A Brief History of Central Banking

Remember, remember the fifth of November Gunpowder, treason and plot. I see no reason, why gunpowder treason Should ever be forgot. Remember, remember, the fifth of November, Gunpowder, treason and plot! A stick or a stake for Damned Reserves' sake Will you please to give us a fagot If you can't give us one, we'll take two; The better for us and the worse for you!

The most dangerous thing to a free republic is the power of greed. From the birth of our nation till the present day, our way of life, our liberty has been under constant attack. The threat was not from the imperial overreach of the British Empire. It was not the moral quandary of slavery or the peril posed by fear itself. It would likewise be foolish to think that a single religion, even the morally twisted shadow of one, is a credible threat to the will of a free people.

The greatest foe our nation has ever faced is the power held in the hands of the global banking cartel, a.k.a., the planetary central banking system.

In this writing I hope to elaborate on the truly unfathomable and utterly maligned principles that is represented by the Federal Reserve. I will discuss the history of the central banks in the United States, some of the flawed theories that govern the modus operandi of this select elite, and finally I will offer some insight into the actions we see today and why it will all fail to stem the crisis.

The History of Central Banking in the United States

The history of the Federal Reserve dates back much further than the bill signed into law by Woodrow Wilson. It predates the civil war and, in fact, was brought into existence while George Washington was still in office as president.

In 1791 President Washington signed the Bank Bill into law which created the First Bank of the United States. This was a creation of Alexander Hamilton and was primarily designed along the same lines of our current central bank. It was an entity that was not an extension of the federal government; it was a private bank. It created the currency and issued it to the government in the form of loans, with interest. It also instituted fractional reserve lending, a process by which the bank actually dispenses more money than it holds in its vault based on the faulty logic that depositors will never simultaneously request their funds, en masse.

Thankfully, our government in 1791 only allowed the central bank to hold it's charter for 20 years. In 1811, the charter expired and the First Bank of the United States ceased to operate. Some blame fractional reserve lending as the culprit that sank it while others believe that partisan politics caused the charter to fail. Considering the United States was new to the brilliant "boom and bust" business cycle (please feel free to add as much sarcasm to that statement as you are comfortable with), my personal belief is that the charter failed to find support because many Americans did not appreciate a bank that could distort and influence the free markets with private interests driving it.

But we Americans are truly gluttons for punishment and only five years later we decided to have another go at it with the Second Bank of the United States. So, in 1816 this second bank was signed into law, following the same structure as the First Bank of the United States. The motivation was real enough, the US was struggling to recover from the losses incurred during the War of 1812 and at first the new central bank made good on it's charter. For three years following its creation agriculture exploded in America. Much of this was due to a very damaged agricultural sector in Europe and a subsequent high demand for food stuffs from the US (resultant of the Napoleonic Wars). However, this was not to last. The Panic of 1819 exposed the central bank for the fraud that it was:

Austrian school economists view the nationwide recession that resulted from the Panic of 1819 as the first failure of expansionary monetary policy. This explanation is based on the "Austrian theory" of the business cycle. Government borrowed heavily to finance the War of 1812, which caused tremendous strain on the banks' reserves of specie and led inevitably to a suspension of specie payments in 1814. The suspension of the obligation to redeem greatly spurred the establishment of new banks and the expansion of bank note issues. This inflation of money encouraged unsustainable investments to take place. It soon became clear the monetary situation was bad, and the Second Bank of the United States was forced to call a halt to its expansion and launch a painful process of contraction. There was a wave of bankruptcies, bank failures, and bank runs; prices dropped and wide-scale urban unemployment began. By 1819, land measures in the U.S. had also reached 3,500,000 acres, and many Americans did not have enough money to pay off to their loans.

[source: Ohio History Central courtesy of Wikipedia]

Sound familiar? Keep this passage in mind, I will expand on the points offered a little later.

Following the Panic of 1819 and the three year long depression that occurred in its wake caused opinion of the central bank to turn quite negative. In 1830, with Andrew Jackson at the station of the presidency, a full blown war effort was assembled to take down the bank before the charter expired in 1836. Jackson's efforts were successful and in 1833 tax revenue was diverted from the central bank to state banks, effectively killing the institution. The Second Bank of the United States closed its doors in 1841.

Now, the effects of shutting down the central bank were not good. In 1837 yet another panic struck the country but it could be argued that this had less to do with the fall of the central bank and more attributable to the monetary policies of Andrew Jackson. The culprit was the massive amount of bank notes that had flooded the market. Jackson's remedy was to drastically reduce the amount of currency in circulation by raising land prices. The effects were needed but still quite devastating. Again, keep this in mind, it is a point we'll revisit.

Following the closing of the second bank, America entered uncharted waters during a period known as the Free-Banking Era (or wildcat banking, 1837-1862). No central bank existed and all sorts of problems cropped up. Money supply was extremely volatile and the value of currency changed drastically from bank to bank. The average lifespan of a bank during this period was about five years with most failing as a result of being unable to redeem its notes.

The central government, in an effort to add stability to the system and fund the Union's war effort in the Civil War, implemented the National Banking Act (1863-1913). This created a series of federally regulated banks that were, in theory, supposed to challenge the state's banking centers with less volatile currency and a lower rate of failure. These "national" banks were still privately owned and were really set up in the same manner as our current central banks, albeit with much less influence or macro policy capability.

State banks issued currency based on precious metals compared to national banks which issued currency based on Treasury securities. The reason state banks had such volatility in its currencies was because the fractional reserve ratio changed from bank to bank, which caused the amount of currency in circulation to vary constantly. Typically these fluctuations were localized and if a recessionary event took place, it too was localized and not a nation level event.

National banks, however, were subject to much greater levels of distortion. Since the currency issued by the national banks were backed by ever changing Treasury securities, constant valuation changes throughout the banking system resulted in never-ending margin calls, interest rate spikes, loan recalls, and general widespread market distortions. State banks remained throughout the National Banking Era highly competitive and usually the bank of choice.

But everything started to change in 1907, with the Banker's Panic.

This was an important event in the history of central banks because it provided the final impetus to propel our nation towards the establishment of a second government. I call central banking the second government because it has far more control over the economy than the official government. It is comprised of members that do not answer to the people, and indeed, are so far removed from the plight of the average American to be considered royalty when cast in the light of history. But I digress. In order to gain a better understanding of the events that surround us today, you need to look very closely at the circumstances that led to the collapse of the stock market in 1907.

The panic started when three men hatched a plan to corner the stock of a copper producer, United Copper. The idea was simple: Corner the stock and then force the short sellers to return the shares they had borrowed. The "squeeze" would force the price up and the three men would make a fortune. What sweetened the deal was that one of the three men actually owned the company in question, making it a near certainty that they could acquire the largest block of stock with ease. However, the plan misfired. They overestimated their ability to corner the market and the short sellers were able to meet the call. The price of the stock collapsed making all three of the men, and the banks that backed them, instantly insolvent. A contagion of fear and mistrust surrounded any institution that had dealings with these men which resulted in a massive bleedout of liquidity. Soon, banks that were healthy and had no associations with the aforementioned villains found themselves being purged of funds by scared investors and depositors.

This panic continued until J.P Morgan, and a number of other private investors including the US Government, began injecting huge sums of money into the financial networks of Wall Street. Even this did not stop the system from crashing until Theodore Roosevelt allowed several institutions to merge, against the anti-trust legislation, which restored the shaken confidence of the market participants.

Following these events our leaders of business and government thought it best to adopt the European system of central banks which seemed, at the time, capable of meeting the demands placed on the system when liquidity became scarce. For additional Newsvine reading concerning the history of the Federal Reserve from 1913 on, please visit a great article on the history of the Fed.

Now, I understand that this article has been very brief considering the span of history covered. My point behind this writing isn't to expand your knowledge of American financial history (which I hope has been added to somewhat, but feel free to read more about it) but rather to point out some trends that do show the direction that we are headed.

The Boom and Bust Business Cycle

Looking back on the history of the US, we have been plagued by at least eight significant financial sector panics:

1. The Panic of 1797, caused by the central banks of Europe
2. The Panic of 1819, caused by the Second Bank of the United States through excessive monetary expansion
3. The Panic of 1837, caused in part by the collapse of the Second Bank of the US, Andrew Jackson reducing the amount of currency in circulation, and the Bank of England raising interest rates
4. The Panic of 1857, caused by corporate corruption, slavery based land speculation, and monetary inflation
5. The Panic of 1869, caused by criminal commodities manipulation, namely an attempt to corner gold
6. The Panic of 1873, caused by government intervention; removal of silver as a medium of exchange resulting in contraction of the monetary supply, railroad collapse, and mining sector collapse
7. The Panic of 1893, caused by railroad overcapacity which triggered multiple bank failures, a run on gold, and multiple railroad failures
8. The Panic of 1907, caused by debt based speculation, corruption, and hyper-expansive monetary policy

The reoccurring theme in the boom and bust cycle is monetary expansion, i.e., credit/inflation, followed by contraction. During the expansion phase, risk signals become diluted because cash is easy to acquire with little or no premium attached. It is a simple supply vs. demand issue demonstrated: The more money in circulation, the lower the rate of interest, making businesses more inclined to operate on debt rather than equity. Eventually, overcapacity arrives usually at the same time inflation starts to settle in. Consumers, including businesses, become saturated and overextended. Additionally, as risk signals become muted and distorted, speculation increases leading to eventual malinvestment. At this point all that is needed is one bad bet to trigger a panic.

The idea that a group of banks, private investors or a central bank can inject liquidity into a free market system that has been disrupted by too much liquidity is a foolish notion. Granted, it can work for a while. Looking at the history of our nation following the establishment of the Federal Reserve is evidence enough that intervention will work for a while. The end result is more debt, which requires higher service payments, which in turn requires more borrowing, and this cycle continues until confidence flatlines.

The Greenspan Liquidity Experiment

During the past decade or so we've been ringside to the biggest economic experiment ever devised. This science project was conducted without our knowledge or consent. It was carried out by the aforementioned "second" government that I described earlier. Following the disaster of 9-11, Alan Greenspan opened the cash spigot and flooded out system with liquidity. This extremely loose fiscal policy continued from the beginning of 2002 until late in 2004. I call this the Liquidity Experiment.

What the goal of this experiment was is hard to gauge. You could say that the hopes were to hyper-stimulate the economy to avoid the crash we were headed into. Possibly the end result could have been, had the investments been more sound, a nation whose infrastructure was bulletproof. Had the massive amounts of liquidity been poured into something that would have truly helped our nation, such as energy independence or transportation reform, then it is very possible we would be lauding the efforts of Mr. Greenspan.

However, if history serves to prove anything it is that the banking sector seems to be incapable of serving the interests of the public. Furthermore, central banks seem to only exaggerate, mute, or obfuscate market signals. At nearly every crossroad of financial panic the very institutions that caused the malfunction can only ask for more power in order to avoid the next bust.

Final Thoughts

It is my opinion, contrary to the beliefs of many, that a truly free market can exist. It cannot, however, thrive when institutions like the Federal Reserve are present. It is a classic conflict of interest that an institution which, in theory, is master of oversight, policy, and macro level influences is also staffed by the same entities it holds sway over. My reference to this being our second government is not an exaggeration. In fact, I would easily go so far as to say that these are our true masters. Even our government borrows from it, paying interest, and all decisions regarding the economy are ultimately decided by it.

You could draw the frightening conclusion that, as Ludwig von Mises remarked, if all wars are the effect of economic causality, and the Federal Reserve is the final word in economic policy; would it be at all unfathomable that our current predicament is not the result of failed democratic or republican policy, but the failure of our Constitution dating back to December 23, 1913.

For those of you who do not know the significance of that date it is when our Congress abdicated it's responsibility under Article 1, Sec 8, 4th clause of the Constitution of the United States.

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The Federal Reserve & The Fiat Monetary System

everyonesacritic

Sat Oct 11

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