Panic in the Streets, Part II: State Power and Money Creation

We mentioned yesterday that the world hasn't ended as a result of the downgrading of U.S. debt from AAA to AA; that it's actually the perfect opportunity to get things back on the right track. While technically the first downgrading of federal government securities, this is extremely misleading. For the relatively new United States, most of the 19th century, frankly, had all the appearance of one financial disaster after another . . . following hard on the economic catastrophe that was the 18th century.

The chaos of the 18th century and the social disruption of the 19th resulted in part from ignoring the reinvention of commercial banking and the invention of central banking in the political order just as "new" methods of finance were providing the funding for the incredible expansion of agriculture, industry and commerce throughout the world. The problem was that most people in Europe were cut off from full participation in economic development through private property (and thus political development) by lack of access to what should have been freely available as a social good: capital credit.

Only the existence of America, where one form of capital was more or less freely available, land, kept the lid on. The New World provided an outlet for the new freedom that economic development engendered — and which freedom was itself the result of the rebirth of commercial banking after two and a half millennia. Face facts, folks: look at any graph of economic development and population growth, and common sense will tell you that it couldn't possibly have been financed out of past savings. The frustrations eventually led to the "Year of Revolution," 1848, which America avoided . . . until the end of "free" land triggered the Panic of 1893 and the first Great Depression.

No, the downgrading of America's credit rating is hardly a unique event. We've recovered from much worse with much less to work with, as our nation's history demonstrates — and so have others. The roots of the trouble are the partial, even erroneous ideas about money, credit, banking and finance that infect the political and financial world even today. It continues with the spread of misunderstandings about basic institutions such as private property, the role of the State, and the sovereignty of the individual.

Take, for example, the role of the State with respect to the regulation of the currency and money creation. The Articles of Confederation allowed both the individual states and the central government to emit bills of credit, that is, create money. This was common practice in England at the time, especially after the Crown refused to grant the new Bank of England its charter in 1694 unless it loaned its specie reserves to the State in exchange for government securities.

As a result, people became convinced that the business of a central bank is to finance government operations instead of discounting and rediscounting private sector bills of exchange, coordinating and overseeing clearinghouse operations, ensuring adequate reserves of liquidity to defuse sudden demands on the commercial banks, and maintaining a stable and uniform currency to facilitate private sector agriculture, industry, and commerce. Even to this day, the work of Henry Thornton, the English "father of central banking," is widely misunderstood and even used to justify the very policies against which Thornton himself protested: backing the currency with something other than the present value of existing and future private sector marketable goods and services, thereby allowing the State to take over the finances of the country. Thornton was, in fact, a populist a century before the rise of populism. He was an early advocate of abolition, private property, and limited government — and a sound and uniform currency and elimination of the national debt.

Unfortunately, across the pond the citizens of the new United States were suspicious of concentrated power of any kind, whether economic, political, or military, and whether or not adequate checks and balances were in place, or direct ownership of capital was widespread throughout society. An effective counter to the power of the states and central government to raise money at will by emitting bills of credit, the independent first central bank of the United States (the Bank of North America) under the Articles of Confederation had its charter revoked by Robert Morris's political enemies playing on the fears of the people regarding concentrated economic power.

The first draft of the new Constitution had a provision that expressly permitted the federal government to emit bills of credit, instead of relying on tax revenues and borrowing out of existing accumulations of savings to meet demands on its purse. This provision was removed over the protests of George Mason and some others. They feared that, without the power to create money, the federal government might find itself in financial difficulties during emergencies.

While the Constitution as it stands today does not explicitly prohibit the federal government from emitting bills of credit (and such operations account for the bulk of revenue . . . and debt . . . of the federal government), a body of evidence suggests that the Founding Fathers intended to prevent the Congress from being able to finance its own operations without recourse to the taxpayer. Alexander Hamilton certainly believed that to be the case, as he hinted in his 1791 Opinion as to the Constitutionality of the Bank of the United States when questions were raised as to the power the new federal government had to charter a corporation to do business across state lines.

It wasn't a question as to whether the federal government had the power to create money. No one believed at that time that it did. Common belief was that only the private sector had the right to create money by drawing bills of exchange. Through the process of discounting and rediscounting, bills could either be used directly as money by the drawers and holders in due course, or taken to a commercial bank and exchanged for notes of the bank to use as money.

Congressman George Tucker, of the Virginia Tuckers, believed that in the 1830s merchant's and banker's acceptances of this sort accounted for well over 95% of the money supply in the United States. By the early 20th century with the growth of the power of the central government, this had fallen to an estimated 75-80%, while a rough calculation for 2008 suggests that only 60% of the money supply was created by the private sector, and is believed to have fallen even lower in the years since as a result of the massive bailouts and "Quantitative Easing" that has taken place. Despite the obvious fiction of an independent Federal Reserve, the balance of the money supply was and is under the direct control of the government.

Even in light of the obvious necessity for and advantages of a central bank, politics resulted in the refusal to recharter the (First) Bank of the United States, America's second central bank, in 1811, just in time to cripple the financing of the War of 1812. The Second Bank of the United States operated from 1817 to (effectively) 1833 when Andrew Jackson withdrew federal funds from the bank and redeposited the money in other private banks belonging to his political friends.

The National Bank system operated from 1863 to 1913 as a quasi-central bank. The National Banks functioned to concentrate ownership of industrial and commercial capital by only discounting and rediscounting bills of exchange for large accounts, and deflating the banknote currency on which the farmers and small businesses relied for financing. By requiring that the National Bank Notes be backed by government debt and deflating the United States Notes (direct obligations of the Treasury, as were the Treasury Notes of 1890) to restore parity with gold, the nation was saddled with an inelastic, debt-backed currency for consumers and small business and farmers at a time when there was a serious need for an elastic, asset-backed currency to maintain an adequate level of effective demand to support the industrial and commercial expansion and finance small business and agricultural development.

The Federal Reserve System and the Sixteenth Amendment — both viewed as populist triumphs by William Jennings Bryan — laid a solid foundation for a fiscally responsible yet adequate money and credit system. Unfortunately, the Federal Reserve was only allowed to operate as designed for two years before the politicians hijacked the central bank to finance the U.S. entry into the First World War. Keynesian policies embedded in the New Deal completed the transformation of an independent central bank into an effective branch of the State that permitted politicians to spend without direct accountability to the taxpayer.

The effect was to replace the elastic, private sector asset-backed Federal Reserve Note currency, with an elastic, government debt-backed Federal Reserve Note currency, an example of political and financial sleight-of-hand that confused people due in large measure to the fact that the two types of currency are completely indistinguishable. The appearance of the currency was unchanged, the ostensible mechanism for creating the currency ("open market" operations — originally intended only to supplement rediscounting of private sector commercial paper) was unchanged, but the backing was shifted from the present value of existing and future private sector marketable goods and services, to the present value of future government tax collections out of wealth that might never be created.

The failure, bad design, or mismanagement of these institutions created a series of financial disasters that, more than once in the 19th century, put the financial future and the faith and credit of the United States government, even its survival, in serious danger. We'll take a look at some of the more catastrophic of these tomorrow, then finish off with our recommendation for turning things around in the shortest possible time.

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