The aftermath of the Panic of 1893 revealed serious problems with the National Bank system that attempted to impose some degree of uniformity on the U.S. currency, restore the credit of the United States following the Civil War, and regulate the amount of currency in circulation and the value thereof. The National Bank Acts of 1863 and 1864 were not failures so much as inadequate to the task of providing the financial resources in the shift from a predominantly rural, agricultural economy to an industrial and commercial powerhouse. Following the British Bank Charter Act of 1844 closely, the National Bank Acts (and thus Congress and much of the financial system) failed to take into account the bills of exchange (merchants’ and bankers’ acceptances) that even today constitute the bulk of the money supply, as much as 60% in 2008 by a rough estimate, and down from an estimated 95-99%, according to Congressman George Tucker, writing in the 1830s.
The Panic of 1907 finally convinced people that something had to be done. At first, the “Aldrich Plan” attempted to continue the old system under a privately controlled central authority. This was developed during the meeting on Jekyll Island in 1910, an event that has entered “conspiracy theory” lore and legend, but which was substantially different from what became the Federal Reserve Act of 1913. As Dr. Harold G. Moulton, president of the Brookings Institution from 1916 to 1952 explained, the Federal Reserve AS DESIGNED was something new and different from the National Bank system it replaced.
As stated in the preamble to the Federal Reserve Act of 1913, the purpose of establishing the Federal Reserve was to provide the private sector with sufficient credit, described as an “elastic currency,” that expanded and contracted directly with the needs of agriculture, commerce, and industry. This was to be done by “discounting” and “rediscounting” bills of exchange for qualified agricultural, commercial, and industrial projects for a period not to exceed 90 days, printing currency or creating demand deposits in exchange for a lien on the present value of existing and future marketable goods and services represented by the privately issued bills of exchange. Creating money for the federal government was strictly prohibited via the refusal to grant the Federal Reserve banks the power to discount government securities.
Unfortunately, the Federal Reserve had to deal with the problem of retiring the National Bank Notes. National Bank Notes were backed by government debt as mandated by the National Bank Acts of 1863 and 1864. This meant that the Federal Reserve had to be able to purchase government securities on the open market either from the National Banks or private brokers in order to replace the National Bank Notes with Federal Reserve Bank Notes indistinguishable from regular Federal Reserve Notes backed by private sector hard assets. (The program to replace the National Bank Notes with Federal Reserve Bank Notes was discontinued in the 1930s when there were few, if any, National Bank Notes left in circulation.)
In sum the Federal Reserve’s primary job was to provide the private sector with sufficient liquidity to carry out agriculture, commerce, and industry by means of a stable and uniform currency in the form of Federal Reserve Notes, demand deposits, and large denomination promissory notes. This was to be supplemented with gold and silver coin, gold and silver certificates, United States Notes backed by gold, and (the largest part of the money supply) privately issued bills of exchange. The method of supplying credit was the rediscounting of bills of exchange presented by member banks, supplemented with limited “open market” operations dealing with bills of exchange issued by non-member banks and individual companies. Open market operations in government securities was only ever intended as a way of redeeming the National Bank Notes, with the goal of replacing the debt-backed National Bank Notes, with asset-backed Federal Reserve Notes.
The system worked as intended for two years. Then the politicians decided to finance the U.S. entry into the First World War by borrowing instead of taxing, just as Secretary Chase had decided to finance the Union effort in the Civil War. The loophole allowing the Federal Reserve to purchase secondary government securities on the open market to redeem the National Bank Notes was all that was necessary to allow massive purchases of government securities under the fiction that these were “open market operations.”
From the end of the war until the Great Depression the Federal Reserve supplied the private sector with credit by rediscounting bills of exchange, and financed limited government by buying and selling government securities on the alleged open market. Private discounting ended in the mid-1930s when the Federal Reserve lost its independence and became a de facto branch of the federal government. Since then, the Federal Reserve has been restricted to monetizing government debt and financing politically motivated projects, such as bailouts and stimulus packages.
By cutting the necessary tie between a private property stake in the production of marketable goods and services and the money supply, achieved by backing the currency not with private sector assets as intended, but with government debt, the Federal Reserve’s policies are necessarily inflationary. The only check on the upward pressure of inflation is whether the Congress can keep spending under control. Absent a private property stake in the backing of the currency and when controls are removed, an inflationary bubble is inevitable.
The problem is that, as it currently operates, the Federal Reserve’s policies are necessarily inflationary because the amount of currency in circulation depends on how much the government spends. Whether inflation actually occurs (defining “inflation” as a rise in the price level) depends on whether the private sector can produce enough to offset government spending; government spending does not increase production. When, as in a depression or recession, the private sector stops producing, adding more currency to the economy necessarily causes “classic” inflation: more units of currency chasing fewer marketable goods and services. This causes a bubble because, as Jean-Baptiste Say explained 200 years ago, we really only purchase what others produce with what we produce. If we don’t produce, we cannot purchase. Consistent with the laws of supply and demand, prices start to rise, and as more debt-backed currency is created, they rise faster and faster until the bubble bursts.