The banks attempted to organize during the latter part of the 19th century, trying to put in the safe guards offered by a central bank. Under the strains of war the government did assist in 1860’s under the National Currency and Banking Acts. These efforts actually only allowed for more credit expansion, made the system more unstable, and the panics continued at a faster rate.
There was a very prominent banking family during this time by the name of Morgan. In the end of the 19th and beginning of the 20th century the patriarch was J.P. Morgan. He was all too aware of the limitations and risks posed by the current banking system. Even his, the largest and most powerful bank in America, could be destroyed by a bank run like any other.
Another banking family emerged after the Morgan’s. The name of this family was Rockefeller, the patriarch of this family was J.D. Rockefeller. Rockefeller started making his fortune in the oil business. He became amazingly wealthy drilling black gold, but even he was lured to the easy gains possible in the banking industry.
There was a major banking panic in 1907 that nearly brought Wall Street to its knees. The story goes that the only thing that prevented the system from a complete crash was J.P. Morgan, who acted as lender of last resort, recapitalized the banks, and halted the bank run. There is evidence that the initiation of the crash was actually planned by Mr. Morgan.
Whether by design or happenstance the panic of 1907 provided an opportunity for the banking industry to take a page out of Nicholas Biddles’ playbook. They would attempt to persuade public, as well as political opinion, to insist that the only answer to panics, such as the one in 1907, was a central bank. A central bank would be a governmental solution and under the “control” of the government. After all it was JP Morgan’s bank that halted the last crash, what if a private entity did not have the will or ability to stop the next crisis, a governmental solution was needed, or so the argument for yet another central bank went.
The banking interests went to work in both politics and the newspapers to attempt to put in place a central bank.
This scheme required tremendous coordination and a secret meeting was held between the representatives from the Rockefellers, Morgan’s, as well as Senator Aldrich the political arm of the banking industry. An academic from Harvard was also included in the meeting for good measure. This meeting was held on Jekyll Island, a resort along the Georgia Coast.
The meeting was held under tight secrecy to the point that all of the representatives traveled under assumed names.
The point of this meeting was not to determine how to set up the bank so as best to serve the American people, but to find a way to sell the idea of a central bank to the people and their representatives in the Senate and House of Representatives. The meeting was denied for years afterward but eventually the truth of the secret meeting was acknowledged.
The Federal Reserve Act founding the Federal Reserve Bank of the United States was passed in December of 1913. Besides gold and silver it established the Federal Reserve note as the only legal tender of the land. Private Banks would no longer issue their own currency. There is a quote of J.P. Morgan before congress several years later that makes his own feelings about this new currency more clear -"Gold is Money, Everything Else is Credit."
The Federal Reserve Bank, though it sounds like it is some kind of government entity and its board members are appointed by the president, has shareholders just like the prior US central banks. These shareholders, though not known by name are presumed to be the large American banks. They are paid a dividend by law. The Fed doesn’t sound like any other government agency. It sounds like a corporation or more descriptively, since it includes all of the banks working in concert, a cartel.
The Federal Reserve Act and the Currency and Banking Acts of the 1860’s allowed for a completely new basis for the nation’s money. Prior to that point money could be created from debt through fractional reserve bank loans, but the basis for those loans was always gold and silver, barring the issuance of completely un-backed fiat paper money called greenbacks during the civil war. The new Federal Reserve had the ability to create new money based only on debt.
For the first few years only corporate debt could be used as a basis for the initial creation of money, a few short years later government bonds could also be used. This money is backed by the entity originating the debt having the ability to pay it back, so in the case of corporate debt the money would be backed by that corporation’s profit. Considering that corporate debt based money is backed by the corporation’s only means of paying back their debt, its profit, then it is understandable that money based on government debt would be backed by the only form of revenue the government has, its ability to tax its citizens.
Isn’t it ironic that earlier that year the government passed an amendment to the Constitution to be able to directly tax their citizens’ income? Yep, the birth of our third central bank coincided with the income tax.
The creation of this new debt based money is simple. A corporation or the US government wants to borrow money and issue bonds. The bonds are traded for money created by the Federal Reserve, and then the government or corporation spends that money into the economy. Voilà money is created. This new money is then further expanded through the normal fractional reserve banking system. As the famous 20th century economist John Kenneth Galbraith said “The process by which banks create money is so simple that the mind is repelled.”
Before we move on I would like to drill down a debt based monetary system using a fractional reserve system to only one, and the first transaction: The bank makes a loan to a merchant for 1000 dollars, and like all loans it has interest, we’ll say 5% after one year. After that year the bank attempts to collect. The merchant has the 1000 dollars and pays it back, but since these 1000 dollars are the only money in existence how could he ever pay back the additional 50 dollars? Well there is one way; the bank could ask the merchant to wax the banks floor, or some other service that the bank could pay the merchant 50 dollars out of the 1000. The merchant would then have 50 dollars to pay the bank back with.
So simplifying even further the banker, through essentially no effort, created the money and the loan. The merchant takes the loan and is beholden to provide a service to the banker. This seems like a great scheme for the banker to be able to put whoever is foolish enough to take out a loan into servitude. Said another way, the banker makes the borrower his slave.
Though there is certainly some of this scheme going on, allowing the bankers to once again take much more than their fair share, they cannot remove the 1000 dollars from the economy without dire consequences. As we have shown, decreasing the money supply would result in a crash. So to ensure that there is not a deflationary crash, under a purely debt based monetary system, the debt outstanding must grow each year based on the interest accrued the year before. The money in the system will also grow but at a slower rate. In the example above it is easy to see that when money is created, 1000 dollars, more debt is created, 1050 dollars.
The mathematically inclined probably just had their ears perk up. They will know that whenever something is growing by a certain percentage each year it sets up an exponential system, granted it’s based on changing interest rates, but it still acts as an exponential system. We’ll show this in more detail later.
This requirement of debt based money to continually grow at a faster and faster pace is at the heart of many of the policies our nation undertook over the next century. Many of the policies are touted as progress, but are only in place to perpetuate the debt based monetary system through ever expanding credit or loan creation. Think of all the governmental “programs” that involve loans.
Another point should be made; if a debt based monetary system must grow based on the interest rate it would put it in direct conflict with the other monetary system being used at the time, precious metals. Gold and silver in an economy can only grow based on the mine supply or by trade surplus. The growth of the two money supplies are based on completely different variables. This makes the two completely incompatible. Some different types of money can be used together, and can even complement each other; precious metals and debt based money do not.
There was a provision under the Federal Reserve Act that there was to be 40% gold backing for Federal Reserve Notes. This can be completely ignored. The reason this can be ignored is it had no real effect on how debt based money functioned. If 100 dollars of Federal Reserve notes were created, 40 of them would act no differently than gold certificates or gold itself in the economy; this is not the case with the remaining 60 dollars of debt based money. This provision was put in place to calm the concerns of some lawmakers in 1913 who may have thought this would put some kind of control as to how much money could be created. But in practice, every time the connections to gold limited, or threatened to limit, the debt based money creation the laws were changed to allow for further expansion.
The only substantive reigning in of fractional reserve banking was that done by Andrew Jackson. From that point in the 1830’s till the Civil War, the government mainly stayed neutral. The Currency and Banking Acts of the 1860’s begins a trend of cooperation between the Government and the Banking industry. With the creation of America’s third central bank that trend intensifies and perpetual strengthening of debt based money, fractional reserve banking and the ties between banking and government becomes the norm. Some of these events were large some small, and all were portrayed as beneficial to the American people, but nothing could be further from the truth.
To say that the government strengthened the debt based monetary system might be misleading. Fractional reserve banking is inherently weak and prone to breaking, without government help it would fail. Debt based monetary systems are like communism, weak, non-organic and without strong governmental support destine to fall apart under their own poor structure. It would be more accurate to say that the government spent the next century supporting debt based money.
The banks and government over the following century continually added patches such as the Federal Reserve to continue the credit expansion that is so necessary for fractional reserve banking to continue. Their hands may seem to be forced, but only in the light that debt based money and fractional reserve banking is the only option, which is not the case. One thing that is very consistent when observing these patches is they will always directly benefit the government and or the banks in a very direct manner, while they will be publicly touted to be for the greater good.
Shortly after the creation of the Federal Reserve the world fell into the largest war the world had ever seen. The creation of the new central bank allowed credit expansion and monetary expansion in the United States similar to the central banks of Europe. This credit extended by the central banks of the time financed World War One, but the real effects of the new Federal Reserve occurred during the following decade.
As mentioned, during the First World War the Federal Reserve gained the ability to purchase government debt in addition to corporate debt, this was forbidden under the original structure to prevent debt monetization. Debt monetization is when a central bank creates money to trade for existing government debt to fund the government when rational investors will not. It was also assumed that private debt would add to goods and services in the economy commensurate with the added money that was created when the Fed bought the corporate loans. This would prevent prices from increasing, but when buying government debt, particularly the kind to fund war, there was a much better chance of price inflation.
Some terminology also changed during this time period, the term inflation was deemed to be synonymous with price increases when the government started tracking price increases and called the measure inflation. In addition the term panic to describe a crash was replaced with recession and depression. These changes were probably not just a natural progression of the English language. It is more likely they were changed to induce confusion about economics, and the effects of increasing the money supply.
Then came the roaring twenties which were “roaring” simply because it was a boom created through credit and monetary expansion brought on by the strengthening of fractional reserve banking and introduction of a truly debt based monetary system.
This, the largest credit created boom to that point was punctuated by a crash in the stock market. This crash ushered in the Great Depression. As previously discussed credit created booms often are defined by misallocation of resources, but a generally accepted cause of this crash was that investors were taking on debt to buy stocks. This debt is called margin debt. Using debt to buy any asset is also termed “levering up”. It is called levering because if you borrow to buy assets, the gains, if that asset goes up in value, are intensified, just like the force when using a lever.
The other side of the coin when using borrowed money to buy assets is the losses can also be amplified. If you put 20% down to buy say, 100,000 dollars’ worth of stock and it drops by 20%, you have just lost all of your investment. Not to mention you still owe the full 80k, and interest! So you can lose much more than the amount you invested. This exacerbates the panic to sell when a credit driven investment bubble begins to pop.
The drop in assets put tremendous pressure on the banks but before we delve into the banks and governments response to the inevitable crash of the roaring 20’s I would like to revisit the second portion of the Von Mises Quote mentioned earlier.
Here is the quote in its entirety:
"There is no means to avoiding the final collapse of a boom brought on by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
I finish the quote now while we are discussing the 1920’s because in the beginning of the ‘20’s a very prominent government of the time took the second option to ending a credit expansion. The nation was Germany or the Weimar Republic. The debt that caused this crash was imposed on them by the victors over them in World War One in the form of reparations. The debt was un-payable in real terms, but Germany attempted to make good on those debts in a very familiar fashion, they turned to the printing press.
The German central bank used their power to print money, but France and England quickly caught on and demanded repayment of reparations in gold. Though in the beginning of this experiment a small economic boom did occur in Germany, the conditions were right for the monetary inflation to quickly cause prices to start to rise and in turn an infamous hyperinflation. Any Germans holding their savings in the currency lost it all. An interesting development considering the Federal Reserve was in many ways modeled off of the German central bank. The hyperinflation destroyed the German economy for years to come and made it vulnerable to a charismatic, yet dangerous and insane leader.
Now back to the United States that voluntarily abandoned further credit expansion. The banks understood what the falling stock prices could precipitate into. In an attempt to instill confidence a representative of the banks arrived on the trading floor of the stock exchange and began buying stock, even above the current market rates. At its essence this attempt to instill confidence was market manipulation, and like most market manipulations the attempt failed; this manipulation failed faster than most. The commercial banks, even with considerable resources, were getting into trouble themselves, and did not have the ability to stem the tide of selling. The one entity that may have been able to extend the boom that it created, the Federal Reserve, did not.
The real action after this crash took place was in the governmental arena. One of the major reasons for this was an economist named John Maynard Keynes. Keynes looked at the booms and busts that had occurred throughout the history of fractional reserve banking and concluded that the booms, causing real economic growth, could be extended indefinitely. There is no doubt that Keynes was brilliant, his logic appears to be sound at first glance, and many were lulled into believing it. His thoughts did have a huge advantage over other kinds of economic thought. It told the banks and government what they wanted to hear.
His ideas boiled down to this these two key points. First, interest rates were generally too high and central banks should intervene to lower them during economic downturns, the crash. Second, during the crash the government could act as the borrower of last resort to pick up the slack from the private economy until confidence was revived. The opposite was true during the booms the central bank could raise rates and government pay back what it had borrowed during the downturn while the private sector started borrowing again. The idea was the booms associated with credit expansion via fractional reserve banking could be smoothed out and the crashes could be eliminated. It was a very tempting theory but upon further examination and in practice proves to be false.
The huge advantage this thought has was it not only enticed banks to continue their scheme it also asked governments to spend more as a necessity for economic growth.
Now to define power, power is the ability of a person or entity to give or withhold something another wants or needs. Power is far from a bad thing, the breadwinner in a household holds power over the family, but if that person is benevolent and has the families best interest at heart there is nothing wrong with that power. There are many examples of power being held over others that isn’t necessarily bad, but often power is sought after by the worst among us. In a capitalist society there are many examples of power, but in a free marketplace the power is divided purely based on voluntary transactions.
The economic theory put forth by Keynes required the government to take a larger role in the economy, thus the government would become more powerful.
Herbert Hoover started to pursue some of these policies by borrowing to start public works projects to attempt to put the American people back to work, but the central bank did not follow the second portion of Keynes’s economic vision, loosen monetary policy, and lower interest rates. In fact at times they even did the opposite and increased interest rates.
Next we have an example of the incompatibility of a debt based fractional reserve monetary system and gold. The president following Hoover, Franklin D. Roosevelt, attempted to follow Keynes’s economic cure. He wanted to loosen monetary policy, which means creating more money. The question was how to accomplish this with failing banks who didn’t want to lend and potential borrowers becoming more cautious, as is normal during an economic downturn, thus there was no demand for loans. All that while the fed was raising interest rates. This ruled out the possibility of money creation through the normal means of fractional reserve banking.
Another means to add to the money supply was to revalue the gold already in the hands of the American people. If each ounce of gold in circulation was worth a percentage more in dollars than its original $20.67, the inflation in the money supply would help stave off the deflation going on in the banking system. The easiest way to complete this would be to have all Americans holding gold return it to the US mints. For every ounce of gold that was stamped with 20$ that individuals turned in, they would receive an ounce of gold stamped with 35$. Who wouldn’t sign up for that? People would flock with their gold to have it revalued and the deflation would quickly be halted, and borrowers would have an easier time paying off the debt overhang.
This, allowing the American people to retain their wealth, would not be allowed. Instead the president issued executive order 6102. The executive order stated that all Americans were required to turn in their gold to the federal reserve banks. In return for their gold they would receive 20 dollars in Federal Reserve notes, the same value that was stamped on the gold they had turned in.
Americans at the time were trusting of their government and for the most part complied, but those that did not we labeled by their government to be hoarders, not to mention those that did not comply faced the possibility of 10 years in jail or a 10,000 dollar fine. To put that fine into perspective, that is equal to about 500 ounces of gold or a 625,000 dollar fine today. That’s a heck of a motivation in case anyone was wondering if they should or should not turn in their gold. Much of the nation’s gold was turned in to the government and as the saying goes; he who has the gold makes the rules.
The next rule to come down was gold was to be revalued from 20 dollars an ounce to 35 dollars an ounce. So if the people were paid 20 dollars an ounce for their gold and now it was worth 35 dollars an ounce, who gets the other 15 dollars per ounce? The answer was the US government. So in this roundabout way the government stole 43% of the nation’s monetary wealth held in gold. So the reason they did the necessary revaluation in this much more labor intensive (not to mention logistical nightmare) fashion was so that the government could gain access to this huge percentage of the American Wealth.
They used this money, as well as borrowed money to give Americans what they were desperate for, work, actually, work for pay, so they could sustain themselves. This work again came in the form of public work projects. Government spending during a downturn was a page out of the new economics playbook written by Keynes. The government gained the ability to give the people what they desperately needed, and thus the government gained additional power. Those with these government jobs were now dependent. Whenever a person, company, or government, makes a person or people dependent on that entity, that entities power naturally increases.
The other major change was in the banking system. The government found a way to increase its power, now the other major power in the country, the bankers, needed to increase theirs. It came in the form of deposit insurance. Deposit insurance simply was the government backing the demand deposits at banks up to a certain amount. Banks were failing by the hundreds in the early 30’s, people were losing money simply by holding it in the banking system. Depositors were losing faith that is paramount in a fractional reserve banking system, and something had to be done. Once again, at the time, the government was still trusted and with it backing banking deposits the doubts held by Americans were, for the most part, put at ease. The money flows reversed and money started going back into banks. The final result is the American people were reassured by a guarantee that ultimately THEY were backing. But the fact that the American people collectively backed their own accounts was covered by just enough steps people didn’t appear to make the connection.
Reserve requirements were replaced with capital requirements, but this doesn’t change the fact that we have a debt based monetary system. I will still continue to use the term fraction reserve to describe our system since the change was not really material.
Even with these “patches” put in place to help the “people”, the real economy didn’t recover and floundered during the 1930’s . Perhaps these patches were not really put in place to help the people; possibly it was just a power grab, by those that already had a foothold.
So to recap, the Federal Reserve was created in 1913 and supported the already established fractional reserve banking system to cause a rapid expansion in the money supply. After World War One there was the predictable boom that would be expected after an expansion in the money supply. The equally predictable crash after the boom happened toward the end of the 20’s. The government, after seizing a huge portion of the nation’s wealth, used that wealth as well as borrowed money to position itself as the savior, increasing its power and control. The banking system also was strengthened by a guarantee on deposits they were not on the hook for, the American people were. The banks put pressure on the government, the government created the Fed, the Fed and banks caused a boom and crash, and after this failure both the banks and government came out stronger.
Power is like a pie chart, the pie can grow but the percentages always equal 100%, so if the banks and government took up a larger percentage of that pie, who lost. The answer was the people and non-financial sectors of the economy lost power during this time.
Continue Reading: A New Boom, Fleecing the World, Volcker and Reagan