The Federal Reserve today is, in essence, a "money machine" for the federal government. This is a far cry from its original purposes, and directly contrary to the economic and political interests of the United States. Not unexpectedly, misuse of the Federal Reserve has put the United States in an extremely vulnerable position both domestically and internationally. As Henry C. Adams pointed out more than a century ago in Public Debts,
As self-government was secured through a struggle for mastery over the public purse, so must it be maintained through the exercise by the people of complete control over public expenditure. Money is the vital principle of the body politic; the public treasury is the heart of the state; control over public supplies means control over public affairs. Any method of procedure, therefore, by which a public servant can veil the true meaning of his acts, or which allows the government to enter upon any great enterprise without bringing the fact fairly to the knowledge of the public, must work against the realization of the constitutional idea. This is exactly the state of affairs introduced by a free use of public credit. Under ordinary circumstances, popular attention can not be drawn to public acts, except they touch the pocket of the voters through an increase in taxes; and it follows that a government whose expenditures are met by resort to loans may, for a time, administer affairs independently of those who must finally settle the account. (Henry C. Adams, Public Debts, An Essay in the Science of Finance. New York: D. Appleton and Company, 1898, 22-23.)The question becomes, first, how did we manage to get ourselves into this dangerous situation, and, second, how do we get out of it? The next several postings will cover how we got into this mess, after which we will look at how best to get out of it.
As we have already seen, today's unnecessarily restricted understanding of reserves derives from the definition of money derived from the tenets of the mercantilist British Currency School. The Currency School essentially defined money as whatever the State says it is, viewing "money" exclusively as an outstanding obligation of the State, backed only by the State's promise to pay out of wealth belonging to the citizens: a debt currency.
The error of the Currency School was to confuse the thing owned, with the right to and rights over the thing owned. In short, the Currency School made the fundamental error of misunderstanding private property, and thus everything based on private property, such as money, credit, and banking. If it is not already plainly evident, private property is not the thing owned, but the natural right to be an owner, and the socially determined bundle of rights that define how an owner may use that which is owned, and how the owner relates to others, and others to the owner, with respect to the thing owned. This confusion in the principles of the Currency School is reflected in today's mainstream schools of economics, most notably Keynesian, but also Monetarist and Austrian.
This is in contrast to an orientation based on the tenets of the British Banking School. The Banking School viewed money as something conveying a private property right used to carry out a transaction to which both parties contribute equally. To be considered "money," the promise is necessarily backed by something with a definable present value in which the issuer has a private property right: an asset currency.
As we have seen, the Federal Reserve was designed for the most part in accordance with the principles of the Banking School, that is, the application of the real bills doctrine, the foundation of central and commercial banking. This was to be able to link increases and decreases in the money supply directly to correlative increases and decreases in production of marketable goods and services. Just as important, this would require that the present value of existing and future marketable goods and services and the capital assets necessary to generate the marketable goods and services lead in the process of money creation, not the other way around, as the tenets of the Currency School assume is the case.
That is, the real bills doctrine assumes that present value exists before a bill can be drawn on that value and money created, where the Currency School assumes that money is first created (thereby redistributing purchasing power) and then present value is brought into being. It was the small, seemingly unimportant exception that permitted government securities — fictitious bills — to be included in the definition of real bills that qualified as reserves and thus for rediscounting, combined with the belief that money creation precedes rather than derives from the present value of existing and future marketable goods and services (in other words, that production is a derivative of money rather than money being a derivative of production) that allowed the camel’s nose to get under the tent.
Consequently, the Federal Reserve, an institution intended to implement the real bills doctrine, is used to implement the principles of the Currency School. These principles are directly opposed to the real bills doctrine. The principles of the Currency School rely on treating fictitious bills issued by the United States government that do not convey a private property right, as if they were real bills based on private property. The chaos that now pervades the global economy is the inevitable result of the massive misuse of banking and the whole monetary and financial system.
The change did not happen overnight. When the Federal Reserve went into operation in November of 1914, there was every intention to use the institution for its primary purpose, to provide an "elastic currency." That is, to supply the private sector with sufficient liquidity for industrial, commercial, and agricultural purposes without inflation or deflation through the operation of the real bills doctrine.
The war that began in Europe in August 1914, however, caused conditions to change. As Dr. Harold G. Moulton described the situation,
During the first two years of its operation the Federal Reserve System was little used. The reduction of reserve requirements of the member banks by the Federal Reserve Act, coupled with an inflow of gold from Europe, resulted in a very great increase in the lending power of the individual banks. Accordingly, the rediscount facilities of the Federal Reserve banks did not appear to be necessary, and there developed the view on the part of many of the bankers of the country that the importance of the Federal Reserve System had been greatly exaggerated, and that the capital which they had invested in the system was a bad investment. (Dr. Harold G. Moulton, The Financial Organization of Society. Chicago, Illinois: The University of Chicago Press, 1930, 578.)Consequently, from 1914 through 1916 discounts by the Federal Reserve amounted to a little under $72.5 million, a relatively paltry sum, all of it in the form of commercial bills and notes, none secured by U.S. government obligations. (Ibid., 581.) As Moulton points out, however, "The entrance of the United States into the war, however, quickly disillusioned the bankers as to the adequacy of their own financial resources." (Ibid., 578.)
In 1916, before the United States entered the war, the ratio of cash to notes and deposits in the regional Federal Reserve banks was approximately 87%. This was a substantial amount of reserves in excess of requirements. By 1917 when the United States formally entered the war, this ratio had fallen to approximately 77%. (Ibid., 579.) After the needs of business depleted excess reserves, the commercial banks started rediscounting at the regional Federal Reserve banks. Commercial bills and notes went from a little over $30 million in 1916, to just short of $400 million in 1917, but falling to a little over $300 million in 1918.
All of this, however, was simply using the Federal Reserve as intended, in accordance with the real bills doctrine to monetize the productive capacity of the nation. It still does not explain the change in the definition of reserves or why the Federal Reserve shifted away from the providing liquidity for the private sector, to being the lender of first resort to the federal government, the very situation that the designers of the system were careful to try and avoid.
The fact is that the First World War put enormous demands on the United States financial system, primarily from two sources: 1) expanding business activity and rising prices necessitated an increase in the money supply, and 2) government financing of the war through borrowing rather than politically-unpopular recourse to taxation ensured that there would be an enormous increase in Federal Reserve Notes and demand deposits.
This was similar to what happened during the Civil War when Abraham Lincoln's Treasury Secretary Salmon P. Chase decided to finance the war primarily through borrowing rather than by raising taxes. This was politically popular (at first), but financially disastrous. As Charles A. Conant relates,
Secretary Chase made the fatal mistake at the outset of relying upon loans to supply the means of carrying on the war instead of appealing to the productive resources and the patriotism of the people. . . . It was not until his annual report of 1863 that Secretary Chase awakened to the importance of taxation as a means of supporting the public credit, and suddenly expressed his desire for providing "for the largest possible amount of extraordinary expenditures by taxation." (Charles A. Conant, A History of Modern Banks of Issue. New York: G. P. Putnam's Sons, 1927, 403.)Unfortunately, most politicians and many economists misunderstood Chase's actions. A confused description of the Secretary's program in Volume II of Joseph Dorfman's The Economic Mind in American Civilization (New York: The Viking Press, 1953, 967-983) confirms the mental chaos that allowed such a fundamental change in the Federal Reserve System, evidently without raising serious questions among those who should have been most concerned with the proper running of the institution. Chase, for example, is referred to as a "Hamiltonian" for his efforts to establish a national banking system, but Alexander Hamilton's principles were directly opposed to those of Chase. Chase sought to use the commercial banking system and, later, a national bank as a means of financing government through debt. Hamilton advocated a national bank as a means of providing adequate liquidity and circulating media for the private sector to encourage economic development.
Thus, what with the seemingly small but significant weaknesses built into the Federal Reserve System, and the lack of comprehension of the proper use of the system on the part of politicians and economists, the situation was ripe for abuse. All it needed was a trigger. That trigger was provided by the entry of the United States into the First World War. As noted, there were two circumstances especially led to the change in the mission of the Federal Reserve.
One, there was a great expansion of business and a period of rising prices. Between 1915 and 1918, the volume of business expanded greatly in response to the war. As the "excess" reserves resulting from the Federal Reserve Act were exhausted, the banks took advantage of the discount power of the Federal Reserve System. Rediscounting of "eligible paper" greatly increased the asset-backed money supply. (Financial Organization of the Economic System, op. cit., 579-580.)
Two — and by far the more important factor — there was a vast increase in government borrowing. Having finally arrived at a sound banking system centered on a central bank, however, Congress did not make the mistake of simply printing money and running up the debt indiscriminately. The First Liberty Loan Drive was directed first to individuals, and then to banks that had excess lending capacity. (Moulton, Financial Organization and the Economic System, op. cit., 391.)
Individuals and a number of banks purchased the Liberty Bonds, often using the bonds themselves as collateral to raise cash for additional bond purchases. Available liquidity was thereby drained out of the system. (Ibid.) When the second Liberty Loan Drive came around, commercial and deposit banks had already patriotically purchased all the bonds they could. To purchase the second issue, they needed a new source of liquidity — and found it in §§ 14 and 19 of the Federal Reserve Act, which permitted commercial member banks to rediscount any and all paper included in the definition of reserves.
The Act, however, had to be amended to permit the wholesale rediscounting of federal government securities. The Act was amended in 1916, and the floodgates were open. The Federal Reserve still could not purchase primary government securities. The National Banks, however, which were authorized to purchase primary (new) issuances of federal government securities from the United States Treasury, did so, thereby turning primary government securities into secondary government securities. These securities were deposited with the local Federal Reserve Bank in exchange for National Bank Notes and Federal Reserve Bank Notes that were intended to replace the National Bank Notes. (The Financial Organization of Society, op. cit., 538-539)
The Federal Reserve Banks were also permitted to purchase secondary government securities from commercial banks in order to regulate reserve requirements and to provide liquidity to the commercial banking system at need. Since the Aldrich-Vreeland Act of 1908 in the wake of the speculation-driven Panic of 1907, commercial banks had been forbidden to hold corporate shares as reserves as speculative corporate equity does not meet the definition of real bills. Unfortunately, an exception was made for federal government securities that also do not meet the definition.
Thus, when the Second Liberty Loan Drive was initiated, commercial banks purchased the primary securities directly from the Treasury, and immediately discounted them at their local Federal Reserve Bank as secondary government securities. This allowed the Treasury to circumvent the prohibition against the Federal Reserve dealing in primary government securities, and established the so-called "open market operations" — originally intended to do nothing more than supplement the rediscounting of qualified private sector paper — as the primary tool of the Federal Reserve System to effect whatever monetary and fiscals goals had been set by Congress. As Moulton describes the effect of this change in basic Federal Reserve policy,
That the Federal Reserve system enabled the financing of the war to be carried through with a minimum of difficulty is not to be denied. The most that can be said against the system is that it made the financing of the war too easy, encouraging the use of bonds for that purpose, thereby causing an inequitable distribution of the burden of war costs. Responsibility for the large use of bonds as a means of financing the war cannot, however, be placed primarily at the doors of the Federal Reserve system, the Treasury rather than the Federal Reserve officials being responsible for the methods of war finance. (Financial Organization and the Economic System, op. cit., 392.)Consequently, in 1917 the Federal Reserve created $283 million in new money to purchase government securities. Naturally, the Federal Reserve could not purchase these securities directly from the Treasury. This included the bonds backing the National Bank Notes and their replacements, the Federal Reserve Bank Notes. This is because the bonds were purchased not by the Federal Reserve Banks, but by the National Banks that were members of the Federal Reserve System. As a way of retiring the National Bank Notes, the bonds were then deposited with the local Federal Reserve Bank to back the National Bank Notes and the Federal Reserve Bank Notes. (As the old National Bank Notes were redeemed or retired, they were replaced with Federal Reserve Bank Notes indistinguishable from ordinary Federal Reserve Notes.)
The Federal Reserve System had been changed from the lender of last resort for the private sector to the lender of first resort for the State — and all for what seemed the best and most patriotic of motives.