Wednesday, March 10, 2010

Own the Fed, Part II: The Evolution of the System

The original mission of the Federal Reserve System was straightforward. The network of twelve regional development banks was to create money either to rediscount bills (for new securities), or to engage in open market operations (for existing securities), buying and selling bills. From 1915 to 1937 rediscounting and open market operations involving private sector bills and securities declined dramatically, while the amount and number of transactions involving government bills and securities increased enormously. (Financial Organization and the Economic System, op. cit., 383-384.)

Since the fundamental sea-change wrought in the American economy by the New Deal and institutionalized by the Second World War, the idea that the Federal Reserve System was established to provide an elastic (i.e., non-inflationary, non-deflationary) currency for the private sector has become viewed as alien, even radical by the authorities in charge of the system as well as by academic and professional economists. In consequence, individuals and groups such as the recent "Tea Party" movement and various conspiracy-oriented groups have, since the 1930s, called for the abolition of the Federal Reserve, or a restructuring of the institution along lines that would prevent its original purposes from being restored. This results from the perception of the Federal Reserve as a means by which the State, in union with the rich and powerful, manipulates the economy for it own benefit and as a means of oppressing people.

Abolition or emasculation of the Federal Reserve System would, however, undoubtedly be an even bigger disaster than that caused by the misuse of the institution. Central banks fill a critical role in an advanced economy, a role increasingly vital as globalization spreads. Clearly reform to conform to the institution's original purposes, not abolition or substantial change is in order. As Dr. Harold Moulton explains,
It has already become abundantly clear that the Federal Reserve system did not give us a unified banking system, prevent bank failures, or eliminate economic and financial crises. The fact that it proved unable to surmount the weaknesses inherent in the dual banking system, and to bring stability to a highly complex business system operating in the midst of world economic disorganization, does not of course prove that the system was ill-conceived or badly administered. On the whole, the Federal Reserve system has rendered a great service, the significance of which can be appreciated only by reflecting upon the conditions which might have prevailed had we continued to operate on the basis of the old decentralized banking system. (Financial Organization and the Economic System, op. cit., 362.)
The diversion of the Federal Reserve as the lender of last resort for the private sector to the lender of first resort for the State resulted from a series of what can only be called historical accidents. The designers of the Federal Reserve in 1913 had a good, if slightly flawed (but correctible) understanding of the role of a central bank. They had four stated purposes in mind when passing the Federal Reserve Act: 1) "to provide for the establishment of Federal Reserve Banks," 2) "to furnish an elastic currency," 3) "to afford means of rediscounting commercial paper," and 4) "for other purposes." (Public Law No. 43, 63rd Congress, H.R. 7837, § 1.) The "for other purposes" is a fairly standard provision to allow amendment and reasonable interpretation of an Act, as well as allow for open market operations to supplement the rediscounting of commercial paper. As designed, the Federal Reserve System fulfilled those purposes adequately, some have said brilliantly:
The panic of 1907 forcibly directed public attention to the fact that the nation's industry and commerce had grown faster than its banking facilities. A measure affording some relief — the Aldrich-Vreeland Act — was passed in 1908, but the important event in that year was the appointment of a Monetary Commission to consider the whole problem of currency legislation. The Republicans were not anxious to alter the existing order of things and the Democrats, swept into power in 1913, took advantage of their opportunity to enact currency and banking reforms which combined the principles of great social control with a sufficient amount of decentralization to prevent any single financial group from getting too much power. As Professor Beard suggests in "The Rise of American Civilization" the Federal Reserve Act of 1913 represents the union of "Jacksonian hopes" with "financial propriety." (Norman Angell, The Story of Money. New York: Frederick A. Stokes Company, 1929, 305-306)
The problem was that the basic structure of the Federal Reserve System followed the design of the system in place in the Second Reich, at the time possibly the best-organized and well-regulated banking system in the world. The new German imperial government had been forced to deal with an extremely complicated financial system, both economically and politically, following reunification in 1871. This it had done competently, even superbly — but there were still flaws in the system, of which three were the most significant, as they were carried over into the design of the Federal Reserve System. (A good synopsis of the process and the complexities involved in restructuring the German financial system can be found in Karl Helfferich, Money. New York: The Adelphi Company, 1927, 147-174.)

First, there was the insistence on maintaining convertibility of the paper currency into gold or silver — specie — even when the vast bulk of the money supply was in the form of "real bills." A real bill is "pure money," that is, a piece of paper or some substitute that conveys a property right in the present value of hard assets, usually existing or future marketable goods and services. Existing marketable goods and services are in the form of inventories for goods and contracts for services, while future marketable goods and services are, absent speculation, represented by the present value of the capital required to produce the goods and services. Traditionally, bills have been drawn primarily on existing inventories for a period of ninety days, but during times of capital expansion have frequently been drawn on capital investment (equity) for extended periods of time. A real bill has the advantage — and disadvantage — of only being as good as the word of the maker of the promise to convey a property right. In contrast to a gold or silver coin, a real bill has no intrinsic value.

Despite the general desirability of gold and silver, specie-based currencies had been causing problems for centuries. There is no way to link the amount of gold and silver or any other precious metal (specie) to the present value of the existing or future marketable goods and services in an economy except by assuming economic stagnation and fixing the amount of gold and silver in the economy. There has, however, never been an example of a truly stagnant economy that lasted long enough for variations in the quantities of precious metals to cause significant problems; a stagnant economy has much more serious problems to occupy its attention.

Variations in the amount of gold and silver available alternated between causing inflation when the supply exceeded demand, that is, the needs of commerce, industry, and agriculture, and deflation when there wasn't enough to supply the channels of trade with sufficient circulating media. The Spanish Empire had experienced 400% inflation from the 16th to the 18th centuries as a result of the tremendous amounts of gold and silver flowing in from the New World — increases in the money supply that were not matched by increased production of marketable goods and services.

At the opposite extreme was Andrew Jackson's 1836 Specie Circular, a tactical move by Jackson in his "war" with the Second Bank of the United States. The Specie Circular took effect in 1837 during the administration of Martin Van Buren. The Circular prohibited the federal government from accepting anything except gold or silver in payment of taxes, customs duties, or to purchase land. This caused hoarding of precious metal, drained gold and silver reserves from commercial banks, and forced the banks to suspend convertibility of their banknotes into specie. This constricted credit, deflated the currency, and plunged the economy into a depression, "Hard Times." (See, e.g., William Lawrence Royall, Andrew Jackson and the Bank of the United States: Including a History of Paper Money in the United States. New York: G. P. Putnam's Sons, 1880; Edward S. Kaplan, The Bank of the United States and the American Economy. Westport, Connecticut: Greenwood Press, 1999; George Rogers Taylor, ed., Jackson versus Biddle: The Struggle over the Second Bank of the United States. Boston: D. C. Heath and Company, 1949.)

The immediate problem with attempting to maintain convertibility into specie in a modern industrial economy such as the United States had developed since the end of the Civil War, however, was the fact that it mandated fractional reserve banking. This was to conform to the tenets of the British Currency School, which — consistent with its roots in mercantilism — defined "reserves" as gold, silver, and banknotes backed with government debt. Using the tenets of the British Banking School, on the other hand, would have mandated 100% reserves — but defined "reserves" as gold, silver, and, especially, real bills representing the present value of existing or future marketable goods and services. (Real bills representing the present value of capital assets in the form of corporate equity were excluded due to the belief that including them would allow bills drawn on speculative equity issues to be discounted, and because equity is usually issued to finance long-term capital, that is, with a useful life of more than a year — and which usually takes more than a year to generate sufficient income to repay the original investment. Traditionally — and this was completely arbitrary — central banks would not discount anything
that had a term longer than ninety days except government securities.)

As even a cursory reading of the original thirty-one page act reveals, the Federal Reserve System was clearly designed to operate in conformity with the "real bills doctrine" — mostly. Briefly, the real bills doctrine is that the money supply may be increased or decreased without inflation or deflation if directly linked through private property to increases or decreases in the present value of existing or future marketable goods and services or any asset with a definable and stable value. A "real bill" is thus a derivative drawn on something with a definable present value (which eliminates speculative assets and equity investments) and is thus backed with "hard assets."

A real bill is in contrast to a "fictitious bill," that is, a bill drawn on something that does not represent a private property claim on the present value of existing or future marketable goods and services or assets, or have a stable, non-speculative value. Money backed by government debt representing future tax revenues is therefore a fictitious bill, where money backed by private sector hard assets is a real bill. This is because the necessary private property interest is absent from a bill drawn on a government issue, and, in general, the amount of borrowing is not tied to a specific period of tax collections, which are difficult to estimate with the required accuracy in any event. Taxation is not the exercise of a property right on the part of the State in the wealth of its citizens — as many people, especially economists, seem to believe (see Thomas Hobbes's Leviathan) — but a grant from the citizens to allow the State to defray necessary costs of operation (see John Locke's Second Treatise on Government).

What the banking system of the German Reich and, consequently, the central bank of the United States with the Federal Reserve System ended up with was something of a wretched compromise. The design left the door open to subversion of the system the moment the politicians managed to redefine "reserves." In the original Federal Reserve Act of 1913, reserves are defined as gold, silver, real bills drawn on qualified industrial, commercial, and agricultural assets and commodities — and United States government securities purchased on the open market . . . fictitious bills. (Federal Reserve Act of 1913, op. cit., §§ 13, 14, 19.)

The definition of reserves in the Act led directly into the second problem, a vague definition of money. Reserves must be in the form of money, generally construed as cash, or a cash equivalent that can readily be converted to cash. In common usage, "cash" (that is, coin and banknotes) is synonymous with "money," to which nowadays is usually added demand deposits — checks. Under the tenets of the Currency School, the definition of money is limited to coin, currency, demand deposits (although Currency School purists still argue whether demand deposits should be included in the definition since the State does not issue an individual's or business's checks), and State-issued promissory notes backed by government debt. The Currency School does not define real bills as money, and thus a real bill does not meet a commercial bank's reserve requirements, even if it can be rediscounted at the central bank and turned into currency instantaneously.

The Banking School, on the other hand, defines money as anything that can be used in settlement of a debt. Convertibility into gold and silver is maintained by making the promissory notes of member commercial banks exchangeable for "lawful money" at the central bank, usually by a commercial bank on behalf of one of its customers, rather than the customer going directly to the central bank. Under the Banking School definition of money, cash and banknotes are included in the definition of money, as are demand deposits, but also any and all real bills — including those drawn on equity — which thereby qualify as reserves, although equity issues are usually excluded in practice for the two reasons cited above, 1) the dangers inherent in speculation, and 2) a payback period of more than ninety days.

Under the tenets of the Banking School, State promissory notes — government securities — do not qualify as real bills, and so cannot be included in the definition of either money or reserves. State debt instruments can only be included in the definition of money by passing a positive law in contravention of the basic principles of banking and accounting. By this means the State changes the definition of something, causing it to mean whatever the State wants it to mean; an exercise of raw power on the part of the State. This is why John Maynard Keynes claimed that the State had the power to change reality by "re-editing the dictionary." (John Maynard Keynes, A Treatise on Money, Volume I: The Pure Theory of Money. New York: Harcourt, Brace and Company, 1930, 4.)

The vague understanding of money included in the Act lead to the third major problem, a lack of clarity as to which school of thought concerning money provided the parameters for and the guiding principles of the institution. By picking and choosing among the principles of the Currency School and the Banking School, the way was left wide open for manipulation of the system the moment it became expedient to circumvent a primary objective of the framers of the Act, both Democrats and Republicans: preventing the federal government from being able to monetize its deficits by gaining access to the discount window.

The Federal Reserve was carefully designed to prevent the federal government from using the institution to monetize its deficits, that is, from turning the central bank from a bank of deposit for the State, into a bank of issue for the State. Thus the Federal Reserve did not — and does not — have the power to deal in primary government securities, that is, to purchase debt paper directly from the Treasury. The only way in which the Federal Reserve is empowered to make purchases of federal government securities is through "open market operations," as specified in § 14 of the original Federal Reserve Act, covering the types of paper described in § 13.

Even the purchase of government securities was allowed only so that the Federal Reserve could affect reserves held by commercial banks, as § 19 makes clear: "Any Federal reserve bank may receive from the member banks as reserves, not exceeding one-half of each installment, eligible paper as described in section fourteen properly indorsed and acceptable to the said reserve bank." Perhaps most surprising to today's banking experts, who, in accordance with the dictates of the mercantilist Currency School, define "reserves" solely in terms of vault cash and commercial bank demand deposits at the Federal Reserve (and, effectively, federal government securities), the original 1913 Act included in the definition of reserves all types of real bills except corporate equity and derivatives ("bills") "drawn for the purpose of carrying or trading in stocks, bonds, or other investment securities, except bonds and notes of the Government of the United States." (§ 13.)

Due to the ultimate triumph of the Currency School, the idea that commercial bank reserves can consist of anything other than cash or commercial bank demand deposits at the central bank is completely incomprehensible today. This is directly related to the idea that money cannot consist of anything other than State-issued or authorized promises to pay, essentially purchase orders deriving from the State's presumed ability to levy taxes. Private property, as well as anything related to or derived from private property (such as real bills) has been removed as a critical feature of money and credit. In consequence, the Federal Reserve, an institution specifically designed to operate in accordance with the real bills doctrine, today deals almost exclusively in fictitious bills, to the great cost of the government, the people, and the whole of the common good.

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