The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble (22 page)

In our present era, the complexity of the Internal Revenue Code (IRC) has created an army of specialized lawyers and accountants. Even attempts at reform are out of control. A “technical corrections” bill exceeds 900 pages of adjustments. In fact, by the beginning of the twenty-first century, the tax codes exceeded 7 million words, about nine times longer than the Bible; and the IRS was sending out about 8 billion pages of forms and instructions every year—at the cost of about 300,000 trees! All this effort translates to about 5.4 billion hours spent every year by Americans just complying with the tax rules.

From 1913 to 2005, the income tax has enabled, entitled, empowered, and engorged the federal government, states, and local governments, private enterprises, and millions of private citizens. Spending has grown by more than 13,592 percent.

The income tax gives the federal government a blank check to spend money, even money it does not yet have. The federal government lays a claim on all future economic activity of its citizens; its massive debts are a lien on the earnings of people who have not yet even drawn their first breaths. What’s more, the income tax could be used as both an economic tool and as a political weapon.Tax rates could be manipulated, for example, to punish or reward favored political groups.

When the Constitution was ratified in 1789, the colonists in the New World believed they had won for themselves a measure of freedom and independence. “A republic, if you can keep it,” Benjamin Franklin warned. But by the end of 1913, a scant 124 years later, Americans were happy to lose their republic; an empire was what they wanted.

But the income tax was only the beginning. If one of the defining features of empire is an open-ended source of funding, another is the shift of power away from the legislature in favor of the central executive. In 1913, a second amendment tipped the scales of authority toward Washington in a way hardly conceived of in the debates of the late eighteenth century.When the Founding Fathers set down the rules for how senators were to be elected, they anticipated a balance between states’ rights and the central government. In its original form, the Constitution reads:

The Senate of the United States shall be composed of two Senators from each state, elected by the people thereof, for six years; and each Senator shall have one vote. The electors in each state shall have the qualifications requisite for electors of the most numerous branch of the state legislatures.

When vacancies happen in the representation of any state in the Senate, the executive authority of such state shall issue writs of election to fill such vacancies....

The founding fathers saw the indirect election of senators as a means for keeping a balance of power, enabling the states to exert control over the federal legislative branch. The Senate was perceived originally as serving two roles:

Keeping one eye on states’ rights and interests, and the other wary eye on the executive branch, the federal courts, and the House of Representatives. It was contemplated that members of this body would be older, wiser, more experienced, and better qualified than members of the House and members of state legislatures. Appointed Senators were expected to be somewhat isolated from knee-jerk reactions to current public debates.

They would answer for their political acts to state legislatures, and only indirectly to public mobs and voters.
⁹

“The preservation of the states in a certain degree of agency is indispensable,” stated John Dickinson, the Delaware delegate at the 1787 Constitutional Convention, “It will produce the collision between the different authorities that should be wished for in order to check each other.”
¹⁰

James Madison, primary architect of the U.S. Constitution, noted that indirect elections would serve as “a defense to the people against their own temporary errors and delusions [and would] blend stability with liberty.”
¹¹

Each state—acting through its own legislature—should have the right to direct its senators how to vote on issues and how to best represent the state’s interests. But along came the great humbug,William Jennings Bryan (again). He maintained the Senate was controlled by corrupt state legislatures. Bryan, who tried to win the presidency three times (in 1896, 1900, and 1908), was described by C. H. Hoebeke, Fellow in Constitutional History at the Center for Constitutional Studies:

Secretary Bryan put his seal upon the reform that, in the expectations of those who had labored for it, would end the dominance of party “bosses” and the state “machines,” stamp out the undue influence of special interests in the Senate, make it more responsive to the will of the people, and of course, eliminate, or greatly reduce, the execrable practice of spending large sums of money to get elected.
¹²

The Seventeenth Amendment “improved” the original way that senators were picked by making the election system more democratic. Senators would now be elected by a direct vote of the people of each state. The ills of indirect democracy would thereby be cured . . . by more direct democracy.

As so often happens in the annals of world improvement, the cure was worse than the malady. Corruption and undue influence were not undone by the amendment; they were simply shifted to Washington. The states were reduced to vestiges of their former selves.

Taken together, the Sixteenth and Seventeenth Amendments greatly increased the power of the central government.The original constitutional system involved taxing power at the state level, with revenues submitted to the federal government for the funding of common needs (raising an army, protecting the coast, printing money). Since 1913, the process has been completely reversed. The federal government now collects most of the money from the income tax, and then doles out the revenue to the individual states, usually with many provisos, dictates, and commands attached.This allows the central government to exert great influence over state funding and in many areas not mentioned in the Constitution: highway speed limits, education, health care, medical matters, ownership of weapons, food and drug oversight, police and law enforcement, libraries, the environment, business practices—the list is long and dreary. And now with Homeland Security and the Patriot Act, the list is getting longer.

A central bank, as the name implies, is intended as a national center for the control of currency in circulation. It referees the exchange of funds between states and their own banks, and manages debt, both domestically between banks, and internationally between the host country and other governments. The republic, in the years leading up to 1913, had an uneasy relationship, at best, with the notion of a central bank.

Alexander Hamilton, first treasury secretary of the new nation, struggled with high debts from the Revolutionary War. He proposed a central bank to manage the war debt and to create a single currency. In 1791, Congress drafted a charter for the First Bank of the United States. But by 1811, the national emergency had subsided; Congress decided the bank no longer served any purpose, so it was closed.

As a consequence of closing the central bank, state banks flourished. They issued bank notes and the widespread debt-based exchange system went far beyond banking itself. The system grew like zucchini. Every location large enough to have “a church, a tavern, or a blacksmith shop was deemed a suitable place for setting up a bank,” said John Kenneth Galbraith.
¹³
These banks issued notes, and even barbers and bartenders competed with banks in this respect.

But the delightful free-for-all banking situation couldn’t last forever. Predictably, the War of 1812 ended with a large war debt and inflation rose to about 14 percent per year. President James Madison signed a new bill in 1816 creating the Second Bank of the United States—with the purpose of again managing debt caused by war.

By the end of the 1820s, a conflict had grown between the bank and President Andrew Jackson, who saw the system as a threat to the virtues of the republic. Jackson argued that the bank should be disbanded. Jackson prevailed, and the bank’s charter was vetoed in 1832, with the Second Bank of the United States closing in 1836. The period that followed—1837 through 1862—is known as the era of “wildcat” banks; only state-chartered banks operated, limited to activities mandated by each state’s laws.

The legal footing for the creation of currency is limited in the Constitution. Article 1, Section 8 permits Congress to coin money and regulate its value, and Section 10 denies the states the same right. But because any agreed-on medium serves the purpose that we associate with money (an exchange of value) there is no absolute ban on state banks issuing notes. Nor is there any reason a private individual cannot issue his own IOUs, for that matter.

At the beginning of the wildcat bank era, the Supreme Court ruled that state banks had the right to issue notes as media of exchange. When Michigan became a state in 1837, it allowed a bank to gain a charter if it met specific criteria, without also requiring permission from the state legislature. Banks came and went like nail salons. A study of 709 banks in four states found that between 1838 and 1863, half of the banks failed, and a third were not able to honor redemption of notes for gold or silver specie. Overall in the period, banks remained open only five years on average.Widely circulated bank notes—often not backed by reserves—replaced the national currency. States struggled with widespread counterfeiting, inflated note valuation, and the natural instability of the free market.

But the War between the States brought the wildcat banking era to a crashing halt. The first National Banking Act of 1863 brought control over banking to the federal government once again. In addition to creating a uniform national banking system and a single national currency, the new law also provided a secondary market to the U.S. Treasury to finance the growing debts of the Civil War. The change was gradual. By 1870, there were 1,638 national banks versus only 325 state banks. However, state banks continued to operate, having replaced the bank note system with a new concept: the checking account. By 1890, only about 10 percent of the U.S. money supply was represented by currency. The rest was transacted primarily through the bank drafts customers used through their checking accounts.

Then, the same financial crises that induced national support for the income tax, tipped the scales in favor of a permanent national banking system. The Wall Street Panic of 1907 was blamed for the worst depression in U.S. history up to that time. Unemployment climbed to 20 percent. Dozens of banks failed. J. P. Morgan saved several New York banks by granting personal loans.

By 1910, Wall Street executives and Washington politicians saw an opportunity. They met at Jekyll Island off the coast of Georgia, in seclusion and secrecy, to discuss formation of a centralized monetary agency. Senator Nelson Aldrich met with executives of what is today known as Citibank; Morgan Bank; and Kuhn, Loeb Investment House. The so-called Aldrich Plan recommended the formation of 15 regional banks controlled by a national board. The banks would be allowed to make emergency loans to members and create a flexible currency, serving as the monetary arm of the federal government. Although the original plan was defeated in the House, the formula modeled what is now known as the Federal Reserve System.

The legislation, variously called the Currency Bill and the Owen-Glass Act, emerged as the Federal Reserve Act of 1913. It created a dozen regional Reserve Banks to be coordinated by a chairman who would be appointed by the president.While the Constitution grants Congress the right to print money, under the Federal Reserve Act of 1913, Congress approved a plan to delegate this right to the Fed, which is not part of Congress. The U.S. dollar is not issued by the U.S. Treasury but by a privately owned organization, which also influences bank interest rates, the amount of currency in circulation, and even the levels of inflation in the United States. After months of testimony, debate, and over 3,000 pages of documentation of the hearings, the bill was passed and, on December 23, 1913, ratified and signed. For the first time, privately issued debt instruments (currency) would be issued by a private institution but guaranteed by the full faith and credit of the United States.

This last innovation—the establishment of the Federal Reserve System—plays a special role in shaping America’s unique system of imperial finance, as we will see later.

If 1913 was the year that set the stage for the empire, the 1930s were years of heavy plot development. Franklin Roosevelt’s New Deal had many components but, more than anything else, it was organizing the government for its imperial tasks. In the Old Republic, government was a referee between individuals and between states. Laws were rules of order that were intended to be relatively neutral. Relatively few laws were passed because most of what happened was thought to be out of the range of the rule makers.

But this idea of government changed radically in the 1930s. The government would no longer be accurately described as functioning solely as a law-making and law-enforcing body. This new government would make things better!

It is rarely talked about these days, but at the time the New Deal programs were being passed into law, most people believed they were intended to be temporary measures. At the very least, these programs were never thought to be the cornerstones of a long-term change in the homeland.

In 1935, when the Social Security Act was passed, the promise was that every American would have a secure, if minimal, retirement (if he or she beat the averages and outlived the retirement age of 65). The government, once and for all, would eliminate the common ailments related to old age—sickness, homelessness, disability, and poverty. This was a radical departure from American tradition. The New Deal created a permanent, paternal central government that has only grown more paternal and more centralized in the years since.