Thursday, March 25, 2010

Own the Fed, Part XI: The Age of Regulation

Part and parcel of the change in the Federal Reserve under the New Deal was the enormous increase in government regulatory bodies, matched — or exceeded — only by the volume of new regulation and State intrusion into people's daily lives. What we find is that with the New Deal, the transformation of the Federal Reserve from what it was intended to be, to what it has become today was virtually complete. The central bank changed from an institution designed to operate in a manner consistent (for the most part) with Say's Law of Markets and the real bills doctrine, to one completely enmeshed in the misleading and false assumptions of the Currency School.

Fitting in perfectly with the assumptions of both the New Deal and the Keynesian economics on which the New Deal was based, the changes in the Federal Reserve extended and enhanced the economic as well as political role of the State. The process fixed in people's minds the belief that nothing could be done except by the State — the realization of Thomas Hobbes's totalitarian vision in Leviathan. This helped set the stage for today's almost complete functional overload of the State that the world is currently experiencing.

We examined some of the lesser-known new regulations of the Federal Reserve in the previous posting. In this posting we will take a look at three more widely known and, in one sense, more critical regulatory changes. Two of these were cut from the same cloth as the five measures we looked at in the previous posting, but the other was critical, one might even say an essential regulation, especially from the perspective of the Just Third Way: The Banking Act of 1933, more popularly known as "the Glass-Steagall Act" from the names of its co-sponsors, Carter Glass and Henry B. Steagall.

First, however, we need to look at the "bad" regulations, the Glass-Steagall Act of 1932 (referred to by Moulton as the "Glass-Borah law of 1932"), and the establishment of the Open Market Committee in 1935. Of the two, the establishment of the Open Market Committee caused the most damage; Glass-Steagall/Borah falls into a gray area: well-intentioned, but with unforeseen consequences. The 1932 Glass-Steagall Act (in contrast to the Banking Act of 1933) demonstrates the ease with which even the best-designed or well-intentioned institutions and laws can be corrupted and converted into doing exactly the opposite of what they were established to do.

True, the Federal Reserve System, for all it was and remains — at least in its original form — a work of genius and possibly the best-designed central banking system in the world, embodied some serious flaws. As we have seen, the powers-that-be were not slow to exploit these flaws when the opportunity arose. Whether this was out of malice or, more likely, out of the best of intentions, inspired by an honest desire to improve the institution but based on ignorance, is irrelevant. The process was carried out without reference to the laws and characteristics of social justice (cf. Rev. William J. Ferree, S.M., Ph.D., Introduction to Social Justice. Arlington, Virginia: Center for Economic and Social Justice, 1997), or to the precepts of the natural moral law embodied in, for example, the binary economics of Louis Kelso, particularly as explicated in the two books Kelso co-authored with Mortimer Adler (The Capitalist Manifesto, 1958; The New Capitalists, 1961) — especially the critical point highlighted in the subtitle of the second book, "A Proposal to Free Economic Growth from the Slavery of Savings."

Although this was clearly not the intent of the law, the 1932 Glass-Steagall/Borah Act substituted government securities for gold and commercial asset backing of the currency. This opened a way for the Federal Reserve to get out of the business of rediscounting private sector paper altogether. The law was promulgated in an effort to get out of the Keynesian "liquidity trap." As we recall from a previous posting, the Keynesian liquidity trap is an attempt to explain the failure of businesses to borrow, no matter how low the interest rate is set. According to Keynes, under certain conditions the demand for money becomes "infinitely elastic." Demand cannot be increased regardless how low the price.

The obvious flaw in Keynes's theory is that money and credit, neither one necessarily tied to the amount of savings already existing in the system, are not commodities. Not being commodities with a fixed quantity, money and credit will not behave in the manner of commodities and "obey" the laws of supply and demand. As Louis Kelso pointed out (and as we have previously noted), "money" is a measurement of wealth, necessarily tied to the wealth through the institution of private property, not wealth itself.

It is consequently foolish in the extreme to claim that derivatives of production — money and credit — cannot be matched exactly to the present value of existing and future marketable goods and services. The laws of supply and demand do not apply to money and credit. Keynes's liquidity trap theory is thereby invalidated. The reason businesses were not borrowing desperately needed financial capital from the banks is because they did not qualify as sound prospects, usually because of a complete lack of or unsatisfactory quality of the collateral offered.

Whatever the reason or reasons businesses were not borrowing, commercial banks were not issuing the commercial bills that qualified for rediscounting at the Federal Reserve. This resulted in a serious deflation of the money supply. This also caused a continuous decline in the inventories of commercial paper held by the regional Federal Reserve banks, which then had to back their note issues and demand deposits with gold.

Putting the cart before the horse, the authorities reasoned that if the insufficiency of commercial paper was causing deflation, a substitute was needed to back the money supply to counter the deflation. Thus, rather than figure out a substitute for the lack of collateral that was behind the "refusal" of private commercial banks to lend and the inability of businesses to borrow, Federal Reserve authorities requested permission to back new money with government securities, thereby freeing up gold and presumably countering the deflation that appeared to be at the root of the business downturn. As Moulton explained,
The continuous decline in the volume of commercial bills in the portfolios of the Federal Reserve banks necessarily meant that the Federal Reserve notes came increasingly to be backed by gold instead of by commercial paper. In 1932 the amount of Federal Reserve notes outstanding was approximately 2,900 million dollars, of which about two billions was secured by gold and 900 millions by eligible paper. The Glass-Borah law [Glass-Steagall Act] of 1932 authorized the Reserve system to substitute in place of gold as backing for Federal Reserve notes its holdings of government securities, to the extent of 740 million dollars. Thus 740 million dollars of gold was released and made available for open market operations, which were intended to check the deflation. As we shall later see, this operation was not successful in staying the course of the depression. It did, however, mark the end of the attempt to maintain an elastic bank note currency based on commercial paper assets. (Financial Organization and the Economic System, op. cit., 385.)
The effective closing of the discount window to private sector assets was followed a short time later in 1935 by the establishment of the Open Market Committee. As stated in the original Act, the primary business of the Federal Reserve banks was supposed to be creating money to purchase commercial paper presented by member banks for rediscounting. Obviously, being charged with regulating the money supply for the entire economy, there had to be some accommodation for non-member banks and other institutions that issued commercial paper. As such securities were on the "open market," each Federal Reserve bank was empowered to create money to purchase qualified industrial, commercial, and agricultural paper on the open market.

This ability to deal in secondary issuances — qualified securities offered on the secondary market — was only supposed to be a supplement to the Federal Reserve's power to rediscount primary issuances of member banks. As dealing in government securities began to assume greater and greater importance under the tenets of the Currency School, and the Federal Reserve was prohibited from monetizing government deficits by rediscounting primary issues of the federal government, open market operations involving the creation of money to purchase government securities began to supplement the System's stated principal purpose of rediscounting private sector primary issuances. As Moulton noted, "these open market operations in due course came to be regarded as a very important means of controlling the volume of credit." (Financial Organization and the Economic System, op. cit., 368.) As he continued,
Although the original Federal Reserve Act provided that such open market operations were subject to the "rules and regulations prescribed by the Federal Reserve Board," in actual practice Federal Reserve banks themselves, particularly the Federal Reserve Bank of New York, assumed the direction of these policies. The Federal Reserve Board made serious efforts over the years to regain its authority, and finally, in the Banking Act of 1935, an Open Market Committee was provided for. (Ibid.)
In other words, as the Federal Reserve abandoned its primary justification and its orientation in accordance with the real bills doctrine and Say's Law of Markets, it surrendered its ability to affect the quantity of money in the economy directly. It also found a way to embody in law what the framers of the original Federal Reserve Act had carefully designed the institution to avoid doing: acting as a source of financing for government expenditures, thereby circumventing the essential prohibition against monetizing government deficits.

The picture was not all dark, however. The "Glass-Steagall Act of 1933" — officially the Banking Act of 1933 — was also co-sponsored by Carter Glass. Glass was one of the prime movers in getting the original Federal Reserve Act of 1913 enacted, with the able assistance of President Woodrow Wilson and Wilson's Secretary of State, William Jennings Bryan.

The original act, however, had a serious flaw (more than one, as a matter of fact, but only one that concerns us at this point). That is, there was no effective means of preventing commercial banks from extending massive amounts of credit to their investment banking arms, thereby creating money to finance speculative or unsound flotations of securities.

To give some context, "commercial banking" consists of taking deposits, making loans, and issuing promissory notes. This last is the means whereby a commercial bank creates money backed by a lien on the assets so financed, with collateral added to secure the lender against the possibility of default on the part of the lender.

Investment banking, on the other hand, consists solely of acting as a financial intermediary between savers and investors. Investment banks are a type of deposit bank. That is, an investment bank extends credit out of its existing resources in order to purchase blocks of securities from issuing companies. It then turns around and sells the securities to investors. It cannot create money by issuing promissory notes as a commercial bank does. Instead, what an investment bank does is much closer to speculation than investment. Properly only a middleman, a financial intermediary, the temptation for an investment bank is often overwhelming to manipulate the values of the equity and debt in its inventory in order to make more than the profit to which it is entitled for the service it provides.

Reliance on existing accumulations of savings or having to go to an independent commercial bank presumably inhibits or prevents investment banks from accepting issuances that are too speculative or otherwise have too great a degree of risk — they are presumably more cautious and careful risking existing resources and loans for which they are on the hook than they would be when dealing with resources that they can, in a sense, create out of thin air. When commercial banking and investment banking are combined, however, the effect is to give free rein to people and institutions already inclined to gamble and engage in speculation. With direct access to the money creation powers of a commercial bank or even, in extraordinary circumstances, the central bank, an investment bank can, in effect, engage in margin purchases of questionable, risky, and speculative debt and equity issuances with a 0% margin, leveraging the purchase 100% on credit, and with no collateral other than the issuances themselves.

This appears to have been at least part of the reasoning of Henry Simons, founder of the "Chicago School" of economics — "the Monetarists" — and his proposal to implement a 100% reserve requirement. As proposed, the "Chicago Plan" would have prevented commercial banks from creating money for speculative purposes. It would, unfortunately, in a move that threw the baby out with the bath, also have prevented commercial banks from creating money for productive purposes as well.

Essentially, Henry Simons's idea, as summarized in his noted essay, "A Positive Program for Laissez Faire" (Henry C. Simons, Economic Policy for a Free Society. Chicago, Illinois: The University of Chicago Press, 1948, 62-63), was to eliminate commercial banking and transform all commercial banks into banks of deposit by prohibiting the issuance of promissory notes: "All institutions which maintain deposit liabilities and/or provide checking facilities (or any substitute therefore) shall maintain reserves of 100 per cent in cash and deposits with the Federal Reserve banks." (Ibid.)

The Federal Reserve's money creation powers would also be eliminated, except to purchase government bonds with which to back the currency it issued. The Federal Reserve would be unable to rediscount commercial paper or engage in open market operations. Instead, the Federal Reserve would be restricted to acting more or less in the capacity of a centralized national bank, more or less in accordance with the National Bank Act of 1864. The Federal Reserve would no longer be a central bank, per se. The Federal Reserve would ensure a uniform currency by acting as the federal government's principal depository and creating all new money backed by government debt.

The Federal Reserve would not, however, be able to function in the capacity of a true central bank by creating money to supply the private sector with liquidity in accordance with the real bills doctrine. The intent appears to have been to force the economy to rely entirely on existing accumulations of savings to finance capital formation, and restrict all new money creation to finance government expenditures.

The amount of money the government would be able to create through issuing new securities each year would be set by a "national Monetary Authority," with no other power than to determine the amount of new money that the government could safely create. To make certain that private sector monopolies and monopolistic industries were stripped of the power to manipulate the economy to their own advantage ("Eliminate all forms of monopolistic market power," ibid.), the rules under which the Monetary Authority operated would be "definite, intelligible, and inflexible" (ibid.), i.e., no appeal to a higher authority would be possible from the Authority's decisions.

Having seen the ease with which the Federal Reserve had been transformed from one sort of institution to another, however, Simons was also very concerned that the federal government as well as elements in the private sector be prevented from seizing control of the Monetary Authority. He was never able, however, to develop any system of checks and balances that would prevent the government from somehow manipulating the system to its own benefit. Simons ultimately refused to push for the implementation of his own proposal.

Simons's refusal to use his considerable prestige to push for the adoption of the Chicago Plan irritated such diverse individuals as Irving Fisher and Father Charles Coughlin, both of whom felt that the 100% reserve plan should be implemented immediately. Fisher believed that the proposal would the fastest way to "reflate" the currency and restore the price level. Coughlin believed such a move would break the presumed power of the Jews over the money supply. Fisher and Coughlin (among others) viewed Simons's concerns as needless scruples: people needed plentiful money and easy credit now. Control measures could wait; fix the problem first and worry later whether it was the best or even the right thing to do.

There was, however, a twofold problem that dwarfed even the extremely serious danger that the State would somehow be able to seize control of the Monetary Authority. That is, 1) forcing the private sector to rely exclusively on existing accumulations of savings for the financing of new capital formation, and 2) allowing the State to create money rather than be restricted to its proper role of setting the standard of value and regulating the currency as provided for in the Constitution would be an economic disaster.

Money is a derivative of production. Prohibiting the private sector from drawing bills on the present value of existing and future production of marketable goods and services, and preventing commercial banks from issuing promissory notes backed by such real bills would result in serious deflation. (Evidence suggests that at least two-thirds of GDP before the current Great Recession consists of transactions involving conveyances other than coin, currency, and demand deposits.) Restricting all new money creation for the purpose of purchasing government securities to serve as reserves backing the new money would mean that the private sector would be completely at the mercy of the State for the financial means to engage in industry, commerce, and agriculture. It would also undermine any effort at economic recovery, as Moulton explained in The Formation of Capital in his discussion of the dangers of cutting consumption in order to finance capital expansion. (The Formation of Capital, op. cit., 37-48.)

Glass-Steagall — the Banking Act of 1933 — while it did not manage to prevent commercial banks from being able to create money for speculative purposes, did institute a necessary "internal control" measure on the financial system: separation of incompatible functions. By forcing different types of financial institutions to separate, the Act cut investment banks (a type of deposit bank) off from commercial banks (a type of bank of issue), Glass-Steagall added a level of scrutiny between institutions that can create money, and institutions that can use the money to bid up the price of securities, thereby engaging in manipulation and speculation. As the summary provided by the Congressional Research Service of the Library of Congress and quoted on the Wikipedia (a very useful source when doing some basic research, as it directs you to primary sources) put it,
In the nineteenth and early twentieth centuries, bankers and brokers were sometimes indistinguishable. Then, in the Great Depression after 1929, Congress examined the mixing of the "commercial" and "investment" banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions' securities activities. (
Glass-Steagall set up a "formidable barrier to the mixing of these activities." (Ibid.) Glass-Steagall also attempted to add a level of security for existing accumulations of savings, although not of the same character and effectiveness of a systemic internal control measure like separating incompatible functions. That was to establish the Federal Deposit Insurance Corporation, the "FDIC."

The Banking Act of 1933 was, all things considered, one of the most effective as well as necessary pieces of legislation to come out of the New Deal. It was not perfect, but it served to put in place an essential internal control feature that put the brakes on (or, at least, had the potential to slow the acceleration of) money creation for speculation instead of true investment. It did not eliminate the possibility of money creation for such purposes. The Act, however, did make money creation for such purposes more difficult by making certain that it would not be to the advantage of a commercial bank to misuse its money creation powers under most circumstances.

The problem with Glass-Steagall was not in the provisions of the Act itself. It could be argued that the Act did not, in fact, go far enough by managing to find a way to halt all market manipulation and speculation. The problem was that the Act straddled two incompatible approaches to understanding money, credit, and banking: the Currency School and the Banking School. Glass-Steagall addressed a few systemic changes that were necessarily limited in scope. It was not able to address the basic systemic problem of trying to reconcile mutually exclusive paradigms.


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