Last week we
decided that having private property in capital is absolutely essential if
someone is to have the power to exercise his or her rights, thereby becoming
more fully human. This is because (as
Daniel Webster reminded us nearly two centuries ago), “Power naturally and
necessarily follows property.” You need
power — the ability for doing — to exercise rights, and thus private property
to have power in order to make your rights effective.
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| Webster: "Power follows property, you Devil!" |
That gloomy scenario,
however, assumes that the only source of financing for new capital formation is
existing accumulations of savings that resulted from reductions in consumption,
or from transfers of wealth from one set of persons to another, either by
direct redistribution through the tax system, or indirect redistribution by
manipulating the currency. There is,
however, an alternative to this “slavery of savings.”
Consider this: if
decreasing consumption in the past is harmful to the rate of new capital
formation in the present, why not switch to increasing production in the
future? Is that even possible?
Yes. Harold Moulton studied the situation in the
1930s in great detail, and compared it with other periods in U.S. history. He discovered that periods of rapid economic
growth did not follow periods in which consumption was reduced, but periods in which consumption increased!
In other words,
if conventional wisdom was correct that you have to reduce consumption in order
to save to have enough money to finance new capital, then periods of rapid
economic growth had to follow periods in which consumption was reduced . . . but
this was not the case. In
each and every period in which the country experienced rapid, almost explosive
economic growth, it always followed a period during which consumption
increased!
But . . . but . .
. but . . . (that motor boat again) . . . where did the money come from? Moulton answered that question as follows:
In order to make the problem of financing this capital
expansion appear as difficult as possible, let us assume, for the moment, that
the increasing flow of funds through consumption channels has been accompanied
by a decreasing flow through savings channels. (We shall presently show,
however, that this would not long continue.) Under these conditions would not
the formation of new capital be rendered impossible? The answer is that even
though the flow of funds from individual savings for investment purposes may,
for the moment, be inadequate, it is still possible to procure liquid funds
with which to buy essential materials and employ the necessary labor.
Funds with which to finance new capital formation may be
procured from the expansion of commercial bank loans and investments. In fact,
new flotations of securities are not uncommonly financed — for considerable
periods of time, pending their absorption by ultimate investors — by means of
an expansion of commercial bank credit.
(Moulton, The Formation of Capital, op. cit., 104.)
Many historians
have ignored Moulton’s findings, contending that the financing for America’s
rapid expansion came from Europe, principally England. The problem is that there is no evidence of
such massive transfers of cash from Europe.
While significant amounts of investment capital did come from Europe, it
was nowhere near the amount needed to finance the incredible growth the United
States experienced in the latter half of the nineteenth century.
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| The Panic of 1893 resulted from an inelastic, debt-backed reserve currency. |
The sudden
demands to liquidate U.S. investments in the early 1890s as a result of the
falling price of silver that triggered the Panic of 1893 and the Great
Depression of 1893-1898 were disastrous only because European investors
demanded their funds in American gold instead of mortgages, bills of exchange, silver, or the debt-backed and inelastic National Bank Note reserve currency. This drained the commercial
banks of gold reserves (essentially working capital for the financial sector),
which meant that U.S. banks had to stop extending credit domestically for
commerce, industry, and agriculture, or fail to meet reserve requirements. This caused an almost instantaneous financial
crash and depression until the banks could meet reserve requirements and begin
lending again after the inflow of reserve gold from Europe in payment for wheat
exports from the U.S. bumper crops of 1897 and 1898 that resulted from crop
failure in Europe. The gold that had flowed out five years before returned as suddenly as it had gone.
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| Crash of 1929: Precipitous decline in the value of collateral. |
Something similar
happened in the early 1930s. When the
stock market crashed in late 1929, the value of industrial, commercial, and
agricultural capital plunged. Since
existing capital was used in many cases as collateral to secure loans from
commercial banks, what in August 1929 was a rock solid business loan became by
December 1929 a loan with insufficient collateral, which triggered a “call” of
the loan. Banks could not extend credit,
and the country went into a depression. The
banks could only start lending again when businesses had a customer for what
they could produce: the U.S. government, which needed all available goods and
services to fight World War II.
Thus, when banks
cannot create money by extending credit for sound and otherwise financially
feasible capital projects, whether ongoing or to form new capital, industry,
commerce, and agriculture dry up and the economy goes into a tailspin. As Moulton realized from his analysis,
existing wealth — savings — is not the primary source of financing for new
capital formation or for working capital.
Rather, commercial banks create money by turning a part of the present
value of future increases in production into money, and borrowers use this
money, this “pure credit” (“pure” because it can be extended without regard to
existing pools of savings), not existing savings, to finance new capital.
But don’t banks
still have to have reserves and collateral to be able to expand credit and
create money? Don’t you still “need
money to make money”?
Of course you do
— and we’ll look at that tomorrow.
