Governments have always had an interest in controlling (and manipulating) the money supply, and the history of doing so is a long catalog of abuse. Central banks like the Federal Reserve — founded in 1913, technically not a government-controlled entity — emerged from a handshake deal to take the monetary plumbing off the government’s plate. The Fed runs interest rates, supports the employment mandate, and serves as a lender of last resort. The defining shift came in 1971, when Nixon closed the gold window and every world currency became fiat.
Have you ever wondered why bankers are some of the richest people in the world? Or perhaps why a house only cost $7,000 in 1950, but today you have to come up with a $250k down payment, sell both kidneys, and go into indentured servitude to buy a 600-square-foot condo in Marin County?
By decree, President Nixon took the whole world off the gold standard in 1971. The following decades would see the steady rise of inflation, the acceleration of inequality, and the ballooning of government debt. But how did we get to that point? Under what circumstances was the US in a position to make that call? Why have things played out so unfavorably for the middle class?
And most important of all…
What does this have to do with crypto?
At a certain point, you gotta trust that I’m not intentionally abusing your attention. We’re here learning about the backstory of central banks because a major selling point in crypto‘s value is its decentralized nature. If you don’t understand the risks of centralized financial systems, the merits of decentralization don’t quite hit right.
Let’s dive in.
Power and meddling with a currency go hand-in-hand
Throughout history, the temptation of debasing and devaluing currency has been too great for many leaders to resist.
During the Roman Empire, coins were the currency du jour and emperors had direct control over coinage. As the saying goes, give a mouse a cookie… he’s gonna want some milk. Managing coinage is a big responsibility. And one that some emperors found too tempting to not abuse.
In the late stages of the Empire
When expansion was not as rapid, and conquest not as profitable, emperors would increase their ability to finance various initiatives by mixing base metals with precious metals. By this action, they were reducing the intrinsic value of the coin. But here’s the milky part: the face value would remain unchanged.
In a free market
If the precious part of the coin was reduced, and the ugly ass base metal part was increased, the natural reaction would be: what once cost 2 silver coins, now costs 3.
But because leaders in a late-stage empire aren’t particularly tuned in to the needs of the plebians, they did an especially nasty thing: in addition to debasing the currency, they also declared that prices would remain fixed.
The effect? An artificial increase in their spending power at the expense of the people.
It gets worse
If your conquerable prospects are limited (i.e. Roman empire has nowhere else to expand) or you need to use this “new” money to pay off existing debts, you can all but count on hyperinflation of goods, excessive taxes, and a worthless currency. We call this “economic turmoil”, and it’s under these conditions that emperors start getting assassinated.
Debasing a currency is not necessarily a bad thing…
If you’re using these funds to plunder new lands (and get access to more natural resources, i.e. precious metals) or spur economic growth, then you might be able to work this effort in your favor without dealing too much damage to the plebs (at least it should be temporary).
But paired with fixed prices and declining growth prospects, you’re asking for trouble.
The birth of central banks
Fast forward to Europe, late 17th and early 18th century.
Governments aren’t having the easiest time. They’ve got a lot on their plates! On top of ruling, they also had to manage the money supply. Who has time for all that?
So, some financially savvy financiers came up with a proposal for a new type of institution. The idea was this: an independent bank would loan the government a bunch of money in exchange for taking over certain monetary responsibilities. They were to be bankers to the government.
How it was pitched
These banks could support a greater level of financial stability — and this would be good for the people. They would manage government debt, the gold and precious metal reserves, the exchange of coinage, and most importantly… the issuance of paper banknotes. It was all very centralized — must be why we call them “central banks”.
Let’s talk about the banknotes thing
The issuance of paper notes was not new. Commercial banks had been doing it for a while, but it required trusting that the commercial bank wouldn’t do something dumb and go out of business. Central bank-issued notes garnered a bit more trust because they were backed by a government with the power of taxation.
Another form of debasement was underway
Unlike a coin where you can literally see the quality decline as the precious metal content gets reduced, a bit more digging is required to “see” paper money lose value.
If we think of paper banknotes as receipts for the precious metal in the banks’ reserves, then it would stand to reason that printing more notes than you can pay out in reserves would be a bad idea. Well, bad for the people who hold the paper notes. But the temptation was too great!
Central bankers abused this power, first casually, and then aggressively. But so long as the money was invested responsibly, they could keep the charade going without causing people to lose trust in the value of their banknotes.
However, central bankers weren’t always super responsible with their investments. And every now and again, mistakes were made, panic would ensue, a banker would get exiled, the currency would suffer, then slowly come back. The cycle produced a series of unpredictable booms and busts throughout the 18th and 19th centuries.
But there was one constant: bankers were getting very rich.
Not to be outdone by the Europeans, the United States enters the playing field
While European central banks managed a variety of functions, there was one responsibility that, in the eyes of John Pierpont Morgan (friends called him “JP”), was too important to go unfulfilled.
There was no “lender of last resort.”
In the late 19th century, financial crises in the US were a dime a dozen
Financial regulation was an afterthought, speculation was relatively unchecked, bank runs[^1] were frequent, investor sentiment in the United States was questionable, and the system was still reeling from the economic devastation of the Civil War. In turn, commercial banks failed at an alarming rate.
[^1]: A “bank run” is when everyone is like “I want my money and I want it now!” and they storm the bank to pull out their cash — and if the bank doesn’t hold all their deposits (which is pretty standard because banks use deposits to make loans), shit hits the fan.
In 1907, the US financial system faced a reckoning
The stock market had been frothing for years as the banking regulation had all but disappeared. This meant banks could loan money freely to less-than-worthy borrowers. Those less-than-worthy borrowers took that money and put it into less-than-worthy investments. This is how bubbles form.
As they tend to do, the bubble burst.
A run on the banks rippled across the United States and a total financial collapse and subsequent depression were only narrowly avoided because of one man: JP Morgan. Morgan tapped his personal wealth and rallied his rich friends to provide an emergency infusion of cash into the system.
Never let a crisis go to waste
The Panic of 1907 was the fodder that Morgan needed to make the case for a “lender of last resort” — on the eve of a financial collapse, commercial banks would now have a central bank to lean on.
If you’re thinking, “wait, wasn’t it poor risk management on behalf of the banks that led to the instability in the first place?” then I’m right there with you.
Get this
JP Morgan — a billionaire banker in today’s terms — couldn’t just go to Congress and say, “Hey, let’s create a central bank that can create money out of thin air to bail out commercial banks when they do their jobs really badly.” That wouldn’t be particularly popular with the public.
Instead, a plan was hatched…
Jekyll Island (it even sounds malevolent)
At the Jekyll Island Club off the coast of Georgia — a private retreat whose members were essentially a who’s who of American oligarchy (Morgan, Rockefeller, Vanderbilt, Pulitzer) — a small group of Morgan and Rockefeller lieutenants met with Senator Nelson Aldrich in November 1910 to outline a proposal for a new central bank. They called it the Federal Reserve and drafted up a bill.
The Federal Reserve Act of 1913 claimed that this new central bank would support the government in managing the stability of the financial system by doing three things:
- controlling the money supply and interest rates
- keeping employment high through monetary policy
- and serving as a lender of last resort to commercial banks.
To get the bill passed, they revved up the propaganda machine. Backs were scratched, promises were made, and they got the thing through.
Woodrow Wilson, who would sign the bill into law, had written in The New Freedom earlier that same year:
“A great industrial nation is controlled by its system of credit. Our system of credit is privately concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men.”
Then he signed the bill anyway.
The structure of “The Fed” is worth commenting on
It’s not one big bank. The Federal Reserve System includes a Board of Governors — seven members, appointed by the President and confirmed by the Senate — and 12 regional banks scattered around the US. Each regional Federal Reserve supports the commercial banks in their vicinity. Sorta like a babysitter.
The Board of Governors is somewhat accountable to Congress, but the regional banks are actually owned by the commercial banks they support. Wait, what?
Stock in the regional Feds is held by commercial banks
Yes, the Federal Reserve (at the regional level) is owned by banks. And who owns the shares of those commercial banks? A lot of bankers (not exclusively, but you get my point).
So in a not-so-roundabout way, JP Morgan’s bank and friends engineered a system created and owned by bankers to help banks… but all in the name of the public good. And that’s what I call a #bankshot.
A new global monetary system
Fighting in a war is rarely good for the wealth of a nation — win or lose. But what about selling resources and materials to the nations doing the fighting? That’s when war becomes a profitable enterprise. And the United States learned this over the course of two world wars, selling supplies to allies across the pond and receiving payment in gold.
In this process, the United States Treasury would come into possession of approximately two-thirds of the global supply of gold.
After World War II
There was a global consensus that the world was in need of a new financial system. So what do you do?
Well, you rent a giant Airbnb in New Hampshire and hash it out! That’s what happened at Bretton Woods in 1944. Delegates from 44 nations got together and agreed to create the International Monetary Fund (to help stabilize exchange rates) and the World Bank (to support economic development in the post-war period).
Aaaaaaaand one other thing
They agreed that the United States dollar would be the global reserve currency. And the US dollar would be backed by gold.
This system worked pretty well for a while!
The post-World War II decades were economically stable. Exchange rates were fixed because foreign currencies were pegged to the dollar, and the dollar was pegged to gold. Trade BOOMED.
But, as history would remind us… those who can meddle, will. And the Federal Reserve found this temptation a bit too hard to resist.
By the late 60s, the United States had expanded its currency supply so drastically (something that wasn’t explicitly ruled out in the Bretton Woods agreement — strange, I know), that they no longer held enough gold to support the sum of dollars in circulation.
Foreign governments caught wind of this
And began aggressively redeeming their dollars for gold, effectively kicking off a bank run on the global bank that was the United States Treasury.
President Nixon, realizing that the US was on a path to bankruptcy if the trend continued, was like, “Okay um sorry guys you can’t do that anymore.”
Other countries were like, “Why?”
To which, Nixon responded, “Because I say so.”
And on August 15, 1971 he suspended the convertibility of dollars into gold, pushing for a “new international monetary system”. And ya know what? Nobody really put up a fight.
In the blink of an eye, every world currency became a fiat currency. And every central bank was endowed with the power to create more of that currency as they saw fit.
Here’s the thing
The Federal Reserve is unable to infuse new money directly into the real economy. It has to go through an intermediary. And that intermediary is called our financial system.
When the Federal Reserve creates money, it goes to the commercial banks
From there, the money can make its way into the real economy, usually in the form of loans. When affordable loans are given to responsible people and businesses, the impact is typically a positive one. And to be fair, commercial banks normally do a pretty good job of making this happen.
But sometimes they don’t
Next up, we’ll take a close look at what can go wrong when financial institutions fail to manage risk (which is pretty much their whole job).
We’re going to unpack the 2008 financial crisis. It’s gonna be great.
Nothing in this essay is investment, legal, or tax advice. It’s a general discussion of concepts I find useful in my work and shouldn’t be relied on as a recommendation for your specific situation. Talk to a qualified advisor (ideally one who knows you) before acting on anything here.
