Thursday, February 5, 2015

Standards, X: The Federal Reserve Made Easy


As we saw in yesterday’s posting, the Federal was established to resolve “the money question,” and (at least according to the Federal Reserve Act of 1913) provide the country with an elastic, asset-backed reserve currency, convertible into gold on demand.

As designed, the Federal Reserve was intended in part to establish and maintain an elastic, asset-backed reserve currency backed by the present value of existing and future private sector investment in the form of industrial, commercial, and agricultural assets.  This would be accomplished by gradually retiring the debt-backed National Bank Notes and Treasury Notes of 1890 (and, eventually, the United States Notes), and replacing them with debt-backed Federal Reserve Bank Notes.  The Federal Reserve would purchase the government bonds backing the National Bank Notes and Treasury Notes of 1890 through open market operations, paying for them with newly issued Federal Reserve Bank Notes.

As the government redeemed the bonds (i.e., paid off the national debt), the Federal Reserve would replace the debt-backed Federal Reserve Bank Notes with indistinguishable asset-backed Federal Reserve Notes.  In an application of the real bills doctrine, the procedure was as the government bonds were redeemed, the Federal Reserve would either increase its acceptances of qualified (asset-backed) private sector paper from member commercial banks through the discount window, and (if rediscounting commercial paper proved insufficient), purchase qualified private sector paper issued by non-member banks and private enterprises on the open market.  Any additional liquidity demands by the economy would be met the same way, eventually achieving a zero national debt and a fully asset-backed, elastic reserve currency, convertible into gold on demand, no inflation or deflation.

Then the politicians decided to finance World War I the same way they did the Civil War: on debt.  The First Liberty Loan drive sucked all the excess liquidity out of the system, so for the Second and the Victory Loan, commercial banks and brokers purchased the bonds, then sold them on the open market to the Federal Reserve.  This backed all the new money with more government debt.

After the war, great strides were made to repay the debt, but something else came along: the stock market frenzy of the late 1920s.  The commercial banking system created money at a tremendous rate to pour into the stock market.  This drove prices up beyond all reasonable levels.  What baffled the experts, however, was the fact that there was also a great deal of legitimate money creation for new capital formation — to people convinced that all financing had to come out of past savings, this was incomprehensible.

After the Crash of 1929, under the influence of Keynes the New Deal was financed with massive issuances of government debt.  Ironically, this may have dragged out the Great Depression of the 1930s to twice the length of those of 1873-1878 and 1893-1898, during which the federal government took no action.  In extenuation, the Homestead Act brought the country out of the Great Depression of 1873-1878, while crop failure in Europe and bumper crops in the U.S. brought the country out of the Great Depression of 1893-1898.  World War II, not the New Deal, ended the Great Depression of the 1930s.

Monetarily speaking, the New Deal marked a shift from an elastic, private sector asset-backed reserve currency convertible into gold on demand, to an elastic, government debt-backed currency not only not convertible into gold, but making owning gold illegal.  It also made it possible for the government to finance deficits at will, without being immediately accountable to the taxpayer, as would have been the case had the government not been able to monetize its own debt.

Fortunately, it is relatively simple — though probably not easy, politically speaking — to correct the problem, as will be seen in the next and final posting in this series.

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