I. Introduction

The Federal Reserve is the central banking system of the United States. Founded in 1913, the Fed's purpose is to conduct monetary policy to create ideal conditions for maximum employment and economic growth. The Fed is also charged with supervising the banking system in order to protect consumers, providing financial services to the US Government, and economic stability.[1] Many libertarians see the Federal Reserve as an institution that creates more problems that it solves, and advocate for its abolition. At the moment, Congressman Ron Paul is the face of the End the Fed movement, and over half of the House of Representatives has signed onto H.R. 1207, the bill to audit the Federal Reserve.[2]

The main branch of the Federal Reserve System is located in Washington, D.C., though branches exist all over the country. The nearest branch to Wake Forest is in Charlotte, though it is technically a branch of the Federal Reserve Bank of Richmond.

II. Central Banking

Libertarian opposition of the Federal Reserve is rooted in a deeper opposition to central banking in general. One may note that the nature of central banking has been put forth very clearly by both libertarian thinkers and authoritarians. For example, Thomas Jefferson, an advocate of limited government, wrote of central banking:
  • “I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow banks to control the issue of their currency, the banks and corporations that will grow up will deprive the people of all property until their children wake-up homeless.”[3]

Meanwhile, Karl Marx, who advocated for everything to be brought under state control, wrote on the same topic:

  • “(To achieve total State control), centralize credit in the hands of the State, by means of a national bank with State capital and an exclusive monopoly…this cannot be effected except by means of despotic inroads on the rights of property.”[4]

While Jefferson and Marx had different views on whether or not central banking should be utilized, they both understood that it would lead to a massive increase in government power and a corresponding decrease in freedom and individual liberty. The freedom argument is merely one strike against the Fed, as it also proves very problematic for the US and global economies.

III. Origins

The Federal Reserve was founded in 1913 on Jekyll Island off the coast of Georgia. A first red flag that pops up when looking at the Fed is who founded it. Its largest supporter in government was Senator Nelson Aldrich, a Republican. However, he had extensive ties outside of government, particularly with JP Morgan and John D. Rockefeller, Jr. A group that consisted largely of bankers and politicians came together on Jekyll Island to lay out the plan that eventually became the Federal Reserve Act.[5]

IV. The Fed and the business cycle

A. The Fed as a cause of the business cycle

One of the best arguments against the Federal Reserve is that it is a root cause of the Business Cycle, also called the Boom-Bust Cycle. The Business Cycle is a process by which an economy grows at a fast rate, but then has a large recession or depression, and repeats this cycle over and over. This graph is a very basic example of what the business cycle looks like:

A simple illustration of the business cycle
A simple illustration of the business cycle

While the business cycle is a common phenomenon in modern economies, this does not mean that it is inevitable. The fact that there is a bust at all means that at some point, entrepreneurs have made a mistake and invested capital into markets for which there is no real demand. Thus when the time comes for them to sell what they have produced or invested in, there is no one there to buy. This was the case with the housing market in the economic collapse of 2008 -- there was far too much investment into the housing market, and at the end of the day the real demand was not there to support all of this investment and production.

Thus the question becomes: why would entrepreneurs make such a mistake? Why would there be a cluster of errors on the part of entrepreneurs that was so large and so widespread that it led to an economic collapse? The answer, according to opponents of the Fed, lies largely in the Federal Reserve's manipulation of interest rates.

B. The Federal Reserve and interest rates

1. What Is an Interest Rate?

An interest rate can most easily be thought of as the "price of money." Thus, when interest rates are low, money is "cheap," and it is easier to borrow to start new projects. When interest rates as high, money is "expensive," and it is harder to borrow to start new projects.

Interest rates would exist absent of any form of central bank. Just as prices would exist in a perfectly free market, so would interest rates, as, again, interest rates are essentially just the price of money.

In a natural free market, an interest rate is determined by how much money people save or invest vs. how much they spend. It is generally thought that people prefer present goods to future goods. For example, if I could have an Xbox 360 either now or in a month, I would rather go ahead and have it now, as that is an entire extra month that I would have the Xbox 360. So, the signal being sent when people save a lot of their money is that there is something in the future that they want to purchase that they value more than anything that they could purchase at the moment. People also will save there money is if there is a good that they want in the present, but cannot afford. Still, the present goods vs. future goods rule holds, because this action of saving money on the part of an individual shows that they would prefer having this expensive good in the future over having a good that they could afford in the present.[6]

2. Interest Rates and Economic Growth

As stated before, low interest rates tend to lead to growth, as it is easier to borrow money and begin new projects when money is "cheap." Not only do low interest rates make it easier to borrow, but they also give banks a greater incentive to lend. This is because the natural cause of low interest rates, lots of money being saved in banks, means that banks have extra money on reserve. They will use this extra money to seek extra profits.

Banks make their profits by lending out money. The more money they have, the more money they can lend. More lending stimulates economic growth and generally leads to more market entry, increased competition, lower prices for consumers, and an increase in the general standard of living. However, a key point to note is that there is a natural cause of low interest rates -- a high investment rate.

To sum up, there are two primary reasons that low interest rates stimulate economic growth:

  • Low interest rates increase the incentive for banks to lend money
  • An interest rate, like a price, is an economic signal, and a low interest rate signals that investors plan to spend their money in the future, not the present, telling entrepreneurs that they can produce a lot now and they will be able to sell it in the future.

3. Interest Rate Manipulation by the Fed

The Federal Reserve uses its money supply manipulation powers to increase the amount of currency in the banking system. While it is often said that the Fed "prints money," the reality is that most of the money that the Fed puts into the banking system is digital money in the form of zeros and ones in a computer. The Fed has a target interest rate called the Federal Funds Rate, which is supposed to be a safe interest rate that is low enough to stimulate growth but high enough to maintain the value of the dollar. The idea is that when the Fed adds currency to the economy, it will stimulate borrowing and lending, thus stimulating economic growth. This is the "boom" part of the boom-bust cycle.

The boom can last for some time. Interest rates were held extremely low during the majority of the 2000's until the economic collapse of 2008. However, eventually the natural interest rate will break through the Fed's manipulation. This is because money cannot be added to the economy forever. If money is constantly added, the currency will eventually be destroyed, as was seen in Wiemar Germany during the years between World War I and World War II.

At the end of the day, the natural cause of low interest rates, a high investment rate, never occurred. If there was no investment, that means that people never actually preferred future goods over present goods to the extent that entrepreneurs believed. All the signals being sent were false. Investments either cannot be sold, or were sold to people who could not in fact afford to maintain them. This distortion of the marketplace was commented on by Ludwig von Mises in On the Manipulation of Money and Credit:

  • "The ultimate cause, therefore, of the phenomenon of wave after wave of economic ups and downs is ideological in character. The cycles will not disappear so long as people believe that the rate of interest may be reduced, not through the accumulation of capital, but by banking policy."[7]

This also means that a lot of money was lent to people who cannot pay it back. The result is an economic collapse -- the "bust."

C. Boom, Bust, and Aftermath

As noted above, interest rate manipulation by the Fed is a key cause of the disastrous boom-bust cycle so often endured by the US economy. An understanding the economic and political ramifications of this cycle is essential to a strong argument for the abolition of the Federal Reserve.

While the impact of the boom and bust certainly are felt throughout the economy, certain areas are hurt more than others.

1. The Banking System

The banking system is the mechanism through which the Federal Reserve's artificial interest rates "infect" the wider economy. This is due to fractional reserve banking, a practice by which banks lend out money that they themselves have borrowed. While libertarians disagree on the ethical and practical merits of fractional reserve banking, almost all libertarians agree that fractional reserve banking is disastrous when it is based in currency that has been acquired via artificial interest rate manipulation by the Fed. Not only does the money being lent have no intrinsic worth, as it was simply created by the Fed, but it is being simultaneously borrowed by multiple individuals. Worthless money being used for production on multiple fronts is a recipe for disaster.

Also, when firms that have borrowed money for productive endeavors realize that there was no real investment to lower interest rates, and thus no real demand for their products, they cannot pay back the banks from which they have borrowed money. This not only spells disaster for the bank that lent the money, but it also causes a chain reaction throughout the banking sector, as banks have often borrowed from other banks via fractional reserve banking. This is one of the reasons that so many banks wanted bailouts in the days after the 2008 economic collapse -- they had lent out funds that no one could pay back.

2. Capital Intensive Industries

Capital intensive industries also bear a large portion of the "bust." This is because of the nature of the boom that accompanies low interest rates -- entrepreneurs are planning to sell items in the future. This stimulates production, but production for future goods involve more capital-intensive industry than production for present or near-present goods. Thus, during the boom the capital structure is lengthened, as all the firms involved expect to get a return on their investments in capital in the future.

One of the most basic forms of capital is labor, or potential labor. One market that deals a great deal in both labor capital and material capital is the construction industry. So, it should be no surprise that the construction industry took an extremely hard hit during the 2008 collapse. In California, the number of construction workers employed went from 930,000 in 2006 to 630,000 in 2009.[8] The impact was not just felt in the United States, as in the UK 829 construction firms became insolvent in the first three months of 2009, along with 734 manufacturing firms.[9]

V. Alternatives to the Federal Reserve

While even many advocates of the Fed admit that it is problematic, a common argument in its defense is that it is a necessary evil. The argument is made that without the Fed, the economy would become unstable, and the private banking sector would prey on unwitting consumers. However, there are several alternatives to the Federal Reserve that have been proposed.

A. Free market banking and competition in currency

The Federal Reserve currently has a monopoly on currency. It is often argued that it is not necessarily government-manufactured fiat currency that is the core of the problem with central banks, but rather the fact that central banks are given a monopoly on producing currency. The reason for such a monopoly is fairly obvious -- fiat currency would not be able to compete in a free market of currency, as it would be up against specie with intrinsic value like gold.

However, advocates of competition in currency do not advocate for the absolute adoption of a gold standard. They rather simply argue that currency should be subjected to the same laws of competition as everything else in the marketplace. F.A. Hayek made such a case in Choice in Currency. He wrote:
  • "But why should we not let people choose freely what money they want to use? I have no objection to governments issuing money, but I believe their claim to a monopoly, or their power to limit the kinds of money in which contracts may be concluded within their territory, or to determine the rates at which monies can be exchanged, to be wholly harmful."

B. The Gold Standard

  1. ^ "The Federal Reserve System Purposes and Functions." Board of Governors of the Federal Reserve System. Web. 12 Apr. 2010. <http://www.federalreserve.gov/pf/pf.htm>.
  2. ^ "Update - HR 1207 - 319 Co-sponsors! | Ron Paul 2012 | Campaign for Liberty at the Daily Paul." Ron Paul 2012 | Campaign for Liberty at the Daily Paul | Blog. Web. 11 Apr. 2010. <http://dailypaul.com/node/90775>.
  3. ^ "Jefferson on Politics & Government: Money & Banking." University of Virginia Library. Web. 11 Apr. 2010. <http://etext.virginia.edu/jefferson/quotations/jeff1325.htm>.
  4. ^ Marx, Karl. "II -- Proletarians and Communists." Manifesto of the Communist Party. Australian National University. Web. <http://www.anu.edu.au/polsci/marx/classics/manifesto.html>.
  5. ^ Griffin, G. Edward. The Creature from Jekyll Island: A Second Look at the Federal Reserve. Westlake Village, Calif.: American Media, 2002. Print.
  6. ^ Chapter 6 "Production: The Rate of Interest and Its Determination" in Rothbard, M. N. (2004), Man, Economy, and State, A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, pp. 367.
  7. ^ Von, Mises Ludwig. On the Manipulation of Money and Credit. Ed. Percy L. Greaves. Dobbs Ferry, N.Y.: Free Market, 1978. Print.
  8. ^
    "More California Jobless Now 'Long-Term' Unemployed - Cbs5.com."CBS 5 - San Francisco Bay Area's Source for News, Weather, Traffic and Sports. Web. 12 Apr. 2010. <http://cbs5.com/business/unemployment.long.term.2.1155252.html>.
  9. ^
    "Construction Industry Hit Hard by Recession - Colliers CRE Property News." Colliers CRE Home - Leading UK Property Consultancy, Find Property for Sale, Offices to Let, Commercial Services for Hotels, Industrial, Leisure, Licensed, Residential and Retail Property. Web. 12 Apr. 2010. <http://www.collierscre.com/newsEvents/property_development_investment_news_3139313430383032.aspx>.