The Constitutionality and Morality of the Fed

The constitutionality of the Fed is something that has long been debated by parties on all sides.  It is especially popular with conspiracy theorists, who like to make it sound as though Jekyll Island was more dramatic than it really was.  The reality is that Jekyll Island, while beginning as a secret, didn’t end that way.  In fact, there was a fair bit of open debate surrounding the creation of the Fed – debate that unfortunately ended with the creation of the monster.  That said, there might be still be something left regarding the debate about the constitutionality of the Fed.

The Federal Reserve Act came into being on December 23, 1913, though it was dreamed of long before then.  In fact, our current Federal Reserve was not the first central bank in America.  The subject of central bank creation was hotly debated, even among the Founding Fathers.  In fact, the first central bank, the Bank of North America, was chartered in 1781.  However, the state of Pennsylvania repealed its charter a scant four years later amid complaints of corruption, favoritism for foreigners, and fictitious credit.

The First Bank of the United States, which was signed into being by none other than George Washington in 1791, was essentially a revival by Alexander Hamilton of the Bank of North America.  Hamilton’s plan for a central bank was closely modeled off of the Bank of England.  Thomas Jefferson was no fan of the bank and viewed it as an engine of corruption and speculation, among other things.  In fact, Jefferson, Madison, and others railed against the creation of this bank, stating that is was not included in the enumerated powers of Congress and therefore could not be created.  In any case, despite Hamilton winning the initial debate, Congress didn’t renew its charter in 1811, and it never controlled greater than 20% of the US money supply.  At that point, Congress took control of the US money supply by issuing Treasury Notes.

In 1816, James Madison signed the charter for the Second Bank of the United States in hopes that it might end some of the runaway inflation that had occurred during the previous five years after the dissolution of the First Bank of the US.  Andrew Jackson, eternal enemy of central banks, was responsible for the demise of the Second Bank of the United States.

After the death of the Second Bank, there was a period in which there was no real central bank.  There were state banks and lenders of last resort.  Perhaps the most famous of these was the Suffolk Bank of Boston, which acted as a clearinghouse for other banks.  The Suffolk Bank was quite successful for some time, in fact.

After the panic of 1907, the subject of a central bank was again brought to the table for discussion.  The issue of constitutionality, so far as I know, was not raised.  The matter was more or less settled in the 1819 ruling of McCulloch vs. Maryland, when the Supreme Court ruled that the creation of a central bank fell under the implied powers clause.  So if we look only to legal precedent, it would seem that the case is won by the Fed, since the Supreme Court has never changed its ruling and doesn’t seem likely to do so any time soon.

But what of the original intent?  Well, as usual, not everyone agreed on the issue.  However, Jefferson, Madison, and Randolph adhered always to the strictest of constitutional views, meaning that if it was not specifically laid out in the powers enumerated in the Constitution, the government lacked the authority to do it, and the power rested with the states alone.  There will be libertarians on both sides of this argument, but I have yet to meet a follower of Austrian economics who thinks that the Fed is a good idea.  In any case, the constitutionality of the Fed seems, for all practical purposes, a settled issue, even though some (many) of us would like to see it reopened for debate in the federal government.

So what exactly does the Fed do, anyway?  Without going into a long, boring explanation, the Fed controls the expansion of the money supply (M3) and interest rates.  How does it control the money supply?  It buys or sells various securities, which can include Treasury securities issued by the US government.  It also alters the reserve requirements that commercial banks must hold in reserve against deposits.  Finally, it can adjust the discount rate – that is, the interest rate charged to commercial banks.  When the Fed wants to shrink the money supply – it’s been a long time since that happened! – it sells securities and raises the reserve limit on the banks.  Raising interest rates will also help control inflation.

What is inflation?  Simply stated, inflation is the increase in the money supply.  No more, no less.  If the Fed is inflating the money supply, inflation is happening.  Period.

Why might this be a bad thing?  Well, when the Fed is increasing the money supply, as it has been doing for some time now, it tends to lead towards higher government debt.  The Fed will continue buying up Treasury securities, which basically means that the government has a blank check to spend whatever it wants.  While it allows the US to continue overseas expenditures and programs that might otherwise have to be cut during economic hard times, this expansion of money and credit simultaneously devalues the currency.  As the money supply increases, prices go up, up, up.  In fact, we’re seeing it at the gas pump now.  Wonder why those gas prices are going higher?  It’s because oil is primarily traded in US dollars, and more and more of them are needed to purchase a barrel of oil.

Unfortunately, the problem with printing money out of literally nothing has the result of creating more money out of thin air.  Suppose we have a bank called “Liberty Bank.”  Liberty Bank deals US government securities, kind of like Goldman-Sachs or J.P. Morgan.  The Fed has decided to buy $1 billion in US securities from Liberty Bank.  Liberty Bank happily skips home with its free money, cashes the check, and then unleashes the money on the market.  Within a relatively short period of time – a matter of weeks or even less – that bank will have further expanded the credit to the tune of about $9 billion more dollars.  In other words, what begins as a comparatively paltry sum quickly grows to the size of an elephant.  Using that knowledge, think about how much the Fed as expanded the money supply since 2008.

So what happens if the money supply gets inflated too far?  Well, several things could happen.  If the Fed raises interest rates to avoid hyperinflation, it will make the US debt instantly unmanageable.  We will no longer be able to meet our minimum payments.  In other words, the US government is going to be getting a lot of angry phone calls from debtors and collection agencies.  The result in this case may be the government admitting insolvency.  In other words, the government would be bankrupt and unable to meet the burden of its debt.  Debt would have to be written off, government programs would likely be scaled back en masse, and government agencies would be be cut.

Think this is an unlikely scenario?  Think again.  According to a report in 2010 by Bloomberg, the IMF has already said, in not so many words, that the US is already bankrupt.  At the time the article was written two years ago, the author calculated the actual indebtedness of the US government to be somewhere around $202 trillion, including off-balance sheet liabilities.  The IMF made the claim that the debt-to-GDP ratio was too high, and that in order to stabilize that fiscal gap, the US government would have to make a permanent adjustment equal to 14% of the GDP.  At that time, 14% of the GDP was how much the government was taking in with tax revenues.  In other words, taxes would have to double their current rate for the government to get into the IMF-determined “safety zone.”

Hard-line Keynesian economists like Paul Krugman have repeatedly made the claim that adding more and more money to the economy isn’t a bad thing.  In fact, every time I read an article from that guy, he’s railing on about how we should be spending more.  Well, he’s wrong.  According to Bloomberg and, frankly, common sense, it’s all a matter of arithmetic.  Basically, whatever isn’t paid at the end of the year (14% of the GDP, for example) will be added to the government “credit card bill,” which will roll over on the next year’s balance.  In short, the debt will continue to grow, and it will eventually reach the point of being too big to even meet the minimum payment, if allowed to snowball indefinitely.

At the same time, the possibility of hyperinflation looms.  Think hyperinflation can’t happen?  Think again.  In the 20th century, hyperinflation happened multiple times: Weimar Germany, Argentina in the late 1980s and early 1990s, Russia in 1992, China in 1949-50, Brazil in 1989-90, Zimbabwe in 2006-09, etc.  Yes, it can happen.  Before it was all said and done in Weimar Germany, it was something like $1 billion marks to $1.  Argentinians woke up one morning unable to withdraw money from savings.  When they were finally able to get their money out, they discovered that it had only half of its original value.  Life savings were wiped out.

How might this happen?  Two years ago, Thorsten Polleit contributed an article to the Mises Institute that suggested we may experience a crack-up boom – that is, people finally come to the conclusion that the Fed will continue to print money at an unrelenting rate.  They begin buying things for which they actually have no need, if only to get rid of the paper money, which is quickly becoming worthless scrap.

He also suggests that another credit crisis is possible when creditors are no longer willing to roll over maturing debt at prevailing interest rates.  Borrowers can neither meet their obligations nor afford the increased borrowing rates.  They go bankrupt and collapse.  This will set off a chain of similar events that will finally result in the collapse of the credit structure.  He goes on to note that, should investors expect more bailouts financed through money creation, the demand for money will dry up.  The central bank will extend more and more money in an attempt to stop the wildfire spread of bankruptcies, and thus the crack-up boom will come home to roost.  Scary, huh?

At this point, I might highlight the reason I included the word “morality” in the title of this post.  When all is said and done, which people really lose the most in these scenarios?  The people who receive the money last, the poor and middle classes, lose the most.  Those receiving the money first, namely the bankers and so on, are having more and more wealth transferred into their hands.  Those on the bottom lose the most as their purchasing power evaporates and their savings become more and more worthless.  The question of the desirability of such a transfer of wealth is not economical, but ethical: is it right to take people’s money away in this manner?  Ask the folks at Occupy what they think about the rich getting richer and get back to me!

The moral hazards of the fiat money created by the Fed also include the ability to prolong war (see Iraq, Afghanistan, Libya…), the slow decline of the financial system, the expansion of an irresponsible state, and many others.  I think it would be hard to deny, at this point, that we are not experiencing at least one, if not all, of these things.

So the question now is do we really want the Fed?  Are they really doing more good than harm?  We are now four years into this recession, and there don’t appear to be many signs that things are getting better.  If anything, it seems that the Western world is in a state of financial decline that is getting worse by the month.  Krugman says that we haven’t done enough, that we haven’t pumped enough money into the economy.  Is that the case, or could it be that the Fed’s policy of fast and easy money is causing a slow, painful death of the US economy?  Are we only prolonging what may now be inevitable?

I don’t want to seem doom-and-gloom about this.  I really don’t.  Unfortunately, I don’t see a situation that is improving.  That said, I don’t want to leave my readers without hope.  Is it too late?  I don’t know, and that is the honest truth.  But here’s what you can do.  Educate yourself about the Fed and Austrian economics.  Hell, educate yourself about Keynesianism.  If you believe as I do that the Fed is at the very heart of this “evil empire,” write some angry (but cordial) letters to your representatives and tell them to support HR 459 or S 202, which are the current incarnations of the Audit the Fed bills.  The Fed has never received a full audit that would include off-balance sheet transactions and tell us where the money is going.  (Aren’t you interested in knowing if there might be some conflicts of interest or primary beneficiaries of that money?)  Sign the Audit the Fed petition online; it only takes about two minutes of your time.

Please take some time and read the following material.  It helped me write this article, and some of it is invaluable reading.  I encourage you to download the (free!!) PDF file of Murray Rothbard’s The Case Against the Fed.  It isn’t very long, and it explains things rather concisely.  I will also freely admit that I used his billion-dollar credit expansion example.  Given how Rothbard and most folks at Mises felt/feel about “copyright infringement,” somehow I doubt that he’d mind.

Read and do more!

Sign the Audit the Fed Petition

US is Bankrupt and We Don’t Even Know It – Lawrence Kotlikoff via Bloomberg

The Federal Reserve vs. the Constitution – Ron Paul

Hyperinflation, Money Demand, and the Crack-Up Boom – Thorsten Polleit via The Mises Institute

For and Against Paper Money – MisesWiki

The Case Against the Fed – Murray Rothbard (PDF available for free download courtesy of the Mises Institute)

Visit Campaign for Liberty, as they do a lot towards auditing the Fed.

More suggested reading: End the Fed by Ron Paul, Gold, Peace, and Prosperity: The Birth of a New Currency by Ron Paul, America’s Great Depression by Murray Rothbard, The Case for Gold by Ron Paul and Lew Lehrman (free PDF available from Mises)