Thursday, July 26, 2012

Lies, Damned Lies, and Definitions, XXII: Currency School v. Banking School

As we saw in yesterday's posting, bad assumptions about how new capital is financed virtually ensured that only the rich had an equitable opportunity to acquire the increasingly expensive advancing technology. While commentators like Henry Adams might wax philosophical and muse with vague bafflement over the differences in societies oriented toward the Virgin or the Dynamo, characterizing one as human and the other anti-human, they ignored the real problem of the lack of access to the means of acquiring and possessing capital. Man was only building machines he could not control — control, as Kelso observed, being ownership in all codes of law — because the people working with the machines, and the people purchasing the products of the machines didn't own the machines.

Abraham Lincoln's 1862 Homestead Act opened up access to landed capital, but it did not address either other forms of capital, or the means of properly developing any capital once obtained. As a result, it seemed as if the growing disparities in wealth were a law of nature, required if there were to be any economic growth. As Keynes asserted without a shred of proof, "The immense accumulations of fixed capital which, to the great benefit of mankind, were built up during the half century before the war, could never have come about in a Society where wealth was divided equitably." (John Maynard Keynes, The Economic Consequences of the Peace (1919), 2.iii.)

The problem was that Keynes considered Walter Bagehot one of the greatest economic thinkers of the 19th century — and said so, in his first major published article in 1915, "The Works of Walter Bagehot." (The Economic Journal, 25:369-375.) Not only was Bagehot an elitist who wrote favorably of the contributions of Thomas Hobbes to political science and sneered at Magna Charta, his economic and financial thinking was pure "currency school."

That is, Bagehot dismissed Say's Law of Markets, ridiculed the real bills doctrine, maintained the fiction that the only way to finance new capital formation is to cut consumption and save, and defined money as currency, limiting it to gold, silver, and government-emitted bills of credit. Keynes adopted Bagehot's views almost in their entirety, with the exception that Keynes, buying in to Georg Friedrich Knapp's "chartalism" that is the basis of "Modern Monetary Theory," saw no need for a gold and silver currency if the government had the power to force its bills of credit on the economy as a fiat currency.

Superficially similar to an asset-backed currency resulting from the discounting and rediscounting of private sector bills of credit, a government debt-backed fiat currency is one of the most deceptive weapons in the Keynesian arsenal. Most people either see no difference between a commercial or central bank creating money backed by private sector assets, and the same institutions creating money backed by government debt, or are convinced that, given the belief that only the State should create money, all private sector bills of exchange must be outlawed, and the whole of the money supply should consist of government-issued bills of credit.

Prior to World War I, the "bullionist" faction of the currency school held center stage. Due to the flood of silver on world markets, a silver-based or bimetallic currency was considered inadequate, unsafe, or inflationary. This left gold as the preferred monetary metal, and silver was largely demonetized throughout the world by the end of the 19th century. Still, not realizing that the bulk of financial transactions in any advanced economy were carried out by means of private sector bills of exchange, the debate among most economists was whether a specie currency of gold or backed by gold, a paper currency backed by government debt, or some combination thereof was the soundest arrangement.

By and large, it was felt that a gold currency supplemented with a government debt-backed paper currency was the safest. The financial upheavals of the 19th century, starting with the Panic of 1825, made politicians leery of relying too heavily on government debt, but the supply of gold was clearly inadequate for the needs of commerce. An inelastic (that is, fixed) currency that preserved the faith and credit of the government so that future debt issues could be easily floated at need was what the politicians wanted to hear — and that is what Bagehot told them.

The U.S. Federal Reserve System, following the lead of the Reichsbank, broke away from the currency school model in 1913, and adopted the banking school model based on Say's Law of Markets and the real bills doctrine. The banking school model provides for an elastic currency that expands and contracts directly with the needs of commerce. This is done by discounting and rediscounting bills of exchange, thereby backing the paper currency with private sector hard assets.

As a conservative measure to satisfy Republican demands, the fixed or "inelastic" portion of the currency would consist of gold. Satisfying Democratic demands, there would be an "elastic" portion of the currency — but it would be backed by private sector hard assets, not government debt. Thus the country would have a sound currency convertible into gold on demand, but at the same time have the capacity to expand and contract if more or less money was needed in the economy, but without the need for government action to increase or decrease outstanding debt.

Meeting the political needs of both parties as well as the financial and economic needs of all sectors of the economy, the Federal Reserve Act was considered one of the greatest legislative achievements ever made by Congress. It lasted for two years before the politicians found a way to circumvent the system for their own advantage.

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