Thursday, March 19, 2015

An Untapped Source for Private Sector Growth

Yesterday we asked the question on everyone’s lips.  That is, besides, “What’s for lunch?”  (What you didn’t eat for dinner, of course.)  And that is, what should the Federal Reserve system be doing?  Financing government?  No.  Financing private sector growth.

Henry Thornton (1760-1815)
Supplying funds to the money market and controlling the cost of these funds through the discount rate has long been recognized as the orthodox instrument of monetary policy.  In 1802, Henry Thornton, the “Father of Central Banking,” described the operation of the real bills doctrine, and explained the function of commercial and central banking in a book he wrote to address the currency crisis of 1797, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain.  So, what’s this “real bills doctrine”?

Jean-Baptiste Say (1767-1832)
An application of Say’s Law of Markets, the real bills doctrine holds that, all things being equal, if the present value of mortgages and bills of exchange discounted by merchants and commercial banks and discounted or rediscounted by the central bank equals the present value of existing and future marketable goods and services, there will be neither inflation nor deflation, but a uniform, stable, elastic, and asset-backed money supply that exactly meets the needs of the economy. In a well-run and properly regulated system, the money supply will be convertible on demand into an asset-backed reserve currency.

That’s a lot to try and take in, though.  Perhaps an easier way to understand it is to keep a few basic principles in mind:

1) People can only ethically make promises for themselves, not others, to keep.  (When government creates money, it’s making promises for other people to keep.)

Government manufacturing promises: good as its word.
2) People who make promises should have the capacity to keep the promise when it comes time to keep it.  (When government creates money, the citizens may or may not have the capacity to keep the promise . . . which they may or may not grant to the government.)

3) Making more promises than there is stuff to keep the promises with means that those who make the promises are stealing from those who have to keep them.  (When government creates money without the capacity to redeem it, it is stealing from everyone who accepts the government’s promise.)

4) Making fewer promises than there is stuff to keep the promises with means that those who make the promises are stealing a second time from those who have to keep them.  (When government deflates the currency, it lowers prices, forcing debtors who borrowed money when prices were high to repay when prices are low, and thus repay far more real value than they borrowed.)

Private sector manufacturing promises: good as gold.
The only ethical thing to do is to restructure the system so that those who make the promises (producers in the private sector) are the ones who have to keep them, and to link the amount of money in the system directly to the present value of existing and future marketable goods and services in the economy through private property.  This can be done by having the central bank rediscount private sector bills of exchange (“eligible paper”) offered by commercial banks, and forbidding future acceptance of government bills of credit.

The Federal Reserve currently makes little use of its power to rediscount “eligible paper” held by commercial banks or to make direct loans to banks out of existing deposits to meet their liquidity needs in fostering commercial and industrial development. Instead, the Federal Reserve controls the money supply and interest rates through its other main money-creating powers:

• By its open market purchases and sales of government securities,

• By altering reserve requirement ratios, and

• By controlling the “federal funds rate” (the rate at which one bank charges another for overnight borrowed funds).

Sadly, the Federal Reserve currently allocates 100% of the money it creates to support public sector growth or politically motivated private sector bailouts, none to support private sector growth.


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