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.”
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| 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.
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| 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.
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| 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.
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| 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).
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| 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.