The Fed Is Not “a Good Idea that Became Corrupt”: It Always Was Corrupt

Published on December 3, 2022

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George Ford Smith
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There’s an idea rooted among some libertarians that the Federal Reserve was originally a sound institution but has grown corrupt. As a bankers’ bank, it was fine, they believe, but not as the monster it has grown to be. If we could only go back to the Fed’s founding charter, all would be well.

I’m thinking of two well-known financial analysts who are unsurpassed in their analytical brilliance and knowledge of markets and who rightly regard the bureaucratic Federal Open Market Committee (FOMC) as the father of bubbles, busts, stagnation, and market privilege. In their articles, Peter Schiff and David Stockman hammer the Fed relentlessly and rightfully for its cluelessness, corruption, and threat to our material and spiritual well-being. They have authored engaging bestsellers on the state of the economy and place blame where it belongs, on the monetary policies of the Federal Reserve.

Yet, strangely, their recommendations stop short of eradicating the cancer altogether. They want the Fed reformed, not abolished. In each case they believe the Fed in its infancy was an institution compatible with free markets. Peter Schiff writes:

The role of a central bank is limited: to control the currency so as to keep prices and interest rates fairly stable. . . . This sort of central bank is one I could have supported. But the Federal Reserve Bank of the United States never functioned this way, and it probably was never meant to. . . . We never should have trusted the Fed to respect its boundaries.

He adds,

The ultimate destroyer of the U.S. dollar was the Federal Reserve System, which was supposed to be the guardian of the currency. As I discussed in chapter 2, the original idea of the Fed was a good one: providing a uniform currency backed by gold.

In The Great Deformation, David Stockman tells us that “the Federal Reserve System, therefore, was intended to be a ‘banker’s bank,’ not an agent of national economic management. This founding charter has been literally blotted out of modern day discussions.”

In his closing chapter, Stockman lists various steps he believes will avoid the worst possible catastrophes. He begins with the restoration of the Fed as a banker’s bank and the adoption of sound money, by which he means a gold-backed dollar.

Why Was the Fed Created?

Before the Fed, the number of nonnational banks was growing steadily, as was their percentage of total bank deposits. By 1896 the number of nonnational banks had grown to 61 percent and their share of deposits to 54 percent; by 1913 those numbers had increased to 71 percent and 57 percent, respectively. Thus, Wall Street power was waning. It was also being diminished by a new trend in which businesses financed growth from profits rather than borrowed funds. Bank interest rates were too high for many ventures.

Then there was the long-standing problem with depositors. They would leave their money with a bank, believing it was available on demand, and the banks would turn around and loan it out. If enough customers lined up to withdraw their money, the bank could only close its doors (or get an exemption from government).

So, from Wall Street’s perspective, there were the problems of competition from nonnational banks, industry’s preference for thrift over debt, and the public’s irritating tendency to panic and run on banks.

To address this situation, four representatives of J.P. Morgan, John D. Rockefeller, and Kuhn, Loeb, along with Senator Nelson Aldrich and assistant secretary of the Treasury A. Piatt Andrew, met secretly at Morgan’s retreat on Jekyll Island, Georgia, in November 1910. The bankers accounted for an estimated one-fourth of the world’s wealth.

Led by Paul Warburg of Kuhn, Loeb, they devised a banking cartel that was written into law in late 1913. The money powers—Wall Street—sold the plan to the public as a means of controlling the vast power of Wall Street.

How was Wall Street shackled? It wasn’t. By appointing Wall Street bankers to the Federal Reserve Board and to the most important post in the new system, governor of the New York Fed, they increased Wall Street’s influence.

The original manifestation of the Fed included these developments:

The Fed monopolized the issue of all banknotes; national and state banks could only issue deposits, and the deposits had to be redeemable in Fed notes and gold.
All national banks were drafted into the Fed, and their reserves had to be kept as demand deposits at the Fed.
As banks around the country sent their depositors’ gold to the Fed, they received Fed notes in return. Thereafter, when the public made withdrawals, they were handed Fed notes instead of gold coins. The disuse of gold coins not only encouraged inflation, but it also made confiscation easier later on.
With the centralizing of gold and bank reserves, the Fed doubled the inflationary power of the banks by reducing the reserve requirement from 5:1 to 10:1. With more credit available, the banks could lower their interest rates.

Banks Violate Their Depositors’ Property Rights

As I note in chapter 5 of The Jolly Roger Dollar, the key to the success of free markets is the establishment and defense of property rights. Government law has never recognized the right of depositors to their property, meaning their deposits. Alan Greenspan in his famous 1966 essay writes:

Since it is rarely the case that all depositors want to withdraw all their gold at the same time, the banker need keep only a fraction of his total deposits in gold as reserves. This enables the banker to loan out more than the amount of his gold deposits.

Observe the language: “the banker need keep only a fraction of his total deposits.” How different the impact of that sentence would be if Greenspan had said: “The banker need keep only a portion of his customers’ property, which they entrusted to him for safekeeping”:

As Rothbard observed, a bank that fails to meet its deposit obligations is just another insolvent, not an embezzler. Following the British ruling in Foley v. Hill . . . in 1848, U.S. courts consider that money left with a banker is, “to all intents and purposes, the money of the banker, to do with as he pleases.” This holds even if the banker engages in “hazardous speculation.” Thus, according to the state there can be no embezzlement because the money belongs to the bank, not the depositor. (The Jolly Roger Dollar, chap. 4)

A “Banker’s Bank” without Government

The desire for a banker’s bank is not misguided as long as it’s disconnected from the government:

In the interval between the War of 1812 and the Civil War, banking was de-centralized into state-chartered banks issuing banknotes redeemable in gold or silver coins. One of the highlights of this period was the development of a clearinghouse in Boston called the Suffolk Bank.

Formed by prominent merchants, the Suffolk System allowed New England banks to accept the notes of other banks, including country banks, at par with specie. Members of the system had to keep a sufficient reserve of specie at Suffolk to redeem all the notes it received. Suffolk could not keep banks from inflating but it could remove them from the list of approved banks and cause their notes to trade at discount.