Monday, September 21, 2015

Banks and the Stock Market, VIII: Eliminating Fractional Reserve Banking


As we saw last week, the real problem with fractional reserve banking is not that it allows commercial banks to create money.  That’s what commercial banks were invented to do.  The problem is that fractional reserve banking forces a bank to make a pre-determined amount of loans, regardless of the actual needs of the market and the economy as a whole.  After the repeal of Glass-Steagall, banks could use “excess reserves” to speculate in the stock market — which, as we’ve been hinting all along in this series, is not a proper function of a bank.

Henry Thornton, Banking Principle Guru
Surprisingly, all these abuses can easily be stopped by the implementation of a 100% reserve requirement under Banking Principle assumptions.  If all loans made by commercial banks qualified for rediscount at the central bank (the Federal Reserve in the case of the United States), then all loans would ipso facto be good loans — at least as far as human judgment could determine that (or the loans would not be made, obviously).

It would not even be necessary actually to rediscount all the loans, or even a majority as long as they qualified.  With electronic communications, rediscounting could be virtually instantaneous, and it would be pretty much irrelevant whether a loan was rediscounted — as long as it qualified for rediscounting.

In the beginning of such a program, of course, it would be best to enforce 100% immediate rediscounting of all loans.  This would ensure proper implementation of the program across the board, especially if the commercial banks were prohibited from issuing promissory notes to back new demand deposits until the central bank approved the loan and issued its own promissory note to back the commercial bank’s promissory note.  Every bank would periodically be required to rediscount all of its outstanding loans without advance warning.

When the system was in place and any bugs eliminated, and banks used to the new requirements, the need for rediscounting could be eased.  As an automatic audit, however, there should be random checks on commercial banks for immediate rediscounting of all loans held.  Since a bank would never know when such a demand would come, it would have to ensure that all loans met the requirements for rediscounting at all times, i.e., be qualified loans.

The obvious benefit to this form of the 100% reserve requirement is that a bank would be “forced” to make only financially feasible, qualified loans — and the market would determine the actual needs of the economy, not some government bureaucrat or academic economist.  This would also facilitate the shift from a debt-backed to an asset-backed reserve currency, and be completely elastic, matched directly to the market-determined needs of the economy.

Henry Simons
Note that while there is a similarity with the “Chicago Plan” developed by Henry Simons in the 1930s, there is a significant difference.  Simons’s proposal for a 100% reserve requirement assumed as a given that all banks are banks of deposit, functioning solely within the past savings paradigm.  Commercial banks and central banks, not being within the Currency Principle, based on past savings, had no place in Simons’s plan.  They would all be converted to purely “depository institutions.”

This created a problem.  By abolishing commercial banks and central banks, Simons’s proposal removed the possibility for most people of being able to finance economic growth with the present value of future increases in production — that is, with bills of exchange.  Instead, any increase in the money supply would come from new issuances of government debt — bills of credit, backed only by the faith and credit of the government, meaning the ability of the government to collect taxes in the future out of existing or future wealth.  The currency would be debt-backed rather than asset-backed.

Fortunately, however, Simons realized there was a fatal flaw in his plan, one that he as an opponent of monopoly power refused to countenance.  Part of his proposal was to have a special commission appointed to determine the amount of new money each year to be created by government.

Knowing that politicians inevitably managed to circumvent such regulatory requirements whenever they wanted more money (and when did a politician not “need” more money?), Simons refused to endorse his own proposal until and unless a means could be found to prevent politicians or private special interests from seizing control of the commission.  Simons’s plan, however, required human beings to become perfect and incorruptible as a matter of course, and no means of “guarding the guards” and preventing a government or capitalist takeover of the economy was ever devised.

Full, private sector asset-backed reserves are one essential feature to restoring a market economy.  A 100% reserve requirement, however, will only work if based on future savings, not past savings.  Anything else simply concentrates more and more power in the hands of the people who control past savings, whether it’s a capitalist private sector, or socialist State sector.

Tomorrow we’ll look at how misuse of the banking system by both the private sector and the public sector has set the stage for a stock market meltdown.

#30#

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