Where Money Comes From, part 2

Last week, I talked about where money comes from (thin air), and a little about how our money is a physical representation of our debt. This week I want to talk about why and how this came to be. I will go over a brief history of the Federal Reserve (the Fed), with a few highlights. I will try to show how having a national banking system might influence monetary decisions made by congress and some of the advantages and disadvantages of having the Fed.

The Fed was signed into law today 100 years ago, December 23, 1913 by President Franklin Roosevelt. It was not the first attempt at a national bank, there were a few before it, never lasting long. People were afraid to put that much power in the hands of bankers. The currency back then was loosely backed by gold and silver, at one point before central banking local banks used to issue their own currency representing the gold in its reserves. During bad years there would be times where everyone would want to take their money out causing widespread panic and recession. The reasoning behind the Fed was to standardize the banking industry and try to make the economy smoother and more predictable.

What actually happened was that no one really had a good idea of the policies needed to effectively run an economy. Congress was given a blank check do whatever they wanted. The central bank made it much easier for the world to do things like go to war because of the blank check given to it by the Fed. By sheer coincidence, it was decided that an income tax was needed to support this new governmental power of the checkbook, so also in 1913 the 16th amendment was passed. This is the amendment giving congress the power to collect income taxes on individuals and corporations.

After WW1, the Fed basically stopped using gold as the standard for monetary policy and started selling the debt from the government called government bonds to banks on the open market. This was called “open market operations”, and was used all during the 1920’s to keep the economy rolling, until it crashed in 1929. The great depression was cause directly from the fiscal policies of the Fed, not by crazy unregulated Wall Street and banking industry like they teach you at school. The policies of Fed caused the great depression, and made it worse, and the policies of the government made it much worse. Probably what happened is that the people running the Fed did not really have a good idea of how to fix things, so what they did compounded the problems.

The first major reform as a result of the great depression was the Glass-Steagall act. This separated commercial banks and investment banks. It also created the FDIC, and made the Fed in charge of making sure that open market holding companies were adhering to the standards set by the act. Also President Roosevelt made it illegal to own gold and silver and banks getting loans from the Fed had to use government securities as collateral. This action was the second time that we were taken off the gold standard and was designed to be temporary. In 1933 congress passed the gold reserve act, fixing the price of gold and making it attractive for foreign countries to trade gold for American dollars so they could use dollars to pay off their war debt. America amassed a massive amount of gold because of this and most of our money was being kept overseas.

After WWII, the Fed’s monetary policy was creating a problem for the rest of the world so the old monetary system was scrapped and a new monetary system was created called Bretton Woods system. This basically made the US dollar the standard currency that every other countries currency was based on. The US dollar was still indirectly based on the gold standard, but the rest of the world was on the US dollar standard. This didn’t last long, and less than 30 years later they were scrambling for the 3rd monetary system for the world.

In 1971 under President Nixon, we went off the gold standard officially and completely. The US dollar was now called a “fiat currency”. This means it is not backed by anything other than the power of the government. It also means the Fed could start expanding the money supply at their leisure. Up to that point the money supply grew at an overall even way, but now all bets were off. In 1959 there was 300 billion dollars in circulation, by 2006 it had climbed to almost 12 trillion. In the 100 years since the Fed was instituted, the dollar has lost 95% of its value.

Eventually, like all fiat currencies, the dollar will fail. We are starting to see the signs all over the world. Russia’s currency is on the verge of collapse, many European countries are close to collapse and the American dollar is close to collapse. In short, there is very little or no evidence that having the Fed has improved our economic situation at all. At the same time, no one can say we would be better without ever starting the Fed, but in comparing the goals of the Fed to the outcomes in those areas, they have failed to live up the their promise. At best we need to have the power to do a full audit on the Fed at scheduled intervals, at worst we should scrap the whole system and start over. It probably wouldn’t be as scary as it sounds.


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