Thursday, April 29, 2010

Own the Fed — the Program, Part XI: The Two-Tier Interest Rate

The period immediately preceding the Crash of 1929 was marked by excessive use of bank credit to finance purchases of speculative equity issues on the secondary market. What puzzled the authorities and experts (at least those trapped within the tenets of the Currency School) was the fact that there also appeared to be plenty of credit for genuinely productive business purposes. According to the theory enshrined in economic dogma as the "production possibilities curve," there exists only so much credit, representing the supply of loanable funds — existing accumulations of savings.

As the prevailing (and incorrect) theory has it, printing money or creating demand deposits can shift existing savings around through the redistributive effects of inflation and deflation ("forced" or "involuntary" savings; see Keynes, General Theory, op. cit., II.7.iv, IV14.i, V.21.i,; Harold G. Moulton, George W. Edwards, James D. Magee, Cleona Lewis, Capital Expansion, Employment, and Economic Stability. Washington, DC: The Brookings Institution, 1940, 26). Within the framework of the Currency School, the process of money creation — or, more accurately, the creation of more currency or currency substitutes — cannot bring additional savings into existence out of nothing.

Currency School theory and all the schools of economics that accept the principles of the Currency School ignore the bulk of the real money supply. This is the promissory notes and other negotiable instruments collectively known as real bills that can be issued on the basis of the present value of future marketable goods and services. The only way within the paradigm bounded by the tenets of the Currency School to finance new capital formation is to cut consumption, save, then invest.

Coincident with the financial system's slavery to existing accumulations of savings is the failure to distinguish between good and bad uses of credit. Driven solely by profits, with little regard for how profits are generated or where they come from, essential principles of ethics — the precepts of morality, usually justice — are ignored or forgotten. If it is possible to squeeze money out of something, whether or not anything of value was produced by the activity, then the only standard is how much money can be accumulated.

True, the absolute belief that capital formation can only be financed out of existing accumulations of savings does not necessarily lead to justifying any and all means of getting money — but it doesn't help any, either. Within the various paradigms dictated by this basic precept of the Currency School, those with vast wealth are considered essential to financing new capital formation and thus providing the jobs by means of which the vast bulk of humanity gains subsistence. (See Keynes, The Economic Consequences of the Peace, op. cit., III.2.)

Such is the corrupting influence of concentrated power, especially economic power, that the "slavery of savings" quickly turns into "slavery to those with savings." Whether a small private elite, or the State itself, whoever controls access to savings controls everything. As Mayer Anselm Rothschild is alleged to have declared, "Give me control over money and credit, and I care not who makes the laws." Those with access to savings are venerated, even worshipped outright as a special breed, becoming an unelected and, in many cases, unappointed economic dictatorship. They come to view their activities as a form of conquest of the system, of others in their milieux and, finally, of the rest of humanity.

People come to believe (or, at least, convince themselves) that greed is not only good, it is the greatest virtue. Greed alone is held to be responsible for driving these exceptional individuals to accumulate more and more. Greed makes it possible for people to finance new capital formation, create jobs, save the economy, and therefore the nation. Those who have indulged their greed to the maximum become viewed as saviors, and then as gods. If greed is good, then Greed is God, "for only God is good."

In reaction, if not outright disgust, people whose moral compass has not been entirely decalibrated begin viewing all profit as a manifestation of greed, and all the laws of economics as necessarily wrong. Everything associated with the system that enshrines greed as god, whether the business corporation, wealthy or well-off individuals, mass production — anything that excites the ire of such self-appointed moral authorities — is necessarily evil.

People with some vestiges of morality, though often lacking in reason, quite properly reject capitalism for its emphasis on, even worship of greed. Unfortunately, they often then overcompensate and assume that socialism based on envy (usually under another name or in a different outward form) is the only acceptable system. Private property must be abolished in its present form, by which they usually mean in its substantial nature. Since obviously not everyone can own the means of production, the right to be an owner must not truly be a natural right, inherent or absolute in every human being. Instead, it must be prudential matter, a manmade expedient or, as one commentator declared, "a right, but not an absolute right."

The descent into the envy of socialism derives from the assumption that people should get what they need, not what they are due in exchange for their inputs, and that distribution on the basis of need is an application of justice. This, in turn, leads to other conclusions, equally erroneous. For example, since most people do not have accumulated savings, they cannot participate in the economy as owners. Most people are therefore restricted to supplying labor. Since the world was made for everyone, that must mean that capital is not truly necessary for production, and labor alone is ultimately responsible for all production. If God had meant everyone to own capital, He would have given them savings.

Thus, the flawed assumptions of the Currency School, taken and worshipped as absolutes — especially the presumed necessity for using only existing accumulations of savings to finance capital formation — leads to a pendulum swing between greed and envy. The action finally settles into the gray sameness of the Servile State in which both Greed and Envy join and share the throne. Greed and Envy become a Janus, presenting two faces to the world. Depending on how you choose to look at it, the system's slavery to existing accumulations of savings is either good or evil, but you're stuck with it, and there is no way out.

Both the "greedists" and the "needists" (The Capitalist Manifesto, op. cit., 97; also Two-Factor Theory, op. cit., 12-29) make the same fundamental error. Which side they take usually depends on whether they have separated faith from reason, or reason from faith. Since faith enlightens reason, and reason guides faith, separating one from the other splits the human mind in two, as G. K. Chesterton characterized the abandonment of the Intellect as the basis of the natural law in favor of the Will, epitomized by the claims of Siger of Brabant in his debate with St. Thomas Aquinas. As Chesterton explained the issue,
Siger of Brabant said this: the Church must be right theologically, but she can be wrong scientifically. There are two truths; the truth of the supernatural world, and the truth of the natural world, which contradicts the supernatural world. While we are being naturalists, we can suppose that Christianity is true even if it is nonsense. In other words, Siger of Brabant split the human head in two, like the blow in an old legend of battle, and declared that a man has two minds, with one of which he must entirely believe and with the other may utterly disbelieve. (G. K. Chesterton, St. Thomas Aquinas: The "Dumb Ox." New York: Image Books, 1956, 92-93.)
A bad economic assumption — the presumed absolute necessity of existing accumulations of savings to finance capital formation — thereby leads to bad reason and bad faith. The shift in the basis of the natural moral from Intellect to Will (see Rommen, The Natural Law, op. cit., 51-52) provides the philosophical framework (such as it is) to justify both greed and envy. The same bad economic assumption also leads to bad monetary and fiscal policy, especially when it comes to the prevailing fantasy that the federal government and the Federal Reserve together actually (and effectively) control the economy, as we explained in the first posting in this series.

Thus we see that within the Currency School model the only way to inhibit or reduce the use of bank credit for speculative purposes is to discourage all uses of credit. This leads automatically to the belief that the central bank, the Federal Reserve System, can reduce speculative uses of credit (and, unfortunately, productive uses of credit at the same time) by raising interest rates to eliminate — presumably — the possibility of speculative bubbles in the economy. Interest rates are thereby construed as a different form of "sin tax," that is, an excise tax levied to discourage what those in power view as objectionable behavior, such as smoking, drinking, gambling, and so on. Legislators often find sin taxes both lucrative and profitable, especially when they become desperate for revenue.

The same technique is applied when Federal Reserve authorities believe that the economy is becoming "overheated," that is, economic growth is going at too fast a rate. This, presumably, is fertile ground for speculative bubbles, and needs to be headed off at all cost. Stock market gambling evidently being an objectionable activity, imposing a sin tax in the form of higher interest rates presumably solves the problem, although it has the undesirable side effect of also punishing presumably unobjectionable genuinely productive activity.

The Obama administration has refined this approach. It has recently started calling for a "bailout tax" on financial institutions. As reported in an editorial in The Wall Street Journal, this will (presumably) "discourage excessive risk-taking and prevent systemic risk." ("Global Bank Heist," The Wall Street Journal, 04/29/10, A18.) While the editorial does not refer to the bailout tax as a sin tax, it points out that the proposed tax would probably not discourage bailouts or discourage the activity that leads to the presumed necessity for bailouts. Further, the proceeds would probably not be used to bail out banks, any more than the Social Security trust fund was safe from being pillaged to finance other government expenditures.

Even the faulty reasoning behind the manipulation of the interest rates and the wealth sin tax — having enough wealth to excite the envy of others evidently constituting a sin — does not explain, however, the rationale behind the support that the Federal Reserve authorities have given to bringing the stock market back to its old levels as fast as possible after the precipitous decline that bottomed out in March and April of 2009. By any measure, the "miraculous" recovery of the secondary markets since that time, far from the great good it's being trumpeted, is actually a very dangerous sign of much worse things to come.

For the purposes of comparison, let's take a look at events following the 1929 Crash. In September of 1929 the Dow hit an all-time high of $381.17. In the darkest days of the Great Depression, the Dow was down to $41.22. The Dow did not recover its pre-Crash level of $381.17 until the mid-1950s, a full quarter century after the Crash.

In comparison, the Dow reached an all-time high of $13,390.01 in October of 2008. The Dow then fell to $7,062.93 by March of 2009. By the middle of April of 2010, the Dow was at $11,145. This was touted as an astonishing recovery. The Federal Reserve authorities abandoned their cautious optimism and announced that the recovery was well under way and the worst was definitely over. The strength of the American economy was demonstrated by the fact that the Dow took a little over a year to recover 83% of its former high, doing what it took the economy from 1930-1955 — twenty-five years — to accomplish after the Crash of 1929.

There are other significant differences between the situation in the 1930s and that of today, all of them involving disastrous, as opposed to merely terrible monetary policy. Much of the problem, however, seems to boil down to one thing. Despite the fact that massive money creation for speculative purposes was one of the driving forces behind the Crash of 1929 as well as the sub-prime mortgage meltdown of 2007, government policymakers and Federal Reserve authorities seem convinced that massive money creation for non-productive purposes is the way to advance economic recovery — only they refuse to admit that is what they are doing.

There was, of course, massive money creation by the federal government and backed by debt during the Great Depression. The money, however, financed government spending and boondoggling — artificial job creation. The money went directly into increasing effective demand. Moulton pointed out this was backwards, that increased production would increase effective demand, but there was a temporary decrease in unemployment. Unfortunately, Federal Reserve authorities (just as today) were unable to distinguish between productive uses of credit and speculative uses of credit. When they decided that growth was proceeding too fast and a speculative bubble or overheated economy might form, Federal Reserve authorities began raising rates in the mid-1930s. As a result, the tenuous recovery took a nosedive, and the country experienced the Crisis of 1937.

In contrast, today's massive money creation has gone into bailouts and speculation. There is no recovery, much less a tenuous one. On the contrary, Federal Reserve authorities have concentrated on fostering, even promoting speculation in the stock market, while at the same time announcing that it was keeping a careful eye on economic growth. This, of course, is apart from the obvious speculative bubble of the stock market. The Federal Reserve stands ready to begin raising the rates the moment the productive sector of the economy shows sustainable signs of life. Unfortunately, raising the rates could easily not only cause another crash, but completely stifle business, which is in bad enough shape already.

Still, perhaps the most truly astonishing thing about the recovery of the stock market in a little over a year is that Federal Reserve authorities and government officials as well as Wall Street pundits and academic economists continue to assure the public that the rapid rise in share values is not a speculative bubble. The megadollars pumped into bailing out failed gamblers and speculators and into price supports and subsidies for toxic assets are, remarkably enough, alleged to have absolutely no speculative effect. It would be interesting to find out if Mr. Bernanke, President Obama, Mr. Geithner, Mr. Paulson, and the great numbers of experts have ever read Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds (1841).

Should the Federal Reserve authorities and government policymakers ever wake up to the insanity of their approach, there is a solution ready to hand. There is a Just Third Way solution that would encourage money creation for good, productive purposes and virtually eliminate money creation for speculative purposes, consumption, and government spending. This is the "two-tiered interest rate."

In outline the concept is very simple. All money creation for speculative and other non-productive purposes must cease immediately. Just saying that, however, does nothing other than state the obvious. There is, nevertheless, a simple and most effective means by which money creation for speculation and non-productive purposes can be stopped and money creation restricted exclusively to monetizing the present value of existing and future marketable goods and services. That is to require all bills presented for discounting at a commercial bank and subsequent rediscounting at the Federal Reserve be backed by sound and properly vetted inventories of existing or future marketable goods and services — that is, constitute a "real bill," a negotiable instrument with a definable and reasonably assured present value standing behind it in which the drawer has a private property stake.

The "interest rate" on discounted and rediscounted real bills would be set at the cost of actually creating the new money. This would be the first "tier." Careful and virtually continuous scrutiny of all loans made at this tier would be built into the system. A bank's loan officer would, of course, subject such loans to the normal scrutiny. Collateral would necessarily be examined frequently as a result of using capital credit insurance to replace traditional forms of capital for loans made to finance new capital formation. For money created by discounting loans made using existing inventories of marketable goods and services, loan officers or other holders in due course would naturally confirm the existence and stated value of the inventories or contracts.

Thus, all new money would only be created in response to qualified and properly vetted industrial, commercial, and agricultural capital projects — "blue chips" — and confirmed and vetted existing inventories of marketable goods and services. All loans made out of newly created money to finance capital formation would also be required to expand direct ownership of the means of production to qualify for discounting or rediscounting.

Calling this first tier an "interest rate," however, is something of a misnomer. This is because the money would actually be "interest free," both in the traditional sense of lacking a preexisting ownership interest, and the more common sense of a return due to the supplier of existing accumulations of savings. The credit would be "pure," unadulterated by the need to cut consumption in order to accumulate the savings necessary to repay the financing.

Money creation by any means other than discounting and rediscounting real bills must be strictly prohibited — and enforced with rigor. The second "tier" interest rate would thus be the market cost of capital for existing accumulations of savings. This would be for capital projects that do not meet the qualifications for pure credit financing. This would include speculative ventures, unproven technologies, and individuals or groups with "bad credit." Also in this category — and probably accounting for the bulk of loans extended out of existing accumulations of savings — would be government borrowing, especially since (as we have seen) government borrowing is by nature nonproductive. Finally, consumer borrowing would necessarily come out of existing accumulations of savings, as would all insurance and reinsurance pools, especially capital credit insurance. (The Capitalist Manifesto, op. cit., 243-244; The New Capitalists, op. cit., 60-68.)

One of the results of this fundamental change in the way the financial system operates is that gamblers, improvident consumers, and government bureaucrats will no doubt express great outrage. This is understandable. Speculators and gamblers will have to purchase their jetons out of their own resources instead of using what Justice Brandeis called "other people's money." Consumers will have to stop living beyond their means. Government bureaucrats will suddenly become accountable to the taxpayer for every dime. It will not be possible to spend anything that is not backed up by the present value of marketable goods and services — production.

Of course, once they become used to the new state of affairs, gamblers, consumers, and even State bureaucrats will realize that the benefits that accrue to them and to society as a whole far outweigh the inconvenience associated with living within your means. Speculation, for instance, actually serves a useful purpose in the financial system — at least, as long as it is carried out using existing accumulations of savings. It is a good way to assess the risk associated with various investments, and thus in determining whether an investment is speculative, or qualifies for pure credit financing.

Consumers will be forced to consider purchases of all things on credit more carefully — but in "exchange," the prices of major items such as automobiles and houses would not be subject to the sort of speculative pressures that caused the sub-prime mortgage crisis. State bureaucrats will find themselves acting in a more responsible manner as they are forced to consider the results of their decisions on the ability to collect taxes or borrow money.

Small savers and retirees on fixed incomes should benefit more than anyone else, as this is the group that tends to purchase government bonds. The market rate of interest, being freed from manipulation by the Federal Reserve and allowed to rise to its own level, should rise rapidly at first as the federal, state, and local governments compete for a limited pool of savings. The virtues of thrift and the wise use of public credit will gradually replace present spending patterns as frivolous or non-essential programs become starved for cash.

To sum up, a two-tiered interest rate is a key monetary reform under Capital Homesteading that distinguishes "good" uses of money and credit (i.e., to finance broadly owned private sector growth and production) from "bad" uses of credit (i.e., to fuel nonproductive consumer and government debt, or speculation). The Federal Reserve's rediscount power would be available exclusively to member banks and members of the Farm Credit system for rediscounting eligible paper for feasible, ownership-expanding industrial, commercial, and agricultural projects, while open market operations would be restricted to dealing in similar instruments issued by non-member banks and other institutions, as intended in the original Federal Reserve Act of 1913.

Under this policy, credit and "new money" for Capital Homesteading, i.e., feasible business projects linked to broadened ownership (Tier 1), would be financed "interest-free" through the rediscount mechanism of the central bank, at a service charge based on the cost to the central bank of creating new money and regulating the lending institutions (0.5% or less). Credit and money for nonproductive, ownership-concentrating uses (Tier 2) would come from existing accumulations of savings ("old money"), and would be charged an interest rate determined by normal market yields on such savings. Under Capital Homesteading, local lenders would add their normal transaction fees and risk premiums for servicing capital acquisition loans, and the new loans would be collateralized by newly issued shares and newly acquired capital assets. Premiums paid to capital credit insurers and reinsurers would be pooled to spread the risk of default.


No comments: