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The Trouble with our Banking System

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The Trouble with our Banking System

Courtesy of Tom Burger at Applying the Lessons of Free Market Economics 

The modern US banking system came into existence with the passage of the Federal Reserve Act in 1913. This legislation established the Federal Reserve System as the central bank of the United States with monopoly privileges to create and manage the nation’s currency as it saw fit. After almost 100 years of experience with the Federal Reserve, most contemporary economists, it seems, can’t even imagine our economy without a central bank.

The Federal Reserve’s objectives were spelled out in the 1913 Act: "… to promote effectively the goals of maxi­mum employment, stable prices, and moderate long-term interest rates.” The Fed’s current web site goes on to discuss the expected benefits of its monetary stewardship: 

" When prices are stable and believed likely to remain so, the prices of goods, services, materials, and labor are undistorted by inflation and serve as clearer signals and guides to the efficient allocation of resources and thus contribute to higher standards of living. Moreover, stable prices foster saving and capital formation, because when the risk of erosion of asset values resulting from inflation—and the need to guard against such losses—are minimized, households are encouraged to save more and busi­nesses are encouraged to invest more."[1]

Of course, swallowing this line is a bit difficult for anyone with knowledge of economic history. Twenty five years ago, in 1984, Murray N. Rothbard noted an interesting fact:

"Since instability, inflation, and depressions have been far worse since the inception of the Federal Reserve, many economists have concluded that the Fed has failed in its task and have come up with various suggestions for reform to try and get it on the correct track." [2] 

Since the early 1980s, our central bankers proudly note, the Consumer Price Index has fallen steadily to levels that are currently very low. Nevertheless, the remainder of Rothbard’s statement appears to be just as valid in 2009 as it was in 1984. There may not be many economists criticizing the Fed itself today, but reformed bank regulation is now being discussed as one government response to our latest economic crisis.

So why is it that the Federal Reserve has been unable to perform its price stabilization and counter cyclical duties? Something sure seems to be amiss. After all, it was Alan Greenspan himself who told us the Fed couldn’t be expected to identify a bubble before it broke. Does the Fed need to be fixed?

The Federal Reserve System has been a Rousing Success

Murray Rothbard, Ludwig von Mises’ brilliant and prolific student, offered an alternative explanation for these concerns back in 1984. After studying the Federal Reserve System’s history at length [3], Rothbard concluded that the Fed had in fact accomplished its intended purpose. Continuing from the quote above, Rothbard explained:

"It is possible … that the current critics of the Fed have missed the essential point: that the Fed was designed to meet very different goals. In fact, the Fed was designed by the banks as a cartelizing device. … Just as other industries turned to government to impose cartelization that could not be maintained on the market, so banks turned to government to enable them to expand money and credit without being held back by the demands for redemption by competing banks. In short, rather than hold back the banks from their propensity to inflate credit, the new central banks were created to do precisely the opposite. Indeed, the record of the American economy under the Federal Reserve can be considered a rousing success from the point of view of the actual goals of its founders and those who continue to sustain its power."[4]

If that seems like a shocking conclusion, just consider the undeniable fact that bankers and government officials have long considered banking to be the road to personal wealth for themselves — and unconstrained spending by government.

"Give me control of a nation’s money and I care not who makes the laws."

- Amschel Rothschild

"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered."

- Thomas Jefferson

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard."

- Alan Greenspan, 1966

These historic quotes make the potential for abuse rather clear, and the truth of Rothbard’s statement is easily seen when one examines the Federal Reserve’s history.

History of the Federal Reserve System

One excellent, entertaining book on the subject of central banking, and the Federal Reserve System in particular, is The Creature from Jekyll Island, by G. Edward Griffin. Mr. Griffin’s book provides a wealth of information about money, banking, and central banking in general, but his story is focused on the history of the Federal Reserve System. The book’s title derives from the location of a super secret meeting held in 1910 — at a private resort on Jekyll Island, Georgia. The participants at this meeting included a US Senator, the Assistant Secretary of the US Treasury, and top level representatives from the biggest New York City banks.

In his book, Mr. Griffin backs up the following statement with extensive documentation:

"The purpose of this meeting … was to come to an agreement on the structure and operation of a banking cartel. The goal of the cartel … was to maximize profits by minimizing competition between members, to make it difficult for new competitors to enter the field, and to utilize the police power of government to enforce the cartel agreement."[5]

This meeting, its purpose, and its clandestine nature gradually leaked out over the years. To mention just one such instance, Frank Vanderlip, one of the participants, published an article in the Saturday Evening Post in 1933 in which he described the extraordinary security measures the Jekyll Island participants took to avoid detection. As Vanderlip admitted in this 1933 article: "If it were to be exposed publicly that our particular group had got together and written a banking bill, that bill would have no chance whatever of passage by Congress." [6]

To understand what the Federal Reserve conspirators were up against, we need to realize that this was the fourth central bank chartered in United States history. The first three central banks lost their charters because a majority in Congress became convinced that they were harming the country — or at least convinced that is what voters thought. In that era, the big New York bankers were so unpopular that the Federal Reserve proponents, both in banking and in government, went to great lengths to create the illusion that the bankers hated the proposed legislation.

As Griffin says: "To cover the fact that a central bank is merely a cartel which has been legalized, its proponents had to lay down a thick smoke screen of technical jargon focusing always on how it would supposedly benefit commerce, the public, and the nation; how it would lower interest rates, provide funding for needed industrial projects, and prevent panics in the economy." Senator Aldrich, who attended the Jekyll Island meeting, laid out the plan with uncharacteristic clarity when he spoke on the record to the American Bankers Association: "The organization proposed is not a bank, but a cooperative union of all the banks of the country for definite purposes."[7]

Reading The Creature from Jekyll Island some years ago was an eye opening experience for me. After taking another look while writing this post, I may read it again.

Okay, so the Fed is Running a Secretive Cartel; What’s the Problem?

The historic quotes above make it pretty clear that a banking system can endanger our wealth. The confiscation mechanism is simply commercial banks’ proclivity to create new currency "out of thin air." Look at the result: by the government’s own calculations the dollar has lost something like 95% of its purchasing power since the Federal Reserve Act was signed into law in 1913. Rothbard and Griffin are explaining to us that this dollar devaluation did not happen in spite of the Federal Reserve’s efforts to ensure price stability — it happened because the Federal Reserve was created to facilitate the ongoing credit expansion. But there are more problems.

Consider the Fed’s impact in 2009. The Fed’s ultra low interest rate policy has devastated the income of retirees and savers of all ages, and the Fed’s record-breaking money creation — to bailout bankers — is certain to dramatically continue the dollar’s devaluation in future years. But there are still more problems.

As I have previously argued in The Trouble with Credit Expansions, our problems with monetary inflation do not end with a rising CPI. Under normal circumstances, in fact, the bigger problem is relative price distortions and resulting malinvestments. Long running inflationary booms distort investments and unsustainably skew the nation’s productive structure (see The Interest Rate – What is It? for a discussion of the Austrian structure of production concept). The inevitable result is a recession, elevated unemployment rates, and many disrupted lives. But even those problems are not all.

Inflation, i.e. an increase in the money supply, has been a long running human scourge with many debilitating consequences. Here is a quote from Henry Hazlitt which I first posted in Unintended Consequences

"It [Inflation] discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse."[8]

So What Can We Do?

Eliminating central banking’s pernicious effects is obviously desirable, but doing so will be excruciatingly difficult — so many people benefit from the confiscated wealth. Legislators and other government officials benefit because they can spend just about any amount of money they choose — and we all know that politicians find many ways to skim off some of that money for their personal benefit. Bankers and investment bankers benefit as well, of course — as do many other people in the broader money management industry. Even supportive economists benefit from the largess because government, the Fed, and the financial industry employ thousands of people with advanced economics degrees — and shower University programs with research grants, funded "chairs," and other financial benefits. Those economists who rise to auspicious university positions also become candidates for high level and powerful positions advising government bureaucrats and politicians. A select few even end up sitting on the Federal Reserve’s governing board.

Adding to the difficulty for those of us who want to stop the Fed’s predations, the public at large loves inflationary booms. People are quick to accept rising asset prices and effortless wealth creation as the norm; it’s only the bust that people abhor. The central bankers understand this human weakness and use it to their advantage — by taking credit for the booms and then blaming bursting bubbles on everyone but themselves. For nearly 100 years this strategy has worked exceptionally well, and now we are treated to the spectacle of the Federal Reserve brazenly transferring trillions of dollars from taxpayers to bankers — all for our benefit, of course.

The only hope, it would seem, is education and a growing public awareness. Congressman Ron Paul is one of very few politicians who both understands the nature of the banking system and wants to stop its destructive behavior. Toward that end, he has been the only member of Congress to ask the Fed Chairman seriously pointed questions, and just recently he proposed legislation, HR 1207, that would require an independent audit of the Federal Reserve System. With 165 co-sponsors now, maybe this is one way to gain a little bit of public awareness — but there is a very long way to go.

References and Notes 

Most notes for this post refer to two publications:

("Creature"): The Creature from Jekyll Island, A Second Look at the Federal Reserve,
G. Edward Griffin
Fourth Edition, 2002
Available from the author’s web site, the catalog link is here.
Amazon also seems to have a few of these books still available.

("Cartelization Device"): The Federal Reserve as a Cartelization Device, The Early Years, 1913 – 1930
Murray N. Rothbard, 1984
Published as Chapter 4 in:
Money in Crisis: The Federal Reserve, the Economy, and Monetary Reform
Edited by Barry N. Siegel, Pacific Institute for Public Policy Analysis


[1] Federal Reserve, Official web site, Monetary Policy and the Economy

[2] Cartelization Device, page 89

[3] See, for example, A History of Money and Banking in the United States, The Colonial Era to World War II.

[4] Cartelization Device, page 90

[5] Creature, page 8

[6] Creature, page 11

[7] Creature, page 19

[8] Henry Hazlitt, Economics in One Lesson, page 176



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