From the February 2010 issue of Research Magazine • Subscribe!

The Fed and Its Enemies

The central bank is at the center of controversy. It has been there before.

The Federal Reserve is under siege. Proposals abound to curtail the institution's power, through stepped-up congressional involvement or the transfer of some of its responsibilities to other agencies. A political movement led by Rep. Ron Paul (R-Texas) seeks to abolish the central bank altogether. Public enthusiasm for the Fed, including for its role of recent years in bailing out financial institutions, is distinctly low.

The Fed has been controversial throughout its history -- and indeed even before that as proposals for a central bank generated heated debate in the run-up to the Fed's establishment in 1913. Considerable contention persists over matters ranging from the organization's structure to the particulars of its interest-rate decisions. And while there is ample room for reasonable disagreement on such issues, running through much discussion about the Fed are unreasonable beliefs and lurid conspiracy theories.

Ideas that are dubious or worse, but still widely circulated, include that the Fed is a private institution rather than a governmental one, that it acts in the interests of a secret cabal (who, in some variations on that theme, are foreigners), that the Federal Reserve Act that created it is not legally valid and even that President John F. Kennedy was assassinated because he was trying to rein in the power of the Fed.

That such ideas are outlandish does not make them inconsequential. Rather, they seep into the climate of opinion, diverting attention from legitimate policy issues (such as whether the Fed should seek to identify and deflate asset bubbles before they burst) and eroding the insulation from short-term political pressure that economists generally believe a central bank needs in order to conduct sound monetary policy.

Debates about the Fed's future should be informed by accurate accounts of the institution's past, and that means disentangling history from some baseless, even bizarre, beliefs. Moreover, obscure figures are not alone in propagating the misconceptions. Consider how so prominent a politician as Ron Paul promotes the idea that the Fed is private in this passage (p.150) from his bestselling book End the Fed: "Law permits this highly secretive, private bank to create credit at will and distribute it as it sees fit."

Elsewhere in the book (p.28), Paul offers a more defensible but still misleading description that "the Fed is a public-private partnership, a coalition of large banks that are the owners working with the blessing of the government, which appoints its managers."

In reality, the Fed's Board of Governors, which has the final word on policy, is a clear-cut government agency, with members appointed by the U.S. president and confirmed by the Senate. The Fed's regional banks, meanwhile, are private in a nominal sense but function in effect as government entities; banks own shares in them that cannot be traded, and almost all of the regional banks' profits are remitted to the U.S. Treasury.

To call this complex system a "private bank" is, to say the least, apt to generate confusion. Moreover, these institutional arrangements arose from events around the Fed's founding that have been wildly distorted by bogus history.

Jekyll Island Tales

From the expiration of the Second Bank of the United States' charter in 1836 into the early years of the 20th century, the U.S. had no central bank. In the Panic of 1907, J.P. Morgan Sr. led a makeshift consortium of banks that funneled funds to distressed institutions. That such power was in private hands, and had averted economic meltdown only narrowly, raised alarms among policymakers and the public, sparking calls for a central bank.

In 1910, a handful of bankers and politicians, including Sen. Nelson Aldrich (R-R.I.), gathered on Jekyll Island, a bucolic getaway off the Georgia coast, to sketch out a plan for central banking. This meeting has given rise to much conspiracy theorizing, including a book with the memorable title Creature from Jekyll Island. The Fed, in such interpretations, was hatched in secret to serve a powerful few.

The Aldrich plan would have set up a central banking system largely under bankers' control, with little government oversight. That seems to have reflected a not-so-sinister desire to keep politics away from the central bank lest it become, as banker Paul Warburg put it, a "national Tammany Hall." But if this was a conspiracy, it didn't get very far. The 1910 elections gave control of Congress to Progressive-era Democrats who had much suspicion of bankers -- and so the Aldrich plan didn't stand a chance.

Indeed, hostility to big finance was a major factor in the legislative maneuvering that preceded the Fed's creation. Rep. Ars?ne Pujo (D-La.) convened hearings in 1912 to investigate whether a Wall Street "money trust" was controlling the economy. Near the end of that year, Rep. Carter Glass (D-Va.) proposed a system of regional reserve banks that would lend to banks around the country, diluting the power of New York financiers.

Woodrow Wilson, the newly elected president, insisted there be a board of presidential appointees to oversee the reserve banks. After much congressional wrangling, the Federal Reserve Act passed in December 1913. It was aimed at reconciling diverse interests; agrarian populists got their regional banks, but a New York Fed would carry much weight in the system, which helped reassure a wary Wall Street, and in Washington a Board of Governors would keep an eye on all of this.

It was, in short, a compromise, not a conspiracy.

Was it Constitutional?

A recurrent objection to the Federal Reserve, presented by Paul and others, is that it is unconstitutional. In End the Fed, Paul notes that the Constitution does not explicitly mention a central bank, and moreover that it does say (as he excerpts Article I, Section 10): "No state shall ... make anything but gold and silver coin a tender in payment of debts" -- meaning, in Paul's opinion, that paper money is also unconstitutional.

Actually, the passage reads: "No state shall enter into any treaty, alliance, or confederation; grant letters of marquee and reprisal; coin money; emit bills of credit; make anything but gold and silver coin a tender in payment of debts; pass any bill of attainder, ex post facto law, or law impairing the obligation of contracts, or grant any title of nobility." Thus, the framers' intent evidently was to deny monetary authority to state governments (which were barred even from minting coins), not the federal government. Multiple court rulings have affirmed that Federal Reserve notes are lawful money.

Similarly, the argument that a central bank is unconstitutional because the Constitution does not explicitly mention one has been rejected by the Supreme Court since 1819 when, in the case of McCulloch v. Maryland, it decided that the Second Bank of the United States was valid under implied powers in the Constitution. Paul expresses chagrin about this decision, but acknowledges that the Supreme Court has shown little inclination to reverse itself on this one.

One odd claim, found in crank literature, is that the Federal Reserve Act was passed without a quorum in Congress and therefore is invalid. The Constitution requires that the House and Senate have half their members present for a quorum. As it happens, this requirement was met with ease. The legislation passed the House by a vote of 298-60 on Dec. 22, 1913, and then passed the Senate by a vote of 43-25 on Dec. 23. (There were 48 states and thus 96 senators then, while the House had 435 members, as it does now.)

Dark Thoughts

Perhaps the wildest accusation against the Fed is that it was involved in Kennedy's assassination. This idea was promoted by a 1989 book Crossfire: The Conspiracy That Killed Kennedy, by a writer named Jim Marrs, who also has written about conspiracies involving Freemasons, psychics and extraterrestrials. Crossfire was an influence on Oliver Stone's film JFK.

The alleged Fed conspiracy has to do with Executive Order 11,110, which was signed by Kennedy on June 4, 1963. It delegates to the Treasury secretary the president's authority to issue silver certificates, paper dollars that were redeemable in silver coins or bullion. Marrs presented this as an effort by Kennedy to replace Federal Reserve notes with silver certificates, thus transferring power from the Fed to the Treasury -- and providing a possible motive for the president's assassination less than half a year later.

However, the executive order was just a technicality. It did not expand the issuance of silver certificates -- which actually were being phased out, since rising silver prices had raised concerns that redemptions would drain the Treasury's silver supply. Indeed, Kennedy also signed a bill giving the Fed authority to issue small-denomination notes to replace the silver certificates, something hard to explain if he were trying to reduce the Fed's involvement with the money supply.

Someone tell Oliver Stone.

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Tough Job

In the early 1980s, as the Federal Reserve ramped up interest rates to fight surging inflation, Chairman Paul Volcker faced considerable public and political hostility.

During congressional hearings in the summer of 1981, Volcker, in a haze of cigar smoke, calmly explained that further monetary tightening would be needed. Members of the House Committee
on Banking responded with rage. Rep. Frank Annunzio (D-Ill.) pounded his desk and shouted "Your course of action is wrong." Rep. George Hansen (R-Idaho) said the Fed's policies were "destroying middle America." Rep. Henry Gonzalez (D-Texas) called for Volcker's impeachment.

Public dislike for Volcker grew as the economy slipped into recession. Contractors sent him bricks and two-by-fours to represent the houses they were not building. Car dealers sent him keys for vehicles they could not sell. Farmers brought tractors to the capital and blockaded the Fed's headquarters. A Kentucky trade association put up "Wanted" posters of Volcker and the other Fed governors.

Volcker left office in 1987 amid widespread plaudits for having tamed inflation.

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