PDF Summary:The Creature from Jekyll Island, by G. Edward Griffin

While Jekyll Island might sound like something out of horror fiction, the island is a real place—and popular resort—in the state of Georgia. But author Edward Griffin argues that it was also the birthplace of a horrifying finance cartel disguised as a government agency: the Federal Reserve System. Griffin believes the Fed destabilizes the economy and encourages banks to engage in fraudulent practices that harm the general public and benefit elite financiers.

In our guide to The Creature from Jekyll Island, we’ll consider Griffin’s theories about the conspiracy of financiers that he says created—and continues to control—the Federal Reserve. Then we’ll review his criticism of how the Federal Reserve actually operates and his arguments that it’s detrimental to regular citizens. Finally, we’ll consider Griffin’s proposed solution to the problems he identifies. Throughout, we’ll compare Griffin’s perspective with the perspectives of economists like Thomas Sowell (Basic Economics), Saifedean Ammous (The Bitcoin Standard), and Henry Hazlitt (Economics in One Lesson).

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Businesses stop borrowing and start trying to cut expenses. Some repay their loans, others default on them, and the same process that caused the money supply to expand now works in reverse, causing it to decrease exponentially. With money in short supply, the economy goes into recession. This is how fractional lending causes boom-and-bust cycles in the economy.

Austrian Business Cycle Theory

Griffin did not originate the idea that fluctuations in the money supply destabilize the economy by amplifying business cycles—this concept is central to Austrian Business Cycle Theory, which is a key component of the Austrian School of economic thought. The Austrian School offers some additional perspective on the subject, as well as some additional criticism of central banks such as the Federal Reserve.

The Austrian School asserts that central banks destabilize the economy not only through fractional lending but also by artificially lowering interest rates. The Fed (and other central banks) loan money to banks at a “discount window” or “discount rate,” increasing the availability of capital and driving down interest rates throughout the economy. Fractional lending, then, amplifies this effect by further increasing the money supply as loans are taken out at rates that are lower than they’d be if subject to natural economic pressures.

According to Austrian economic theory, interest rates reflect the value of money plus time, and allow business people to assess whether a project is worth taking on: Will a business venture return more profit than interest rates would, given time?

But interest rates that the Fed sets lower than they would be based on market forces lead to inaccurate projections, which lead to failed business ventures. As these failed ventures accumulate, they trigger contraction of the money supply as they are liquidated to pay off their loans or default on them outright. These small contractions are amplified by fractional lending, leading to ever-larger economic contraction and triggering economic recession.

Thus, according to Austrian economic theory, the Fed introduces microeconomic instability by artificially depressing interest rates, and fractional lending (which, as Griffin points out, the Fed facilitates) amplifies the effect, resulting in macroeconomic instability.

(Note: Despite the name, the Austrian School is not geographically confined to Austria—it merely originated there. It is the third most common economic perspective in the United States after Keynesianism and Monetarism.)

Protecting Banks From Bad Investments

The second way that the Fed destabilizes the economy, according to Griffin, is by sheltering banks from the consequences of poor business decisions, thereby incentivizing them to engage in risky business practices. He discusses three mechanisms that remove banks’ incentive to operate responsibly.

Mechanism 1: Lender of Last Resort. One of the Fed’s original core functions was to act as a benevolent “lender of last resort,” allowing banks to borrow practically unlimited funds in case of a liquidity emergency (a situation where the bank doesn’t have enough cash or other “liquid assets” to operate). By performing this function, the Fed insulates banks from risk by ensuring that they can always borrow enough funds to meet their immediate obligations. This incentivizes practices like fractional lending, where the bank would be obliged to pay out more money than they have if all their depositors withdrew their money at the same time.

Mechanism 2: Bailouts. When a large enough bank gets into financial trouble, the government typically steps in to prevent it from failing, ultimately transferring the bank’s losses to American taxpayers. But, perhaps more importantly, the government also bails out large corporations and foreign governments that borrow from banks in the US. As such, if the borrower is big enough to be eligible for bailout, then the bank doesn’t need to consider the soundness of the borrower’s business practices. The availability of large loans to fund risky or wasteful business ventures leads to large failed business ventures, which contribute to economic instability.

This is because the loan carries no risk for the bank, since even if the borrower defaults, someone (usually American taxpayers) will still pay back the loan with interest. Griffin concedes that in bailout situations, banks often take a token loss, but he argues that the amount banks write off in such cases isn’t large enough to make a dent in their profit from the loan. He also notes that, while Congress is responsible for most bailouts, the Fed facilitates the process.

Mechanism 3: Deposit Insurance. Through the Federal Deposit Insurance Corporation (FDIC), the Fed insures all bank deposits, so depositors have little reason to vet the credibility of their banks, and banks don’t have to compete with each other for depositors’ trust by adhering to sound business practices.

Griffin thinks that if the FDIC were abolished, private insurance companies would begin offering deposit insurance to banks. He expects these companies would scrutinize each bank’s business practices and adjust their premiums based on the risk that each bank posed. This would incentivize banks to avoid risky practices (fractional lending, for example), in contrast to the FDIC’s flat rates, which provide no incentive for banks to handle their depositors’ money responsibly.

How Much Does the Fed Really Protect Banks From Risk?

Some economists argue that banks aren’t sheltered from risk as much as Griffin says because the picture that he paints of how the FDIC and the Fed operate is incomplete.

In the case of the Fed acting as a lender of last resort, most economists acknowledge that this function does involve a moral hazard (a financial incentive to take risks because you’re sheltered from the consequences), but they argue that not having a lender of last resort would present an even greater hazard overall. Without a lender of last resort, banks facing liquidity crises would fail. Bank failures disrupt the business of the bank’s depositors, which, in turn, disrupts the economy. Thus, the economic instability introduced by bank failures is arguably greater than the economic instability introduced by the moral hazard of having a lender of last resort for banks to fall back on.

In the case of bailouts, generally, the government only bails out businesses whose failure would cause systemic collapse of the US economy. A bank can’t know in advance whether the government would bail it out during a crisis. For example, in the 2008 housing market crash, the government bailed out several large financial institutions, but it let Merrill Lynch fail and be bought up by Bank of America. Thus, banks are unlikely to base their business decisions on the chance of a bailout.

It’s also worth noting that, in the case of the 2008 bailouts, the US Treasury reports that in the end, the financial institutions it bailed out not only survived but eventually repaid the money they received with interest, so the bailout ended up being a good investment of taxpayers’ money. This tends to imply that, while these companies unquestionably made some poor business decisions leading to the crash, at least they learned from their mistakes and went on to become profitable again.

Furthermore, with the passage of the Dodd-Frank Act in 2010, the government seems to be trying to get out of the bailout business. The Dodd-Frank Act endeavors to replace bailouts with “bail-ins.” In a bail-in, a financial institution that gets into financial trouble but whose failure would jeopardize the economy at large is allowed to cannibalize its depositors’ “unsecured assets.” (Unsecured assets are those not protected by the FDIC, such as deposits in excess of the threshold that the FDIC insures.) Basically, a bail-in enables a financial institution to avoid a complete failure without the injection of outside capital by passing on some of its losses to its depositors.

As such, bail-ins highlight the limitations of FDIC deposit insurance, and imply that banks do have to compete for the trust of their depositors, since their depositors are at risk of losing money if the bank has to execute a bail-in. This is especially important for large depositors, whose balances are more likely to exceed FDIC thresholds.

The Fed Taxes Us Through Inflation

Griffin asserts that the Fed is responsible for inflation, and he is concerned that inflation constitutes an unfair, hidden tax whereby the American people pay for the government’s expenditures without realizing it.

As Griffin explains, the Fed issues the fiat currency of the United States. Fiat currency, by definition, isn’t backed by gold or silver or any other tangible material, so in principle, there’s no limit on how much currency the Fed can create.

In practice, the Fed creates as much additional currency as the government needs to finance its operations. However, as the supply of US dollars increases, the purchasing power of each dollar decreases, meaning American consumers can’t buy as much with their money—this is inflation. Thus, by creating more currency and causing inflation, the Fed takes purchasing power away from everyone else who owns US dollars.

Griffin concedes that not all deficit spending money comes from the Fed. When the government needs money, it borrows it by issuing bonds. Some of these bonds are bought by private parties, but if Congress issues more bonds than people want to buy, the Fed is legally obligated to buy the rest. And it does so by creating additional dollars.

(Shortform note: If you’re an investor looking to build a low-risk portfolio for dependable income, US treasury bonds may be exactly what you need. Treasury bonds provide predictable income from the interest that the government pays on the bonds, and carry very little risk, in contrast to stocks, which promise a higher rate of return, but carry a much greater risk of loss.)

Is Taxation Through Inflation Unfair?

Griffin asserts that inflation—which the Fed creates by issuing additional currency—constitutes an unfair tax. It’s easy to see how inflation can be considered a tax if the government is creating new dollars to fund projects, while reducing the purchasing power of the money that was already in circulation, but how is this unfair? When money loses value, the loss in purchasing power is distributed among everyone who has money, and scales according to the amount of money they have, so those with the most money lose the most purchasing power and those with the least money lose the least. Some might argue that this makes it a very equitable tax.

But other authors have developed the case for the unfairness of inflation more fully. In Economics in One Lesson, Henry Hazlitt explains that inflation doesn’t happen all at once, but rather ripples outward from the point where the government first spends the new money. This means different groups will be affected differently as inflation takes effect.

When the government first buys goods and services with newly issued dollars, prices for those goods and services rise with the surge in demand. The businesses that sell them respond to the increased prices by expanding their operations, increasing the demand for labor and thus driving up wages in that particular line of business. Their employees eventually spend their increased incomes on other goods and services, increasing demand for most consumer goods and causing prices to rise. Increased prices again cause other suppliers to expand their operations, thereby raising wages—this time more generally—and the process repeats itself until the economy reaches a new equilibrium.

In the process, a few people saw their wages rise before the price of consumer goods started to rise, and thus actually benefited from this cycle of inflation, at least in the short-term (in the long term, the reduction in the value of their savings might outweigh this benefit). But other people (likely the majority) didn’t see their wages rise until after they’d been hit with higher prices, so they took a loss on top of the loss of value of their savings. So the effects of inflation are not uniform, but affect different people differently.

Additionally, in Basic Economics, Thomas Sowell argues that inflation disproportionately affects the poor because wealthy people have the resources to insulate themselves from inflation. The rich rarely keep any significant portion of their wealth in cash. Instead, they invest it in stocks, real estate, or other assets which will hold their value, rising in price as inflation occurs. But the poor generally can’t afford to invest in these kinds of assets and thus keep what little money they have in cash, which loses value as inflation progresses. So the poor end up losing a greater percentage of their purchasing power due to inflation than the rich do.

These principles—namely that in the short term, some people benefit from inflation while others lose out, and that in the long term, the poor lose the most purchasing power to inflation, while the rich lose the least—tend to strengthen Griffin’s argument that inflation is an unfair tax.

The Fed Finances War and Waste

Griffin goes on to assert that by creating as much money as the government wants to borrow, the Fed encourages the government to waste money on projects that voters wouldn’t support if they had to pay for them through taxes (or if they knew that they were paying for them through inflation).

The primary example that Griffin gives of wasteful government spending is war and defense spending in preparation for possible wars.

(Shortform note: The unlimited financing that the Fed provides in time of war can also increase the scale of a war and thus the damage that the war causes, as Saifedean Ammous notes in The Bitcoin Standard while discussing the problems of fiat money. Ammous reasons that under a hard-money standard, where all currency is backed by gold or otherwise inherently limited in its supply, the government can only finance a war until its treasury is depleted. This gives governments an incentive to avoid war and limits the scope and scale of the wars they can fight. But the government’s ability to create fiat money removes these constraints, allowing it to continue fighting a war until it has exhausted all the resources of its entire population.)

Aside from war, Griffin expresses concern that welfare programs, foreign aid, and environmental protection initiatives often end up spending money wastefully. If the Fed couldn’t create unlimited currency to loan to Congress, these types of programs would have to be cut or at least run more efficiently.

(Shortform note: There are reasons to believe that if limited funding forced aid programs to run more efficiently and be more accountable, that would increase their effectiveness. In When Helping Hurts, Steve Corbett and Brian Fikkert observe that a key problem with aid programs is that they provide the wrong kind of aid, defaulting to doling out temporary relief to people who really need other forms of assistance (such as training or opportunities for networking, leading to better job options). More limited funding might force aid programs to cut back on handouts, and greater accountability for how they are using their funding might motivate them to analyze situations more carefully and provide the right kind of relief.)

How to Abolish the Federal Reserve

Based on the problems we’ve discussed, Griffin insists that the Fed should be abolished, but he concedes that simply repealing the law that created the Fed and shutting down the system would be disastrous for the US economy. This is because the economy runs on currency issued by the Fed. If all that currency disappeared, the economy couldn’t function. So Griffin proposes a sequence of actions that would successfully abolish the Federal Reserve System and correct the problems we’ve discussed.

For one thing, since the Fed facilitates government borrowing, Griffin sees the national debt as a problem that needs to be addressed prior to closing it. He proposes having the Fed issue enough money to buy up all the treasury bonds that it doesn’t already own, effectively paying off the national debt with newly issued money.

Of course, the Fed is also responsible for managing America’s fiat currency, so before we can abolish the Fed, we need to abandon fiat currency. Griffin proposes phasing out fiat dollars in favor of a new currency backed by precious metals. We’ll call that new currency “precious metal dollars,” or PMD’s.

Once fiat dollars are fully phased out, the Fed can be shut down. Without the regulation and safeguards that it provided, some banks will undoubtedly fail. But others will adjust their business practices to manage risk more conservatively, abandoning practices like fractional lending. And this shift toward better banking practices among the surviving banks will ultimately make the economy more stable.

An Alternative Solution: The Bitcoin Standard

Cryptocurrency may offer an alternative approach to abolishing the Fed, or at least solving the problems that it creates, according to Griffin. In The Bitcoin Standard, economics professor Saifedean Ammous criticizes fiat currency and the central banks that issue it for many of the same reasons that Griffin criticizes the Federal Reserve, including inflation, wasteful government spending (especially on wars), and artificially low interest rates that destabilize the economy by enticing businesses to borrow money for bad ventures.

But rather than trying to abolish fiat currency by abolishing central banks, Ammous suggests that using bitcoin as an international monetary standard could lead to the abolition of fiat currency through the natural operation of market forces.

Bitcoin—and currencies fully backed by bitcoin—wouldn’t suffer from the problems of fiat currency because, as Ammous explains, Bitcoin is impossible for any government to control. This, in turn, is because of its decentralized network structure, which is distributed across many independent parties in many countries. And it’s equally impossible for anyone to arbitrarily issue more bitcoin like governments issue fiat currency, so the supply of bitcoin is stable—much like the supply of precious metals.

In Ammous’s solution, the Federal Reserve wouldn’t necessarily need to be abolished. Its power over the economy would be greatly diminished, and some of its functions might become increasingly irrelevant. But it might be able to serve a more useful function by holding a large reserve of bitcoin (similar to its current gold reserves), and buying and selling bitcoin from other central banks to smooth out fluctuations in the demand for bitcoins.

Ammous doesn’t address the problem of the national debt explicitly, but if market forces drove the US economy to use primarily bitcoin-backed dollars, the demand for US fiat dollars would decrease, and with it the value of fiat dollars. Because the US national debt is owed in fiat dollars, that would mean the real value of the debt would also diminish, making it easier to pay off and less of a problem in the meantime.