This is because under fractional reserve banking individual commercial banks retain the power to create money for any purpose whatsoever. There is no way to prevent this in all circumstances, for the fractional reserve requirement regulates only the amount of money that a commercial bank can create, not the quality of the loans that back the money. Under fractional reserve banking, as long as a bank has sufficient reserves, the quality of the loans made by the bank is to a large degree a matter of subjective opinion of the financial institution, not a determination by an independent entity based on more objective market criteria. Fractional reserve banking thus violates essential principles of internal control. Regulation of the quality of loans made by commercial banks under fractional reserve banking relies on individual commercial banks adhering to rules and regulations imposed from outside the system — and such external controls as well as their enforcement are often heavily influenced by both political considerations and public opinion.
Capital credit insurance addresses the problem of the quality of loans made. Nevertheless, while insurance provides independent, third party verification of a transaction (assuming proper separation of function within the financial services industry), capital credit insurance is only a single added layer of scrutiny. Requiring immediate and mandatory rediscounting at the Federal Reserve of all loans extended by commercial banks to finance new capital formation and present working capital needs would add another layer of scrutiny. Mandatory rediscounting would impose a 100% reserve requirement, that is, all demand deposits would be backed 100% by cash or commercial bank demand deposits at the central bank.
Mandatory rediscounting would also ensure that all new money is issued at par with all other new issues, and all existing issues remain at par. This is one of the primary tasks of a central bank. Immediate rediscounting would ensure that the money supply always reacts virtually instantaneously with changes in the liquidity needs of the economy, thereby avoiding the lag time often associated with attempts by the federal government to manipulate the economy through changes in monetary and fiscal policy.
Commercial banks would continue to have the power to make loans for speculative purposes, consumer spending, and to finance government deficits. All loans made for such purposes, however, would necessarily come out of existing reserves, that is, out of the commercial banks' capitalization, retained earnings, and accumulations by savers maintaining depository accounts. Whether a commercial bank should make loans for such purposes out of existing reserves, of course, is a matter for State regulators, the board of directors, the shareholders, and common prudence to decide.
A commercial bank would, in essence, function as a deposit bank instead of an issue bank when making loans for non-productive uses out of existing reserves. It might be that reenactment of Glass-Steagall or legislation along similar lines, as well as common sense, would result in increased specialization in the financial services industry, and thus in commercial banks restricting their activities in these areas. Commercial banks would have enough to do in carrying out their unique function: monetizing the present value of existing and future marketable goods and services, thereby providing liquidity for the productive private sector.
It is important to note again that capital credit insurance, the two-tiered interest rate, and now the 100% reserve requirement apply only to commercial bank credit. Such reforms do not affect what we have termed "private sector money" — that part of the money supply represented by bills that circulate in the economy that are "disintermediated," that is, not discounted at a commercial bank, rediscounted at the Federal Reserve, or purchased by the central bank in open market operations. As late as 2008, this private sector money accounted for approximately 60% of the total money supply, and in the Jacksonian era of the early 19th century, a period in which the power of the central government was narrowly circumscribed, approached 95%. (This figure is based on the analysis by George Tucker in his 1839 book.)
The 100% reserve requirement is not a new idea. Deposit banks have always had a 100% reserve requirement for the simple reason that they are structurally incapable of loaning out more money than they have on deposit. During the 1930s there was serious consideration given to abolishing the commercial banking system by transforming all commercial banks and the Federal Reserve banks into banks of deposit, and restricting all money creation to the United States Treasury, to be backed 100% by government debt.
The proposal was popularly called "the Chicago Plan." Henry Simons (1899-1946), generally considered the founder of the Chicago School of economics — the Monetarists — developed the original proposal. The basic idea was that all commercial banks that functioned as issue banks would be abolished, the Federal Reserve's power to create money would be eliminated, and deposit banks would provide all the financing necessary for economic growth and development. (Henry C. Simons, "A Positive Program for Laissez Faire," Economic Policy for a Free Society. Chicago, Illinois: The University of Chicago Press, 1947, 62.) All money would be backed 100% by federal government securities held in National Banks that would function as a Sub-Treasury system. (Ibid., 62-63.)
In essence, Simons's proposal was to reestablish the National Banking system organized under the National Bank Act of 1864. The Federal Reserve System would be reorganized as a network of national banks, not a central banking system under the Federal Reserve Act of 1913. Even "national bank" is incorrect in this context, for a national bank is by definition a type commercial bank, and commercial banks have the power to create money.
To get around Fullarton's objections to the illogic of assuming that a fixed amount of currency (and demand deposits) could adequately meet the needs of the economy (John Fullarton, On the Regulation of Currencies of the Bank of England. London: John Murray, 1845, 3-4) and provide for an elastic currency, Simons proposed the formation of an independent regulatory body ("National Monetary Authority") that would determine the amount of new money to be created (or canceled) each year. (Simons, op. cit., 63; Norman Angell, The Story of Money. New York: Frederick A. Stokes Company, 1929, 7.) As described by Simons in his essay, "A Positive Program for Laissez Faire," the basic elements of the Chicago Plan are:
1. Outright federal ownership of the Federal Reserve banks.The problem from the perspective of binary economics, of course, is that Simons's proposal, modeled on the British Bank Charter Act of 1844 and the United States National Bank Act of 1864, represents the logical conclusion and the highest possible development of a system based on existing accumulations of savings. Simons included demand deposits in the definition of "money," and made the currency elastic (in an arbitrary fashion that did not really address Fullarton's concerns), but his proposal was otherwise no different from the classic tenets of the Currency School. Simons implicitly rejected the real bills doctrine and assumed the necessity of existing accumulations of savings to finance capital formation.
2. Annulment of all existing bank charters (as of a date, say, two years in the future), and enactment of new federal legislation providing for complete separation, between different classes of corporations, of the deposit and lending functions of existing deposit banks.
3. Legislation requiring that 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.
4. Provision during the transition period for gradual displacement of private-bank credit as circulating medium by credit of the Federal Reserve banks.
(This implies enormous increase in the investments and in the demand obligations of the Reserve banks — i.e., long continued open-market purchases which would serve to inject the substitute credit medium and also to facilitate gradual liquidation of the investments of existing deposit banks. At the end of the transition, the Reserve banks should find themselves in possession of investments amounting to a substantial portion of the federal debt — or, perhaps, in possession of the greater part of the debt itself — thus eliminating the burden of the debt, to that extent, without taxation and without inflation.)
5. Displacement by notes and deposits of the Reserve banks of all other forms of currency in circulation, thus giving us a completely homogeneous national circulating medium.
(This implies permanent retirement of all United States notes ["greenbacks"], all silver dollars and silver certificates, all gold coin and gold certificates, and all national bank notes. Subsidiary silver might be retained [though it might better be replaced by coins of a cheaper and more durable metal]. Monetary gold would be held exclusively by the Reserve banks, in the form of bars, and utilized only for settlement of international balances.)
6. Prescription in legislation of an explicit, simple rule or principle of monetary policy, and establishment of an appointive, administrative body ("National Monetary Authority"), charged with carrying out the prescribed rule, and vested with no discretionary powers as regards fundamental policy.
7. Abolition of reserve requirements against notes and deposits of the Reserve banks, and broad grants of powers to the "national Monetary Authority" for performance of its strictly administrative function.
(The foregoing measures contemplate an economy in which the rules of the game as to money are definite, intelligible, and inflexible. They are intended to avoid both the "rulelessness" of the present system and the establishment of any system based on discretionary management. "Managed currency," without fixed rules of management, appeals to me as among the most dangerous forms of "planning." To establish, as part of a free-enterprise economy, a monetary authority with power to alter vitally and arbitrarily the position of parties to financial contracts would seem fantastic.) ("A Positive Program for Laissez Faire," loc. cit.)
In the system that Simons sought to reform, money created to finance federal government deficits already was and remains backed 100% by government securities. The money created through the commercial banking system by means of increases in demand deposits, on the other hand, was and is backed only partly by government securities. The rest is backed by liens on whatever collateral a borrower has put up to qualify for a loan, or in some cases only the borrower's faith and credit — an unsecured loan. The requirement that demand deposits of commercial banks be backed only partially by government securities and cash (the same thing, ultimately, given that cash in the current system is backed by government securities) is fractional reserve banking.
Simons appears to have reasoned, logically enough, that if the entire money supply could be backed 100% by United States government securities, the soundest in the world, instead of split between 100% reserves for money backed by State debt paper and fractional reserves for money backed by questionable commercial debt paper, the problem of scarce money and tight credit could be solved. To make certain that the politicians didn't seize control of the Federal Reserve, a monetary agency could be established to determine the amount of money needed in the economy. The State would issue debt paper to the authorized amount, sell it to the Federal Reserve, spend the money without having to tax people, and the free market, laissez-faire capitalist economy could take it from there.
There was, however, a serious problem with the Chicago Plan. As an adherent of free market economics, Simons was far from comfortable with turning over the money power to a monopoly, to say nothing of the lack of accountability that abolishing certain taxes would insert into the system. As Simons stated in "A Positive Program for Laissez-Faire," the 100% reserve requirement based on government debt would,
Eliminate all forms of monopolistic market power, to include the breakup of large oligopolistic corporations and application of anti-trust laws to labor unions. A Federal incorporation law could be used to limit corporation size and where technology required giant firms for reasons of low cost production the Federal government should own and operate them . . . . Promote economic stability by reform of the monetary system and establishment of stable rules for monetary policy . . . . Reform the tax system and promote equity through income tax . . . . Abolish all tariffs . . . . Limit waste by restricting advertising and other wasteful merchandising practices.Simons, however, at least had seen (for good or ill) the various stratagems by means of which politicians had seized control of the world's central banks, even the United States Federal Reserve System. He was therefore fully aware of the necessity of devising some means to prevent the politicians from seizing control of his recommended independent monetary authority. A number of authorities viewed Simons' concerns as needless scruples: people in the Great Depression needed plentiful money and easy credit immediately. Control measures could wait; fix the problem first, and worry later whether it was the best or even the right thing to do.
The problem with immediate implementation was that Simons was very well aware of the dangers of just charging forward without implementing adequate controls, or the checks and balances Bagehot had dismissed so blithely. Simons struggled valiantly to develop some system to provide control over his system. He was, however, faced with an impossible situation, a problem that could not be solved within the paradigm in which he was operating. He was attempting to reconcile a State monopoly over money and credit with free market principles. As State ownership or monopoly and free markets are diametrically opposed, he could not do it. The laissez-faire principles supporting issue banking simply could not be reconciled with the monopolizing principles supporting State-funded deposit banking.
As devised by Simons, then, the Chicago Plan required intrusive, even overreaching State control at the same time that Simons's own principles rejected all forms of monopoly power. (See, e.g., Henry C. Simons, "Some Reflections on Syndicalism," The Journal of Political Economy. Volume LII, March 1944, No. 1, 1-25.) As he declared, "The great enemy of democracy is monopoly, in all its forms: gigantic corporations, trade associations and other agencies for price control, trade unions — or, in general, organization and concentration of power within functional classes." (Quoted in John Davenport, "The Testament of Henry Simons," Fortune magazine, Volume XXXIV, No. 1.) This presented a problem, for State control over the creation of money would impose the most powerful monopoly of all, and vest that control right where it should not be. As the Wall Street Journal pointed out, "The effect of the plan, of course, would be to concentrate the entire banking and credit function in the hands of the government." ("Powerful Support Under Way For '100% Reserve Plan'," The Wall Street Journal, 02/19/35, 6.)
Simons, of course, understood the paradox. He addressed this problem in a general way, but was never able to develop a specific proposal to prevent total State control of the economy, whether the State did so directly or by taking over the regulatory body. ("Rules versus Authorities in Monetary Policy," Journal of Political Economy, XLIV, No. 1, February, 1936, 1-30.) Despite the urging of such diverse authorities as Senator J. W. Elmer Thomas of Oklahoma, Irving Fisher, and Father Charles Coughlin, Dr. Simons refused to push for implementation of the Chicago Plan. ("Powerful Support Under Way For '100% Reserve Plan'," loc cit.; David Laidler, "Review of Meltzer's History of the Federal Reserve," Department of Economics, University of Western Ontario, (No date) 24n.) Father Charles E. Coughlin, the noted "Rosary Priest," held views on money that appeared to be derived from a more extreme understanding of the position of the Currency School. His version of the 100% reserve requirement was substantially different from that of both Simons and Fisher. (See Charles E. Coughlin, Money! Questions and Answers. Palmdale, California: Omni Christian Publications (No date).)
Using an improved 100% reserve requirement that allowed for the operation of the real bills doctrine would have solved Simons's problems. A 100% reserve requirement under binary economics and the real bills doctrine would put control over the money power back into the hands of ordinary citizens. That is, ultimate power would be vested in anyone who presented financially feasible proposals for capital formation to a commercial bank for discounting — a real bill.
Under the Capital Homesteading version of the 100% reserve requirement, a commercial bank would not keep a portion of the bank's assets on hand in the form of vault cash, demand deposits at the Federal Reserve, and federal government securities to meet fractional reserve requirements. Instead, all of the bank's assets representing loans made for qualified industrial, commercial, and agricultural capital projects would be in the form of vault cash or commercial bank demand deposits at the local Federal Reserve Bank. To avoid all possibility that the federal government would be able to circumvent the prohibition against monetizing its deficits, "reserves" would be strictly redefined to eliminate all forms of government debt from the definition.
Consequently, in order to maintain 100% reserves, all commercial banks would have to discount all loans made at the local Federal Reserve Bank. This would also force a greater level of scrutiny on the commercial banks to ensure that all loans met the financial feasibility requirements for rediscounting at the central bank. The commercial bank would otherwise risk losing its access to the discount window. This would force the commercial bank to become a savings bank (a bank of deposit), or put it out of business.
Thus, the 100% reserve requirement under the Capital Homesteading proposal of the Just Third Way is materially different from Simons's Chicago Plan. This is based on the fact that Capital Homesteading has a completely different orientation toward money creation. Under the tenets of the British Currency School, money is presumed to be created first, then savings and capital formation can take place. This was the assumption embodied in the Chicago Plan, in which a monetary authority would estimate the amount of money needed in the economy, create it, and turn it over to the banks to lend out. The sequence in money creation is presumed to be 1) create money, 2) cut consumption and save, 3) locate a project or inventory of marketable goods and services with present value, then 4) invest. As should be obvious, there is a serious danger of either inflation or deflation in this process if the monetary authority happens to guess incorrectly.
Under the tenets of the British Banking School and in accordance with Say's Law of Markets and the real bills doctrine, however, no money is or can be created until and unless a potential borrower brings a financially feasible project to the commercial bank. The present value of existing or future marketable goods and services is determined, and money is created by means of the issue of a promissory note, then invested in the capital project, after which money is taken out of the future stream of income and used to repay the loan. The sequence is 1) locate a project or inventory of marketable goods and services with present value, 2) create money to finance the project in an amount no greater than the present value of the project, 3) invest, and 4) save. As should be equally obvious, there is no danger of either inflation or deflation, as money can only be created as needed in response to existing present value.
While this is the soundest method of creating money, one thing more is needed, and is eminently feasible by using a central bank properly in the way in which it was intended. Instead of having each commercial bank be individually liable for its privately issued promissory notes, a central bank can purchase all loans made by commercial banks to finance industrial, commercial, and agricultural projects that have been properly vetted and collateralized. Thus, just as an individual borrower exchanges his or her personal credit for the less risky and more acceptable institutional credit of a commercial bank, individual commercial banks would exchange their credit for that of the nation itself by discounting all loans at the central bank.
All new money created by the extension of commercial bank credit would thus be direct issues of promissory notes not of individual commercial banks, but of the central bank. All currency and demand deposits would automatically pass at par because all would, in effect, be promissory notes of the central bank, and all promissory notes a borrower obtained from any commercial bank would be backed 100% by promissory notes issued by the central bank. This would institute an automatic 100% reserve requirement, but without the necessity of direct State control of the economy.
In conjunction with a 100% reserve requirement of this nature, the central bank would not be permitted to hold government debt, whether issued by the government and sold directly to the central bank (primary securities) or "secondary securities" issued by the government and sold to the public and subsequently purchased by the central bank on the open market. In effect, the central bank's role with respect to the State would be restricted to acting solely as a depository for State funds, and would not be able to issue promissory notes backed by government debt.