A Blog of the Global Justice Movement

Thursday, July 22, 2010

Interest-Free Money, Part III: Reality-Based Money

Throughout the decade of the 1930s, when the world was in the grip of the Great Depression, Dr. Harold G. Moulton, president of the Brookings Institution, chronicled the gradual takeover of the U.S. economy by the State. Control was established in an effort to force a recovery artificially without regard to economic, financial or (ultimately) political reality. These efforts were, in large measure, based on erroneous concepts of money and credit — even the nature of humanity and personal sovereignty — and relied on profound mismanagement of the financial system. Moulton's opinion was that State interference was not only theoretically unsound, but that it was both ineffective and counterproductive even as an expedient in the face of the global economic catastrophe.

Control Over Money and Credit

Illustrating the truth of the possibly apocryphal declaration by Meyer Anselm Rothschild to the effect that he didn't care who made the laws if he could control money and credit, the chief means by which the State seized control of the economy was to take over the central bank. Consistent with the spread of fascism as the prevailing philosophy of government, the State monetized government debt and was thereby empowered to implement politically motivated monetary policy. This was made possible by misusing the power that a central bank has to regulate the currency and supply the private sector with an elastic currency. As Moulton explained, writing in 1938 on the eve of the Second World War,
That these policies did not prove effective in controlling the general business situation is all too evident. Since the spring of 1937 we have had a stock market collapse and an acute business depression. As may be observed by referring again to the movement of stock prices . . . and to the general trend of business . . . the current fluctuations have been quite as sharp as those of former times. The inability of the Board of Governors of the Federal Reserve system to control the business situation is simply evidence that many of the forces, which account for business fluctuations, lie beyond the control of monetary policy.

In concluding this discussion of the Federal Reserve system attention should be called to a point of view embodied in the new legislation, which marks a profound departure from the conception that had prevailed during the long period from the Civil War to 1933. As a result of the experience of the early nineteenth century in connection with the First and Second national banks and in the light of banking history in other countries, the opinion had crystallized that an efficient monetary and banking system, responsive to the requirements of business, necessitated detachment from political control. This conviction was responsible for the Independent Treasury system; for the segregation of the monetary from the fiscal functions of the Government in the Currency Act of 1900; for vesting in the National Banking system the power to issue notes; and for the democratic organization of the Federal Reserve system and the independent political position accorded the members of the governing board. While the Secretary of the Treasury was ex officio a member of the Board, the view prevailed that the Treasury should not be permitted to dominate Reserve policies in the interests of government fiscal requirements.

Under the new organization, as we have seen, the powers of the Board of Governors have been greatly expanded, thereby circumscribing the independence of action of the member banks; and at the same time the Board of Governors has been placed more definitely under political control. This is accomplished through that provision of the law which makes the governor of the Board removable at the will of the President.

This shift is a reflection of the philosophy that not only is it a proper function of the Government to assume control over the entire credit system, but that only the Government can be depended upon to exercise such control in the interest of the public welfare as a whole. This conception appears to be the result of two factors — the failure of the former system of control to prevent financial crises, and the greatly increased importance of government fiscal and financial operations in the larger scheme of things. Whether the new alignment will be able to avoid the weaknesses disclosed in former periods of political control, time will demonstrate. (Harold G. Moulton, Financial Organization and the Economic System. New York: McGraw-Hill Book Company, Inc., 1938, 416-417.)
Moulton's other books written during the 1930s go into great detail describing exactly how the federal government seized control of the financial system and the deleterious effects of this takeover. Nor is it evident that we have learned anything in the intervening three-quarters of a century. On the contrary, takeover by the State of the economy in general, and the financial system in particular through control of the Federal Reserve System and the financial markets has accelerated enormously. (Vide Jim Kuhnhenn, "Obama Sings Sweeping Financial Overhaul into Law," Associated Press, 07/21/10)

The Proper Role of the State

The State, however, does not legitimately have anything other than a very limited role in the economy. People, individually or in free association with others, are primarily responsible for economic activity, and the direct care of the whole of the common good at every level. As Alexis de Tocqueville related in his monumental study, Democracy in America (1835, 1840),
In some countries a power exists which, though it is in a degree foreign to the social body, directs it, and forces it to pursue a certain track. In others the ruling force is divided, being partly within and partly without the ranks of the people. But nothing of the kind is to be seen in the United States; there society governs itself for itself. All power centers in its bosom, and scarcely an individual is to be met with who would venture to conceive or, still less, to express the idea of seeking it elsewhere. The nation participates in the making of its laws by the choice of its legislators, and in the execution of them by the choice of the agents of the executive government; it may almost be said to govern itself, so feeble and so restricted is the share left to the administration, so little do the authorities forget their popular origin and the power from which they emanate. The people reign in the American political world as the Deity does in the universe. They are the cause and the aim of all things; everything comes from them, and everything is absorbed in them. (Alexis de Tocqueville, Democracy in America, I.iv.)
Obviously, then, the money supply consists of far more than the limited (and limiting) currency and demand deposits with a token nod toward limited time deposits. It clearly consists of everything — everything — that is used as the medium of exchange in settlement of a debt and as a store of the present value of existing and future marketable goods and services. Money is thus not wealth itself, but a symbol of wealth. Money is a "derivative" of the present value of existing and future marketable goods and services. What most people and, evidently, virtually all economists think of as money — coin, currency, and demand deposits — are actually derivatives of money, just as money is a derivative of the present value of existing and future marketable goods and services.

Allowing the State to control the economy by controlling money and credit does little or nothing to halt the abuses that may occur when control over money and credit is in private hands. On the contrary, just as the abuses of concentrated control over (ownership of) the means of production in private hands under capitalism are not corrected by shifting control over the means of production to the State in socialism, the abuses of concentrated control over the means of acquiring and possessing private property in the means of production — money and credit — in private hands are not corrected by concentrating control even more in the hands of the State.

There is, in fact, no substantial difference between a monopoly over owning or controlling the means of production, and a monopoly over owning or controlling the means of acquiring ownership or control of the means of production. Vesting concentrated control over either in private hands is capitalism, while concentrating that control in the State is socialism, whatever you might call it.

In both capitalism and socialism a "despotic economic dictatorship" (Pope Pius XI, Quadragesimo Anno ("On the Restructuring of the Social Order"), 1931, §§ 105-106) seizes power and maintains an iron grip on the economy . . . ironically with an ineffectiveness and, frankly, stupidity that cause ordinary people to question the sanity of their leaders in both politics and business.

This proves a fruitful breeding ground for "conspiracy theory," and the incentive to start targeting unpopular groups for punishment or elimination. Ordinary people tend to blame others out of confusion and fear, while "leaders" (the term is used advisedly; most leaders today fail to lead in any meaningful sense) often feel themselves forced to find a scapegoat to blame for their own failure to lead and for their lack of vision. Thus, depending on whom people choose to blame, we see an upswing in Jew-hating, capitalist-baiting, and pointless searches for presumably guilty parties when it is the system itself and its underlying assumptions that are at fault.

It isn't a conspiracy. It is, rather, the failure to realize that those in charge have no real idea what they are doing, or how the financial system really operates. This can, in large measure, be traced to the fact that conventional economists and the policymakers who rely on them do not understand money and credit, or even define money properly or completely.

What, Then, is "Money"?

Given the definition of money as anything that can be used in settlement of a debt, and recognizing the necessary private property link between money creation and what the money buys, we realize that "money" is a symbol. It is not valuable in and of itself, but only in terms of the property right it conveys in the process of carrying out exchanges of marketable goods and services. As Jean-Baptiste Say pointed out when explaining the concept to the Reverend Thomas Malthus, noted author of the 1797 Essay on Population,
Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own. To the proprietor of the mines whence this money is obtained, it is a production with which he purchases such commodities as he may have occasion for: to all those into whose hands this money afterwards passes, it is only the price of the productions which they have themselves created by means of their lands, capital, or industry. In selling these, they exchange first their productions for money; and they afterwards exchange this money for objects of consumption. It is then in strict reality with their productions that they make their purchases; it is impossible for them to buy any articles whatever to a greater amount than that which they have produced either by themselves, or by means of their capitals and lands. (Jean-Baptiste Say, Letters to Mr. Malthus on Several Subjects of Political Economy and on the Cause of the Stagnation of Commerce. London: Sherwood, Neely & Jones, 1821, 2.)
Money is thus a derivative of the present value of existing and future marketable goods and services. We add "future" because a reasonably expected stream of income in the future has a defined present value. Having a defined present value, a financial instrument can be created to convey a private property stake in that future production as well as in existing inventories and anything else with a defined present value. Creating such an instrument is called "drawing a bill," and can take many forms. Sometimes a simple handshake or verbal agreement is all that is necessary. The most common form of drawing a bill today is writing a check drawn on a demand deposit. If the bill or note is to circulate as money beyond the immediate parties to the contract, however, a more concrete form of the agreement is usually necessary.

In that case, the maker of the promise creates a "promissory note" — a bill of exchange. Assuming that the credit of the issuer of the note is good, the recipient can take the note and either hold it to maturity, or exchange it with his or her debtors to settle a debt of his or her own. The note or "bill" can be passed from hand to hand in this fashion until redeemed at maturity by the issuer.

Bills and notes created in this fashion rarely circulate at face value. Instead, the issuer typically pays a debt that is currently worth, say, $98,000, with a note with a maturity value of $100,000. This is called "discounting," because the amount received in exchange is discounted from the face value of the instrument. As the maturity date of the instrument draws near, the discount is reduced. When a holder in due course with whom the note has been discounted uses the note to pay a debt instead of holding it to maturity, the process is called "rediscounting."

Discounting and rediscounting may be carried out between private individuals without any involvement or interference by the State or even commercial banks. This is called "disintermediation." Of course, an issuer or holder in due course can always take the note to a commercial or central bank for discounting or rediscounting. Commercial banks were invented to discount these "bills of exchange," while central banks were invented to rediscount bills of exchange that had previously been discounted by commercial banks. Rediscounting bills of exchange at a central bank ensures that the money supply is denominated in units of currency that have the same standard value. A central bank may also purchase bills of exchange on the open market ("open market operations"), but the primary business of a central bank is supposed to be the rediscounting of bills of exchange for commercial banks.

In brief, a commercial bank and a central bank operate in the same way as private issuers of bills and notes, only with greater security for all parties to the transaction due to the spreading of risk. Omitting a discussion of collateral at this point, a prospective borrower presents something with a definable present value to the loan officer of a commercial bank. As noted, this can be existing inventories of marketable goods and services, or a firm proposal to form capital to produce marketable goods and services in the future.

The loan officer scrutinizes the loan and, if it appears financially feasible (that is, the existing inventories can be sold soon enough to repay the loan, or the proposed capital can be put into operation and generate sufficient income to meet all expenses, provide an adequate income, and meet the debt service payments on time), makes the loan. The loan may either be an interest-bearing note, or be discounted at less than face value. The effect is the same, except that when discounting, the lender takes the fee up front.

If a central bank is operating, the commercial bank may rediscount the note at the central bank. This gives the commercial bank 100% reserves behind the banknotes or demand deposit it created to purchase the note from the original borrower. As the original borrower repays the loan, the commercial bank turns around and repurchases the note from the central bank. The central bank sells the loan back to the commercial bank (which has already sold the note back to the original borrower, who cancels it), and the central bank cancels the money it created to purchase the loan from the commercial bank. In this way (ideally), the money supply always matches the present value of existing and future marketable goods and services in the economy.

Bills of exchange are therefore money. They may have many names, such as promissory notes, drafts, commercial paper, and so on, but they all circulate as money in the economy as a result of being used to store value and settle debts. While conventional economics continues to insist that currency and demand deposits alone constitute "money," this is simply denying reality. As a textbook for a course in "applied business mathematics" clearly stated in the chapter on discounting and rediscounting notes, "A promissory note, like a check or currency, is a negotiable instrument. That is, it can be sold to another party (a person, a business, or a bank), or it can be used to purchase something or to pay a debt." (Virginia H. Graves, Nelda W. Roueche, and Michael D. Tuttle, Business Mathematics, A Collegiate Approach, Ninth Edition. Upper Saddle River, New Jersey: Pearson-Prentice Hall, 2005, 442.)

In other words, promissory notes are money. Conventional economists can theorize to their heart's content and influence policymakers to distort, even ruin an economy to conform to their theories. When, however, it comes to practical aspects of business and conformity with reality, they would do far better to observe what actually happens in real life and use the full definition of money as it is used in carrying out exchanges every day.

The Real Bills Doctrine

The procedure we have outlined above has a name: the "real bills doctrine." When allowed to operate without the State or anyone else drawing bills on something that does not have a defined present value or in which the issuer does not have a private property interest (the creation of "fictitious bills"), the volume of money — the real money supply, that is — expands and contracts with the present value of existing and future marketable goods and services in the economy.

Everything else being equal (that is, no fictitious bills are drawn and all issuers redeem their bills at face value), there is neither inflation nor deflation of the money supply in applying the real bills doctrine. The amount of money in the economy exactly matches the present value of existing inventories of marketable goods and services plus the present value of future marketable goods and services that determines the value of capital.

Most economists today reject the real bills doctrine. This is because the real bills doctrine uses a definition and understanding of money that lies outside the framework established by the Currency School. It does not seem to occur to most economists that their critiques of the real bills doctrine and thus Binary Economics, being based on a different definition of money than is used in the real bills doctrine and Binary Economics, simply do not apply. Conventional economists and the policymakers who rely on these different definitions ignore financial and economic reality and, by doing so, lock themselves into a hopeless situation.

The danger of going contrary to reality should be obvious. If we take the incomplete definition of money as a State-issued or authorized claim on existing marketable goods and services and nothing else, with no necessary private property link between money creation and the present value of existing marketable goods and services, and interest as the cost of money, we become trapped. The money supply becomes constrained by the amount of savings already existing in the economy, and is construed as "the supply of loanable funds," which in part determines the "production possibilities curve." Money comes to be treated as a commodity instead of a social tool by means of which we make the process of exchange and conveyance of private property more convenient.

Understanding money as a commodity and interest as the price of money, the question becomes what policy will best serve the needs of society: the government setting the price (Keynesian economics), the private sector setting the price (Monetarist and Austrian Schools), or an uneasy and unworkable combination of the two? This conundrum has stymied development of sound monetary and fiscal policy for decades. This stalemate is unnecessary, for it should immediately be obvious that the more fundamental question has not been asked; all current schools of economics appear to accept as a given the understanding of "interest" as the cost of money.

In the next posting, then, we need to answer the question, "What is interest?"

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