Wednesday, March 17, 2010

Own the Fed, Part VI: The Roaring Twenties

The actions of the Federal Reserve in averting the Crisis of 1920, while ineffective, signaled a profound change in the policy of the central bank as well as in how the government and even private business viewed the institution and understood the role it was supposed to play in the economy. Based on a different definition of money and combined with the actions of Henry Ford and the theories of John Maynard Keynes and the effect they had on the understanding of private property, investment, and finance, the changing perception of the mission of the central bank virtually ensured that the original purposes for which the Federal Reserve had been established — to furnish an elastic currency and afford means of rediscounting commercial paper — would eventually be set aside in accordance with the mercantilist belief that only existing accumulations of savings can be used to finance new capital formation.

To recap briefly, under the tenets of the Currency School — and thus Keynesian, Monetarist, and Austrian economics — the State alone has the right to define and create money. “Money” ceases to be anything that can be used in settlement of a debt, and becomes whatever the State says it is. This makes access to capital credit a political, rather than an economic decision, and turns money and credit into a commodity, strictly limited in amount, and controlled by a small elite. Increasing or decreasing the number of units of the currency, regardless whether it is for productive or non-productive purposes, automatically changes the price level.

To what degree and in what manner changes in the volume of currency affects the price level is a matter of acrimonious debate among the Keynesians, Monetarists, and Austrians. All agree, however, with the basic principle and with the underlying assumption that only existing accumulations of savings can be used to finance capital formation. The change in the price level compensates for the “spreading out” or concentration of the value of the accumulated savings that back the currency, and which the State can eventually tax to make good on the promise it made when issuing the currency.

Consistent with Fisher’s claim that issuing money necessarily implies a property right (Irving Fisher, The Purchasing Power of Money. New York: Macmillan, 1931, 4.), assuming that the general wealth of the economy backs the money supply implicitly assumes that the State has ultimate ownership of everything, just as Hobbes asserted in Leviathan. (If the States creates all money, and “the general wealth of the economy” backs the money supply, the State effectively claims ownership of the general wealth of the economy and thereby abolishes private property.) Added to the accomplishments of Ford and Keynes, this understanding of money virtually guaranteed that most people would never own a significant capital stake, and be forced to rely on wages and welfare for the bulk of their consumption incomes.

There was, however, another important change that Ford and Keynes managed to bring about. This was the change in how people viewed investment in corporate equity. Traditionally, a business would decide whether to finance growth and expansion out of debt, that is, by borrowing, or by equity, that is, by bringing in new owners. For a business enterprise, the downside to debt financing is that the lender assumes fewer risks than an investor. The lender passes the risk off to the owners in the form of fixed interest rates and principal payments. Whether or not a business makes money, the lender must be paid the agreed-upon interest rate and is also due return of the loan principal. The downside to equity financing is that, under traditional rights of property, the old owner must share control and enjoyment of the fruits of ownership (the income) with the new owner(s).

Between the two of them, Ford and Keynes changed the parameters of the decision. Lenders were still due the agreed-upon interest and return of the principal. Equity owners, however, if they owned less than a controlling block, were now effectively denied the right to do anything except sell their shares in the hope of realizing one-time capital gains instead of long-term dividend income. It is not by accident that Ford Motor Company equity is divided into "Class A Common" carrying a single vote per share, and "Class B Common" carrying multiple votes per share, and that the Ford family owns Class B, while ordinary shareholders — now in the majority — own Class A. Consequently, as Dr. Harold Moulton noted,

The proportion of industrial capital raised through stock sales increased rapidly during the twenties at a time when the stability of industrial enterprise was increasing. The great argument in favor of stock issues is that greater flexibility is permitted in adjusting disbursements of income in the light of changing business conditions. (Financial Organization and the Economic System, op. cit., 149.)
In other words, at a time when conditions were stable for industry — which ordinarily would have swayed businesses in favor of fixed cost debt financing — Dodge v. Ford Motor Company, supported by Keynes's economic theories, removed the necessity of sharing control and paying dividends from equity financing. This eliminated the downside of equity financing, and accelerated the concentration of control, if not actual ownership, of the means of production in fewer and fewer hands. (See, e.g., the comments in Quadragesimo Anno, § 105.)

Adding to the popularity of using equity rather than debt to finance capital expansion was the fact that the whole understanding of and orientation toward investment had changed. Instead of purchasing primary equity issues to receive the anticipated future stream of dividends in perpetuity, the investor would buy and sell secondary equity issues on the exchanges to receive a one-time capital gain. That is, investment strategy shifted from investment proper, to speculation. Wall Street, a secondary market for corporate debt and equity — and thus the primary means of carrying out speculative activity instead of true investment — increased enormously in importance in the public consciousness.

This confusion of investment and speculation, combined with a fundamental misunderstanding of interest, had been building up for for some, as exhibited in the great debate over usury in the 16th and 17th centuries. For hundreds of years, "high finance" had been the exclusive pursuit of the rich and of governments. When ordinary people financed anything, it was usually limited to borrowing out of necessity to meet consumption needs, or to finance the acquisition of a farm or small shop. It was not until the 1920s that ordinary people began dealing in corporate equity. Even then, it was not to secure ownership of a capital stake sufficient to supplement and, eventually replace income from labor, but to imitate the wealthy and engage in speculation. "Playing the market" was, and continues to be seen as a way of duplicating the presumed ability of governments and the wealthy elite to get something for nothing and avoid genuine productive activity, i.e., "work."

In consequence, a problem that had afflicted only individuals and governments unwise enough to try and finance consumption through recourse to unproductive borrowing pervaded the financial system. This can be attributed to the almost religious adherence to the tenets of the British Currency School, especially as developed in the economic theories of John Maynard Keynes and the financial practices of Henry Ford, and their adamantine belief — contradicted by the facts and the financial history of the Industrial Revolution — that only existing accumulations of savings can be used to finance new capital formation. The global financial system had become, in the pithy expression of G. K. Chesterton, "the utopia of the usurers." The understanding, even basic definitions of dividends and interest had changed dramatically.

Ethically there is no difference between profit sharing in the form of interest, and profit sharing in the form of dividends. Legally, "dividends" are paid to holders of title, that is, to equity owners, while "interest" is paid to a lender of savings. "Usury" is the taking of interest on a loan of money that financed a project that did not generate a profit; all usury is interest, but not all interest is usury.

These definitions, while more or less adequate, are incomplete. As late as the closing decades of the 19th century, some economists were still using interest to mean the return to an owner. Derived from "ownership interest," profits and interest were generally interchangeable terms. The "rate of interest" as Adam Smith and other 18th century economists used the term is more accurately understood today as "return on investment." "Interest," "dividends," and "usury" were all different terms for various classifications of "profit," as attested to in the title of a document issued by Pope Benedict XIV in 1745, Vix Pervenit, "On Usury and Other Dishonest Profit."

As the tenets of the Currency School gained acceptance, however, definitions changed. "Interest" changed from being construed as profit sharing, to the "rent," "price," or "cost" of money. This is a philosophically untenable definition, but very useful within a paradigm with a limited understanding of money and credit — and very damaging to any effort to gain a better understanding of banking and finance. The change in definition shifted interest from a sharing of profits due to the owner of savings by right of private property, to a cost of supplying money, whatever its origin.

To explain, when interest was understood as profit sharing, the lender or whoever provided the savings, was due a pro rata share of total profits generated by a project, based on the relative contribution of the savings to the productive process. When a "projector" (one who initiates and carries out a project, analogous to today's "entrepreneur") borrowed someone's existing accumulation of savings, the amount of ownership interest due to the lender was based on supply and demand — how much the borrower was willing to share of the profits compared to how much the lender desired to take, based on the anticipated profitability of the project, the risk involved, and other factors. Within a free market, the rate of interest due to a lender tended to approximate the actual value of the lender's contribution to production.

When in the 18th century commercial banks began creating money, the perception of interest started to change. Originally justified as a legitimate share of profits of productive enterprise, interest was now understood as the cost of supplying money. The same rate was therefore interest charged — not profits shared — for the use of money, whether it came out of existing accumulations of savings, or had been created by a bank or other financial institution.

Ethically, of course, this was wrong, although we need not go into the lengthy arguments employed by Aristotelian and Scholastic philosophers here. A lender of existing accumulations of savings is due a share of profits by right of private property. A creator of money that does not derive from existing accumulations of savings is due a fee for the trouble he or she takes to create the money, and a "risk premium" to compensate for the risk that the borrower will default. There are, however, no existing savings on which to base a sharing of the profits of the enterprise. The "lender" of newly created money is not due any interest, there being no prior "ownership interest."

Thus, most interest now tended to be usurious in nature, if not, strictly speaking, usury. Very little new capital formation tends to be financed out of existing accumulations of savings. Savings — retained earnings — are used more often for collateral than for direct investment. Commercial banks create the money for most capital investment, and are due a fee for the service and a risk premium, but not interest.

With the reign of the Currency School secured by the rise of Keynes and his economic theories, however, especially Keynes's insistence even in the face of massive evidence to the contrary that existing accumulations of savings are essential to new capital formation, the way to supply the economy with money is to manipulate the rate of interest, and to inflate or deflate the currency to transfer purchasing power through "forced savings." (In the Keynesian lexicon, "forced savings" refers to the transfer of purchasing power that results from inflating the currency, thereby driving up prices for consumers who then pay producers more for the same amount of goods and services.)

The Keynesian technique is to lower the rate of interest in order to lure businesses into undertaking new investment, and raise the rate to discourage new investment. (Keynesian monetary policy ignores the paradox that if savings equals investment, as Keynes insisted, then there can be no new investment without liquidating old investment.) There is no question of commercial banks creating money directly for new investment through discounting, and rediscounting at the central bank through the operation of the real bills doctrine. Keynes rejected the real bills doctrine and Say's Law of Markets — they undermined his theories, and were therefore impossible.

Bank credit was now viewed as a commodity, and interest as the price of the commodity. (Financial Organization and the Economic System, op. cit., 402.) That being the case, the cost of credit had to be the same (although the rate must be subject to manipulation by the State or the central bank), whether based on existing accumulations of savings, or created out of the creditworthiness of a borrower and the present value of existing or future marketable goods and services belonging to the borrower.

Taking the change in the definition of interest into consideration, we can begin to understand the dramatic shift in the mission of the Federal Reserve in the 1920s, and start to grasp the otherwise incomprehensible "hijacking" of the institution. We have already seen that the Federal Reserve was abandoning the direct creation of money for qualified industrial, commercial, and agricultural purposes with its plan to manipulate the discount rate in response to the Crisis of 1920. It had already violated a fundamental principle of central banking by allowing itself to be used to monetize government deficits to finance the war. An institution founded principally on the tenets of the Banking School — the real bills doctrine and Say's Law of Markets — was being used to implement applications of the tenets of the Currency School: that money is a special creation of the State, and interest is the cost of money, not a share of profits.

Federal Reserve policy now began shifting from using the discount window as its primary tool to provide an elastic currency and supply the private sector with adequate liquidity and a stable currency, to using open market operations to finance government deficits and manipulate the interest rate and reserve requirements of commercial banks. As Moulton explains,
Prior to 1923 the Federal Reserve banks had bought government securities primarily as a means of earning operating expenses; but in that year the principle was enunciated that the purchase and sale of government securities should henceforth be undertaken only as a means of assisting in the regulation of general credit and business conditions. The theory was advanced that, in a time of depression, the Federal Reserve banks might increase the amount of money in circulation by purchasing government securities and in a time of active business they might decrease the circulation by selling such securities. (Financial Organization and the Economic System, op. cit., 400.)
This is pure Keynesian theory, and a fundamental shift from viewing money as conveying a private property right in an exchange, to money as a means whereby the State creates a property right in what is otherwise the personal wealth of private citizens. The quasi-religious character of Keynesian monetary theory is illustrated by the fact that, although applications based on Keynes's theories have never worked and the theory is fundamentally unsound, economists and policymakers continue to implement them with increasing fervor. This is in contrast to real religion, which generally has to show a certain logic through reason and demonstrate some kind of effectiveness, even if the basic premises are accepted on faith. As Moulton analyzed the self-defeating reliance on Keynesian theory,
These security transactions did not, however, automatically control the quantity of credit in the channels of circulation. When securities were purchased Federal Reserve money did, of course, find its way into the money markets and thus into deposits of member banks, but since business was declining these funds were not used by the banks as a basis for expanding credit; rather they were employed to liquidate rediscounts at the Federal Reserve banks. Similarly, the heavy sales of securities in 1923 withdrew large sums from the deposits of member banks; but instead of contracting credit the member banks replenished their reserves by borrowing heavily from Federal Reserve banks through the rediscount method. The purchases of securities in 1924 and 1927 were again accompanied by a decline in rediscounts of like proportions; while in 1928, as securities were sold, rediscounts registered a more or less parallel advance. Thus the open market operations in the main merely shifted the character of bank assets from securities to discounts, or the reverse, without having an appreciable effect upon the total reserves and lending power of the member banks. (Financial Organization and the Economic System, op. cit., 401.)
As Moulton further explained, "It should, however, be clear from the experience cited above that the purchase of bonds in the open market does not put money into the ultimate channels of circulation — that is, into the pockets of the people." (Ibid.) The only way for Keynesian theory to be effective in any degree is to affect reserve requirements of commercial banks through manipulation of the interest rate by engaging in open market operations, (Ibid.) a hit-or-miss method that operates indirectly, based on the assumption that commercial banks cannot create money, and that financing new capital formation necessarily comes out of existing accumulations of savings — neither of which assumptions are true. As Moulton observed,
The truth is that low interest rates on bank loans have little power to stimulate recovery. Throughout the course of the recent depression [Moulton was writing in 1938] we have tried more or less continuously to promote expansion by means of credit policies. The Federal Reserve banks have engaged in open market operations on a vast scale and interest rates have been reduced to the lowest levels ever known. When these attempts did not bring results, cooperating credit committees of business men and banks were organized to help put currency into the channels of circulation. But all efforts were in vain as long as the economic situation as a whole remained unfavorable; money, like labor, remained unemployed. It was not until a combination of various factors started the recovery process that demands for increased banking accommodations began to appear. In fact, a phenomenon of the entire expansion period from 1933 to 1937 was the negligible increase in bank loans, even though interest rates remained at the lowest levels ever known. (Financial Organization and the Economic System, op. cit., 403.)
Thus, in the 1920s, Federal Reserve policy underwent a fundamental change from the direct effectiveness of the real bills doctrine and Say's Law of Markets, to the indirect — and grossly ineffective — use of open market operations and manipulation of the interest rate to meet the demands being put on the system as a result of the misuse of the institution.


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