Is the Fed Too Big To Fail?
by Gary North
The mark of political sovereignty is legal immunity from failure. For example, the government of the United States cannot be sued without its consent. It is above the law. It must consent to expose itself to the possibility of failure in a court.
In school, we are taught about an ancient idea that is long out of favor: the divine right of kings. What did it mean? I think most people would find it difficult to say. It meant that there was no earthly court of appeal above the king. The king’s judicial word was law, because no higher authority could lawfully overturn his word.
The two revolutions of the seventeenth century brought that doctrine to an end in England and the colonies. First Cromwell (1649), then Parliament (1688) removed kings from their thrones. Over the next century, the West substituted a new doctrine: the divine right of legislatures. This sovereignty was never called divine right, because in the era of the Enlightenment, intellectuals have been hostile to the idea of a God who interferes in history. Civil governments have claimed autonomy, which is another word for divinity. Maybe we can say that divinity abhors a vacuum.
Officially, there is a right of revolution. The People – capital P – are said to be sovereign. This is a convenient legal fiction. It keeps the citizenry satisfied and subdued. All civil governments have made armed revolution illegal. Every revolutionary movement claims the right of revolution. In all cases, when a revolutionary movement topples the previous regime, the right of revolution officially ceases within the formerly revolutionary camp.
Maybe you think this: “If the sovereignty of the citizens is a legal fiction, then why are they allowed to vote?” Answer: for the same reason they were allowed to vote in the Soviet Union. Voting provided the Communist government with a bogus sense of legitimacy. In Western political theory, the process of voting supposedly legitimizes the despotic regime. The choices on the ballot were screened by the Communist Party. So, the citizens’ votes counted for only one thing: to provide a religious sanction from the official god who then submitted, namely, the People. The People was a phony collective god without meaningful sanctions.
Conclusion: the agency that imposes final sanctions in terms of its own final word is the god of a society.
This brings me to the topic at hand: central banking.
The advent of the Bank of England in 1694, just six years after Parliament’s “Glorious Revolution,” added a new factor to the doctrine of political sovereignty. To what extent is a central bank sovereign? That is, to what extent is it immune from lawsuits? To what extent is it its own court of final appeal? To what extent can it impose autonomous sanctions?
Over the last three centuries, battles have raged between central banks and legislatures for the title of “final sovereign.” Central banks have usually won the war over the last century.
The Bank for International Settlements is the representative institution of this victory. It was established in 1930. It operated during World War II as a way for central banks to conduct business with each other despite the deaths of 60 million people. The cause of central banking triumphed over the competing causes of the battlefields.
We are seeing this battle being played out in the United States. This is the first surfacing of the battle ever since the Federal Reserve System was created by the government in the last days of December 1913. Ron Paul persuaded a majority of the House of Representatives to demand that the Government Accountability Office audit the Federal Reserve System. The FED resisted. The senior members of Congress resisted. The bill was killed. The new financial reform bill gutted the original bill.
Here is another example. Last year, Bloomberg LLC sued the Board of Governors of the Federal Reserve to produce evidence of which banks received TARP loans. The FED refused to comply. A Federal judge last August told the FED to comply. The FED appealed the case. On March 19, the appeals court told the FED to comply. The FED has not complied. I have been unable to find out what the status of the case is today. Bloomberg has not mentioned it as far as I can discover on Google. The FED has hired Lawyer Delay. He seldom loses a case. Bloomberg has hired Lawyer Silence. He rarely wins one.
This is functional sovereignty. Legally, the Board of Governors is a Federal agency and is therefore under the provisions of the Freedom of Information Act. Yet in fact, it is almost as sovereign as the CIA or the NSA (“No Such Agency”). The latter have guns. The FED does not. This is most peculiar.
How can this be? Because the FED has the authority to make or break a bank that gets into trouble. The FED holds the hammer over the economy, because the big banks are at the center of the economy. It is the lender of last resort.
The FED is not legally required to buy Treasury debt. It does, or rather used to. These days, it sits on old Treasury debt – not much – and Fannie Mae and Freddie Mac debt: lots. It sits on toxic assets that it swapped at face value for Treasury debt in order to restore the big banks’ balance sheets to official solvency. The FED answers to no one about its balance sheets. It keeps all assets at whatever price it chooses. Gold is held at $42.22 per ounce. Toxic assets are held at face value.
The Federal Reserve System possesses so much sovereignty that it holds the U.S. Government’s gold in trust. Anyway, it says it does. There has been no government audit of the gold since 1951. No one in government knows how much gold there is in Fort Knox and the vault of the Federal Reserve Bank of New York, a private bank. The government does not assert its right to know.
The FED reigns supreme over commercial banks. It is going to be granted far more authority if the proposed bank reform bill passes. Bernanke recently praised the bill in a June 16 speech.
The Federal Reserve System is universally regarded as too big to fail. Put another way, it is beyond negative sanctions. It therefore possesses what was once called divine right. It is beyond legal constraints. It is beyond market constraints. It answers to no one. It is autonomous.
Nice work if you can get it. The Board of Governors got it.
Also, only 12 private entities in the United States possess comparable sovereignty: the regional Federal Reserve Banks. They are under the legal umbrella of the Board of Governors. Nice work if you can get it.
Federal Reserve sovereignty is premised on two things: (1) the government’s refusal to exercise Constitutional authority over the FED, which was created by the government; (2) the FED’s ability to create money. It decides who is too big to fail and who isn’t. This is the mark of sovereignty.
WHO WINS? WHO LOSES?
Year after year, decade after decade, century after century, we hear warnings about banking institutions that are too big to fail. This goes back decades before British author Walter Bagehot wrote “Lombard Street” (1873). He argued that the Bank of England should serve as a lender of last resort. In an economic crisis, the Bank should make credit available.
As it turned out, no such policy was adopted by the Bank for over 50 years, yet there were no major financial crises until after World War I. That was when the Bank began serving as the lender of last resort. The result was the suspension of the gold standard in 1931. Without the threat of a drain of gold, the Bank could then function as the lender of last resort by creating fiat money at will.
This is what the phrase “lender of last resort” really means: the creation of fiat money by the central bank. It means breaking the normal rules of the fiat money game. It means bailouts.
The problem of moral hazard was seen by Bagehot. If the central bank stays in the background as the lender of last resort, the commercial bankers’ need for prudence and restraint is reduced. They will get bailed out if their investment portfolios shrink due to unforeseen conditions.
Then there is the question of questions: Which banks or institutions will get bailed out? The answer in both theory and practice is the same: big banks. Why? Because they could take down the fractionally reserved banking system if they were to suspend payment and default on their contractual obligations.
With the central bank ready to bail out the big banks, the senior managers of these banks can put their banks’ capital at risk by investing in high-return, high-risk investments. Think “derivatives.” Then think “toxic assets.” Then think “exchange our toxic assets at face value for liquid T-bills.” This is what the Federal Reserve did for the major banks.
The result? The six largest American banks have been highly profitable in 2010 – far more so than in 2009. But they have made their money through trading, especially high-risk derivatives. They did not make it by lending to businesses. In short, they are back to the pre-2008, pre-TARP world. Happy days are here again! For them.
This is why Wall Street is on the fast track to Easy Street, while Main Street remains on the detour. The FED decided who would win and who would lose. Main Street is losing. But this is nothing new. This is as old as the Federal Reserve System.
THE POWER TO DESTROY
In the case that established the sovereignty of central banking in the United States, “McCulloch v. Maryland” (1819), Chief Justice John Marshall wrote the famous words, “The power to tax is the power to destroy.” Because historians have never read the actual trial documents, they are unaware of the context.
The state of Maryland was trying to tax a branch of the Second Bank of the United States. The Bank was refusing to pay, on this legal basis: its sovereignty as an agency of the government. Its lawyer was the ever-indebted Daniel Webster.
The following never makes it into the textbooks. The state’s attorney argued that the Bank did not possess Federal sovereignty, because it was a private agency. The Court rejected this argument, 7 to 0. We still live under the burden of that decision.
John Marshall stole Webster’s slogan: “The power to tax is the power to destroy.” He saw his opportunity, and he took it. It is his most famous aphorism. Yet it came from the lawyer who was defending the sovereignty of the central bank.
Here are some additional powers to destroy:
The power to inflate is the power to destroy.
The power to deflate is the power to destroy.
The power to subsidize members of one group by transferring wealth from members of another group is the power to destroy.
The power to keep large bankrupt institutions from failing, yet let other institutions just like it fail, is the power to destroy. In short, anything that places the power to manipulate the economy into the hands of salaried bureaucrats who do not personally bear the consequences of their actions is the power to destroy.
Such power will eventually be used.
The Federal Reserve System has created the boom-bust cycle, just as Ludwig von Mises described it in 1912. The FED’s prior policies of monetary inflation created the boom. Its policies of monetary stabilization created the bust. It then doubled its balance sheet (the nation’s monetary base) in October 2008. The only thing keeping this from doubling the money supply and possibly doubling consumer prices is the fear of commercial bankers. They refuse to lend the money they are legally entitled to create. They are hoarding digital money at the FED. To put this in terms even a central banker can understand:
Commercial bankers, acting on their depositors’ behalf, are hiding the depositors’ digital money under the mattress: the FED’s excess reserve account.
FUNDING THE FEDERAL DEFICIT
At some point, lenders will refuse to lend money to the Treasury at low rates. At some further point, the Federal debt will have to be funded by the FED in order to keep rates from rising.
If the FED keeps funding the Treasury, this will produce monetary inflation. This will go to mass inflation: over 20% per annum. If it continues, this will go to hyperinflation.
That will destroy the dollar. The power to inflate is the power to destroy. The FED will transfer massive, comprehensive destruction to the general population.
To stop this from happening, it will have to cease buying Treasury debt. It will stabilize the money supply. That will create the great depression.
At that point, we will see who is sovereign: Congress or the FED. If Congress nationalizes the FED and inflates, then the FED will have failed. It will be proven for all to see that it was not too big to fail.
On the other hand, if the FED refuses to buy the Treasury’s debt, the Federal government will default. It will be proven as not too big to fail.
For freedom’s sake, both should be allowed to fail: the FED’s fiat money and the Federal debt. The very concept of too big to fail rests on the idea of coercive wealth redistribution by the state. Such power is the power to destroy.
The problem is this: to get people to act like the People will take a lot of failures of very large banks. The big banks will fight this outcome. The FED will fight on their behalf. Central banks have won this battle for over 300 years.
This is why there is going to be a great deal of economic destruction.
June 26, 2010