by Ron Paul
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 a 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 our 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 profits and socializing 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 times 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 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 no-where to 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 twentieth 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 the 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 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 toward 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 at banking history, we see that the drive for 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. 1 He places the blame on the very institution of fractional-reserve banking, the notion that depositors’ money currently in use as cash may also be loaned out for speculative projects and then redeposited. 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, a bank turns to other banks to provide liquidity. But when the failure becomes systemwide, it turns to the 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 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 deposits of $10,000. 2 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 on it 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, that is, 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 back in the story, since fractional-reserve banking had already become part of established banking practices in the nineteenth century, a fact that 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 of the incipient central bank was not renewed and it expired in 1811.
In 1812, with war raging between Britain and the United States, the government issued notes to finance the conflict, resulting in suspensions of payment as well as inflation. Inflation during wartime 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 nineteenth-century American banking theorist Condy Raguet explains: 3
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. 4 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. This 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 were beginning to rely on more and 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, began long before. Jacob Schiff, head of Kuhn, Loeb, & 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. 5
Once the groundwork was laid, the crisis atmosphere of 1907 assisted greatly in creating the conditions that led to the founding 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 crises have 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 Bank of New York, Kuhn, Loeb, Bankers Trust Company, and the Continental National Bank of Chicago. The NMC traveled around Europe and returned to the United States to continue the propaganda.
By 1909, President William Howard Taft had already endorsed a central bank, while the Wall Street Journal ran a fourteen-part series on the need for a central bank. The un-signed series was written by an NMC member, Charles A. Conant, who was the commission’s 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 drafting 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. Those who attended 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 twelve 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, a
nd 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 un-changed 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.” 6
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 that 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.” 7
And here is another remarkable promise from the Comptroller of the Currency: 8