The Impetus Behind Forming the Federal Reserve System

In part one of this series, we began exploring the Federal Reserve, what it does, and how it can impact your financial well-being. In this part, we’ll delve a little deeper into why the Fed was formed, how it operates, and how its operations have impacted the economy.

The Aftermath of the Panic of 1907

The Panic of 1907 gave rise to more calls for a central bank in the United States. Proponents of a central bank pointed to the experience European countries had, claiming that Europe weathered crises far better than the US. Congress decided to establish a National Monetary Commission that undertook a study of the US banking system as well as the banking systems of various leading European countries.

The commission finished its work in 1912 and issued a report along with legislation calling for the establishment of a National Reserve Association. But popular distrust of Wall Street and of centralization of financial power resulted in backlash against the Commission’s plans.

Despite that resistance, and the opposition of both Presidential candidates in the 1912 election, Congress nonetheless passed banking reform legislation in 1913 that resulted in the creation of the Federal Reserve System. And despite the resistance to centralization, there was no doubt that monetary power was going to be centralized under the new system.

The most important function of the new Federal Reserve System was to provide for an elastic currency, meaning that the money supply would be increased whenever demand for money increased, and decreased whenever demand for money waned. But how does this occur?

What Does the Fed Do?

For years, the primary function of the Federal Reserve in bringing about an elastic currency was its performance of open market operations. Open market operations are when a central bank goes to the open market to buy and sell securities, whether government bonds or other types of securities.

If the Fed judges that the economy needs more money, i.e. more liquidity, it will purchase securities on the open market and keep them on its balance sheet. If it judges that liquidity needs to be drained from the system, it will go to the open market and sell securities.

But where does the Fed get the money to buy these securities? Here’s where the problem lies. It creates this money out of thin air. In theory, the Fed could purchase every one of the $30 trillion of outstanding Treasury securities in existence, doing so by creating money out of thin air. But the effects of doing that would be immediately inflationary and catastrophically so, therefore the Fed has operated on a much smaller scale.

The problem with open market operations is that once money is injected into the financial system, it is difficult to remove it. That’s because the increase in the money supply also has the effect of lowering interest rates. More money available to lend means lenders can offer that money at a lower interest rate, since the interest rate is the market price of borrowing money.

Projects that might be economically unfeasible at, say, a 10% interest rate all of a sudden become profitable at a 5% interest rate. And once banks and businesses become accustomed to these low interest rates, raising them by pulling liquidity out of the system, or even by ceasing the injections of money into the financial system, becomes painful for them.

How Has the Fed Impacted the Economy?

It is this addictive property of easy money that results in ever higher inflation. An “elastic currency” in practice only is elastic in one direction, never the other. Once the printing presses start, shutting them off is almost out of the question.

Indeed, if you look at historical money supply figures, you’ll see that the Fed has done nothing over the course of its existence but create money. According to the money supply data from Friedman and Schwartz, total M3 money supply in 1913, when the Fed was created, was $19.31 billion. By 1920 it had more than doubled, to $39.83 billion. By the time the Great Depression hit in 1929, it was up to $55.20 billion, and by 1947 it was $166.76 billion.

And what is M3 today? Well, that’s a good question, because the Fed stopped publishing M3 data in 2006, when M3 had passed $10 trillion. The best guess we have is from OECD data, which estimates US M3 at $21.84 trillion, a more than 1100-fold increase since 1913.

That’s not an elastic currency, that’s an inflation machine. Is it any wonder then that prices have increased so much since then, and that your dollars purchase so much less?

In practice the Fed is a one-trick pony. All it knows how to do is to inflate the money supply. The last time it tried seriously to pull money out of the system, it helped bring on the Great Depression.

That’s because the nature of the business cycle has at its roots monetary expansion. Those companies that relied on easy money and cheap credit to borrow money, expand operations, and increase production found out the hard way that the cheaper money wasn’t because individuals were saving more money in order to increase their future consumption, it was because the central bank was creating money out of thin air.

So once these companies brought their products to market, the market just wasn’t there. The easy money created by the Fed caused a malinvestment, a misallocation of resources away from things demanded by consumers and into more capital-intensive industries whose products weren’t actually in demand.

The classic example of this was the housing bubble that was being built during the 2000s and that collapsed in spectacular fashion in 2008. It was built on easy money and cheap credit, and collapsed once demand for houses was shown to have been artificially built up through easy money.

It’s a vicious cycle that is well understood by economists of the Austrian School, and indeed anyone else with an understanding of economics. But the “experts” at the Federal Reserve are intellectually blinded by their own hubris, and can’t possibly comprehend that they are the reason behind these successive crises, rather than the cure.

Even today the Fed fails to take responsibility for rising inflation. It’s clear to everyone who has been paying attention the past two years that the $5 trillion the Fed has pumped into the financial system has boosted the money supply to such an extent that prices are rising faster than they have been in 40 years.

The M2 money supply has increased 19% over the last 18 months, yet Fed Chairman Jay Powell is still trying to explain away rising inflation as the consequence of supply chain disruptions. That’s how out of touch the Fed is with its own actions.

The next installment of this series will take a deeper dive into the Fed’s actions over the past several decades, including the Fed’s involvement in creating the various recessions that have plagued the US economy over the years. And we’ll also take a deeper look at just why so many people invest in gold to protect themselves against the Fed’s actions.