It Is Dangerous to Be Right When the Government Is Wrong

by Andrew P. Napolitano

  In normal economic times, this wouldn’t present much of a problem; Dan would repay his loan, and Bob would repay his. Thus, there would never be a shortage of cash as the depositors make withdrawals. The problem, however, arises when depositors get scared that numerous investments will go sour, and thus they will lose their money. They then rush to the bank to make withdrawals—legal claims which the bank is clearly not capable of honoring under this system of fractional reserve banking. The end result, of course, is that you have lost your hard-earned savings. As we discussed earlier, this process is known as a bank run.

  211

  It is because of this process that banks in this system pushed for centralization of control with government backing, or a government-backed banking cartel. With this cartel the commercial banks could utilize cheap (sometimes free) loans from the central bank, so the commercial banks would have access to all the money they needed to conduct daily transactions, and honor legal claims in the event of a bank run. Moreover, the government would set up an insurance system, the Federal Deposit Insurance Corporation (FDIC), to protect deposit accounts from the risk of losses. The FDIC is funded, of course, by taxpayers’ dollars.

  If the banks received government backing, they would then be able to profit from their gains and pass their losses along to the taxpayers in the form of bailouts, just as President Andrew Jackson warned about and predicted 180 years ago. Big Government, constantly needing money to fund its military adventurism, welfare state, and campaigns for more power, would clearly benefit from this system, as would the cartel members. Everyone else, by contrast, would be outright robbed of their savings through inflation.

  Inflation, a rise in prices, is caused by an increase in the money supply. The reason this happens is, as explained before, money or currency is just a medium of exchange you use to acquire other goods or save for the future acquisition of goods. When money printing and fractional reserve banking increase the money supply, there is more money bidding up the prices on the same supply of goods. Moreover, an increase in the supply of money does not increase real wealth, since money is used only in exchange.

  To illustrate the actual effects of inflation as caused by the Fed, consider that what cost $25,000 in 1913 would cost about $536,000 in 2010. If a person had $25,000 in 1913 and did not keep it in a bank or a (risky) investment account, by 2010 he would have lost 93 percent of his money’s purchasing power, or the amount of goods or services that can be purchased per unit of currency. Even if someone had saved $25,000 in a savings account at the average interest rate yield of 1.3 percent over the same ninety-seven-year period, he would have $87,500 in the bank. He would still need an additional $339,000 to buy in 2010 what his $25,000 would have purchased in 1913. Thus, even by saving his $25,000 for ninety-seven years, he would have lost 83 percent of the money’s purchasing power at the end of the ninety-seven years.

  212

  The Creature from Jekyll Island

  Now that we can see the fractional reserve system’s propensity to cause bank runs, and the role of central banks in creating inflation, let us return to the foundation of the Fed. On November 22nd 1910, Senator Nelson W. Aldrich (R-Rhode Island), with five companions, set forth under assumed names in a privately chartered railroad car from Hoboken, New Jersey, to Jekyll Island, Georgia, allegedly on a duck-hunting expedition. The need to maintain secrecy was extremely important to the men who were aboard the train traveling to J. P. Morgan’s private retreat at the Jekyll Island Club. The full guest list would be later revealed as including Senator Aldrich (Rockefeller kinsman), Henry P. Davison (a J. P. Morgan partner), Paul Warburg (a Kuhn Loeb & Co. partner), Frank A. Vanderlip (a vice president of Rockefeller’s National City Bank of New York), Charles D. Norton (the president of Morgan’s First National Bank of New York), and Professor A. Piatt Andrew (head of the National Monetary Commission research staff), who had recently been made an assistant secretary of the treasury under President Taft, and who was a technician with a foot in both the Rockefeller and the Morgan camps.4

  These powerful banking elites would devise the new central banking system and draft what is now known as the Aldrich Plan. However, the plan was defeated in 1912 after the Democrats took the White House and Congress. A later change in power revived it. After losing the Republican nomination to Taft, Teddy Roosevelt founded the United States’ Progressive Party, or the Bull Moose Party, in 1912. The Bull Moose Party and the Republican Party would split votes, which subsequently led to the election of Democratic candidate Woodrow Wilson, the perfect candidate for U.S. banking interests. The Aldrich Plan formed the substance of the Federal Reserve Act which, once Wilson took office, was passed in 1913. The Federal Reserve would cause the first Great Depression only sixteen years later.

  213

  Professor Murray N. Rothbard described this system here:

  The Fed was given a monopoly of the issue of all bank notes; national banks, as well as state banks, could now only issue deposits, and the deposits had to be redeemable in Federal Reserve Notes as well as, at least nominally, in gold. All national banks were “forced” to become members of the Federal Reserve System, a “coercion” they had long eagerly sought. This meant that national bank reserves had to be kept in the form of demand deposits, or checking accounts, at the Fed. The Fed was now in place as lender of last resort. With the prestige, power, and resources of the U.S. Treasury solidly behind it, it could inflate more consistently than the Wall Street banks under the national banking system. Above all, it could and did, inflate even during recessions, in order to bail out the banks. The Fed could now try to keep the economy from recessions that liquidated the unsound investments of the inflationary boom, and it could try to keep the inflation going indefinitely.5

  Shortly after the Fed was established, the United States entered World War I, and abandoned the gold standard, thus enabling the Federal Reserve to print money to fund the war effort. One way the government generates money to fund its conquests is by issuing bonds. When the Federal Reserve starts to purchase the bonds, it sends a signal to all other investors. This signal that is sent is one that says come what may, this bond will always be paid off, either at the bond’s maturity date by the government, or by a private investor who might purchase it, or by the Federal Reserve. When these bonds are auctioned off, people are willing to pay more money for them, since payment is guaranteed. The higher the amount of the bond means the lower the yield; a lower yield means a lower interest rate. A lower interest rate means it is less painful for the government to borrow money. This system led to the national debt ballooning from $2.6 billion in 1910 to $25.9 billion in 1920, which also led to the sharp spike of inflation that followed.

  This caused massive expansion, and eventual contraction, and the Fed was forced to raise interest rates to stabilize the volatile economy. Once the economy stabilized in the early 1920s, the economy saw massive growth, but beneath the surface most of this growth was distorted by a Fed-generated inflationary credit expansion which lowered interest rates, causing a boom in the stock market. This was Hayek’s worst nightmare come true. The bust that Hayek’s theory explained was caused by the massive credit expansion and lower interest rates and came in the form of the Wall Street stock market crash of October 1929.

  214

  Congressman Ron Paul, in his book End the Fed, has described this same process as it occurred in the context of the current financial crisis:

  Prosperity can never be achieved by cheap credit. If that were so, no one would have to work for a living. . . . Artificially low rates of interest orchestrated by the Fed induced investors, savers, borrowers, and consumers to misjudge what was going on. Multiple mistakes were made. The apparent prosperity based on the illusion of such wealth and savings led to misdirected and excessive use of capital.6

  History, it seems, has an odd habit of repeating itself.

  Armed with Federal Reserve funding, President Franklin D. Roosevelt attempted an interesting solution to the 1929 sto
ck market crash. This plan was to spend our way out of the depression and into prosperity, which is the exact opposite of rational logic and what the economy needed. This recklessness turned the stock market crash into the Great Depression, which lasted for fifteen years.

  Unable to fund the massive debt he contemplated, FDR, during his first month in office and acting as a ruthless dictator, abandoned the gold standard for individuals, and confiscated every American’s gold.7 As well, FDR made ownership of gold illegal. The abandonment of the gold standard only made the Great Depression that much greater. Many of the policies of the New Deal exacerbated the Great Depression, and many economists believe these policies kept the country in the depression until after World War II.

  The easy credit that led to the Great Depression, as explained by the Austrian Business Cycle Theory, was only made easier by the abandonment of the gold standard. Commercial banks now only needed to keep Federal Reserve notes as bank reserves, and the Federal Reserve was the only bank that needed to store gold. With a reduction of the fractional reserve ratio to 10 percent, the Federal Reserve could loan out ten dollars for every one dollar it had on reserve in gold. These loans went to commercial banks, and could be used as these banks’ reserves. The commercial banks could then loan out ten dollars for every one dollar they had on reserve in their bank’s vault. So a dollar’s worth of gold in the Federal Reserve Bank can be turned into one hundred dollars of loans to the public.

  215

  Getting Out of the Woods

  The great nations of the world would abandon the gold standard in order to print money to fund World War II. With the massive debt accrued by European nations to fight the war, as well as the need for the United States to pay its bills for the war, a new monetary system had to be formed. Shortly after World War II, Lord Keynes and Harry Dexter White, a U.S. Treasury official, prepared the plans for a new global financial system. Representatives of the financial rulers of the United Nations assembled in Bretton Woods, New Hampshire, and they enacted the new global monetary system. This system fixed the price of gold at thirty-five dollars an ounce, and created a fixed exchange rate between all currencies of the world and the dollar. The Federal Reserve would store the world’s gold, and the rest of the world’s banks would store Federal Reserve notes as their reserves. Only foreign central banks were able to redeem their Federal Reserve notes in gold; individuals were denied this right. Since the right to trade is a natural right, the prohibition on gold ownership assaults that right.

  The federal government would succumb to the temptation of printing more money than it had reserves in gold; and once the different international bankers became aware of this, they started to claim their share of the gold reserves. On August 15th 1971 came the nail in Bretton Woods’s coffin. President Nixon on that day instructed his treasury secretary to cancel the dollar’s convertibility into gold—only temporarily, he claimed. Recall Milton Friedman’s warning about the permanence of temporary government programs. This meant the dollar was backed by nothing, except the laws that made it the nation’s legal tender, and the government’s promise not to print too much of it. Naturally, massive inflation followed.

  216

  Inflation and Its friends

  Massive increase in the money supply, or inflation, by way of fractional reserve banking and a fiat-based monetary system (or a monetary system that has currency which is not backed by any intrinsic value and is considered money just because the government says it is; oddly reminiscent of legal Positivism) causes prices to rise as well as the boom-and-bust cycle. The people who benefit from this inflationary system are the ones who get their hands on the money first, the banks. The banks get to make their investments before the prices of assets rise in response to the increase in the money supply. By the time the money trickles down to the rest of the people in the economy, the symptoms of inflation will have begun to settle in and devalued money will mean the money has less purchasing power, which will cause the phenomenon of rising prices.

  This inflationary system robs people of their savings. Every time the Federal Reserve expands the money supply through this system, all money that was already in circulation loses purchasing power, and the people who get their hands on the money first gain that lost purchasing power. Normally, the banks loan money to the government by purchasing treasury bills. Treasury bills have been one of the safest investments in the past since the federal government’s debt is guaranteed to be repaid with interest, by you and me, the taxpayers. The government can now decide what to do with this money, say, funding any one of its special interest projects, or even our collective welfare, if it feels so ambitious.

  As you can see, it is the banks, the government, and the corporations the government favors that benefit from this system, while everyone else is robbed of their purchasing power in order to fund it. This is exactly what Jefferson predicted in a quote attributed to him: “If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and the corporations which grow up around them will deprive the people of all property until their children wake up homeless on the continent [of] their fathers.”

  217

  There is no difference between the Federal Reserve’s system of fractional reserve banking that inflates the currency to transfer your purchasing power to the special banking interests, government, and corporate interests and a thief who hacks into your bank account and removes funds from it. This inflationary system of theft that causes the boom-and-bust cycle makes it impossible for the average American to save for his own retirement (unless he converts his savings into gold and hopes the ghost of FDR in the White House at this writing doesn’t confiscate it). Prior to the abandonment of the gold standard, Americans could work and earn gold as their income, store it in a bank vault, and it would appreciate in value all on its own, serving as their retirement safety net. Fed inflationism depreciates people’s savings over time, and the busts the Fed creates wipe out the retirement investments people make in the stock market. The Fed, stated simply, is an abomination to the Natural Law and the Constitution.

  When I Was Your Age!

  Surely, any young person today can think of stories told by their parents that sound something like “when I was your age, I could buy a movie ticket for twenty-five cents, a round-trip subway ticket for ten cents, a bag of chips for five cents, and a soda for ten cents!” Now it costs over sixteen dollars to go to the movies—ten dollars for a ticket, two dollars for the chips, and four dollars for the soda, and that’s before transportation costs and the tax! This exorbitant increase in price occurred only within a time span of about fifty years; that is a 3,100 percent increase in price! For some reason, people just take price increases for granted as a normal occurrence that happens with the passage of time or blame it on the businesses that charge the higher price and call them evil and greedy.

  Let us take a look at the money supply—literally the cash in circulation and in bank accounts in the United States—over this same fifty-year period.8

  218

  The increase in the monetary base is the reason for such absurd occurrences as the 3,100 percent increase in the cost of attending a movie. The money supply really started to increase drastically in the mid-1960s, and once Nixon took America off the gold standard in 1971; money creation grew out of control. Nixon broke away from the quasi-gold standard of the Bretton Woods agreement because there was no other way to pay for the debt racked up by Lyndon B. Johnson’s Vietnam War and Great Society, which provided “guns and butter” for all of America, according to Johnson.

  “Guns and butter” is just another way of describing LBJ’s warfare agenda abroad in Vietnam—ultimately financed by the Fed—as well as his massive increase in domestic spending. He spent money the government did not have; and he spent wildly on programs such as these: The Economic Opportunity Act of 1964, which created an Office of Economic Opportunity (OEO) to oversee a variety of community-based anti
-poverty programs; his War on Poverty, which began with a $1 billion appropriation in 1964 and spent another $2 billion in the following two years; the Elementary and Secondary Education Act of 1965, which was initially allotted more than $1 billion for inner-city schools; the Higher Education Act of 1965, which gave federal money to universities, as well as created scholarships and low-interest loans for students; and LBJ’s Great Society, which created the bottomless pits of Medicare and Medicaid. The two medical programs have been complete disasters that are not only broke, but are unfunded to the tune of $76 trillion and counting.

  Moreover, the debt is not just a financial issue. Admiral Michael Mullen, at this writing chairman of the Joint Chiefs of Staff and thus America’s highest-ranking military official, proclaimed that “our national debt is our biggest national security threat.” Can you imagine that, from a military man! His greatest fear is not terrorists, but government debt! Secretary of State Hillary Clinton further explained the nature of this threat: “It undermines our capacity to act in our own interest, and it does constrain us where constraint may be undesirable. And it also sends a message of weakness internationally.” There is no chance this debt monster could have grown so out of control if the United States operated on a full gold standard.

  Every day the federal budget grows, every person loses more and more freedom. The bigger the government, the smaller the amount of individual liberty; the bigger the government, the more it can regulate every aspect of our lives which strips us of our rights and liberties. Each day the Federal Reserve System exists is one more day that the government can fund its growing budget, increase its size, and deplete our savings and pass them along to its friends. Each day of Big Government is one more day of assaults on our liberties.