Monday, July 20, 2015

Solving the Greek Debt Crisis, X: From Debt to Asset Backing

Last Thursday, as a build up to explaining how to straighten out the Greek debt crisis, we looked at the problem the United States had in the 19th century with its basket of debt-, semi-debt-, and asset-backed currencies.  This confused financial system was in part responsible for the Panics of 1873 and 1893, and the resulting Great Depressions of 1873-1878 and 1893-1898, respectively, and wholly responsible for the Panic of 1907, “The Bankers’ Panic.”

Debt-Backed and Elastic
The basic problem was similar to that which afflicts Greece today: a debt-backed currency issued by the government, not an asset-backed currency tied directly through private property to the present value of existing and future marketable goods and services.  The only advantage that the Greek debt-backed currency of today enjoys over the U.S. debt-backed currency of yesterday is that the Greek currency is elastic (that is, has the systemic capacity to expand or contract), while the U.S. currency of the 19th century was inelastic: fixed in quantity until and unless the government specifically changed the amount.

Elasticity of a debt-backed currency, of course, is not really an advantage, as it has given the Greek government the power to spend at will as long as they can get away with it.  Now that the bill has come due and promises have to be kept (or, more accurately, promises to keep promises have to be kept), many people are outraged that people in Greece can no longer keep consuming what other people are producing.

Key to making Greece productive, of course, is a stable and asset-backed currency.  Instead of creating money in ways that increase debt, then, Greece must shift to creating money in ways that increase production.

Jean-Baptiste Say
It’s not a question of not enough money.  Exactly enough money as is needed can be created — created for production, that is, not consumption or government spending.  By Say’s Law of Markets, if you produce a marketable good or service, you have at the same time generated potential income.  If you meet your own demand and consume the good or service yourself, that is the same as if you had traded what you produced for what you consumed, or (as the economists would say) realized effective demand.  That’s why Say’s Law is summarized as “supply generates its own demand, and demand its own supply.”

The first step, then, is restoring an asset-backed currency for Greece, if only to lay the foundation for completely eliminating the debt.  Greece has already proven it can’t handle a “managed currency” (nor can the U.S., for that matter. . . .), so the obvious thing to do is just get rid of the temptation.  If there’s one thing a few thousand years of civilization have taught the human race, if a politician can spend money, he will — sort of a Murphy’s Law of Finance.

For business, not government.
How did the U.S. do it — or, more accurately, arrange to do (and fail to follow through)?  It took five years and more politicking than we can get into here, but Congress passed the Federal Reserve Act of 1913 and instituted a plan that, had it not been for the politicians figuring out a way around it, would have worked brilliantly.

There were a number of important provisions in the Federal Reserve Act.  The part we’re interested in, however, is how the U.S. planned to replace the three currencies backed with government debt (National Bank Notes, Treasury Notes of 1890, and United States Notes) with a single currency backed with private sector hard assets — and without causing financial loss to the commercial banks that had been required by law to purchase government bonds to back their note issues.

This had to be done gradually, or the value of the government debt would drop, causing a loss to the banks.  The first step, then, was to authorize the Federal Reserve Banks to purchase the bonds held by commercial banks over time through open market operations.  This was not the main reason for instituting open market operations, however.  The main reason was to enable each Federal Reserve Bank to increase or decrease the money supply rapidly in the event of a financial panic or other emergency.

Federal Reserve (Bank) Note, Series 1914
The Federal Reserve would purchase the bonds with “Federal Reserve Bank Notes,” and the commercial banks would immediately retire the National Bank Notes, replacing them with Federal Reserve Bank Notes.  Obviously this took time, because each bank’s notes circulated anywhere in the country, and wouldn’t come in for redemption all at once.

The process took twenty-five years, in fact, and the program ended in 1938.  At that point, all remaining outstanding National Bank Notes were declared Federal Reserve Notes (not, it is important to note, Federal Reserve Bank Notes — you’ll see why in a moment).

This, however, simply replaced one debt-backed currency with another.  At the same time, then, commercial banks started rediscounting loan paper at their local Federal Reserve Banks.  The Federal Reserve Bank would issue a promissory note, and use it either to back a new demand deposit in the commercial bank’s name, or Federal Reserve Notes that were delivered to the commercial bank (usually both).

Check drawn on demand deposit, July 6, 1915.
If not enough qualified paper was offered for rediscount, the local Federal Reserve Bank would engage in open market operations to purchase qualified private sector securities (commercial paper, usually), again paying for it with Federal Reserve Notes or new demand deposits.

The Federal Reserve Notes and Federal Reserve Bank Notes were indistinguishable from one another.  That made it easier to implement the asset backing.  As the government redeemed its debt held by the Federal Reserve, all the Federal Reserve had to do was make bookkeeping entries shifting liabilities and assets around to balance the books.

It was not necessary to call in the debt-backed Federal Reserve Bank Notes with Federal Reserve Notes that looked exactly the same.  Instead, the liability was subtracted from the Federal Reserve Bank Note account, and added to the Federal Reserve Note account.

Tomorrow we’ll look at how this technique can be applied in Greece.



Baseball Billy said...

Dear Professor GRAYnee, I would venture to say that, to most people, this is difficult material. You may have broken it down to the most basic explanation possible, but to most people, including me, it is difficult. Whatever explanation of the subject material that you may be inclined to provide would be appreciated. Bill Baltar, the man who never returned

Michael D. Greaney said...

That's PERfesser; I ain't Piled it Higher and Deeper (Ph.D.).

It's very difficult material for a number of reasons, the first of which is that (for many more reasons) "money" has acquired a certain mystique that obscures what the concept actually means. Second, most economists don't understand money ... or basic arithmetic in many cases (or we wouldn't have the Keynesian "money multiplier" that defies logic). Third, most economists and virtually all politicians reverse cause and effect with money, i.e., they think economic activity comes from money. No, money comes from economic activity.

All three reasons (and there are many more, but you don't want a treatise) can be addressed by giving the most basic definition of money: anything that can be accepted in settlement of a debt. Everything about money and monetary theory derives from a (mis)understanding of that definition.

This is because (as Adam Smith put it) "Consumption is the sole end and purpose of production." That being the case, we get Say's Law of Markets: all things being equal, the only way to consume is to produce. Either you produce what you consume, or you produce something to trade to someone else to obtain something he produced so you can consume it.

Trade is another way of saying exchange or commerce: entering into contracts. All contracts consist of "offer", "acceptance", and "consideration." Consideration is "the inducement to enter into a contract," i.e., make an exchange, transferring one thing of value for another. This gives us the strict legal definition of money: all things transferred in commerce. Thus, all money is a contract, just as (in a sense) all contracts are money.

Currency is a type of money-contract that is supposed to be uniform, stable in value, and a standard of value, as well as a way of storing and transferring value. Politicians long ago figured out, however, that they can manipulate the currency by saying one thing and doing another, i.e., saying e.g. this coin contains one pennyweight of silver (24 grains) when it really contains little or no silver at all.

That wouldn't matter if, when the coin or banknote was presented for redemption, it was exchanged for something worth, e.g., one pennyweight of silver . . . but that's not what happens. Instead of booking the "agio" or "seniorage" (the difference between the face value of the currency and what it cost to manufacture it) as a liability, governments typically book it as a profit: the same side of the accounting equation, but the exact opposite of what something is, i.e., the equation is "Assets = Liabilities + Equity." By construing agio as a profit, they increase equity instead of liabilities. As a result, the currency falls in value.

So money is actually a very simple concept. What's complicated is what economists and politicians do to try and avoid the consequences of their acts, i.e., screwing around with contracts, accounting, math, and property.