Wednesday, June 16, 2010

Common Cause, Part I: The Current Crisis

Recent events in the European Union adequately highlight the problems associated with establishing a political or monetary union — or both — without first securing the right of access of each individual human being to the means of acquiring and possessing private property in the means of production. Consequently, as of this writing, the future of the Euro, the common currency of the European Union (to say nothing of the political future of the Union) appears to be seriously in doubt. Monetary and fiscal shenanigans connected with attempting to force the economies of different countries to maintain a stable common currency, while at the same time relying on Keynesian deficit spending that naturally undermines that same currency, insert a basic paradox into the system that is ultimately impossible to resolve.

The founders of the European Union and its currency forgot or ignored two critical principles, one political, the other, economic. One, fundamental human rights, especially life, liberty, and the pursuit of happiness are impossible to protect or maintain in any secure or lasting fashion without a direct ownership stake in the means of production: the recognized and protected natural right to acquire and possess private property. No one may be prevented from becoming an owner except for just cause and through due process, nor may the exercise of property be limited in any way that effectively takes away the right to be an owner.

Two, the natural right to be an owner necessarily includes the right of access to the means of becoming an owner: money and credit. If someone is otherwise qualified to use money and credit — qualifications established in part by a defined private property right in something — that person may not be prevented from using the established and regulated system of money and credit for anything other than established just cause and implemented by due process. As a corollary to this right of access, no individual, group, organization, or political entity may, without a clear and well-established private property right, have access to or otherwise control — own — money and credit.

Thus, the State should have the right to establish the currency and regulate its application to ensure a uniform standard of value with a stable value. The State does not, however, thereby acquire the right to create money, manipulate the value of the currency, or otherwise interfere with the function of money as the medium of exchange. Money can only be created where a private property right exists, and the State, a public institution, by definition does not own private property. The State's role with respect to money and currency is limited to regulation and enforcement when necessary. The State is not, and never was, the legitimate provider of money, for it lacks the essential private property stake necessary to engage in money creation.

Can the State Change Reality?

The bottom line is that the current global economic crisis can be traced directly to the fixed belief, embedded in Keynesian economics, that the State can change reality — "re-edit the dictionary" — and, consequently, that wealth can be redistributed forever without ever having to produce anything. As Keynes asserted in his General Theory, production is not a problem. Demand is the thing. ("The Principle of Effective Demand," The General Theory of Employment, Interest, and Money, 1936, I.3.) As long as there is sufficient effective demand, Keynes believed that production would follow. This is true — up to a point. Keynes's method of creating effective demand, however, sabotages the effort to increase production by relying on redistributing existing wealth, instead of creating new wealth to generate effective demand by the operation of Say's Law of Markets, which Keynes rejected. Say's Law states that, rather than redistribution of existing wealth, supply (production) creates its own demand (income), and demand, its own supply.

Consequently, in the Keynesian version of reality, when there is insufficient demand, there must be job creation. This is because a wage paid for labor is (according to Keynes) the only source of effective demand for most people — ideally, for everyone. Contradicting Say's Law, as well as the fundamental precept of Adam Smith that the purpose of production is consumption, Keynes believed that income from capital is not for consumption, but to invest in additional productive capacity to create jobs and thereby increase effective demand. The State's job, therefore, is to manipulate the currency, run up debt, and create "full employment" in order to stimulate demand without worrying about production — or the rights of private property that give the owner the right to receive and dispose of the income — "effective demand" — generated by productive activity.

This is because in Keynes's economic universe the only source of financing for new capital investment — and thus job creation, the source of increased effective demand — is existing accumulations of savings. According to Keynes, cutting consumption is the only way to save. The Keynesian economic dilemma is thus to calculate exactly by how much consumption must be reduced to provide financing for new capital formation without harming the financial feasibility of the new capital.

Finding the right mix requires constant adjustment and continuous "fine tuning" of monetary and fiscal policy by a central authority with unlimited power. Since the primary means of carrying out this "fine tuning" is manipulating the currency to induce inflation or deflation as well as the raising and lowering taxes without regard to the State's legitimate need for revenue to cover expenditures, the process necessarily requires complete disregard for private property. As Dr. Harold G. Moulton explained Keynes's Sisyphean task, "The dilemma may be summarily stated as follows: In order to accumulate money savings, we must decrease our expenditures for consumption; but in order to expand capital goods profitably, we must increase our expenditures for consumption." (Harold G. Moulton, The Formation of Capital. Washington, DC: The Brookings Institution, 1935, 28.)

The Slavery of Savings

The whole of Keynesian economic theory, and thus virtually the whole of modern monetary and fiscal policy, is based on a false assumption. That is, Keynes asserted as a given that the only way to save is to cut consumption; that existing accumulations of savings are the only source of financing for new capital formation.

Keynes's assumption is completely wrong, despite the fact that the other major schools of economics (as well as virtually all of the minor ones) accept it. The only substantial difference between Keynesian economics and, say, the Monetarist or the Austrian schools, is how far the State should go to try and impose desired results by means of its monetary and fiscal policy.

The Keynesians, for example, end up trying to impose virtually total State control, (General Theory, op. cit., V.24.iii) Monetarists are sometimes embarrassed into admitting the need for some State involvement, (Milton & Rose Friedman, Free to Choose. New York: Avon Books, 1981, 61) while the Austrians tend to dismiss any economic role for the State. (Vide Ludwig von Mises, Human Action: A Treatise on Economics. Chicago, Illinois: Henry Regnery Company, 1949.) All of them, however, fail to see the one point on which they are in full agreement, and the shoals on which all their theories inevitably come to grief: the fixed belief that the only source of financing for new capital formation is existing accumulations of savings. Given that, the only recourse is to surrender and become effectively Keynesian, as Milton Friedman himself was forced to admit: "In that sense, we are all Keynesians now." (Time magazine, December 31, 1965.)

The irony is that all this dogmatism, all the reversals and paradoxes, even the humiliating embarrassment of academic economists forced to backpedal in the face of reality, are completely unnecessary. In The Formation of Capital, Moulton presented hard evidence and solid reasoning to demonstrate that existing accumulations of savings are unnecessary to finance new capital formation. He then pointed out that using past savings actually militates against sound economic growth and a stable currency. As he explained, using the commercial banking system and the Federal Reserve as they were clearly intended to be used would provide adequate liquidity for productive private sector investment and supply the country with an "elastic currency" that expands and contracts with the needs of the economy without inflation or deflation — and without State interference. The backing of the currency would change from massive government debt (Moulton was appalled that the New Deal increased federal government debt from c. $19 billion to more than $30 billion), to private property stakes in the present value of existing and future marketable goods and services produced by industrial, commercial, and agricultural assets.

Financing New Capital Investment

The process is relatively straightforward. A prospective investor or entrepreneur locates a capital project that, after due diligence and proper vetting, has a reasonably determined present value. That is, the anticipated stream of income to be realized from the project by producing and selling marketable goods and services in the future has a more or less specific value assigned to it. For example, someone offers to sell a prospective buyer his or her truck and a delivery route for X dollars. The buyer calculates that he or she can realize so much per month by charging for deliveries, that expenses will be a certain amount, and his or her time and trouble are worth something. The fact that he or she will be receiving the income in the future instead of right now also enters into the calculations. If the total amount calculated is less than X, the buyer would be foolish to make the purchase. If more, and assuming the investment is otherwise sound, the purchase is probably a good investment.

The next step is to finance the purchase. Most people simply do not have sufficient savings accumulated to be able to purchase a business. Even if they did, we have to understand that "savings equals investment." Thus, unless a saver has accumulated his or her cash in a mattress or hole in the ground, it has been deposited in a bank. If the bank is a bank of deposit, the savings have either been loaned out to someone else, or invested in government securities (loaned to the State) in order to earn something instead of sitting idle. Withdrawing accumulated savings from a bank of deposit necessarily means liquidating one investment to make another; there is no net new capital formation.

If the bank is a "bank of issue," that is, a financial institution that can create money through the issuance of promissory notes, the effect of withdrawing savings is similar. The most common type of bank of issue is the commercial bank. Under a fractional reserve requirement, a bank of issue must keep a certain amount of reserves on hand, either as "vault cash" or demand deposits in the bank's name at the central bank. A bank of issue cannot legally expand its loans beyond a multiple of the required reserves.

Thus, if there is a 10% reserve requirement, and a bank of issue takes in $1,000 in someone's savings, the bank can issue promissory notes up to the amount of $10,000. This is "the multiplier effect." (It is important to note that the Keynesian explanation of the multiplier effect, i.e., that commercial banks somehow create money by depositing loan proceeds in a series of banks, is fallacious, as was proved by Moulton in The Formation of Capital, op. cit., 77-80.) Conversely, if a saver withdraws $1,000 and the bank has loaned out the legal maximum, the bank must either call in loans, or sell some of its loans to a bank with excess reserves in order to maintain the required minimum reserves. In either case there is no net increase in investment, just a shifting around of existing investment.

This means that the buyer needs to figure out some way to create money if the investment is to be considered new. It doesn't matter whether someone is purchasing existing capacity or nothing has yet been constructed. What the investor is buying is not the actual capital, per se, but the future stream of income to be realized by using the capital. Thus, conceptually, all purchases of capital qualify as "new" if two conditions are met: 1) the capital is being purchased to gain the future stream of income and not to realize speculative gains from changes in the value of the capital itself, and 2) money is created to finance the purchase instead of being taken from existing accumulations of savings. (This, by the way, is an application of the principle in accounting and finance that sunk costs must be ignored when making investment decisions. The money is gone. Get over it.)

How to Create Money

If the seller is willing to "take back paper," the problem of financing solves itself. The seller is thereby entitled to payments of principal on some agreed-upon schedule. He or she is also entitled to a share of the profits representing his or her remaining ownership stake ("interest"), and, usually, something extra to compensate him or her for the risk assumed by not taking the full purchase price right away. The buyer and the seller between them thereby create money: the promise of the buyer to make payments of principal and interest in the future. The money is backed by the present value of the future stream of income to be realized from the capital being purchased.

The seller-financed loan is repaid with "future savings" without the necessity of cutting current consumption — merely refraining from increasing future consumption until the loan is repaid. We use the term "future" savings as distinct from "forced" or "involuntary" savings because Keynes and adherents of the other major schools of economics re-edit the dictionary and understand something different by forced or involuntary savings. (Vide Keynes, General Theory, op. cit., II.7.iv; IV.14.i; V.21.i; VI.22.vii.) Keynesians and others do not recognize the validity of future savings. (Vide Harold G. Moulton, Capital Expansion, Employment, and Economic Stability. Washington, DC: The Brookings Institution, 1940, 26.)

If the seller wants his or her money right away, however, a different financing technique must be used. There is, of course, always the possibility of interesting a venture capitalist in the investment. This, however, would merely be to shuffle existing investment around as described above. There would be no true new investment. Many people don't realize it, but cash itself is an investment, although one that does not, by its own nature, generate a stream of income. As working capital in a business, however, or as financial capital to purchase income-generating assets, cash qualifies as an investment — just not new investment if the cash is taken from existing accumulations of savings.

Pure Credit Financing

This brings in the technique of "pure credit," that is, credit extended without the necessity of using existing accumulations of savings. Actually, we have already explained the use of a pure credit mechanism when we looked at the case of a seller willing to take back paper. Now, however, we need to go beyond the individual approach to the social approach. We need to look at an institution — "Any custom, system, organization, etc., firmly established" (Black's Law Dictionary, op. cit.) — specifically designed to assist people to create money out of the present value of existing and future marketable goods and services: the commercial bank. We will try and be as brief as possible. This is not, after all, a treatise on money and banking, but a somewhat informal look at common currencies.

The concept is simple, once we free ourselves from the assumption that credit must be based on past savings. Someone with a feasible productive project goes to a local commercial bank. The project must be designed to generate a stream of income in the future, or the process simply will not work.

The banker and the borrower come to an agreement as to how much the project is worth. The borrower "draws a bill," a promissory note based on the present value of the project. That is, the borrower creates a financial instrument, a "bill of exchange." The bill conveys a private property right in the calculated present value of the existing or future marketable good or service given certain terms and conditions. The borrower takes the bill to the bank, and "discounts" the bill, that is, sells it to the bank at less than face value.

The banker prints banknotes or creates a demand deposit, and exchanges it for the bill of exchange signed by the borrower and backed by the present value of the project or asset. This is usually calculated on an existing or future marketable good or service. The loan paper — the bill of exchange (a bill of exchange is money, but it does not circulate as readily as banknotes or checks drawn on demand deposits) — backs the new money, just as the present value of the income-generating assets purchased by the new money backs the loan paper. When the borrower repays the lender (or, more properly, "redeems" the bill of exchange), "buying back" his or her loan, the banker takes the money back and cancels it. This prevents the creation of unbacked money. As long as the bank only creates money backed by the present value of income-generating assets, the process can continue indefinitely. Everything else being equal, there will be neither inflation nor deflation of the money supply.

The Role of the Central Bank

A single local commercial bank, however, is not the safest arrangement, as the United States discovered in the early 19th century with the prevalence of "Wildcat Banking." Many things can go wrong. A banker can be dishonest and print more currency or create more demand deposits than he or she can back with the present value of existing and future marketable goods and services. Natural disasters or widespread business failure can ruin the productive capacity of a region. Subverting the purpose of the system, borrowers (including or especially governments) can obtain loans — discount bills — for consumption or speculation "on anticipation" instead of production or investment. This used to be called creating "fictitious bills" instead of "real bills" backed by the present value of hard assets. (Henry Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. (1802) London: George Allen & Unwin, Ltd., 1939, 84-89.)

The solution to this is the central bank. A central bank is a bank for bankers, not for government or speculators. For a central banking system to operate properly, commercial banks must first stop printing their own currency or creating unbacked demand deposits. All new currency must come from the central bank, whether in the form of coin, paper money, or demand deposits. (The private sector must, of course, continue to create money at will in the form of bills of exchange that circulate between businesses, but this necessarily passes at par with the "official" money coming from the central bank.) When all the reserves of a commercial bank are loaned for productive projects and people are still bringing feasible projects in for loans, the commercial bank obtains more money by selling some of its "inventory" of loans to the central bank. This is called rediscounting. The central bank buys the paper by printing currency, striking coin, or creating demand deposits. It cancels the money when the loans are repaid.

In this arrangement, when properly structured, a central bank has no effective power of its own. It is completely "reactive" instead of proactive. Money is created only when the present value of hard, productive assets provides the backing or "underlying." Allocation of credit is decentralized and kept in the hands of the local people who originate the productive projects, rather than determined politically. It is to the interest of the local banker to ensure that there is a democratic distribution of the ownership of productive assets.

There is also safety in numbers in financial matters. The larger the area served by a central bank, the less risk of fluctuations in the value of the currency. If central banking is carried out only in this fashion, it does not matter if there is a single, unified currency for the entire world, or a single central bank, for power would be diffused. Local interests and national sovereignty would not only be protected, but strengthened given the benefits of a sound, non-inflationary uniform currency.


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