It Is Dangerous to Be Right When the Government Is Wrong

by Andrew P. Napolitano

  Supporters of the Fed maintain that secrecy is the only way the system can achieve its twin goals of “maximizing full employment” and “stabilizing the currency.” If the system became politicized and open to public criticism, so the argument goes, it would not be able to achieve those two goals. Yet, since the institution of the secret Federal Reserve in 1913, the U.S. dollar has lost about 93 percent of its value, and the U.S. economy has seen countless boom-and-bust cycles that have destroyed private wealth and caused massive unemployment. Moreover, as we are currently witnessing, the temptation to spend through crises, as is facilitated by the Federal Reserve System, is too great for most politicians to resist.

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  The Founders and drafters of the Constitution understood this danger, having witnessed it when the unsound Continental (the predecessor to the dollar, and basis of the phrase “not worth a Continental”) fell victim to hyperinflation in the early days of the nation. Accordingly, the Constitution made clear that only gold and silver could be used as legal tender. Nonetheless, what should have ended with a simple question of constitutional interpretation has grown into a massive system which has handicapped the ability of individuals to exercise their natural right to seek prosperity. As we shall see, the Fed, cloaked in its secrecy and esotericism, has offended the Natural Law as surely as any government agency we have yet witnessed.

  Money Does Not Grow on Trees

  This system of secrecy, conspiracy, and fraud naturally had its origins in secrecy, conspiracy, and fraud. To understand truly and appreciate fully why this system is so dangerous and unstable, we must understand where money comes from, how it led to the earliest banking systems, and how government management of it has caused economic chaos.

  When human beings first started trading goods and forming societies, the method of trade was direct exchange, or barter. Persons who wished to engage in trade had to come across a double coincidence of wants; if you produced apples and wanted oranges, you had to find someone who produced oranges and wanted apples. This system was obviously cumbersome and inefficient. What happens if the orange farmer did not want apples? Then the apple farmer was out of luck. Also, it is very difficult for producers to calculate their profits, how well they were engaging in trade, and how much each good was actually worth. Moreover, apples only stay fresh for a few weeks and are only produced at certain times of the year, so the apple farmer is forced to flood the market with all of his excess apples. Apples are, in other words, a poor store of economic value.

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  Gold Is the Gold Standard of Currencies

  Humans responded to these inefficiencies by using goods that were in very high demand, durable, easily divisible, available in large quantities, and hard to produce (or counterfeit) as a universal medium of exchange, or a currency. In this system, the producer trades not for goods with the immediate intention of consuming them, but with the intention of trading them for other goods which he may consume at a later time. To use a simple example, consider the use of cigarettes as a medium of exchange amongst inmates in prisons. Not every prisoner who collects cigarettes smokes them, but the prison population’s demand for cigarettes is so high that they can always be traded for practically anything available within the prison’s walls.

  Over time, the best mediums of exchange became gold and silver. Both of these metals were attractive because they have always had a high value-to-weight ratio, are very durable, are difficult to counterfeit, and are easily divisible. Also, neither metal could be easily produced, since mining them was and is a slow process. Throughout history individuals remained calmly assured that the two metals’ value would remain stable if they wished to save their profits for future consumption, rather than consume them all at once.

  Fool’s Gold

  A goldsmith’s original job was to transform the gold that was extracted from the earth into coins of equal weight and value. They had very secure buildings in which to store the gold, safe from the reach of thieves. Since people also began to stockpile these highly valuable metals for future security, they, too, had to protect their gold from thieves, and to keep their gold in the goldsmiths’ vaults (for a fee, of course). This was a very lucrative business for the goldsmith. When people deposited their gold in the goldsmiths’ vaults, in return they received a certificate which was a claim for the amount of gold they had stored in the vaults; not the very same gold which they brought to the goldsmith, but its precise equivalent. Since it was very inconvenient to go back and forth continually to the goldsmiths’ vaults to claim your gold in order to trade at the market, people started leaving their gold in the vaults and trading the claim certificates.

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  Goldsmiths started realizing this, and saw an opportunity. If most people were leaving their gold in the vaults for safekeeping, goldsmiths typically did not have to worry about exchanging all of the gold in their vaults for the claim checks at once. Thus, they could start loaning out claim checks for a fee (i.e., interest payment), for more gold than they actually had in their vaults. If someone wanted to claim his own gold, or see if there was gold in the vault, there was still a significant amount there to make good on the small day-today transactions. When people became aware of this fraud, they panicked and frequently rushed to the goldsmith to claim their gold (this panic is now commonly known as a bank run), only to find out they were conned, and there was not enough gold to be claimed for all the outstanding claim checks. People were furious to have been robbed of their hard-earned gold; furious because their natural rights to property had been violated.

  I Now Pronounce You Bank and State

  Kings and governments saw great opportunity with this system, however, since it created an institution that could provide massive funding for projects and wars which would in turn expand their empires and power. Thus, government-sponsored fractional reserve banking was born. Since government-chartered (authorized) banks were able to loan out more currency than they had in their vaults as reserves (just as the goldsmiths had done), there still remained a possibility of a bank run. In an attempt to mitigate this possibility, the government created a lender of last resort: A government-sponsored, and privately owned, central bank, that would control the issuance of all currency within the nation. If banks suffered a run, they could always turn to the central bank for immediate loans to keep them in business. In other words, this system of central banking “propped up” the fraud highlighted above.

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  Like any action which possesses the capacity to violate the Natural Law, this power should never have been given to a person, institution, or government. The famous rags-to-riches banker Mayer Amschel Rothschild reflected on this power: “Let me issue and control a nation’s money and I care not who writes the laws.” Thomas Jefferson expressed his own concerns for a central banking system (and a prescient anticipation of our present woes) which printed and loaned money to the government: “And I sincerely believe, with you, that banking establishments are more dangerous than standing armies; and that the principle of spending money [today] to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.” Jefferson understood that the Natural Law can be violated not just with guns, steel, and fire, but also with the printing of money.

  The first central bank in America, the First Bank of the United States, was chartered to pay off the debts that accrued from the Revolutionary War. This bank spread the debt evenly among the colonies, and was relatively small, controlling only about 20 percent of the nation’s money supply. Jefferson, however, was not fooled into believing the bank’s influence would remain this small, and while president wisely allowed the bank’s charter to expire.

  The Second Bank of the United States was chartered five years later in 1816 by Congress and signed into law by President James Madison. This second bank’s life only lasted until 1833, when President Andrew Jackson allowed the charter to expire after a bank panic. Jackson faced the hard decision of letting banking institutions fail
, causing unemployment in the short term, or bailing them out with the central bank system, causing erosion in the value of the nation’s currency in the long term. He explained to the managers of the bank:

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  Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves.2 (Emphases in original)

  President Jackson expressed concerns about banks funded by a central bank because bankers would have an incentive to take as much risk as possible, sharing the profits amongst themselves, and the losses amongst the taxpayers as the ultimate lender of last resort. The future of this country would be brighter had all presidents since Andrew Jackson possessed both his understanding of the dangers of “too big to fail” and his personal courage necessary to resist its temptations.

  State-sponsored Moral Hazard

  To illustrate President Jackson’s fears, as relevant today as ever, take, for example, the real estate boom and bust during which banks were making massive profits from extremely risky lending practices. They were lending money to people they knew could not pay them back, investing in extremely risky collateralized debt obligations (CDOs), and utilizing exorbitant leveraging ratios (lending out forty dollars for every one dollar of actual bank equity, for example) in order to maximize gains on their investment. That also maximized their risk of loss, and the size of that loss should it occur, as it eventually did. When the banks profited, the bankers gave themselves million-dollar bonuses; and as spoken by Andrew Jackson, when this system failed, the “den of vipers and thieves” were bailed out by taxpayers’ money.

  About thirty years after Jackson ended the Second Bank of the United States, the debt accumulated by the federal government during the Civil War made a return to a system of central banking extremely attractive to the Lincoln administration. This debt prompted Congress to pass and President Lincoln to sign the National Currency Act of 1863 and the National Bank Act of 1864. Although the American economy continued to grow despite being dominated by this third system of central banking, it nonetheless saw great turbulence with many boom-and-bust cycles, and bank panics. In 1873, 1893, 1901, and 1907, massive panics caused a series of bank failures, and proved how unstable this central system of fractional reserve banking was. The response to the 1907 bank panic, caused by the Morgan-Rockefeller–dominated fractional reserve banking industry, was the Federal Reserve Act of 1913, discussed in greater detail below.

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  Hayek Busts the Bubble of Conventional Economic Wisdom

  Austrian economist Friedrich A. Hayek did not accept the conventional view and foundational assumption of the Federal Reserve System, that the boom-and-bust cycle was inexplicable and unavoidable. Hayek provided an explanation of why there was a period with such a large cluster of entrepreneurial errors that led to the shrinking of businesses and increased bankruptcy, which in turn led to bank failures. His explanation of the boom-and-bust cycle laid the foundation for the Austrian Business Cycle Theory (ABCT) (later expanded upon by Ludwig von Mises, Murray Rothbard, Henry Hazlitt, and other very influential Austrian economists), and would eventually win Hayek the Nobel Prize in economics in 1974. (Austrian is the name of the economic school of thought, not the personal ancestry of those who espouse it.) But what exactly were Hayek’s findings?

  In brief, this theory is centered on the time-coordinating feature that interest rates play in the economy. There are two ways in which interest rates can fall. The first way is when individuals save more of their money in banks. When the supply of money which banks have to lend rises, banks then compete for borrowers’ business in order to clear this increase in the money supply. At the same time, when people save more of their money in banks, they defer some of their consumption (i.e., demand) from the present to the future. This causes a shrinking of the retail sector of the economy. The three productive resources of land, labor, and capital that were being used in the retail sector are now freed up and can be purchased cheaper for use in other sectors of the economy such as mining, manufacturing, and technology. These projects are farther away from the consumer and take a longer time before they can start churning out profits, so these businesses will be taking out long-term loans to complete these projects. When the interest rate is low, it makes long-term borrowing and production cheaper, incentivizing investment.

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  In sum, when consumers save more, interest rates decline. This will cause a net flow of capital from consumption to long-term investment projects necessary to sustain a healthy economy. You can see how interest rates play a very important role in coordinating the economy over time, by matching up the markets for goods and markets for capital.

  The second way interest rates can fall is if a central bank with governmental authority commands lower interest rates, or through fractional reserve banking or money printing, injects more money into banks’ vaults, inducing them to lower interest rates. The current consumer is incentivized to borrow and spend since interest rates are low (think of the teenager who just received his first credit card), causing a growth in the retail sector which bids up the cost of the three productive resources—land, labor, and capital. The low interest rate once again incentivizes long-term production projects, but this time there are no resources being freed up from the retail sector, so they cost more money. Moreover, since consumers have not deferred any of their consumption to the future, the pool of resources these long-term projects seek to draw from is either much smaller than they calculated, or does not exist. Since these long-term projects do not churn out profits while being completed, and thus are not able to make profits once they are completed because of the unchanged or smaller pool of resources, they are forced into bankruptcy. This means all of these projects constituted a waste of the three productive resources since there was never a profit being made, or an increase in wealth; these resources will be lost forever. All this because interest rates were artificially low; that is, they were brought low by government command or money printing, not by free market forces.

  Hayek concluded that the causes for bank panics and the boom-and-bust cycle were the increase in credit brought about by a government- or central bank–induced lowering of interest rates and a massive increase in the money supply through the fractional reserve central banking system. When a bank can loan out more money than it has on reserve, automatically the money supply can be greatly expanded. Stated differently, it was the system of fraud and counterfeiting, which violated every individual’s property rights with respect to their money, that was distorting the free market of exchange so grossly that it caused massive depressions and severe economic harm.

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  This boom-and-bust cycle could never happen if there was a 100 percent reserve banking system.3 Let’s look at this. You deposit $1,000 in your checking account at your bank. If there was a 100 percent reserve banking system, you would just pay a fee to the bank for the safekeeping of your money. There would be a decrease in your currency holdings by $1,000, and an increase in your checking account by $1,000; the total money supply in the economy would remain unchanged.

  The only way the bank could loan out the funds you deposited without risking a violation of your property rights is if you agreed not to withdraw your money for a certain period of time. During this time, you would be free to monitor the loans the bank has given with your money, thus ensuring that the loans are sound and profitable. In this system, banks could never get too big to fail, banks could never collapse an entire economy, and banks could never increase credit to create the mal-investment that leads to a boom-and-bust cycle. Moreover, people would n
ever be at risk of losing the money they deposited in their checking accounts; they would only be at risk for the money they voluntarily agreed to allow the bank to loan out. Thus, a 100 percent reserve system is not only congruent with, but necessary for the enforcement of the Natural Law.

  Forget a Money Tree; We Create It Out of Thin Air

  Let us return to our history lesson. In stark contrast to Hayek’s insights, the solution to the boom-and-bust cycle proposed by the deceptive bankers was to cartelize it and have it backed by the government. A cartel is an agreement amongst competing firms to fix prices and to refrain from serious competition. The prices are normally set above the market rate so these firms can make larger profits. However, there is an extremely strong incentive for firms to bust the cartel, because there is a great amount of untapped demand at the normal market price. Because of this temptation, someone always ends up breaking the cartel, and thus there needs to be some form of coercion to ensure all firms do not lower prices to their natural, market level. Coercion? This is where the government steps in.

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  The way bankers make profits in this system of counterfeiting and fraud is simple. Take the same example above. You deposited $1,000 in a checking account at your bank. In a fractional reserve system, your bankers would only have to keep 10 percent of your deposit on reserve, giving them the opportunity to loan out up to 90 percent of your money. In other words, once you deposit $1,000 in the bank, its reserves would be increased by $1,000, and the bank now has $900 in excess reserves that it can loan out.

  So let’s presume that your bankers found Bob, a business owner who needed a loan. The bank would loan out the $900 and charge Bob 5 percent interest for a one-year loan. Right away, the money stock in the economy would have increased by $900, now totaling $1,900: The $900 issued to Bob, plus the $1,000 note given to you, which effectively functions like cash ($100 is kept on reserve at the bank). Bob, a widget manufacturer, then pays Carl the $900 for raw materials. Carl then deposits this $900 in a different bank, which can now loan out $810 to Dan (holding 10 percent, or $90, on reserve). Now, we have a total increase in the money supply of $2,710, compared with a mere $1,000 initial deposit. This process continues, the money supply growing larger and larger until it has vastly outstripped the amount of your original deposit.