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Wednesday, July 14, 2010

Common Cause, Part XVI: The Federal Reserve

In a pattern that has become depressingly familiar in the 20th and 21st centuries, the "Panic of 1890" revealed structural weaknesses in the global financial system. No sooner had the world recovered from the relatively minor shock of 1890, however, than the "Panic of 1893" ensued. This precipitated what would be known until the 1930s as "the Great Depression." Nowadays, of course, we avoid the terms "panic" and "depression." We prefer "downturn" and "recession," but the effect is the same. In principatu commutando saepius, nil praeter domini nomen mutant pauperes — "In changing rulers, the poor usually change nothing but the name of their master." (C. Iulius Phaedrus, I.15.i)

The Panic of 1893

Not too many people today even know about the Panic of 1893. It was, nevertheless, a turning point in American financial history. As Harold Moulton explained, "The Panic of 1893 precipitated a genuine agitation for the improvement of our banking system, but before any legislation on the subject could be passed, there occurred the political campaign of 1896, the issue of which was once more the silver question." (Harold G. Moulton, Financial Organization of the Economic System. New York: McGraw-Hill Book Company, 1938, 343.)

The "silver question" refers to the late 19th century Populist demand for "free silver." Free silver was the push to inflate the currency by minting as much cheap silver as necessary to bring the U.S. currency back to its wartime value. During the Civil War, Treasury Secretary Salmon P. Chase's policy of financing the Union war effort with debt had led to massive inflation. Naturally enough, it also caused the virtual disappearance of gold, silver, and even copper coinage from circulation. To restore the credit of the United States, the National Bank system, established in 1863 (amended in 1864), and the Coinage Act of 1873 were intended to deflate the currency and restore the pre-war parity.

Efforts to restore the value of the U.S. currency and secure the national credit were, all things considered, successful — but at a high cost. During the war, farmers had borrowed "cheap," that is, inflated currency. This now had to be paid back with "dear" or deflated currency. With the decline in prices due to both the tremendous increase in production and the deflation of the currency, a farmer had to produce (for example) 100 bushels of wheat at 50 cents instead of 50 bushels at $1.00.

The figures are grossly oversimplified, of course. It does, however, demonstrate the dilemma in which the farmers found themselves. In the burst of Populist sympathy that resulted from the Panic of 1893, the Coinage Act of 1873 came to be seen as a criminal conspiracy. This was because the effect of the Act was to destroy the ability of the farmers to repay their debts on the same terms on which the debts had been incurred. It was then — twenty years after the passage of the Act — that it entered agrarian and conspiracy lore and legend as the "Crime of '73." (Walter T. K. Nugent, The Money Question During Reconstruction. New York: W. W. Norton & Company, Inc., 1967, 65.)

According to Moulton, however, the real question was not to what degree the government should be manipulating the currency, but whether it should be manipulating it at all. Both camps, the Republicans and conservative Democrats who pushed for a sound currency by linking it to gold and maintaining the value by constricting the money supply, and the Populists, who demanded inflation by linking the currency to a bimetallic standard of both gold and cheap silver, were locked into the mindset of the British Currency School. That is, they believed that "money" consists of gold and silver coin, and paper certificates issued by the State. Demand deposits — checking accounts — and certain time deposits were added later. This gave us the standard M1 and M2 definitions of money currently used by the Federal Reserve.

Completely ignored in all of this was the fact that money consists of far more than mere coin, currency, demand deposits, and small value savings accounts. Money, in fact, is anything that can be used in settlement of a debt. Currency, whatever form it takes, is merely a symbol, a derivative of money, just as money itself is a symbol, a derivative of the present value of existing and future marketable goods and services in the economy.

Banks can create sound money at need, without inflation or deflation, as long as the new money is directly backed by the present value of existing and future marketable goods and services in which the issuer has a private property stake. Consistent with Say's Law of Markets, there is never any excuse, in an economy characterized by widespread direct ownership of the means of production and with a well-regulated and functional banking and financial system, for there to be either an inadequate or excess supply of money.

The Slavery of Savings

Unfortunately, trapped in the paradigm dictated by the British Currency School (and which subsequently shackled Keynesian economics), the monetary commission appointed in 1897 looked only at currency, and not at the banking system. The subsequent bill that resulted from the investigations — the Currency Act of 1900 — did not address the main issue. As Moulton remarked, "In the main, . . . this act was concerned primarily with the money question. On the banking side all that was attempted was a stimulation of the growth of national, as compared with state, banks by decreasing the capital requirements and by permitting the issue of notes up to the full value of the government bonds held as security." (Ibid.)

The most common complaint during the depression that followed the Panic of 1893 was that there wasn't enough money in circulation to keep the economy running. As one authority described the situation,
A currency famine followed. The hoarding of money drove silver and paper as well as gold to a premium at New York on and after July 30, 1893. Money brokers advertised offers to purchase currency payable by certified check. Bank depositors in need of money bought currency from the brokers at a higher premium. The currency famine continued until early September, with premiums varying from day to day. (Gerald T. White, The United States and the Problem of Recovery after 1893. University, Alabama: The University of Alabama Press, 1982, 3.)
All of this was, of course, unnecessary. Had merchants and manufacturers been able to draw bills and discount them at commercial banks, there would have been no problem. Unfortunately, the amount of currency that the National Banks could issue was limited not by the amount of qualified paper presented for discounting, but by the banks' reserve requirement and the amount of government bonds they held as backing for the currency.

There was no central bank to provide accommodation either for the commercial banks or for the private sector as a whole. When an individual bank lacked the capacity to discount bills of exchange, there was nowhere to go, no "lender of last resort" for industry, commerce, and agriculture. The best that could be done within the framework dictated by the Currency School was to increase the amount of government debt that could be used to back the currency. This helped create the illusion that inflation is the remedy for an economic downturn.

The Panic of 1907

No sooner had the country recovered from the depression that followed the Panic of 1893 than the stage was set for the next financial shakeup. As Moulton pointed out, the basic problem remained unsolved: the banking system was grossly inadequate to serve the needs of an advanced economy. To make matters worse, virtually all financial power had become concentrated in the hands of a very few people. Effectively, the financial center of the country was New York City, just as it is today. Where people had focused on preventing the concentration of financial power in government hands by preventing the establishment of a central bank, power had concentrated in private hands. This set the stage for a series of events that culminated in the "Panic of 1907."

Financier J. P. Morgan certainly did not intend to drive the United States and most of Europe into a major depression. All he wanted to do was carry out business as usual, and squash a competitor like a bug in the grand tradition of laissez faire capitalism. It was unfortunate for Morgan and the rest of the world that his business-as-usual triggered events that rapidly spiraled out of control.

In 1907, the president of the Knickerbocker Bank and Trust, the third largest bank in New York, got his bank into a great deal of trouble by speculating in copper shares. At that time, regulations permitted commercial banks to own and deal in securities other than their own equity shares or government bonds. It wasn't until after 1929 that commercial banking and investment banking were separated. This was reversed with the repeal of Glass-Steagall, leading directly to the current economic malaise.

Because of the attempt to manipulate copper, the Knickerbocker was in desperate need of cash to prevent a run on the bank. A run would almost certainly result in the failure of the institution, and the loss of everything by creditors and depositors. The president of the Knickerbocker applied to J. Pierpont Morgan for emergency funds to keep his bank open. Seizing the opportunity to rid himself of a competitor, Morgan refused. The resulting run on the Knickerbocker spread like wildfire, causing a financial panic throughout New York, then the nation and, finally, Europe.

Congress Acts

A Congressional investigating committee determined that Morgan's stranglehold on the control of money and credit was the single most important factor in causing the Panic of 1907. For this and other reasons, not the least of which was the need for such an institution, Congress decided to make a fourth attempt to establish a central bank for the United States. There were, however, two serious problems that had to be addressed before any successful attempt could be made.

The first of these was the paradoxical concept of breaking up a private monopoly over the control of money and credit by establishing a government monopoly over the same thing. If a standard central banking system were established, the only change would be concentration of power in governmental, rather than private hands.

The other problem was the strong suspicion and distrust in America of banks of any kind, but especially central banks. This distrust had already brought down three attempts to create a central bank for the United States — the Bank of North America, the Bank of the United States, and the Second Bank of the United States. The word "bank" itself would probably be enough to guarantee failure. (Interestingly, the Bank of North America, after a convoluted series of mergers, is still in existence today, owned by Wells Fargo & Co., and doing business as Wachovia.)

The unique solution to these problems was, in retrospect, the only one possible under the circumstances. Instead of establishing a "Central Bank of the United States," Congress installed a "Federal Reserve System," a description rather than a name. In an astounding move, the national currency consisting of gold coin, subsidiary silver, bronze and copper-nickel tokens, gold and silver certificates, and treasury notes of various types was put officially into a secondary or supplementary role in the economy.

This had, of course, always been the case, as Henry Thornton demonstrated in 1802 in his book, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. Nor did the United States lag behind. According to Congressman George Tucker, the amount of gold and silver coin that circulated in the United States during the 1830s — inadequate by any standard — was dwarfed by the number and amount of bills of exchange that circulated, constituting possibly as much as 95% of the money supply. The unusual thing about the Federal Reserve Act was that, in sharp contrast to the British Bank Charter Act of 1844 and the United States National Bank Act of 1864, it acknowledged the reality that "money" consists of more than gold, silver, and State-authorized certificates.

The New Currency

Paradoxically, the primary currency of the United States was not to be a national currency at all, but the product of a currency union embracing twelve independent districts. Each would have its own, separate currency which would pass at par in all the other districts as well as being legal tender everywhere. The Federal Reserve Act established not one, but twelve central banks for the United States, each independent, and each the final authority and recourse in monetary and credit matters within its own district.

Through the process of rediscounting, twelve separate currencies would be provided that would expand and contract to meet the needs of industry, commerce, and agriculture in a specific region. This would avoid the twin pitfalls of inflation and deflation, and maintain parity among the twelve districts as well as the national currency by pegging it to the official price of gold at a little over $20 per ounce. The currency would be backed with the present value of existing and future marketable goods and services in the economy, and supplemented with gold and silver coin and certificates.

One very important provision of the Federal Reserve Act of 1913, and one technically still in full force today, was the absolute prohibition against any Federal Reserve Bank purchasing primary government securities, that is, government bonds and notes issued by the United States Treasury and sold directly to the ultimate holder. This was to prevent the government from "monetizing" its deficits by printing money through the central bank.

In order to regulate commercial bank reserve requirements and retire the old National Bank Notes, however, the Federal Reserve had to be permitted to buy and sell secondary government securities that served as the backing for the National Bank Notes. Government securities were the only asset, aside from cash, that a commercial bank could hold as reserves to back their note issues. "Secondary" securities are debt or equity instruments that have already been sold once, and are now up for sale by a holder in due course who is not the issuer.

The new Federal Reserve Notes were emitted through the rediscount mechanism in 1914 and 1915 in denominations of 5, 10, 20, 50 and 100 dollars. These were the old "horse blanket" notes, used until the reforms of 1928 decreased the size of the paper currency. The designs would be familiar to anyone today. The usual currency for ordinary people was still gold and silver coin, particularly since the lowest denomination Federal Reserve Note, five dollars, represented almost a week's pay for an average worker. Coin was supplemented with gold and silver certificates and other notes issued by the Treasury, but the most important currency for commerce was now the Federal Reserve Note. The Half Eagle, the $5 gold piece, continued to be the large denomination workhorse of the system, with the Half Dollar the primary currency for most silver transactions.

The Federal Reserve also began purchasing the outstanding government debt held by the National Banks on the open market. This was to replace the National Bank Notes backed by government debt held by the National Banks, with Federal Reserve Bank Notes backed by government debt held by the Federal Reserve. In appearance the Federal Reserve Bank Notes were indistinguishable from ordinary Federal Reserve Notes. The only difference was that Federal Reserve Notes were backed by qualified short-term loan paper representing the present value of existing and future marketable goods and services, while the Federal Reserve Bank Notes were backed by government debt taken over from the National Banks.

The idea was first to replace all National Bank Notes in circulation with Federal Reserve Bank Notes. The process was relatively straightforward. The Federal Reserve System would take over the government debt held by the National Banks to back their note issues, retiring the National Bank Notes and substituting Federal Reserve Bank Notes. The Federal Reserve would then phase out government debt as the backing for the currency by replacing government debt with rediscounted qualified loan paper representing private sector industrial, commercial, and agricultural assets.

The Hijacking of the Federal Reserve

All of the controversy surrounding the establishment of the Federal Reserve System, however, was to no avail. The carefully worked out design of the system lasted only a few years, never really getting the chance to operate as intended. The common currency of the twelve Federal Reserve districts was transformed into a de facto national currency. What happened was World War I.

The Federal Reserve was established in 1913, a short time before Archduke Francis Ferdinand, the heir-apparent to the throne of Austria-Hungary, was assassinated in Sarajevo. When the United States entered the war, the government was faced with the problem of financing the war effort. Taxes are, of course, perennially unpopular, and no professional politician will levy them except as a last resort. The only other recourse was debt financing. This created problems.

After saturating the market with the first Liberty Loan drive, liquidity in the system was used up. The only way to raise more money outside of raising taxes was for commercial banks and brokers to sell their Liberty Bonds to the Federal Reserve. Misusing the program that had been developed to retire the National Bank Notes (although with the most patriotic of motives), the Federal Reserve then created the money to purchase the bonds from these secondary holders in due course. The secondary holders in due course then turned around and bought more Liberty Bonds from the government.

The result was that a way had been found to monetize government deficits without violating the letter of the law. As Harold Moulton noted, however, "Responsibility for the large use of bonds as a means of financing the war cannot . . . 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." (Harold G. Moulton, Financial Organization and the Economic System. New York: McGraw-Hill Book Company, Inc., 1938, 392.)

With the New Deal and the effective loss of autonomy of the regional Federal Reserves, the concentration of power in the Board of Governors, the discontinuance of rediscounting for the private sector and the formal institution of the Open Market Committee, the federal government assumed near-total control of the financial system. (Ibid., 407-417.) The formal establishment of the Open Market Committee in the 1930s, in fact, institutionalized the operation of the Federal Reserve as a backup for government spending — the lender of first resort for the State, rather than of last resort for the private sector. The United States common currency experiment, while an exemplary model of the way a central banking system can be designed for a currency union without any one region, state, or nation dominating the situation, had been forced into objective failure by politicians intent on misusing the central bank's control over money and credit. As Moulton commented,
In concluding this discussion of the Federal Reserve system attention should be called to a point of view embodied in the new legislation, which marks a profound departure from the conception that had prevailed during the long period from the Civil War to 1933. As a result of the experience of the early nineteenth century in connection with the First and Second national banks and in the light of banking history in other countries, the opinion had crystallized that an efficient monetary and banking system, responsive to the requirements of business, necessitated detachment from political control. This conviction was responsible for the Independent Treasury system; for the segregation of the monetary from the fiscal functions of the Government in the Currency Act of 1900; for vesting in the National Banking system the power to issue notes; and for the democratic organization of the Federal Reserve system and the independent political position accorded the members of the governing board. While the Secretary of the Treasury was ex officio a member of the Board, the view prevailed that the Treasury should not be permitted to dominate Reserve policies in the interests of government fiscal requirements. (Harold G. Moulton, Financial Organization of the Economic System. New York: McGraw-Hill Book Company, 1938, 416-417.)
It is no wonder Moulton declared that, "This shift is a reflection of the philosophy that not only is it a proper function of the Government to assume control over the entire credit system, but that only the Government can be depended upon to exercise such control in the interest of public welfare as a whole." (Ibid., 417.)

As a result, control over money and credit is more concentrated today than it was in 1907, and the United States currency union effectively no longer exists. Even lip service is no longer paid to the ideal established in 1913: the new Federal Reserve Notes "hide" the specific bank of issue in a very obscure manner. They appear to be liabilities of the system as a whole, not of a specific region. The notes are clearly not the product of a currency union, but a national currency. Instead of regional "elastic" currencies to meet the private sector development and liquidity needs of different regions of the country, the United States has a single currency managed for political ends of the central government.