The Federal Reserve System, Its History and Function, Part 2

This is the concluding part of a special post on the U.S. Federal Reserve System. It is written in response to the rise of the Occupy Wall Street movement. Part 1 was published on October 30. The next regularly scheduled reply on the crisis of the dollar system will be published on November 20.

Monetary policy under the New Deal

With the rise of Adolf Hitler to power in Germany in 1933, it was clear that a new European war was inevitable within a few years. Therefore, as soon as Roosevelt stabilized the price of gold—or more accurately the gold value of the dollar—in 1934, many wealthy Europeans, fearing that they could lose their gold due to the war and the revolutions that might result from the war, sold their gold hoards to the U.S. Treasury at the new official price of $35 an ounce. They reasoned that their money was much safer in the form of dollar deposits in the U.S. banking system than it was in the form of gold bars or coins in Europe.

Not all the gold that was flowing into the U.S. Treasury came from wealthy Europeans. A lot came out of gold mines as well. The collapse in commodity prices during the Depression and subsequent devaluations meant that, unlike the 1920s, commodity prices, when calculated in terms of gold, were now below their real values. This is shown by the record levels of gold production that occurred in the 1930s.

Therefore, the Roosevelt administration did not finance the New Deal by “running the printing presses.” The considerable expansion in the U.S. money supply reflected the growth in the quantity of gold in the United States, even if this gold was no longer circulated in the form of gold coin but stored instead in the vaults of the U.S. Treasury. Though prices rose in 1933-34 due to the dollar’s devaluation, thereafter prices stabilized at dollar levels that were still below the prices that prevailed during the 1920s.

These prices were even lower when calculated directly in gold. Therefore, despite the government deficit spending and the dire prophecies of right-wingers and Republicans that Roosevelt was bankrupting the United States, the U.S. was in reality awash in cash. This was in sharp contrast to the house of cards credit system that had marked the 1920s. The foundation for the post-World War II prosperity as well as the means to finance the war were being established not by the policies of the New Deal but by the effects of the Depression itself.

The artificial recession of 1937-38

What historians call the “Great Depression” consisted of not one but two separate recessions. One was the prolonged recession of 1929-33, which was unique in its combined length and severity. The other was the sharp but rather brief recession of 1937-38. While the recession of 1929-33 was a normal cyclical crisis of overproduction magnified by the effects of World War I and the other special factors explained in Part 1, the recession of 1937-38 can be traced to specific policies of the Roosevelt administration.

First, after Roosevelt’s reelection in 1936, the administration declared that the Depression was over, though the country was still suffering from double-digit unemployment. Roosevelt moved to wind up the WPA programs, where the federal government directly hired unemployed workers to carry out useful public works projects. Money had also begun flowing into the newly established Social Security Trust Fund but no payments were yet being made to beneficiaries. In effect, the Social Security Trust Fund was hoarding money.

Second, the Federal Reserve Board increased the reserve requirements of the commercial banks. The reserve requirements specify the amount of dollars kept in reserve to meet the withdrawal demands of bank depositors—either in the form of actual cash that banks keep on their premises or the banks’ deposits in their district Federal Reserve banks.

Finally, the U.S. Treasury was instructed to “sterilize” the gold that continued to flow into the United States. While foreigners could still sell gold at the price of $35 an ounce—as could U.S. mining companies that were mining and refining gold within the U.S.—the U.S. Treasury was instructed to borrow a dollar for every dollar in gold that flowed into its vaults and then hoard, not spend, the dollar.

Under the gold sterilization policy, the gold flowing into the U.S. Treasury no longer expanded the reserves of the commercial banking system. Instead, the U.S. Treasury buried the gold in the its vaults. (9)

Not surprisingly, these deflationary policies, as economists call them, caused a sudden decline in sales, inventories piled up, orders were suddenly canceled, industrial production plunged, and layoffs swept through the country. The administration soon reversed its deflationary polices and the recession promptly ended. But the whole recovery from the Depression was set back several years by this government-induced recession.

The result was that the Depression lingered on in the form of mass unemployment until the war economy of World War II replaced it. This created another dangerous myth, which says that while the New Deal failed to pull the economy out of the Depression, World War II did.

This implies that war can prevent Depression and ensure prosperity—a handy argument for the warmongers. But as we have seen, World War I, by driving commodity prices far above their real values, made the Great Depression of the 1930s possible in the first place.

Why did the Roosevelt administration follow policies that threw the U.S. economy into a violent if brief recession when the U.S. economy was still far from fully recovered from the Depression? The administration claimed that the huge amount of idle cash that was accumulating in the U.S. banking system could bring about a runaway economic boom that would end in an even worse Depression in the future.

But did it make sense to adopt such violently deflationary policies to restrain an economic boom that hadn’t even begun yet? Perhaps the real reason for Roosevelt’s deflationary policy in 1937-38 is to be found in the stormy rise of the U.S. union movement that occurred between 1934 and 1937. The widespread belief that the Roosevelt administration was “pro-labor,” as well as a wave of price increases tied to the devaluation of the U.S. dollar in 1933-34 that was lowering real wages of U.S. workers, helped fuel a mighty strike wave.

The largest strikes occurred in three cities: Toledo, Ohio; Minneapolis, Minnesota; and San Francisco, California. The Toledo strike played a crucial role in the rise of the United Autoworkers Union. A strike of truck drivers in Minneapolis transformed the weak Teamsters Union into the powerful union it became in subsequent years. In San Francisco, a full-scale general strike led to the rise of the International Longshore and Warehouse Union, which remains an important union today.

The new industrial unions broke with the old American Federation of Labor—AFL—and formed the Congress of Industrial Organizations—CIO. In 1936, the unionization movement gained further momentum with a wave of sit-down strikes in the automobile factories around Detroit, Michigan. The sit-down strikers demanded that auto bosses recognize the new United Auto Workers union. The current Occupy Wall Street movement is actually an echo of these sit-down strikes that occurred 75 years ago.

Unlike the American Federation of Labor, which organized workers along craft lines and was saturated with racism, the new industrial unions organized all workers in a given industry—unskilled, semiskilled and skilled alike. Though the CIO record on the race question was far from what it should have been, it was still a great improvement over the racist AFL.

It seemed as though nothing would stop this movement until all U.S. workers were organized—that is, until the recession of 1937-38. The sudden rise of unemployment that occurred in late 1937 and the first part of 1938 stopped the union organizing cold as workers once again were happy to have a job at all.

The U.S. union movement has yet to regain the momentum gained between 1934 and 1937. During the war economy of 1941-45 and then during the postwar booms, the number of factory and mine workers grew, and with the growth in the number of workers in already organized industries, union membership rose.

But very few new unions were organized, except in the government sector. Then, when much of U.S. industry collapsed starting in the early 1980s, these now stagnant unions were devastated. Today, the unions are weaker than they were when Franklin Roosevelt was elected president. Capital, little checked by the power of organized labor, has been able to go on a rampage that the Occupy Wall Street movement is now trying to stop.

Open market operations

During the New Deal era, the role of the Federal Reserve System was actually much reduced. Banks were awash in excess reserves and there was a relatively small quantity of commercial paper being created in the now cash-rich but still depressed economy. Therefore, re-discounting, the main tool of the Federal Reserve in its early days, was of little importance.

During the powerful capitalist economic boom—or more technically, a series of booms—that set in after 1945, the super-liquid position of the U.S. economy was gradually run down. The role of the Federal Reserve System began to grow once again.

Re-discounting, however, played a relatively small role in the Federal Reserve System operations after World War II. Instead what are called “open market operations” came to the fore. In open market operations, the Federal Reserve System—or other central banks, like the Bank of England—buys and sells government securities—usually short-term securities—for its own account.

Before 1932, as we have seen, the Federal Reserve System was not allowed to use government securities as collateral for its note and deposit liabilities. It therefore could only buy government securities for its own account if it had extra gold, or what the bankers called “free gold,” to back any additional deposit or note liabilities that were created when it bought government securities. Then during the New Deal era, the huge flow of gold into the U.S. Treasury fueled as we have seen a huge increase of U.S. bank reserves. Under these conditions, there was little role for open market operations.

Open Market Committee

Open market operations are undertaken by the Federal Reserve Bank of New York at the behest of the powerful Open Market Committee. Today, the Open Market Committee consists of all seven members (there are now, however, only five; two seats are  vacant) of the Board of Governors and on a rotating basis five of the 12 presidents of the commercial bank-owned Federal Reserve banks that make up the Federal Reserve System.

Traditionally, the committee has concentrated on a target for the federal funds rate. Contrary to what many believe, the federal funds rate is not the rate at which the Federal Reserve System loans money. The federal funds rate is rather the interest that commercial banks charge other commercial banks when they make overnight loans to one another. One bank might be short of reserves (cash on hand plus its account with its district Federal Reserve bank) while another commercial bank might have “free reserves” on which it wants to earn interest.

The Open Market Committee, though it has no power to set this rate as it is determined by the commercial banks, can manipulate the rate by varying the amount of bank reserves.

Let’s assume that the Federal Reserve System wants to encourage a rise in the pace of business. The Open Market Committee will set a new lower target for the federal funds rate. The Federal Reserve Bank of New York will increase the quantity of short-term government securities it holds in its portfolio. It pays for the new securities through promises to pay in legal tender Federal Reserve Notes, that is by crediting the Federal Reserve accounts of the commercial banks involved in the transactions, raising their reserves.

Since the commercial banks now have more reserves, they are less likely to be short of reserves and more likely to have excess reserves that they will lend to other commercial banks. The fed funds rate falls. The commercial banks will then generally lower their own prime rate (the rate they charge on loans to their most creditworthy customers), and interest rates will tend to fall across the board.

Or perhaps the Open Market Committee is concerned about an inflationary boom in the economy. It will wish to restrain the business boom before it ends in a bust. The Federal Reserve Bank of New York will then sell securities it holds in its own portfolio.

This operation transfers some of the reserves held by the commercial banks to the Federal Reserve System, canceling these reserves. More commercial banks find themselves short of reserves and seek to borrow reserves from other commercial banks, while fewer commercial banks have excess reserves they wish to loan out. The federal funds rate now rises. Interest rates rise across the economy, loans become harder to get, and sooner or later the pace of business slows and unemployment rises.

Another tool the Federal Reserve System uses to manipulate the federal funds rate are repurchase agreements. The New York Fed will borrow money from the commercial banks using short-term government securities as collateral. A repurchase agreement—repo for short—is a way of quickly removing reserves from the banking system if the federal fund rates falls below the target set by the Open Market Committee. There are also reverse repurchase agreements, where it is the Federal Reserve Bank of New York that does the lending rather than the borrowing. This is a quick way of adding reserves to the banking system if the fed funds rate rises above the target set by the Open Market Committee.

Economic crisis of the 1970s, the end of the gold standard, and inflation

During the 1930s, the world, especially the United States, was awash with gold. This made it possible to finance the most destructive war in history, World War II, and then finance the huge capitalist economic expansion that followed the war.

But by the end of the 1960s, the world was once again facing a gold shortage. This was reflected in the rise in commodity prices, first during World War II and then during the Korean and Vietnam wars, as well as the economic booms that followed  World War II. The rise of commodity prices in terms of gold had reduced the purchasing power of gold and made it less profitable to mine and refine gold.

After the mid-1960s, gold production rose very little, and starting around 1970 it began to fall. For the first time since the outbreak of the Depression 40 years earlier, the world was facing a gold shortage. Once again the production of commodities had exceeded the capacity of the market to absorb the commodities at profitable prices.

Traditionally, this would have meant a severe shortage of credit, falling prices and sharply rising unemployment—a deeper than average economic recession that would restore the balance between the ability of the capitalist industry to expand the production of commodities and the ability of the market to absorb them.

Keynesian economics and its fatal flaw

But this time, the governments and central banks of the capitalist countries were determined to avoid a really deep recession. And they thought they knew how to do it. Instead of basing the currency on gold, why not simply create whatever amount of currency was necessary to keep the economy growing? Not only had generations of monetary reformers advocated this, as we saw above, but such a “managed currency” system had been strongly supported by John Maynard Keynes.

If the banks or corporations insisted on hoarding the newly created money, then the federal government could borrow and spend it itself, whipping up whatever amount of “effective monetary demand” was needed to keep the economy growing. These polices are known as Keynesian economics after their best-known advocate, the English economist John Maynard Keynes. But there is a fatal flaw in Keynesian economics that we have already explored.

As already explained, capitalist production is carried out privately by capitalists for their own account. With no coordination under a central plan, capitalist production and the allocation of society’s labor power is regulated—very imperfectly—via price and profit fluctuations in the market. Because of this, a special commodity requiring labor to produce—not paper money—is necessary to measure the labor value of all other commodities in terms of its own use value. (10)

What Keynes called a “managed currency” backed by the wealth of the nation as a whole requires a system of planned socialist production. But Keynes was a supporter of capitalism who strongly opposed socialism. You cannot create a “managed currency” independent of gold on the basis of a capitalist economy. For this reason, Keynesian economics is doomed to fail.

Originally as mentioned in Part 1, the Federal Reserve System was required to hold 40 cents in gold for every dollar bill it issued. Under the New Deal, the Federal Reserve banks were required to exchange gold for gold certificates that still represented actual gold deposited in the U.S. Treasury. This reform simply meant that some of the central banking functions were being shifted from the Federal Reserve System to the Treasury. Back then, there was no shortage of gold.

Starting in 1945 when gold was still plentiful, the gold backing behind Federal Reserve Notes was reduced to only 25 percent. But this had little effect at the time, since the U.S. was still awash with gold. Then in 1969, with a developing gold shortage and gold flowing out of the the U.S. Treasury, the requirement that the combined Treasury and Federal Reserve central banking system hold a certain amount of gold behind each dollar it created was dropped altogether.

The gold pool

Under the Bretton Woods agreement of 1944, the U.S. promised to redeem U.S. dollars at the rate of $35 an ounce as established by the Roosevelt administration in 1934, at the demand of either foreign governments or central banks. This requirement put considerable pressure on the U.S. Treasury to keep the price of gold on the international market from rising much above $35 an ounce.

If gold rose above that level, the central banks and governments of other countries would be tempted to cash in the dollars they were holding for gold. They could then sell this gold on the open market at the higher dollar gold price, increasing the number of dollars they had in their reserves or simply holding on to the gold, which they might see as more solid backing for their own currencies than depreciating dollars.

In the early post-World War II years, gold was still plentiful relative to world commodity production, trade and prices. With most of the gold in the hands of the U.S. Treasury, the money-short countries of Western Europe were quite happy holding dollars—or rather short-term dollar-denominated U.S. government securities that, unlike gold, yielded interest.

However, in the wake of a recession that occurred in 1957-58, there was growing expectation that the U.S. government would again devalue the dollar—raise the dollar price of gold. The Western European countries, especially France, began to cash in some of their dollars for gold.

In order to stop this gold drain from the U.S. Treasury, an agreement was reached in 1962 between the United States and Western European countries establishing a gold fund, or gold pool. This pool became a crucial part of the central banking system during the boom years of the 1960s. The pool would sell gold in the open market if the dollar price rose above $35 and buy it back if it fell below $35. For a few years this worked.

But then as world commodity prices began to rise due to the combined effects of the Vietnam War and the great economic boom of the 1960s, gold production began to level off. The slowdown in the growth of the global quantity of gold caused the demand for it to soar.

Gold pool collapses

The final straw that broke the back of the gold pool was the Tet offensive by the Vietnamese resistance fighters in January 1968. The markets feared that the U.S. would greatly increase the number of U.S. troops and would finance this with newly printed dollars. In March 1968, what amounted to a bank run developed against the gold pool. Capitalists moved to purchase gold at $35 before what was seen as the inevitable rise in the dollar price of gold occurred. In some ways, this was a little like what happened in 1933 between the time Roosevelt was elected and when he took office. The expectation of a rise in the dollar price of gold led to a run.

Within weeks, the gold pool was forced to suspend the sale of gold and was wound up much like a failed bank. An important part of the central banking system supporting the value of the U.S. dollar had failed.

With the gold pool gone, a so-called two-tier gold price was established. The U.S. Treasury still promised to redeem its dollars at the rate of one ounce of gold for $35 presented to it by governments and central banks, but it gave up the attempt to hold the price of gold on the open market at $35.

At the time, this was presented by the media and economists as the final steps towards the “demonetization of gold.” Most professional economists believed that gold was money because governments and central banks held it in reserve and treated it as money. The professional economists who held this belief included not only the followers of John Maynard Keynes but also the anti-Keynesian Professor Milton Friedman of the University of Chicago, the darling of the political right. As the governments moved to “demonetize” gold, these economists assured us the dollar price of gold would drop, since gold has relatively few uses besides its role as money.

But our economists—Keynesian and Friedman and his supporters alike—got it, as they often do, exactly backwards. Governments and central banks hold gold reserves because gold is money and not the other way around. Despite the predictions of the economists that the price of gold would fall as it became “demonetized,” with some fluctuations, the details of which we do not have room to go into here, the dollar price of gold soared on the open market.

When it rose above $40 in 1971, the French government under Charles De Gaulle began to present dollars for payment at the U.S. Treasury’s “gold window.” In August 1971, the then U.S. president, Richard Nixon, announced that the U.S. was defaulting—of course, they used different words—on its promise to redeem dollars for gold on the demand of the foreign central banks and governments.

As the dollar price of gold soared during the 1970s, the price of oil and other primary commodities rose as well. Increasingly, these price increases worked their way into prices you pay at the store—retail prices. These high dollar prices were caused not by too many dollars chasing to few commodities, still less did they reflect high wages—real wages were declining as money wages rose less than the cost of living.

Instead, the high prices reflected the growing depreciation of the paper dollar against real money—gold. As each dollar represented less gold—hard cash—on the open market, prices in terms of dollars rose, even as the prices of commodities in terms of gold actually dropped sharply.

Since the purchasing power of the mass of the people declined as dollar prices rose, economic growth stagnated. Indeed, there were not one but three recessions during the stagflation. (11) And two of these were very severe. One, called at the time the “Great Recession,” occurred in 1973-75. The other recession, sometimes called the “Volcker shock,” unfolded between 1979 and 1982.

By the end of 1982, even the official unemployment statistics in the U.S. had reached Depression-like double digits. Though some banks failed, there were no bank runs. But inflation did erode the value of bank accounts. Is it any better to lose 50 percent of the purchasing power of a bank account because prices have doubled as opposed to getting say 80 percent with some delay after the bank is liquidated? (12)

Sky-high interest rates plant the seeds of today’s crisis

During recessions, the rate of interest, including rates on mortgages, falls. Before World War II, the cost of living would also fall, even during mild recessions. To some extent, the fall in consumer prices cushioned the effects of unemployment or reduced hours of work. Indeed, those who were lucky enough to work as many hours during a recession as they did during prosperity saw a rise in their standard of living as long as cuts in their money wages were less than the drop in the cost of living.

But during the “stagflation” crisis of the 1970s, the cost of living in dollar terms rose sharply. The living standards of people that depended on wages and salaries fell across the board. Not only commodity prices rose but so did interest rates. The big capitalists were losing confidence in the future value of the dollar and other paper currencies tied to the dollar. In order to protect themselves from the expected further devaluation of the dollar—a further decline in the quantity of gold that each dollar represented in circulation—they demanded higher and higher interest rates. The more dollars the Federal Reserve System created, the higher interest rates rose rather than the reverse.

The only way to halt this rise in interest rates was to end the depreciation of the dollar. But halting the depreciation of the dollar required a further rise in interest rates to restore the confidence of the capitalists in the currency, followed by a sharp recession and rapid rise in unemployment. Only once the confidence of the capitalists in the currency was restored would interest rates finally fall.

Both the leaders of the U.S. government and the Federal Reserve tried to find a way out of the crisis without drastically raising interest rates even further. After all, wasn’t one of the reasons given for ending the gold standard to allow the central banks to lower interest rates so they could fight recessions without having to worry about protecting their gold reserves?

But the highest interest rates ever were recorded not during the years of the gold standard but under the system of paper money. In the end, neither the Federal Reserve System, the U.S. Treasury, or the two operating together could escape the economic laws that govern the capitalist system.

Finally, starting in September 1979 the growing crisis reached a climax. While there were no runs against individual banks, a huge run developed against the entire system of paper money centered on the U.S. dollar. The dollar price of gold, which actually measures not the value of gold but rather the gold value of the dollar, soared from under $300 at times in August 1979 to $875 at one point in January 1980. (For a more detailed explanation, read this post.)

Within less than six months, the dollar had lost more than half its gold value! This run against the dollar and the other paper currencies linked to it brought the world capitalist economy to the brink of collapse. The Federal Reserve System was forced to move decisively to halt the run against the dollar and other paper currencies.

Volcker shock

In order to halt this run, the Federal Reserve System, then headed by Paul Volcker, announced that it would start targeting the quantity of money rather than  the federal funds rate. In effect, they were saying that due to the run against the dollar, we have lost all control of interest rates. Instead, we will allow interest rates to soar to whatever level is necessary to halt the run against the dollar-centered international monetary system.

The attempt to repeal the laws that govern that capitalist system by “demonetizing gold” had ended in complete failure. At the height of this crisis, even the U.S. government had to pay about 15 percent a year to borrow money. What this episode shows is that contrary to what your high school or college economic textbooks might say, a central bank cannot in the end determine the rate of interest. If the central bank abuses its power to issue paper money not backed by gold, it will lose control of the money market and interest rates will then soar to incredible heights making a severe economic slump inevitable.

This lesson is lost on those well-meaning “progressive” but still pro-capitalist economists such as Paul Krugman and Dean Baker. These economists believe that the central bank can always lower interest rates by printing more money until “full employment” is achieved—perhaps with the help of deficit spending by the government as well—while allowing the 1 percent to keep their wealth. These economists believe that if we have mass unemployment today it is not because of the nature of the capitalist system but because of false policies that are being followed by the government or the Federal Reserve System, or both.

If the Fed really had the power to end unemployment, it would be important to demand that they follow policies that would achieve this even if this meant giving capitalism a new lease on life. But in reality, neither the Federal Reserve System nor the broader central banking system that the Federal Reserve is a part of has the power to do this.

If the Federal Reserve attempted to do this, the result could be a new run against the dollar and its satellite paper currencies even worse than 1979-80, a steep fall in the real wages of the workers ending in a sharp rise of interest rates, followed by levels of unemployment that might well exceed the levels of the 1930s Depression. Indeed, the attempt by the Federal Reserve Board to limit unemployment in the 1970s caused tremendous harm to the U.S. economy that has led to even higher unemployment in the long run.

Long-term damage to the economy by attempts to suppress capitalism’s economic laws without abolishing capitalism

Normally at the start of an economic recovery, profit rates are high and interest rates are very low. This was the case right after World War II. The combination of high profits and low interest rates encourages the capitalists to act as industrial and commercial capitalists rather than money or financial capitalists. Under these circumstances, little money can be made by loaning money, but there are many opportunities to make high profits by producing and selling actual commodities rather than so-called “financial products.”

But though profits were very high at the beginning of the recovery of the 1980s, so were interest rates. This encouraged the large corporations that function as collective capitalists to loan money to consumers, especially against mortgages. Instead of moving to build new and more productive factories and expand industrial production like they had done after the Depression of the 1930s and earlier economic crises, corporate America began dismantling the mighty American industrial machine that had been built up by the labor of generations of workers.

Instead, industrial production was increasingly moved to countries where wages were far lower and profits consequently far higher. This has acquired a name you might have heard of—”de-industrialization.” This way there would be plenty of profit to go around for both Wall Street and the local capitalists.

The losers would be workers in both the United States, Europe, Japan, and many Asian and other countries where peasants were being driven from the land into factories that paid only pennies per hour. Many of the workers whose labor has been so brutally exploited are children. What is called the race to the bottom was under way.

Never before had the world’s workers been as exploited as they were during what economists have called “the Great Moderation,” which lasted from 1983 to 2007. U.S. debt, especially debts owed by homeowners and other consumers, soared.

Traditionally, due to its highly developed industry combined with a very productive agriculture and rich mineral and hydrocarbon deposits, the U.S. ran a surplus in its balance of trade. As the U.S. sold commodities abroad, money flowed into the U.S. and the home market expanded. But by the end of the 1960s, the trade surplus had largely disappeared. After several decades of world wars and the Depression, Western Europe and Japan were able to rapidly expand their industry. By the 1970s, the U.S. was running a small deficit but still remained the world’s largest creditor nation.

Running a modest trade deficit after years of trade surpluses was not itself a big problem. But with the de-industrialization that followed the 1970s inflation, the U.S. turned to commodities produced abroad to maintain something like its traditional standard of living. The U.S. trade balance swung into a long-term deficit. Over time with some ups and downs these deficits have gotten worse.

Within a few years, the U.S. creditor balance was wiped out and the U.S. emerged as the world’s leading debtor. Since the central banking system—the U.S. Treasury plus the Federal Reserve System—issues the world’s main reserve currency, the debtor position of the U.S. has caused great instability for the entire global financial system.

Debt explosion

As U.S. and European capitalists increasingly converted themselves into money lenders, interest rates began to fall. But they started falling from such a high level, it took many years before they fell to historically normal levels. During the “Great Moderation,” instead of a healthy recovery powered by industrial investment, we had a tremendous explosion in debt. This process has come to be called “financialization,” which was simply the flip side of “de-industrialization.”

During the “de-industrialization-financialization” years, factory jobs in the U.S. and other older industrial countries that were unionized and paid relatively good wages steadily declined and Wall Street came to dominate the U.S. economy as never before. Workers who in earlier generations would have gotten good union jobs have became dependent on low-paying service jobs, assuming that they could find employment at all.

But what turned out to be bad for “Main Street” was great for Wall Street. As interest rates began their generation-long decline from the heights reached during the Volcker shock, Wall Street stocks and bonds enjoyed the greatest bull market in their history. The largely wealthy individuals who write for the media saw their own stock and bond portfolios soar in value.

They and the professional economists who also as a rule own many stocks and bonds really believed that the U.S. was experiencing the greatest prosperity in its history. Turn on a smart phone or a laptop or tablet computer or simply walk along a street and the latest stock quotations from Wall Street are displayed. What the pundits and the economists wonder is, why do the mass of the American people fail to realize how great the U.S. economy is doing?

But it turned out the “ordinary people” and not media pundits and the professional economists were right. During the prosperity years of 1983-2007, the U.S. economy was rotting away at its productive heart.

Ultimately, it is the growth of production in industry, mining and agriculture that determines the health of an economy and not the trading volume and stock market prices on Wall Street. It is the workers in factories, mines and agriculture—assisted by the scientists and technologists that create the scientific and technological basis of modern production—that make today’s workers far more productive than their ancestors, that create wealth, and not the investment bankers on Wall Street.

The Federal Reserve, gold and the end of ‘quantitative easing’

The credit bubble was at its worst in the residential construction industry. As the bubble approached its peak around the middle of the last decade, mortgage bankers employed crooked salesmen who offered mortgages to working people even if they didn’t have the income to meet the monthly mortgage payments, let alone pay them off.

These mortgages required little or no down payment. Why not buy a home, these salesmen explained, since you will be paying in monthly mortgage payments no more than you are already paying in rent. Since real estate prices always rise, the salesman claimed, not only would the borrowers be able to easily afford the mortgage payments but they would quickly be able to build a large equity in their homes and realize a large “capital gain” when and if they sold them.

One of the most basic material needs after food—the need for shelter from the elements—was being treated as though it was a stock market. What the salesmen did not explain was that the low mortgage payments were just the initial “teaser” rates and that mortgage rates would rise steeply after a year or so. The mortgage bankers knew full well that many of the new “homeowners” would not be able to meet their mortgages payment and would inevitably default.

But by that time, the mortgage bankers figured they would have sold off their mortgages to Wall Street investments banks. These banks then used these mortgages to create so-called mortgaged-backed securities that could be palmed off on pension funds and other naive investors. Today, many of these toxic mortgage-backed securities are owned by the Federal Reserve System—thanks to ‘quantitative easing’—and are listed as collateral behind the U.S. dollar.

The resulting inflation in food and energy prices was a fine way of passing the weight of the mortgage debacle onto small savers whose savings are denominated in terms of the U.S. dollar or its satellite currencies—the rest of the world’s paper currencies—and the working class in general.

As the housing boom continued through the middle of the past decade, neither Democrats nor Republicans did anything to stop the huge swindle. If they did, the “boom” would end and an economic downturn would begin. So neither they nor Fed chief Allan Greenspan or his successor, Ben Bernanke, did anything. Instead, they issued reassuring statements boasting about how wonderfully the U.S. economy was doing.

When the first signs appeared in 2006 that the housing bubble was about to burst, Bernanke claimed that the problem would be “contained.” In August 2007, however, it became clear the problem was “not contained” and the credit market began to freeze up. Most capitalists and stock market speculators assumed that the Federal Reserve System would simply do what it did when the U.S. stock had crashed in 1987 and again when the giant Long-Term Capital Management hedge fund collapsed in 1998. Then the Fed had simply created additional dollars, and credit markets quickly thawed out. But this time the crisis was much more serious.

The Fed had to worry not only about the credit system seizing up and in the worst case massive runs against the banks, but they also had to worry about a new run on the dollar such as last occurred in 1979-80. A run on the dollar would have even more disastrous consequences today than it had in 1979-80 when the U.S. was still a creditor nation. Indeed, under modern conditions a major economic crisis does not occur until the central bankers are faced with a choice between a freezing up of the credit system on one hand and a run against the currency that would wipe out the entire basis of credit on the other.

The Federal Reserve System faced precisely this choice in 2007. It could flood the banking system with newly created paper money in a bid to break the developing credit crisis. But this would almost certainly have led to a 1979-80 type run against the dollar. Or it could allow a massive credit crisis to develop and then flood the banking system with a huge amount of cash in order to prevent the credit crisis from degenerating into a bank run that would dwarf that of 1931-33.

Under Bernanke’s leadership, the Fed followed the second course. The result has been mass unemployment, a huge centralization of capital in the banking system, waves of home foreclosures, and countless small business failures. The banks were bailed out and the people were sold out. But considering the cards it had to play, this was really the best that the Fed could do under the capitalist system that the Fed serves.

An example from history—what happened when ‘the Fed’ was really ended

What would have happened if we had followed Ron Paul’s advice and “ended the Fed”? Actually, this was tried once before in the 1830s. In 1836, the pro-slavery Democratic President Andrew Jackson succeeded in ending “the Fed” of the day—the Second Bank of the United States. The era of free banking began. What happened?

The commercial banks were free to issue banknotes without any check whatsoever. Within a year, a terrible economic crash hit the United States and spread around the world. Banks failed in droves and their banknotes became worthless. It was one of the worse economic crises in American history aside from the Great Depression. Among the international consequences were that a couple a young German intellectuals named Karl Marx and Frederick Engels became radicalized.

The depression that started with the panic of 1837 lingered into the early 1840s. Still, this early capitalist crisis was a storm in a teacup compared to what would occur if we “ended the Fed” under today’s conditions.

The next time you hear a Ron Paul supporter rant about “ending the Fed” just ask him or her about the panic of 1837. If the Paul supporter has never heard of this crisis, refer him or her to any high school or college level American history book that covers that era.

How do we get out of the current crisis?

If “ending the Fed” would only bring on a complete disaster, how can we get out of the current crisis?

Different schools of economists advocate different remedies. One school, the right-wing conservatives—also called neo-liberals, including Congressman Paul—believe that wages should be slashed, Social Security and unemployment insurance should be cut and ideally abolished altogether. In Marxist terms, they want to increase the rate of surplus value—the part of the workday that the workers work for the bosses rather than for themselves.

Once the rate of exploitation has increased sufficiently, these economists explain, business investment will rise and prosperity and full employment will be achieved.

The other school, associated with followers of Keynes, agrees with the right-wing economists that the key to restoring prosperity is to increase the profits of the capitalists, especially the uppermost 1 percent.

But they believe that the way to do this is to increase the purchasing power of the 99 percent by expanding the money supply and having the government further expand its already huge deficit spending. Eventually, enough demand will be created, they claim, to raise the rate of profit for the big capitalists—the 1 percent—to such an extent that they will finally increase their investment leading to full employment and prosperity.

Since the Keynesian economists, even the most left wing and progressive among them, are reconciled to the continued domination of the upper 1 percent, at least for the foreseeable future, they believe that at the least the more enlightened section of the 1 percent can be won to a program of increasing “effective demand” in order to increase their profits, thus reconciling the interests of the 1 percent with the interests of the 99 percent.

Though they differ in their means, both schools of economists believe the key to restoring economic prosperity and full employment is to increase the profits of the 1 percent, though they they differ on how to do this.

Marxists take a different approach. We believe that everybody who is able to work must indeed work and in return for their labor receive a decent wage. We also believe the right of people to shelter is more important than the profits of the banks.

If the capitalist employers refuse to employ the unemployed, it is they who must step aside and yield the ownership and management of the means of production to those who produced them in the first place, the workers. This does not mean that small businesspeople and farmers who run their businesses and farms with their own labor should have their businesses taken over by the government. On the contrary, the right to operate their farms and small businesses with their own labor as long as they wish must be defended.

Today, many small businesspeople are losing their businesses as the bankers force them into bankruptcy just like people are being driven out of their homes when they cannot meet their mortgage payments. This must stop. Any move on the part of small businesspeople and farmers toward a more cooperative mode should be up to them, though a government of the workers would be willing to help out with this if it were requested to do so.

But in order to free them from the tyranny of the 1 percent, the 99 percent need a leader. The only possible leader is the class that earns its income from wage labor. This class must form its own political party and, in the words of the “Communist Manifesto,” win the battle for democracy—and end forever the tyrannical rule of the upper 1 percent of the population.

The alternative is the periodic return of crises of overproduction, with the crises growing worse over time; the continued centralization of capital into fewer and fewer hands; larger and more powerful banks; and the continued growth of a central banking system that will be less and less able to control these worsening crises despite its best efforts. This is really no alternative at all.


9 How do we know that the 1937-38 downturn was a government-caused recession and not caused by a downturn in the capitalist business cycle like most recessions are? First, cyclical recession are normally preceded by a flow of gold out of the central banking system—or U.S. Treasury—not into it. Under today’s system of paper money not convertible into gold, this takes the form of sharp rises in the dollar price of gold. People become obsessed with owning gold. Just the opposite was occurring in 1937-38, however. There were also no bank runs or any other type of banking crisis.

In addition, we can trace the causes of the recession to particular government policies. As soon as these policies were reversed, the recession ended. This is not what occurs in real cyclical crises of overproduction.

10 This is best explained by Karl Marx in the first three chapters of his epoch-making book “Capital.”

11 I arrive at a total of three—1969-70, 1973-75 and 1979-82—by treating the entire period of 1979-82 as a single recession. If we count the sharp decline of industrial production that occurred in early 1980 under President Carter’s “credit controls” as one recession and the other, more prolonged decline of industrial production that started in late 1981 and continued until the end of 1982 as a second recession, we would not have three recessions over this period but four.

12 In the days before government-backed deposit insurance, when a bank ran out of cash, payments on its deposits would be suspended. Its assets—loans and securities—would then be sold to other banks and the cash that was raised would be used to repay creditors of the bank including its depositors. The cash though it probably would not be sufficient to cover the entire deposit would pay off part of it—for example, 80 percent.

The depositor would then lose $20 on a $100 deposit plus the interest that would have been earned on the $100 if the bank had not failed. However, since bank runs were accompanied by falling prices, the actual loss in purchasing power would be reduced by the extent of the fall in prices.


2 thoughts on “The Federal Reserve System, Its History and Function, Part 2

  1. As usual a very good analysis.
    Unfortunately, I think your Marxist remedy isn’t radical enough.
    A revolution in productive relations means that no one will be selling their labour so there will be no wage.
    Furthermore, all the means of production will be under direct democractic control – i.e. no small businessmen & no market.
    Your refernce to a political party suggests that the state gets taken over by the workers.
    The Leninist two stage approach of workers state, whereby a vanguard lead the workers who impose their will on the 1%, which can be trusted to transform itself into communist direct democracy & the abolition of political parties at some future, undetermined date.
    The 20th century experience has taught us differently.
    Although I accept that material conditions largely explain the why we had one-party dictatorships, the organisational approach that postpones equality in decision-making, lessens the actual likelihood of achieving quality in decision-making.
    In otherwords, Leninist parties inadvertently become an obstacle to communism.
    Although today’s occupy movement are theorectically lacking in their understanding of capitalism & the need for communism, they are actually putting into practice the key point of communism – equality in decision-making.
    People want participation.
    Give it to them & they will find their way.
    Do not ask them to follow a party who follow a central committee.

  2. ,,A revolution in productive relations means that no one will be selling their labour so there will be no wage.”
    I agree with you Duvinrouge! It is not logic the workers to work still fr wages under socialism when then the property will belong to all workers.

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