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Wednesday, July 28, 2010

Interest-Free Money, Part VI: Pure Credit Financing

As we have seen, there is no conceivable link in rhyme or reason that ties the productive capacity of an economy to the amount of savings accumulated in the system. Only by limiting the definition of savings to cuts in consumption, and the definition of money to coin, currency, demand deposits, and selected time deposits (M2) can we justify this artificial situation.

Past Savings and the Rate of Interest

By tying the productive capacity of an economy to a limited supply of loanable funds, the rate of interest on accumulated savings assumes exaggerated importance. Further, by assuming that interest is what is due to a lender as the cost of capital, instead of (in terms of moral philosophy) a form of profit sharing, it becomes possible to override private property.

Yes, from the point of view of the mechanics of the situation, interest paid qualifies as a cost, just as interest received qualifies as income, whether or not the payer construes it as a cost or as profit sharing. We are not concerned with the income statement classification at this point, however, but with the moral justification of paying or receiving interest. If dividends and other forms of profit sharing were to be made tax deductible at the corporate or business level (as proposed under Capital Homesteading), "interest" could be properly classified as profit sharing. From the standpoint of Binary Economics and its grounding in Aristotelian and Thomist moral philosophy, classifying interest as a business cost is an illegitimate way of gaining a legitimate deduction.

Unfortunately, by construing interest as the cost or rent of existing accumulations of savings, and existing accumulations of savings as the sole source for financing new capital formation, the Keynesians are able to override private property directly. Keynesian economic policy does this by manipulating the market rate of interest for political purposes, vesting the State with effective ownership of the savings presumably being loaned out. For their part, the Austrians override private property indirectly. They do this by failing to recognize that what is due from a borrower to a lender of existing accumulations of savings, is substantially different from what is due from a "borrower" to a "lender" who is in reality not lending, but performing the service of monetizing the present value of assets that belong to the "borrower."

The Keynesian inroad on private property is obvious. "Ownership" and "control" are the same in all codes of law. In addition, enjoyment of the fruits of ownership — income and the right of disposal — is considered to convey title, despite where specific legal title might reside. By setting the interest rate and allocating resources, the State in Keynesian economics is effectively claiming ownership of that which generates the income by controlling how much income someone is allowed to enjoy, and who may enjoy it.

The Austrian inroad on private property, being indirect, is consequently less obvious. Like the Keynesians, of course, the Austrians refuse to recognize that anything other than existing accumulations of savings can be used to finance capital formation. They correctly state that what is due to a lender of existing accumulations of savings should be set by the free market. By not recognizing that a pure credit loan does not involve lending existing accumulations of savings, however, they naturally apply the market rate of interest for existing accumulations of savings to the extension of bank credit that is not based on existing accumulations of savings.

As we have seen, in a pure credit loan, the "lender" is due a fee for monetizing the present value of the assets brought to the bank for financing, plus a risk premium to insure against the possibility that the principal of the "loan" will not be repaid. Everything else — all interest (profit) belongs by natural right to the "borrower," for it is the borrower's assets that will generate the income — the future savings — out of which the extension of credit will be repaid. By insisting on charging the same rate on pure credit loans as on loans of existing accumulations of savings (or any charge at all that partakes of interest or any other form of profit sharing), the "lender" undermines the "borrower's" rights of property, and thus the natural right to be an owner.

Practical Problems With Past Savings Financing

As we might expect, believing that all new capital formation must be financed out of existing accumulations of savings when that is not, in fact, the case, causes serious problems. Not the least of these, of course, is that because academic economists and policymakers misunderstand how capital formation is actually financed, they will inevitably do the wrong thing when attempting either to stimulate or dampen economic growth. This is true whether the powers-that-be are attempting to follow the dictates of Keynes, or are trying to let the free market operate.

Nowhere is this more evident than in the confusion generated by what Dr. Harold Moulton called, "the economic dilemma": "In order to accumulate money savings, we must decrease our expenditures for consumption; but in order to expand capital goods profitably, we must increase our expenditures for consumption." (The Formation of Capital, op. cit., 28.) Keynes believed that induced inflation and manipulation of the interest rate would solve this dilemma. As Kelso and Adler analyze the process, however,
At first glance, it might appear that in any event inflation would tend to counteract the effects of the growing concentration in the ownership of capital. Property-less (i.e., capital-less) workers who borrow money to finance consumption can in any event pay back their loans in inflation-debauched dollars, thus offsetting the effects of concentration of ownership of capital. However, the reverse is true.

Consumer credit, which is generally the only form of credit that is resorted to outside the field of business finance, bears rates of interest that are well in excess of any inflation we have suffered so far. Instead, it is the small savers, the owners of savings accounts, savings-type insurance policies, or government bonds, who collectively are the creditors, that mainly suffer from inflation. A corporation that borrows 50 million dollars from one or more insurance companies on a 25-year loan during a period when the annual rate of decline in the purchasing power of the dollar is 2 percent will ultimately have almost half of its loan repaid through inflation. Stated in another way, the small savers whose insurance policies are about as close to capital ownership as they can come — and this is anything but close — will lose about half the purchasing power of their savings to the borrowing corporation over the term of the loan. (Kelso and Adler, The New Capitalists, op. cit., 43-44.)
Thus, in simpler terms, "capitalists" (current owners of capital) use this inflation-induced "saving" — reductions in consumption — to invest in new capital formation. Inflation and the use of "other people's money," (Louis Brandeis, Other People's Money and How the Bankers Use It. New York: Frederick A. Stokes & Co., 1932) instead of permitting the debt-ridden consumer to pay off his or her loans with "cheaper dollars," actually results in a shift of "purchasing power" (the new definition of money, as opposed to "medium of exchange") from non-owners to owners. The rich become richer, while the poor lose what little they have.

Nor is the damage reduced or ameliorated by raising fixed wage and benefits packages, or increasing defined benefit pensions or government entitlements. The nature of the beast is such that "catch-up" measures inevitably lag behind the inflation they are meant to counter. No politician or union leader could justify raising entitlements or wages when there is no perceived necessity for it — it would not be politically expedient, and they would lose public support. Instead, all efforts during a time of falling profits and prices are directed toward maintaining past gains, not acquiring new ones.

Solving the "Economic Dilemma"

In spite of the harm done to non-owning wage workers and consumers on fixed incomes, it is perfectly legitimate in the Keynesian view for the State to increase the money supply without bothering to back the new money with anything other than the State's power to tax away existing wealth in the future. The State can then redistribute existing wealth through the "hidden tax" of inflation. In Keynes's line of reasoning, the State is the ultimate owner, anyway. In Keynes's view, all the State is doing by increasing the amount of currency in circulation without increasing the present value of existing or future marketable goods and services in the economy, thereby raising the price level, is redistributing its own wealth among different recipients.

As Moulton proved, however, this "economic dilemma" is ephemeral, and totally dependent on the belief that only existing accumulations of savings can be used to finance capital formation. All of Keynes's circumlocutions and redefinitions were, in fact, unnecessary, and remain both unnecessary and extremely damaging in our modern economy. A commercial banking system has the power to create money as needed for new capital investment, and this without inflation or deflation. As Moulton explained,
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. (Ibid., 104.)
Moulton, of course, was referring to the real bills doctrine. Again, the real bills doctrine is that money can be created as needed if backed by the present value of existing or future marketable goods and services, and there will be no inflation — defining inflation as a rise in the price level caused by an increase in the money supply not matched by an increase in marketable goods and services. (See Dr. Norman A. Bailey, "A Nation of Owners: A Plan for Closing the Growing U.S. Knowledge and Capital Asset Gaps," The International Economy, September/October 2000.) Under the real bills doctrine, the volume of trade is what determines the volume or quantity of money; the quantity of money does not determine the volume of trade.

Pure Credit Capital Financing

Consistent with the real bills doctrine, the quantity of money can be increased or decreased without inflation or deflation, respectively. Producers do this by "drawing bills" (issuing money) backed with a direct private property link to the present value of the existing or future marketable goods and services being monetized. When the direct private property link is missing or attenuated, as when the State issues currency backed by future tax collections (anticipation notes, such as make up most of the official money supply today), the result is "fictitious bills," i.e., fraudulent or deceptive financial instruments not backed by a definable or secure present value.

A correct understanding of money as the medium of exchanging a property right in the present value of existing and future marketable goods and services leads naturally into the solution as to where the money is to come from to finance new capital formation without having to rely on existing accumulations of savings. Given a sound capital project, it is possible to calculate a present value based on the expected future stream of income to be generated by the capital.

Even if the capital does not yet exist, the proposal — if sound — has a present value. Under the real bills doctrine, the owner of the proposal — the producer or prospective producer of a marketable good or service — can draw a bill or bills backed by that present value. If other people in the community accept the bills, the issuer can use them the same as any other money to finance the formation of the new capital. If other people in the community prefer their money in a more regulated or "current" form — currency — the issuer takes his or her bill and discounts it at a commercial bank in exchange for currency, for which the commercial bank takes a fee, the "discount."

If there is a central bank, the commercial bank can rediscount the bills at the central bank. This ensures a uniform and, presumably, stable currency in the region served by the central bank. Under the real bills doctrine, there is always sufficient money in the system to finance new capital formation and purchase all the goods and services produced without either inflation or deflation. The market rate of interest does not thereby become irrelevant or unimportant. It does, however, cease to have the same importance that it does under the assumption that only existing accumulations of savings can be used to finance new capital formation.

The market rate of interest on existing accumulations of savings has a different importance in a pure credit system. The market rate of interest is a critical factor in determining the risk premium that is charged on all loans, whether pure credit or extended out of existing savings. The risk premium is calculated by subtracting the "risk free" market rate of interest from the rate of interest actually charged.

There is no way to determine the actual risk free rate of interest, but we can reach an approximation, given the operation of a truly free market in which the interest rate is not manipulated by the State. The State can, presumably, tax the wealth in the economy in order to meet its legitimate obligations. That being the case, a loan to the State is (again, presumably) the most secure and sound of all loans. For all practicable purposes, then, a loan to the State is effectively "risk free."

Of course, we know that is not actually the case. All governments are insecure to one degree or another. This "risk free" rate is therefore an approximation, not something that can be determined with scientific precision. It is, however, a very useful approximation against which to measure the risk premiums on various types of loans.

A Pure Credit System (Almost) in Operation

We will go into this in more detail in the next posting, but a system that embodied the essentials of a pure credit financing system was implemented in the United States with the passage of the Federal Reserve Act of 1913. By the terms of the Act, the Regional Federal Reserves had (and technically still retain) the power to rediscount qualified industrial, commercial, and agricultural paper issued by member banks, and to engage in open market operations in qualified paper issued by non-member banks and private businesses as a supplement to rediscounting.

The Federal Reserve System was established to provide the economy with an "elastic currency" that would be asset-backed, and avoid both inflation and deflation. Discounting of primary government securities was not permitted in order to avoid monetizing government deficits, but dealing in secondary government securities was allowed because government securities — the only legal backing for national banknotes under the National Bank Act of 1864 — were included in the definition of "reserves."

As a result of the liquidity problems associated with the Panic of 1893 and the Panic of 1907, the idea was that the Federal Reserve would serve as a lender of last resort for the private sector. Because policymakers decided to finance America's entry into the First World War by borrowing rather than taxing, however, the Federal Reserve gradually became the lender of first resort to the federal government. Tantamount to chartalism, this is in accordance not only with Keynesian economics, but also with Monetarist and Austrian economics, all of which take for granted the disproved assertion that capital formation can only be financed out of existing accumulations of savings.

Reliance on existing accumulations for the financing of new capital formation led to a fiscal and monetary paradox in the United States and, eventually, the world. The federal income tax was established at the same time as the Federal Reserve System. The idea was to complement the central bank's financing of the private sector by providing the federal government with a source of revenue.

Presumably, prohibiting the Federal Reserve from discounting bills of exchange ("bills of credit") would prevent the federal government from being able to monetize its deficits by issuing bills of credit and discounting them at the central bank. This provision was already in place for the states to take away the power of the individual states to have state currencies, and to impose a uniform national currency. In 1789 there was evidently no reason to suppose that the federal government would ever issue bills of credit, and the issue was not addressed — specifically.

The 9th and 10th Amendments, however, clearly state that if a right is not specifically vested in the federal government, the federal government does not have that right. The right of the federal government to emit bills of credit is not mentioned in the Constitution. Logically (and legally), then, the federal government does not have the power to monetize its deficits by discounting bills of exchange at a commercial bank or a central bank, or by selling bills on the open market for later purchase by the banking system through open market operations. The Federal Reserve Act of 1913 merely reflected the constitutional effort to prevent the states or the federal government from monetizing deficits. Open market operations in government securities are a legal fiction to circumvent the U.S. Constitution.

Thus, the Federal Reserve shifted from being the provider of liquidity in the form of an elastic currency for the private sector, to being the chief source of financing for the federal government. Under the illusion that existing accumulations of savings are essential to the process of financing capital formation, the income tax was shifted at the same time from being the chief source of financing for the federal government, to being the provider of liquidity for the private sector in the form of savings induced by manipulating disposable income and taxing income in different ways in an effort to encourage new capital formation.

In consequence of their being grossly misused in this fashion, the tools we know as the Federal Reserve System and the Internal Revenue Service have become possibly the most hated and feared institutions in the United States. Accusations of conspiracy and fraud abound, along with tyranny and allegations of unconstitutionality. All of this would be avoided, possibly even unthinkable, were the tools used as designed. The question is, Keynesian economics and the other major schools of economics having failed to provide the principles for the design and implementation of a sound and sustainable system, what system will do the job?

Binary Finance

We find the answer in the work of Louis O. Kelso and Mortimer J. Adler. Harold Moulton described the operation of a pure credit system and how the financial and capital markets could be restructured to conform to sound principles of economics and finance. Moulton did not, however, address the issue of expanded ownership of the means of production in any meaningful fashion.

To Moulton's findings, then, Kelso and Adler added that, for consumption to expand simultaneously with production, the new capital must be broadly owned by people who will use the income from capital first to generate the future savings to service the acquisition debt, and then for consumption, not reinvestment.

A critical feature of Kelso and Adler's proposal is to replace usual forms of collateral with capital credit insurance and reinsurance. Banks are reluctant to lend without some reassurance that they will be repaid. With the volatility of the stock market, the value of the usual collateral has become uncertain — as was the case in the 1930s. Instead of relying on government and the Federal Reserve manipulating interest rates and artificially bolstering share values on Wall Street and calling it a recovery, it would make more sense to go with a private sector solution in the form of broadly owned private capital credit insurance and reinsurance companies. This has the potential to foster genuine growth instead of ephemeral gains on the stock market.

Binary Economics thus differs from virtually all other schools of economics by taking into account law and finance, as well as accounting. Other schools simply either ignore these things and thus manage to mis-define law, human nature, and money and credit, or declare that they are other than what they are.

Determining Interest Rates

We come, finally, to the issue of interest under a pure credit system integrated into the principles of Binary Economics.

Determining this "interest rate" for existing accumulations of savings is fairly simple when the market is allowed to operate without undue interference or control on the part of the State or any other monopoly power. This is where the concept of "opportunity cost" comes in. A lender of existing wealth is due what his or her contribution to the production process is worth in the overall process. This can best be determined by what the next best alternative is offering — the "market rate" of interest on savings put into a comparable investment.

That leaves the "interest rate" due to the owner who forms the capital and makes the project productive, and which may be used as the discount rate in determining the estimated present value of an investment. The total interest generated by the project must be sufficient to cover what is due to the lender as a share of the profits and a return of the principal, meet the operating expenses of the business, and, finally, give the owner an adequate return for his or her efforts. This is based not on the market cost of (financial) capital used to finance the investment — the return due to savers who lend their accumulations — but on the return on the investment itself, based on the return to comparable investments.

In making the determination whether a capital project is worth the while, "net present value analysis" is often useful. The concept is fairly simple. The future stream of income is "discounted" to its present value by imputing an interest rate to the future stream of income from the investment itself sufficient to meet expenses, the desired return to the owner, principal payments, and the interest — the share of profits — due to the lender.

The cost of the project is subtracted from this discounted cash flow. If the remaining amount, the "net present value," is positive, then the investment is probably a "good buy." If the net present value is negative, then the investment is probably not a good buy. Obviously, the "discount rate" used in calculating the present value of the project has to be greater than the market rate of interest paid to the lender, or there would never be any point in engaging in productive activity.

The Two-Tiered Interest Rate

The above discussion applies to financing new capital out of existing accumulations of savings. The case is different when calculating the interest rate using newly created money in a pure credit financing system. From the point of view of the lender, there is no question of receiving a share of profits, because there are no pre-existing savings on which to pay a share of profits. There is therefore no "interest rate" in the same sense as there would be applied to a loan of existing accumulations of savings.

To be as clear as possible, while the term "interest" in the classical sense is perfectly correct when applied to the return to an owner of an investment, it would probably be better to refer to the rate of profit not as "interest," but as "return on investment," or "ROI." The lender in a pure credit transaction, however, is not due a return on investment simply because he or she did not make an investment in the strict sense.

As we will see in the next posting on a brief history of banking, a bank of issue that creates money out of the present value of existing or future marketable goods or services is not actually lending anything. Instead, the bank exchanges its general credit, presumably accepted throughout the community, for the particular credit of a borrower who brings a financially feasible project with a definable present value to the bank for financing. For this service, the bank properly receives a fee, plus (depending on the specific arrangement) a risk premium.

We say, "depending on the specific arrangement" because in Capital Homesteading we advocate replacing traditional collateral (used to spread risk) with capital credit insurance and reinsurance. The risk premium can thus be used to make the premium payments on a capital credit insurance policy instead of being used by the bank to self-insure. Whether the borrower or the lender takes out the policy is a question for future discussion, and need not concern us at this point.

What we end up with in a pure credit system under the Just Third Way, then, is a "two-tier" interest rate. The first "tier" is the market rate of interest based on a just share of profits to the lender of existing accumulations of savings. Past savings should be used for all consumption loans and loans made to government, as well as for speculative investment that does not qualify for pure credit financing. The second "tier" is, in the usual meaning of the term today, not interest at all, but a service fee for monetizing the present value of existing and future marketable goods and services and a risk premium.

Thus, interest as such is as a general rule charged only on existing accumulations of savings — "old money" — for the loan of which a saver is due some return. "New money," however, does not bear an interest rate in today's meaning, and can thus be said to be created "interest (but not cost) free."