Thursday, March 29, 2012

Blind Leading the Blind, II: Banking and Income

When Pippi Långstrump took up residence at Villa Villekulla with her monkey (Mister Nilsson) and her horse (Lilla Gubben — "Little Buddy," "Old Man" in some translations), she also brought with her a modicum of financial security in the form of a suitcase full of gold coins. Despite her sometimes lavish spending habits and attempts by the unscrupulous and thieving to deprive Pippi of her wealth, the suitcase always seemed full.

Not too many of us have bottomless suitcases of gold — and even if we did, gold would cease to be worth much. (Sorry, Ron, there's nothing magical about a gold standard . . . or silver, either.) Gold isn't automatically money, any more than money has to be gold. Before the flood of silver that lowered the price of that metal throughout the world in the latter half of the 19th century, most of the world was on a silver standard, not gold. There simply wasn't — and isn't — enough gold to meet the needs of commerce.

With the spread of commercial and central banking, however, the amount of gold (or silver) became, to all intents and purposes, irrelevant. The only time the precious metals became important for monetary purposes was when a country insisted on pegging its currency to a specific weight of metal and permitted "convertibility" to give the public confidence in the currency.

The ability to convert a paper currency into gold or silver does not, however, mean that the paper currency is backed by gold or silver. Convertibility simply gives the public confidence that those pieces of paper are worth what it says on the face. What backs the currency are the bills and notes "accepted" by the issuing bank or State treasury. If the bills and notes represent the present value of existing or future marketable goods and services, the currency is asset-backed. If the bills and notes represent the present value of future tax collections by the State, the currency is debt-backed.

The problem that faces us today is, how do we shift from an ubiquitous and wildly fluctuating debt-backed currency, to a stable and uniform asset-backed currency?

Reform of the Banking System. As we noted yesterday, the Federal Reserve was established in part to provide the private sector — not government — with adequate liquidity to finance capital formation whenever existing accumulations of savings or other private resources failed or were inadequate. As Dr. Harold Moulton pointed out in The Formation of Capital (1935), using existing savings to finance new capital formation actually militates against economic growth as it decreases effective demand, making new capital investment less feasible. It is far better to monetize existing and future marketable goods and services by discounting qualified paper at commercial banks and rediscounting the paper at the Federal Reserve. This would ensure an adequate supply of loanable funds by tying the money supply directly to production, and back the currency with the present value of hard assets to which it would be bound by the institution of private property.

Current projections published recently in the Wall Street Journal reveal that by the end of the current fiscal year (09/30/12), the U.S. national debt will be 72-1/2% of GDP. This means that the money supply will consist mostly of instruments backed by government debt, and less than a third in the form of instruments backed by private sector hard assets. In 1913, government debt accounted for less than 20% of GDP. (We don't have time to do the actual calculation, and most sources today hide figures by giving past data in adjusted 1990 "international dollars," so we're using the statement found in Moulton's in Principles of Money and Banking, 1916, that private sector bills of exchange at that time accounted for 80% or more of all transactions.)

One of the goals of the Federal Reserve was to replace the National Bank Notes of 1863-1913 and the Treasury Notes of 1890 — all backed by government debt — with Federal Reserve Bank Notes backed by government debt purchased from the National Banks. The Federal Reserve Bank Notes would be replaced in turn with indistinguishable Federal Reserve Notes backed by the present value of private sector hard assets as private sector asset paper replaced government debt paper as the backing of the currency.

Ignoring the confusing distinction between the identical Federal Reserve Bank Notes and Federal Reserve Notes, a similar program could be carried out today simply by prohibiting the Federal Reserve from either discounting or rediscounting of primary or secondary government securities, or engaging in open market operations in secondary government securities. The only Federal Reserve transactions permitted with respect to government securities would be to sell — not buy — its holdings.

To restore confidence in the currency and the economy, it might be advisable to retire debt held outside the United States first, followed by government debt held by commercial banks, then the Federal Reserve. Any domestic holdings by institutions and individual investors could be left outstanding for a time, as these were purchased with existing savings, and were therefore not inflationary. This, of course, requires that all efforts be focused on increasing production of actual marketable goods and services, not pumping more inflationary government debt into the system.

According to the "National Debt Clock" (accessed today, 03/29/12), more than $5 trillion in U.S. debt is held outside the United States. Assuming all exports are purchased with U.S. dollars, that means that the U.S. has to export $5 trillion more than it imports to transfer the debt "in house." Note, however, that doesn't retire the debt. It simply shifts the holders of the debt from foreign companies and countries, to U.S. producers of exported goods.

Looking again at the National Debt Clock, we see that the total national debt is a little short of $16 trillion. (Half a trillion dollars or so is an immense amount of money, but it can get spent very quickly with little or no result, as we have seen, so we'll use $16 trillion.) We remember reading somewhere or other that no government can exact more than 20% of GDP as taxes without triggering a financial meltdown. That 20% is not the tax rate. It's the percentage of GDP that can be diverted into taxation, a different thing.

Assuming that's true, the United States is going to have to produce $80 trillion in marketable goods and services to generate the $16 trillion in tax revenues necessary to retire the debt — and that's on top of the $5 trillion trade surplus required to shift the foreign debt to domestic debt. That's $85 trillion of production that we're already on the hook for . . . plus whatever is needed to keep the government running in the meantime.

Assuming that government spending gets reduced and the total government budget is maintained at around $4 trillion for all government, local, state, and federal, annual GDP must increase — without inflationary distortion — to $25 trillion every year (a 66.67% rate of growth) in order to retire the debt at a rate of $1 trillion each year, or sixteen years. Reducing the debt at a rate of $500 billion a year gives us a target GDP of $22.5 trillion (50% growth rate) and a 32-year timetable. Debt reduction at the rate of $250 billion per year would give us a target GDP of $20.625 trillion (37.5% growth) and a 64-year timetable . . . but why go on? — and we're not even counting all the promises that have been made for Social Security and Medicare and (if the administration has its druthers) Obamacare.

At current rates of growth of around 1%, these targets for growth are more than unrealistic. They're in Fantasyland. If, however, we maintain the current rate of (non) growth, but reduce the entitlements that currently take up two-thirds of the federal budget by half, or approximately $1 trillion, we can apply those savings to debt reduction, and come up with the same 16- to 32-year timetable — you know a target of $1 trillion each year simply couldn't be met without a revolt, so cut it in half and double the time needed to pay down the debt.

Plus, you can't just cut people off. By phasing out entitlements instead of going cold turkey, however, replacing Social Security, Medicare and welfare gradually with Capital Homestead Accounts, we can get a reasonable 64-year timetable (call it 65, to tie in to a lifetime's capital accumulation under Capital Homesteading), reducing the debt by $250 billion each year, starting with zero debt reduction the first year and assuming that CHA income replaces entitlements dollar-for-dollar at an even rate as people start building toward capital self-sufficiency until entitlements are eliminated and the annual savings reach the full $2 trillion annually in year 65.

That's still painful, of course, but it can be done — if we get a Capital Homestead Act . . . and control spending and eliminate all monetization of government deficits that would add to existing debt. First, all credit extended for speculation, consumption and government expenditures would have to come out of existing accumulations of savings. The market should set the interest rate. This would at one and the same time be a boon to pension plans, retirees who invested in government bonds, and others, and discourage speculation, unnecessary consumption and government spending as the true cost became evident.

The primary business of the commercial banking system and the Federal Reserve, however, would be to provide the private sector with sufficient money and credit to finance capital formation. This would mean reinstituting measures similar to Glass-Steagall to separate financial institutions by function, such as all forms of issue banking from all forms of deposit banking (e.g., commercial banking from investment banking, and both from insurance). There should also be specialization within both issue and deposit banking to avoid conflicts of interest and getting outside the institution's area of competence.

Reform of the "Income System." Most people today are trapped within the wage and welfare system as their sole source of income. Only a few are able to take advantage of the "ownership system," in which all or most of their income comes from capital ownership.

To institute a viable and sustainable economy that works for everyone, it is essential that every child, woman and man be able to participate in the economy to the best of their individual abilities and capacity. Most people would agree that anyone who is willing and able to contribute his or her labor should have the opportunity. That is not the problem. Lack of capital ownership is the problem. Most production today comes from capital, not labor — yet only those who currently own existing capital have, in general, both the opportunity and the means of owning future capital.

As capital replaces labor in the production process, the situation becomes critical. Because the rich and the State currently control the means of acquiring and possessing private property in capital, people remain dependent on wages and welfare for their subsistence. More and more people must own capital if the economy is to survive and thrive, but fewer and fewer people are able to.

Louis Kelso and Mortimer Adler advocated that the money creation powers of commercial banks backed up by the Federal Reserve be used to extend credit so that people who currently own little or no capital be able to purchase it in the form of new equity issues of corporations. The shares could be paid for using dividends paid on the shares themselves. Traditional collateral would be replaced with capital credit insurance and reinsurance, the premiums being paid with the risk premium charged on all private sector loans.

In this way people without savings could purchase capital and pay for the capital with the profits generated by the capital, just as the rich have done for centuries. The price of labor could fall (or, more likely, rise as prospective employers had to compete with ownership income to hire enough workers) to its true market value. Government manipulation of the currency to stimulate demand would become unnecessary as people met their own wants and needs through their own efforts. This would also decrease government expenditures for welfare, and shrink the federal and state budgets.

The wage and welfare system would be abolished (but obviously not wages and welfare!). Workers with ownership income would have the option of turning down a wage they did not consider adequate, thereby making wages rise naturally. If wages became too high, of course, human labor would be replaced with technology — but since the workers themselves would own the technology, it would increase income rather than eliminate it. As the tax base was rebuilt, those unfortunates unable to find work and whose investments were either failures or insufficient to meet their needs could receive welfare if private charity was unable to assist — and there would be a much larger funding pool.

These are some of the critical features of Capital Homesteading, which should be examined seriously by the current crop of political contenders. After all, few of us are able to dip into a suitcase full of gold coins to meet our needs as Pippi could.

#30#

No comments: