The Federal Reserve

I recently read a book called "The Creature of Jekyll Island" by G. Edward Griffin. It offered a really interesting analysis of the history of banking and the effects of fractional reserve banking and central banking's monetary policies. The title refers to a secret meeting that took place on Jekyll Island off the coast of Georgia with several bankers and politicians to craft a plan for creating a central bank in the US patterned after European central banking. The ultimate result of this was the creation of the current central bank of the US, the Federal Reserve. The meeting was later documented by participants, but it was kept secret at the time because public knowledge of the banking industry's involvement in the creation of the draft plan would have killed the political possibility of it being passed as legislation.

I've dabbled in economic theory, but as any economist can attest, I'm no economist. It was helpful to have some economic background going into that book, but I found my understanding of money was dramatically improved by reading it. Griffin gives historical examples of governments that enforced a policy of money backed by precious metals and the resulting stability of the money supply and value.

If Griffin is to be believed - and I think his research is pretty thorough, though I may not be in the best position to critique his analysis - the United States has had only one brief period near the beginning of its existence in which the money supply was truly tied to a precious metal - silver. In other eras, although we haven't had central banking during many of those years (we've actually had three central banks - four if you count the bank of the colonies prior to the revolution), we have allowed publicly-chartered and/or regulated private banks to employ fractional reserve banking, which allows banks to inflate the money supply by a fairly large multiplier depending on the reserve percentage.

In other words, even when we had a gold standard, fractional reserve banking allowed our money system to be inflated by the banking industry with new money generated by debt. If a fractional reserve percentage of 10% is enforced, then as much as 90% of the money supply could be based solely on debt with the other 10% based on precious metal. That's sort of a hybrid between a gold-standard and fiat money. Now, of course, we have total fiat money with no backing by anything of value.

The stability of a gold- or silver-backed money supply, Griffin argues, comes from the fact that the money is itself something with intrinsic value. This money, then, when it becomes less valuable, can be converted into other things of value and taken out of circulation, which bolsters the value of the remaining money. When it becomes too scarce (and consequently more valuable), individuals and firms will be more motivated to conduct mining operations or find some other method by which to obtain some of this more valuable money. Those activities bring the value of the money back down. Thus, traditional market forces tend to stabilize the value of the money itself just as they do with any other commodity when there is no government interference.

With a fiat system, the government indirectly dictates the value of the money through various control mechanisms. The idea that a central control mechanism would offer greater stability is a very socialistic idea. Why would a group of bankers/economists in Washington be more capable of stabilizing the vast financial system than millions of individuals operating within the framework of a free market?

According to Griffin, the brief period following the ratification of the Constitution in which the US money supply was truly tied to silver generated an incredible period of growth and prosperity. As I said, I can't really critique his analysis, but if it's true, it begs for a closer look at the virtue of a sound money supply with value controlled by a distributed market instead of centrally controlled by bureaucrats.

Call me crazy, but I'm more and more convinced that freedom is a key ingredient in the formula for prosperity. Thanks to Mr. Griffin, I have a few more ideas solidified in my mind that give me a stronger theoretical foundation for that belief.