Wednesday, April 28, 2010

Own the Fed — the Program, Part X: Capital Credit Insurance as Collateral

In the previous posting in this series we explained why all money creation by the State and financial institutions, including the central bank, for non-productive purposes must stop. Expansion of bank credit for anything other than capital projects that are expected to pay for themselves within a reasonable period of time or to monetize existing inventories of marketable goods and services is illegitimate. Creating money for other purposes must be discouraged, if not prohibited outright. This should be done both by the most effective method of structuring of the system properly with adequate internal controls, as well as by passing external laws and regulations enforced by the State or appropriate regulatory agencies. The only legitimate money creation is for properly vetted and adequately collateralized capital projects intended to result in the production of marketable goods and services, or to monetize existing inventories of marketable goods and services.

Further, all capital projects financed with new money backed by the present value of future marketable goods and services must have their financing structured in a way that creates new owners rather than concentrating ownership of the means of production in fewer and fewer hands. Only in this way will the income generated by the capital after its financing has been repaid be used for consumption, not reinvestment. This will sustain aggregate effective demand, provide an adequate tax base, supply people with an adequate and secure income, and keep the economy stable.

This, of course, assumes a complete overhaul of the tax system. The goal of tax reform is twofold: 1) Simplify the tax system and make it more equitable, leaving more money in people's pockets to meet their own needs without recourse to government assistance, and 2) Return the tax system to its proper function of raising revenue to meet legitimate State expenditures, and not as a tool for social engineering. Our object in this survey, however, is monetary reform, not fiscal reform — at least directly. Important as reforming the tax system is, we will only refer to it in passing or as appropriate to make a specific point.

To return to the subject of monetary reform, we specify the present value of future marketable goods and services as the source of backing for new money used to finance new capital formation and new ownership opportunities for a good reason. By ancient rights of private property, the present value of existing marketable goods and services belongs, obviously, to existing owners of the labor, land, and capital that produced those same goods and services. Many of the troubles afflicting the economy of many countries and regions — and thus the political systems — can be traced directly to the fact that most people own little or nothing in the way of income-generating capital assets. As Kelso and Adler explained,
Under a system of private ownership of capital, the ownership may be highly concentrated in the hands of the few at one extreme, or widely diffused among the population at the other extreme; or its degree of concentration or diffusion may fall somewhere between these two extremes. Insofar as it is highly concentrated, it gives the few economic power with which they can exert undue influence on the organs and personnel of government. Insofar as it is widely diffused, it gives the people generally the economic independence they need to bulwark their political liberty. (The Capitalist Manifesto, op. cit., 94.)
Our concern at this point, however, is with new capital formation, not existing capital in which present owners have rights — and in which they must, at all costs, be secure if these reforms are to have any credibility, a measure of support, or even a modicum of acquiescence among the currently wealthy. It makes no sense to open up capital ownership to everyone, if ownership itself ceases to have any meaning. We cannot advocate diluting or abolishing the property rights of some, even for the benefit of the poorest of the poor, and expect the new property rights of the poor to be any more secure the moment we decide that they have too much, are not fit to be owners, or whatever other flimsy justification comes to mind to help us get what we want — usually power over others.

We use a present value approach in this analysis for a simple reason. Comparing the price of a capital asset with the present value of the anticipated future stream of income generated by the production of marketable goods and services is often used to decide if a capital asset is a good investment. If the "net present value" (the present value of the anticipated future stream of income less the cost of the asset) of the asset is zero or greater, then the asset is usually considered a good investment, that is, the asset is expected to generate at least enough to cover the actual cost of the asset plus the opportunity cost associated with foregoing another investment. If the net present value of the asset is less than zero, then the asset is usually considered a bad investment, that is, the asset is not expected to generate at least enough to cover the actual cost of the asset plus the opportunity cost associated with foregoing another investment.

Obviously, the net present value method of trying to determine the value of a capital asset, in common with all forecasting in all fields of human endeavor, is based on a number of semi-educated estimates and a lot of guesswork. Other factors also enter in to a decision whether to invest your time, effort, and credit into a capital project. There is, for instance, no way to know for certain whether a capital project will generate a profit or a loss. There is also the fact that some people invest in a less remunerative project for personal satisfaction and the expected intangibles derived from that particular project or endeavor.

On a more "practical" level, when deciding whether to invest in new capital, a prudent investor is extremely conservative about the anticipated stream of income from the production of marketable goods and services. Once the asset is obtained, however, the investor — if a worker-owner — tends to produce (or try to produce) at the maximum level, thereby maximizing income.

The point here, of course, is that neither the buyer nor the seller know that the asset will, in fact, be as productive as either hopes or fears. If the individuals most closely associated with the transaction cannot make this determination, then, how likely is it that a lender will be able to do so?

It is because of this uncertainty about the future that lenders require additional assurance that they will get their money back — collateral. They cannot simply rely on financial projections and present value calculations based on more or less educated guesses. Of course, we include in the category of lender both people with existing accumulations of savings to loan out (the existing supply of "loanable funds") and financial institutions that have the power to issue promissory notes and thereby create money through the expansion of bank credit (commercial and central banks).

The problem becomes how to finance the acquisition of capital by people who currently lack the wherewithal — the existing accumulations of savings that generally constitute collateral — to acquire and possess a meaningful ownership stake of income generating assets . . . without taking anything from current owners of wealth (who thereby have an effective monopoly on existing collateral) except the virtual monopoly over ownership of future, as-yet uncreated wealth.

We have already examined at great length and disproved the claim that existing accumulations of savings are necessary in order to finance new capital formation. That being so, there should be nothing standing in the way of people who lack ownership of existing accumulations of savings or capital investment from acquiring ownership of new capital assets.

Logically, that is the case. In practicable terms, however, there is what amounts to an insurmountable barrier against people without existing accumulations of savings acquiring and possessing private property in the means of production. That is the universal demand for collateral to secure any loan. Existing accumulations of savings may not be used in many cases to finance capital formation directly, but existing savings — usually in the form of corporate retained earnings — are critical in providing collateral for financing new capital formation.

Kelso and Adler addressed this problem in their second book, The New Capitalists (op. cit.), highlighting the critical nature of the universal demand for — and necessity of — collateral in securing financing for new capital formation. They proposed to replace traditional forms of collateral with capital credit insurance and reinsurance.

Kelso and Adler briefly addressed the idea of insurance in The Capitalist Manifesto as well. They introduced the concept both as a replacement for traditional forms of collateral as to protect ownership income. The latter, of course, was in answer to the all-too-common objection by elitists that ordinary people should not be subjected to the risks of ownership, or are somehow not capable of owning a meaningful private property stake in the means of production, and so on.

Evidently the risks associated with being utterly dependent on an employer who may or may not be beneficent are preferable to an ownership stake in the means of production — as long as you are not the one forced into a condition tantamount to slavery. As Hilaire Belloc pointed out in The Servile State (1912), where the small owner worries about whether his or her efforts will generate sufficient income for his or her family and dependents, the proletarian (non-owning) wage worker is suffused with the fear of "getting the sack," that is, losing his or her job.

Consequently, the proletarian necessarily gives absolute fidelity, obedience and first priority in all things, not to his or her own interests and those of the people dependent on him or her, but to whoever or whatever can best secure the worker a wage system job, be it the employer, the union, or the State. This, naturally enough, builds conflict into the system, both where the wage worker finds him- or herself in conflict between his or her own best interests, and those of the employer, union, or State, as well as in the conflicts that necessarily arise between employers, unions, and the State in the inevitable struggle that ensues as each one attempts to gain absolute control over the worker and thereby secure its own power.

To break the dependency of the propertyless worker on those who, however well intentioned, cannot have the best interests of the worker as a person at heart, Kelso and Adler proposed a type of portfolio insurance to safeguard capital income the way life insurance safeguards labor income:
Where a household is primarily dependent for support upon its ownership of capital, the primary risk to be guarded against is simply the business risk inherent in a competitive and technologically evolving economy. In large measure this risk can be minimized through investment diversification, but beyond this it should be possible to devise casualty insurance designed to protect the family income against a coincidence of business failures that would materially impair the support derived from capital holdings. (The Capitalist Manifesto, op. cit., 241.)
It is the idea of insurance as a replacement for traditional forms of collateral — that is, existing accumulations of savings — where insurance can play its most important role. This is not to say that Kelso and Adler were hostile to savings, as some might infer from the subtitle of The New Capitalists: "A Proposal to Free Economic Growth from the Slavery of Savings." Their "hostility," if you even want to call it by that misleading term, was reserved for the fixed — and erroneous — belief of Currency School adherents that new capital formation can only be financed out of existing accumulations of savings. That is, despite the fact that this dogmatic belief has been disproved time and again, Currency School adherents firmly believe that "saving" is always defined in terms of cutting current consumption, and that reductions in consumption necessarily precede investment in new capital.

On the contrary, as Moulton explained at some length in several of his books, "the formation of capital is accompanied by a virtually concurrent expansion in the production of consumption goods." (The Formation of Capital, op. cit., 47.) In English, that means periods of capital expansion are not necessarily preceded by cuts in consumption. The assumption of the Currency School — and thus the conclusions of Keynesian, Monetarist, and Austrian schools of economics to the degree that they rely on that assumption — is wrong. The historical data Moulton assembled from 1830 to 1930 in the United States show a consistent pattern of increases in capital investment preceded not by decreases, but by increases in consumption.

Moulton's observation presents us with an apparent paradox. If cuts in consumption are absolutely necessary in order to save and accumulate the wherewithal to finance new capital formation, where do investors obtain the savings necessary to finance new capital formation when consumption, far from declining, is increasing?

The answer is, "from the future." The concept of financial feasibility is predicated on the fact that a capital project is expected both to pay for itself and generate an acceptable return to the investor over its useful life. An astute investor purchases a capital asset — even out of his or her existing accumulations of savings — on the expectation that those savings will be replaced in the future as the capital becomes productive and generates a stream of income through the sale of marketable goods and services.

Future income generated by the new capital is used in part to repay the acquisition loan or replace the savings expended instead of being used for consumption. In that sense, yes, consumption is being reduced in order to finance new capital formation. The key, however, is that refraining from increasing consumption in the future in order to repay the acquisition cost of capital is fundamentally different from reducing current consumption in order to accumulate savings for the same purpose.

In the former case, the investor can maintain, even increase consumption as his or her income rises and only a portion is used for debt service payments on the capital. In the latter case, the investor necessarily reduces consumption, thereby rendering not only his or her investment less feasible, but, if all or even a determinant amount of new capital formation is financed by cutting current levels of consumption, having a detrimental effect on the entire economy.

The problem, however, is how to guarantee that capital acquisition loans will, in fact, be repaid, even when the capital project fails to generate sufficient income to justify the investment. The answer is "collateral" . . . but most people lack something — existing accumulations of savings — they can use as collateral.

Kelso and Adler's answer to this conundrum is capital credit insurance and reinsurance. Technically, insurance is coverage or security by means of a contract that binds one party to indemnify another party against a specified loss or losses in return for premiums paid. Reinsurance is "insuring the insurance." That is, reinsurance is the practice whereby an insurer (usually an insurance company) transfers a portion of the risks he or she (or it) has assumed to someone else — the "reinsurer." The legal rights of the insured — the policy holder(s) — are not affected in any way by this practice. The insurer (the original issuer of the policy) or his or her assigns remains liable to the insured for any benefits or claims.

Because the role of collateral is to insure a lender against the risk of loss, the substitution of an insurance contract for traditional forms of collateral seems obvious once it is stated. That is why Kelso and Adler expressed such bafflement that so obviously beneficial an improvement had not been adopted: "It is singular . . . that we have not to any significant degree employed an insurance system as such in dealing with the risk of entrepreneurial error." (The New Capitalists, op. cit., 57.) As Kelso and Adler explain the concept,
The existence of an insurance fund for capital acquisition financing should help to reduce underwriting costs, since the risk of failing to sell qualified stock issues within a reasonable time might either be greatly diminished or entirely eliminated. This, with a revision of the corporate income tax laws designed to discourage long-term debt financing, would not only dry up a major source of concentration but would also facilitate equity diffusion. It is important to note that such an insurance arrangement — let us call it the "Capital Diffusion Insurance Corporation" — would not directly underwrite any of the risks of the business enterprise. That is the function of the stockholder. It would only be insuring or guaranteeing the stock subscriber's or stock purchaser's obligation to pay for the stock that he purchases. (The Capitalist Manifesto, op. cit., 241.)
The concept and proposal are greatly expanded in The New Capitalists. Of most use in this survey, however, are not the technical details of the proposal. These are subject to change in any event as the concept is adapted to existing conditions and the needs of the market. What we're after here is the basic proposal, with the details to be fleshed out when specific legislation is developed, and the insurance industry designs the new products.

The proposal can be outlined very briefly. A potential owner — or, more likely, the potential owner's investment advisor (assuming that the potential owner doesn't automatically channel his or her capital credit allocation into the company for which he or she works) locates a financially feasible and properly vetted investment. The potential owner brings the investment to a commercial bank loan officer, who further scrutinizes the loan. Assuming that the investment passes muster, the loan officer passes it on to an insurance company to do an assessment of the risk and determine the risk premium. This provides an additional level of scrutiny.

Some of the requirements for an investment to qualify are 1) full payout of all earnings attributable to the shares, 2) tax deducibility of such dividends at the corporate level, 3) all dividends received subject to taxation at the ordinary rates except for any and all dividends used to make acquisition debt service payments, and 4) full voting rights attached to the shares going to the investor. Taxation of dividends at ordinary rates to the recipient for anything not used to make debt service payments and meet associated investment costs (such as the premiums on capital credit insurance policies) will be largely offset for most people by greatly increasing the personal exemption to realistic levels, eliminating most deductions except for increased deductions for education and healthcare, and a deferral for any and all qualifying assets put into a Capital Homestead Account.

Assuming everything is in order, the loan officer makes the loan and purchases an insurance policy on the loan, paid for with the risk premium by means of which financial institutions currently "self-insure" against loss. The premium for a capital credit insurance policy on a loan will, of course, be much less than the usual risk premium, however, even for a similar loan. This is because the typical risk premium on a traditional loan is determined based on the risk associated with that particular borrower, with no spreading of the risk. The premium for an insurance policy made for the same purpose, even for a loan made to the same borrower, will be much less because the risk is spread out among an entire population of loans instead of just a single individual. All loans are therefore "non-recourse" against the borrower, who thereby protects his or her other assets.

In order to make certain that people with absolutely no savings at all and a complete inability to cut consumption by any degree whatsoever can obtain capital credit to purchase income generating assets, the bank making the loan should pay the premiums on the policy, although the full cost of the premiums will be passed through to the investor once the investment starts generating dividend income. In addition, the bank will be compensated for the service it performs not by an ongoing interest charge, but a one-time service fee on each loan, taken directly out of the loan principal (discounted) to ensure that no existing accumulations of savings are needed at any step.

To make certain that all loans are backed at least 600%, all qualified loans — and no commercial bank would find it profitable to make loans other than qualified loans — will be rediscounted at the Federal Reserve, which was established for just this purpose. Thus, all loans will be backed by 1) the present value of the assets they were made to finance (100%), 2) the capital credit insurance policy (200%), which is in turn backed up by the insurance pool (300%), and the reinsurance pool (400%), not to mention 100% reserves (500%), and the full faith and credit of the federal government that by law assumes direct responsibility for all issues of the Federal Reserve (600%), which is in turn backed up by the tax base of a much sounder economy. In contrast, today's recognized money supply, M1 and M2, are backed up by government debt, as well as at present (April 2010) more than $1.2 trillion in toxic mortgage-backed securities, both of which are supported by a seriously depleted and decayed tax base in a disastrously weakened economy.

As the investment becomes profitable and begins paying dividends, the borrower will make the debt service payments, thereby redeeming his or her promissory note. The bank cancels the money, terminating the lien it took on the assets financed by the loan. If the investment fails to generate sufficient income and the loan goes into default, the capital credit insurance policy pays off. This allows the bank to cancel the loan and the amount of money created by the loan, avoiding any danger of inflation. To avoid encouraging banks to make deliberately bad loans in order to make a fee and increase profits unjustly, the full amount of a loan will not be insurable.

As an additional safeguard, no insurance or reinsurance company will be permitted to invest its insurance pool in the industry or group of industries for which it issues capital credit insurance policies.

In this way Kelso and Adler devised a way out of the Keynesian liquidity trap without the necessity of the State relying on deficit spending or for the Federal Reserve to manipulate interest rates artificially. Capital credit insurance would also make it possible for people who currently lack existing accumulations of savings to become owners of productive assets.

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