[NOTE: My goal for this essay was to keep it short and easy to understand, while linking it to current events. Although I sacrificed some accuracy and precision in places, I think it works okay.]
THE MONETARY MONOPOLY
Although legislation exists in most of the developed world to prevent the formation of monopolies and cartels, one product where monopoly is not only tolerated but strictly enforced is the supply of money. In the United States, the Federal Reserve has sole responsibility for maintaining and modifying the stock of U.S. Dollars, while legislation suppresses the emergence of competition. However, at the beginning of the Civil War, the Federal Reserve was yet to be established and the money stock of the United States was provided by private banks. The story of how the United States’ monetary order changed from a competitive market to a government monopoly is too long to reproduce here in full, but its consequences should not be misunderstood. Despite often claiming the issuance of money a prerogative of government, proper management of the money supply has long eluded public officials. Whether the Federal Reserve creates too much money or too little, the general public usually has few options but to accept what they are given, and the effects have been injurious to the welfare of American citizens.
Since modern monetary monopolies create money through the banking system, such consequences are felt most acutely there. Although banking systems normally coordinate the spending plans of savers and borrowers, when the money supply is under the arbitrary control of a monopoly this function is regularly perverted.
Although we call money placed in a bank account a “deposit,” it is actually a kind of loan to the bank. The term “deposit” is a hangover from a time when banks operated like warehouses and money was stored until claimed by a depositor. When someone “deposits” into an account today, they are relinquishing ownership of the currency in exchange for bank IOUs, so a bank account is not a record of how much money a customer has “in the bank,” but a record of the bank’s debt to a customer. Since bank customers do not frequently withdraw all of their deposits, a bank can operate successfully while holding only a fraction of total deposits on hand. For example, if customers only withdraw 5 percent of their deposits on average, then a bank can operate comfortably while holding only 10 percent on hand, while lending the remaining 90% for investments. Although depositors run the risk that they may be unable to withdraw if too many people try to cash in their IOUs all at once, banks compensate depositors by eliminating storage fees and paying interest on accounts.
The total amount of a bank’s investment spending is constrained by the spending rate of its depositors. When depositors’ withdrawals decline, banks can operate with a smaller fraction of deposits on hand for withdrawal. Thus, if depositors save by reducing withdrawals for consumption spending, then credit becomes cheaper, and total spending on investments increases to produce the goods and services that savers will demand tomorrow. If depositors reduce withdrawals on their account for investment spending (for example, purchasing stocks and bonds) then spending will merely be shifted from som investments to others.
By coordinating the spending of savers and borrowers, banks help direct investment spending toward productive ends. Any disruption of this process will have a propensity to distort prices, generate malinvestment, and create fluctuations in economic growth.
The market for private money in the United States began to disappear during the Civil War; it had long been plagued by “unit banking” laws, established in most states since the early 19th Century, that prohibited banks from opening branches. For private banknotes to be accepted in trade, recipients must be confident in the soundness of the issuing bank. An insolvent or illiquid bank may not be able to honour its debts upon demand, and so a note from a suspect bank may not be accepted on the same terms as another with the same face value. The farther a banknote travels away from its issuer, the more risk is had from accepting it; lack of local knowledge concerning the issuer and the costs of transporting banknotes for redemption result in a poor exchange rate. In consequence, the early United States saw a proliferation of local monies and specialist currency exchangers who made it their business to know about faraway banks. Without the ability to open branches where banknotes could be redeemed far from home, it was extremely difficult for any bank to see its currency circulating across all of the United States.
Against this backdrop, the American Civil War began, and the U.S. Treasury had to start seeking ways to fund it. Up until 1863, banks were chartered by states, but afterward banks could apply for a Federal charter. The new national banks would not issue their own banknotes, but national banknotes created by the Treasury, and so the the problem of banknotes being rejected or accepted at poor exchange rates far from their issuer was eliminated. Much the same could have been achieved by abolishing restrictions on branch banking; Canada, during this same period, had no restrictions on branch banking and its private banknotes enjoyed national circulation. However, the Federal Government had an ulterior motive: national banks were to secure their banknotes with Treasury bonds, and thus artificially increase demand for government debt to help finance the Civil War.
Many in the Federal Government expected state banks to seek Federal charters or be driven out of business. However, despite legislative privileges of the national banks, state banks continued to enjoy strong demand for their banknotes and financial services.
Through the early 1860s, the Federal Government’s favoured method of financing the Civil War became dangerously inflationary; without a contraction in the supply of national banknotes, prices would soon begin rising out of control. However, the Federal Government was loath to reduce its own monetary expansion, and instead sought to eliminate alternative monies. In 1864, the National Bank Act was passed; it levied a 10 percent tax on all state banknotes, driving them from circulation by "effectively taxing state banknotes out of existence." Through legislative acts like this, state banks were forced to seek Federal charters or go out of business.
From 1866 onward, the competitive market for money all but disappeared entirely. Many changes to the monetary system occurred, but the established monetary monopoly persisted.
In 1913, a special institution was established to oversee the financial sector and money supply, The Federal Reserve. The Federal Reserve today has extensive powers over banking and money. As well as managing the supply of physical currency, the Federal Reserve can manipulate the quantity of available credit in the banking system. Banks are prohibited from issuing private banknotes and cannot determine how much money they have on hand to satisfy withdrawal demands. To coordinate the spending of savers and borrowers, banks depend on the Federal Reserve to provide them with the necessary funds. Rather than each bank having its own monetary policy with customers picking winners and losers, the Federal Reserve determines a single monetary policy for the entire United States.
Money is one half of every transaction, so the Federal Reserve is an exceptionally powerful institution. When the Federal Reserve errs in its monetary policy, the entire economy is likely to suffer the consequences.
In early 2008 the Federal Reserve erred in its monetary policy. Following a bursting bubble in real estate, the rate of spending in the economy began to decline, and the Federal Reserve did not change its monetary policy. The banking system was unable to respond the reduced rate of spending by increasing the availability of credit, and the total nominal expenditure of the United States’ economy fell for the first time in decades. In consequence, the rate of spending that established prices had been predicated upon did not materialise, and the fate of millions jobs became precarious. The panic that ensued culminated in a financial crisis, and severe losses spread throughout the banking system. What should have been a minor recession induced by a bursting bubble turned into the Great Recession, because the Federal Reserve did not adjust its monetary policy to changing economic conditions.
Speaking before the Before the National Economists Club, Washington, D.C. in 2002, Ben Bernanke, current Chairman of the Federal Reserve said, “Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy's underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures.” However, it was not until late 2008 that the Federal Reserve finally changed monetary policy from its previous trajectory, at which point the price level had already began declining and a unprecedented expansion of the monetary base was necessary.
By early 2009, layoffs had reduced millions to unemployment, but there are few serious repercussions for the Federal Reserve. The monetary monopoly is almost untouchable: American citizens have little choice but to patronise the monopoly supplier of U.S. Dollars. The Federal Reserve is an institution born of hubris and immune to discipline. Its role in the economy is nothing less than a Soviet-style central planner of the money supply, and it has been about as successful. Legislation exists in most of the developed world to prevent the formation of monopolies and cartels, and one product where monopoly should be no less tolerated is in the supply of money.