Thursday, November 1, 2012

Let's Make a Deal, I: A Recipe for Disaster

In 1910, the United States was in serious trouble. The financial system was in a shambles following the Panic of 1907 that occurred relatively soon after the Panic of 1893 and the Great Depression of 1893-1898. The growing power of the Trusts and giant corporations, the accelerating loss of property by farmers and small owners, and the concentration of financial and economic power was countered by increasing demands for State control of the economy.

From 1901 to 1908 Theodore Roosevelt had made great advances in reining in the power of the great corporations, but without succumbing to the temptation to replace the unbridled power of the vested interests of the private sector with the iron fist of the State. From the Just Third Way perspective, however, there were two problems Roosevelt faced that he failed to solve.

Roosevelt's failure was not due to any lack of initiative or vision on his part. It was simply that the necessary institutions were not in place. The first of these was an adequate financial system. The second of these was the act of social justice.

Both an adequate financial system and the act of social justice had, to some extent, existed at one time in the United States. Prior to the Civil War there had been three attempts to establish a central banking system to provide a uniform and stable currency and adequate liquidity for private sector economic development. These were the Bank of North America from 1782-1787, the Bank of the United States from 1792-1811, and the Second Bank of the United States from 1817-1836.

All three of these institutions had been shut down out of fear of concentrated control over money and credit. Few people understood that a properly run commercial or central bank cannot simply create money by fiat, the way a government can by forcing people to accept its debt paper — "bills of credit."

A "bank of issue" (and commercial and central banks are banks of issue) can only create money by issuing promissory notes when accepting ("discounts" or "rediscounts") bills of exchange offered by a maker or holder of the bill. A "sound" banker will always carefully examine the creditworthiness of the maker of the bill.

This is because the bank is liable to any holder or holder in due course on a promissory note it issues who presents the note for payment. A bank that issues promissory notes in excess of the present value of the bills it discounts or rediscounts (a practice called "overbanking" or "overtrading") is making promises that it is not reasonably certain can or will be kept — and for which the bank is responsible.

Assuming that commercial banks properly examine all bills brought to it for discounting, and assuming there is a central bank to ensure that rediscounting is available to make certain that the currency is uniform and in adequate supply, there will always be sufficient money in circulation to provide for the needs of commerce without inflation or deflation.

Without a central bank, the State tends to take over control over money and credit instead of being confined to a regulatory and enforcement role. This effectively puts the economy under direct government control, whether the economy calls itself capitalist or socialist. Only a central bank that is not under political control and that does not accept government bills of credit can carry out its proper function of ensuring a uniform and stable asset-backed currency and providing the private sector with sufficient liquidity to meet the demands of trade and commerce.

A central bank is therefore a vital necessity for any economy that advances beyond the agrarian stage and subsistence agriculture. During the Civil War, then, there was a fourth attempt to establish and maintain a central banking function, the National Bank system. Although it was seriously flawed, it lasted from 1863 to 1913 until replaced by the Federal Reserve system.

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