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Ron Paul and the Fed: how we got to this point

Rep. Ron Paul held up a silver coin

REUTERS/Jonathan Ernst

Rep. Ron Paul held up a silver coin as he questioned Federal Reserve Chairman Ben Bernanke about monetary policy in February.

In his book “End the Fed,” Ron Paul asserts that “ending the Fed would address the most vexing problems of politics of our time,” including “an end to dollar depreciation” and “ending the business cycle.”

Further, he says, “The Federal Reserve should be abolished because it is immoral, unconstitutional, impractical, promotes bad economics, and undermines liberty.”

Paul’s ideas are at the heart of Kurt Bills’s U.S. Senate campaign as well.  Though Bills recently backed away from abolishing the Fed immediately (see Eric Black’s recent piece) his campaign manager told The Weekly Standard, “We’re all Ron Paul fans on economics.”

Hamilton vs. Jefferson

Paul’s ideas are the latest chapter in an age-old American argument between a more centralized and nationalistic economic policy, identified with Alexander Hamilton, and a decentralized, individualistic policy connected with Thomas Jefferson. In a sense, American monetary history is the result of these contrasting points of view fighting it out over time.

So, here’s a quick look at how we got to today’s system.

Hamilton and, more generally, the Federalists argued that a strong national government, including a central bank modeled on the Bank of England, was a critical element in economic development.  Jefferson and the Democratic-Republicans disagreed with that view, arguing that a decentralized system without a central bank was superior.

The U.S. swung back and forth between these two systems from 1789 to 1913.

Congress gave a 20-year charter to the (first) Bank of the United States in 1791 and then let it die in 1810. Six years later, it created a (second) Bank of the United States with a 20-year charter but then once again killed it.

A period of “Free Banking” lasted from 1837 to 1863. During this time, the federal government issued only coins; paper money consisted of banknotes issued by private banks. These banknotes were backed by the gold, silver and other assets held by the banks. (Art Rolnick and Warren Weber of the Minneapolis Fed did yeomen's work in researching this area.) 

The Civil War brought centralization back to the fore.

Congress passed the National Banking Act in 1863 in order to raise funds for the war; specifically, anyone who wanted to set up a national bank had to purchase U.S. bonds, which then allowed the bank to issue banknotes.  The banks were required to hold a fraction of their deposits as a reserve but could then lend the rest.  Borrowers received their funds through a bank account, from which they could withdraw funds as banknotes.  At that point, however, the banknotes of all national banks were identical, except for the inclusion of the issuing bank’s name on the note. 

Further, a 10 percent tax was levied on privately issued — i.e., non-national-bank — banknotes.  The result was that private bank notes disappeared, and for the first time, America had a standardized currency.

But that wasn’t the end of the story.

State governments did not want to get cut out of the banking business, so between 1865 and 1913, they offered banks a deal similar to that of the federal government: Buy bonds and you, too, can set up a bank.  But, there were two important differences.

First, most states allowed their state-chartered banks to hold lower levels of reserves than national banks. This meant that state banks could lend more money per dollar of deposits than national banks and thus make larger profits per dollar. 

Second, since the 10 percent banknote tax made it expensive for state banks to issue their own banknotes, states started experimenting with alternative ways for banks to allow their customers access to their funds.

This is when checking accounts were born.  Banks didn’t have to issue banknotes, they could simply supply documents that allowed someone to draw on the funds a depositor held in a bank. 

Enter the Fed

There was a big problem with this system: Every few years, there was a wave of bank failures across the land. These failures had real economic costs in terms of lost deposits, disrupted loans and, ultimately, deep recessions. 

The Federal Reserve was set up to deal with these problems, but the Hamiltonian/Jeffersonian disputes had to be dealt with once again. For instance, should there be a single central bank located in, say, New York? This would make sense, given that New York was the financial center, but didn’t this give too much clout to already powerful bankers?

That issue led to a compromise — a system of 12 regional banks, all equal in stature and each with its own board of directors. A Federal Reserve Board, consisting of seven members appointed by the president, was supposed to supervise the regional banks, but the board was not given any powers to carry out this mandate. Thus, instead of a single central bank, we created 12 mini-central banks.

Paul tells a different story about the creation of the Fed.

First, he states that “bank failures are no more to be regretted than any other business failures. They are a normal feature of the free enterprise system.” In particular, the possibility of banks collapsing will encourage depositors to be more vigilant about monitoring the banks to which they entrust their money.

Paul then argues that the real reason the Fed was created was to create a central bank that could bail out banks whenever they got into trouble. This short-circuited the natural stabilizing effect of competitive banking and gave the larger banks even more power than before.

What next?

Fear of centralized financial power is at the center of Ron Paul’s concerns about the Federal Reserve. Observers on the left side of the political spectrum voice similar fears about banks that wield enormous financial and political influence.

The big questions concern how to deal with these problems: Should we end the Fed? If so, what (if anything) should we put in its place?  Should we reform the Fed?  If so, what should its goals (or goal) be?

I’ll address those questions next week.

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Comments (11)

End the Federal Reserve?

This column is a good, informative summary history of banking in the US or maybe a summary of the history of the fear of central banking. The problem is that unless there is a central bank with legally defined powers, not having one won't prevent that void from being filled by a rough equivalent. Before the Federal Reserve, we had a "Money Trust" that had global reach and which had leaders (like J.P. Morgan) who performed the role of a central bank. But on his terms and for a great profit. And this ended up being unable to fill the void to prevent the Panics of 1893, 1903 and 1907.

Ron Paul and his supporters have an easy and facile solution: return to the gold standard. This country's adherence to the gold standard has been at the root of the most severe and painful economic crises we've experienced as a nation. As a solution to our current problems, like so many conservative solutions today, have been tried and failed. That they would return to the failed ideas of the past reveals just how little insight into the problems they really have.

Ending the Federal Reserve Charter

Firstly, I would like to extend my appreciation for a well written seemingly un-biased article.

The alternative to the Federal Reserve banking system is still an unclear answer since we do not yet know the full inner workings of the Federal Reserve. The Audit of the Fed is moving forward and we are going to continue trying to understand what it is that is broken within the monetary system we use in the US.
For perspective, five years ago if you had asked the average American if the Federal Reserve was a Federal Gov't institution they would have responded ... YES! In five more years we all might have learned much more about how we can move forward succesfully with a strong monetary policy.
For now, we have identified one of the sources of our monetary problems. One thing that will be interesting is next year when the 100 year Congressional Charter of the Federal Reserve ends, will our Representative Democracy actually "represent us".

Great Article

Great article! I'm glad you're talking about this.

I generally side with Ron Paul on the Fed issue, however for me it goes further. I would argue that the place of banks in society is to act as utilities, just like Xcel Energy acts as a utility company for generating electricity - banks should act as utilities for people wishing to safely deposit their money.

The problem with The Fed is that all their money (currency and credit) is loaned into existence, and it must be paid back with interest. This is why there will ALWAYS be more debt than available money to pay the debt in our system. This is why we must have economic growth, or the system fails - money supply must constantly expand in order to service principal + interest on prior loans. It is also why we will never pay down the national debt - because it is mathematically impossible.

As you said, we did have various banknotes prior to 'Federal Reserve Notes.' They consisted of Gold & Silver Certificates, National Currency Notes, and United States Notes. Unites States Notes were issued as "bills of credit" and were issued by the Department of Treasury directly into circulation free of interest. Federal Reserve Notes however, are backed by debt that the United States incurs whenever The Fed purchases US Treasuries.
http://en.wikipedia.org/wiki/United_States_Note

The morally-questionable aspect of the Fed's business practices is the fact that it loans money into existence out of nothing. When a person writes a check, he or she must have funds available for the check to clear, but when The Fed writes a check, it creates money out of thin air. Is this not an extraordinary power? People must work to obtain their money, but The Fed simply prints it from nothing.
http://www.chrismartenson.com/crashcourse/chapter-8-fed-money-creation

The other problem with the Fed is that it has never been audited (yes there are audits from the Govt Accountability Office, but I digress), and it has also stopped providing information about its M3 money supply as of March 2006. While it is not the best measure of economic activity, I cannot help but question this decision.
http://www.federalreserve.gov/releases/h6/discm3.htm

Perhaps this is why people talk about ending The Fed.

A bank is not a bank is not a

A bank is not a bank is not a bank.

All banks are not equal. The local bank (or credit union)that performs normal checking, savings and loan functions is not the same as JP Morgan and Goldman Sachs.

That is where the problem is.

When JPM and GS (and others) have the ability to burn the entire financial world into ash, it is an imperative that a firewall be built and maintained so that does not happen. Why should my retirement be dependent upon a JPM VP desire to do almost anything to make his quarterly bonus target?

That is the Fed that is required. Not the Fed that insulates the big players from the consequences of their actions, but a Fed that protects the interests of the ordinary citizens and limits the dangerous games that the big boys play.

It is a sign of Paul's and others delusions that they take the attitude of "let the markets decide". The fact is that the banks are too big and hold too much leverage on the financial world to pretend that removing regulation and oversight is a smart thing. At a time when "too big to fail" was supposed to be changed, they are even bigger. We have had the S&L crisis, the dotcom boom, the real estate bubble, and the debt crisis, all with causes that can be laid at the feet of the purely financial speculators.

I, like almost every person in the world, have had REAL financial damage done to me by the big financial players and their games. I haven't been made whole, yet they have. And it is clear that the European crisis will continue on for years, due to their manipulation and disguising of debt. (Have you read of how much GS made from their disguising of the true Greek debt?)

Sure, do away with the Fed. Weaken the Fed. Prepare to be further impoverished.

Love Ron Paul.He knows the

Love Ron Paul.

He knows the score.

R. Paul is not an economist

Paul is an MD. His only economic credential is his loyalty to Ayn Rand, and the Chicago School of economic ideology.

Wonderful

What a wonderful article, I look forward to your next one!

Checks and balances

Checks and balances... we've had one audit of the federal reserve and it showed a system that in less than a three year period lent out $16 Trillion that is >60% more than entirety of the United States budget over the same period. It's hard to not see this as an incredibly excessive amount of power in a single, private organization.

I know full reserve banking has little mainstream support, but to me the ability for a bank to make money out of thin air is crazy... Full Reserve doesn't even require a gold standard, manipulation of the fiat money supply could still be an effective control for monetary policy, if we decided it was required.

It amazes me that we can hit recession after recession, on the gold standard, off the gold standard, with the federal reserve, without it, and never stop to ask if fractional reserve is really a good idea?

National vs. Central Banking

You make the typical error of today's historians: you confuse national and central banking. Hamilton set up a National Bank, mostly owned by U.S. government shares and a mixed board of directors. While it may have had certain formal similarities to the Bank of England, there were crucial differences: the Bank of the U.S. dedicated itself to development of the United States, the Bank of England to the British Empire. Big difference.

The Federal Reserve is NOT a national bank, but a central bank, independently owned by a coterie of private bankers. The US government has little control over it, except the dog and pony show known as confirming a Fed Chairman. This group of bankers, like the Mafia, set up the Fed to mediate disputes amongst various "godfathers".

Who lobbied the most to repeal Glass Steagall in 1999 and set up the current ongoing financial crises? Alan Greenspan.

End of story, and End of Fed.

they key statement in the article ...

The key statement in the article is Dr. Paul's "“bank failures are no more to be regretted than any other business failures. They are a normal feature of the free enterprise system.” In particular, the possibility of banks collapsing will encourage depositors to be more vigilant about monitoring the banks to which they entrust their money.

While the quotation marks end before the complete citation from the article above, I suspect the rest of the statement would be endorsed by Dr. Paul. In my view, this is the ONLY way monetary policy or any economic system as a whole can function. Simply put, THERE MUST BE RISK and THERE MUST BE PAIN. Human beings, at least human beings in our current fallen state, simply must have the threat of law and/or the consequences of failure held over their heads, mine included(!), like the sword of Damocles. It cannot be otherwise.

The Fed needs to go and the pain needs to flow.

Wildcat Money

For a lively first-hand description of the monetary system before the Civil War, when every bank printed its own notes, read the Wild-Cat Money section of George Merrick's "Old Times on the Upper Mississippi."

One quote from the time that Merrick was a steamboat cleerk: "At Dunleith, before starting on the up-river trip, we were handed by the secretary of the company, a Thompson's Bank Note Detector, and with it a list of bills that we might accept in payment for freight or passage. We were also given a list of those that we might not accept at all; and still another list upon which we might speculate, at values running from twenty-five to seventy-five percent of their face denominations. Thus equipped, we started upstream, and the trouble started with us."

Maybe you can imagine. The book is definitely a good read in this and all respects. But I've always found the description of life without a central bank and with banknotes whose value fluctuated like the stock market to be especially humorous, instructive and best left in the 19th Century.