Thursday, April 10, 2014

Focus on the Fed, IV: Elastic Reserve Currency


In yesterday’s posting we stressed the importance of having a reserve currency — or any other weight or measure — that has a standard and stable value, and is asset-backed.  In today’s posting, we take a look at why, while a stable standard is absolutely critical, “elasticity,” that is, a money supply that expands and contracts with the needs of the economy, is also important, especially in a rapidly growing economy, or one in which most of the participants are not personally known to one another.

The "Lazy 2" National Bank Note
The need for an elastic asset-backed reserve currency was one of the main reasons for the establishment of the Federal Reserve System.  The National Banking System of 1863 to 1913 had implemented and maintained an inelastic and debt-backed reserve currency, the National Bank Notes and the United States Notes (“Greenbacks”).  Stability (and, after a few years, uniformity) was achieved by reestablishing full convertibility into gold on demand following the Civil War.

The failure to make capital credit available on a democratic basis led to growing disparities between consumption and production, disrupting the functioning of Say’s Law of Markets.  This caused financial panics followed by depressions in 1873 and 1893.  The lack of an elastic reserve currency as well as weaknesses in the clearinghouse system and the lack of separation between commercial and investment banking caused the Panic of 1907.

The "Bull Moose" Ticket — literally
Two of the most critical issues in the election of 1912 were the problem of growing concentration of wealth in the hands of a few, and the need for financial reform.  The establishment of the Federal Reserve System addressed only the latter.  As the Preamble to the Federal Reserve Act of 1913 states,

An Act To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.

The plan was very simple in substance.  When there was insufficient money in a local economy to meet the demand for a region’s need for financing growth of industry, commerce, and agriculture, the Federal Reserve regional banks would rediscount bills of exchange (“commercial paper”) of member commercial banks, providing them with adequate reserves in the form of newly created money to be able to increase lending.

If there was still insufficient money in circulation, the regional Federal Reserve Banks would create money to purchase qualified private sector securities on the open market.  If there was too much money in circulation, the Federal Reserve Banks would sell securities.

A $2 Treasury Note of 1890
Dealing in government securities was intended only to be used to retire the debt backing the National Bank Notes, the Treasury Notes of 1890, and the United States Notes, replacing these currencies with Federal Reserve Notes backed by private sector hard assets as the debt was paid down.  The United States would thus establish and maintain an elastic, asset-backed reserve currency, and eliminate the national debt, except for short-term borrowing out of existing savings to meet emergencies or temporary shortfalls in tax revenues.

If you think this is the rational way to manage a currency, join with CESJ and the Coalition for Capital Homesteading tomorrow, Friday, April 11, 2014, for the 10th annual Rally at the Fed, outside the Federal Reserve Board of Governors Building on Constitution Avenue from 11:00 am to 1:30 pm.

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