Why should central banks be independent from the government?

July 16th, 2008

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Yesterday, one of our readers asked us this question:

Why is it important to keep central banks independent from the government? Wouldn’t it be better if the board of directors of a central bank are selected by the people, and therefore held accountable to the people for decisions, mistakes, and misjudgements?

At what point did central banks become concerned about targeting inflation? Before they existed, inflation was close to 0%, so surely they wouldn’t have been created with inflation targeting in mind?

The more I read, the more I feel that your ideal of a 100% reserve banking system with no central bank is the best way to control inflation (and to allow the people to understand the true cost of government projects [wars, etc] that is currently paid for through inflation). But why didn’t this work in the first place?

To answer these questions, we will turn back to history. As we explained before in A brief history of money and its breakdown- Part 2,

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ?currency? was just a definition of a weight of gold. For example, the ?dollar? was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury.

Under an international gold standard, there was an automatic market mechanism to keep government from inflating the money supply and to keep each country’s balance of payment in equilibrium. Hence, the world enjoyed the benefits of only one monetary medium, which facilitated trade, investment and travel. Prices were also kept in check (see What is inflation and deflation?). During that time, there were periods of price rises (e.g. during war) followed by periods of price falls (e.g. when war ends), with relatively stable prices in between.

Why did it not work out in the end? Well, thanks to the First World War. As we all know, modern wars are terribly expensive. Under a gold standard, no country can ‘afford’ to fight any war for an extended period of time. Therefore, the only option was to go off the gold standard and resort to purely fiat paper money as it is today. You can read the rest of the monetary breakdown story at A brief history of money and its breakdown- Part 2.

Now, you know how the US is able to ‘afford’ to fight extended wars in Iraq and Afghanistan with expensive professional armies today.  A gold standard will make this truly unaffordable.

Today, the central banks of the US and Australia follows an inflation targeting policy. That is, monetary policy is set ensure that there is a consistent price rise within a target range. How did inflation targeting develop? Well, it is another long story. You can read about it straight from the RBA at Inflation Targeting: A Decade of Australian Experience.

Next, we come to the most important part: why should central banks be independent from the government?

First, we have to understand the basics. What is the purpose of money? In essence, money functions as (1) a medium of exchange, (2) unit of account and (3) a store of value. To perform these functions, money has to fulfil certain properties as described in Properties of good money and its integrity cannot be tampered with.

Now, consider the situation that we described in Recipe for hyperinflation:

… imagine you are the only person in town who has the authority to create money out of any piece of paper with your own signature. Wouldn?t this make you a pretty powerful person in town? With such power, you can acquire anything you wish at the expense of others.

Under the gold standard, gold is money that is under the control of the free market. No one or institution ‘owns’ or control the money. But today, the central bank is the only institution that has the authority to create money out of thin air. As we said in Recipe for hyperinflation,

Look at any piece of paper money today and you will find the words of a government decree (e.g. ?This Australian note is legal tender throughout Australia and its Territories?) and perhaps a signature or two.

In Australia, the signature belongs to the RBA governor.

What if we give the government (which already has executive power) the power to create money? This will give the government a deeper concentration of power! If you believe the old adage that power corrupts and absolute power absolutely corrupts, then you will not want such a deep concentration of power. As we said before in Have we escaped from the dangers of inflation?,

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

That is why today, central banks are independent of the government, with complex and elaborate rules of money and credit creation (the exception will be Zimbabwe under Robert Mugabe). Our fear is that with this credit crisis worsening by the day, deflation may prove such a unthinkable threat (e.g. see How do we all pay for the bailout of Fannie Mae and Freddie Mac?) that the government will ‘roll back’ all these rules one by one in order to keep the entire financial system solvent. As the ancient Chinese saying goes, the journey of a thousand mile begins with the first step. Therefore, the journey towards a hyperinflation hell will begin with such measures (see Recipe for hyperinflation). Your belief in whether you will see hyperinflation in your lifetime will depend on your faith on the government to maintain the integrity of money.

Next, what if we let the people vote for the board of directors who control the central banks? If shareholders have trouble keeping the directors of their company honest and accountable, then it will be the same for the central bank.

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  • Steve Karma

    I said in my own blog, and I will repeat it again, unlike the Federal Reserve, I do believe the Reserve Bank of Aust headed by Glenn is doing a fantastic job, and receiving unnecessary criticism for raising rates early on when the FEDS were dropping them. Yes we printed money, but we raise rates to control inflation at one point, and placed somewhat arguably (I am sure most won’t agree here) control around the surging AUD. Despite short term spikes in inflation, the RBA saw instability and took into account the middle term rather than the immediate CPI/inflation figures, to decide to keep rates steady the last few months. Something they could not do if they had not raise rates early as they did.

    Furthermore, allowing retail banks to independently raise rates is a 2 (or more) birds with one stone effect, allowing the battered financial sector to recoup, while assisting in kerbing consumption on the domestic side, all while keeping the dollar in check. I’m no economist by anyone’s measure but despite the pain I feel with my own home loan, I believe the RBA is doing a great job, and I hope they will never be corrupted or persuaded by the political pressure put to them by the Federal Government’s criticism – whichever is in power.

  • Steve Karma

    I said in my own blog, and I will repeat it again, unlike the Federal Reserve, I do believe the Reserve Bank of Aust headed by Glenn is doing a fantastic job, and receiving unnecessary criticism for raising rates early on when the FEDS were dropping them. Yes we printed money, but we raise rates to control inflation at one point, and placed somewhat arguably (I am sure most won’t agree here) control around the surging AUD. Despite short term spikes in inflation, the RBA saw instability and took into account the middle term rather than the immediate CPI/inflation figures, to decide to keep rates steady the last few months. Something they could not do if they had not raise rates early as they did.

    Furthermore, allowing retail banks to independently raise rates is a 2 (or more) birds with one stone effect, allowing the battered financial sector to recoup, while assisting in kerbing consumption on the domestic side, all while keeping the dollar in check. I’m no economist by anyone’s measure but despite the pain I feel with my own home loan, I believe the RBA is doing a great job, and I hope they will never be corrupted or persuaded by the political pressure put to them by the Federal Government’s criticism – whichever is in power.

  • Hi Steve!

    …but despite the pain I feel with my own home loan, I believe the RBA is doing a great job, and I hope they will never be corrupted or persuaded by the political pressure put to them by the Federal Government’s criticism – whichever is in power.

    We hope so too. On the other hand, we wonder how many people think the same way as you do.

    Professor Steve Keen believes that the RBA is wrong and should not be raising rate because deflation is the greater threat. Since the RBA are accountable to no one, he suggested that monetary policy should be placed under politician’s control instead because they are answerable to the people.

    But we have the people who prefer immediate pain relief than take harsh medicine, especially when the deflation will probably get much more painful in the years to come. These people will then place pressure on the politicians, especially during the election year. If politicians controls monetary policy, then we hope Australia will have lots of luck.

  • Hi Steve!

    …but despite the pain I feel with my own home loan, I believe the RBA is doing a great job, and I hope they will never be corrupted or persuaded by the political pressure put to them by the Federal Government’s criticism – whichever is in power.

    We hope so too. On the other hand, we wonder how many people think the same way as you do.

    Professor Steve Keen believes that the RBA is wrong and should not be raising rate because deflation is the greater threat. Since the RBA are accountable to no one, he suggested that monetary policy should be placed under politician’s control instead because they are answerable to the people.

    But we have the people who prefer immediate pain relief than take harsh medicine, especially when the deflation will probably get much more painful in the years to come. These people will then place pressure on the politicians, especially during the election year. If politicians controls monetary policy, then we hope Australia will have lots of luck.

  • Alex

    Thanks for that post, CIJ

    Steve, I’m by no means an economist either – just a layman – but my feelings are that the RBA is doing a good job as well. I don’t think anything in CIJ’s post is attacking the RBA.

    What does seem strange to me is that a democracy can have central bankers that aren’t elected by the people, and that aren’t held accountable to the people.

    On another note:

    I feel the following statement may not represent the truth: “Why did it not work out in the end? Well, thanks to the First World War. As we all know, modern wars are terribly expensive. Under a gold standard, no country can ?afford? to fight any war for an extended period of time. Therefore, the only option was to go off the gold standard and resort to purely fiat paper money as it is today”

    In my opinion the adoption of fiat money was a cop-out. The government felt it wasn’t able to convince people to make the necessary sacrifices for a prolonged war, so it chose to secretly force them to make those same sacrifices through inflation.

    I don’t believe that governments switched to fiat because they couldn’t afford the war on a gold standard… because they also couldn’t afford it using fiat money without causing significant inflation.

    In my opinion, on a gold standard the government would need to convince the people to make sacrifices in order to fight a prolonged war. If the government couldn’t afford to buy the required amounts of food, weapons, oil, transport, etc, off the people at market rates, then (in order to fight the war) the people would need to make sacrifices and provide these items at a discount. Perhaps even growing and supplying food for free, or asking soldiers to fight for free, or building weapons and transport and providing oil for free, etc.

    This is obviously a significant challenge for any government, and would be pure hypocracy given their battles against communist regime’s.

    Given this limited understanding, in my opinion the adoption of fiat money was a cop-out. It’s far easier to secretly discount these items through inflation, than to convince the people to make those sacrifices knowingly. It’s easier to ask forgiveness than approval.

  • Alex

    Thanks for that post, CIJ

    Steve, I’m by no means an economist either – just a layman – but my feelings are that the RBA is doing a good job as well. I don’t think anything in CIJ’s post is attacking the RBA.

    What does seem strange to me is that a democracy can have central bankers that aren’t elected by the people, and that aren’t held accountable to the people.

    On another note:

    I feel the following statement may not represent the truth: “Why did it not work out in the end? Well, thanks to the First World War. As we all know, modern wars are terribly expensive. Under a gold standard, no country can ?afford? to fight any war for an extended period of time. Therefore, the only option was to go off the gold standard and resort to purely fiat paper money as it is today”

    In my opinion the adoption of fiat money was a cop-out. The government felt it wasn’t able to convince people to make the necessary sacrifices for a prolonged war, so it chose to secretly force them to make those same sacrifices through inflation.

    I don’t believe that governments switched to fiat because they couldn’t afford the war on a gold standard… because they also couldn’t afford it using fiat money without causing significant inflation.

    In my opinion, on a gold standard the government would need to convince the people to make sacrifices in order to fight a prolonged war. If the government couldn’t afford to buy the required amounts of food, weapons, oil, transport, etc, off the people at market rates, then (in order to fight the war) the people would need to make sacrifices and provide these items at a discount. Perhaps even growing and supplying food for free, or asking soldiers to fight for free, or building weapons and transport and providing oil for free, etc.

    This is obviously a significant challenge for any government, and would be pure hypocracy given their battles against communist regime’s.

    Given this limited understanding, in my opinion the adoption of fiat money was a cop-out. It’s far easier to secretly discount these items through inflation, than to convince the people to make those sacrifices knowingly. It’s easier to ask forgiveness than approval.

  • Hi Alex!

    I feel the following statement may not represent the truth:…

    … In my opinion the adoption of fiat money was a cop-out.

    That’s why we put a quotation in the word “afford.” We agree with you on that because that’s what we have in mind when we say war is ‘unaffordable’ under a gold standard.

  • Hi Alex!

    I feel the following statement may not represent the truth:…

    … In my opinion the adoption of fiat money was a cop-out.

    That’s why we put a quotation in the word “afford.” We agree with you on that because that’s what we have in mind when we say war is ‘unaffordable’ under a gold standard.

  • Steve Karma

    Hi CIJ – thanks for the reply. I wonder if Professor Keen was from the same school as Bernanke. I suppose there will always be different definitions of deflation – perhaps he meant destabilization of the asset bubble? (sorry I shouldn’t second guess). All I know is, I hope for a soft landing for us despite the wave of destruction from the Bernanke camp 2003 – the scars were written in stone, not water. But credit where credit is due, he is starting to sound like he wants to target inflation – finally.

    Hi Alex – oh no, god no. I don’t think CIJ is attacking RBA at all, I bias the view of independence of the Reserve, however I think the opposite of the Feds. Quite the contrary, was a great post from the editor, very well balanced and not biased like mine. Hope it didn’t come across that way, never meant it.

  • Steve Karma

    Hi CIJ – thanks for the reply. I wonder if Professor Keen was from the same school as Bernanke. I suppose there will always be different definitions of deflation – perhaps he meant destabilization of the asset bubble? (sorry I shouldn’t second guess). All I know is, I hope for a soft landing for us despite the wave of destruction from the Bernanke camp 2003 – the scars were written in stone, not water. But credit where credit is due, he is starting to sound like he wants to target inflation – finally.

    Hi Alex – oh no, god no. I don’t think CIJ is attacking RBA at all, I bias the view of independence of the Reserve, however I think the opposite of the Feds. Quite the contrary, was a great post from the editor, very well balanced and not biased like mine. Hope it didn’t come across that way, never meant it.

  • Hi Steve!

    I wonder if Professor Keen was from the same school as Bernanke.

    Ben Bernanke was said to be ‘Keynesian.’ We suspect it is an error to pigeon-hole Bernanke into a category. But for Steve Keen, he is definitely not from the Austrian School. Neither is he from the mainstream neo-classical or Keynesian economist.

  • Hi Steve!

    I wonder if Professor Keen was from the same school as Bernanke.

    Ben Bernanke was said to be ‘Keynesian.’ We suspect it is an error to pigeon-hole Bernanke into a category. But for Steve Keen, he is definitely not from the Austrian School. Neither is he from the mainstream neo-classical or Keynesian economist.

  • Stephen Johnston

    Good question what is Steve Keen?
    Eventually he will have to make a decision hayek Austrian School or a Keynesian large central planner like Ben Bernanke.
    Way things are going Steve Keen soon have to play his cards his track record is close to Canberra my hunch is he will be a large central planner.
    Temptation of great power and telling everyone how their business should be run is wonderful for many central planners.
    The comment about Glenn Stevens RBA is right he is the best.
    The man knows to let the free market work and keep the central planners away or they will stuff it up.
    Read Glen Stevens comments humble and understands boom and busts what needs to be done.

  • Stephen Johnston

    Good question what is Steve Keen?
    Eventually he will have to make a decision hayek Austrian School or a Keynesian large central planner like Ben Bernanke.
    Way things are going Steve Keen soon have to play his cards his track record is close to Canberra my hunch is he will be a large central planner.
    Temptation of great power and telling everyone how their business should be run is wonderful for many central planners.
    The comment about Glenn Stevens RBA is right he is the best.
    The man knows to let the free market work and keep the central planners away or they will stuff it up.
    Read Glen Stevens comments humble and understands boom and busts what needs to be done.

  • Hi Stephen!

    Steve Keen is the (associate??) professor at the University of Western Sydney’s school of economics/finance. He has reservations about the current economics method of mainstream economics. His methodology involves some ideas borrowed from engineering, namely dynamic systems and systems thinking.

    You can read his debt deflation blog here.

    We agree with Steve Keen regarding the problem of debt bubble we have in Australia, which makes us vulnerable to a deflation. But we differ from him regarding the cure.

  • Hi Stephen!

    Steve Keen is the (associate??) professor at the University of Western Sydney’s school of economics/finance. He has reservations about the current economics method of mainstream economics. His methodology involves some ideas borrowed from engineering, namely dynamic systems and systems thinking.

    You can read his debt deflation blog here.

    We agree with Steve Keen regarding the problem of debt bubble we have in Australia, which makes us vulnerable to a deflation. But we differ from him regarding the cure.

  • Stephen Johnston

    Thank you for your comment about Steve Keen
    His research on debt in this country regarding mortgages is excellent right on.
    Stagflation problem is very real.
    A friend try to sell a property in the western suburbs of Sydney marcurther area and atleast take a 20% loss on his original capital investment.
    Because Steve Keen is close to Canberra he may use his research on debt levels to pressure the central planners in Canberra to lower interest rates and thus cause major inflation problems.
    Reducing interest rates is not the answer America and Japan both try it and we have see the results so far.
    More central planning experiments North and South Korea. East and West Germany.

  • Stephen Johnston

    Thank you for your comment about Steve Keen
    His research on debt in this country regarding mortgages is excellent right on.
    Stagflation problem is very real.
    A friend try to sell a property in the western suburbs of Sydney marcurther area and atleast take a 20% loss on his original capital investment.
    Because Steve Keen is close to Canberra he may use his research on debt levels to pressure the central planners in Canberra to lower interest rates and thus cause major inflation problems.
    Reducing interest rates is not the answer America and Japan both try it and we have see the results so far.
    More central planning experiments North and South Korea. East and West Germany.

  • dt

    It seems a bit of quandary, with arguments for democracy and free market and concern to centralised planning/control on the one hand and on the other, support for absolute control (and so absolute monetary power) of our monetary finances by a centralized authority devoid of accountability to the democracy. It questions does a democratic government really exist, if the essence of our economic system, the creation and supply of money and credit conditions are controlled by a centralized unaccountable authority. I?m not sure one is better than the other and as a ‘layperson’ I may be wrong, but it would seem to me one has to accept that we have a global situation of relatively free markets and monetary control by centralised banking and so if the global economic problems foreboded, either hyperinflation or deflation, continue to unfold, their responsibility must fall squarely at the structure of those markets (likely leveraging and derivatives) and central bank authority feet (money supply and credit creation control) and the rules and methods employed. It seems little point in blaming government efforts now, who maybe vainly trying to shut the gate after the horse has well bolted, and if this is the case, one hopes that they wake up to it being too late and take the deflationary medicine, as I would agree the ?democracy? will pay a greater unfair cost of a ?free? market hyperinflation bail out. It would also seem reasonable to me for the elected government to reflect on this situation, that is why we call it government for better or worse.

  • dt

    It seems a bit of quandary, with arguments for democracy and free market and concern to centralised planning/control on the one hand and on the other, support for absolute control (and so absolute monetary power) of our monetary finances by a centralized authority devoid of accountability to the democracy. It questions does a democratic government really exist, if the essence of our economic system, the creation and supply of money and credit conditions are controlled by a centralized unaccountable authority. I?m not sure one is better than the other and as a ‘layperson’ I may be wrong, but it would seem to me one has to accept that we have a global situation of relatively free markets and monetary control by centralised banking and so if the global economic problems foreboded, either hyperinflation or deflation, continue to unfold, their responsibility must fall squarely at the structure of those markets (likely leveraging and derivatives) and central bank authority feet (money supply and credit creation control) and the rules and methods employed. It seems little point in blaming government efforts now, who maybe vainly trying to shut the gate after the horse has well bolted, and if this is the case, one hopes that they wake up to it being too late and take the deflationary medicine, as I would agree the ?democracy? will pay a greater unfair cost of a ?free? market hyperinflation bail out. It would also seem reasonable to me for the elected government to reflect on this situation, that is why we call it government for better or worse.

  • In the view of CIJ, what is the solution to the credit bubble (and house price bubble) here in Australia?

    How does Steve Keen’s view differ from that?

    btw – really appreciate this view informative blog.

  • In the view of CIJ, what is the solution to the credit bubble (and house price bubble) here in Australia?

    How does Steve Keen’s view differ from that?

    btw – really appreciate this view informative blog.

  • Hi Steven!

    Someone did asked Steve Keen this question: “What policy would you advocate for Japan’s deflation case?” Steve Keen said that if he has the authority in Japan, he would legislate the rise of wages in Japan.

    So, this is what we interpret his view to be…

    He understands that the credit bubble is very dangerous and that he would have raised Australia’s interest rates very early to pop the housing bubble. We agree with Steve that with so much debt accrued in the Australian economy, deflation is a serious threat.

    At this point onward, here is where both our points differ. Steve Keen advocate further inflation to solve the problem. Specifically, we believe that he wants policies to enable wage inflation without further inflation of the credit bubble. That would mean inflation + economic restructuring.

    For us, we would advocate a painful cleansing and correction of the bubble so that all the mal-investments be cleaned up in order to put the economy back into a sustainable growth path. While Steve Keen conceded that such a cleansing will no doubt clear the excesses, he fears that such a process will be too painful.

    We are not sure whether his policy recommendation will work or not. If it does not work, we believe the risk will be hyperinflation.

    Anyway, this is just our interpretation of his views.

  • Hi Steven!

    Someone did asked Steve Keen this question: “What policy would you advocate for Japan’s deflation case?” Steve Keen said that if he has the authority in Japan, he would legislate the rise of wages in Japan.

    So, this is what we interpret his view to be…

    He understands that the credit bubble is very dangerous and that he would have raised Australia’s interest rates very early to pop the housing bubble. We agree with Steve that with so much debt accrued in the Australian economy, deflation is a serious threat.

    At this point onward, here is where both our points differ. Steve Keen advocate further inflation to solve the problem. Specifically, we believe that he wants policies to enable wage inflation without further inflation of the credit bubble. That would mean inflation + economic restructuring.

    For us, we would advocate a painful cleansing and correction of the bubble so that all the mal-investments be cleaned up in order to put the economy back into a sustainable growth path. While Steve Keen conceded that such a cleansing will no doubt clear the excesses, he fears that such a process will be too painful.

    We are not sure whether his policy recommendation will work or not. If it does not work, we believe the risk will be hyperinflation.

    Anyway, this is just our interpretation of his views.

  • Stephen Johnston

    Thank you for your insight into Steve keens thinking cleansing the system would be too painful?
    First like to say Steve Keen thinking is trying to help, however the best good intentions can lead to ruin for the economy.
    What has happen to Australian society wrap everyone in cotton wool and we have become a bunch of wimps!
    Our great grandparents survive a depression and the second world war!
    Our grand parents live within their means and if they could not afford some thing they would wait until they had the cash.
    Now we can get the new house with 2 bathrooms and the latest furniture new four wheel drive all on credit.
    Only about 33% of Australains with big mortgages and only a small percentage that are financially ready to go under because greed wanting everything now. (Some say it’s more and cause great meltdown however they have thier own hidden agenda probably one of the 15% )Lets say a top figure of 15% of all mortgages go under does that mean the other 85% have to paid for it through higher inflation thanks to government policy of lower interest rates and higher wages.
    The banks will survive and the other 85% will keep living the grandparents right way.
    15% will have to learn the hard old values of our grandparents.

  • Stephen Johnston

    Thank you for your insight into Steve keens thinking cleansing the system would be too painful?
    First like to say Steve Keen thinking is trying to help, however the best good intentions can lead to ruin for the economy.
    What has happen to Australian society wrap everyone in cotton wool and we have become a bunch of wimps!
    Our great grandparents survive a depression and the second world war!
    Our grand parents live within their means and if they could not afford some thing they would wait until they had the cash.
    Now we can get the new house with 2 bathrooms and the latest furniture new four wheel drive all on credit.
    Only about 33% of Australains with big mortgages and only a small percentage that are financially ready to go under because greed wanting everything now. (Some say it’s more and cause great meltdown however they have thier own hidden agenda probably one of the 15% )Lets say a top figure of 15% of all mortgages go under does that mean the other 85% have to paid for it through higher inflation thanks to government policy of lower interest rates and higher wages.
    The banks will survive and the other 85% will keep living the grandparents right way.
    15% will have to learn the hard old values of our grandparents.

  • dt

    I came across this quote (unfortunately belatedly) that might be of interest to this discussion -perhaps even more significant to the actual state of the FED, but still worth a thought:

    ?If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.?

    – Thomas Jefferson, Letter to Treasury Secretary Albert Gallatin (1802)

  • dt

    I came across this quote (unfortunately belatedly) that might be of interest to this discussion -perhaps even more significant to the actual state of the FED, but still worth a thought:

    ?If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.?

    – Thomas Jefferson, Letter to Treasury Secretary Albert Gallatin (1802)

  • Hi dt!

    Great quote! It goes to show how far the US has drifted from their founding father’s Constitution.

  • Hi dt!

    Great quote! It goes to show how far the US has drifted from their founding father’s Constitution.