Tuesday, September 1, 2015

How Not to Cause a Great Depression


We probably should have said something about this yesterday, but we were looking at what we think is the single most important factor that caused the Great Depression of 1930-1940: a sudden decline in the value of business loan collateral, and the lack of a replacement collateral when traditional collateral went down the tubes.  Today we’re looking at one of the “causes behind the causes”: lack of internal control in the financial services industry.

External Control
Yes, we know: BOR-ing.  Besides, with an all-powerful State and a Keynesian economy, who needs internal, systemic controls for the financial system?  If something has to be done, the State will order it, and it will be done — external control.

Won’t it?

That was the reasoning behind the repeal of Glass-Steagall (certain provisions of the Banking Act of 1933, (Pub. L. 73–66, 48 Stat. 162), anyway.  Who needs the system to be set up to operate properly when we have the government to tell people what’s right and wrong?  People will do the right thing naturally, and if they get out of line, the government will fix it.

. . . just as it did in Greece and other places.

The fact is that all forms of external control only work effectively if the system itself is structured properly, i.e., has the right kind of internal controls.  This is basic accounting.

For example: in a business (or anywhere else) you don’t want the same people authorizing disbursements who issue and sign the checks.  Why?  Because it is too easy for a dishonest person to authorize a payment to him- or herself, and then issue the check, with no one the wiser until checks start bouncing all over the map because someone cleaned out the business’s accounts and moved to Andorra, which has no extradition treaty with the U.S. — and one of the longest life expectancies in the world for both men and woman . . . and nobody knows where it is, making it even harder to track someone down.

Andorra in a snapshot.
Okay, Andorra is a tiny principality in the Pyrenees, ruled by its bishop, with foreign relations jointly administered by France and Spain.  It’s 468 square kilometers, so don’t abscond there if you’re claustrophobic.  (The Vatican is even smaller, and doesn’t have an extradition treaty, either, but it’s a little tough to immigrate to.  San Marino, Malta, Monaco, and Lichtenstein are also smaller than Andorra if you're really in to "small is beautiful" in a non-Fabian socialist sense.)

How does this apply to the financial system?  Before the Crash of 1929, commercial and investment banking were linked.  That meant that stock brokers in an investment bank could go to the related commercial branch and have the commercial branch create money to loan to an investor, sometimes with as little as 3% down.

This resulted in massive money creation that fueled speculation on Wall Street, driving up the prices of shares to unheard-of heights.  When people realized there was nothing behind the rise in share values except private sector debt backed by the rise in share values, the stock market crashed.

Senator Carter Glass of Lynchburg, Virginia.
To correct this and prevent it from happening again, Senator Carter Glass of Virginia (who had been instrumental in the passage of the Federal Reserve Act of 1913) and Representative Henry B. Steagall of Alabama insisted on provisions in the Banking Act of 1933 that separated commercial and investment banking.  There were, unfortunately, some loopholes, especially those that permitted money creation backed by government securities (or, more accurately, didn’t prohibit it), but by and large Glass-Steagall effectively instituted solid principles of internal control into the financial services industry.

In the 1980s efforts began to repeal Glass-Steagall, which was accomplished in two phases.  The first resulted in the savings and loan debacle, and the second led directly to the home mortgage meltdown.

The current wild fluctuations in the stock market are, in a sense, not directly related to the repeal of Glass-Steagall, as they are funded largely by government instead of private sector money creation.  The lack of separation of function between investment and commercial banking makes this easier, but that is all.  Commercial banks are channeling funds to speculation instead of using their money creation powers backed up by the Federal Reserve to finance private sector investment in new capital.

That is why sound principles of internal control would mandate not merely a separation of investment and commercial banking again, but also mandate that financial institutions of all types stick strictly to the purpose for which they were instituted.  A commercial bank would make commercial loans, a savings and loan would make consumer loans, an insurance company would offer only insurance, an investment bank would mediate between stock issuers and stock purchasers, and so on.

Government debt-backed Twenty Dollar Treasury Note of 1890.
Above all, there would be no creation of money backed by government debt.  If a government borrows, it must be out of existing savings.  The only reason the Federal Reserve was permitted to deal in government securities on the open market was to retire the debt-backed United States Notes, National Bank Notes, and Treasury Notes of 1890, and replace them with Federal Reserve Notes backed with private sector hard assets.  (The fact that Federal Reserve Notes today are backed with government debt is another story.)

The bottom line here is that if proper internal controls are in place, it is no longer a question whether the government or the banks are creating too much or not enough money for non-productive spending and speculation.  The question answers itself, because the system would prohibit ALL new money creation except that which is backed by non-speculative, private sector hard assets.  Governments, like the rest of us, would have to learn to live within their means, meaning what can be raised by taxation, not issuing government debt-backed funny money.

To ensure the viability of such a move, it would have to be linked to an aggressive program of expanded capital ownership, such as Capital Homesteading, increasing the number of capital owners, rebuilding the tax base, and decreasing the need for massive government entitlements.

It’s something to consider, anyway.

#30#

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