Is The Federal Reserve System Constitutional?

The Wall Street Journal carried a very interesting editorial on Saturday by Mark Spitznagel, the hedge fund manager who currently employs Nassim Taleb, the author of a noted book on financial systemic risk, "The Black Swan."


Spitznagel's piece focuses on Austrian Ludwig Von Mises' predictions of credit problems in the 1930s, and his book, The Theory of Money and Credit.


The editorialist cited Von Mises' work as he noted the folly of current Fed interest rate policy,


"Government-imposed interest rates artificially below rates demanded by savers leads to increased borrowing and capital investment beyond what savers will provide. This causes temporarily higher employment, wages and consumption.


Ordinarily, any random spikes in credit would be quickly absorbed by the system- the pricing errors corrected, the half-baked investments liquidated, like a supple tree yielding to the wind and then returning. But when the government holds rates artificially low in order to feed ever higher capital investment in otherwise unsound, unsustainable businesses, it creates the conditions for a crash. Everyone looks smart for a while, but eventually the whole monstrosity collapses under its own weight through a credit contraction or, worse, a banking collapse.


The system is dramatically susceptible to errors, both on the policy side and the entrepreneurial side. Government expansion of credit takes a system otherwise capable of adjustment and resilience and transforms it into one with tremendous cyclical volatility."


With these passages in mind, I wondered aloud, over coffee, to a colleague this weekend whether the Federal Reserve Act was unconstitutional?


How could the income tax have required a constitutional amendment, whereas creating a central bank did not?


Surely, as you read the Constitution, you cannot find any basis on which Congress can simply create a central bank. There's not even a reference to the control of the US currency in the founding document.


From another Journal editorial last year, I know that the creation of the Federal Reserve System dates from the Progressive Era of about a century ago. It was a sop to the Populist movement which demanded free coinage of silver to inflate farmers out of their debt problems.

In retrospect, it's clear that the modern Fed is particularly susceptible to precisely the sort of errors of which Spitznagel, citing Von Mises, writes. Only two Fed Chairmen in its long history are accorded almost unalloyed respect- William McChesney Martin and Paul Volcker. Both are revered for their ability to stand up to administrations and Congress, executing their office's responsibilities for long term US economic health, rather than short term credit demands.

Martin was responsible for the famed Korean War era Accord, by which the Fed was released from its obligation to fund Treasury debt and keep rates low as part of that accommodation. Though a senior Treasury official when he authored the Accord, Martin immediately became Fed chairman upon McCabe's resignation, which was triggered by the fallout from the Accord and Truman's Treasury Secretary's refusal to work any longer with McCabe.

In that linked source on the Accord's history, it is notable that there was an exchange between McCabe and a Senator regarding which had primacy, the Treasury or the Fed. The lack of clarity over this point, and the Fed's "bolted on" nature remains to this day, nearly 60 years later.

It would be asking a lot to now reverse course nearly 100 years after the Fed was created. But I truly fear that we are, as a nation, arriving at several "tipping points" simultaneously, and one of them is the Fed's continuing wrongheadedness with respect to interest rate and liquidity policies.

It has been a major cause of bad credit decisions in the US economy from the day that Alan Greenspan began easing monetary policy in the post-9/11 environment. While not by any means the only governmental actor nor agency which contributed to the real estate-based credit bubble, the bursting of which, in 2007 and 2008, wreaked such global economic havoc, the Fed certainly did more than its share to facilitate the mess.

Its current 0% rate policy seems to be repeating the Greenspan's error of 2001, with hardly a voice of dissent nor caution that we should have learned from the former's mistakes earlier this decade.

I believe Milton Friedman was right on both political as well as economic grounds when he argued for dissolving the Federal Reserve's role in monetary policy and, instead, setting a single annual growth rate for the nation's monetary base.

Such a law, passed by Congress, would certainly be Constitutional, whereas it seems there is absolutely no basis in the Constitution for the creation of the Federal Reserve System.