Democratize the Fed

If Mr. Bernanke is serious about overhauling the Federal Reserve regulatory system ("Bernanke Says Regulatory Overhaul Needed," Associated Press, 03/10/09) he might want to start with the Federal Reserve itself, and start adhering to the spirit as well as the strict letter of the law of the Federal Reserve Act of 1913. Many people evidently don't realize it, but the Federal Reserve Act, in an effort to prevent the government from being able to monetize its deficits, forbids the Federal Reserve from dealing in primary government securities, that is, securities purchased directly from the federal government.

Unfortunately, there is a loophole in the law. By law, bank reserves must be only in the form of cash or federal government securities. Cash, in this instance, is defined as "vault cash," that is, cash on hand at a commercial bank, and the commercial bank's own demand deposits at the local Federal Reserve Bank. Under fractional reserve banking, the Federal Reserve must have the power to regulate reserve requirements, and in order to do that, it must have the power to buy and sell secondary government securities, that is, securities purchased from a holder in due course other than the original issuer, the federal government.

The fiction that the federal government and the Federal Reserve maintain is that the vast amounts of federal government securities that pass briefly through the hands of a small but select group of special bond brokers are secondary government securities. They can thus be freely bought and sold by the Federal Reserve in their "open market operations." "Open market operations" is something of a euphemism, for they are effectively closed to everyone except the Federal Reserve and the select group of bond brokers who are, to all intents and purposes, agents of the federal government. In consequence, the letter of the law is adhered to, while the spirit is flouted continually.

Four necessary steps suggest themselves — if Mr. Bernanke is serious about genuine reform.

One, reinstitute the separation of function imposed on financial institutions by Glass-Steagal and similar legislation. Avoiding incompatible functions and relying on systemic checks and balances is critical when attempting to regulate a system. The repeal of Glass-Steagal in the early 1980s set the stage for both the Savings and Loan debacle and the current financial meltdown.

Two, institute an immediate 100% reserve requirement for commercial banks, to consist exclusively of vault cash and commercial bank deposits at the local Federal Reserve Bank. This will remove the justification for the Federal Reserve to deal in either primary or secondary government securities. The Open Market Committee can be shut down, and the Federal Reserve can gradually divest itself of its holdings of government securities as the national debt is paid down. The Federal Reserve will itself provide the reserves to commercial banks by discounting qualified industrial, commercial, and agricultural private sector loans, not government securities, resulting in a currency backed by hard assets, not government debt.

Three, enact the Capital Homestead Act. All credit extended through discounting by the Federal Reserve will result in broadened ownership, thereby creating jobs and increasing effective demand for consumer and thus capital goods, as well as rebuilding the tax base.

Four, buy out the current "shareholders" of the Federal Reserve (a term that must be used advisedly, anyway, for the "shares" do not carry dividend or voting rights), and issue every American citizen and permanent legal resident a single lifetime, voting, participating, non-transferable share in this extremely valuable national resource. The shares will cost nothing when issued, but the estate of the holder will also not be compensated at death when the single share is surrendered.

A great deal else needs to be done, of course. These four steps, however, should provide good guidelines as to what sort of thing we should be looking at instead of trying to pass more unworkable laws to police an inherently contradictory system having a serious identity crisis.