Wednesday, May 5, 2010

Own the Fed — the Program, Part XIV: Extend the Term of Qualified Paper

According to the provisions of the original Federal Reserve Act of 1913, the central bank was only to be concerned with temporary increases or decreases in the money supply in order to avoid the twin evils of inflation and deflation. Consistent with classic commercial banking theory, the focus was on rediscounting short-term commercial paper with a term of ninety days or less in order to meet temporary liquidity needs of the private sector.

By far the largest part of the money supply in 1913 consisted of what we have termed "private sector money," that is, bills drawn on the present value of existing and future marketable goods and services. The vast bulk of such private sector money circulated, as today, between businesses and even countries without being discounted at a commercial bank in exchange for currency or (more usually) demand deposits. Even today, when the Federal Reserve has vastly increased the amount of debt-backed money in circulation, this asset-backed private sector money accounts for up to 60% of the money supply, and is the only thing keeping the economy going.

Under the terms of the original Federal Reserve Act, private sector money was to be supplemented (in order of importance) by 1) commercial bank discounts of short-term paper as well as long-term notes for fixed capital financing, 2) savings deposited in commercial banks, 3) government-issued coin and notes (e.g., gold and silver certificates and United States Notes), 4) Federal Reserve rediscounts of qualified primary issuances of commercial paper originally discounted by member banks, and — in distant last — 5) Federal Reserve open market purchases of secondary issuances of qualified securities issued by non-members banks and other private sector institutions. The Federal Reserve was thereby construed as the lender of last resort to the private sector in order to provide adequate liquidity to prevent both inflation and deflation, and to ensure that control over money and credit would be decentralized.

An important aspect of the deconcentration of control over money and credit was the prohibition against the central bank monetizing government debt. The dangers of allowing the government to finance itself without recourse to taxation was, of course, the most important reason for prohibiting the Federal Reserve from dealing in primary issuances of government securities. The only provision for dealing in government-issued debt paper was in §§ 14 and 19 dealing with reserve requirements for commercial banks. The Act restricted transactions involving government securities to secondary issuances bought and sold on the open market to ensure that the Federal Reserve had the direct power to affect reserve requirements.

As the report of the Pujo Committee (U.S. Congressional House Committee on Banking and Currency, Report of the Committee Appointed Pursuant to House Resolutions 429 and 504 to Investigate the Concentration of Control of Money and Credit, February 28, 1913. Washington, DC: U.S. Government Printing Office, 1913) made clear, one man effectively controlled money and credit in the United States: financier J. P. Morgan. The motive behind the design and implementation of the Federal Reserve System was to break up the concentration of control of money and credit centered in New York City, yet leave full control in the hands of the private sector.

Thus, instead of a single central bank, the Federal Reserve System was designed as a network of twelve regional development banks. As we have seen, this was similar to a proposal made by Congressman George Tucker of Virginia in 1839, for a network of national banks to provide discounting services for the private sector, thereby regulating the value of the currency without direct State control. (George Tucker, The Theory of Money and Banks Investigated. Boston: Charles C. Little and James Brown, 1839.)

As "lenders of last resort" for the private sector, the regional Federal Reserve banks were to stand ready to supplement — never to replace or control — the supply of private sector money that provided and still provides the bulk of the money supply for the economy. Built into the system was the assumption that long-term capital investment is a matter for the private sector to deal with. The Federal Reserve was there to ensure that the currency would be stable, would always pass at par, and that short-term (90 day or less) liquidity needs of the economy would be adequately provided for without inflation or deflation. Short-term liquidity needs would be met by means of an elastic currency maintained by rediscounting qualified industrial, commercial, and agricultural paper issued — discounted — by member banks, supplemented when necessary with open market purchases of similarly qualified commercial paper issued by non-member banks and individual industrial, commercial, and agricultural enterprises.

Clearly the original mission of the Federal Reserve is not inconsistent with the Just Third Way, especially as applied in Capital Homesteading. There are, however, certain changes that need to be made in order to make the Federal Reserve — an integral part of a well-run financial system and sound economy — into something that is fully consistent with the Just Third Way and Capital Homesteading.

The task is twofold: 1) reform the Federal Reserve so as to restore it to its original mission to "furnish an elastic currency, to afford means of rediscounting commercial paper, [and] to establish a more effective supervision of banking in the United States." 2) Within the parameters established by adherence to the principles of sound finance and banking found in the principles of the Banking School (exemplified by Say's Law of Markets and the real bills doctrine), restructure the operations of the Federal Reserve to conform to the demands of the Just Third Way, especially as found in the Capital Homesteading proposal.

Of the necessary reforms to accomplish our goal, we have already covered the need to stop all monetization of government deficits, replace traditional collateral with capital credit insurance and reinsurance, establish a two-tiered interest rate, mandate a 100% reserve requirement for commercial banks, and restore the autonomy of the regional Federal Reserve banks. All of these reforms, however, are largely directed at restoring the original function of the Federal Reserve, or in eliminating certain functions that have managed to get themselves added but that have nothing to do with the original purpose for which the Federal Reserve was established. We now have to consider what new provisions need to be put in place so as to bring the structure and operation of the Federal Reserve System into conformity with the Just Third Way and meet the demands of a Capital Homesteading program.

As we have already noted, the Federal Reserve was intended to provide for the short-term liquidity needs of the private sector. For reasons we need not get into at this point, the function of the Federal Reserve was more or less gradually changed from its inception in 1913 from being the lender of last resort to the private sector, to acting as the chief financier of federal government operations — the lender of first resort to the State. Ironically, the central bank of the United States was carefully designed to try and prevent the federal government — or any other level of government — from being able to monetize its deficits. The dangers of allowing the State to avoid the accountability that direct taxation naturally affords were obvious to the framers of the Act, as was the more immediate danger represented by concentrated control over money and credit that the Act was designed to break up.

In order to emancipate humanity from what Kelso and Adler called "the slavery of savings" (meaning, of course, past savings, not the future savings on which financial feasibility of any viable capital project relies), the Federal Reserve needs to stop all financing of government debt, and begin financing all new capital formation by monetizing the present value of future marketable goods and services by rediscounting qualified industrial, commercial, and agricultural paper discounted by the commercial banking system.

We specify future marketable goods and services in this discussion because of the need to extend the term for loans made to finance new capital formation in a way that creates new owners of that capital. The Federal Reserve was established in part to provide liquidity for the private sector by monetizing short-term loans backed by the present value of existing inventories of marketable goods and services — which inventories already belong to the owners of the capital that produced those inventories.

This does not mean that we advocate that the Federal Reserve not resume rediscounting of short-term qualified paper. This function remains critical to supplying adequate short-term liquidity needs of the private sector, even if it does not create a single new owner. We advocate replacing the present long-term financing of government deficits with long-term financing of new capital formation in ways that create new owners of the new capital.

The necessity of monetizing the present value of existing inventories of marketable goods and services is easily demonstrated. The present value of existing marketable goods and services can be — and frequently is — monetized by drawing bills on the present value of those goods and services. These bills can be used as — and, in point of fact, are — money. This private sector money — as we have seen — accounts for approximately 60% of all financial transactions in the American economy. These bills can be discounted at a commercial bank and exchanged for currency or demand deposits, but that is not, strictly speaking, necessary in order for the bills to circulate as part of the money supply. Frequently this private sector money circulates in the economy without the intermediation of financial institutions.

In accordance with Say's Law of Markets, these bills, backed by the present value of existing marketable goods and services belonging to the producer of the goods and services/drawer of the bill, are the primary source of the aggregate effective demand by means of which the producer/issuer purchases the marketable goods and services produced by others. The real bills doctrine therefore provides the mechanism by means of which Say's Law of Markets operates so that supply can create its own demand, and demand its own supply. Obviously, then, in order to ensure that adequate effective demand is distributed throughout the economy, ownership of the means of production, whether labor, land, or capital, must also be broadly distributed throughout the economy.

This answers the objection that some critics of binary economics insist on raising. Locked into the assumptions of the Currency School that defines "money" solely in terms of State-issued coin and currency, and (usually) bank-created demand deposits, they assert that if all "money" is created only to finance new capital formation, then the money supply will necessarily dwindle and, finally, disappear as the capital formation loans are repaid. This is because, as they claim, the bank necessarily takes back more money in the form of interest than it created to finance the new capital in the first place.

As should immediately be obvious, even if the assumptions of the Currency School were perfectly valid and the money supply consisted exclusively of State-issued coin and currency, and bank-created demand deposits, the objection is without foundation. A bank does not cancel or destroy the amount it receives over and above the amount it created, that is, the original loan principal less the bank's discount. Instead, it books the amount it receives in excess of the original loan principal as revenue, and uses the revenue to meet costs, expand operations, and distribute profits. The money does not disappear, but reenters circulation as the bank expends it.

Further, the process is going on all the time. Even if the money supply were dwindling away as such critics assert, there would be a continual creation of new money as the bank participated in the financing of new capital projects and the economy grew. The objection assumes 1) an economy in which there is exclusive reliance on existing accumulations of savings to finance capital formation, 2) the money supply exists exclusively of bank- or State-created money, and 3) a condition of total economic stagnation — none of which even remotely resembles reality.

In any event, the bottom line is that the money needed to clear existing inventories of marketable goods and services can be created as needed by discounting bills backed by the present value of those inventories at a commercial bank, with the commercial bank immediately rediscounting the bills at the regional Federal Reserve in accordance with the 100% reserve requirement. Such transactions are necessarily short-term, as financing operations in this manner usually requires redeeming a bill within 90 days, with shorter terms more usual. Our interest at this point is to ensure that there is adequate liquidity to finance new capital formation, and that such financing results in the creation not just of new capital, but of new owners of that capital. This requires that the Federal Reserve rediscount bills with terms longer than 90 days.

Fortunately, there are precedents. Obviously the mounting federal deficit and the nearly $1 trillion of M1 and M2 backed by government debt held by the Federal Reserve is an example of effective long-term financing, regardless of the term of any specific government debt instrument. There is no real difference between extending long-term credit for fifty or more years, and extending short-term credit that is automatically refinanced every 90 days for generations. Realistically speaking, the Federal Reserve has effectively financed federal government deficits with loans that have been outstanding now for nearly a century — a century and a half, if we include government debt dating from the American Civil War that backed the note issues of the national banks and which were assumed by the Federal Reserve in the 1920s and 1930s.

Switching to private sector loans that have an asset rather than debt backing, and which have terms of no longer than ten years on the average would have a number of obvious advantages. One, the currency would rapidly change from being debt-backed to being asset-backed. Two, the replacement of indefinite term government loans with definite term private sector loans is clearly more financially prudent. Three, government loans are backed only by the power that the State has to collect taxes at some vague time in the future, while private sector loans collateralized with existing inventories or capital credit insurance are guaranteed to pay off, one way or another, within the specified period of time.

There is, however, a much better precedent — and we do not refer to the approximately $1.2 trillion in "toxic" mortgage-backed securities that the Federal Reserve purchased in recent years in direct contravention of the provisions of the Federal Reserve Act that prohibit the central bank from dealing in speculative securities. The inadvisability of these purchases is demonstrated by the panic that spread rapidly when it was announced that a few members of the Federal Reserve Board of Governors were considering thinking about divesting the Federal Reserve of some of its toxic holdings. ("Several Fed Members Favor Selling Mortgage Assets Soon," CNBC, 04/23/10). Within the current economic and financial framework far removed from the common sense of binary economics, a sell-off would drive up interest rates and depress the housing market, triggering inflation and stalling the recovery. It would be much better if the Federal Reserve had concentrated on production, especially production in which everyone participates both as owners of labor and as owners of capital.

Financing capital formation, democratic or otherwise, would require that the Federal Reserve extend credit for such purposes for longer terms than the standard 90 days. This addition to the functions of the Federal Reserve is in conformity with sound principles of finance and the theory and practice of commercial banking, especially as detailed in Moulton's The Formation of Capital (op. cit.). As Moulton expanded on this in a later analysis,
The commercial banking system has always been an important source of intermediate and long-term, as well as short-term, business credit. Although the commercial banks nominally made loans in the form of short-term loans, by means of extensions and renewals, as well as by demand loans of indefinite duration, they furnished a substantial part of the capital requirements of small and developing enterprises. (Harold G. Moulton, George W. Edwards, James D. Magee, and Cleona Lewis, Capital Expansion, Employment, and Economic Stability. Washington, DC: The Brookings Institution, 1940, 152-157.)
Moulton noted that the usual duration of "term loans," as distinguished from short-term loans, was five years, although ten years was not unusual (ibid., 152), depending on the type of business and the asset being financed. As Moulton noted, "Term loans are made for a wide variety of purposes. They include the provision of additional general working capital; the purchase of machinery and equipment; and the liquidation of trade credits and bank loans." (Ibid., 153.)

Further, term loans enjoy certain advantages over bond issues. For example, a term loan of even five to ten years is both cheaper and more flexible (ibid., 154) than a standard bond issue of twenty or more years. Bond issues normally incur high flotation costs, and are subject to premiums and discounts with the manipulation of interest rates that seriously affect the ability of a business to raise money through the issuance of bonds.

It is important not to confuse a "bond discount" with the practice of commercial bank discounting of term loans and similar paper. The former reflects a change in the present value of the bond itself to adjust for the bond bearing an interest rate below the market. The latter is the fee charged by the financial institution for monetizing the present value of the assets behind the term loan, and has no effect on the face value of the loan contract.

Term loans are also more advantageous than a bond issue because loans are usually repaid in installments, while a bond issue is usually redeemed on maturity. A business can, of course, establish a sinking fund to retire a bond issue, or add a call feature to allow gradual redemption, but this is not required, and in any event adds administrative costs that at times can be very significant. Gradual liquidation of a liability lessens the danger that a large principal obligation will come due at an inconvenient time (e.g., during an economic downturn), while a term loan can be liquidated in full on any of the payment dates.

Further, Moulton pointed out that a banker responsible for making a term loan would ordinarily keep a close eye on the financial position of the company. As Moulton remarked, "While continuous advice from the [commercial] banker may at times be irksome, it is likely to be helpful from the standpoint of maintaining sound credit conditions." (Ibid.) All a business is likely to get from an investment bank that floated a bond issue is a bill for services. Moulton concluded that, "The extension of commercial bank credit for intermediate and fixed capital purposes has a legitimate place in banking operations." (Ibid.)

Of course, such a presumed departure from tradition was not without controversy. "Those who adhere to the old conception of commercial banking as being properly related only to the financing of the production and distribution of goods look upon it as a dangerous innovation which threatens to undermine the safety of the commercial banking system." (Ibid.) Not surprisingly, Moulton countered this argument by pointing out that extending the term of commercial bank loans for the purpose of financing intermediate and fixed capital was hardly an innovation, dangerous or otherwise, as it had been standard (if unacknowledged) practice for centuries.

In any event, the Federal Reserve was there to ensure that the commercial banking system always had sufficient reserves to meet short-term working capital needs. (Ibid.) Moulton pointed out that the risks involved in extending the term of loans and rediscounting them at the Federal Reserve entailed far fewer risks than the "more informal methods" previously used by commercial banks, in which short-term accommodation ostensibly for working capital needs became de facto long-term financing by the simple expedient of continually refinancing the loans as they came due. (Ibid., 155.)

Still, Moulton's analysis required that the Federal Reserve be specifically empowered to rediscount qualified industrial, commercial, and agricultural paper for terms of longer than 90 days. Extension of the term of qualified paper was made under an act passed on June 19, 1934 (73 Cong. 2 sess., 48 Stat. L. 1105). Under the terms of the act, the Federal Reserve was granted the power to make loans with terms of up to five years directly to private sector companies, bypassing the commercial banking system and the financial markets. (Ibid.)

Making such intermediate term loans directly to businesses represented two departures from the customary usages of the Federal Reserve. One (as we already noted), the Federal Reserve was only supposed to make short-term (90 days or less) working capital (commercial) loans. Two, the Federal Reserve was only supposed to rediscount loans made by member banks. Four conditions were laid down before such loans could be made:
• "The circumstances must be exceptional.

• "The business must be an established one and be unable to get the accommodation on a reasonable basis from the usual sources.

• "The loan must be for the provision of working capital.

• "The maturity must not be over five years." (Ibid., 155-156.)
The third condition was (re)interpreted rather liberally. Moulton pointed out that while a little over 70% of the loans made under the act were, in fact, made for working capital, a significant proportion were made to finance new capital formation as well as other purposes. (Ibid., 156.) Significantly, the act also provided that a Federal Reserve bank could discount or purchase similar loans made by any financial institution within its district on the same terms, with the added stipulation that the financial institution making the original loan had to bear 20% of any loss. (Ibid.; cf. the proposal for capital credit insurance and reinsurance, in which a lender should not be permitted to insure for the full amount of the loan.) This tended to confirm Moulton's claim that the commercial banking system, backed up by the Federal Reserve, was well equipped to handle intermediate and long-term financing without danger or by assuming an undue amount of risk.

Evidently the authorities agreed. In 1938, the Board of Governors of the Federal Reserve issued new regulations permitting member banks to purchase loans having a maturity as long as ten years, and to grant generous repayment schedules by permitting no repayment of principal in the first year, and 75% over the term of the loan. The new regulations were issued with the concurrence of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. (Ibid.) Implicit in the new regulations was the ability of commercial banks to rediscount such loans at the Federal Reserve, for it would make no sense to permit commercial banks to make such loans, and yet deny them eligibility.

Thus, it is no great innovation or even drastic change to require that Federal Reserve banks extend the term of loans that qualify for rediscounting — and to include among the qualifications that such loans must be made in a way that extends ownership of the new capital so financed to people who currently lack ownership of the means of production.


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