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Monetary Policy

[The Congress shall have Power] To coin Money, regulate the Value thereof, and of foreign Coin….

U.S. Constitution, Article I, Section 8, Clause 5 (excerpt)

U.S. Monetary History

The U.S. Constitution gives authority to the Congress to establish a system of currency — coins and, less explicitly, paper money — and to regulate the value its value and its relationship with foreign money.

Many of the founders opposed the establishment of a central bank. Alexander Hamilton, our first Treasury Secretary, crafted a compromise between the states that allowed the establishment of such a bank (which was supported generally by the northern states and opposed by the southern) in return for moving the nation’s capital from New York to a more southern locale on the Potomac River. Thus was born the First Bank of the United States, which operated on a twenty-year charter from 1791 to 1811.

Congress allowed the First Bank’s charter to expire, which lead to rampant inflation and economic instability. About five years later, a new bank — cleverly called the Second Bank of the United States — was given a twenty-year charter. It operated from 1816 to 1836, after which Congress let its charter expire too.

From 1837 to 1862, the U.S. monetary system was in the hands of state chartered banks. This “Free Banking Period” was marked by some amount of chaos, as you might expect. Some states regulated their banks well, and some did not. Many banks failed, leaving depositors without their hard-earned money.

After the U.S. Civil War began in 1861, the federal (i.e., Union) government needed a more reliable banking system to finance the war effort. In 1863, Congress enacted the National Banking Act to create a system of national banks with tighter regulation and oversight than the state-based system. Under this system, a uniform national currency was established and the national banks were required to hold U.S. Treasury securities.

The system still had some problems. Fluctuation in the value of U.S. Treasury securities caused instability. There were also seasonal changes in liquidity caused by rural banks withdrawing funds from the national banks at times of higher need…that is, during the planting season in agricultural areas. These problems caused periodic bank runs, culminating in the “Panic of 1907” which wiped out about half the value of the New York Stock Exchange and bankrupted countless local banks across the country.

Following the panic, Congress began to plan the creation of a new monetary system. Senator Nelson Aldrich (R-RI) developed a plan for a politically independent network of regional reserve banks. He presented it to Congress beginning in 1912 but it failed to gain traction. President Woodrow Wilson (D) was elected later that year and began to advocate the plan, with the notable change that the system would be overseen by a board which would be nominated by the president with Senate approval.

The Federal Reserve Act was passed in 1913, establishing the Federal Reserve system that is still in place today.

The Federal Reserve

The Federal Reserve system that was established in 1913 had one main, overriding objective: to prevent bank panics like the “Panic of 1907.” But the establishing law also stated that it should “furnish an elastic currency” and “establish a more effective supervision of banking in the United States.”

Its role has changed over time, but “the Fed” now has three primary mandates established by Congress: maximizing employment, stabilizing prices, and moderating long-term interest rates.

It does this by acting as our central bank. Our paper money — dollars — are actually Federal Reserve Notes; they say so right at the top of the front side. The Fed also serves as a check clearing system, the nation’s the lender of last resort, and the primary regulator of private banks. For a time, it was formally subordinated to the executive branch…but now it is treated as an independent entity. The members of the Federal Reserve Board are appointed by the president and confirmed by the Senate, and it is, of course, subject to federal law…but otherwise it has no direct government oversight.

This raises an interesting constitutional question that remains largely unanswered. If the Constitution gives an authority to Congress, can Congress then delegate that authority elsewhere? It seems clear that it can delegate some things to the executive branch, since the literal purpose of the executive branch is to put Congress’s laws into action, but can it delegate authorities to independent agencies outside of the government? And is the Federal Reserve actually part of the government or not?

And, even if we put aside these thorny legal questions, we still have to consider whether the Fed does its job properly. Bad Fed policy contributed to the 1929 stock market crash and the “Great Depression” that followed. It also seems clear that the Fed contributed to the 2008 crash, and, although increased monetary liquidity in the aftermath was probably needed, it drove significant inflation (which it then lied about).

We also need to consider whether it makes sense to have a purely fiat currency — that is, currency that not backed by actual assets. By going off the gold standard, we got ourselves stuck in a constant cycle of inflation, restricted only by the fact that the Fed has done a decent job of policing itself. This is despite the fact that one of the Fed’s mandates is to keep the value of money stable.

What Should We Do?

I’m not an economist. And most economists seem to think that it’s critically important to maintain the Federal Reserve’s political independence. But the U.S. Constitution gives authority over money to Congress, and Congress should not entirely abdicate this role. It has an obligation to at least provide Fed oversight. And it should also periodically consider whether changes to the Federal Reserve system are necessary.

As a first step, Congress should assert it’s authorities to oversee — and to audit — the Federal Reserve. Many of the Fed’s activities are done in secret. This is unacceptable in a free country. We have the right to know what they’re up to and why. The Fed audit and other analyses must be made public.

And, depending on what we find out, we may need to significantly reform the system. At the very least, we need to clarify what the Fed’s primary mandate should be, and then monitor them closely to ensure that they live up to that mandate. The answer should be that it’s primary role is to maintain a stable currency with low inflation…and that the best way to do that is to link the value of money to some real asset, such as gold or property.

This may result in a slight increase in instability — like recessions — but those recessions will be less severe and we will emerge from them faster. This is preferable to the current cycle, where serious recessions are fairly rare, but when they occur they are quite severe.