How the US Created a Monster in the Federal Reserve

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.

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