How the US Created a Monster in the Federal Reserve

The world needs to move away from fiat currencies, and the monopoly of central banks in creating money must end if we are to avert the next big crisis

Published: Sep 14, 2013
How the US Created a Monster in the Federal Reserve
Image: Raju Patil for Forbes India
Shanmuganathan Nagasundaram

From the perspective of the history of monetary economics, 1913 should be considered the single most important year “ever”. We are still feeling the impact of that year. In fact, the roots of what happened in 2008 and subsequently—the credit crisis, the fiscal crisis, the banking crisis, the currency crisis—can all be traced back to the creation of an entity in that year.

That was the year in which the US Federal Reserve was created. Before that, barring brief periods in between, the world had operated on the gold standard—with each currency being defined in terms of specific weights of gold or silver. For example, the US dollar was defined as 1/20th of an ounce of gold; the pound sterling was originally defined as a pound of silver and later as 1/4th of an ounce of gold, the Indian rupee was about 11 gm of silver.

So, for a bank to issue a dollar note, it needed to stock 1/20th of an ounce of gold that any customer in possession of the dollar note could redeem. By definition, these currencies operated with fixed exchange rates and maintained their purchasing power over hundreds of years, if not longer.

At this point, it is worthwhile clarifying what the gold standard really is. First, it means there is no central bank. Market participants are free to issue their own currencies and there is no state monopoly on money. One may ask: Why then should gold be the currency? The answer is: This privilege was conferred on gold not by governments, but by free market choices due to gold’s unique characteristics and consumer preferences.

Gold became money for the same reason why aluminium is used in planes, copper in wires and zinc in galvanising. Certain unique properties lend these metals to their end uses and, in the case of gold/silver, these two happen to be ideally suited to serve the function of money because of the five reasons Aristotle had observed—they are convenient, consistent, durable, divisible and have value of their own.

In a true gold standard, any market participant is free to issue any currency of his/her/its choice based on gold, copper, real estate, art or, for that matter, even thin air—without any legal tender laws granting any currency special status. Free markets then would quickly and very efficiently weed out the inefficient players.

Money then is a “good” in much the same way cars, soaps and chocolates are. The market produces them in the quantity desired by consumers. One of the prevailing misconceptions about a gold standard is that world economic growth is held hostage to mining output. This is a very fundamental misconception about money, and as Murray Rothbard explains in What Has Government Done to Our Money?, the quantity of money circulating in the system is irrelevant. Whether we have six billion or just six million ounces of gold in circulation, or $5 trillion instead of the current $50 trillion, it does not matter. The prices of goods and services move up or down to adjust to the quantity of money circulating within the system.

Another popular misconception (and possibly the one that governments would like their citizens to believe) is that the gold standard caused the great depression of the 1930s and early 1940s. Again, as Rothbard would explain in America’s Great Depression, or, as Jim Rickards would point out in his recent book, The Currency Wars, the depression was not caused by the gold standard, but at least in part because the price of gold was artificially fixed at a lower value without accounting for the inflation of the roaring twenties.

How the US Created a Monster in the Federal Reserve
Image: Arnd Wiegmann / Reuters
Pre-cast bars of gold at a Argor-Heraeus SA refiner plant in Mendrisio, Switzerland. Gold and silver are ideally suited to serve the purpose of money as they are convenient, consistent, durable, divisible and have their own value

The bigger reasons include regulatory interventions in the market’s natural cleansing process adopted by Herbert Hoover and Theodore Roosevelt. In any case, the US ceased to be on a gold standard after 1913.

The US Fed was formed ostensibly to implement the gold standard, but through a series of step-wise devaluations and relentless mission-creep, it deviated from its original role. The first step was the monopoly status granted to the Fed through the Federal Reserve Act in 1913; this was followed by the Bretton Woods Agreement in 1943 that banned convertibility for citizens; and finally, in 1971, Richard Nixon delinked gold from the dollar.

What the current fiat currency system unbacked by gold does is enable a transfer of purchasing power from the productive sections of society to the government as the latter can inflate additional monies at zero cost. So inflation is really a mechanism of taxation where the ill-effects (ie prices rising) can be blamed on greedy multinationals, supply bottlenecks, poor monsoons and, ironically, even growth!  Growth, incidentally, happens to be one thing that diminishes the pernicious effects of inflation.

Exactly 100 years after the US Fed legislation, and after we have moved away from the gold standard, the world is now staring at a monetary precipice. Year 2008 was just a warm-up, but the main crisis lies ahead as a consequence of decades of easy money. Indeed, the intervening years have been used by various central banks to worsen the imbalances by printing trillions of new currency units. The current crisis can be resolved only by moving back into some form of a gold standard.

In the last 3,000-plus years of the history of recorded commerce, no fiat currency has survived for extended periods of time—for good reason—and it will be no different this time around. India is in a sweet spot where it has a very good stock of gold in private hands that will allow us to implement the gold standard. Instead of decrying gold as an unproductive investment, which is anything but the truth, our government could adopt policies for a sustainable monetary standard.
 
Even if the government doesn’t believe in this, it loses nothing by repealing laws that grant a monopoly status to the Reserve Bank and allowing gold to circulate as an additional currency. But if we do go down this path, when the crisis hits the fan, as it undoubtedly will in the next few years, we would at least have a functioning solution in place.

Shanmuganathan “Shan” Nagasundaram is the founding director of Benchmark Advisory Services, an economic consulting firm. He is also the India Economist for the World Money Analyst. He can be contacted at shanmuganathan.sundaram@gmail.com

(This story appears in the 20 September, 2013 issue of Forbes India. You can buy our tablet version from Magzter.com. To visit our Archives, click here.)

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  • Imtiyaj Kaji

    Courageous article. Congratulations. We are in a era of money system, which creates money out of thin air. So far we were saved of privatization of money creation but now our banks too are private. Please read my blog about it and give your precious comments. http://ireadlearnwrite.blogspot.in/2011/09/privatization-of-banking-in-india.html

    on Sep 19, 2013
  • Ashok Rudrappan

    I will say the whole system was created in 1930 by A President Franklin Delanore Roosevelt,In the 1930s by providing jobs to the unemployed by giving jobs from building Skyscrapers,moterways, metros factories by providing a nominal amount and food the factories built was for making Arms for the allieds which made USA a world power with minimal bloodshed later turned for for commercial products, I Remember in my young age the workers of Farms were paid in commodities which was exchanged for other needs the reminder was in money not in paper but in copper,Silver and Gold saved or spent on Festivities and Speciol occations we indians have a loan offered by banks for gold.The amount of Gold held by Indians just imagine if collected ill be to what extent how many Fort Knox and Most Lucrartive business was smuggling gold and silver.I believe that one person made use of this make his family the richest in the world.

    on Sep 15, 2013
  • Abhijit Kale

    A great piece of information !!

    on Sep 14, 2013
  • Abhijit Kale

    A great peace of information!!

    on Sep 14, 2013
  • Rohan Lawrence D\'souza

    It was the Panic of 1907 when there was NO Institution which could step in and be the Lender of Last Resort that JP Morgan stepped in and ensure the bank run did not happen. Because of this and the realization that there may not be Another J P Morgan who could or would step the Federal Reserve was created to ensure this NEVER repeats. In Today\'s day and Age do we have a J P Morgan we can count on.

    on Sep 14, 2013
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