Trampled Liberties: The Federal Reserve Bank, And Fiat Currency

permalink         categories: politics · trampled liberties         originally posted: 2006-04-23 15:03:32

Ah, finally, the bane of blog readers everywhere: American politics. I never said I would resist its siren song, never said I wouldn't blat out my opinions on this most overwrought of topics. That said, my opinions and conclusions are different from most. Does that make me an original thinker, or a marginalized crank? By all means decide that for yourself—my only hope is that you read, and think.

In point of fact, this posting is the first in a series I've been mulling over for a while. I planned to call it Top Ten Ways The US Government Tramples The Constitution Every Day. I had originally thought it would be one posting, with sound-bites on each topic, but that was unsatisfying and unpersuasive. There is so much to write on this topic that, even with individual postings on the various subjects, I'll only be able to scratch the surface.

Today's topic is relatively obscure, but one which I think everyone should not only know about but be furious about: the Federal Reserve Bank. Even this is a gigantic topic, and I'm going to do a lot of skipping over detail. I urge you to read more on the subject yourself, and decide for yourself whether I'm right or wrong.

(Also, technically none of these are momentary fascinations. I've been grinding my teeth about these subjects for years...)

The Founding Fathers And Money

Article II, Section 8: Powers Of Congress
  The Congress shall have Power to [...] coin Money, regulate the Value thereof,
Article II, Section 10: Powers Prohibited Of States
  No State shall [...] make any Thing but gold and silver Coin a Tender in Payment of Debts;
Throughout history, mankind has been plagued by power-seeking individuals. There have always been, and always will be, those who wish to hold power over others. If you seek this power, the best place to find it is in government; it is there that you can bend the law to your whims, and legally bring force to bear on those you wish to control. As a result, governments are inevitably populated by unscrupulous, power-seeking individuals. The Founding Fathers were excellent students of history, and they wisely foresaw this would happen in America sooner or later. So they designed the Constitution to contain many roadblocks to curtail the power of these power-seekers to come.

One thing they knew was a great evil was "fiat currency", also called "paper money". A fiat currency is currency not made of, or backed by, a precious commodity (like gold or silver). It is currency by fiat, by simple declaration—"this is money because I say so." And it is ripe for terrible abuse. Why this is a great evil—what abuse lay in it—I'll get to in a moment. But for the moment let's take it for granted that it is evil—that it leads directly to a vast, malicious incursion into our individual sovereignity. And the Founding Fathers wanted to prevent it from ever happening in the US-of-A.

What did they do to prevent it? They specified in the Constitution that only Congress may "coin Money". Although you and I read that with two hundred years' distance, where the meaning has become less certain, the Founding Fathers meant something very specific: Money here meant coins made out of gold and silver. For example, that's why it says coin money and not print money. (As originally proposed in 1787 during the constitutional convention, this clause actually said "coin money and emit bills". That would have allowed for paper money. This proposal met with overwhelming opposition from the other delegates.)

More importantly, they quite specifically require that States cannot make anything but silver and gold coin be legal tender. I remind you that the USA was created as a republic—a loose confederation of individual states. The Federal Government was meant to be a weak institution; nearly all the real power was intended to reside with the states. The Federal Government's only real jobs were to force the states to cooperate with each other and to defend the country as a whole from foreign aggressors. So they made this legal tender requirement apply to the states because that was more binding. This way, the states could not make anything be legal tender but gold and silver coin, and Congress did not have the right to supercede this prohibition.

This worked for more than a century—all American money was backed by gold or silver. Paper money, when it existed, was no more than a "warehouse receipt", directly redeemable on demand for gold or silver.

But it didn't last forever.

The Federal Reserve Bank

At 11:30pm, on December 23rd, 1913, the Congress of the United States passed "The Federal Reserve Act". This established The Federal Reserve Bank (hereafter "The Fed"). Among its duties were the creation of a new currency, the Federal Reserve Note, which was the new official currency of the United States. This Dollar was on the gold standard; it was fixed at 1/20 ounces of gold.

It wasn't long after the creation of The Fed that the US Government noticed that, gosh, it wanted a whole lot more money than it currently had. There was this whole World War brewing over in Europe, and the President wanted in on the action. Much of the US financing of the war was through the new Income Tax, or borrowing from the public by posting bonds. But some of the funding was from new money, created out of thin air, without having the gold to back it up.

Why did they contend this was legal? Simple: The Fed is a private corporation. Technically it is not part of the government. Sure, its Board Of Governors is part of the Executive Branch of the Federal Government; its members are appointed by the President. And banks are required by federal law to be members of The Fed and follow its dicta. But, on paper at least, it's not officially part of the US Government. So, to their minds, this had the patina of legality.

The US continued creating money out of thin air, initially to pay for World War I, and later to combat the Great Depression. In 1933, when the Great Depression was in full swing, President Franklin Delano Roosevelt revalued the Dollar to 1/35 ounces of gold. That year FDR also issued Presidential Order 6102, barring any US citizen from owning ("hoarding") gold. Under this perverse arrangement, the dollar was still tied to gold, but was no longer redeemable in gold by US citizens. (Hardly the intent of the Founding Fathers!)

The US kept up appearances of a gold standard in this way for a few decades. Finally, in 1971, President Nixon formally took the US completely off the gold standard. The US Dollar was no longer tied in any way to gold or silver. It was a totally fiat currency, and it remains so to this day.

Is any of this legal? Well, gosh, no, not if you ask me. Today all states make a Thing that is neither gold nor silver Coin a Tender in Payment of Debts. This is in direct violation of the US Constitution. And the Constitution has never been amended to allow it.

But why is it bad?

Inflation

In a single word: inflation. Inflation is the creation of new money. It causes prices (and as a result wages) to go up, but that is merely a side effect. The cause is inflation.

I'll give you a quick illustration of how inflation works, and why it is so insidious. Keep in mind that this is a tremendous simplification, and whole books have been written about the subject. (I hope you'll read a few!) This is only intended to give you the flavor of it.

Let's pretend that you and I live on an island with, oh, let's say a hundred people. And, because we are foolish little islanders, we elected a guy named Bongo to be the "government". We picked him because he's bigger than everyone else, thus making him able to enforce the laws—and because Bongo said he'd beat us up if we didn't.

One day, Bongo decides that he doesn't have enough money, so he declares a 50% tax. He goes to each person on the island in turn, and holds a dagger to their throat, and says "give me half of your wealth". Once he's done with his little visits, he has 50% of the wealth of the island. Is that fair? Probably not. Would people get angry with him? Almost certainly. Would they attack and depose him? They very well might.

So let's say instead that Bongo does something really smart. He declares a new law that invalidates what we'd previously been using for money. Instead of gold coins, or pearls, or clam shells, or heavy rocks, we must all now use his new BongoBucks as money. Bongobucks are pieces of paper printed by Bongo. This is a big step forward, says Bongo, because they're so much easier to carry and transfer. And, since he took over the island's only printing press last week, Bongo is the only person who can make Bongobucks. So nobody needs to worry about counterfeiters.

There's a big day where everyone must turn in their gold coins / pearls / clam shells / heavy rocks, and Bongo throws symbolically throws them off a pier into deep water. He then prints up the equivalent number of Bongobucks and hands them out. At the end of the day, everyone has the same wealth they started with; it's just in Bongobucks instead of the old money. If you were twice as wealthy as me, you'd still be; you'd just have twice as many Bongobucks now. Bongo also makes a big show of dumping all his old money in the sea, and issuing himself the equivalent new Bongobucks. Everything is totally fair.

But then! That night, after everyone has gone to sleep in their huts, Bongo sets to work. He sits up all night printing new Bongobucks. He prints up so many that he doubles the amount of Bongobucks on the island. But he doesn't tell anyone. Suddenly his can afford many more things; his standard of living goes shooting way up. The other islanders vaguely notice, but since he didn't take anybody's Bongobucks at knifepoint, nobody's really upset.

As Bongo spends his money, a curious thing happens: prices increase. Let's say Bongo couldn't afford many eggs before, but with his new-found wealth he starts buying eggs every day. Since there's more demand for eggs, but no new chickens, the egg seller can easily raise their prices, and they do. In a month, the price of a dozen eggs goes from 1 Bongobuck per dozen to 2. Now, our man Bongo wants lots of things, and he's got lots of money to buy them with. And since the egg seller is making more money too, they can also buy more of what they want. The net result is that demand for pretty much everything goes up—and correspondingly the price of pretty much everything goes up too. Prices eventually stabilize at about double what they used to be. So now our Bongobucks only buy half as much!

In the end, the effect is exactly the same as the 50% tax. Bongo now controls half of the wealth of the island. But there's a big difference: this time nobody noticed. You didn't see Bongo walk away with your wealth, and from all appearances you have the same amount of money as before. But you are half as wealthy. Is it fair? No. Would people get angry with Bongo? Not until they figured it out. And if Bongo was careful, that might never happen.

Again, this is a vastly oversimplified illustration. But the principles at work here are absolutely real. Just as there is supply and demand for computers and baseball cards, there is supply and demand for money. The more money there is, the less demand there is for money, which drives down its value. Inflating the money supply drives down the demand for money, which means it buys less, which means you need more of it to buy something, which means that prices go up. These "prices" include the price of labor, so in other words wages go up too. But if prices go up faster than wages, you can be in the curious situation of having more money but being able to buy less with it.

So that's what the politicians were angling for in 1913. They wanted to create new money—to inflate the money supply—but could not as long as the US was on a gold standard. But once they could take the Dollar off the gold standard in 1914, they did so. They inflated the money supply: slowly at first, but eventually by massive amounts, nearly tripling the money supply by 1939. (That's what forced FDR to revalue the dollar in 1933.) The last estimate I heard says that, since the creation of The Fed, the US has inflated the money supply 1300%.

Inflation is an invisible tax. The government uses it to silently steal your wealth.

But It Doesn't End There

Inflation has many other ramifications.
  • The massive injection of new money after 1914 caused a massive distortion in the market, which caused massive misinvestment, and a massive stock market bubble. And, as inevitable as the law of gravity, this led inevitably to what economists call a "correction"—in this case, the stock market crash of 1929. And that's what started the Great Depression.

    Of course, this crash needn't have resulted in The Great Depression. The correction would have been over much sooner—but for the US Government's continual meddling in the market. But that's a topic for another day.

  • The distortion in the market also results in random secondary redistributions of wealth. Obviously, the government benefits most directly from its inflation. But those who the government buys directly from also benefit. In the above example, the egg seller was one of the first to experience increased demand, and therefore one of the first to raise their prices. Even though all the prices on the island eventually stabilized, the egg seller's prices were higher earlier. As a result, they were hurt much less by the devaluation. They probably wound up with less wealth overall, but they came much closer to breaking even after the price increases than people whose products Bongo didn't buy.

  • Harry Browne (rest in peace) has proposed that, without the creation of the Income Tax and the ability to inflate, the US Government wouldn't have had the money to get involved in the First World War. He further suggests that just prior to the US's involvement, the war had mostly ground to a standstill. Without the US's entry into the war, he suggests the warring countries would have likely arranged their own peace. With the US entry into the war, the Allies were greatly bolstered and won a decisive victory. They then inflicted terrible punative damages on the Germans. This led to Hitler's rise to power, and that led directly to the Second World War. In short, Harry suggests that without The Fed, the history of the last century might have been very different—and considerably less bloody. Is he right? No one can say for certain—that's a whole lot of "ifs". But it's certainly food for thought.

  • If inflation happens too fast, it can become runaway inflation. In runaway inflation, money is losing its value so fast that prices are rising every day. The moment you get money, you should rush out and spend it, because the longer you wait the less you could buy. Very soon after this, no one will accept the money in trade for anything—at which point it is totally worthless.

    This happened to the German mark in the 1923. The mark had already been undergoing inflation for the past nine years; in January of 1923, it took 2,785 marks to buy what 1 mark bought in July 1914. By November it took 726,000,000,000!

    This also happened to the Hungarian pengö in the 1940s. It happened to the French assignat in the 1790s, and when they replaced it with the mandat it happened immediately with that too. It can happen with any fiat currency.

It's clear that inflation brings with it many evils. But it's also easy to see that the temptation to inflate is too great for any government to resist. If a government has the ability to inflate the money supply, it will do so. The only remedy is to prevent the government from inflating altogether.

Thomas Jefferson said:

That paper money has some advantages, is admitted. But that its abuses are also are inevitable, and, by breaking up the measure of value, makes a lottery of all private property, cannot be denied. Shall we ever be able to put a constitutional veto on it?
I guess the answer was no.

Further Reading

I've only scratched the surface here. If you'd like to read more, here's a short reading list to get you started.
  • Many people, including myself, feel the first seventy-eight pages of Harry Browne's 1970 book How You Can Profit From The Coming Devaluation are the clearest explaination of these principles ever published. It hasn't been in print since the mid-70s, but it was a sensation in its day, so used copies are still plentiful. (The book accurately predicted the rapid deflation of the Dollar in the 1970s. After Nixon took the US off the gold standard, gold rose from $35/oz to $125/oz in only two years—and by 1980 it was nearly $700/oz!)

  • Richard J. Maybury's book Whatever Happened To Penny Candy? also explores the topic of inflation. Sadly it employs a strange literary device: it's written as a series of letters written by an "Uncle Eric" to his nephew "Chris". This device quickly becomes labored and fatiguing for adult readers. In general the book is targeted to younger readers, so it rarely delves deeply into any area. But it is an excellent introduction to the topic as a whole. (And it's still in print!)

    Nearly all the books in the "Uncle Eric" series are worth reading; for instance, The Clipper Ship Strategy explores the "secondary redistribution of wealth" topic much more thoroughly.

  • For the hardcore, there surely can be no better reading than Murray N. Rothbard. Regarding the Federal Reserve Bank, his most relevant publication is surely The Mystery Of Banking. With respect to the Gold Standard, What Has Government Done To Our Money? The Classical Gold Standard will surely inform. But personally my eyes tend to glaze over after a while. I generally prefer his audio lectures, which give you a much better sense of the man and his jovial humor.

  • The Wikipedia is always a good source for strictly factual information. It has entries on:

  • On the subject generally of "ways the US Government tramples the Constitution", you might enjoy reading Michael Badnarik's book Good To Be King. Badnarik was the Libertarian Party's candidate for US President in 2004. (Harry Browne was the LP's candidate in 1996 and 2000.)

    Badnarik is a strange bird; he makes me look positively moderate by comparison. But his book is very well researched, and full of important and interesting minutia. It's from this book that I learned exactly when the Federal Reserve Act was passed, and about the "emit bills" clause.

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