Federal Reserve: Constitutional or Merely Legal?

The Federal Reserve headquarters in Washington, DC (Photo credit: RD Smith)

The Federal Reserve headquarters in Washington, DC (Photo credit: RD Smith)

The Federal Reserve is the central bank of the United States. It is in charge of printing money issuing bonds and setting interest rates for those bonds. Article 1, Section 8 of the Constitution says, “The Congress shall have Power … to coin Money, regulate the Value thereof.” The Federal Reserve is never mentioned. Has it always been this way? Does any other country do this? How did the Federal Reserve get its power over our currency and our economy? And the issue that so many are interested in today: is the Federal Reserve constitutional?


Has it always been this way?

At the dawn of the republic, our first Secretary of the Treasury Alexander Hamilton issued several reports which in many ways set the tone and pointed the way for the development of America in the economic sphere. His first report on the public credit recommended that the new central government not only honor the debts contracted under the original government as established under the Articles of Confederation but that it also assume the war debts of the States. This recommendation was followed by Congress and the Washington administration created what has evolved into a permanent national debt.

In 1790, Hamilton submitted his second report which asked Congress to charter the Bank of the United States. Several aspects of the bank Hamilton proposed will sound familiar and it can be seen that they provided the mold for the Federal Reserve. His plan was closely modeled after that used by Great Britain’s Bank of England. According to Hamilton’s vision, the Bank of the United States would be a public/private hybrid. It would have an exclusive charter for twenty years. Its initial capitalization would be ten million dollars consisting of eight million from private investors and two million from the government. Congress would give the Bank the right to print paper money up to the ten million held in deposit. Most importantly, the central government would declare that the notes issued by the Bank would be the only notes which would be accepted in payment for taxes. This would give the notes of the Bank of the United States credibility and value, which none of its state chartered competitors could match. This was Hamilton’s proposal. Now all he had to do was get it passed into law.

The report was introduced into Congress in 1790 and by February 1791 it passed both the House and the Senate and arrived on the desk of President Washington. This is when the battle of the Titans really began. Leading Anti-Federalists and strict constructionists such as James Madison, Thomas Jefferson, and Edmund Randolph, argued that the Constitution did not grant the government the power to incorporate a bank. According to their line of reasoning, it was not an enumerated power and therefore it was reserved to the States or the people. Those arguing for a strict interpretation of the newly minted Constitution, which Madison and Randolph had helped write, urged Washington in a written report not to sign the bill.

Ever the fulcrum between his philosophically divided advisors, Washington presented Hamilton with the argument opposing his plan and asked him to present his argument in favor. Hamilton, using his excellent reasoning and communication skills, presented President Washington with the original argument for the implied powers granted to the central government by the Constitution. This report appealed to what is now known as the “Necessary and Proper” clause. He argued that the government was inherently empowered to do whatever was necessary to implement the laws required to use the enumerated powers. President Washington accepted Hamilton’s argument, signed the bill, and the first Bank of the United States was born.

Beginning on July 4, 1791, the first thing the new bank did was inflate a financial bubble by offering the largest initial stock offering the nation had ever seen. Investors showed their confidence in Hamilton’s plan by quickly buying the options on the first issue of stock. Many of these initial investors were members of Congress. The initial price for the options was $25. This was soon bid up to over $300. It soon crashed to $150. Thus within days of its first action, this original central bank inflated a bubble that soon burst. However, Secretary Hamilton, setting the example for the central bankers to follow, stepped into the breach and averted a general financial panic by purchasing government securities with public funds thus stabilizing the markets and rewarding those who had initially speculated and “Too big to fail” was born.

The bank opened for business in December of 1791. All manner of people, landowners, manufacturers, merchants, politicians, and most important of all, the government of the United States lined up to deposit money and to obtain the new bank script. Within months, the bank was the single largest economic enterprise in the nation.

Beginning a pattern that would be repeated over and over, the bank which had been created to ensure a firm foundation for the American economy inflated another bubble and caused another crash.

First, the bank flooded the market with easy loans and a massive issue of paper dollars. This move added liquidity pushing the new securities market into a sharp rise. However, then the bank reversed course and began calling in many loans. Investors and speculators were especially affected as they were forced to sell securities to pay the loans. When the largest of the speculators, William Duer, was forced to declare bankruptcy, the markets collapsed. This in turn caused the financial markets to freeze up, putting a stop to much of the nation’s credit and commerce. This is known as the Panic of 1792. The crash didn’t last long, because Secretary Hamilton once again stepped in and bought government securities with public funds, injecting much needed capital into the economy.

Over its 20 year life, the first Bank of the United States functioned as the central bank. It worked to regulate state banks, closing those that issued too much paper. It attempted to guide the entire economy through its monetary and interest policies. It coordinated all its branches up and down the east coast to project a united front in its economic policy by either tightening or loosening credit.

By the time it came for a renewal of the bank’s charter, the Federalists were no longer in the seats of power and the newly ascendant Democratic Republicans, led by Thomas Jefferson, defeated its bid for another twenty years, and the first bank of the United States, America’s initial experiment with central banking, was over.

Does any other country do this?

Yes, many other countries have central banks. Today it is considered a hallmark of an advanced economy.

How did the Federal Reserve get its power over our currency and our economy?

There were subsequent attempts to re-establish central banking in the United Sates. There was a Second Bank of the United States chartered in 1816, but after being blamed for a series of bubbles and crashes. its charter was not renewed and it ceased operations in 1836. In 1863 in the depths of the Civil War Congress passed the National Banking Act which chartered numerous Federal Banks. This law also taxed paper money issued by State banks but not paper money issued by the Federal Banks giving them a decided advantage.

In 1913, the Federal Reserve System was born. It established what is known as a decentralized central bank in that it has semi-autonomous branches. It was given the power to control the currency, issue bonds, and set interest rates for those bonds. It was established as a public/private concern and actually owned by stock holders. Who are these stock holders? They are private banks, and ownership of stock is required to participate in the system. The system was instituted to provide the foundation for a stable banking industry and an elastic currency that could be used to smooth the rough edges of the business cycle. Whether this latest experiment in American central banking has fulfilled its mission, each citizen should judge for themselves.

Is the Federal Reserve constitutional or merely legal?

The first Bank of the United States was never challenged in court as to whether or not the government had the power to create a central bank. But the second bank was. The Supreme Court in 1819 ruled in McCulloch v. Maryland that it was in fact constitutional due to the implied powers clause. Thus looking to precedent, and unless the Supreme Court reverses itself, the Federal Reserve is considered to be authorized within the confines of the broadly interpreted Constitution.

There was an important constitutional issue born with the creation of America’s first Central Bank. With the birth of the First Bank of the United States the acceptance and use of implied powers became the central government’s method to expand its powers beyond those expressly delegated in the Constitution. This in turn paved the way for our acceptance of things that are clearly unconstitutional just because they are legal.

The argument of Madison, Jefferson, and Randolph upholding a strict constructionist view would be codified and added to the Constitution in the same year the bank was charted, and perhaps in response to it, in the 10th Amendment, but this did not end the appeal to implied powers as a means to the government’s ends. In theory this sounds good. In practice it has turned our limited government into an out of control leviathan crushing the free out of our free market and sucking the liberty out of the American experiment.

As my favorite American philosopher, Yogi Berra once said, “In theory there is no difference between theory and practice. In practice there is.”

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