Five Levers of Change: Money and Credit

Today’s blog posting is adapted from the book, Economic Personalism, which you can get free from the CESJ website, or from Amazon or Barnes and Noble.

As we have seen in the previous postings on this subject, the meaning and purpose of life — becoming virtuous to become more fully human — requires that people have power. As a rule, to have power, people must have private property. In order to have private property and be secure in its possession, people must have access to the means of acquiring and possessing private property, and that requires access to the just and responsible use of money and credit.

How Commercial Banks Create Money

In the previous posting on this subject, we looked at the idea of money, notably the definition used by Louis O. Kelso.  Today we want to look at how people think the banking system operates as opposed to the way it actually does operate.

When the Chips are Down

Watching “cop shows” on television it is easy to get the impression that a police officer’s work is a constant round of burglaries, bar fights, “domestic incidents,” investigating crooked cops, murders, and (if it’s a comedy) lots of doughnuts.  Television cops (the funny ones, anyway) have a hunger for doughnuts that would shame Homer Simpson.

Usury Question and Answer

As loyal readers may have noticed, we like to get those softball questions to answer . . . you know, the kind from people who clearly don’t know what they’re talking about, but who “jus’ gotta” show somebody else up.  Next best, of course, are those who make a snarky comment asserting something that we know isn’t true.  Take for instance the following comment we got in response to someone coming across our ideas on monetary reform, i.e., interest-free money and the Banking Principle:

How Long?

Last week we got a very good question from a faithful reader.  It involved how long before we would start to realize the benefits of a Capital Homesteading program one it is enacted, and some of the details.  Pretty quickly, all things considered, as you’ll see from our response.  First, however, the question:

A Two-Tiered Interest Structure

The fun never stops around the Just Third Way.  One of the funnest things (our grammar is as good as Keynesian Modern Monetary Theory, “MMT”) is the absolute refusal of many commentators to realize that the Just Third Way, being based on the binary economics of Louis Kelso and Mortimer Adler, is not your usual past-savings based system.  It’s a past- and future-savings-based system.

A (Very) Short Discourse on Interest

It’s appropriate that we take a look at interest today, because the way interest rates have been manipulated in modern times is one of the biggest April Fool pranks in history.  Since the invention of central banking in 1694 with the institution of the Bank of England, the public has been mulcted by having to pay interest on the loan of “pure credit” (i.e., not based on past savings) money.

Some Notes on Discounting Acceptances

Believe it or not, the title of this posting is not gibberish — unless, of course, you are irrevocably stuck in the Currency Principle that underpins today’s three mainstream schools of economics, the Keynesian, the Monetarist/Chicago, and the Austrian.  In that case, none of this will make any sense at all to you.

"On Usury and Other Dishonest Profit"

Last week or so (it might have been two weeks ago) we came across a posting in a LinkedIn group to the effect that Pope Benedict XIV's 1746 teaching, Vix Pervenit ("On Usury and Other Dishonest Profit") "proved" — consistent with the poster's interpretation of the vaguely cited work of the solidarist Father Heinrich Pesch, S.J. — that all interest is forbidden by Catholic social teaching. Since the posting verged at times on the incoherent, we ignored it, although we were briefly tempted to respond.

Yesterday, however, we got a request from the "owner" of the Catholic Financial Professionals LinkedIn group (not where the posting appeared) to give our opinion on this understanding of Vix Pervenit. He had evidently come across the same or a similar posting, and thought that some discussion on the subject in a group that at least knew the fundamentals of money, credit, banking and finance might be more useful than the broad condemnation issued by people unfamiliar with the subject.

The main problem with condemnation is that Father Pesch's economics — and the social teachings of the Catholic Church, as well as Judaism and Islam — is based on Aristotelian philosophy . . . and Aristotle did not condemn all interest as usury.

Here's the thing. Discussion on Vix Pervenit pops up every couple of years, especially when economic conditions take a downturn. The problem is that most people lack the framework to understand what the document says. This is due to the general decline in understanding of Aristotelian/Thomism, especially with respect to private property, contract, and thus money and credit.

We have the claim that Vix Pervenit "proved" that all interest is usury, and therefore dishonest. On the contrary, "interest" — which comes from "ownership interest" — is, in classical economics, the profit due to the owner of capital. Consistent with the classical division of the factors of production into land, labor, and capital, "rent" is the profit for the use of land, and "wages" are the profits accruing to labor.

Consequently, to claim that all interest is usury and therefore dishonest is the same as saying that all profit from capital is dishonest — which we know is not the case, or the natural right of private property would be completely meaningless. "Property" is not the thing owned, but the natural right to be an owner, absolute and inherent in each human person, and the bundle of socially determined and necessarily limited rights that define the exercise of property within a specific society.

An important right of property is the right to receive the fruits of ownership — the "use" or the "usufruct." This means that the owner of a thing has a right to control the use of the thing, and to receive the benefit of its use, whether directly in the form of whatever the thing is used to produce, or indirectly by receiving the income generated by what is produced. If an owner lends a thing to be used by another, the owner is entitled to a share of the profits that result from the use of the thing — though not all, just a market-determined rate representing the owner's pro rata contribution to production by allowing the use of his or her capital.

Thus (avoiding the long argument showing the linkage between money and property), if someone has accumulated savings in the form of money, and lends the money to another to purchase capital or otherwise engage in an activity designed to produce a marketable good or service, the owner of the savings is, in moral philosophy, a partner of the borrower, and is entitled to share in the profits — and suffer the losses — resulting from the investment. This share is called "interest," and is a legitimate right of property.

It happens all too frequently, however, that investments do not pay off. Also, before the reinvention of commercial banking in the 16th century and the ability to monetize the present value of future production, which financed the Industrial Revolution, borrowing for investment (i.e., capital formation) was relatively rare. Most borrowing was for consumption, not investment.

Neither failed investments nor borrowing for consumption generate a profit. In that case, no profit is due to the lender. More, for a failed investment, the lender may even lose the principal lent, while for a loan for consumption, the lender is due in justice only what was lent. If the lender still insists on taking a profit in that case, he or she commits an injustice. This taking of a profit when no profit has been justly earned is called "usury," for by means of it, a lender of money exacts what he or she has not earned — because nothing has been earned. The profit taken is dishonestly gained.

Vix Pervenit was issued in the mid-18th century soon after the invention of central banking made commercial banking more sound, and thus an important factor in the economic growth that characterized the period and stimulated invention and expansion of commerce and industry. Unfortunately, the human tendency to try and get something for nothing led many people to manipulate the new financial institutions and contracts to circumvent traditional teachings on usury and take a profit at every opportunity, whether or not a profit was made.

Vix Pervenit was issued to clarify Church teaching on the difference between honest interest (profit) and dishonest interest in light of the advances that had been made in finance. This accounts, in part, for the extreme complexity, even confusing nature of the document for the modern reader.

Adding to the difficulty of understanding it is the fact that the document assumed as a given that all investment and spending is financed out of existing accumulations of savings. That is not, in fact, the case. Commercial banking — the oldest type of banking, dating back to the dawn of civilization — has a special function. A commercial bank is defined as a financial institution that takes deposits, makes loans, and issues promissory notes. A promissory note is an obligation that the bank issues when accepting a "bill of exchange." A bill of exchange is an offer of the present value of future marketable goods and services. It becomes "money" — a contract — when accepted.

Because a bill of exchange is not based on past savings (that is, savings already accumulated by cutting consumption), but on future savings (increases in production in the future), a lender, be it a bank or another business or individual who accepts a bill of exchange, is not due interest. Instead, the lender is due a fee for accepting the bill, based on the present value of whatever is to be delivered in the future, and a risk premium based on the creditworthiness of the drawer of the bill. This "discount rate" — which usually includes the risk premium — is the difference between the face value of the bill and its present value — again, not an interest rate because it is not based on a share of profits.

Thus, Vix Pervenit tried to address a system based on both past and future savings, but from within a framework that assumed that all loans came out of past savings. Nevertheless, the principles hold true, even if understanding them and applying them properly calls for a deeper analysis and understanding than the teaching is usually accorded by the simplistic modern commentator.

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The "Two-Tiered" Interest Rate, Part III: Some Effects

Some people, especially those on fixed incomes with a significant proportion of their assets (such as they are) invested in, e.g., government bonds, are quite properly worried about their security of income once Capital Homesteading is in place. This is a serious issue, and one that deserves a serious response.

Thus, when we say, "not to worry," we mean just that. True, most retired people would not realize as much as others from Capital Homesteading if it were enacted tomorrow. The benefits don't really start accumulating until you've been purchasing capital for a couple of decades or so. Capital Homesteading does not promote reinvestment of earnings (or, at least, discourages it), so that the "magic of compound interest," or earnings on earnings, does not operate. Consistent with Say's Law of Markets, income is meant to be consumed or used to retire acquisition debt, not accumulated to finance new capital.

There are, however, features of the monetary and fiscal reforms in Capital Homesteading that will greatly benefit those who have cut consumption and saved in the past, even if not in the future. First, of course, there will be a significant tax deferral on current income if existing investments are deposited in a Capital Homestead Account. A retired person might not be able to accumulate $1 million by taking his or her annual capital credit allocation, but could receive the same tax benefits on existing accumulations. And remember — the personal exemption under Capital Homesteading would be raised to an estimated $30,000 per non-dependent. Conceivably, many retired people living on modest incomes might not pay taxes for the rest of their lives.

But what about the fiscal reform that would prohibit the monetization of government deficits, and the proposal to repay the entire outstanding government debt within a generation?

Again, this is nothing to worry about. First, of course, when the government monetizes its deficits by issuing bonds that are purchased on the open market by the Federal Reserve, the currency is inflated, and the purchasing power of anyone on a fixed income is reduced, often even if the number of dollars he or she receives is increased. Wage earners and people on fixed incomes are always hurt to some degree by government deficits. The only people who benefit are owners of capital, who receive higher prices for fewer goods and services — a process Keynes called "forced savings," and relied upon to provide financing so that the rich can acquire even more capital at the expense of the poor.

What about when the government is unable to create money at will and set the interest rate? First, many people are unaware that Federal Reserve profits are not distributed to the nominal owners of the Federal Reserve — the member banks. Instead, profits are turned over to the U.S. Treasury. Effectively, the government pays a small service fee, sometimes not even that if the member banks have paid for services. The government can actually make a profit on Federal Reserve operations, and receive all of its funding for "free." The interest rate on government bonds sold to the Federal Reserve is irrelevant.

Second, under the two-tiered interest rate, the government will not only not be able to borrow from the Federal Reserve any more, whether directly or indirectly, but will have to go to existing accumulations of savings to borrow. Naturally, in accordance with the laws of supply and demand, this will drive the market rate of interest on existing savings very high — the government is a borrowing addict, and will not be able to stop cold turkey. That means that retirees and others invested in government bonds will see their incomes rise significantly as the government is forced to pay actual market-determined rates of interest on what it borrows in competition with all the other borrowers, including consumers, who will be cut off from money creation for anything other than financing new productive capital.

The foundation of this new system is found in Dr. Harold G. Moulton's The Formation of Capital (1935). The idea is that existing accumulations of savings are not a financially feasible source of financing for non-speculative capital investment, but should be used for consumption, including government spending and speculation. All financing for new capital that meets eligibility requirements (including widespread ownership) should be financed using the "pure credit" methods described in The Formation of Capital, and refined by Louis Kelso and Mortimer Adler in The New Capitalists (1961).

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The "Two-Tiered" Interest Rate, Part II: Using Money

As we saw in yesterday's posting, there are two views of money and credit, and thus two views of interest. Within the Currency School, all loans and investment come out of the "supply of loanable funds," and thereby determine the "production possibilities curve." In this view, the only source of investment and consumption funds consists of whatever has been withheld from consumption in the past and is now available for reinvestment. In some of today's schools of economics, if this supply is too large or businesses and consumers are not borrowing enough, the government lowers the interest rate to encourage investment and borrowing, and discourage saving. If the supply is too small, the government raises the interest rate to discourage investment and borrowing and encourage saving.

Within the Banking School, there are two sources of funds. Financing for sound capital investment can be obtained in any amount by drawing bills on the present value of future marketable goods and services, as long as the total of bills drawn does not exceed the present value of the future marketable goods and services (a process called "overtrading" that results in "fictitious," that is, fraudulent bills), and the bills are adequately collateralized. Strictly speaking, such "pure credit" loans (that is, loans not based on existing accumulations of savings) do not carry an interest rate. They carry a discount rate representing the present value of the bill at maturity (the time value of money), and a "risk premium" based on the soundness and creditworthiness of the drawer of the bill. As noted above, these bills can be used directly as money, or discounted at a commercial or central bank and exchanged for the promissory notes of the bank, a more convenient and recognized form of money.

The other source of funds in Banking School theory consists of the present value of existing inventories of marketable goods and services — existing accumulations of savings, if we define "existing savings" as "unconsumed marketable goods and services." Because this supply of funds is limited at any point in time, it can, in a sense, be treated as a commodity, and the interest rate (if allowed to do so) can respond to changes in the supply and demand for the pool of existing savings. If we are consistent with our pure theory, the existing supply of funds should only be used for consumption, government spending, speculation, and capital projects that have a low present value, even zero or less, due to the risk involved.

Thus, within the Just Third Way, pure credit loans should never bear interest, while loans made out of existing accumulations of savings should bear an interest rate reflecting market-determined levels set by the laws of supply and demand. Dr. Norman G. Kurland of the Center for Economic and Social Justice has formalized this understanding of the two sources of loanable funds in his proposed "two-tiered" interest rate. All loans made for sound capital investment by discounting bills drawn on the present value of the future goods and services to be produced by the new capital would not bear interest, being limited to the discount rate reflecting the time value of money, and a risk premium reflecting the creditworthiness of the drawer of the bill. All loans made for any other purpose must come out of existing accumulations of savings, either by cutting consumption and accumulating money savings, or by drawing bills on the present value of existing inventories of marketable goods and services. Such loans would bear an interest rate reflecting the market-determined cost of capital, plus risk premium, regardless for what purpose the loan proceeds were used.

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The "Two-Tiered" Interest Rate, Part I: Defining Money

One of the most serious financial problems today is how we understand money and credit, and thus banking and finance. This has led to massive government deficits, and financing consumption through an ever-increasing burden of consumer debt. Fueled by the belief that it is impossible to finance new capital formation — or anything else — except by cutting consumption, accumulating money savings, then investing, the financial system and the economy as a whole have come to rely on inflation and State price control of an increasing array of goods and services in a failing effort to keep the economy running by undermining its foundation.

What is money? Money is anything that can be used in settlement of a debt. Period.

As for credit, according to Henry Dunning Macleod, credit is simply another form of money (The Theory of Credit, 1894). Unfortunately, at present most authorities define money very narrowly, as coin, banknotes, demand deposits ("checking accounts"), and some time deposits ("savings accounts").

This understanding of money is based on almost universal acceptance of the principles of the "British Currency School" of finance. That is, "money" is restricted to State-issued claims on the present value of existing inventories of marketable goods and services. "Credit" — the "supply of loanable funds" — is limited to what has been accumulated in the past in the form of money savings by cutting consumption. A "bank" is defined as a financial institution that takes deposits and makes loans.

In Currency School theory, the backing of the currency (considered the same as the money supply) is limited to gold and silver (uncommon these days), and government debt. This permits the government to manipulate the value of the currency to achieve political ends through induced inflation and deflation, with the private sector faced with period shortages or surpluses of loanable funds. This in turn results in manipulating the interest rate in order to encourage or discourage private sector investment.

In contrast, the Just Third Way is based on the principles of the "British Banking School" of finance. In this "school," "money" is defined as "anything that can be used in settlement of a debt."

This is the legal and accounting definition of money, and implies that all money is a contract, just as all contracts are money, regardless of the physical form the money takes; currency (coin, banknotes) and currency substitutes (demand deposits and time deposits) are only one form of money. The bulk of the money supply consists of privately issued "bills of exchange" that are either used directly as money by their issuers and holders in due course by discounting and rediscounting until redeemed at maturity ("merchant's acceptances"), or discounted or rediscounted at a commercial/mercantile bank and exchanged for currency or currency substitutes in the form of promissory notes issued by the commercial bank ("banker's acceptances") — a bank being defined as a financial institution that takes deposits, makes loans, and issues promissory notes.

The commercial bank may, in turn, rediscount such paper at the central bank, thereby spreading the risk of default and ensuring a uniform and stable currency backed directly by the present value of private sector hard assets. Because both existing and future inventories of marketable goods and services have present value, the "supply of loanable funds" is not limited to the present value of existing marketable goods and services, but to the present value of any financially feasible capital investment plus existing inventories.

Thus, financing is, in theory, available for any sound capital investment by discounting and rediscounting bills of exchange based on the properly vetted present value of the marketable goods and services to be produced once the capital has been formed. This precludes manipulation of the interest rate in order to encourage or discourage private sector investment. There is exactly enough money in the economy to provide financing for all feasible capital investment. For all capital investment financed by creating money by discounting and rediscounting bills of exchange, the interest rate becomes moot.

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Interest-Free Money, Part IX: Reforms

The global economy is a system built to collapse. The stresses caused by the terrorist attacks on 9/11 merely exposed serious problems that had been building up for nearly two centuries. As advancing technology made labor redundant and cheaper labor in other parts of the world became increasingly accessible as a result of improvements in transportation systems, wages alone proved insufficient to provide adequate income.

The Root of the Problem

This would not have been a problem had not the belief in the necessity of existing accumulations of savings — achieved only by cutting consumption — to finance capital formation become accepted as a virtual religious dogma. This ensured that most people would have to rely on wages as their sole source of income at a time when technology was rapidly becoming the predominant factor of production. Only the rich have the ability to save by cutting consumption without suffering deprivation, so — as a general rule — only those who already owned the capital that was generating most production and thus income were and are able to own future capital.

The fact that the utility of existing accumulations of savings in financing new capital formation is problematical at best has made no difference. People (especially those with political and financial power) believed it to be true, and shaped the institutional environment — "the system" — to conform to that belief. As we have seen, however, the idea that new capital formation cannot be financed except by cutting consumption and savings does not conform to reality.

The flaws built into the system have thus resulted in a situation in which, to try and hold things together, those in power have extended their control over both politics and economics. While this has resulted in most people losing a great deal of control over their own lives, it has not brought about the hoped-for results.

In the political realm, the effort to try and keep the system functioning has resulted in increasing amounts of legislation attempting to impose results, rather than reforming the system itself so that it functions properly. Economically, this has resulted in seriously distorting monetary and fiscal policy to try and force the system to work against human nature and common sense.

Manipulation of the Rate of Interest

As one major example, almost exclusively due to the belief that only existing accumulations of savings can be used to finance new capital formation, the money creation powers of the Federal Reserve, the central bank of the United States (intended to be used to provide the private sector with adequate liquidity), have been used to finance government operations. To further this objective, interest rates — the share of profit due to owners of savings — on existing accumulations have been artificially manipulated, and imposed unjustly on pure credit loans when no existing accumulations were involved except as collateral or to provide reserves.

This method of funding government expenditures has deprived the private sector of this source of financing. In addition, misuse of the central bank by the State has resulted in a currency that is almost completely backed with government debt and "toxic" assets purchased to provide politically motivated price supports for failed stock market speculation. To encourage the savings that mainstream economists and the policymakers who rely on them believe are necessary to finance new capital formation, the tax system favors the concentrated ownership on which Keynesian economics relies, and treats property income differently from wage income.

Within the conceptual framework dictated by what Kelso and Adler called "the slavery of [past] savings," the State ends up trying to do everything. The role of the State expands from its legitimate job of policing abuses, enforcing contracts when there is a dispute over the terms, and in general providing a "level playing field" — in short, caring for and maintaining the common good — to attempting to care for each person's individual good.

The common good is not the aggregate of individual goods in society, nor is it goods that, for the sake of expedience, are owned "in common" by the State on behalf of the citizens. The common good is the one good that is common to all humanity: the analogously complete capacity to acquire and develop virtue, "virtue" being construed as "human-ness."

"Man is by nature a political animal." (Aristotle, The Politics, I.ii.) This means that the human person is an apparently unique combination of individual and social. He or she thus carries out the task of developing as a human being within the consciously structured framework of the polis, that is, the political unit. The common good, therefore, manifests itself as the complex network of institutions that make up "the system," and which is intended to assist each human being to develop more fully as a human person.

The State's job is therefore not to provide for each person's individual good, except as an expedient in a time of extreme emergency. Rather the role of the State is to ensure that each person has an equal opportunity to pursue his or her individual goods, assisting in this process by maintaining a justly structured institutional environment within the political unit under its purview.

Functional Overload

When the State goes beyond this legitimate but limited sphere of action, it rapidly approaches a condition of "functional overload." By trying to do everything, the State ultimately ends up doing nothing other than spreading chaos. As a result of the slavery of savings, methods of corporate finance and the tax system concentrate ownership of the means of production. This requires increasing levels of State control to keep the economy running until it takes on too much and implodes. In the meantime, the wealth gap increases, society decays, and extremism is heightened.

A less-than-modest example of the functional overload of the State is the colossal mess of Social Security and Medicare. These programs were "sold" to the American public as an emergency social safety net and, as such, never intended to provide the entire retirement package for everyone.

Prior to the September 11 attacks, according to the Washington Post, congressional estimates projected that the government would drain almost all the Social Security surplus to operate at current levels through 2011, "imperiling the retirements of the baby-boom generation." (Michael Grunwald, "Terror's Damage: Calculating the Devastation," The Washington Post, October 28, 2001, A12.) In the face of massive layoffs and economic displacement caused by the attacks, Congress must now consider in its budget debates the billions needed to cover the replacement of destroyed property, insurance losses, homeland security, rebuilding postwar Iraq and Afghanistan, and the massive cost increases caused by the various stimulus packages and bailouts. In the long-term, then-Federal Reserve Chairman Alan Greenspan warned that the demand for added security will force firms to cut back on employment and productive activities such as research and capital investment. (Ibid.) That this has taken place in the present "Great Recession" is obvious.

The bipartisan Presidential Commission on Social Security issued its final report, Strengthening Social Security and Creating Personal Wealth for All Americans, on December 11, 2001. The report concluded: "Social Security is in need of an overhaul. The system is not sustainable as currently structured. . . . (p.7)" While the commission members agreed on the use of Private Savings Accounts (PSAs) to allow Americans to invest in the stock market a portion of their Social Security funds, they were unable to offer a unified set of recommendations. There was no consensus on what percentage of Social Security assets should be put into publicly traded securities. It was also assumed that there was no better way for workers to invest than to place their wages and savings in the stock market (mainly via mutual funds). Even more important, as many commentators observed, the commission failed to recommend any significant structural reforms for maintaining the long-term viability of Social Security.

Flawed Assumptions

At the inception of the Social Security program in 1936, the United States Government promised explicitly, "What you get from the Government plan will always be more than you have paid in taxes and usually more than you can get for yourself by putting away the same amount of money each week in some other way." (Social Security Board, "Security in Your Old Age" Washington, DC: Government Printing Office, 1935.) Unfortunately and predictably, however, the increase in benefit obligations over time has made the original promise unsupportable, even though today 76% of Americans pay more in payroll taxes than they do in federal income taxes. (Michael Tanner, "Privatizing Social Security: A Big Boost for the Poor," report by the Cato Project on Social Security Privatization, July 26, 1996, SSP No. 4, p.8.)

The basic problem even with the solutions is obvious. Everyone assumes as a given that the only way to finance new capital formation is by cutting consumption, saving, then investing. This automatically shuts out from ownership anyone who does not have enough income to meet current consumption needs, as well as those who, even if not in debt (a very rare condition these days) cannot afford to reduce consumption and suffer a decline in the standard of living. Clearly what is needed is a program by means of which people without savings can invest without cutting consumption.

Capital Homesteading for Every Citizen

The Capital Homestead Act is a comprehensive national economic strategy for empowering every American citizen, including the poorest of the poor, with the means to acquire, control and enjoy the fruits of productive corporate assets. This long-range agenda involves major restructuring of our tax system and our Federal Reserve 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.

The Capital Homestead Act's central focus is the democratization of capital (productive) credit. By universalizing citizen access to direct capital ownership through access to interest-free productive credit, it would close the power and opportunity gap between today's haves and have-nots, without taking away property from today's owners.

The Capital Homestead Act is designed to: 1) Generate millions of new private sector jobs by lifting ownership-concentrating Federal Reserve credit barriers in order to accelerate private sector growth linked to expanded ownership opportunities, at a zero rate of inflation. 2) Radically overhaul and simplify the Federal tax system to eliminate budget deficits and ownership-concentrating tax barriers through a single rate tax on all individual incomes from all sources above basic subsistence levels. Its tax reforms would: a) eliminate payroll taxes on working Americans and their employers; b) integrate corporate and personal income taxes; and c) exempt from taxation the basic incomes of all citizens up to a level that allows them to meet their own subsistence needs and living expenses, while providing "safety net" vouchers for the poor.

The basic interdependent components of the Capital Homestead strategy are like the legs of a three-legged stool:

Democratization of productive credit. Capital Homesteading would reform monetary policy to conform to the goal of sustainable, market-oriented, non-inflationary growth. The new policies would aim at an immediate reduction in prime supply-side credit charges to 3% (without subsidies) for private-sector investment, through a two-tiered credit policy. Central banks would:

(a) Be restrained from further monetization of deficits or encouraging other forms of non-productive uses of credit (i.e., demand-side credit), which would then be forced to seek out already accumulated savings at market interest rates; and

(b) Use the Fed discount mechanism exclusively for discounting, at low discount charges but subject to a 100% reserve requirement, "eligible" industrial, agricultural and commercial paper financed through its member commercial banks. This reform would synchronize the supply of real money with real growth of the economy. It would provide, from the bottom-up, an asset-backed currency reflected in more efficient instruments of production and keep basic economic decisions and corporate accountability in local hands.

Simplification of tax systems. Capital Homesteading reforms would be centered around taxing incomes from all sources (above poverty levels) at a single rate. This would offer a universal yardstick for political hopefuls to compete against, and a direct means for:

(a) Balancing national budgets and restraining overall spending, including social security and Medicare programs;

(b) Ending the use of the tax system to circumvent the appropriations process; and

(c) Eliminating double taxation of profits in ways that maximize greater savings and investments in new plant, equipment, rentable space and infrastructure, plus removing other taxes that discourage expanded capital ownership as a basic pillar of national economic policy.

Linkage between all tax and monetary reforms to the goal of expanded capital ownership. This would encourage every citizen to share directly in the equity growth and profits from our ever-expanding high-technology frontier, and would insure the broadest possible base of private sector stakeholders (and thus political supporters) of reforms affecting "green growth" policies.

In contrast to mounting social security deficits, this strategy would create for every voter a "Capital Homestead Exemption" for accumulating over his or her working lifetime an income-producing, tax-sheltered personal estate of up to $1 million, a modern equivalent of the 160 acres of land that government made accessible to American pioneers.

Citizens would accumulate their Capital Homestead shares in many ways, including such "credit democratization" vehicles as: Employee Stock Ownership Plans (ESOPs); Capital Homestead Accounts (CHAs); Consumer Stock Ownership Plans (CSOPs); and Citizens Land Cooperatives (CLCs). These high-powered financing vehicles would systematically close the wealth and income gap by linking all new monetary and tax incentives for productivity growth under the proposed Capital Homestead strategy, with an ever-expanding base of empowered citizen-shareholders.

Effects of Capital Homesteading

Capital Homesteading will have an immediate effect on the economy. This is because the new capital goods, as Harold Moulton pointed out in The Formation of Capital, are only capital goods to the purchaser — they are consumption goods to the seller. Thus, the immediate effect on the economy in the first year of Capital Homesteading would be a per capita increase in effective demand of approximately $7,000, despite the fact that the Capital Homestead borrower will only get a few dollars, if that, at the end of the year in the first year.

If the government continues to create money backed only by future tax revenues to finance its deficits, we would expect to see moderate-to-high inflation, but the Capital Homesteading program includes cutting off the government from access to the Federal Reserve. What should happen is that the cash that companies have accumulated to finance new capital formation will be distributed as dividends, and treated as tax deductible at the corporate level.

These dividends will, in justice, be paid to the currently wealthy with their virtual monopoly on individual share ownership, and on which they will pay taxes as on regular income. If the rich spend their dividend income, this will generate the consumer demand that drives the demand for capital goods, thereby creating jobs.

If the rich do not spend their dividends, they will have to locate some investment to "park" their surplus . . . yet the capital needs of private sector companies are, presumably, being met completely by Capital Homestead financing. Dividend recipients will either have to find some speculative start-up — or a "safe" investment.

Given that the government will not be able to monetize its deficits, it will be very hungry for funds, and will very likely be the largest borrower of the initial unconsumed dividend payouts that go to the currently wealthy after being taxed as regular income. By draining this "excess effective demand" out of the economy by borrowing and taxing, the government should prevent inflation, even cause a lowering of the price level through a temporary deflation. This will benefit people on fixed incomes, as many of them have invested in government securities as the "safest" investment around. The government will not be able to set the market interest rates any more through its control of the Federal Reserve, and thus retiree income should increase at the same time that the decrease in the price level makes their money go further.

Once private sector companies can discount their paper backed by existing inventories either among themselves ("B2B") or at a commercial bank or even, through legitimate open market operations — as originally intended under the Federal Reserve Act of 1913; it wasn't for government securities — at the Federal Reserve, there will be no question of a permanent deflation, or lack of an adequate money supply. Private companies will simply take advantage of what the Federal Reserve was set up to do in the first place: monetize existing inventories of marketable goods and services through rediscounting and open market operations in privately issued paper, not government bills, thereby providing an "elastic" currency that expands and contracts with the amount of existing marketable goods and services in the economy.

Consistent with Say's Law, private companies that can produce in the near future or have on hand existing supplies of marketable goods and services will, in a sense, create their own money by drawing short-term (90-day) bills (issuing private promissory notes) and either discounting and rediscounting among themselves in high denominations (the lowest denomination of such commercial paper is typically $100,000; $1 million or more is not unusual, there is also a classification for paper denominated in billions now, or, to create money in a form that can be used in day-to-day transactions, discount the paper at a commercial bank in exchange for banknotes (rare, these days) or a demand deposit. Since this type of paper would be based on existing inventories that are already owned and not on future new capital formation that does not yet have an owner, as well as being short-term, the commercial banks should be able to rediscount the paper at the Federal Reserve without the expanded ownership requirement.

Moulton's proposal in the 1930s was not to limit central bank rediscounting and open market operations to monetizing existing inventories, but to finance future new capital formation — financed at the present value of future marketable goods and services to be produced by the new capital — the same way: by rediscounting qualified paper for capital investment for terms of up to five years, not just short-term (90-day) commercial paper backed by existing inventories or the general credit-worthiness of the issuer. Kelso and Adler improved on this by adding that the new capital financed in this way must be broadly owned by people who currently own little or nothing in the way of capital, and adjust the term of the note to make the capital purchase financially feasible.

The bottom line is that, fueled by "interest free money" that does not depend on existing accumulations of savings financing the acquisition of capital by people who currently own nothing, the global economy could conceivably be well on its way to recovery within three months of the passage of the Capital Homestead Act, and make a full recovery within 18 months. Within three to seven years it should be possible to reach the unattainable Keynesian goal of "full employment" — not of labor alone, but of all resources and productive capacity, including labor.

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Interest-Free Money, Part VIII: Good Credit v. Bad Credit

As we saw in the previous posting, a basic shift in the understanding of money and credit early on had a significant influence on how we understand the proper use of these uniquely social institutions and the role of existing accumulations of savings in financing new capital formation. As a result of the idea that "saving" consists exclusively of cutting consumption, the belief grew that money as money is somehow productive, and that interest is somehow the charge for the use of money, rather than a sharing in the profits of a productive enterprise. In consequence, lenders began asserting that, regardless whether the loan of money is put to a productive or non-productive use, the lender is due a fee for the use of the money.

Good Credit v. Bad Credit

This blurring of the distinction between different types of loans has led to the failure to distinguish between "bad" uses of credit and "good" uses of credit. To those with accumulated savings, all uses of credit are "good" because all yield a profit. To those without accumulated savings, naturally enough, all profit therefore tends to become bad.

This did not happen overnight. During the Middle Ages the idea had grown up that "good" doesn't consist of what we can figure out about God's Nature (Intellect) by observing humanity, but in the carrying out of what we believe to be God's commands revealed to us in some fashion. The basis of the natural law thereby shifted from God's Nature or "Intellect" (which by definition is unchanging) to whatever people believe to be an expression of God's Will, usually the Bible — and people's interpretations of anything, but especially the Bible, tend to experience a very high degree of change, as ministers, psychiatrists, and politicians are well aware.

Prior to the Reformation, with varying degrees of success, the three great Abrahamic faiths had uniformly and consistently condemned something called "usury." In Christendom, the authority of the pope backed up by the Magisterium (as the body of official Church teachings is called) supported the ancient ban on usury, which began at least as far back as Aristotle. As late as 1745, Pope Benedict XIV, the head of the Catholic Church, issued an encyclical titled "On Usury and Other Dishonest Profit."

What is "usury"? The easiest (and most correct) way to understand usury is in terms of "good credit" versus "bad credit." Aristotle's definition of usury, which is the systematized basis of the ban on usury in the three Abrahamic faiths (although not restricted to them, as we shall soon see), is straightforward. Usury is the taking of a profit from something that does not, by its nature, generate a profit:

Now money-making, as we say, being twofold, it may be applied to two purposes, the service of the house or retail trade; of which the first is necessary and commendable, the other justly censurable; for it has not its origin in nature, but by it men gain from each other; for usury is most reasonably detested, as it is increasing our fortune by money itself, and not employing it for the purpose it was originally intended, namely exchange. And this is the explanation of the name, which means the breeding of money. For as offspring resemble their parents, so usury is money bred of money. Whence of all forms of money-making it is most against nature. (The Politics, I.x)

As a result of the "usury war" we are about to relate, many translations substitute "interest" for "usury." The Medieval interpretation of what Aristotle said, however, was not that interest is wrong (for interest consists of taking a share of real profits), or that retail trading in goods in which a merchant sells for more than he or she paid is wrong (for that is providing a necessary and valuable service, and should, in justice, be compensated). What is wrong is dealing in money as a commodity or charging rent for it, or buying and selling goods in the hope of gaining by a change in the price (speculation). Charging for the use of money as money is what Aristotle condemned, not taking a share of the profits from a productive project financed by money that is lent by its owner.

Productive v. Non-Productive

Thus, lending money to finance capital formation is "good credit." Lending money to spend on consumption, speculation, or to cover government deficits is "bad credit." Taking interest on a loan of money used to finance capital formation is legitimate, as the interest represents the lender's just share of profits. This is due him or her in justice for contributing to the financing of the project out of his or her existing accumulation of wealth. As long as it is not excessive, that is, constitutes more than what the lender is due as his or her fair share, taking interest does not constitute usury or any other form of unjust profit.

Every culture oriented in accordance with the natural law has condemned usury, although this has been most strongly expressed in Hinduism, Buddhism, and the three Abrahamic faiths: Judaism, Christianity, and Islam. Ancient Vedic (Hindu) texts from India dating back 3,500-4000 years make several references to the Kusidin, or "interest taker," (Lakshmi Chandra Jain, Indigenous Banking in India. New York: Macmillan and Company, 1929.) although it seems clear that by "interest" is meant usury, for lending for a productive project was virtually unknown in the ancient world, east or west; "interest" is a poor translation.

Hindu Sutras from around 700-100 BC, and Buddhist Jatakas from 600-400 BC go into more detail and make it clear that the usurer was universally excoriated. The Hindu priestly and warrior castes were forbidden to engage in usury. The Laws of Manu from the second century AD refine the concept in a way that suggests that there can be legitimate interest taking, though not in excess, describing anyone who takes excessive interest as partaking of "pus and urine." (The Laws of Manu. London: Penguin Books, 1991.)

Monotheism and Usury

Judaism was strict on usury, at least in its teachings. The fact that there are so many prohibitions expressed against the practice suggests that it was as widespread as it was condemned. (Exodus 22:25; Leviticus 25:36-37; Deuteronomy 23:19-20.) Again, however, this is not a condemnation of profit, but of unjust profit, that is, taking a profit when no profit is generated.

The Islamic prohibitions against usury are very clear on the distinction between good credit and bad credit. Still, the Islamic attitude toward interest and usury puzzles people today unfamiliar with economic and philosophical history. There is a general refusal to take usury, or "riba," but usury is clearly distinguished from interest.

This requires a little explanation, for Islamic thought in this area is advanced and rather sophisticated, although fundamentalists have tended to obscure the Prophet's common sense teachings on the matter. There are two types of riba. The first is prohibited in the Qu'ran, and consists of an increase in financial capital without any services being provided. The second is prohibited in the Sunnah, and consists of commodity exchanges in unequal quantities. Both are obviously instances of taking a profit when no profit has been generated. Yet again, it is unjust profit-taking that is forbidden, not a just profit:

Those who charge usury are in the same position as those controlled by the devil's influence. This is because they claim that usury is the same as commerce. However, God permits commerce, and prohibits usury. Thus, whoever heeds this commandment from his Lord, and refrains from usury, he may keep his past earnings, and his judgment rests with God. As for those who persist in usury, they incur Hell, wherein they abide forever. (Al-Baqarah 2:275.)

Condemnations against riba (as distinct from interest) are manifold in the Qu'ran:

God condemns usury, and blesses charities. God dislikes every disbeliever, guilty. Lo! those who believe and do good works and establish worship and pay the poor-due, their reward is with their Lord and there shall no fear come upon them neither shall they grieve. O you who believe, you shall observe God and refrain from all kinds of usury, if you are believers. If you do not, then expect a war from God and His messenger. But if you repent, you may keep your capitals, without inflicting injustice, or incurring injustice. If the debtor is unable to pay, wait for a better time. If you give up the loan as a charity, it would be better for you, if you only knew. (Al-Baqarah 2:276-280.)

O you who believe, you shall not take usury, compounded over and over. Observe God, that you may succeed. (Al-'Imran 3:130)

And for practicing usury, which was forbidden, and for consuming the people's money illicitly. We have prepared for the disbelievers among them painful retribution. (Al-Nisa 4:161)

The usury that is practiced to increase some people's wealth, does not gain anything at God. But if people give to charity, seeking God's pleasure, these are the ones who receive their reward many fold. (Ar-Rum 30:39)

Clearly, just as in Judaism, the problem of usury in Islam was widespread, but was nevertheless looked upon as vile, being universally condemned. Nor were matters any different in Christendom, and, before that, in Paganism. (See, e.g., Plutarch's essay, "Against Borrowing Money," available in Selected Essays and Dialogues. Oxford, U.K.: Oxford University Press, 1993.) The urge to take a risk-free profit, whether or not it is due in justice, is evidently very strong, regardless of your religious beliefs or lack thereof.

The problem is that nobody likes to be told he is doing wrong . . . especially when the wrongdoing is extremely profitable. In common with the modern urge to get rid of the guilt instead of the reason for the guilt, the Medieval proto-capitalist and usurer didn't want somebody sitting on a throne a thousand miles away in Rome condemning him.

The Effect of the Reformation

There were thus two very good economic reasons for "throwing off the yoke of Rome" in the 16th century. One, the Catholic Church's insistence on the personal sovereignty of each individual person prevented, or at least inhibited or ameliorated the drive to centralized, totalitarian rule by the political elite. Two, the Catholic Church's prohibition against taking a profit when no profit is generated interfered with the power of the rising moneyed classes to make as much of it as possible while risking as little as possible. Due to the false assumption that existing accumulations of savings are necessary to finance capital formation, combined with the demand for collateral in the form of existing wealth, the "new men" already had a virtual monopoly on all future ownership of the means of production.

Even before the Reformation the new doctrines of divine right and the incapacity of ordinary people to look after their own interests had resulted in an increasing concentration of ownership of land, the chief productive asset of the time. In Utopia (1516), Thomas More's biting satire on the abuses of the natural law prevalent in Tudor England, mocked the increasing trend toward concentration of ownership.

In several places in the first and second books of Utopia, More declared that the Utopians had carried Tudor policy to its logical conclusion and abolished private property. This has weirdly been reinterpreted by modern academics as advocating the very thing that More was satirizing! (Paul Turner, "Introduction" to the Penguin Books edition of Utopia. London, 1965, 11-12, 13.) Significantly, More put the whole story in the mouth of the "narrator" Raphael (One of the great philosophical problems of the Middle Ages was Raphael the Archangel, a patron of travelers, who tells a lie and deceives Tobit as to his origin and identity.) Hythloday, whose name signifies "Lying Traveler Who Speaks Nonsense." (Turner, op. cit., "Hythlodaeus means 'dispenser of nonsense." 8.)

As a lawyer as well as a student of the "new learning," More (as well as his readers) was fully aware that private property is the basis of civil society. To abolish private property was, as far as the people of that time were concerned, raving insanity. More's point, of course, was that the Tudor policy of concentrating ownership of the means of production was effectively the same as abolishing private property for the great mass of people, and, by destroying their livelihood by clearing agricultural land to raise sheep for the staple, destroying them. This was not only by giving people a justification for theft out of necessity, turning ordinarily honest people into thieves, but by taking away their means of making a living:

"But I do not think that this necessity of stealing arises only from hence; there is another cause of it, more peculiar to England." "What is that?" said the Cardinal: "The increase of pasture," said I, "by which your sheep, which are naturally mild, and easily kept in order, may be said now to devour men and unpeople, not only villages, but towns." (Thomas More, Utopia. New York: Alfred Knoph, Inc., 1992, 26.)

Today's interpretation of what may be one of the most important points in More's book would, in all probability (and taking into account his well-known love of a good joke) have reduced him to helpless, if wondering, laughter. (See the Lives of Saint Thomas More by William Roper and Nicholas Harpsfield, published in a single volume in Everyman's Library, London: J. M. Dent and Sons, Ltd., 1963.)

Usury, of course, is closely related to private property, but represents a serious distortion of the concept. The Catholic Church carefully distinguished between loans for consumption and investment in productive endeavors, the latter being legitimate and a positive good for individuals and the social order. This, however, did not satisfy the greed of those supporting the reformers. As one authority noted,

The denial of the legitimacy of interest was a natural evolution from conditions of the time. The rigors of the church were directed primarily against loans for consumption to persons in need. When saved capital was the exception, and opportunities for organized industry were rare, loans for productive purposes were the exception. When the time came for escaping the restrictions of the canonical laws, several ways were found of doing so. Already, as early as the thirteenth century, Albert le Grand conceded that "if usury is against the perfection of Christian law, it is at least not contrary to civic interests." Even St. Thomas admitted the loss resulting (damnum emergens) to the lender who was kept out of his money, and the interval of time and the value lost (quantum ejus intererat) gave birth to the word interest as a substitute for usury (usura). (Charles A. Conant, A History of Modern Banks of Issue. New York: G. P. Putnam's Sons, 1927, 14-15.)

Risk Sharing v. Risk Elimination

Getting out from under the censuring eye of Rome, the political and economic powers that backed the reformers were now free to demand a profit on a loan of money, regardless of the purpose of the loan. Just as is the case today, a loan of money for consumption was often preferred over a loan for productive purposes. A loan for a productive project was, being construed as a type of partnership, frequently non-recourse in effect, even if such was not specified in the loan agreement. This was because if a loan made for a capital project went into default, it was due to the fact that the project turned out to be worthless along with the collateral, or at least not quite as profitable as projected. Consequently, the lender shared in the loss just as he or she would have shared in the gain.

A loan for consumption purposes, on the other hand, left a borrower's collateral intact, as it was not at risk in a business. Further, a borrower for consumption purposes intended and generally had to prove that he or she could repay the loan out of his or her other resources, making it indifferent for what purpose the loan was made. Thus, a loan made for consumption purposes was, paradoxically, considered more certain than a loan made for a capital project that was intended to generate its own repayment and be subject to the risks of the market.

Consequently, both the political and the economic elites had good reasons for supporting the religious changes of the Reformation. There was sufficient flexibility in the new religious doctrines, especially those rooted in personal interpretation of Scripture, to allow anyone with a plausible argument to force through a desired change, especially if the change happened to be politically or economically to the advantage of the one pushing for the change. The eventual effect was that divine right theory undermined the idea of personal sovereignty and human dignity directly, while the new acceptance of usury undermined private property for the great mass of people, further eroding personal sovereignty and human dignity.

This was in spite of the fact that, by and large, the first generation of reformers made no essential changes in traditional moral philosophy, especially with respect to usury. (See, e.g., Martin Luther's A Treatise on Usury (1520) and On Trading and Usury (1524)) Instead, the changes in such areas as political philosophy and economics only began to make their appearance after people like Luther, Melancthon, and Zwingli, even Henry VIII Tudor, had passed from the scene. These men were, if anything, much more stringent and narrow in their interpretations of traditional moral philosophy than Rome had ever been, if only to allow them to demonstrate the alleged "laxity" of Rome in these matters and justify their break with the body of the Church.

Bending to Presumed Economic and Political Necessity

The problem, however, was that subsequent generations of reformers were in large measure far more dependent on the political and economic powers than their predecessors or Rome had ever been. At the start of the Reformation, the political and economic elite needed the support of the religious reformers to justify their political and economic break with the Empire and the Church. Afterwards, however, the reformers needed the politicians and the rich far more than the politicians and the rich needed the reformers.

There were reformers of the reformed churches, of course, who sought to return to the purity and faith of the original reformers, which they believed to be more consistent with primitive Christianity. The effect of these later reformers, however, was to foster the growth of non-conformist groups at odds with the new legally-established churches under the official control of the head of State, which then created their own conformity, and their own reformers, and so on.

Consequently, not only were there more political theories floating around than you could shake a stick at, views on finance, especially usury, were all over the map. Which view was accepted depended on who had the power to force his or her views on the rest of society — and that meant the political and economic elite, who could (as might be expected) be counted on to promote and maintain whatever theory gave them the most political and economic power over others.

It comes as no surprise that Sir Robert Filmer, who so avidly supported the divine right of kings, also came out strongly in favor of the idea that usury — bad credit — was no longer wrong, unless it exceeded just bounds . . . ignoring the question as to how taking a profit when there had been no profit generated could ever be just, regardless of the amount. That is, it is permissible to take interest on a loan of money as money, only don't exact too much. (Sir Robert Filmer, Quaestio Quodlibetica, or a Discourse, whether it may be lawfull to take Use for Money (1653).) Filmer was harshly criticizing a tract by Roger Fenton, a Bachelor of Divinity, who published A Treatise of Usurie in 1611. Reverend Fenton's treatise accurately defined usury in Aristotelian terms, demonstrating a much more thorough grasp of the subject than Filmer:

In the loane of money (of which principallie it is my purpose to write, being the most usuall and proper for these parts) be it thus concluded out of the premises; That gain or lucre which commeth not merely for loane; (such loane, which is before described) is no usurie. For the object of usurie is mutuum. It is no usurie, I say, if it be for other respective considerations, and not meerely for loane.

A man unskilfull in trading hath a stock of money, which he delivereth to a merchant or tradesman to imploy: receiveth part of gaine, and beareth part of hazard proportionably. This is no usurie, but partnership. No usury, because his money is not lent by mutuation, so long as he reserveth a propertie in it himselfe, in contracta societatis cessat obiectum usurae mutuum. In like manner the stocke of a widow or an orphant is in trust committed to a friend to imploy and use it in charitie, onely to their use: they have the benefit of the increase; which is no usurie; because the money is still theirs, it prospereth or perisheth to them, as to the right owners. (Robert Fenton, A Treatise of Usurie (1611), I.iiii.3.)

There were also commentators claiming that all interest is usury (Philippus Caesar (Philippus Caesar, A General Discourse Against the Damnable Sect of Usurers (1578). Also Sir Thomas Culpeper, A Tract Against Usurie (1621).)), and that no interest is usury (John Dormer (John Dormer, Usury Explain'd, or, Conscience Quieted in the Case of Putting out Mony at Interest (1695). Also Sir Francis Bacon, On Usury (1625).)). In the end, though, it didn't matter what the divines and philosophers said. Having the power (which, as Daniel Webster was to state a few centuries later, naturally and necessarily follows property (Massachusetts Convention of 1820.)), the rich were in the position to be able to dictate whatever truth was most expedient for them.

In this they were helped immensely by the fixed idea that capital formation cannot be financed without first cutting consumption and saving, or (better) having far more income than can be consumed. When their capital produces far more income than they can consume, the rich are "forced" to reinvest the excess in yet more capital, or, more accurately, leave retained earnings in a business. This provides a greater store of collateral that can be used to secure the financing for more capital, and so on, at an accelerating rate. This, in turn, creates yet more income that cannot be consumed, concentrating ownership ever more closely in fewer and fewer hands. As Karl Marx observed, capital breeds capital:

Capital is money: Capital is commodities. [Capital is only money or commodities in the sense that money is a derivative of production and consists of anything that can be used in settlement of a debt, or (to put it another way) can be used to purchase goods and services, that is, "financial capital." Properly speaking, capital means assets that produce a good or service, and thus "brings forth living offspring" in the sense that it generates its own repayment, and provides the collateral for further capital expansion.] In truth, however, value is here the active factor in a process, in which, while constantly assuming the form in turn of money and commodities, it at the same time changes in magnitude, differentiates itself by throwing off surplus-value from itself; the original value, in other words, expands spontaneously. For the movement, in the course of which it adds surplus value, is its own movement, its expansion, therefore, is automatic expansion. Because it is value, it has acquired the occult quality of being able to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs. (Karl Marx, Das Kapital (1867), I.iv.)

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Interest-Free Money, Part VII: A Brief History of Banking

"Money and Credit are essentially of the same nature; Money being only the highest and most general form of Credit." (Henry Dunning Macleod, The Theory of Credit. Longmans, Green and Co., 1894, 82.) In this way Henry Dunning Macleod, a nearly forgotten lawyer-economist, summarized his theory of credit. He idea was that negotiable credit instruments are a form of money, and that credit instruments preceded coinage or any other form of currency as money.

Obscuring Unpopular Truth

Why Macleod's theories remain obscure to this day is easy to understand — and it has nothing to do with the validity of his theories. He was a Scot, writing about economics and finance in a United Kingdom dominated by the Currency School and its crowning achievement, Sir Robert Peel's Bank Charter Act of 1844. He was also not the most facile writer. His books are probably unnecessary verbose, getting into the thousands of pages for ideas that probably could have been handled in much less space. As an adherent of the British Banking School (below), the public was not conditioned to accept his ideas, despite the inherently more egalitarian orientation of the Banking School than that which characterized the Currency School.

Consequently, using a tactic that was later employed against the Binary Economics of Louis Kelso and Mortimer Adler with indifferent success, the economics establishment was able to dismiss Macleod without actually having to do anything to disprove his ideas. As Joseph Schumpeter described the situation,

Many economists of the seventeenth and eighteenth centuries had had clear, if sometimes exaggerated, ideas about credit creation and its importance for industrial development. And these ideas had not entirely vanished. Nevertheless, the first — though not wholly successful — attempt at working out a systematic theory that fits the facts of bank credit adequately, which was made by Macleod, attracted little attention, still less favorable attention. (Joseph A. Schumpeter, History of Economic Analysis. New York: Oxford University Press, 1954, 1115.)

As Schumpeter footnoted the above comment, "Henry Dunning Macleod (1821-1902) was an economist of many merits who somehow failed to achieve recognition, or even to be taken quite seriously, owing to his inability to put his many good ideas in a professionally acceptable form. Northing can be done in this book to make amends to him, beyond mentioning the three publications by which he laid the foundations of the modern theory of the subject under discussion, though what he really succeeded in doing was to discredit this theory for quite a time: The Theory and Practice of Banking, 1855, Lectures on Credit and Banking, 1882; The Theory of Credit, 1889-91."

Evidently the spite exhibited by academic economists is not a recent phenomenon. (In this context the refusal of both Milton Friedman and Paul Samuelson to give serious consideration to the theories of Kelso and Adler are worthy — if that is the word we want — of note.) Macleod's revolutionary theory was that the idea of money developed out of credit, not the other way around. As we saw in the discussion on the real bills doctrine, this is obviously based on an application of Say's Law of Markets. (Say, Letters to Malthus, loc. cit.)

The Origin of Money

Not surprisingly, once we accept the possibility that "money" developed out of credit instead of vice versa, a great many otherwise difficult questions become easy to solve. Two questions head the list. One, there is the problem of matching the money supply to the quantity of goods and services offered in the market. Two, the problem of ensuring that the promise retains its value, that is, the value of the promise remains stable and sound.

Credit is simply the capacity to make and keep promises to deliver something of value — convey a property right — on demand or at some specified time. If what we promise to deliver — a marketable good or service — is backed by the ability to deliver that which we promised, then our credit is good. If anyone who produces a marketable good or service has the power to promise to deliver that which he or she produces, then there will always be sufficient credit to take care of all transactions and the credit will have a stable value.

Coined money, that is, lumps of gold and silver stamped by an authority that people trust, fills the need for a convenient form of credit that serves the needs of a limited economy more or less adequately. That is, specie (gold and silver) fills this role adequately, or at least as long as economic growth and the supply of gold and silver expand and contract more or less together. Usually this describes an economy in the primitive stages of development in which human labor is the predominant factor of production.

Coined money, however, although it appeared at roughly the same time in the west and the east, was a relative latecomer on the scene. Once we know what to look for — credit instruments — we find that money in the form of negotiable instruments was a regular feature of civilization centuries before the appearance of the first coin. Dating from before the days of the construction of the pyramids until well into Roman times, for example, a huge amount of papyri — written records — from Egypt involve agreements that can loosely be categorized as bills of exchange. A bill of exchange is a contract conveying a property right in the present value of a marketable good or service, broadly, a promissory obligation for the payment of money. ("Bill," Black's Law Dictionary. St. Paul, Minnesota: West Publishing Company, 1951.)

These documents are so numerous, in fact, that some Egyptologists who are unaware of the wealth of detail such documents convey about everyday life have been known to complain about the volume of material. Yet, "Literary papyri, whether representing lost or extant works, of course form but a fraction of what has been found." (Vide A. S. Hunt and C. C. Edgar, translators, Select Papyri in Three Volumes, I: Non-Literary Papyri, Private Affairs. Cambridge, Massachusetts: Harvard University Press, 1988, x-xiii.)

Nor was ancient Egypt an isolated case. Possibly as early as three thousand years ago, Assyria had a well-developed system of commercial instruments. These included many of the modern forms, such as promissory notes, bills of exchange, and transfer checks. (Conant, op. cit., 1.) (In a sense, all negotiable instruments are different forms of bills of exchange, including coined money, which presumably carries the commodity being conveyed along with the bill itself.) As this was before coined money, the instruments usually stipulated payment in terms of commodities, but that does not make them any less money: anything that can be used in settlement of a debt.

The Role and Function of Issue Banking

It was only after the invention of coined money c. 700 BC that what most people think of as banks came into being. When wealth was in the form of commodities or livestock, "savings" was, essentially, a meaningless term as there was no difference in the wealth and the form in which it was usually conveyed. "Interest" on someone's "savings" consisted almost exclusively of the natural increase from, say, one's herd of cattle — the most common form of more-or-less portable wealth, and thus currency, before the invention of coinage.

There are two basic types of bank, "banks of deposit" and "banks of issue." We mentioned banks of deposit in passing in Part II of this series. A bank of deposit is what most people think of as a bank. It is a financial institution that takes deposits and makes loans. A bank of deposit cannot make loans in any amount greater than its deposits.

A bank of issue is different. A bank of issue is defined as a financial institution that takes deposits, makes loans — and issues promissory notes. As we mentioned in the previous posting, that means that a bank of issue has the power to create money. More accurately, a bank of issue has the power to "monetize" the present value of existing or future marketable goods and services.

A bank of issue does this by taking a borrower's particular purchasing power based on a bill drawn by the borrower and backed by the borrower's private property stake in that present value. The bank changes this individual purchasing power of the borrower into general purchasing power of the bank. Rather than individual purchasing power backed by a possibly unknown individual, the general purchasing power is backed by the bank's presumably good name and a lien that the bank takes on the present value of existing and future marketable goods and services the borrower brings to the bank for monetization.

The procedure is (relatively) simple. The borrower draws a bill backed by the present value of existing or future marketable goods and services in which the borrower has a private property stake. There are a number of ways to do this. When a private individual draws a bill, he or she does not necessarily need the intermediation of a financial institution, especially if other private individuals or businesses will accept the bill based on the credit worthiness of the private issuer. Despite the fact that this can be done without a bank being involved, such a bill is just as much money as any coin, banknote, or check drawn on a demand deposit. (Fullarton, Regulation of the Currencies of the Bank of England, op. cit., 28-30.) When such a bill circulates among private individuals and businesses, it is called a "merchant's acceptance."

When a bank is involved, such a bill is called a "banker's acceptance." This can get involved, but a borrower can draw a bill and take to a bank for replacement with a bank's promissory note, or the borrower and the bank can collaborate in the bank's issue of a promissory note without first drawing a bill, or any number of other mutually satisfactory arrangements.

Whatever the arrangement, the bank uses the promissory note to back a demand deposit or banknotes. The specific form is irrelevant and depends on whatever is most convenient, efficient, or legal. Both demand deposits and banknotes are equally "money," as all but the most rigid adherents of the Currency School now recognize. The borrower takes the banknotes or checkbook, and spends the money.

Presumably, the money is expended on something that will generate its own repayment in the future. This is the concept called "financial feasibility." Financial feasibility is the essence of Say's Law of Markets and the real bills doctrine. As a side comment, we should note that, in this context, the term "borrower" is not, strictly speaking, accurate. This is because all the "borrower" has done is exchange one form of purchasing power for another, but the term is in general use, and we do not (at present) have a better one.

As the project on which the purchasing power — "money" — has been expended generates a profit — "interest" — the borrower repays the general purchasing power, buying back the lien on the present value of his or her existing or future marketable goods and services. The money — the debt — is canceled as it is repaid, and the borrower regains full possession of the present value of the existing or future marketable goods and services he or she pledged to back the debt.

The Invention of Coined Money

When coined money came into use around 700 BC, there was a moderate leap forward and, ironically, a giant leap backwards. Daily transactions became easier to carry out, and it was easier to accumulate savings in the form of cash. While the first coins were privately issued, it soon became convenient for the State to take over the task of certifying that the lumps of precious metal were all to the same standard of weight and purity. This made it easier to trust the currency. Finally, the use of precious metals as currency made it clear that money as money is not a productive asset (capital), and that charging interest on a loan of money as money is a form of theft — "usury," or taking a profit when no profit has been made.

With the most easily recognized form of money being issued and certified by the State, however, many people became convinced that only the State has the right or even the ability to create money. As we have seen, of course, the only way the State can actually be said to create money is when the State owns the assets with the present value that backs the money — socialism.

The rise of coinage also gave birth to the illusion that money and credit were somehow different. Most credit instruments prior to coinage consisted of papyrus, clay, or parchment documents that clearly were different from the assets and the present value in which they conveyed an ownership interest. When precious metals became to be used as the fabric, however, a thing of value was conveyed along with the contract. The gold, silver, or electrum (a naturally occurring alloy of gold and silver) could be used as a medium of exchange and store of value, or melted down and used as precious metal, a valuable commodity in and of itself. This created the illusion that money as money has value instead of the true, derived value it has as a conveyance of the property right.

Legal Counterfeiting

There was, however, a far more serious problem that rapidly arose. It soon became evident that with a State certification, less than the face value of gold or silver could be put into a coin. In and of itself this need not have been a problem. As with earlier credit instruments made of essentially worthless materials, it doesn't matter of what the fabric of the instrument consists, as long as when the instrument is presented for redemption, the full face value of the instrument at the time of issue is paid out.

Unfortunately, people somehow became convinced that the difference between the cost of the fabric plus the associated costs of manufacture less the face value — seniorage or agio — represents a profit to the issuer. If we stop to think about it for a moment, however, we realize that the difference between the face value of the credit instrument and the cost of producing the credit instrument is not a profit, but a liability on which the issuer must make good or be guilty of theft. The cost of creating the instrument is an expense — no one disagrees about that — but it is not an expense that can be subtracted from the present value conveyed in the instrument. Rather, the cost of drawing the instrument must be added to the present value conveyed.

We see this best in the practice of discounting and rediscounting credit instruments. As we have seen, when a bill is drawn for, say, $100,000, the value conveyed at the time of creation is less a discount to compensate the holder in due course for accepting and holding it. Thus, an instrument with a face or maturity value of $100,000 will be discounted for $98,000, assuming a 2% discount rate. If held to maturity and presented to the issuer for redemption, the $2,000 represents a profit to the holder in due course, not to the issuer. The issuer must make good not the $98,000 of value he or she conveyed at the time the instrument was created, but the full face value of $100,000.

Thus, a State that issues a dollar that costs 98¢ to produce and puts it into circulation at a full dollar does not make 2¢ profit. The State does not redeem dollars for 98¢ — at least not legitimately. By booking the 2¢ as a profit, however, the State might as well have officially depreciated the currency by 2%. This is because taking the agio or seniorage as a profit and spending it means that the State has created unbacked currency of 2¢ for every dollar put into circulation at 98¢, which 2¢ is then "stolen" from all other units of currency, inflating the value.

This of course does not stop States from booking agio as a profit and spending it. Any means by which a politician can evade his or her accountability to the citizens will generally be adopted without a second thought. (Vide Henry C. Adams, Public Debts: An Essay in the Science of Finance. New York: D. Appleton and Company, 1898, 22-23.) This is so prevalent, especially under Keynesian economics, that one noted Keynesian — Nobel Laureate Paul Samuelson — is alleged to have called the issuance of unbacked currency by the State "legal counterfeiting." This does not make it any less theft.

The Development of Post-Coinage Banking

As a result of failing to understand coined money as a credit instrument in the same way as any other credit instrument, banking regressed dramatically. For the next several centuries and even down to the present day, to the public at large, "banking" meant deposit banking, not issue banking. Thus, even though Assyria and Babylon had systems of commercial credit, (Conant, op. cit., 1-2.) Greece and Rome were less sophisticated, although subject to more regulation by the State. Banks began dealing almost exclusively with instruments conveying existing accumulations of savings (Ibid., 2-6.), although there was limited dealing in bills of exchange by the Roman "argentarii," or "silver dealers."

The Roman system survived the transformation of the Empire from the classical period to the Middle Ages. The great decrease in commercial activity during the Middle Ages and the consequent diminution of accumulations of portable wealth (i.e., wealth not in the form of land or fixtures) resulted in a narrowing of people's understanding of wealth, and a shift in the idea of "savings." The popular understanding of "savings" moved from equaling all investment to being hoards of coined gold and silver taken out of the channels of commerce and no longer filling their proper and intended role of circulating media (mostly silver, as gold was not a widely-used coinage metal in the west until the 14th century (Karl Helfferich, Money. New York: The Adelphi Company, 1927, 115-146; Conant, op. cit., 6.)

Consequently, moneychangers took over what was virtually the sole remaining function of banks. Moneychangers became de facto deposit bankers holding and lending existing accumulations of savings for consumption purposes, instead of commercial bankers facilitating investment in new capital formation and mercantile endeavors. This situation was prevalent in the west, in the Byzantine Empire, and throughout the Muslim hegemony and in India. (Conant, op. cit., 6-8.)

China may have retained or been developing some vestiges of commercial banking, but available sources are not clear on this. The issue of paper money seems to have been a way for the State to monetize its deficits, not for people engaged in trade and production to meet the needs of commerce and industry. (Norman Angell, The Story of Money. New York: Frederick A. Stokes Company, 1929, 81; Jack Weatherford, The History of Money. New York: Three Rivers Press, 1997, 125-129; Jonathan Williams, Money: A History. New York: St. Martin's Press, 1997, 149-150, 177.) The Muslim hegemony experimented with paper money on the Chinese model but, again, this appears to have been an attempt to finance State operations with debt, not to provide liquidity for productive activity. (Williams, op. cit., 101.)

In the west, the moneylenders gradually began implementing rudimentary commercial banking through the use of bills of exchange backed by fractional instead of full reserves of coin. This was not true commercial banking, for the bills of exchange were not backed by the present value of existing or future marketable goods and services or capital projects (most such loans being made for consumption or to government), but by the collateral offered by the borrower. (Conant, op. cit., 6-8.)

Modern Banking

What we recognize as "banking" preceded the name. The first "bank" so-called was established in the Venetian Republic late in the 12th century to facilitate dealings in bills of exchange, not to make loans. (Hildreth, op. cit., 5.) This, however, was still a bank of deposit, not a commercial bank, strictly speaking. A true commercial bank has the power to create money in the form of bills of exchange and other credit instruments and backed by the present value of existing and future marketable goods and services. A commercial bank does not act as an investment bank (a type of deposit bank) and deal in bills of exchange as a commodity. A commercial bank is properly a type of bank of issue or circulation. This was the case even with the Fuggers, (Richard Ehrenberg, Capital & Finance in the Age of the Renaissance: A Study of the Fuggers and Their Connections. New York: Harcourt, Brace, 1928) the great Renaissance financiering family that virtually ruled non-Jewish banking in the 15th through 17th centuries.

The Fuggers, to stay in the good graces of both Church and State, avoided both creating money and lending at usury except for the tolerated loans to the State. (Summa, IIa IIae, q. 78, a. 1.3. The language of Aquinas makes it abundantly clear that it is expedient, not lawful, to lend money to the State if refusing to lend would cause the State to be unable to carry out its proper role and function as guardian of the common good. Profit itself being a good and not objectively evil, taking a profit in this instance is allowed. This is both in order to permit the State to carry out its function and safeguard the common good (a very great good indeed, for the common good is the network of institutions within which human beings ordinarily acquire and develop virtue, and so fit themselves for their proper end), and to give an incentive to people to lend to the State.

The Bank of Amsterdam, established in the early 17th century, was restricted to dealing in bills of exchange in order to regulate the currency and facilitate trade, not make loans for commerce. (Hildreth, op. cit., 7-11.) The Bank of England, chartered in 1694, is generally considered the first modern bank of issue, as well as the first true central bank. In both capacities the Bank created money by discounting instead of accumulating existing savings and loaning them out. As one authority stated, "The Bank of England, first chartered in 1694, is the prototype and grand exemplar of all our modern banks." (Ibid., 11.)

The Federal Reserve

As we saw in the previous posting, the U.S. Federal Reserve System was established in 1913 for the purpose of providing an "elastic" currency to ensure that there was always enough liquidity in the private sector to meet the needs of industry, agriculture, and commerce. Both the long debates in the House and the Senate (the documentation of which and the testimony was more voluminous than anything since the founding of the United States) and the wording of the Federal Reserve Act of 1913 make it evident that the Federal Reserve was to fill two critical needs.

One (and most immediate), the Panic of 1907 had finally awakened the authorities to the fact that commercial banks in the United States could no longer be expected to function without a central bank that operated as a public institution on which to draw for emergency reserves. The National Bank system established in 1863 was composed of a network of autonomous, privately owned institutions, and could not be required to assist another bank that got into trouble. A central bank on the other hand could, in the public interest, be required to provide emergency reserves.

Two, the Panic of 1893 had made it equally clear that, while the bulk of business involving industry, commerce, and agriculture could and would continue to be carried on by means of privately issued bills of exchange in high denomination, it was neither advisable nor financially feasible to continue using gold coin supplemented with National Bank Notes and a subsidiary silver coinage as the currency for day-to-day transactions. The National Bank Notes were backed by government debt, and — gold being relatively fixed in quantity — the amount of currency in circulation could not be increased at need without increasing unproductive government spending.

Consequently, the Federal Reserve Act was intended to do four things:

• Oversee and regulate clearinghouse operations (i.e., transactions between private financial institutions),

• Provide additional reserves as needed to commercial banks by rediscounting eligible paper directly from member banks and engaging in limited open market operations to rediscount eligible paper from non-member banks and individual businesses,

• Supply the country with an "elastic currency" that would expand and contract with the level of business and so avoid both inflation and deflation by rediscounting eligible paper, and

• Phase out the debt-backed National Bank Notes and replace them with asset-backed Federal Reserve Notes.

The vast bulk of the money supply would continue to be bills of exchange drawn by private sector businesses and discounted either at other businesses or, to a lesser degree, commercial banks. Consistent with Say's Law and the real bills doctrine, this would be money, but not currency, per se. Next would be commercial bank demand deposits at the Federal Reserve and Federal Reserve Notes. This was to be the "elastic" component of the currency, backed by liens on qualified industrial, commercial, and agricultural assets, and would expand and contract with the short-term needs of business. Finally, there would be gold coin and gold certificates, supplemented by the subsidiary silver coinage and silver certificates for daily transactions.

For the first time in history, a government had acknowledged the reality of Say's Law of Markets and the real bills doctrine. By the terms of the Federal Reserve Act, the federal government recognized that "money" consists of anything that can be used in settlement of a debt, and is a derivative of the present value of existing and future marketable goods and services. As one authority remarked, "As Professor Beard suggests in 'The Rise of American Civilization' the Federal Reserve Act of 1913 represents the union of 'Jacksonian hopes' with 'financial propriety'." (Angell, The Story of Money, op. cit., 305-306.)

One deviation from "pure" pure credit theory that did not reflect the reality of financing capital formation or the monetization of existing or future marketable goods and services was that the discount rate and the other rates used by the Federal Reserve were to be set by the market. This would, presumably, prevent unfair competition with private savers and venture capitalists, and encourage commercial banks to go first to the private sector before having recourse to the discount powers or open market operations of the regional Federal Reserves, thereby unnecessarily expanding the money supply. The Federal Reserve was intended to be the lender of last resort for the private sector, and avoid monetizing government deficits.

The Federal Reserve Hijacked

Unfortunately, this more or less happy state of affairs did not last long. It turned out that there was an unintended loophole in the design of the system, through which what became the Keynesian past savings dogma could once again insert itself into monetary and fiscal policy. In order to retire the debt-backed National Bank Notes and replace them with Federal Reserve Bank Notes (indistinguishable in appearance from ordinary Federal Reserve Notes), the regional Federal Reserves had to be able to purchase the government securities that the National Banks had on deposit as backing for the National Bank Notes.

The idea was that as the National Bank Notes were retired, they would be replaced with Federal Reserve Bank Notes with which the Federal Reserve would purchase the government bonds held by the National Banks. Because this involved purchasing secondary bonds from the commercial banks instead of directly from the government, the transactions were carried out via open market operations, instead of the prohibited discounting of primary government securities. The Federal Reserve Bank Notes would thus also be debt-backed. The plan, however, was for the federal government to redeem the bonds gradually. By this means Regional Federal Reserve bank operations involving private sector assets would replace the government debt-backed Federal Reserve Bank Notes, with private-sector asset-backed Federal Reserve Notes.

The system operated this way for two years. Then came the need to finance the entry of the United States into the First World War. It being more politically prudent to borrow rather than raise taxes, the First Liberty Loan Drive drained available liquidity out of the economy. During the Second Liberty Loan Drive and the Victory Loan Drive, commercial banks purchased the bonds and then resold them to the Regional Federal Reserves — there was and remains no provision in the law for the direct sale of a bond from the federal government to a Federal Reserve bank in order to prevent the government from monetizing its deficits. The roundabout transactions, while in compliance with the letter of the law, violated the spirit.

Under the influence of Keynesian economics and its rejection of Say's Law and the real bills doctrine, most central banks in the world today do little or no rediscounting of private sector paper, even though this was the reason for the development of central banking. Instead, central banks engage almost exclusively in open market operations in secondary government securities to finance government deficits.

The question becomes how this situation, so opposed to sound money, credit, and banking, came to be regarded as normal.

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