Monday, June 21, 2010

Why the Credit Crunch Won't Go Away

In today's Wall Street Journal, we found a very interesting analysis of the "credit crunch" afflicting small businesses — you know, the largest part of the economy. While interesting, however, and very insightful, there was no real solution suggested. The implication seemed to be that things aren't going to change until and unless people begin acting contrary to their own nature. On the contrary, the solution has been staring us in the face for almost a full century — half a century if you want to add the necessary refinements of Kelso and Adler.

Emily Maltby
Staff Reporter
Wall Street Journal
200 Liberty Street
New York, NY 10281

Dear Ms. Maltby:

Your article in today's Wall Street Journal, "The Credit Crunch That Won't Go Away" (R1, R3), addressed the most critical problem in an economic recovery: adequate liquidity to provide financing for private sector, not government growth. Ironically, the problem was solved once, with the passage of the Federal Reserve Act of 1913.

The Regional Federal Reserves had (and technically still retain) the power to rediscount qualified industrial, commercial, and agricultural paper issued by member banks, and to engage in open market operations in qualified paper issued by non-member banks and private businesses as a supplement to rediscounting. An application of the real bills doctrine, the Federal Reserve was established to provide the economy with an "elastic currency" that would be asset-backed, and avoid both inflation and deflation. Discounting of primary government securities was not permitted in order to avoid monetizing government deficits, but dealing in secondary government securities was allowed because government securities — the only legal backing for national banknotes under the National Bank Act of 1864 — were included in the definition of "reserves."

As a result of the liquidity problems associated with the Panic of 1893 and the Panic of 1907, the idea was that the Federal Reserve would serve as a lender of last resort for the private sector. Because policymakers decided to finance America's entry into the First World War by borrowing rather than taxing, however, the Federal Reserve gradually became the lender of first resort to the federal government. Tantamount to chartalism, this is in accordance not only with Keynesian economics, but (oddly) also with Monetarist and Austrian economics, all of which take for granted the disproved assertion that capital formation can only be financed out of existing accumulations of savings.

On the contrary, as Dr. Harold G. Moulton demonstrated in his 1935 classic, The Formation of Capital. Moulton, first president of the Brookings Institution (1916-1952), presented an alternative to the Keynesian New Deal in a series of four volumes of which The Formation of Capital is the most important. Moulton's contention was that in periods of intense capital formation, financing for new capital does not come out of existing accumulations of savings. Rather, the financing comes from the extension of bank credit for productive purposes, accompanied by a simultaneous expansion of consumption, from which the demand for new capital derives.

To Moulton's findings, Louis O. Kelso and Mortimer J. Adler added that, for consumption to expand simultaneously with production, the new capital must be broadly owned by people who will use the income from capital first to generate the future savings to service the acquisition debt, and then for consumption, not reinvestment. Kelso and Adler presented their case in their second collaboration, The New Capitalists (1961), a deceptively small book with a very big idea, summarized in the subtitle: "A Proposal to Free Economic Growth from the Slavery of Savings."

A critical feature of Kelso and Adler's proposal is to replace usual forms of collateral with capital credit insurance and reinsurance. As you suggest, banks are reluctant to lend without some reassurance that they will be repaid. With the volatility of the stock market, the value of the usual collateral has become uncertain — as was the case in the 1930s. Instead of relying on government and the Federal Reserve artificially bolstering share values on Wall Street and calling it a recovery, it would make more sense to go with a private sector solution in the form of broadly owned private capital credit insurance and reinsurance companies. This has the potential to foster genuine growth instead of ephemeral gains on the stock market.

If any of this interests you, you might find the "Capital Homesteading" proposal of the Center for Economic and Social Justice ("CESJ") in Arlington, Virginia, something worth investigating.


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