Thursday, April 28, 2016

Why a Central Bank: More Practical Considerations


This past Monday we addressed the problem of the “Automatic Gainsayer” who keeps insisting that (in our example) Country Y is so corrupt that we could never institute Just Third Way reforms, especially of the financial and tax systems.  For the sake of the argument, we demonstrated that even if the reforms turned out to be impossible from the top down — which, with the right leader, is a non-issue — it would still be possible to institute reforms from the bottom up.
Today we will conclude our little dissertation on why a properly run central bank is essential in an economy that wants to engage in sustainable growth and development by giving a few specifics on what a properly run central bank should be doing.  Since this is the Just Third Way blog, we’ll do this within the framework of the Four Pillars of an Economically Just Society,
·      A Limited Economic Role for the State,
·      Free and Open Markets,
·      Restoration of the Rights of Private Property, and
·      Expanded Capital Ownership.
A Limited Economic Role for the State,
Most people (and all politicians . . . by which we don’t necessarily imply that politicians aren’t people) think that central banks were invented to finance government.  No, that was just an accident of history.  Central banks were invented to ensure that commercial (mercantile) banks always had “accommodation,” that is, sufficient credit and reserves to engage in commerce.
Legal Counterfeiter for the Government
When the “Merchant Adventurers” formed the Bank of England, they pooled £1.2 million in gold and silver to serve as reserves to meet demand for conversion of note issues and redeem obligations for which there were no offsetting balances.  William III, short of cash, demanded a “loan” of the gold and silver as a condition of granting a charter, replacing the specie with “government stock” (i.e., unbacked bills of credit) that were — by government fiat — “good as gold” (which begs the question that if government debt was “good as gold,” why did the government need the Bank’s gold?).  Thus, by the stroke of a pen, the Bank of England was transformed from a private sector venture into a de facto government agency.
The first central banking reform, then, is to forbid further monetization of government debt, a form of "legal counterfeiting," an oxymoron like the "living constitution" that killed the U.S. Constitution, or "government intelligence" (no comment).  If the government wishes to borrow, it must go to existing pools of savings, not create obligations backed by its own obligations — i.e., promises to pay backed by promises to pay.  Being unable to operate except by raising money through taxation or borrowing existing funds necessarily restricts the economic role of the State by making it dependent on the people, rather than the other way around.
Free and Open Markets
Free and open markets are the best means yet found for determining just wages, just prices, and just profits.  The problem is that few people these days have the means to participate in the market, free or unfree.
A free market is one to which everyone has means of access.
By “free market,” of course, we do not mean a market in which “anything goes” (laissez faire), but one in which everyone is free to participate, that runs by fair and just rules that everyone can understand, and that apply to all.
One definition of money being “the medium of exchange,” it necessarily follows that participation in a free market includes access to money and credit — the media of exchange.  (According to Henry Dunning Macleod, money and credit are simply two different aspects of the same thing.)
By prohibiting further monetization of government debt, the central bank can return to its original function: providing liquidity for private sector development.  By allowing anyone with a qualified project access to a commercial bank, and all commercial banks access to the central bank, there could always be enough media of exchange to carry out all transactions.  This would provide the means for every citizen to participate freely in the market.
Restoration of the Rights of Private Property
When a government monetizes its own debt, it inflates the currency by creating more claims on existing wealth, but without owning the wealth on which it is creating claims.  It is, essentially, making promises for other people to keep — again, a form of "legal counterfeiting."
Inflation steals value
That is, when a government monetizes its own debt, it is violating the property rights of its citizens by decreasing the value of privately held financial assets denominated in the national currency, and transferring the value to its own coffers.  By not allowing governments to monetize their own debt, private property is restored to that degree.
Of course, the primary object of this “pillar” is to secure to corporate shareholders a meaningful vote and the income attributable to their pro rata share of ownership.  That does not, however, preclude restoring other rights of private property by reforming the central bank.
Expanded Capital Ownership
A reform of the central bank is essential to any program of expanded capital ownership.  It answers the question, Where is the money to come from?
The key to Capital Homesteading is to realize that capital is “inherently financeable.”  That means not that you pay for capital, bur that the capital pays for itself.  That being the case, if a proposed capital project is reasonably expected to pay for itself out of its own profits in the future, why should you pay for it out of what you have withheld from consumption in the past?
Just as existing unconsumed production from the past can be conveyed by a contract called a mortgage, future uncreated production can be conveyed by a contract called a bill of exchange.  The requirement, after all, is the same in both cases: the contract must be redeemed on the specified date; you don’t have to have the production on hand when you enter into the contract.  You only have to be able to deliver the production when you fulfill the contract.
Thus, anybody with a financially feasible capital project can take a contract for the purchase of the capital to a commercial bank, and the bank will examine it.  If the bank agrees that the project will pay off as expected, it will accept the contract and issue a promissory note.  This promissory note will back a new demand deposit, which the borrower will draw on to finance the new capital.
Once the capital becomes profitable, the borrower will pay off the promissory note, redeeming the contract, and enjoy the rest of the income him- or herself, having become a capital owner.
The central bank’s role in this is to accept the contract from the commercial bank, issuing its own promissory note to back a demand deposit in the name of the bank, which provides 100% reserves to cover the bank’s loan to the original borrower.  This ensures a uniform and stable, elastic, and asset-backed currency for the region served by the central bank.
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2 comments:

Baseball Billy said...

This is great stuff, Michael. You know I'm one of the regular readers of the blog. Even though there is some repetition, I don't mind. I learn or relearn something every Monday through Thursday. BUT, it doesn't sound right to me to use the word, "reserves," as you did at the end of the post. I always think of a bank's reserves being cash on hand, or its equivalent, such as deposits at other banks and the federal reserve; these being a percentage of the total demand deposits of the bank's customers at the bank. So, I'm thinking reserves is a percentage of deposits the bank has accepted and currently holds.

Michael D. Greaney said...

What you describe is "fractional reserve banking," which many people think allows banks to create money at will — no, only by accepting contracts called mortgages and bills of exchange. The reason for mandating fractional reserves is that very seldom does every bank customer want to redeem all of his or her bank-issued obligations at one time, i.e., a "run on the bank."

With a central bank, fractional reserve banking becomes unnecessary, as all acceptances can be sold or rediscounted immediately to the central bank, making it irrelevant whether there is a run on the bank, as every single obligation can be paid in full immediately.

Of course, with modern communications, it really wouldn't matter whether you had zero reserves, fractional reserves, or 100% reserves, as a commercial bank could almost instantaneously rediscount its qualified paper at the central bank and issue a check on the central bank — considered the same as cash in most countries — within minutes of a customer making a demand in excess of vault cash. Doing this in advance of any demand adds more security to the system, as any paper that is not qualified for rediscount at the central bank would not qualify as a loan in the first place; A 100% reserve requirement adds another layer of checks and balances to the system.