By: George Leef
February 12, 2014
The Federal Reserve System recently turned 100, but it has presided over a century of folly, argues Professor Richard Timberlake in his magisterial 2013 book Constitutional Money (Cambridge University Press). Timberlake, professor emeritus at the University of Georgia, makes a compelling case that the U.S. made a terrible blunder in abandoning the gold standard in favor of a fiat monetary system under the control of a few supposed experts.
While the proponents of the Fed were certain that America needed a modern, “scientific” system to control money and credit, what we have learned is that the rule of experts, no matter how brilliant their credentials, is far inferior to the stability of a self-regulating market. We have replaced the rule of law – both constitutional and economic – with the rule of men; that is just as damaging with regard to money as with any other aspect of life.
Before starting his analysis of “the monetary constitution” Timberlake sets the stage with a brief discourse on the emergence of money, a market phenomenon, and the detrimental results that have always followed governmental tampering with it. Throughout history, rulers have debased the currency to enrich themselves and their political allies at the expense of productive people. It’s hard to find an instance where the state has not taken advantage of its control over money to aggrandize itself.
The Founders understood that the new nation would not prosper under an unstable, readily manipulated monetary system and they drafted the Constitution accordingly. Article I, Section 8 gives Congress the power “to coin money and regulate the value thereof” and Article I, Section 10 provides that state governments may not “coin money, emit bills of credit, or make any thing but gold and silver coin a legal tender in the payment of debts.” Also pertinent is the Tenth Amendment, which says that the federal government is only to have those powers expressly granted to it.
Using the power under Article I, in 1792 Congress defined the dollar as a coin containing 24.74 grains of pure gold, and also a coin containing 371.25 grains of pure silver, reflecting the current market values of the two metals. That put the U.S. on a bimetallic standard. Such a system is workable, but leads to the problem of changing market ratios between the two metals. That is why, Timberlake shows, the Founders included the language about “regulating the value” of coined money, since they knew that it would be necessary to periodically adjust the dollar’s metal content. (Such a “regulation” was made in 1834, devaluing the gold dollar 6.6 percent.)
Timberlake devotes the bulk of the book to discussion and analysis of the Supreme Court’s decisions in cases involving money. Of those, the most crucial were the post-Civil War Legal Tender Cases, a series of disputes arising out of the federal government’s resorting to the printing of paper money, declared to be legal tender, to help pay for the enormous costs of the war.
The second of those cases, Knox v. Lee, (1871) was a disastrous break with the language and intent of the Constitution. A Republican-dominated Court (in those days, the Democrats were the “hard money” party) held that there was nothing unconstitutional about the “greenbacks” and making them legal tender. Worse still, the majority opinion went further, holding that the government has “general power over the currency, which has always been an acknowledged attribute of sovereignty.”
That idea, Timberlake argues, is entirely at odds with the meaning of the Constitution, which clearly did not give the government any such authority. The majority, he writes, “offered a nationalistic apologia” for unrestrained federal control over money. Thus, Knox v. Lee undermined the monetary constitution and opened the door to any and all government monetary schemes under the unconstitutional rubric of “sovereignty.”
Timberlake’s chapters on the history of the Fed are extremely illuminating. The Fed, he notes, was not initially created to be a central bank. Central banks can create money and the Fed was not supposed to do that under our constitutional gold standard. Timberlake explains, “It was to be a Gold Standard Central Bank, and to do occasionally what the gold standard did constantly – provide seasonal money as needed, commensurate with seasonal spikes in productions of commodities….It was not created as a centralized manager of the monetary system with unlimited powers, as the legal tender cases had implied, but as a technical device to reduce occasional instabilities appearing in the commercial banking system.”
Some politicians saw the dangers and warned that the Fed would burst its apparent bonds and soon become a money-creating engine. For example, Senator Frank Mondell of Wyoming presciently observed, “The Federal Reserve Board under this bill is an organization of vastly wider power, authority, and control over currency than the reserve associations contemplated by the National Monetary Commission….It is of a character which in practical operation would tend to increase and centralize [power.]”
World War I gave the nation its first taste of the Fed’s ability to create money, with a rise in the price level of about 56 percent from 1917 to 1920. That, however, was just the prelude to the gyrations of the latter half of the ‘20s.
First, the Fed embraced the so-called Real Bills Doctrine (RBD) that rationalized an expansion of the money supply on the basis that expanding production, as indicated by an increase in bank loans to finance such production. The RBD, Timberlake writes, “looks something like a gold standard. Whereas gold is coined into money at a fixed price, Real Bills – bank loans that reflect the production and marketing of goods and services – are also ‘coined’ into new money through the banking system. As long as a Real Bills banking system is operating within the framework on a gold standard, it is harmless. A genuine gold standard will not allow banks to generate too much or too little money for very long, no matter how much credence bankers place in the RBD.”
The problem was that the “experts” at the Fed had come to believe that they should be guided exclusively by the RBD. Money creation increased rapidly. In 1928, however, chiefly due to the influence of Board member Adolph Miller, the Fed turned its policy into a crusade against speculation. Miller’s notion that speculation had to be stopped by exerting pressure on banks was, Timberlake says, “catastrophic” because it denied banks “the emergency credit the Federal Reserve Act had promised, and at the very time that the promise was obligatory.”
Thus began the great contraction. The Fed and the political system then made things much worse by preventing gold from functioning as our monetary base. Gold was demonetized and sequestered in Fort Knox by politicians who wanted to eliminate it so as to facilitate their goal of politicizing the nation’s economy. With gold gone, politicians turned to fiscal policy (which of course gives them enormous power) as a means of “stimulating” production and trade, which had crashed due to the Fed’s contractionary policies. We are still paying a gigantic and growing price for the fallacious notion that government spending can stimulate the production of goods and services.
The magnitude of the damage the Fed and statist politicians did can be seen in Timberlake’s comparison of the money supply that would have existed had the gold standard not been destroyed and what it actually was under the Fed. He calculates that in 1940, the money supply was “hardly more than one-third of what would have occurred with a true gold standard in place.”
In short, the most disastrous economic period in American history would have been avoided if we had not abandoned our constitutional money system in favor of “government sovereignty.”
No case ever challenged the constitutionality of the Fed because of the mistaken precedent in Knox, but Timberlake contends that the Fed, as it has been operating since World War I, is clearly unconstitutional – entirely inconsistent with the Founders’ ideas about the role of government in money.
He is under no illusion that we’ll correct that blunder, but proposes a plan for remonetizing gold that would begin to repair the damage we have suffered by putting power over our monetary system in the hands of a few people rather than sticking with the rule of law the Founders envisioned.
Cato Institute did an event with Professor Timberlake, joined by two esteemed economists (Steve Hanke of Johns Hopkins and George Selgin of the University of Georgia) last year, a podcast of which is available here.
Sound, constitutional money does not prevent the government from enacting a lot of harmful policies, but it impedes the political class from debasing the dollar through unlimited inflation to cover a gusher of federal spending – most of which is also unconstitutional. Three cheers to Professor Timberlake for his extraordinarily illuminating work.