As we saw in yesterday’s posting, the Federal was
established to resolve “the money question,” and (at least according to the
Federal Reserve Act of 1913) provide the country with an elastic, asset-backed
reserve currency, convertible into gold on demand.
As designed, the Federal Reserve was intended in part to
establish and maintain an elastic, asset-backed reserve currency backed by the
present value of existing and future private sector investment in the form of
industrial, commercial, and agricultural assets. This would be accomplished by gradually
retiring the debt-backed National Bank Notes and Treasury Notes of 1890 (and,
eventually, the United States Notes), and replacing them with debt-backed
Federal Reserve Bank Notes. The Federal
Reserve would purchase the government bonds backing the National Bank Notes and
Treasury Notes of 1890 through open market operations, paying for them with
newly issued Federal Reserve Bank Notes.
As the government redeemed the bonds (i.e., paid off the national debt), the Federal Reserve would
replace the debt-backed Federal Reserve Bank Notes with indistinguishable
asset-backed Federal Reserve Notes. In
an application of the real bills doctrine, the procedure was as the government
bonds were redeemed, the Federal Reserve would either increase its acceptances
of qualified (asset-backed) private sector paper from member commercial banks
through the discount window, and (if rediscounting commercial paper proved
insufficient), purchase qualified private sector paper issued by non-member
banks and private enterprises on the open market. Any additional liquidity demands by the
economy would be met the same way, eventually achieving a zero national debt and
a fully asset-backed, elastic reserve currency, convertible into gold on
demand, no inflation or deflation.
Then the politicians decided to finance World War I the same
way they did the Civil War: on debt. The
First Liberty Loan drive sucked all the excess liquidity out of the system, so
for the Second and the Victory Loan, commercial banks and brokers purchased the
bonds, then sold them on the open market to the Federal Reserve. This backed all the new money with more
government debt.
After the war, great strides were made to repay the debt,
but something else came along: the stock market frenzy of the late 1920s. The commercial banking system created money
at a tremendous rate to pour into the stock market. This drove prices up beyond all reasonable
levels. What baffled the experts,
however, was the fact that there was also a great deal of legitimate money
creation for new capital formation — to people convinced that all financing had
to come out of past savings, this was incomprehensible.
After the Crash of 1929, under the influence of Keynes the
New Deal was financed with massive issuances of government debt. Ironically, this may have dragged out the
Great Depression of the 1930s to twice the length of those of 1873-1878 and
1893-1898, during which the federal government took no action. In extenuation, the Homestead Act brought the
country out of the Great Depression of 1873-1878, while crop failure in Europe
and bumper crops in the U.S. brought the country out of the Great Depression of
1893-1898. World War II, not the New
Deal, ended the Great Depression of the 1930s.
Monetarily speaking, the New Deal marked a shift from an
elastic, private sector asset-backed reserve currency convertible into gold on
demand, to an elastic, government debt-backed currency not only not convertible
into gold, but making owning gold illegal.
It also made it possible for the government to finance deficits at will,
without being immediately accountable to the taxpayer, as would have been the
case had the government not been able to monetize its own debt.
Fortunately, it is relatively simple — though probably not
easy, politically speaking — to correct the problem, as will be seen in the
next and final posting in this series.