Tuesday, June 25, 2013

Three Principles of Banking, II: The Solution


Yesterday we described the current financial situation in the world in very broad terms, along with what governments have been doing to try and fix things.  In general, the solution is to print more money backed solely by increases in government debt.  In effect, this is trying to get out of a hole by digging it deeper.

This breaks so many rules of sound finance (much less binary economics) that it is hard to know where to begin.  We will therefore limit ourselves to three of the most important.

One, central banks were never intended to finance government.  They were invented to be “banks for banks,” i.e., where a commercial or mercantile bank could always get “accommodation” (liquidity) on demand by discounting or rediscounting qualified bills of exchange, and selling securities (mortgages and bills of exchange) on the “open market,” i.e., not directly with a member bank to the central bank.

Governments got into it because the Bank of England, the first true central bank, couldn’t get its charter unless it bribed King William III with its gold reserves, which the government replaced with “government stock,” i.e., debt.  This brings in the second principle of banking we’re interested in: an asset-backed reserve currency.

Two, an iron rule of banking is that the reserve currency must absolutely be asset-backed.  For centuries the standard reserve currencies consisted of gold and silver coin and bullion.  The paper currency could be converted into the gold or silver reserve currency on demand.

The United States Federal Reserve System took this one step further, following the example of the Reichsbank.  In the late 19th and early 20th centuries the Reichsbank was the soundest financial institution in the world.

The Federal Reserve was established, in part, to retire the national debt, and phase out the debt-backed National Bank Notes of 1863-1913 and the Treasury Notes of 1890, and, presumably, eventually the United States Notes of 1862-1971, the “Greenbacks.”  These debt-backed currencies would first be replaced with government debt-backed Federal Reserve Bank Notes.  The government debt-backed Federal Reserve Bank Notes would, in turn, be replaced with private sector asset-backed indistinguishable Federal Reserve Notes as the national debt was paid down.

Had this program been carried out as intended, the Federal Reserve would have established an elastic, uniform, stable and asset-backed paper reserve currency — an incredible advance over reliance on the inelastic, albeit uniform, stable and asset-backed gold reserve currency.  This was also, of course, eons beyond any debt-backed reserve currency, a debt-backed reserve currency being radically unstable by its very nature, being dependent on the whims of politicians.

The program as designed would in part have freed economic growth from the slavery of past savings.  Leaving the fractional reserve requirement in place, however, still limited commercial bank lending to a multiple of the bank’s reserves, necessarily in the form of past savings.

Three, central banks should not be dealing in government securities of any kind, except as an expedient in an emergency (and even that is questionable), or as a way of retiring government debt as backing for a currency and replacing it with private sector hard assets.  This latter is the only original reason the Federal Reserve was permitted to deal in secondary government securities.  To prevent the Federal Reserve from being used to monetize government deficits, it was not given the power to deal in primary government securities.

Ironically, the federal government has no power to emit the massive quantities of bills of credit it has been emitting since 1862 (Article I, Section 8 of the Constitution), while the states are specifically prohibited from doing so (Article I, Section 10) — the magic words “and emit bills of credit” were deleted from the first draft of the Constitution after the disaster of the Continental Currency.  “Emit bills of credit” is the constitutional term meaning “create money.”

Violating these three basic principles of banking has been a major factor contributing to the disaster we know today as “the global economy.”

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