It Is Dangerous to Be Right When the Government Is Wrong (36 page)

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The way bankers make profits in this system of counterfeiting and fraud is simple. Take the same example above. You deposited $1,000 in a checking account at your bank. In a fractional reserve system, your bankers would only have to keep 10 percent of your deposit on reserve, giving them the opportunity to loan out up to 90 percent of your money. In other words, once you deposit $1,000 in the bank, its reserves would be increased by $1,000, and the bank now has $900 in excess reserves that it can loan out.

So let's presume that your bankers found Bob, a business owner who needed a loan. The bank would loan out the $900 and charge Bob 5 percent interest for a one-year loan. Right away, the money stock in the economy would have increased by $900, now totaling $1,900: The $900 issued to Bob, plus the $1,000 note given to you, which effectively functions like cash ($100 is kept on reserve at the bank). Bob, a widget manufacturer, then pays Carl the $900 for raw materials. Carl then deposits this $900 in a different bank, which can now loan out $810 to Dan (holding 10 percent, or $90, on reserve). Now, we have a total increase in the money supply of $2,710, compared with a mere $1,000 initial deposit. This process continues, the money supply growing larger and larger until it has vastly outstripped the amount of your original deposit.

In normal economic times, this wouldn't present much of a problem; Dan would repay his loan, and Bob would repay his. Thus, there would never be a shortage of cash as the depositors make withdrawals. The problem, however, arises when depositors get scared that numerous investments will go sour, and thus they will lose their money. They then rush to the bank to make withdrawals—legal claims which the bank is clearly not capable of honoring under this system of fractional reserve banking. The end result, of course, is that you have lost your hard-earned savings. As we discussed earlier, this process is known as a bank run.

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It is because of this process that banks in this system pushed for centralization of control with government backing, or a government-backed banking cartel. With this cartel the commercial banks could utilize cheap (sometimes free) loans from the central bank, so the commercial banks would have access to all the money they needed to conduct daily transactions, and honor legal claims in the event of a bank run. Moreover, the government would set up an insurance system, the Federal Deposit Insurance Corporation (FDIC), to protect deposit accounts from the risk of losses. The FDIC is funded, of course, by taxpayers' dollars.

If the banks received government backing, they would then be able to profit from their gains and pass their losses along to the taxpayers in the form of bailouts, just as President Andrew Jackson warned about and predicted 180 years ago. Big Government, constantly needing money to fund its military adventurism, welfare state, and campaigns for more power, would clearly benefit from this system, as would the cartel members. Everyone else, by contrast, would be outright robbed of their savings through inflation.

Inflation, a rise in prices, is caused by an increase in the money supply. The reason this happens is, as explained before, money or currency is just a medium of exchange you use to acquire other goods or save for the future acquisition of goods. When money printing and fractional reserve banking increase the money supply, there is more money bidding up the prices on the same supply of goods. Moreover, an increase in the supply of money does not increase real wealth, since money is used only in exchange.

To illustrate the actual effects of inflation as caused by the Fed, consider that what cost $25,000 in 1913 would cost about $536,000 in 2010. If a person had $25,000 in 1913 and did not keep it in a bank or a (risky) investment account, by 2010 he would have lost 93 percent of his money's purchasing power, or the amount of goods or services that can be purchased per unit of currency. Even if someone had saved $25,000 in a savings account at the average interest rate yield of 1.3 percent over the same ninety-seven-year period, he would have $87,500 in the bank. He would still need an additional $339,000 to buy in 2010 what his $25,000 would have purchased in 1913. Thus, even by saving his $25,000 for ninety-seven years, he would have lost 83 percent of the money's purchasing power at the end of the ninety-seven years.

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The Creature from Jekyll Island

Now that we can see the fractional reserve system's propensity to cause bank runs, and the role of central banks in creating inflation, let us return to the foundation of the Fed. On November 22nd 1910, Senator Nelson W. Aldrich (R-Rhode Island), with five companions, set forth under assumed names in a privately chartered railroad car from Hoboken, New Jersey, to Jekyll Island, Georgia, allegedly on a duck-hunting expedition. The need to maintain secrecy was extremely important to the men who were aboard the train traveling to J. P. Morgan's private retreat at the Jekyll Island Club. The full guest list would be later revealed as including Senator Aldrich (Rockefeller kinsman), Henry P. Davison (a J. P. Morgan partner), Paul Warburg (a Kuhn Loeb & Co. partner), Frank A. Vanderlip (a vice president of Rockefeller's National City Bank of New York), Charles D. Norton (the president of Morgan's First National Bank of New York), and Professor A. Piatt Andrew (head of the National Monetary Commission research staff), who had recently been made an assistant secretary of the treasury under President Taft, and who was a technician with a foot in both the Rockefeller and the Morgan camps.
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These powerful banking elites would devise the new central banking system and draft what is now known as the Aldrich Plan. However, the plan was defeated in 1912 after the Democrats took the White House and Congress. A later change in power revived it. After losing the Republican nomination to Taft, Teddy Roosevelt founded the United States' Progressive Party, or the Bull Moose Party, in 1912. The Bull Moose Party and the Republican Party would split votes, which subsequently led to the election of Democratic candidate Woodrow Wilson, the perfect candidate for U.S. banking interests. The Aldrich Plan formed the substance of the Federal Reserve Act which, once Wilson took office, was passed in 1913. The Federal Reserve would cause the first Great Depression only sixteen years later.

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Professor Murray N. Rothbard described this system here:

The Fed was given a monopoly of the issue of all bank notes; national banks, as well as state banks, could now only issue deposits, and the deposits had to be redeemable in Federal Reserve Notes as well as, at least nominally, in gold. All national banks were “forced” to become members of the Federal Reserve System, a “coercion” they had long eagerly sought. This meant that national bank reserves had to be kept in the form of demand deposits, or checking accounts, at the Fed. The Fed was now in place as lender of last resort. With the prestige, power, and resources of the U.S. Treasury solidly behind it, it could inflate more consistently than the Wall Street banks under the national banking system. Above all, it could and did, inflate even during recessions, in order to bail out the banks. The Fed could now try to keep the economy from recessions that liquidated the unsound investments of the inflationary boom, and it could try to keep the inflation going indefinitely.
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Shortly after the Fed was established, the United States entered World War I, and abandoned the gold standard, thus enabling the Federal Reserve to print money to fund the war effort. One way the government generates money to fund its conquests is by issuing bonds. When the Federal Reserve starts to purchase the bonds, it sends a signal to all other investors. This signal that is sent is one that says come what may, this bond will always be paid off, either at the bond's maturity date by the government, or by a private investor who might purchase it, or by the Federal Reserve. When these bonds are auctioned off, people are willing to pay more money for them, since payment is guaranteed. The higher the amount of the bond means the lower the yield; a lower yield means a lower interest rate. A lower interest rate means it is less painful for the government to borrow money. This system led to the national debt ballooning from $2.6 billion in 1910 to $25.9 billion in 1920, which also led to the sharp spike of inflation that followed.

This caused massive expansion, and eventual contraction, and the Fed was forced to raise interest rates to stabilize the volatile economy. Once the economy stabilized in the early 1920s, the economy saw massive growth, but beneath the surface most of this growth was distorted by a Fed-generated inflationary credit expansion which lowered interest rates, causing a boom in the stock market. This was Hayek's worst nightmare come true. The bust that Hayek's theory explained was caused by the massive credit expansion and lower interest rates and came in the form of the Wall Street stock market crash of October 1929.

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Congressman Ron Paul, in his book
End the Fed
, has described this same process as it occurred in the context of the current financial crisis:

Prosperity can never be achieved by cheap credit. If that were so, no one would have to work for a living. . . . Artificially low rates of interest orchestrated by the Fed induced investors, savers, borrowers, and consumers to misjudge what was going on. Multiple mistakes were made. The apparent prosperity based on the illusion of such wealth and savings led to misdirected and excessive use of capital.
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History, it seems, has an odd habit of repeating itself.

Armed with Federal Reserve funding, President Franklin D. Roosevelt attempted an interesting solution to the 1929 stock market crash. This plan was to spend our way out of the depression and into prosperity, which is the exact opposite of rational logic and what the economy needed. This recklessness turned the stock market crash into the Great Depression, which lasted for fifteen years.

Unable to fund the massive debt he contemplated, FDR, during his first month in office and acting as a ruthless dictator, abandoned the gold standard for individuals, and confiscated every American's gold.
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As well, FDR made ownership of gold illegal. The abandonment of the gold standard only made the Great Depression that much greater. Many of the policies of the New Deal exacerbated the Great Depression, and many economists believe these policies kept the country in the depression until after World War II.

The easy credit that led to the Great Depression, as explained by the Austrian Business Cycle Theory, was only made easier by the abandonment of the gold standard. Commercial banks now only needed to keep Federal Reserve notes as bank reserves, and the Federal Reserve was the only bank that needed to store gold. With a reduction of the fractional reserve ratio to 10 percent, the Federal Reserve could loan out ten dollars for every one dollar it had on reserve in gold. These loans went to commercial banks, and could be used as these banks' reserves. The commercial banks could then loan out ten dollars for every one dollar they had on reserve in their bank's vault. So a dollar's worth of gold in the Federal Reserve Bank can be turned into one hundred dollars of loans to the public.

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Getting Out of the Woods

The great nations of the world would abandon the gold standard in order to print money to fund World War II. With the massive debt accrued by European nations to fight the war, as well as the need for the United States to pay its bills for the war, a new monetary system had to be formed. Shortly after World War II, Lord Keynes and Harry Dexter White, a U.S. Treasury official, prepared the plans for a new global financial system. Representatives of the financial rulers of the United Nations assembled in Bretton Woods, New Hampshire, and they enacted the new global monetary system. This system fixed the price of gold at thirty-five dollars an ounce, and created a fixed exchange rate between all currencies of the world and the dollar. The Federal Reserve would store the world's gold, and the rest of the world's banks would store Federal Reserve notes as their reserves. Only foreign central banks were able to redeem their Federal Reserve notes in gold; individuals were denied this right. Since the right to trade is a natural right, the prohibition on gold ownership assaults that right.

The federal government would succumb to the temptation of printing more money than it had reserves in gold; and once the different international bankers became aware of this, they started to claim their share of the gold reserves. On August 15th 1971 came the nail in Bretton Woods's coffin. President Nixon on that day instructed his treasury secretary to cancel the dollar's convertibility into gold—only temporarily, he claimed. Recall Milton Friedman's warning about the permanence of temporary government programs. This meant the dollar was backed by nothing, except the laws that made it the nation's legal tender, and the government's promise not to print too much of it. Naturally, massive inflation followed.

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Inflation and Its friends

Massive increase in the money supply, or inflation, by way of fractional reserve banking and a fiat-based monetary system (or a monetary system that has currency which is not backed by any intrinsic value and is considered money just because the government says it is; oddly reminiscent of legal Positivism) causes prices to rise as well as the boom-and-bust cycle. The people who benefit from this inflationary system are the ones who get their hands on the money first, the banks. The banks get to make their investments before the prices of assets rise in response to the increase in the money supply. By the time the money trickles down to the rest of the people in the economy, the symptoms of inflation will have begun to settle in and devalued money will mean the money has less purchasing power, which will cause the phenomenon of rising prices.