In response to yesterday's article, "Fitzgerald Urges Bad-Bank Support on IMF Concern" (Irish Independent, August 31, 2009), it seems more than a little ironic that any Irish economist or politician would advocate setting up a "bad bank" in order to restore the State's power to monetize its deficits. In 1802 the Anglo-Irish MP, Henry Thornton, the "father of central banking," published his Enquiry into the Nature and Effects of the Paper Credit of Great Britain. In his book, Thornton explained that the real basis for the money supply is the productive capacity of the nation. Only by creating money backed by the present value of existing or future marketable goods and services in the private sector would a country have a sound and adequate supply of money and credit. This is the "real bills doctrine" of Adam Smith, Jean-Baptiste Say, Henry Thornton, and John Fullarton — the basic tenet of the "Banking School" of monetary theory.
There are two dangers in the real bills doctrine. One, bankers will be tempted to create money backed not by the present value of existing or future marketable goods and services, but, in search of greater profit, will back new money with derivatives of marketable goods and services ("fictitious" as opposed to "real" bills), or with non-productive speculative investments, consumer debt, or government securities. Backing the currency with anything other than real bills with adequate security causes inflation and debauches the currency. Two, bankers will, out of an excess of caution, refuse to create money on anything other than the very best security, and sometimes not even then. This leads to deflation of the money supply and a constriction of industry, commerce, and agriculture, and thus unemployment and recession or depression.
The school that grew up in opposition to the Banking School — the "Currency School" — missed the boat on this point, and rejected the real bills doctrine. Because of the perceived danger of inflation and the refusal to accept the possibility that it is perfectly feasible through the application of the real bills doctrine to finance capital formation without the use of existing accumulations of savings, the Currency School declared that all paper money except when backed 100% by gold is inflationary. As embodied in Sir Robert Peel's Bank Charter Act of 1844 (7 & 8 Vict. c. 32), the British government would be limited to a permanent floating debt of £14 million to back banknotes issued by the Bank of England, with any increase in the money supply coming from an increase in the supply of gold. This would presumably prevent the State from creating money indiscriminately to monetize its deficits, thereby causing inflation. This was the same rationale behind the United States National Bank Act of 1864.
There are three dangers in the approach of the Currency School. One, the "fixed currency" does not allow for economic growth tied to the productive capacity of the nation, but to the supply of gold. This results in deflation when the increase in the supply of gold is less than the increase in productive capacity, and in inflation when the increase in the supply of gold exceeds the increase in productive capacity. Two, eventually someone like David Ricardo realizes that a gold-backed currency can be replaced completely with a currency backed entirely by government debt, with inflation presumably kept in check by mandating legal limits on the amount of money that the government is allowed to create. Three, governments have always been able to circumvent legal prohibitions against creating money to cover their deficits, whether the practice is completely prohibited, as is still technically the case with the United States Federal Reserve Act of 1913, or simply limited, as with the British Bank Charter Act of 1844.
In consequence, the issue for today's monetary policymakers is not how to eliminate inflation or deflation and foster economic growth and a healthy economy, but how best to finance government spending and manage the presumably inevitable inflation by manipulating the money supply and interest rates. They need to step outside the constraints imposed by their adherence to the defective paradigms of both Keynes and the monetary economists in order to find a viable solution.
A much sounder approach unclouded by the flawed theories of either John Maynard Keynes or Milton Friedman would be to study the case made by Louis Kelso and Mortimer Adler in their 1961 book, The New Capitalists, with its all-important subtitle: "A Proposal to Free Economic Growth from the Slavery of Savings." An application of the principles in Kelso and Adler's book can be found in "Capital Homesteading," a comprehensive national economic strategy for empowering every person, including the poorest of the poor, with the means to acquire, control, and enjoy the fruits of productive corporate assets.
Capital Homesteading's long-range agenda involves a major restructuring of the tax system and central bank policies to lift unjust artificial barriers to more equitable distribution of future corporate capital and faster growth rates of private sector investment. It would shift primary national income maintenance policies from inflationary wage and unproductive income redistribution expedients, to market-based ownership sharing and dividend incomes.
cc. His Excellency Michael Collins, Ambassador of Ireland
Benjamin Bernanke, Chairman, Federal Reserve Board of Governors
Paul Volcker, Past Chairman, Federal Reserve Board of Governors
United States Council of Economic Advisors
David M. Walker, Peter G. Peterson Foundation
The Economic and Social Research Institute
The Center for the Study of the Great Ideas
The Wall Street Journal
The Washington Post
The Washington Times
The New York Times
The Irish Echo
The National Hibernian Digest