Functional Overload

Eventually we plan on posting (after we write it, of course) a series on the problem of "functional overload" in today's society. We will, naturally, go into great detail of how misuse of some fundamental institutions has resulted in their increasing ineffectiveness, ironically as these institutions gain more and more power over the lives of individual people, groups, and the common good as a whole. Today, however, all we want to do is offer some brief (yet amazingly astute) comments on the misuse and consequent functional overload of two critical institutions in our society: the Federal Reserve System and the Internal Revenue Service.

It's generally obligatory when commenting on either of these two institutions to claim they are evil beyond redemption, etc. "IRS," as everyone is supposed to know, is really an acronym for "I Revere Satan," and so on. We'll forgo that rather dubious pleasure, as well as avoid blaming any specific individual for the problems we see embodied in how these two institutions are currently used.

The Biggest, Baddest Idea

The problem is not with the individuals who run the system, but in their bad ideas. This has led to some serious — a rather mild way of putting it — distortions not only in monetary and fiscal policy, but in our political structures and institutions. These serious . . . okay, catastrophic distortions of the financial and political systems are in large measure responsible for the problems we are experiencing with the economy.

The worst of these bad ideas, and the bad idea at the root of virtually all the other bad ideas, is the firm conviction — very nearly a religious dogma — that new capital formation cannot be financed except by cutting consumption and saving. The horrifying results of this demonstrably false assumption are the reason that Louis O. Kelso and Mortimer J. Adler subtitled their second collaboration, The New Capitalists (1961), "A Proposal to Free Economic Growth from the Slavery of Savings."

Here we insert our usual explanation that, while savings per se are essential to the financing of new capital, there is no divinely ordained law of nature that says the savings must come from cutting current consumption. Rather, as Dr. Harold G. Moulton proved in his 1935 classic, The Formation of Capital (coming soon to a Just Third Way blog near you), using such "past savings" actually harms economic growth and development. It is much better to pay for new capital out of income generated in the future by the capital itself — "future" rather than "past" savings. Kelso and Adler added that all new capital must be broadly owned by people who will first use the income first to repay the acquisition of the capital, and thereafter use the income for consumption instead of reinvestment.

What Happened

Both the Federal Reserve and the IRS were born out of the Panic of 1907. Immense research was carried out in an effort to restructure the financial system to bring it into the modern age in a manner consistent both with individual sovereignty and national necessity. This was long overdue: Alexander Hamilton had tried to lay the groundwork of a modern economy back in the 1790s, but was thwarted by people who did not understand money or credit.

The same research and the same justifications (most of them coming out of the Pujo Committee Report published in February 1913) were used for both institutions. The plan was, whatever your opinion of either the Federal Reserve or the IRS, brilliant in concept and simple in execution. A decentralized central bank was established to provide rediscount services for the private sector, ensuring that there would always be exactly enough money in the system to provide liquidity for qualified short term industrial, commercial, and agricultural loans.

To prevent the federal government from being able to monetize its deficits, the Federal Reserve was strictly prohibited from purchasing primary government securities, that is, government debt directly from the Treasury. Unfortunately, the Federal Reserve had to be able to purchase secondary government securities from commercial banks. This is because one of the purposes of the Federal Reserve was to replace the government debt paper that backed the National Bank Notes in accordance with the National Bank Act of 1864, with private sector paper representing hard assets backing the new Federal Reserve Bank Notes (indistinguishable from ordinary Federal Reserve Notes).

The federal government still had to raise money, however. It could no longer raise cash by requiring the National Banks to increase their reserves of government debt and maintaining a large "floating debt," so the Congress passed the income tax. This would, in theory, keep government borrowing to an absolute minimum — the country still had most of the debt from the Civil War still on the books to pay off . . . and still does, today (refinanced, but it's still there). Thus, the idea was that the Federal Reserve would provide liquidity for the private sector, while the IRS would provide liquidity for the federal government.

Enter the Slavery of Past Savings

What happened to this brilliant plan that one economic historian in the 1920s described as the perfect combination of Jacksonian hopes and financial responsibility? The slavery of savings, that's what. You see, the Federal Reserve was designed to operate in accordance with the real bills doctrine. The real bills doctrine is an application of Say's Law of Markets.

Briefly, money is anything that can be used in settlement of a debt, and is thus the medium by means of which people exchange or convey private property in the present value of existing and future marketable goods and services. All the real bills doctrine says is that if you increase or decrease the money supply to match increases or decreases in the present value of existing and future marketable goods and services, and if you link new money directly to the present value of existing and future marketable goods and services through private property, then you will always have enough liquidity in the economy, and there will be neither inflation or deflation. In short, you can create all the money you need for the economy without first having to cut consumption and save.

Unfortunately, along came Keynesian economics. Even more unfortunately, the other major schools of thought may be reactions against Keynesian economics, but they are not reactions against Keynesian assumptions, primarily the Big Keynesian Assumption that new capital formation can only be financed out of existing accumulations of savings.

Consequently, the tax system, which was designed solely to raise money for the federal government, was manipulated to try and ensure that there would be sufficient past savings to finance new capital formation . . . even though past savings are not used directly to finance new capital formation! The Federal Reserve, on the other hand, is now used to create new money to finance government deficits, leaving the private sector out in the cold . . . except for the recipients of government largesse through bailouts and subsidies (real productive, those).

The bottom line is that the IRS, which was designed and intended to provide funds for the government, is being used to generate financing for private sector growth and development. The Federal Reserve, which was designed and intended to provide funds for private sector growth and development, is being used to provide funds for the government.

With the powers-that-be trying to drive nails by hitting themselves on the head with a hammer, is it any wonder the economy and the country are in such bad shape?

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