THE Global Justice Movement Website

THE Global Justice Movement Website
This is the "Global Justice Movement" (dot org) we refer to in the title of this blog.

Tuesday, January 11, 2011

Some Capital Homesteading Questions, Part II: Reserves and Banking

We meandered a bit yesterday in order to set the stage for answering a few questions about Capital Homesteading. Today we need to get down to business. First order of business? Take on one of the monetary conspiracy theorists' favorite whipping boys: fractional reserve banking. Our correspondent asked, "Are you in favor of 100% reserve banking, or fractional [reserve] banking?

That's easy. Short answer: We are in favor of a 100% reserve requirement.

Slightly longer answer: We favor 100% reserve banking, but not quite as Henry Simons or Irving Fisher conceived of it.

Here's why:

Fractional reserve banking ties the amount of money that a commercial bank can exchange in the form of promissory notes and demand deposits for discounted and rediscounted bills of exchange to existing accumulations of savings. This locks the financial system and economic growth into what Louis Kelso and Mortimer Adler called "the slavery of (past) savings." The amount of new capital financed becomes dependent not on the present value of financially feasible projects available in which people have private property, but on the degree to which people have managed to cut consumption in the past. As Dr. Harold Moulton pointed out in The Formation of Capital (1935), this presents an "economic dilemma": capital presumably cannot be financed until and unless consumption is reduced (26-36) . . . but, because the demand for capital goods is derived from consumer demand (47-48), new capital will not be formed if consumption is reduced. (Page references are to CESJ's new edition of Moulton's classic, which includes a new foreword by Norm.)

Dr. Moulton discovered that, from 1830 to 1930, which included periods of rapid capital expansion, in each and every case periods of capital expansion were preceded not by reductions in consumption, but by increases in consumption. That is, people were not saving, but dissaving. The funds to finance the expansion did not come out of existing accumulations of savings, but through the expansion of commercial bank credit by discounting and rediscounting bills of exchange drawn on the present value of existing and future marketable goods and services, with the new money backed by existing inventories and the capital that would be used to produce future marketable goods and services.

The establishment of the Federal Reserve in 1913 was intended to supersede the National Bank System (1863-1913) and correct the inadequacies of the National Bank currency that was backed 100% by government debt. One of the original purposes of the Federal Reserve was to retire the National Bank Notes by purchasing the government debt held by the National Banks on the open market, using Federal Reserve Bank Notes indistinguishable from regular Federal Reserve Notes.

The Federal Reserve Bank Notes would thus be backed by government debt. The Federal Reserve Bank Notes, however, would be retired over time and replaced in turn with Federal Reserve Notes. Federal Reserve Notes would be backed by private sector hard assets on which the regional Federal Reserve Banks had acquired liens by rediscounting qualified bills of exchange drawn on the present value of existing inventories of marketable goods and services and capital in industry, agriculture, and commerce. In this way the national debt that had mushroomed during the Civil War and had been congealed into public policy by Salmon P. Chase as the backing for the National Bank Notes would be retired without draining the country of liquidity (as had caused the Panic of 1873), artificially restraining financially feasible loans (as had caused the Panic of 1893), or permitting concentrated control over money and credit (as had precipitated the Panic of 1907).

The idea was that the Federal Reserve was to supply the private sector with an "elastic currency" by rediscounting qualified private sector paper representing industrial, commercial, and agricultural assets. This was to be supplemented with limited open market operations to purchase and sell private sector bills of exchange issued by non-member individuals and banks. The Federal Reserve was not given the authority to deal in primary government securities, and was only permitted to deal in secondary government securities in order to retire the debt-backed National Bank Notes.

The Federal Reserve itself was viewed as a supplement to and a safeguard for the existing supply of loanable funds, and was only to operate when the existing supply of loanable funds was deemed inadequate for private sector investment, and was then to provide short term (up to 90 days) liquidity in the form of additional reserves by rediscounting bills of exchange and engaging in open market operations. The commercial banking system was left intact, with the fractional reserve requirement left in place. The only effective change was supposed to be the replacement of debt-backed reserves in the form of government securities, with asset-backed reserves in the form of rediscounted private sector bills of exchange.

During the Great Depression (actually the Second Great Depression; there was an earlier one, 1893-1898) Henry Simons of the University of Chicago, one of the founders of the Monetarist/Chicago School of Economics, advocated abolishing all banks of issue, including the Federal Reserve, and transforming them into banks of deposit. This meant that only gold and government securities would be recognized as reserves, and the money supply would be backed 100% by government debt. Private sector bills of exchange would not be recognized as "money," although bills of exchange were the first form of money and had been so recognized for more than 7,000 years.

The only possible way to expand the money supply under the restrictions of the "Chicago Plan" would be for the government to issue more securities, and tax away any excess when there was too much. These are the basic principles of "chartalism," a socialist system worked out by Georg Friedrich Knapp and explained in his 1924 book, The State Theory of Money. Keynes was a supporter of chartalism, as are the modern "post-Keynesians." (Vide John Maynard Keynes, A Treatise on Money, Volume I: The Pure Theory of Money. New York: Harcourt Brace, 1930, 4.)

Irving Fisher and Father Charles Coughlin supported Simons's Chicago Plan. Fisher especially urged its immediate adoption in order to "reflate" the currency and raise prices. The rise in prices would force consumers to pay more for less, thereby shifting purchasing power from consumers to producers in order to generate the presumably necessary past savings for new capital formation, bringing the country out of the Depression. Simons, however, could not in conscience allow the government that much power — he was anti-monopoly and pro competition. He refused to endorse his own plan because he could not come up with any viable means to prevent the State from taking over the money power and exercising a despotic control over the means of acquiring and possessing private property . . . which, as Moulton pointed out in 1938, happened anyway with the effective federal government takeover of the Federal Reserve under the New Deal. (Harold G. Moulton, Financial Organization and the Economic System. New York: McGraw-Hill Book Company, Inc., 1938, 417.)

Kelso and Adler combined Moulton's insights into the real nature of money and credit with Simons's ideas about 100% reserve banking, and advocated central bank rediscounting not just as a supplement to the existing supply of loanable funds, but as a replacement, thereby restoring the functioning of Say's Law of Markets. This is analogous to Kelso and Adler's breakthrough in advocating the replacement of traditional collateral in the form of retained earnings, with capital credit insurance and reinsurance. Both the Kelsonian 100% reserve requirement and the proposal for capital credit insurance and reinsurance effect an emancipation from the "slavery of past savings," thereby breaking the power of the "despotic economic dictatorship" (Quadragesimo Anno, §§ 105-106) by basing economic growth not on existing accumulations of savings — by definition a monopoly of the currently wealthy and those who control money and credit — but on the inherent feasibility of the proposed new capital itself, and opening up access to capital credit backed by the present value of the feasible new capital to everyone.