The truth about the Federal Reserve

The Marriner Eccles building, Federal Reserve Headquarters

I thought I would take the time to write about the Federal Reserve, our nation’s central bank. It amazes me how many people don’t even know about its existence, which is scary considering the power it wields. This is the institution that controls our money, decides how how much of it there is, and where it goes. Tremendous power to have.
 The Federal Reserve isn’t even really “federal”. It’s a privately run bank, although its head is appointed by the President. Although the Fed is required to periodically meet with Congress, it is one of the most, if not THE most secretive organization in our country. It has been said that Congress is more aware of what the CIA does then the Fed.

Current Fed Chairman Janet Yellen, appointed by President Obama

“So why does the Fed exist in the first place? What is its purpose?”

Let’s go back in time….
 When this country was first founded, there was a heated debate as to whether a central bank was necessary for the nation’s economy. It was also debated as to whether or not it was constitutional. Alexander Hamilton, first Secretary of the Treasury and leader of the Federalist party, was the one pushing for it. Thomas Jefferson, leader of the Democrat-Republicans and first Secretary of State, was strongly against it.

Thomas Jefferson
Alexander Hamilton

Hamilton’s argument was this: The government needed to consolidate its debts accrued during the Revolutionary War, which would increase the authority of the central government. If the states were indebted to a consolidated power (thus demonstrating that the government was indeed legitimate), other countries would feel more inclined to lend to the United States. Then government bonds could issued to foreign countries, which would encourage economic growth .

(For those of you who don’t know how a bond works, here’s a quick example: I buy a government bond for $1,000. At some point in the future depending on the terms, the government will pay me back more money, say $1,200. The idea being that the government has money to spend today, and as the country develops and the government collects more revenue, the principal (initial price) as well as the interest will be paid back. If it works right, its a win win.)

Hamilton also argued that the bank was constitutional on the grounds that it fit the descriptions of the Constitution’s “General Welfare” and the “Necessary and Proper” clauses.
 Here was Jefferson’s argument: The bank was unconstitutional. The Constitution says (many don’t know this) that: “The Congress shall have Power to coin money, and regulate the value thereof.” (So technically, our Fed today IS unconstitutional) Jefferson worried that if a monopoly power to control the currency was placed in the hands of a private organization, this would give them power to influence elections, it would open up the US to foreign interests, and it would create economic instability. Jefferson had seen this happen with the Bank of England across the sea.

In regards to the two clauses above, Jefferson argued that Congress could do what it needed to do WITHOUT a central bank, so establishing one would be both unnecessary and problematic. 
 President Washington asked Hamilton to write a response to Jefferson and his party on regards to the constitutionality of the bank. Hamilton wrote his “Opinion as to the Constitutionality of the Bank of the United States” as a response. The basic gist of the writing was the Jefferson didn’t understand what was “necessary” and that a central bank was in the interest of the “public good” (a recurring theme in much of Hamilton’s writing)

For those interested, this is a clip from the HBO series “John Adams” where Hamilton and Jefferson discuss this:
 Washington signed the first Bank of the United States into law in 1791. He agreed to this on the grounds that the District of Columbia was expanded in order to be closer to his Mount Vernon estate, most likely with the intention of increasing his property value. The bank was given a twenty year renewable charter.

The First Bank of the United States

The bank expanded its money supply rapidly, producing millions of dollars. This lead to a 72% rise in prices across the board, from 1791–1796… that is the true definition of inflation. Today we are told that inflation is a rise in prices. However, the rising prices are a CONSEQUENCE of the expansion of the money supply. Real wealth means GOODS and SERVICES. Printing more money just causes the money to lose its value, which is very damaging, especially to the poor. I will write more on this later….
 Congress allowed the bank’s charter to lapse as scheduled, in 1811. However, the government created the second Bank of the United States in 1817, after the country was forced to deal with aftermath of the financial problems caused by the War of 1812. Although President James Madison had been against the first bank, he saw this one as sort of a necessary evil. Chiefly because his administration was in charge of PAYING for the war.

The Second Bank of the United States

The new bank once again, created the usual problem… excessively expanding the supply of money and credit. Several states tried to keep the bank from opening branches by taxing it out of existence in those places.
 This time, there was an additional problem… the second Bank of the United States suspended “specie” payment. (“Specie” refers to precious metals. Specie payment is the ability of a bank to redeem paper currency in exchange for gold and/or silver.)

Since the time the country was founded, banks held paper money, but they were required to hold both silver and gold. Many people (including myself), have misunderstood this. It’s not that the metals “back” the money. It’s that the money is a measurement of the amount of precious metal. For example, $20.67 was made the equivalent of one ounce of gold.

These precious metals were chosen because they have universal value, and it showed that the US currency was indeed a legitimate currency on the world market. It also prevented the banks from inflating their supply of paper money too much, since they would need a corresponding amount of specie. This helped stabilize prices, and restrained what the government could spend. The Founders learned the mistake of pure fiat money (that is money issued on a whim, with no corresponding specie) during the Revolutionary War. Money was printed at will to pay for the war, and it was absolutely worthless by the end.
 Here are some numbers for the second B.U.S.:

By 1818, the bank lent out about 23 million dollars, but had ONLY about 2.3 million dollars worth of gold and silver in its vaults. This lead to a temporary real estate boom (sound familiar?), as people speculated in buying land out west, and investing in canals, turnpikes, farm improvements, etc. Due to the expansion of the money supply, prices also shot up by about 55%.
Many of the loans defaulted, the amount of specie wasn’t available to redeem the paper, and the general lack of confidence in the banks because of these things caused a contraction. This was America’s first depression, “The Panic of 1819”. For the first time in American history, there was large scale unemployment in major cities. Philadelphia for example, saw the number of people in manufacturing to go down from 9,700 to 2,100. Many even resorted to bartering to get by. The panic abated after about twoyears.

This is the only book that has ever been written on the Panic of 1819. This was originally Rothbard’s dissertation paper at Columbia University, that earned him his PhD.

Andrew Jackson’s bank war
 The next president to take on the central bank would be Andrew Jackson, elected in 1829. He called the bank a “hydra headed monster”, because he was aware of the way it manipulated elections and opened the US up to foreign interests. Jackson hated banks in general, and this one the most. He even remarked to Vice President Martin van Buren: “Mr van Buren.. The bank is trying to kill me, but I will kill it!!”

A political cartoon of the time depicting Andrew Jackson trying to destroy the “hydra headed” bank, and the politicians that it corrupted.

Andrew Jackson is personally, one of my favorite presidents. He was the first “commoner” president, the previous six having either been born into, or marrying into moneyed families. He has often been portrayed by court historians as sort of an “ignorant redneck”. However, he and his followers understood the value of hard money, having been schooled in David Ricardo’s school of thought. (For those who don’t know, Ricardo is one of the “classical economists” who argued for free trade, and that a country had to produce and sell more than others on the world markets in order to prosper. This is called “comparative advantage”). Ironic that Jackson’s face ended up on the $20 bill, considering his desire to adhere to hard currency.

David Ricardo

Jackson also pushed for reform of the democratic process. Until he was president, voting rights were only granted to white men that HAD to own property. In some states, it was as much as fifty acres! During his time, this requirement was removed and universal white male suffrage was granted. This was seen as a boon to the working class, who now felt that they actually had a say in their government.
 Congress voted to reinstate the bank. Jackson vetoed it, including this message, which is one of my favorite quotes of all time:
“It is to be regretted that the rich and powerful too often bend the acts of government to their selfish purposes. Distinctions in society will always exist under every just government. Equality of talents, of education, or of wealth can not be produced by human institutions. In the full enjoyment of the gifts of Heaven and the fruits of superior industry, economy, and virtue, every man is equally entitled to protection by law; but when the laws undertake to add to these natural and just advantages artificial distinctions, to grant titles, gratuities, and exclusive privileges, to make the rich richer and the potent more powerful, the humble members of society — the farmers, mechanics, and laborers — who have neither the time nor the means of securing like favors to themselves, have a right to complain of the injustice of their government. There are no necessary evils in government. Its evils exist only in its abuses. If it would confine itself to equal protection, and, as Heaven does its rains, shower its favors alike on the high and the low, the rich and the poor, it would be an unqualified blessing.
 Congress didn’t have enough votes to override his veto. The bank tried to crash the economy, by curtailing lending throughout the country. This created a depression in parts of the country, but Jackson would not budge. Jackson ordered the funds withdrawn from the bank, and placed in his “pet banks” which were placed throughout the country. The bank was shut down, and the building was sold to private interests.
 Jackson’s successor Martin van Buren established the “Independent Treasury System”. This has been debated, but some economic historians, such as Peter Temin consider this to have been the most stable banking system in the 19th century. Some complained that it restricted credit and lending too much, but I would argue the opposite: it forced the government and the people to live within their means. (Quite the opposite of today, no?). There were still bank failures and bad decisions being made, but fewer and farther in between. Banks were required to stand on their own two feet, and wouldn’t be bailed out if they made bad choices.

Martin van Buren- 8th President of the United States

The step towards nationalized banking occurred during the Lincoln administration with the “National Currency Acts”. Before this time, states issued their own currencies. Lincoln also severed the dollar’s tie to gold and silver, in order to print money to pay for the Civil War.

As expected, prices skyrocketed. This was blamed on “speculators, foreigners, immigrants, price gouging, greed”, etc. (Sound familiar?)
 After the war ended, the country went back to a gold and silver standard. This continued until 1900, when the United States went to a pure gold standard. This was due to fluctuations in the silver market, and the fact that its competition with gold made it unstable to have money derived from both at the same time.
 The America of the late nineteenth century saw the greatest economic expansion in human history.. The American economy started off the 1870’s being half as large as Britain’s economy, and by the end was DOUBLE the size of Britain’s economy.
 So without further ado, here is the crux of this blog……
 In 1910, a secret meeting was called on Jekyll Island off the coast of Georgia. The participants traveled in secret, and used code names. Among them were: Rockefeller’s man in the Senate, a J.P. Morgan senior partner, and a representative of the Rothschild family. The men here represented around 25% of the world’s wealth at the time.
 Depending on which version of history you listen to, here’s how the story goes:

The standard, court historian: The banking system was inherently unstable, and there was need for a powerful centralized control. The Federal Reserve was established in order to maintain the value of the currency and balance out the business cycle. This would prevent depressions. The belief was that with the Fed being able to inject “liquidity” (cash, by way of increasing the money supply), this would smooth things out and prevent downturns. 
 The version that I find far more compelling: Wall Street was weakening due to private banks in the western US competing with them. They wanted to find a way to establish a cartel style control over the financial system, so they founded the Federal Reserve under the guise as described above. (For those of you that don’t know, the way a cartel works is very similar to a monopoly, the only difference is that instead of one business dominating a field, in this case several businesses work together to do it.)

They called it “federal”, in order to mislead the public about who actually controlled it. Woodrow Wilson agreed to sign the “Federal Reserve Act” into law, before even becoming president. The act was signed in the year 1913. This was accompanied by the income tax, which is enshrined in the 16th Amendment.

A book describing the circumstances surrounding the meeting that took place

The Fed has failed in what it was intended to do. Before it was established, the American dollar rose 8% in value, relative to the world’s currencies. Since 1913, the American dollar has lost 95% of its purchasing power. Factoring that with the fact that wages for the average person haven’t risen in the last thirty years or so, really makes it clear why the poor are struggling. This started with President Franklin Delano Roosevelt’s decision to reduce the pegging of gold from $20.67 an ounce to $35 an ounce in 1933. It was finished with President Richard Nixon’s decision to sever the dollar from gold altogether in 1971, and leave use with the pure fiat currency that we have today.
 In a truly prosperous time, such as the late 19th century, the money was sound. Since it was based on gold, paper money could only be printed if the government acquired more gold. This kept prices pretty stable. As productivity increased, this put a downward pressure on prices, which enabled people to buy more with what they had. This means that “real wages” (the value of a wage determined by the amount of money proportionate to what can be bought) rose dramatically during this time. As prices fell, extra money could be spent and/or invested elsewhere which fueled economic growth. The population in the United States EXPLODED due to all the immigration and eradication of diseases at the time, yet in spite of this, there were still jobs for all. The economic pie was growing fast enough so that it could feed all mouths.
 Inflation has been called a hidden tax, because it destroys the value of savings. If you have, say $500 in the bank, but the government is expanding the money supply at 10% a year, that money you have in the bank is losing 10% of its value each year. If you spend that money, 3 years later, it will buy you 30% less than it did when you first put it away.
 Another effect of inflation, is that it hurts businesses in their forecasts.. If the price of everything were to rise by say, 10%, that completely throws off their costing. That means that they will have to raise prices, and/or cut back on quality/quantity of goods to make ends meet. Higher prices will lose customers, and that it will be harder to give raises to employees in the future.
 Politicians like inflation, because it gives them the ability to spend money without raising taxes and/or borrowing. If a politician raises taxes, they shoot down their chances of getting reelected. If they borrow money, that has to be paid back by future generations, with interest. That can also unpopular politically.
 Wall Street also likes inflation, because the money that is lent out often finds its way into the stock market.( I will explain below about the role the Fed has in aiding Wall Street below)

Our record stock market highs right now are not caused by a healthy economy, but the fact that much of the loaned money goes into stocks which drive up artificially their value. (This is known as “asset inflation”. No wealth is being created here, the numbers are just being unnaturally propped up by the money printing)

The financial sector of our economy has done exceptionally well under our current system, but Main Street is being bled dry. Former Chairman Ben Bernanke expanded the Fed’s balance sheet from $500 billion, to over $3 trillion. Absolutely mind blowing. Whenever you see “quantitative easing” in the news, that’s what this is… Inflation, just with a nicer name.

Former Fed Chairman Ben Bernanke, appointed by President Bush

The other distinct role that the Fed has is to set the interest rate at which banks can borrow money from it. (The money is printed at the US mint as per requested by the Fed. In modern times, they sometimes don’t even do that… Today, account balances are just changed via computer).

In a truly free market, interest rates are not determined arbitrarily by a central authority. They are determined based on what the economy is doing. If people are saving more, the interest rate comes down, reflecting the fact that there is more capital available to be lent out. This means that people are more willing to lend the money out, with the confidence that it will be paid back fully in a timely manner. If people are consuming more, the interest rate would go up, reflecting the fact that money is becoming scarcer, and that money should only be loaned out if the lender can get a good return.
 The Fed’s current interest rate is 0.50%, just above ZERO. The Fed is basically handing money to the banks, where it is being spent on speculation on Wall Street.

I would also like to point out that since the wealthy have the most invested in stocks and real estate, this is one of the major causes for our widening gap between the rich and poor. This also occurred in the late 1920’s, when the stock market was a bubble. This bubble burst in 1929. The 1920’s have also been frequently demonized by many for the widening income gap. Hence where all those stories came from of millionaires becoming paupers overnight, as the stocks dropped back to their pre-bubble level.
 Personally, it drives me nuts whenever I hear things like “our current economy is proof that capitalism doesn’t work.”, or “the problem is that we don’t have enough regulation.” Or the problems of today are “due to greed”.
 I can refute any one of these points easily.. First off, we haven’t had anything close to capitalism in well over a hundred years. In fact, some would say that we never really had it, because the government intervened via protective tariffs, has imposed regulations that are the biggest burden to small businesses, redistributed wealth, and imposed farm subsidies, oil subsidies, etc. Capitalism means private profits and private losses. Not private profits and socialized losses.
 Our economy is most regulated it has ever been. George W. Bush, a so called “conservative” added 90,000 regulators to the government work force, expanded government more than his three predecessors combined, and added about 10,000 pages of regulations. And that’s just during his time in office. For Obama, its been even more. I know that the Dodd-Frank Wall Street regulation has 2,000 pages on its own. And of course, that’s not even touching on Obamacare…
 We somehow managed to have a thriving middle class and lots of upward mobility before these two came to power. That’s not to say that they’re the sole cause behind our current problems, but they certainly haven’t helped things.
 I hate hearing “the economy sucks because people are greedy.” Blaming a bad economy on greed, is like blaming a plane crash on gravity. Both are constant forces. If the price of something comes down, is it because the seller becomes less greedy? Do people mean to tell me that the wealthy weren’t greedy in the 90’s, 80’s, 50’s, and other stronger economic times?

“But the Fed has helped smooth out the business cycle, right?”

The Fed was founded to prevent depressions, yet we have had the longest sharpest downturns SINCE the Fed was created. We have had no other eleven year long downturns like the Great Depression in our history. The majority of the downturns turned around fairly quickly (usually a couple of years), with the longest one being right after the Civil War. I think that you can figure you why; cities had to be rebuilt, the currency had lost value from war time inflation, and there were just a lot of dislocations in the economy overall. Many of the depressions were caused in some way by government intervention in the economy, and the Fed has only exacerbated the problem.
 I’m not sure that it would be prudent to end the Fed overnight. (Although I do like the expression!)

I do think that at bare minimum, it needs to be stripped of much of its power and has its activities exposed. I often wonder…. where is the Andrew Jackson of today?

Thank you all for reading!

  • STK