In 1913, the Federal Reserve Act was passed at the urging of the nation’s biggest bankers. It was said that the Fed would operate in the “public interest” and that the Act would allow the government to prevent the booms and busts of the pre-Fed era—or at least, make them more moderate. But just sixteen years later, the stock market crashed and we entered the Great Depression. Clearly, the Fed, at the very least, failed in its mission. But the truth is that the Fed caused the bubble that made the crash inevitable—just as it caused the NASDAQ bubble of the late 90’s and the real-estate bubble of recent years.
The key to understanding how this is the case is the Austrian Business Cycle theory. But before we go there, let’s briefly review the pre-Fed history of banking in the United States.
The Original Silver Dollar
The “dollar” became the most commonly accepted medium of exchange naturally via the free market and not by government decree. The original American “dollars” were Spanish coins containing 0.88 troy ounces of silver. Although people would gladly accept other silver and gold coins, the “dollar” was the most popular, and thus, other coins naturally traded at a discount. This is no different than today, when most Americans would accept euros in place of dollars, though not at full exchange value.
During the Revolutionary War, the Continental Congress printed paper dollars that were nominally backed by real silver dollars. But as governments are wont to do, the nascent U.S. quickly printed more paper dollars than the treasury had silver coins, and the people could see through this façade. Soon, paper dollars traded at huge discounts to silver dollars, and eventually the government paper was worthless. Hence the saying, “not worth a Continental.”
The government could have never made people accept pieces of paper as money without telling them that those pieces of paper represented silver coins. Even this wasn’t good enough when it became clear that there weren’t enough coins to redeem all of those paper dollars. This flies in the face of the current understanding of money as a “state institution.” Historically, money has been something that people valued for its own sake, not merely as a medium of exchange and certainly not because the government forced people to accept it.
Anyhow, after the horrible experience with paper money, the framers of the new Constitution prohibited the states from recognizing anything but gold or silver as legal tender and prohibited the federal (central) government from declaring anything legal tender at all. It also prohibited the issuance of “bills of credit”—paper money. This was all thrown out the window, of course, in 1913, but there’s still a little more monetary history to cover before we get there.
The Era of “Free Banking”
With the Coinage Act of 1792, the new Congress exercised its power to “coin money and regulate the value thereof” and created new American dollar coins, which contained roughly the same amount of silver as the Spanish dollars (0.867 troy ounces). Notice, however, that these dollars were not “legal tender”—individuals could not be forced to accept them nor was trading in other currencies made illegal. In fact, many people still preferred the old Spanish dollars.
In the pre-Fed era, banks were free-market institutions that printed their own bank notes. Far from “counterfeiting,” these notes were simply receipts for the underlying gold or silver the bank held in its vaults. A customer could take 100 silver dollars to a JP Morgan bank and exchange them for twenty $5 JP Morgan bills. He could then use these paper bills, which would fit more neatly in his wallet, to make transactions. Eventually, someone with the bills might want to turn them in for silver coins, which he could do by taking them to a JP Morgan branch or some other bank with which JP Morgan had an agreement.
This was an ideal banking system. But soon, bankers got greedy and realized that they had a lot of gold and silver sitting in their vaults that was doing nothing. Why not issue more paper notes, in the form of loans, than they had coins and make some extra interest income? All would be well so long as everyone didn’t try to redeem their paper dollars for coins at once. Surely, the banks could get away with issuing 10% more notes than they had coins, right?
Well, they did. And then they issued 50% more notes. And then double the notes. And then five or ten or twenty times the notes that they had coins for. Bankers who wanted to be honest could not compete in this environment and were put out of business. But eventually, a customer would come in and demand a redemption of his paper dollars for which the bank had no coinage. As soon as the word got out, all of the bank’s customers would try to withdraw their coins, and the customers of other banks would, too. This was known as a “bank run” and it exposed the bankers’ deception.
Now, under a free market, the bankers should have been held accountable for their crimes. They were engaging in counterfeiting, for which the punishment, under the Constitution, is death. But these were men of influence, so far from being held liable, they were able to get governors and presidents to issue “bank holidays” forgiving them of the responsibility of redeeming their notes. This was not a problem of the “free market,” but instead, a problem of government intervention into the free market.
The Federal Reserve Act virtually nationalized all of the nation’s banks and essentially made them agencies of government. Now the banking industry was cartelized, and “fractional reserve banking”—the process of counterfeiting that had gotten bankers into trouble—was made legal. What’s more, the U.S. dollar was unconstitutionally made legal tender, which meant that people could no longer refuse it or opt for other currencies.
Enter the Fed
Between 1913 and 1929, the U.S. dollar lost 42% of its purchase power. In the sixteen years prior to the Fed Act, the dollar had strengthened. This 42% loss of value was due to the Federal Reserve’s monetary expansion, which also led to the stock-market bubble. Similar policies were pursued under Alan Greenspan, which led to a variety of bubbles and busts.
This is the distilled Austrian theory of the business cycle: Central bank-created inflation causes a misallocation of investments during the boom phase, which inevitably leads to the liquidation of those investments and a bust. The Fed’s ultra-low interest rates led to the housing boom, and now that those mortgages (bad investments) aren’t panning out, we’ve entered a serious recession. This is not the fault of the free market, for none of this would be possible under a truly free market in banking, in which inflationary money creation—the cause of booms and busts—would be illegal. The government gives banks permission to inflate, and thus, it is the government—not the free market—that is to blame for booms and busts.
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J.D. Seagraves is a financial writer, libertarian political activist and serial infopreneur. He lives in Saginaw, Michigan, with his wife and young daughter.
Source: http://www.amateureconomists.com/view_articles_detail.php?aid=86
