Auditing the Fed will Audit the State

George F. Smith
Ludwig von Mises Institute
Thursday, July 2, 2009

[An MP3 audio version of this article, read by Floy Lilley, is available as a free download.]

If Ron Paul succeeds in getting the Fed audited, the consequences could be far-reaching. Assuming the audit isn’t rigged to protect the guilty, as a similar bill was in 1978, the Fed will need every obfuscating Keynesian to testify and write editorials on its behalf, to reassure the public that monetary matters really are best left to the gods who rule us, such as Ben Bernanke and Timothy Geithner. Monetarists, too, would likely join the “Save the Fed” crusade, perhaps arguing that even a great free market economist like Milton Friedman considered the Fed useful for preventing and curing recessions.

But the really appetizing part of auditing the Fed is knowing what stands behind it. The Fed is a racket at heart, a con game writ large — what else can you call an organization with the exclusive privilege of printing money in the trillions and handing it over to friends? But if this is true, what does that say about the state, the organization that created and sanctions it? Is the Fed an honest mistake in the state’s otherwise undying efforts to preserve our liberty, or might it be a key component of a bigger racket?

Without the power of the state, there would be no proposal to audit the Fed because there would be no Fed to audit. Like any cartel, it exists to protect its members from market retribution, and only the police power of the state can make us shoulder that burden. A bill to audit the Fed could by force of logic become a state audit, much like the investigations of the 1972 Watergate burglary exposed the grinning skull behind the government’s public persona. During a Fed audit, for example, would it not be reasonable to ask why the people’s elected representatives continue to support a banking system that secretly steals wealth from their countrymen and other dollar holders? Or are we to take the naïve position that most elected officials really are clueless about the Fed’s policy of currency debasement and the effects such policies have had in history?

Partners in Crime

There are any number of ways a Fed audit could bring the state itself under close scrutiny, but let us sketch just one line of argument:

1. It is well known that banks engage in fractional-reserve lending, meaning that bankers use their deposits in lending operations, with only a part of their loans covered by money reserves. Fractional reserves expand the money supply, which, until the age of Keynes and Fisher, was called inflation. [1] It is also common knowledge that when banks extend too much credit, depositors quite naturally get nervous and start withdrawing their money.

   Although fractional reserves would seemingly qualify as a form of embezzlement — the act of taking for personal use other people’s property without their knowledge or consent — government court rulings have never viewed it as such. As Murray Rothbard observed, a bank that fails to meet its deposit obligations is just another insolvent, not an embezzler. Following the British ruling in Foley v. Hill and Others in 1848, US courts consider that money left with a banker is, “to all intents and purposes, the money of the banker, to do with as he pleases.”[2]

   

   This holds even if the banker engages in “hazardous speculation.” Thus, according to the state, there can be no embezzlement because the money belongs to the bank, not the depositor. But was there ever a depositor who thought he was turning his money over to the banker so he could “do as he pleases” with it? Furthermore, when the banker, in loaning the customer’s deposit to another party, essentially creates two claims to the same piece of property (the money deposited), there is no way he can meet his obligations to both depositor and borrower at the same time. Why does the state exempt banks from the law of contradiction?

2. Without a central bank, fractional-reserve banking leads to repetitive crises, as banks are incapable of meeting redemption demands. Banks that have trouble meeting their obligations need money fast, and this is one of the problems a central bank addresses. “The very existence of a fractional-reserve banking system invariably leads to the emergence of a central bank as a lender of last resort,” Jesus Huerta de Soto tells us.[3]

   True, but as de Soto recognizes, central banks don’t emerge from open and candid discussions within the banking community, unless one regards their wish for “a more elastic currency” as an instance of brute honesty. To succeed, central banks need protection from competition; they need to be the monopoly supplier of bank notes. But monopolies in this sense don’t emerge on a free market. A deal needs to be cut between big bankers and influential politicians to create a bank with legal privileges. This arrangement is then forced on us, not presented as a special privilege but as serving the public interest. And we need to be forced to accept the privileged bank’s fiat money in trade for real goods or services. It bears repeating: a central bank “is not a natural product of banking development,” as Vera Smith concluded in her well-known study.[4] “It comes into being as a result of government favors.” What does a government get in exchange for these favors, a Fed auditor might ask?

3. With a central bank, fractional-reserve banking leads to repetitive crises, but they may differ from crises without a central bank in two respects: one, because a central bank enforces a uniform rate of inflation (credit expansion), one bank can’t jeopardize the rest by overexpanding more than others; consequently, the day of reckoning is delayed, and the correction needed is more severe. And two, when the crisis hits, the central bank provides a means for more monetary wrongdoing.Since the requirement of redemption limits the inflationary potential of a central bank, governments sooner or later get around to outlawing money itself and force us to use exclusively what was formerly only a money substitute. Governments, in other words, outlaw gold and make us use their paper. Question from the auditor: how does this arrangement qualify as a free market, as so many commentators today tacitly believe when they blame the crisis on the free market?

   With gold gone the central bank becomes government’s genie, able to grant it almost unlimited spending. Massive spending in the ’30s didn’t cure the Depression, though it did make government a much heavier load for the market to bear.

   Does the central bank’s ability to orchestrate inflation have any connection with a government’s involvement in war? Might the world wars have been far shorter and less destructive of life and property, while propagating fewer bloody shoots of their own, without the aid of central banking and a fiat-paper standard? The enormous monetary outlays of war go to politically favored firms, which thus have an incentive to foster a more belligerent and interventionist foreign policy. Is this military-industrial-congressional complex killing us? How eager will politicians be to go to war or police the world if they no longer have a printing press to pay for their adventures?

Might we all be better off with a money and banking system that is completely severed from government? And might we be better off with a government that can’t feed on inflation?

The Pujo Committee

Prior to passage of the Federal Reserve Act, Wisconsin Senator Robert LaFollette and Minnesota Congressman Charles Lindbergh Sr. delivered scathing speeches attacking “the money trust” for causing booms and busts. LaFollette charged that the entire country was controlled by just fifty men, a claim that a Morgan partner rejected as totally absurd. He knew firsthand the number was not more than eight.

Following Lindbergh’s resolution, Congress created the Pujo Committee to investigate the big bankers, but the committee was firmly in the hands of the trust itself. During the summer of 1912, the committee scared the wits out of people with statistics and testimonies showing the power Wall Street had over the economy. To the public, Congress seemed to be doing its job by cracking down on corruption, though at no time were Lindbergh or LaFollette called to testify, nor did anyone seem to attach any significance to the fact that the biggest bankers were leading the charge for reform.

The committee concluded that banking reform was urgent and necessary to bring Wall Street under control, and a year later Congress and President Wilson gave the country a central bank as an early Christmas present.[5] As Rothbard notes, the composition of the first Federal Reserve Board more or less reflected the power structure of those present at the Fed’s founding meeting at Jekyll Island in 1910, with Morgan man Benjamin Strong actually running the system as head of the New York Fed.[6]

Power grabs are a frequent and predictable outcome of government investigations. However, any audit that exposes the Fed’s relationship to the state will be worth doing, even if the Fed’s friends keep it where it is.

George F. Smith is the author of The Flight of the Barbarous Relic, a novel about a renegade Fed chairman. Visit his website. Visit his blog. Send him mail. See his article archives. Comment on the blog.

An MP3 audio version of this article, read by Floy Lilley, is available as a free download.

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Notes

[1] Jorg Guido Hulsmann, The Ethics of Money Production, Ludwig von Mises Institute, 2008, p. 85

[2] Murray N. Rothbard, The Case Against the Fed, Ludwig von Mises Institute, 1994, p. 42.

[3] Jesus Huerta de Soto, Money, Bank Credit, and Economic Cycles, Ludwig von Mises Institute, 2006, p. 638 (emphasis in original).

[4] Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative, Liberty Press, 1990, p. 169.

[5] G. Edward Griffin, The Creature from Jekyll Island: A Second Look at the Federal Reserve, American Media, 2002, pp. 443–444.

[6] Rothbard, pp. 121–125.