Against the State: An Anarcho-Capitalist Manifesto

4

THE BANKERS’ WAR ON AMERICA:
THE FED

DECEMBER 23, 2013 MARKED 100 years since Congress authorized the creation of the Federal Reserve System. Throughout that century the Fed has enjoyed broad bipartisan support. That’s another way of saying the Fed never appeared on the political radar until Ron Paul broke the rules by actually campaigning against it in 2007.

The Federal Reserve System, as Rothbard makes crystal clear, was the culmination of efforts that continued throughout the nineteenth century to centralize banking.

By the 1890s, the leading Wall Street bankers were becoming disgruntled with their own creation, the National Banking System. ... [W]hile the banking system was partially centralized under their leadership, it was not centralized enough.

As he describes the movement to cartelize banking, Rothbard introduces a dominant theme in his interpretation of twentieth-century American history: the struggle of competing groups of bankers for power.

From the 1890s until World War II, much of American political history ... can be interpreted not so much as “Democrat” versus “Republican” but as the interaction or conflict between the Morgans and their allies on the one hand, and the Rockefeller-Harriman-Kuhn, Loeb alliance on the other.

In the agitation to establish the Fed, the House of Morgan led the way; and Rothbard stresses the importance of the conference held at Jekyll Island, Georgia, in November, 1910, under Morgan control. The entire section of his book The Case Against the Fed that deals with the origin of the Fed shows Rothbard’s incredibly detailed historical knowledge. Though he was too modest to do so, he could had he wished have echoed the boast of Fustel de Coulanges: “It is not I who speak, but history who speaks through me.” Rothbard brings the historical section of the book to a close with a discussion of the Fed’s early years in which the Governor of the New York Fed, Benjamin Strong, guaranteed Morgan control. Only with the coming of the New Deal were the Morgan interests relegated to a lesser role, as the Rockefellers assumed leadership of the Eastern Establishment. Rothbard draws attention to the research of Thomas Ferguson, who has interpreted the New Deal as an anti-Morgan coup.

The Fed was supposed to provide stability to the financial sector and the economy at large. We are supposed to believe it has been a wonderful success. A glance at the headlines over the past five years renders an unkind verdict on this rarely examined assumption.

In 2012 we observed another important centenary — the 100-year anniversary of the publication of Ludwig von Mises’s pathbreaking book, The Theory of Money and Credit, written when the great economist was just 31. The end of an era was approaching as that book reached the public. A century of sound money, albeit with exceptions here and there, was drawing to a close. It had likewise been a century of peace, or at least without a continent-wide war, since the Congress of Vienna. Both of these happy trends came to an abrupt end for the same reason: the outbreak in 1914 of World War I, the great cataclysm of Western civilization.

It was as though Mises had one eye to the past, speaking of the merits of a monetary system which — while not perfectly laissez-faire — had served the world so well for so long, and another eye to the future, as he warned of the consequences of tampering with or abandoning that system. Mises carefully dismantled the inflationist doctrines that were to ravage much of the world during the twentieth century.

That book covered the whole expanse of monetary theory, including money and its origins, interest rates, time preference, banking, credit, inflation, deflation, exchange rates, and business cycles.

Most important for our topic here was Mises’s warning to the world’s monetary authorities not to suppress the market rate of interest in the name of creating prosperity. The failure to heed Mises’s advice, indeed the full-fledged ignorance or outright defiance of that advice, is the monetary story of the twentieth century.

The single most arresting economic event of the Fed’s century was surely the Great Depression. This was supposed to have discredited laissez-faire and the free economy for good. Wild speculation was said to have created a stock market bubble, and the bust in 1929 was what the unregulated market had allegedly wrought. Other critics said the problem had been the free market’s unfair distribution of wealth: the impoverished masses simply couldn’t afford to buy what the stores had for sale. In later years, even so-called free-marketeers would blame the Depression on too little intervention into the market by the Federal Reserve. (With friends like these, who needs enemies?)

Ludwig von Mises offered a different explanation, as did F.A. Hayek, Lionel Robbins, and other scholars working in the Austrian tradition in those days. Murray N. Rothbard, in turn, would devote his 1963 book America’s Great Depression to an Austrian analysis of this misunderstood episode.

The study of business cycles differs from the study of economic hard times. Economic conditions can be poor because of war, a natural disaster, or some other calamity that disrupts the normal functioning of the market. Business cycle research is not interested in those kinds of conditions. It seeks to understand economic boom and bust when none of these obvious factors are present.

Mises referred to his own approach as the Circulation Credit theory of the business cycle. For our purposes, we can describe it in brief.

On the free market, when people increase their saving, that increased saving has two important consequences. First, it lowers interest rates. These lower interest rates, in turn, make it possible for entrepreneurs to pursue a range of long-term investment projects profitably, thanks to the lower cost of financing. Second, the act of saving and thus abstaining from spending on consumer goods, releases resources that these entrepreneurs can use to complete their new projects. If consumer-goods industries no longer need quite so many resources, since (as we stipulated at the start) people are buying fewer consumer goods, those released resources provide the physical wherewithal to carry out the long-term production projects that the lower interest rates encouraged entrepreneurs to initiate.

Note that it is decisions and actions by the public that provide the means for this capital expansion. “If the public does not provide these means,” Mises explains, “they cannot be conjured up by the magic of banking tricks.”

But “banking tricks” are precisely how the Fed tries to stimulate the economy. The Fed lowers interest rates artificially, without an increase in saving on the part of the public, and without a corresponding release of resources. The public has not made available the additional means of production necessary to make the array of long-term production projects profitable. The boom will therefore be abortive, and the bust becomes inevitable.

In short, interest rates on a free market reflect people’s willingness to abstain from immediate consumption and thereby make resources available for business expansion. They give the entrepreneur an idea of how far and in what ways he may expand. Market interest rates help entrepreneurs distinguish between projects that are appropriate to the current state of resource availability, and projects that are not, projects that the public is willing to sustain by its saving and projects that they are not.

The central bank confuses this process when it intervenes in the market to lower interest rates. As Mises put it:

The policy of artificially lowering the rate of interest below its potential market height seduces the entrepreneurs to embark upon certain projects of which the public does not approve. In the market economy, each member of society has his share in determining the amount of additional investment. There is no means of fooling the public all of the time by tampering with the rate of interest. Sooner or later, the public’s disapproval of a policy of over-expansion takes effect. Then the airy structure of the artificial prosperity collapses.

None of these cycles will be exactly like any other. Roger Garrison says the artificial boom will tend to latch on to and distort whatever the big thing at the time happens to be — tech stocks in the 1990s, for example, and housing in the most recent boom.

With this theoretical apparatus as a guide, Mises became convinced as the 1920s wore on that the seeds of a bust were being sown. This was not a fashionable position. Irving Fisher, a godfather of modern neoclassical economics and the man Milton Friedman called the greatest American economist, could see nothing but continued growth and prosperity in his own survey of economic conditions at the time. In fact, Fisher’s predictions in the late 1920s, even in the very midst of the crash, are downright embarrassing.

On September 5, 1929, Fisher wrote: “There may be a recession in stock prices, but not anything in the nature of a crash ... the possibility of which I fail to see.”

In mid-October, Fisher said stocks had reached a “permanently high plateau.” He expected “to see the stock market a good deal higher than it is today within a few months.” He did “not feel that there will soon, if ever, be a fifty- or sixty-point break below present levels.”

On October 22, Fisher was speaking of “a mild bull market that will gain momentum next year.” With the stock market crashing and values plummeting all around him — with declines far more severe than Fisher had been prepared to admit were even conceivable — Fisher on November 3 insisted that stock prices were “absurdly low.” But they would go much lower, ultimately losing 90 percent of their peak value.

What had gone so horribly wrong? Fisher and his colleagues had been blinded by their assumptions. They had been looking at the “price level” and at economic growth figures to determine the health of the economy. They concluded that the 1920s were a period of solid, sustainable economic progress, and were taken completely by surprise by the onset and persistence of the Depression.

Mises, on the other hand, was not fooled by the 1920s. For Mises and the Austrians, crude aggregates of the kind Fisher consulted were not suitable for ascertaining the condition of the economy. To the contrary, these macro-level measurements concealed the economy-wide micro-level maladjustments that resulted from the artificial credit expansion. The misdirection of resources into unsustainable projects, and the expansion or creation of stages of production that the economy cannot sustain, do not show up in national income accounting figures. What matters is that interest rates were pushed lower than they would otherwise have been, thereby leading the economy into an unsustainable configuration that had to be reversed in a bust.

Thus Mises wrote in 1928:

It is clear that the crisis must come sooner or later. It is also clear that the crisis must always be caused, primarily and directly, by the change in the conduct of the banks. If we speak of error on the part of the banks, however, we must point to the wrong they do in encouraging the upswing. The fault lies, not with the policy of raising the interest rate, but only with the fact that it was raised too late.

Once the crisis hit, Mises showed how his theory of business cycles accounted for what was happening. If people could understand how the crash had come about, Mises hoped, they would be less likely to exacerbate the problem with counterproductive government policy.

“The Causes of the Economic Crisis” was the title of an address Ludwig von Mises delivered in late February 1931 to a group of German industrialists. It was unknown to English-speaking audiences until 1978, when it was published as a chapter in a collection of Mises’s essays called On the Manipulation of Money and Credit. The Mises Institute published a new edition of these essays in 2006 under the title The Causes of the Economic Crisis : And Other Essays Before and After the Great Depression.

In that essay Mises was characteristically blunt in describing the causes of the Great Depression, as well as in his warnings that such crises would recur as long as the authorities continued to pursue the same destructive courses of action.

The crisis from which we are now suffering is ... the outcome of a credit expansion. The present crisis is the unavoidable sequel to a boom. Such a crisis necessarily follows every boom generated by the attempt to reduce the “natural rate of interest” through increasing the fiduciary media [in other words, through creating credit out of thin air].

Murray Rothbard has explained how and why the Fed undertook this credit expansion. Benjamin Strong, the Governor of the New York Federal Reserve Bank, was by far the most influential figure in the entire Federal Reserve system from its inception until his death in 1928. He entered into close association with Montagu Norman, Governor of the Bank of England. Both men had enlisted in the Morgan camp:

While the close personal relations between Strong and Norman were of course highly important for the collaboration that formed the international monetary world of the 1920s, it should not be overlooked that both were intimately bound to the House of Morgan.

At Norman’s behest, Strong inflated the U.S. monetary supply, in order to enable Britain to maintain in operation the gold-exchange standard. By doing so, Rothbard claims, Strong bears heavy responsibility for the onset of the 1929 stock market crash and the ensuing depression.

The United States inflated its money and credit in order to prevent inflationary Britain from losing gold to the United States, a loss which would endanger the new, jerry-built “gold standard” structure. The result, however, was eventual collapse of money and credit in the U.S. and abroad, and a worldwide depression. Benjamin Strong was the Morgans’ architect of a disastrous policy of inflationary boom that led inevitably to bust.

Rothbard goes even further in his assault on Federal Reserve inflationism. Contrary to Milton Friedman, the Federal Reserve did not follow a contractionist policy once the depression began. Rothbard assails

the spuriousness of the monetarist legend that the Federal Reserve was responsible for the great contraction of money from 1929 to 1933. On the contrary, the Fed and the administration tried their best to inflate, efforts foiled by the good sense, and by the increasing mistrust of the banking system, of the American people.

The crisis whose wreckage we see all around us right now, a crisis that began in 2008, originated from the same interventions Mises warned against a century ago. Mises would not have been surprised by the Panic of 2008. In 1931 he warned of a recurrence of boom-bust cycles if the policy of artificially low interest rates was not abandoned:

The appearance of periodically recurring economic crises is the necessary consequence of repeatedly renewed attempts to reduce the “natural” rates of interest on the market by means of banking policy. The crises will never disappear so long as men have not learned to avoid such pump-priming, because an artificially stimulated boom must inevitably lead to crisis and depression. ...

All attempts to emerge from the crisis by new interventionist measures are completely misguided. There is only one way out of the crisis. ... Give up the pursuit of policies which seek to establish interest rates, wage rates, and commodity prices different from those the market indicates.

In the 1920s as now, fashionable opinion could see no major crisis coming. Then as now, the public was assured that the experts at the Fed were smoothing out economic fluctuations and deserved credit for bringing about unprecedented prosperity. And then as now, when the bust came, the free market took the blame for what the Federal Reserve had caused.

Let’s look at the crisis of 2008, applying also another vital insight of Mises. Ludwig von Mises had a theory about interventionism. It doesn’t accomplish its stated ends. Instead it distorts the market. That distortion cries out for a fix. The fix can consist in pulling back and freeing the market or taking further steps toward intervention. The State nearly always chooses the latter course, unless forced to do otherwise. The result is more distortion, leading eventually, by small steps, toward ever more nationalization and its attendant stagnation and bankruptcy.

When you think about the Fannie Mae-Freddie Mac crisis, you must remember Mises’s theory of intervention. Reporters will not, but you must, provided you want to understand what is going on. President Bush considered a fateful step in a 60-year-old problem: the nationalization of these mortgage companies. He wanted to guarantee the $5 trillion (that’s trillion with a “t”) in debt owned by these companies. Another option would be to put these monstrosities under “conservatorship,” which means that you and I will pay for their losses directly.

Either way, it turns out that there is no magic way to put every American citizen, regardless of financial means or credit history, in a 3,000 square foot home. Someone, somewhere, sometime has to pay. No matter what rescue plan they are able to cobble together, that someone is you.

The heck of it is that any option would be devastating to the already-suffering housing market. The reason this sector was so wildly inflated is that banks knew that Fannie and Freddie were capable of buying any mortgage debt created by the banking industry. For these companies to be nationalized would effectively end their capacity to do this on a market basis. That means banks would suddenly have to act responsibly.

Now, you might say, if that’s true, the real blame is with the individual bankers that had been making irresponsible loans under the condition that these government-sponsored enterprises would absorb them. But that’s not right. Put yourself in the shoes of a banker over the last 20 years. You have competitors. You have a bottom line. If you don’t extend these loans, you come off as a fool. Your competition eats your breakfast. To stay ahead of market trends means that you have to play the game, even though you know it is rigged.

Place the blame not only on the banks, but also on the institutions that are siphoning off their liabilities for irresponsible behavior, and that would be Freddie and Fannie. And who created these? Travel back in time to the New Deal

They were created by FDR in 1938 to fund mortgages insured by the Federal Home Administration. They were used by every president as a means to achieve this peculiar American value that every last person must own a home, no matter what. So they were given the legal permission to purchase private mortgages and make them part of their portfolios. Still later, under LBJ and Nixon, they became public companies and sold stock. People called this privatization, but that isn’t quite right. They had access to a guaranteed line of credit creation with the US Treasury. They had lower borrowing costs than any private-sector equivalent.

Government-sponsored enterprises are not subject to market discipline like regular private sector companies. Their securities are listed as government securities, so their risk premiums were not dictated by the free market. They could leverage themselves at 50-, 75-, 100-1, pyramiding debt on a tiny foundation of equity. The financial markets have long believed that the GSEs would be bailed out no matter what. And so this put them in a completely different position from a company like Enron, which the markets watched closely. What’s causing the current panic is that the markets have wised up and started evaluating these institutions by market standards. Freddie and Fannie have collapsing market prices, and their bonds are carrying ever-higher risk premiums.

In other words, we are not talking about market failure. If you have a housetop you can shout that from, please do so, because the press and the government are going to make every effort to blame private borrowers and lenders for this calamity. But the origin of both these outfits is with federal legislation. They are not market entities. They have long been guaranteed by you and me. No, they have not been socialist entities either because they are privately owned. They occupy a third status for which there is a name: fascism. Really, that’s what we are talking about: the inexorable tendency of financial fascism to mutate into full-scale financial socialism and therefore bankruptcy.

Mr. Bush might have prevented this meltdown by curbing the privileges of Freddie and Fannie long ago. But no, he had another plan, one which was assisted by the Republican think tanks in Washington (the curious can Google it up). The idea was a new slogan called the “ownership society.”

Sounds nice, doesn’t it? Sounds like free enterprise. But if you think about it, there is nothing particularly free market about the demand that everyone should own anything in particular. The idea of free markets is that your rights to own justly are not to be infringed upon by public or private criminals. The suggestion that everyone should own some particular thing, by whatever means, can only be funded through financial socialism or mass theft. The claim on the part of a government that it will create an “ownership society” can prove to be highly dangerous.

As for the future, Mises’s theory that the government will always favor more government seems wholly sound. Here is John McCain: “Those institutions, Fannie and Freddie, have been responsible for millions of Americans to be able to own their own homes, and they will not fail, we will not allow them to fail ... we will do what’s necessary to make sure that they continue that function.” Not a single Democrat disagrees.

As with the S&L fiasco from years ago, the case of the housing bust followed by the trillions in taxpayer liabilities for the disaster will again be cited as a case of “the shock doctrine” and “disaster capitalism” in which the elites make fantastic amounts of money at the expense of the little guy. The critique will be mostly solid but for the one most important point: this kind of fiasco would not happen in a free market. It happens because government, through credit creation and guarantees, makes it possible.

Look down the road a bit here. What happens when banks won’t lend for houses anymore? What will government do then? We might as well prepare for a future in which applying for a housing loan will have similar features to getting an SBA loan. This is where we are headed.

Government intervention is like a vial of mutating poison in the water supply. We can get by for a long time and no one seems really worse off. One day we wake up and everyone is desperately ill, and blaming not the poison but the water itself. So it is with the housing crisis. Lenders are being blamed for the entire fiasco, and capitalism is going to be subjected to a beating as usual, since Freddie and Fannie are traded in public markets. But the fact remains that there is only one reason that this went on as long as it did and became as bad as it is. It was that vial of government poison.

It is fitting that a century of the Federal Reserve should come to an end at a moment of economic crisis and uncertainty, with the central bank’s leadership confused and in disarray after the economy’s failure to respond to unprecedented doses of monetary intervention. The century of the Fed has been a century of depression, recession, inflation, financial bubbles, and unsound banking, and its legacy is the precipice on which our economy now precariously rests.