End the Fed

by Ron Paul

Under the provisions of the new law the failure of efficiently and honestly managed banks is practically impossible and a closer watch can be kept on member banks. Opportunities for a more thorough and complete examination are furnished for each particular bank. These facts should reduce the dangers from dishonest and incompetent management to a minimum. It is hoped that the national-bank failures can hereafter be virtually eliminated.

  Purchasing Power of the U.S. Dollar, January 1913 = $1.00

  In practice the reality has been much different. One only needs to reflect on the dramatic decline in the value of the dollar that has taken place since the Fed was established in 1913. The goods and services you could buy for $1.00 in 1913 now cost nearly $21.00. Another way to look at this is from the perspective of the purchasing power of the dollar itself. It has fallen to less than $0.05 of its 1913 value. We might say that the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy. 9

  The same is true of other currencies controlled by a central bank. It is not, however, true of gold. Here is a general overview, courtesy of the American Institute for Economic Research: 10

  Purchasing Power in the United States of Gold and Selected Currencies (1913 = 1.0)

  Note: Purchasing power calculated from the implicit price deflator for U.S. GDP and the exchange rates of foreign currencies for U.S. dollars.

  As for business cycles and the abolition of panics, the data show otherwise. Recessions of the twentieth century as documented by the National Bureau of Economic Research include: 1918–1919, 1920–1921, 1923–1924, 1926–1927, 1929–1933, 1937–1938, 1945, 1948–1949, 1953–1954, 1957–1958, 1960–1961, 1969–1970, 1973–1975, 1980, 1981–1982, 1990–1991, 2001, and 2007, which is the current panic of which there is no end in sight.

  Some mathematical impossibility!

  The one aspect of the great promise that has been kept, not entirely but generally, is the promise that banks will not fail in the way they used to. But consider whether this is really a good thing. What if we had a law against business failure? It raises an obvious question: if businesses are not allowed to fail, what guarantee is in place that will give them incentive to succeed with soundness and productivity to the common good? In a capitalist economy, the prospect of failure imposes discipline and consumer service. It is an essential aspect of the competitive marketplace, whereas a promise against failure only entrenches inefficiency and in-competency.

  In other words, bank failures are no more to be regretted than any other business failures. They are a normal feature of the free enterprise system. What about depositors? In a competitive and free system, deposits would not be unsafe; any that were not paid back that were promised would fall under the laws of protection against fraud. Unsafe deposits would be loans to the bank that would be treated like any other risky investment. Consumers would keep a more careful watch over the institutions that are handling their money and stop trusting regulators in Washington, who in fact have not done a good job in ferreting out incompetence.

  But this is not the place to explain the workings of a free-market banking system. I raise the point only to underscore the broader lesson that no firm in a free market should enjoy absolute protection against failure. A continued process of trial and error is the way that institutions achieve the goal of efficiency and soundness. Consider the Soviet case: to my knowledge, no business ever went under in the Soviet system, but society in general grew ever poorer. Think of that Soviet system applied to the banking industry and you have the Fed.

  Understanding this history of the Fed’s founding and effects helps take some of the mystery out of it. Some people claim that the Fed is nothing but a private corporation that is working to enrich itself at our expense. Other people claim that it is a government operation that works to provide funds for the government when it can no longer get away with taxing us.

  Neither opinion is precisely correct. Actually, the Fed is a public-private partnership, a coalition of large banks that are the owners working with the blessing of the government, which appoints its managers. In some way, it is the worst of both the corporate and the government worlds, with each side providing a contribution to an institution that has been horribly detrimental to American prosperity.

  In any case, William Greider is exactly correct that the advent of the Fed represented “the beginning of the end of laissez-faire.” 11 It turned the entire money system over to public management on behalf of political causes.

  Over the years, the Fed has been granted ever more leeway in the means it uses to inflate the money supply. It can now buy just about anything it wants and write it down as an asset. When it buys debt, it buys with newly created money. It maintains a strict system of low-reserve ratios that allows banks to pile loans on top of deposits and take the new deposits as the basis for ever more loans. It can set the federal funds rate at a level to its liking and influence interest across the entire economy. It intervenes in currency markets and other markets.

  There have been many consequences of the Fed that were unforeseen even by its architects. They might have imagined that the Fed would indeed help smooth out the business cycle, provided you think of the real problem of the cycle as its bust phase when credit contracts. The Fed can indeed provide liquidity in these times by a simple operation of printing more paper money to cover deposits. But if you think of the cycle as beginning in the boom phase—when money and credit are loose and lending soars to fund unsustainable projects—matters change substantially.

  In 1912, Ludwig von Mises wrote a book called The Theory of Money and Credit 12 that was widely acclaimed all over Europe. In it he warned that the creation of central banks would worsen and spread business cycles rather than eliminate them. It works as follows. The central bank on a whim can reduce the interest rate that it charges member banks for loans. It can buy government debt and add that debt as an asset on its balance sheet. It can reduce the reserve coverage for loans at member banks. But in doing all of this, it is toying with the signals that the banking industry is sending to borrowers. Businesses are fooled into taking out longer-term loans and starting projects that cannot be sustained. Investors flush with new cash put the money in stocks or buy homes, activities that spread a kind of buying-and-selling fever among the general population.

  The problem is that all of this activity creates an illusory prosperity, a false boom. When lower interest rates result from real saving, the banking system is signaling that the necessary sacrifice of present consumption has taken place in order to fund long-term investment. But when central banks push down rates on a whim, the impression is created that the savings are there when they are in fact completely absent. The resulting bust becomes inevitable as goods that come to production can’t be purchased, and reality sets in by waves. Businesses fail, homes are foreclosed upon, and people bail out of stocks or whatever is the fashionable investment of the day.

  That phony money creates a false boom is not an unknown fact in history. Thomas Paine observed in the late eighteenth century that paper money threatened to turn the country into a nation of “stockjobbers.” In fact, this can even happen when the money is not paper. The famous case of tulip mania in the Dutch golden era was driven by gold inflows from around Europe after the government gave a massive coinage subsidy to all comers. 13

  International markets complicate the picture by allowing the boom phase of the cycle to continue longer than it otherwise would, as foreigners buy up and hold new debt, using it as collateral for their own monetary extensions. But eventually they, too, become ensnared in the boom-bust cycle of false prosperity followed by an all-too-real bust. International markets can delay but not finally eliminate the inevitable results of monetary expansion.

  Now, knowledge of this problem was not well spread among bankers and government officials in 1913 when the Fed was created. But it wouldn’t be long until it would become apparent that the Fed would bring not stability but more
instability, not shorter booms and busts but deeper and longer ones. The longest one of all, dramatically exacerbated by bad economic policy, was the Great Depression.

  We might be entering into another phase of extreme crisis.

  CHAPTER 3

  MY INTELLECTUAL INFLUENCES

  My interest in monetary economics began quite early. Born in 1935, I remember the tail end of the Depression and the shortages of World War II. Being from a family that taught hard work, frugality, and savings as virtues, I knew early on that even a few pennies were not to be ignored. But then again, a copper penny actually had real value.

  I recall walking with my brothers to a local store to buy candy. We each had four or five pennies and got a small bag full of candy for them. Today, we not only can’t afford to make our pennies out of copper, we can’t even afford to make them out of zinc. The penny is destined to be made of steel or eliminated as a cost-savings measure. Indeed, the penny is a nuisance for most of us today.

  My first job, and that of my brothers, was to assist my dad in a small dairy run out of our basement. Even at the age of five, the incentive system was instilled in me. Our job was to make sure all the glass bottles, which had been hand washed, were clean. It was bad for business if a customer saw a black spot in the bottom of a milk bottle. For each dirty bottle we found as we removed them from the conveyer belt and placed them into a wooden case, we were rewarded a penny. It didn’t take long for us to know when a certain uncle was washing the bottles, since more dirty bottles were found on those days.

  This experience taught me the importance of working, and the value of a penny. My parents did not believe in allowances, but I was a natural saver, even in my early years. It seems at times that being a saver or a spender is an innate tendency, and early habits are retained throughout life. My early experience of learning the value of a penny served me well when it came time to pay for my education.

  My dad had two concerns about the milk itself. First, he tested for quality by tasting each can of milk coming in from any of numerous farmers; he could tell if the cows had gotten into an onion patch, for example, which ruined the milk. The other was a concern that the milk that might have been diluted by water. In time I realized that the crime of dilution was identical to the crime of managing an elastic currency by the dilution principle.

  My dad was not a coin collector, but he did understand the value of hard work, savings, and even a penny. Somewhere along the way, out of fascination with the switch from the Indian Head penny to the Lincoln Head penny, he started throwing Indian Heads into a coffee can—pennies that I’m sure came from our retail milk sales. At the time, a quart of milk cost 15 cents.

  I’m not sure of my exact age, but I probably became interested in coin collecting during World War II. I had access to the coins that came in through milk sales, and early on as a newspaper boy for the Pittsburgh Press. That can of Indian Heads sat on a desk in our kitchen for years. By the 1940s, the Indian Head penny had long since left circulation. There were 986 pennies in the can as I recall. I would scan them and sort them, and I knew exactly which pennies were there.

  Although it was obvious that I was the most interested of the five brothers in coin collecting, there was no way that those pennies would become mine because of the fairness doctrine of our parents—“no special favors.”

  I saved my money, and when I had $20, I negotiated a deal with my dad: $20 for 986 pennies. It was a big transaction for me, but only I knew that buried in that can was a 1909-S in good condition, which even then made the purchase a great deal. I still have that particular penny and most of the other 985.

  Pennies are a nuisance for most of us today. But that special 1909-S has kept up with inflation and more due to its numismatic value. As a young boy, I understood how rarity and quality in a coin gave it value—the fundamentals of numismatics. There were only 309,000 1909-S pennies minted. It was years before I understood the relationship between the money supply and the value of our currency and the business cycle, but even back then I was impressed with the relationship of low mintage and value.

  During World War II, I heard the radio announcements urging us all to buy war bonds. We were encouraged at school to do the same, and I’m sure newspapers encouraged their purchase. It was the patriotic thing to do. I did it; my whole family did it as well. We would save $18.75 to buy a $25 war bond that matured in ten years, earning 2.9 percent interest.

  It was only a stunt, as I found out many years later. Almost all the funding for the war came from taxes and the Fed’s inflating of the currency. The Buy Bonds campaign was a psychological tool to keep everyone focused on the war. Wage and price controls and rationing made a bad situation worse, yet it was our duty to march in lockstep with all the mandates and controls.

  From personal memory and historic records, I know the Depression was not ended by the beginning of the war, as many still claim. War’s mass death and property confiscation and destruction are never a benefit to the economy, yet the warning that bad economic times frequently lead to war—when a country can least afford it—is appropriate for today. War distracts from economic problems, a benefit to bad politicians. Unemployment rates go down when millions are engaged in the war effort, even forced into it. All too often these politically convenient wars are not at all necessary.

  I recall as an eight- or nine-year-old wondering about all this while collecting coins, buying stamps, putting them in a book, then buying a bond and thinking it was a bit cumbersome. Why didn’t they just print what they needed? I sought an answer from my oldest brother. Not realizing that’s exactly what they were doing, my brother logically explained to me why that wouldn’t work. He simply said, “If they did that, the money wouldn’t be worth anything.” That may be way over-simplified, yet it was true.

  That short conversation stayed with me over the years as I tried to understand the process of currency inflation and how prices are subjectively established. Although the monetary system may be a crucial factor in itself, it is not the sole deciding factor in setting the prices of goods and services. It’s a bit more complicated than that. It was only after the war and after price controls were removed, with a significant increase in the money supply, that more people knew what was going on. Prices escalated sharply between 1945 and 1947, at an annualized rate of 17 percent.

  I have memories of rationing during World War II. Ration stamps were required for crucial items like gasoline, butter, and meat. When we sold a pound of butter at our house, we had to also collect the ration stamps. These conditions existed along with wage and price controls—hardly a good lesson for young Americans trying to learn what freedom was! Without the designated rationing stamps passed out by the government, these selected goods were not available, unless they were bought in the underground (free) market. Prohibition or rationing was so detrimental that other markets quickly developed out of need.

  I’m sure some believed that rationing scarce resources during the war was absolutely necessary. Others were quite aware that it was part of the war propaganda to keep people focused on the political goal. Those who understood the free market knew that during a crisis or time of shortage, the market is required more than ever.

  In allocating scarce resources, imposing wage and price controls is the last thing we need government to do. 1 It only exacerbates the problem, as I well remember. We really never learn much from our mistakes. Wage and price controls were used again during the Korean War and in the early 1970s, after the breakdown of the Bretton Woods Agreement, the unstable gold-exchange standard system established in haste after World War II.

  I remember my dad as being straitlaced. He believed that we should all follow the rules and obey the government. Yet I do remember being with him on Saturday afternoons when a butcher shop in town had all the meat you wanted, at a price—and without ration stamps. Evidently, it was worth bending the rules a bit to get some meat on the table for his family. There seemed to be no secret about what was going on. Busine
ss was brisk, and the event took place across the street from the police station. This was probably my first real-life experience in the free market solving problems generated by government mischief.

  Sadly, we haven’t learned a whole lot. Even today, as we’re struggling to get out of a gigantic economic crisis, the principle of government meddling in pricing goods and services persists. The worse the crisis gets, the more government interferes in the pricing mechanism. Today the black market in labor and goods is huge.

  Our disastrous tax code has contributed substantially to the need for the underground economy. This need will surely grow as the economy further deteriorates. In economic terms, all this activity is beneficial in the underground, despite politicians’ cries that the government is being cheated out of hundreds of billions of dollars in tax revenue. If the market quits functioning, the underground economy will expand exponentially. In some other countries the underground market is responsible for keeping the economy afloat.

  After World War II, economic conditions improved. My grandparents lived nearby and had some land that they were contemplating selling. I recall my dad urging my grandmother to sell the land, but she was hesitant. She was concerned about the money. My grandfather was born in Germany and came to the United States at the age of fourteen and settled in Pittsburgh. My grandmother was born in the United States, but her parents were both immigrants from Germany. In 1926 they sailed to Germany to visit relatives. I’m sure they heard stories about the German inflation of the 1920s, and this influenced her thinking.

  I remember the answer my grandmother gave my dad. She thought she should not sell and should hold on to the land “in case the money goes bad.” Although the U.S. inflation after World War II was mild compared to the German inflation of 1923, it must have been a concern for her.