Wednesday, May 9, 2012

The Global Debt Crisis, IV: Understanding the Problem

A while back (September 16, 2010) we read an op-ed in the Wall Street Journal, "The Case for a Repeal Amendment," by Randy E. Barnett of Georgetown University and William J. Howell, Speaker of the Virginia House of Representatives. The authors claimed that the income tax has allowed government to overspend and get 'way over its head in debt. Get rid of the Sixteenth Amendment, they declared, and We, the People would once again be able to exercise control over government and rein in the wild spending that's been going on. As the authors stated,

"The 16th Amendment gave Congress the power to impose an income tax, allowing it to tax and spend to a degree previously unimaginable. This amendment enabled Congress to evade the constitutional limits placed on its own power by effectively bribing states. Once states are 'hooked' on receiving federal funds, they can be coerced to obey federal dictates or lose the revenue."

The argument was relatively well stated and argued — and completely wrong. What has allowed politicians to spend beyond our means to repay without substantial changes being introduced into the system is not the income tax, but the monetization of federal debt by the Federal Reserve. Ironically, the income tax was set up in part to ensure that the federal government had adequate financial resources to carry out its legitimate functions.

On the other hand, the Federal Reserve was established not to finance government, but to provide the private sector with an "elastic" and stable uniform currency backed with private sector assets. The idea was to replace the inelastic National Bank Note currency of 1863-1913 backed by government debt, with Federal Reserve Notes backed by the present value of existing and future marketable goods and services.

Unfortunately, the Federal Reserve was allowed to operate for only two years according to plan. The United States then entered World War I and, as politicians in every age have been tempted to do, decided to finance the war effort by floating debt to be repaid tomorrow, rather than by raising taxes to be paid today.

Even this would not have been too much of a problem had the government simply borrowed from the existing pool of savings. That is all the federal or state governments are empowered to do under the Constitution in any event. Creating money backed only by the faith and credit of the government is called "emitting bills of credit." This is explicitly prohibited to the states under Article I, Section 10 of the Constitution, and was specifically removed from the enumerated powers of the federal government under Article I, Section 8 during the debates in 1787 in light of the debacle of the Continental Currency under the First and Second Continental Congresses and the Articles of Confederation.

What happened, however, was that the first Liberty Loan drive drained virtually all existing savings out of the system. The Second Liberty Loan drive and the Victory Loan drive had nothing on which to draw. Faced with a bond issue that wasn't selling due to lack of liquidity in the system (thereby endangering the war effort), the commercial banks stepped forward and purchased the bonds.

Since the commercial banks didn't have either the capitalization or the savings on deposit to purchase the bonds, they turned around and sold the bonds on the open market to the Federal Reserve, as they were empowered to do to retire the government debt they held to back their issues of National Bank Notes. The banks then passed the newly created money on to the U.S. Treasury, pocketing a fee in the process. This kept within the letter of the Federal Reserve Act, but violated the Constitution, just as Salmon P. Chase had done more than half a century before to finance the Union war effort.

A generation later, in response to growing demands that "the government" "do something," what the government did was listen to John Maynard Keynes. Unfortunately, Keynes had a profound misunderstanding of money and credit, as well as the natural rights of freedom of association/contract (liberty) and private property. He even had a unique understanding of the natural law (one that, ironically, has become pervasive in our society), claiming that the State has the power to "re-edit the dictionary" when it came to liberty and property! (John Maynard Keynes, A Treatise on Money, Volume I: The Pure Theory of Money. New York: Harcourt, Brace and Company, 1930, 4.)

The effects of this new orientation were profound and far-reaching. The "new philosophy of public debt" contained at least four false assumptions:

One, there was the belief that "money" consists solely of coin, banknotes, demand deposits (checking accounts) and some time deposits (savings accounts).

Two, "money" is a general claim issued by the State against the general wealth of society.

Three, by emitting bills of credit (issuing debt eventually purchased by the Federal Reserve on the so-called "open market") the government was simply cutting up the present value of existing wealth into smaller and smaller pieces to redistribute it.

Four, government debt paper is a debt the nation owes to itself and doesn't have to be repaid.

The falsity of these assumptions can easily be demonstrated, as we will see in the next postings in this series.

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