generate more, not less of it.

What the largest banks desire is precisely what we might expect any large corporation to desire: privatized profits and socialized losses. The privatized profits come from successful loan activities, sometimes during economic booms. But when the boom turns to bust, the losses are absorbed by third parties and do not affect the bottom line. To cover losses requires a supply of money that stretches to meet the bankers' demands. This is something that every industry would like if they could get it. But it is something that the free market denies them, and rightly so.

The banking industry has always had trouble with the idea of a free market that provides opportunities for both profits and losses. The first part, the industry likes. The second part is another issue. That is the reason for the constant drive in American history towards the centralization of money and banking, a trend that not only benefits the largest banks with the most to lose from a sound money system, but also the government, which is able to use an elastic system as an alternative form of revenue support. The coalition of government and big bankers provides the essential backbone of support for the centralization of money and credit.

If we look back at banking history, we can see the drive for the centralization of power dates back centuries. Whenever instability turns up, so do efforts to socialize the losses. Rarely do people ask what the fundamental source of instability really is. For an answer we can turn to a monumental study published in 2006 by Spanish economist Jesús Huerta de Soto. He places the blame on the very institution of fractional-reserve banking. This is the notion that depositors' money that is currently in use as cash may also be loaned out for speculative projects and then re-deposited. The system works so long as people do not attempt to withdraw all their money at once, as permitted to them in the banking contract. Once they do attempt this, the bank faces a choice to go bankrupt or suspend payment. In the face of such a demand, they turn to other banks to provide liquidity. But when the failure becomes system-wide, they turn to government.

The core of the problem is the conglomeration of two distinct functions of a bank. The first is the warehousing function, the most traditional function of a bank. The bank keeps your money safe and provides services such as checking, ATM access, record keeping, and online payment methods. These are all part of the warehousing services of the bank, and they are services for which the consumer is traditionally asked to pay (unless costs can be recouped through some other means). The second service the bank provides is a loan service. It seeks out investments such as commercial ventures and real estate, and puts money at risk in search of a rate of return. People who want their money put into such ventures are choosing to accept the risk and hoping for a return, understanding that if the investments do not work out, they lose money in the process.

The institution of fractional reserves mixes these two functions, such that warehousing becomes a source for lending. The bank loans out money that has been warehoused — and stands ready to use in checking accounts or other forms of checkable deposits — and that newly loaned money is deposited yet again in checkable deposits. It is loaned out again and deposited, with each depositor treating the loan money as an asset on the books.

In this way, fractional reserves create new money, pyramiding it on top of a fraction of old deposits. Depending on reserve ratios and banking practices, an initial deposit of $1,000, thanks to this "money multiplier," turns into a $10,000. The Fed depends heavily on this system of fractional reserves, using the banking system as the engine through which new money is injected into the economy as a whole. It adds reserves to the balances of member banks in the hope of inspiring ever more lending.

From the depositor point of view, this system has created certain illusions. As customers of the bank, we tend to believe that we can have both perfect security for our money, drawing it in whenever we want and never expecting it not to be there, while still earning a regular rate of return on that same money. In a true free market, however, there tends to be a tradeoff: you can enjoy the service of a money warehouse or you can loan your money to the bank and hope for a return on your investment. You can't usually have both. The Fed, however, by backing up this fractional-reserve system with a promise of endless bailouts and money creation, attempts to keep the illusion going.

Even with a government-guaranteed system of fractional reserves, the system is always vulnerable to collapse at the right moments, namely when all depositors come asking for their money in the course of a run (think of the scene in "It's a Wonderful Life"). The whole history of modern banking legislation and reform can be seen as an elaborate attempt to patch the holes in this leaking boat. Thus have we created deposit insurance, established the "too-big-to-fail" doctrine, created schemes for emergency injections, and all the rest, so as to keep afloat a system that is inherently unstable.

What I've described is a telescoped version of several hundreds of developments, but it accurately explains the continued drive to push forward with money that is infinitely elastic and with banking institutions that are guaranteed, through government legislation, not to fail, i.e., central banking as we know it. Just so that we are clear: the modern system of money and banking is not a free-market system. It is a system that is half socialized — propped up by government — and one that could never be sustained as it is in a clean market environment. And this is the core of the problem.

In examining the history of the Fed in particular, we must start far into the story, since fractional-reserve banking had already become part of established banking practices in the 19th century, a fact which goes a very long way to explain the source of periodic instability.

The story can be said to begin in 1775, when the Continental Congress issued a paper money called the Continental, as in "not worth a Continental." The currency was inflated to the point of disaster, and price controls didn't come close to working to stop it. This was the first great hyperinflation in U.S. history, and it gave rise to a hard-money school of thought that would agitate against central banking and paper money for many generations since. It also explains why the Constitution placed a ban on paper money and permitted only gold and silver as money.

In 1791, the First Bank of the United States was chartered, and in 1792, Congress passed the Coinage Act recognizing the dollar as the national currency, the original of which dates back to the 1400s with the German coin, the "Thaler." Fortunately, the charter on the incipient central bank was not renewed and it expired in 1811.

In 1812, with the war raging between Britain and the United States, the government issued notes to finance the war, resulting in suspensions of payment as well as inflation. Inflation during a war is something you might expect, but instead of permitting normal conditions to return, Congress chartered the Second Bank of the United States in 1816. The bank aided and abetted ever more expansion and the creation of a boom-bust cycle.

The 19th century American banking theorist Condy Raguet explains:

Those who can remember the events of that period will not have forgotten the abuse of the public forbearance exhibited by them upon that occasion. The sanction of the community was extended to them during the continuance of the war then existing with Great Britain, on account of the belief that their condition was forced upon them by the peculiar circumstances of the country; but no sooner had peace returned in the early part of 1815, than all their pledges were violated, and instead of manifesting by their actions a desire to contract their loans so as to place themselves in a situation for complying with their obligations, they actually expanded the currency by extraordinary issues, whilst there was no existing check upon them, until its depreciation became so great that speculation and overtrading in all their disastrous forms, involved the country in a scene of wretchedness, from which it did not recover in ten years.

Finally, the inevitable downturn occurred with the Panic of 1819. This panic ended peacefully precisely because nothing was done to stop it. Jefferson pointed out that, in any case, the panic was only wiping out wealth that was entirely fictitious to begin with. Today this panic is but a footnote in the history books. After massive political agitation, and following Andrew Jackson's Executive Order that withdrew the federal government's deposits from the bank, the Second Bank was also allowed to be closed in 1836.

The war between North and South set off another round of inflationary finance, however, eventually killing off wartime currencies and prompting another deflation after the war that set the stage for a gold standard to be established that was solid but not perfect. It was the existence of flaws — banks were permitted fractional reserves and banks were beginning to rely on ever more regulations to dampen competition — that created the dynamic that led to the Federal Reserve.

The ostensible impetus for the creation of the Federal Reserve was the banking panic of 1907, but the drive, as mentioned before, began long before. Jacob Schiff, head of Kuhn, Loeb, and Co., gave a speech in 1906 that actually began the push for a European-style central bank. He explained that the "country needed money to prevent the next crisis." He worked with his partner, Paul Moritz Warburg, and Frank A. Vanderlip of the National City Bank of New York, to create a new commission that would deliver a report to the New York Chamber of Commerce in 1906. It called for a "central bank of issue under the control of the government." They began to work within other organizations to push the agenda, winning over the American Banking Association and many important players in government.

Once the groundwork was laid, the crisis atmosphere of 1907 assisted greatly in creating the conditions that led to the creation of the Fed. It was a brief contraction but during it many banks suspended specie payments, that is, they stopped paying out gold to depositors until the crisis passed. This led to a consolidation of opinion in favor of a general guarantor of all deposits.

A point we learn from this event and every other banking panic in U.S. history is that a crisis has always led to greater centralization. A system that is mixed between freedom and the state is a shaky system, and its internal contradictions have been resolved not by tending toward a free market but rather through a trend toward statism. It is not surprising, then, that academic opinion swung in favor of central banking too, with most important economists — having long forgotten their classical roots — seeing new magic powers associated with elastic money.

In 1908, Congress created a National Monetary Commission to look into the general idea of banking reform. The commission was staffed mostly by people close to the largest banks: First National Banking of New York, Kuhn Loeb, Bankers Trust Company, and the Continental National Bank of Chicago. The NMC traveled around Europe and returned to continue the propaganda.

By 1909, President William Howard Taft had already endorsed a central bank, while the Wall Street Journal ran a 14-part series on the need for a central bank. The unsigned series was written by a NMC member, Charles A. Conant, who was the chief public-relations man. The series made all the usual arguments for elasticity but added several additional functions that the central bank could play, including manipulating the discount rate and gold flows, as well as actively bailing out failing banks. What followed was a series of public speeches, pamphleteering, scholarly statements, political speeches, and press releases by merchant groups.

By November 1910, the time was right for the drafting of the bill that would become the Federal Reserve Act. A secret meeting was convened at the coastal Georgia resort called the Jekyll Island Club, co-owned by J.P. Morgan himself. The press said it was a duck-hunting expedition. They took elaborate steps to preserve their secrecy. But history recorded precisely who was there: John D. Rockefeller's man in the Senate, Nelson Aldrich, Morgan senior partner Henry Davison, German émigré and central banking advocate Paul Warburg, National City Bank vice president Frank Vanderlip, and NMC staffer A. Piatt Andrew who was also assistant secretary of the Treasury to President Taft.

So we had two Rockefellers, two Morgans, one Kuhn Loeb person, and one economist. In this group, we find the essence of the Fed: powerful bankers with powerful government officials working together to have the nation's money system serve their interests, justified by economists there to provide the scientific gloss. It has been pretty much the same ever since.

They worked in secrecy for a full week. The structure of the Federal Reserve was proposed at this meeting. It was not to be a European-style central bank — or rather, it would be, but the structure would be different. It would be "decentralized" into 12 member banks, providing something of a cover for the cartelization that was actually taking place. The full plan was presented to the National Monetary Commission in 1911. Then the propaganda was really stepped up with newspaper editorials, phony citizens' leagues, and endorsements from trade organizations. The next step was to remove the Republican partisanship from the bill and replace it with a bipartisan appearance, and the bill passed.

The essence of the Federal Reserve Act was largely unchanged from when it was first hatched years earlier. With a vote by Congress, the government would confer legal legitimacy on a cartel of the largest bankers and permit them to inflate the money supply at will, providing for themselves and the financial system liquidity in times of need, while insulating themselves against the consequences of bad loans and overextension of credit.

Hans Sennholz has called the creation of the Fed "the most tragic blunder ever committed by Congress. The day it was passed, old America died and a new era began. A new institution was born that was to cause, or greatly contribute to, the unprecedented economic instability in the decades to come."

It was a form of financial socialism that benefited the rich and the powerful. As for the excuse, it was then what it is now. The claim is that the Fed would protect the monetary and financial system against inflation and violent swings in market activity. It would stabilize the system by providing stimulus when it was necessary and pulling back on inflation when the economy became overheated.

A statement by the Comptroller of the Currency in 1914 promised a ridiculous nirvana would be ushered in by the Fed. It "supplies a circulating medium absolutely safe," the statement said. Further, "under the operation of this law such financial and commercial crises, or 'panics,' as this country experienced in 1873, in 1893, and again in 1907, with the attendant misfortunes and prostrations, seem to be mathematically impossible."

And here is another remarkable promise from the Comptroller of the Currency:

Under the provisions of the new law the failure of efficiently and honestly managed banks is practically impossible and a closer watch can be kept on member banks. Opportunities for a more thorough and complete examination are furnished for each particular bank. These facts should reduce the dangers from dishonest and incompetent management to a minimum. It is hoped that the national-bank failures can hereafter be virtually eliminated.

In practice the reality has been much different. One only needs to reflect on the dramatic decline in the value of the dollar that has taken place since the Fed was established in 1913. The goods and services you could buy for $1.00 in 1913 will now cost nearly $21.00. Another way to look at this is from the perspective of the purchasing power of the dollar itself. It has fallen to less than $0.05 of its 1913 value. We might say that the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy.

The same is true of other currencies controlled by a central bank. It is not, however, true of gold. Here is a general overview, courtesy of the American Institute for Economic Research:

As for the business cycle and the abolition of panics, the data show otherwise. Recessions of the 20th century as documented by the National Bureau of Economic Research include: 1918–1919, 1920–1921, 1923–1924, 1926–1927, 1929–1933, 1937–1938, 1945, 1948–1949, 1953–1954, 1957–1958, 1960–1961, 1969–1970, 1973–1975, 1980, 1981–1982, 1990–1991, 2001, and 2007, which is the current panic of which there is no end in sight.

Some mathematical impossibility!

The one aspect of the great promise that has been kept, not entirely but generally, is the promise that banks will not fail in the way they used to. But consider whether this is really a good thing. What if we had a law against business failure? It raises an obvious question: if businesses are not allowed to fail, what guarantee is in place that will give them incentive to succeed with soundness and productivity to the common good? In a capitalist economy, the prospect of failure imposes discipline and consumer service. It is an essential aspect of the competitive marketplace, whereas a promise against failure only entrenches inefficiency and incompetency.

In other words, bank failures are no more to be regretted than any other business failure. They are a normal feature of the free enterprise system. What about depositors? In a competitive and free system, deposits would not be unsafe; any that were not paid back that were promised would fall under the laws of protection against fraud. Unsafe deposits would be loans to the bank that would be treated like any other risky investment. Consumers would keep a more careful watch over the institutions that are handling their money and stop trusting regulators in Washington, who in fact have not done a good job in ferreting out incompetence.

But this is not the place to explain the workings of a free-market banking system. I raise the point only to underscore the broader lesson that no firm in a free market should enjoy absolute protection against failure. A continued process of trial and error is the way that institutions achieve the goal of efficiency and soundness.

Consider the Soviet case: to my knowledge, no business ever went under with the Soviet system but society in general grew ever poorer. Think of that Soviet system applied to the banking industry and you have the Fed.

Understanding this history of the Fed's founding and effects helps take some of the mystery out of it. Some people claim that the Fed is nothing but a private corporation that is working to enrich itself at our expense. Other people claim that it is a government operation that works to provide funds for the government when it can no longer get away with taxing us.

Neither opinion is precisely correct. Actually, the Fed is a public-private partnership, a coalition of large banks who are the owners working with the blessing of the government, which appoints its managers. In some way, it is the worst of both the corporate and the government worlds, with each side providing a contribution to an institution that has been horribly detrimental to American prosperity.

In any case, William Greider is exactly correct that the advent of the Fed represented "the beginning of the end of laissez-faire." It turned the entire money system over to public management on behalf of political causes.

Over the years, the Fed has been granted ever more leeway in the means it uses to inflate the money supply. It can now buy just about anything it wants and write it down as an asset. When it buys debt, it buys with newly created money. It maintains a strict system of low-reserve ratios that allows banks to pile loans on top of deposits and take the new deposits as the basis for ever more loans. It can set the federal funds rate at a level to its liking and influence interest across the entire economy. It intervenes in currency markets and other markets.

There have been many consequences of the Fed that were unforeseen even by its architects. They might have imagined that the Fed would indeed help smooth out the business cycle, provided you think of the real problem of the cycle as its bust phase when credit contracts. The Fed can indeed provide liquidity in these times by a simple operation of printing more paper money to cover deposits. But if you think of the cycle as beginning in the boom phase — when money and credit are loose and lending soars to fund unsustainable projects — matters change substantially.

In 1912, Ludwig von Mises wrote a book called The Theory of Money and CreditThe Theory of Money and Credit (New Haven: Yale University Press, 1953). that was widely acclaimed all over Europe. In it he warned that the creation of central banks would worsen and spread business cycles rather than eliminate them.

It works as follows. The central bank on a whim can reduce the interest rate that it charges members banks for loans. It can buy government debt and add that debt as an asset on its balance sheet. It can reduce the reserve coverage for loans at member banks.

But in doing all of this, it is toying with the signals that the banking industry is sending to borrowers. Businesses are fooled into taking out longer-term loans and starting projects that cannot be sustained. Investors flush with new cash put the money in stocks or buy homes, activities that spread a kind of buying-and-selling fever among the general population.

The problem is that all of this activity creates an illusory prosperity, a false boom. When lower interest rates result from real saving, the banking system is signaling that the necessary sacrifice of present consumption has taken place in order to fund long-term investment. But when central banks push down rates on a whim, the impression is created that the savings are there when they are in fact completely absent. The resulting bust becomes inevitable as goods that come to production can't be purchased, and reality sets in by waves. Businesses fail, homes are foreclosed upon, and people bail out of stocks or whatever the fashionable investment is of the day.

That phony money creates a false boom is not an unknown fact in history. Thomas Paine in the late 18th century observed that paper money threatened to turn the country into a nation of "stockjobbers." In fact, this can even happen when the money is not paper. The famous case of "tulipmania" in the Dutch golden era was driven by gold inflows from around Europe after the government gave a massive coinage subsidy to all comers.

International markets complicate the picture by allowing the boom phase of the cycle to continue longer than it otherwise would, as foreigners buy up and hold new debt, using it as collateral for their own monetary extensions. But eventually they, too, become ensnared in the boom-bust cycle of false prosperity followed by all-too-real bust. International markets can delay but not finally eliminate the inevitable results of monetary expansion.

Now, knowledge of this problem was not well spread among bankers and government officials in 1913 when the Fed was created. But it wouldn't be long until it would become apparent that the Fed would bring not stability but more instability, not shorter booms and busts but deeper and longer ones. The longest one of all, dramatically exacerbated by bad economic policy, was the Great Depression.