The Independent Institute

 
        

No, Senator Sanders, the Fed Was Always a Creature of Cronyism



fedReforming the Federal Reserve can brighten the future of American democracy—but unless the reforms reflect an understanding of how and why our central bank was created, the Fed will continue to serve the interests of the privileged few at the expense of the rest of us. Regrettably, presidential candidate Bernie Sanders’ misunderstandings about the origin of our central bank could steer the public away from supporting the most badly needed changes and make a bad thing worse.

In his letter to the New York Times on Dec. 23, Sanders claims that the Federal Reserve is “an institution that was created to serve all Americans (which) has been hijacked by the very bankers it regulates.”

“Hijacked” is misleading terminology. The Fed was created on behalf of bankers seeking government favors. Sanders unwittingly propagates the myth that it was created to “serve all Americans.”

More than a century ago, advocates for the creation of a central bank told the American public that the Federal Reserve Act of 1913 would take away control of the money supply from the big banks and give it to the people. To win support, they spread the slogan, “Break the grip of the money (banking) trusts.” Once the Act was made law, the public was told to expect “maximum employment, stable prices, and moderate long-term interest rates.”

The people asked the Fed to achieve these goals by setting the terms of loans between banks, as well as forcing banks to keep a certain amount of deposits in the bank. “Most experts,” wrote the Baltimore Sun, “agree (that the Act) will prevent future ‘money panics’ in this country,” a nod to the Panic of 1907.

Theoretical arguments aside, one key to the Act’s passage was that the identities of the individuals who drafted the initial bill were concealed from the public. In 1910, six confidantes of banker J. P. Morgan (including Jonathan Strong and Paul Warburg) met with US Senator Nelson Aldrich, under guise of a “duck hunt” off the coast of Georgia, but rather than leaving Jekyll Island with a full strap of ducks, they returned with a plan for centralizing the entire American monetary system. The “Aldrich Plan” would serve as the blueprint for the Federal Reserve Act.

Had the public known this fact, the Act likely would have died upon arrival in Congress. Instead, the bill became law, and the political friends of banker Jonathan Strong made him “de facto leader of the entire Federal Reserve System,” likely because of his ties to the powerful New York banks.

While Strong and a few other patrons of the Aldrich Plan would be given jobs at the Fed, the entire banking industry benefited from the Act’s passage. A key provision of the Act, Section 23, requires the Fed to act as lender of last resort if a large bank is about to fail. This financial lifeline gives eligible banks an incentive to take large risks: If the wager pays off, they keep the reward; if the wager fails, the bank will usually receive the funds it needs to stay afloat. Consequently, as a bank grows larger it becomes more and more willing to take risks, because it believes it is very unlikely that the Fed would allow a large bank deemed ‘vital to the American economy’ to fail.

By 1935, the Fed had secured its status as an arm of the U.S. government with its activist monetary policies for dealing with the Great Depression.

In short, the Federal Reserve has always been a cartel that caters to the interests of America’s largest banks. It was created that way. While Bernie Sanders seems to offer radical reforms, even his better ones, such as improving transparency and eliminating some obvious conflicts of interest of Fed board members, fail to address the central issue: a cartel, no matter how heavily regulated, is still a cartel. Genuine reform must move toward breaking up the cartel, primarily by dismantling the foundation on which it rests. Such action not only would strengthen market competition (and market discipline) in an industry distorted by regulatory protectionism, but it would also end a major source of financial instability in the economy: central banking itself.

[David Flemming was a 2015 summer intern at the Independent Institute.]

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