Yesterday we looked at one or two things that should be done to return the Federal Reserve system (or any central bank, for that matter) to its original purpose of providing adequate liquidity for private sector development for qualified agricultural, commercial, and industrial projects. Note that financing government was not one of the original purposes for which central banks were invented. It just turned out that way due to an accident of history . . . if by “accident” you mean “expedient for those wielding political power and who could withhold a charter unless their terms were met.”
|Happy bankers, when most money was in contract, not coin form.|
Today we look at three additional reforms that would make the reserve currency and the entire system even more sound than merely conforming to the system’s original purpose: 1) A 100% reserve requirement, 2) Phasing out monetization of government deficits, and 3) Financing expanded capital ownership. Let’s take these in the order given.
100% Reserve Requirement. Under today’s “fractional reserve” banking system, commercial banks are limited in the amount of loans they can make, based on the reserve requirement and the amount of reserves. For example, if there is a 10% reserve requirement, and the bank has $1 million in reserves, it can make loans — that is, issue promissory notes to “accept,” that is, discount or rediscount, bills of exchange (create money) — totaling $10 million.
|J.M. Keynes: the State creates money by fiat out of nothing.|
Keynesian money multiplier theory (disproved by Moulton — “How the Commercial Banking System Manufactures Credit,” Harold G. Moulton, The Formation of Capital. Washington, DC: The Brookings Institution, 1935, 77-84.) asserts that banks increase the money supply by lending reserves, using the reserves to back new demand deposits. The theory is that when checks are drawn on the demand deposits, the checks are deposited in another bank, and become reserves that the second bank then lends out, and so on (and on, and on).
|People create money by accepting valid contracts|
This neat little Keynesian multiplier theory, however, completely ignores the fact that 1) Checks do not qualify as reserves and 2) Checks are not retained by the accepting bank, but are presented for payment to the bank on which the checks are drawn through the clearinghouse system. As Moulton pointed out, there would thus be a continual transfer of existing money, but no new money creation.
Fractional reserve banking was originally intended to provide uniformity, stability and confidence in the bank’s promissory notes by providing a reserve currency of unquestioned standard value into which other forms of money could be converted. The reserves do not back other forms of money, but are a form of money into which other forms of money can be converted on demand.
Thus, asset-backed reserves would allow convertibility of the bank’s notes into legal tender currency (usually gold or silver). Limited supplies of gold and silver thereby restricted the amount of loans that commercial banks could make.
Given the legal tender status of paper currency and the virtually instantaneous accommodation available from a central bank to its member commercial banks, fractional reserve banking today acts as an unnecessary brake on development. It ties the creation of new money to existing accumulations of savings instead of to the present value of private sector capital projects that need financing. The fact that the U.S. dollars used as the reserve currency are backed almost entirely by government debt (bills of credit) instead of hard private sector assets further undermines the utility of fractional reserve banking.
“Excess reserves” can also have the undesirable and unintended consequence of encouraging unwise lending or imprudent investment by the bank. Excess reserves represent such a temptation in order to avoid having uncommitted assets lying idle. They thereby provide an incentive to channel money into speculative capital projects and secondary securities. This creates “bubble” markets and fuels inflation.
|Coin and currency are only one form of money.|
A reserve currency should consist of asset-backed coin, Federal Reserve Notes, or commercial bank demand deposits at the Federal Reserve. Given rediscounting of all qualified loans made by member banks and supplemented with open market operations in private sector securities issued by non-member banks, companies, and individuals, a 100% reserve requirement would result in an elastic and asset-backed reserve currency tied directly to the present value of existing and future marketable goods and services in the economy.
The money supply would increase in direct proportion to the increase in the present value of marketable goods and services in the economy, and decrease as the goods and services were produced, sold, and consumed, and the bills of exchange backing the money redeemed and cancelled. This would, everything else being equal, avoid both inflation and deflation, and result in a stable, uniform and elastic reserve currency sufficient to meet the needs of the economy in periods of growth and, if it should occur, avoid inflation during periods of contraction.
Termination of Monetization of Public Sector Deficits. A great deal of new, inflationary money enters the economy because the Federal Reserve purchases government securities in its open market operations.
|When the State creates money, money rules the State.|
This sort of thing effectively “monetizes” government deficits, rather than private sector production. In restoring the original discount powers of the Federal Reserve, Congress may wish to consider eliminating control of the money supply through the Federal Reserve’s Open Market Committee. This would discourage future monetization of federal budgetary deficits and would require that the Treasury sell securities directly in the capital markets to finance government debt instead of emitting bills of credit. The Treasury would thereby be forced to compete with consumers and speculators for the pools of existing savings, and oblige borrowers to assume the true cost of borrowing without subsidies or artificial manipulation of interest rates.
Eligible Shares. Under Capital Homesteading monetary reforms, to be eligible for Federal Reserve rediscounting privileges, loans made to ESOPs and other expanded ownership financing vehicles should only be used to acquire “full dividend payout, full voting shares,” with dividends tax-deductible to the corporation and fully taxable as any other source of consumption income to shareholders.
The shares should provide workers and other new capital owners with first-class shareholder rights, including the right to vote the shares on all matters subject to a shareholder vote. This reform would broaden and democratize the accountability system of the corporate sector, a goal impossible to achieve through public and private retirement systems or traditional institutional investors. It would also overcome the “closed system” of corporate finance by shrinking retained earnings while offering corporations a cheaper way (i.e., new stock issuances) to combine growth assets with new shareholders.
Finally, by adding transparency and greater management accountability to worker-owners and other shareholders, most ESOP abuses could be minimized. You’ll never eliminate all abuses, of course. Anytime someone really puts his mind to it, he can usually figure out a way to cheat others. The question is whether the system inhibits such behavior, or encourages it.