THE Global Justice Movement Website

THE Global Justice Movement Website
This is the "Global Justice Movement" (dot org) we refer to in the title of this blog.

Friday, July 30, 2010

News from the Network, Vol. 3, No. 30

Not that it's in any way "news," but the monetary mavens and economic experts have been hedging their bets all week. GDP figures are due out this morning. In light of the "readjustments" in the official figures for the last three years, it turns out that the "recession" was a tiny bit deeper than those preparing and publishing the figures "suspected." Uh huh. When, for example, two unemployment rates are published, one "official," and the other, nearly or more than twice the "official" rate, "unofficial," Something Is Up. (But then, this writer has a nasty, suspicious mind.)

Consequently, it turns out that instead of the "modest" economic growth reported in 2008, it might have been zero. (Next quarter, of course, we'll probably find out that "growth" was actually negative.) This is causing some people to question whether the much-vaunted "end of the recession" (or, for the more conservative, "beginning of the recovery") in "June or July, 2009" actually happened, or if it was just another case of statistics that have yet to be adjusted.

Nevertheless, we've been making significant progress in laying the groundwork to present the Just Third Way as the solution to "What's Wrong with the World," as Chesterton put it, most immediately in the application of Capital Homesteading. The long-term solution, of course, is the restoration of the natural moral law based on the Intellect, not the Will, as the foundation of the system.

Until people have the means of generating an income "large enough to meet ordinary family needs adequately" (Quadragesimo Anno, § 71), however — whether from ownership of labor, of capital, or (preferably) both, you can talk all you want about getting people to act virtuously, but it's all just talk. Absent heroic virtue — and how many of us have that? — it's very difficult to buck the system and acquire and develop virtue when the institutions of the social order (the system) are poorly organized. Frankly, becoming virtuous is hard enough as it is without the system itself working against it. The whole point of social justice is to reform the system so that virtue becomes the optimal, or at least the rational choice.

The solution is not to use our institutions inappropriately to force people to be virtuous. The liberals are right in that: you can't legislate morality (which begs the question as to why, then, they keep trying to do it). Inevitably that leads to trying to use the State, a very specialized institution — social tool — in some extraordinarily inappropriate ways, leading to functional overload of the institution.

As a case in point, take the recent alleged reform of the financial services industry. Instead of looking at the financial system that is badly in need of reform at (duh) the systems level, the powers-that-be have tried to legislate morality (ethics . . . morality being ethical philosophy) by passing a whole raft of laws that will have no lasting effect. Why? Because the system is currently arranged in such a way as to make unethical (immoral) behavior much more profitable.

Possibly the most glaring example of this wrong-headed legislative bumbling is the refusal to put the provisions of the Banking Act of 1933 ("Glass-Steagall") back in place. Glass-Steagall and similar legislation made some of the more glaring of the unethical acts more difficult or impossible. (Vide Lydia Fisher, Cinderella of Wall Street) Instead, what they've done is insist that making more things illegal will reduce the number of illegal acts, at the same time that it remains extremely profitable and rather easy to carry out those same illegal acts. Talk about a Homer Simpson moment.

In spite of that, a number of advances have been made in the last week:
• Numero Uno: Supporting Life is now available on Amazon. It's not yet on Barnes and Noble, and Amazon as of this morning doesn't have the image of the book up (and it's terrific, the cover, I mean, designed by Rowland L. Brohawn . . . I am only admitting that the author of Cinderella of Wall Street is better looking than I, not that her book cover is better than mine), but you can purchase Supporting Life. AND leave adulatory reviews and testimonials.

• We had a couple of glitches with Dr. Harold G. Moulton's 1935 classic The Formation of Capital, but we should be able to start placing orders for it by next week. It's once again in "premedia," a printing term which has deep mystic significance requiring esoteric rituals before the book can be printed.

• We had some very good meetings this week, although "good" and "meeting" in the same sentence usually indicates an oxymoron. On Tuesday we met with a representative of the American Family Business Institute. She was very positive about the whole idea of a Pro-Life economic agenda, and (since we had received the first shipment of books the night before) received the first "regular print run" copy of Supporting Life. She was also interested in the possibilities of implementing "parts" of the Just Third Way — at least as far as possible within the current legal system — by introducing Justice-Based Management and ownership-transferring mechanisms into ethically run companies with a transition problem. For that, Equity Expansion International, Inc. offers the ethical entrepreneur some distinct possibilities . . . and offers a finder's fee to door openers who surface a viable prospect.

• Norman Kurland and Dawn Brohawn went up to Baltimore on Thursday for a seminar on new issues affecting the ESOP. As expected, most of the participants were focused on technical administrative and legal issues, but two people seemed very interested in the whole Just Third Way underpinning the ESOP. As every Kelsonian knows, the ESOP is simply one vehicle, and in some ways not the best, for expanding capital ownership. The ultimate idea is to make every person a direct owner of a significant capital stake. That's why it was so encouraging to discover that at least one lawyer there had actually read Louis Kelso's books (The Capitalist Manifesto and The New Capitalists) and realized that, important as the ESOP is today, it is not an end in itself. Instead, the ESOP should lead naturally into advocacy for broadened ownership through many vehicles, under the umbrella of the Capital Homestead Act, which is itself an application of the principles of the Just Third Way.

• In the "Academic Silliness Department," we were researching something-or-other last week and came across some Catholic theologian who had written a college text that he had put up on the web. The gist of the chapter that we stumbled across was that Father Ferree was "ebullient" about social justice and what it could accomplish, but the poor boob (i.e., Father Ferree) didn't know what he was talking about. The theologian clearly missed Father Ferree's point about a particular act of social justice (long story, read the book), and obviously assumed that Aristotle's general legal justice, and Aquinas's particular legal justice/Pius XI's social justice are just different names for the same thing. Wrong. This is the same mistake that Father Ferree noted that theologians and philosophers have been making for the past 800 years or so, and flatly contradicts what Aquinas rather clearly stated, "Legal justice alone directly looks to the common good." (Ia IIae q. 61 a. 5 4m) It didn't seem worth the effort to correct him, and the explanation is extremely complex, so we put him in the "ignore this one" file. Yesterday, while researching something complete different, we came across another chapter in the same book in which the author rather pompously declared that Leo XIII had innovated — i.e., changed Catholic teaching — by claiming that private property is a natural right and must be regarded as sacred (Rerum Novarum, § 46), and that Aquinas had never said that private property is a natural right. Really? Then who wrote Section IIa IIae q. 66 aa. 1-2 of the Summa Theologica in which somebody using Aquinas's name clearly stated that private property is a natural right? It became evident immediately why the author had disparaged Father Ferree's analysis of social justice and sneered at Leo XIII's defense of private property: he is clearly a "Will-based" natural law thinker instead of "Intellect-based," and was busily proving everybody else in the world wrong on his principles, not theirs. This is a shtick that always works, because — as Chesterton explained in The Dumb Ox — he is always right and everybody else necessarily wrong. As Heinrich Rommen pointed out in his book on the natural law, by basing things on your private interpretation of God's Will, you can have anything you want.

• As of this morning, we have had visitors from 39 different countries and 43 states and provinces in the United States and Canada to this blog over the past two months. Most visitors are from the United States, the UK, Brazil, Canada, and India (see below). People in France, Venezuela , the United States, Brazil, and Spain spent the most average time on the blog. The most popular posting is the posting on "the Right Way to Raise Wages," followed by "The Rich, Who Needs 'Em?" the piece on "No Double Dip" (Because we're still in the first dip), and two of the postings in the "Interest-Free Money" series, which seems to be generating significant interest in India.
Those are the happenings for this week, at least that we know about. If you have an accomplishment that you think should be listed, send us a note about it at mgreaney [at] cesj [dot] org, and we'll see that it gets into the next "issue." If you have a short (250-400 word) comment on a specific posting, please enter your comments in the blog — do not send them to us to post for you. All comments are moderated anyway, so we'll see it before it goes up.


Thursday, July 29, 2010

Money and Morals after the Crash

Geoff Gneuhs, Guest Blogger

The following correspondence was between Geoffrey Gneuhs, a CESJ founding member, and Raymond Waddle, Editor of Reflections, the journal of the Yale Divinity School.

Dear Editors:

I would like to thank you for the fine issue of Reflections, "Money and Morals after the Crash" (Spring 2010).

A number of the essays touched upon the deficiencies of our culture: solipsism and gross self-interest and a lack of any asceticism and self-sacrifice. In a culture where there is no truth, it is not surprising that people cannot nor do not want to reach outward.

I would like, however, to offer a practical tool that could be the basis of systemic change in our atrophied capitalist system, which has not been reformed by President Obama since the very players who brought this crisis on are still involved in policy and decisions, for example, Timothy Geithner, treasury secretary, Ben Bernanke of the Federal Reserve, and the members of Congress.

The idea is Capital Homesteading Accounts (CHAs). Let me give some background.

In 1984 my article "Chesterton's Distributism: Something Elvish" appeared in the Catholic Worker newspaper, of which I was then an editor. Shortly after, Dr. Norman Kurland, lawyer and economist, contacted me. He was forming what was to become the Center for Economic and Social Justice and believed that Chesterton's distributism and emphasis on ownership for all was in line with his ideas for expanded capital ownership and invited me to join him. Kurland had helped develop the legislation for the first Employee Stock Ownership Plans (ESOPs). He had been a colleague of Louis Kelso, economist, and Mortimer Adler, the Aristotelian and Thomistic scholar.

Their book, The Capitalist Manifesto (1958), despite its title, is in fact a critique of capitalism and offers practical ways to enable all citizens to participate in a free economy rooted in principles of justice, fairness, and the common good.

A few years later Hannah Arendt in her essay "Thoughts on Politics and Revolution" in her Crises of the Republic bluntly pointed out: "Our problem today is not how to expropriate the expropriators but, rather, how to arrange matters so that the masses, dispossessed by industrial society [now technological] in capitalist and socialist systems, can regain property. For this reason alone, the alternative between capitalism and socialism is false-not only because neither exists anywhere in its pure state anyhow, but because we have here twins, each wearing different hats."

CESJ's concept of Capital Homesteading Account respects the principle of subsidiarity of Catholic social teaching as well as individual freedom and creativity. It allows for qualified interest free loans for every man, woman, and child to invest in their local business, shop, bodega, and so forth, to be paid back by future earnings. Each year loans would be made to these accounts. In other words credit becomes available for all (right now there is no credit, and when banks start lending again it will not be to the storekeeper, the small farmer, and so on. CHAs address this gross inequity. For a more detailed explanation visit the CESJ website.

Socialism is the politics of envy, and capitalism (or extreme capitalism as Pope John Paul II called it in his encyclical Laborem Exercens) is the politics of greed.

Expanded capital ownership can help build economic democracy within the free market.


Geoffrey Gneuhs '78 (STM)

Mr. Gneuhs:

Thank you for the note about the Reflections (Spring 2010) issue, "Money and Morals after the Crash," and your thoughts on the economy. I happen to be a fan of both Chesterton and Arendt, so I'm interested in their insights on these elusive but urgent matters. Thanks for sharing the idea of CHAs; it is worth exploring further.

Best wishes,


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.


Wednesday, July 28, 2010

Interest-Free Money, Part VI: Pure Credit Financing

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

Past Savings and the Rate of Interest

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

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

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

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

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

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

Practical Problems With Past Savings Financing

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

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

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

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

Solving the "Economic Dilemma"

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

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

Pure Credit Capital Financing

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

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

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

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

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

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

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

A Pure Credit System (Almost) in Operation

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

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

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

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

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

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

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

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

Binary Finance

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

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

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

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

Determining Interest Rates

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

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

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

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

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

The Two-Tiered Interest Rate

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

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

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

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

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

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


Tuesday, July 27, 2010

Interest-Free Money, Part V: The Formation of Capital

Conventional economic wisdom declares that you cannot finance the formation of new capital unless you cut consumption, save, and then invest. Logically, this means that ownership of the means of production must be concentrated, and that the great mass of people must rely exclusively on wages and redistribution for their income.

Keynes and von Hayek

Nowhere is this reliance on existing accumulations to finance capital formation and its effect on our understanding of money and the rate of interest more highly developed than in the economic theories of Friedrich von Hayek. Ironically, although von Hayek and Keynes considered themselves opposed, they agreed on this most fundamental and yet false economic assumption. They differed only on how or to what degree the quantity of money should be manipulated, and whether or to what degree the State should set the rate of interest.

Von Hayek's ideas on money, credit, and banking came from Ludwig von Mises who, as we might expect, was an adherent of the British Currency School — the belief that "money" consists solely of coin, currency and (on occasion) demand deposits and selected time deposits. This "Austrian School" generally includes currency backed by government debt under the definition of money, but claims that it is not legitimate. Specie — gold — is the only legitimate currency and the only basis of a sound monetary policy.

According to von Hayek, ups and downs in the economy can adequately be explained by State interference in the free market. The central bank of a country causes booms and the consequent depressions/recessions by inflating the currency and misallocating credit by means of its monopoly power used to artificially raise and lower interest rates.

As von Hayek explained, "The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process." A monopoly, especially a State monopoly like a central bank, does not have the necessary knowledge, contained only in the general consensus of the free market, to determine the quantity or the price of money, or how to use it.

Naturally, the Keynesians counter that State-issued fiat money à la Knapp's chartalism (Knapp, The State Theory of Money, op. cit.) backed by the government's power to collect future taxes is just as legitimate as specie — and certainly more amenable than gold and silver to management in order to achieve political goals. The economy can't be expected to run itself — not when capital formation can only be financed out of existing accumulations of savings, and capital is responsible for a greater and greater share of production.

Income generated by capital goes by right of private property to the owner of capital. The increasing productivity of capital (even though measurements of productivity are, paradoxically, always in terms of "labor hours") ensures that a relatively smaller share of production, and thus income (effective demand), goes to labor.

Therefore, in order to ensure that most people have sufficient income (effective demand), the State necessarily re-edits the dictionary with respect to the definition of private property by changing the definition of money — to be sound, remember, money must be connected through the institution of private property to the present value of existing or future marketable goods and services. The State then engineers redistribution of effective demand through inflation, minimum wage legislation, and transfer payments. This requires constant "fine tuning" of the economy to ensure that just enough effective demand is transferred to consumers, and just enough in savings is transferred to producers.

Inflation and "Forced Savings"

Friedrich von Hayek, while he made his own monetary mistakes, was quite correct in singling out Keynes's collectivism — "aggregates" — (in addition to an endless argument over the effect of interest rates on the rate of profit for business) for condemnation when he critiqued Keynes's 1930 Treatise on Money. As one commentator analyzed the situation,

In an extended critique of this early rendition of Keynesianism, F. A. Hayek found many inconsistencies and ambiguities, but his most fundamental dissatisfaction derived from Keynes's mode of theorizing — from his "language and apparatus": "Mr. Keynes's aggregates conceal the most fundamental mechanisms of change" (Hayek, 1931a: p. 227). Keynes had argued that changes in the rate of interest have no significant effect on the rate of profit for the investment sector as a whole. Hayek's point was that profit reckoned on a sector-wide basis is not a significant part of the market mechanism that governs production activity. A change in the rate of interest means that profit prospects for some industries rise, while profit prospects for others fall. The systematic differences in profits rates among industries, and not the average or aggregate of those rates, are what constitute the relevant "mechanisms of change." There were fundamental shifts in Keynes's thinking during the six years between his Treatise and his General Theory, but none that could be considered responsive to Hayek's critique. In the General Theory, impenetrable uncertainty about the future clouded the decision processes of investors and wealth holders; the interest rate became a product of convention and psychology, largely if not wholly detached from economic reality; changes in market conditions were accommodated by income adjustments rather than price or interest-rate adjustments; and unemployment equilibrium became the normal state of affairs. (Roger W. Garrison, "Is Milton Friedman a Keynesian?" Mark Skousen, ed. Dissent on Keynes: A Critical Appraisal of Keynesian Economics. New York: Praeger Publishers, 1992, 131-147.)
The logical conclusion of Keynes's thought is that the State owns everything, and everyone becomes an economic as well as political slave of the State. To paraphrase Henry George, the State becomes the universal proprietor without calling itself so. (Henry George, Progress and Poverty. New York: Robert Schalkenbach Foundation, 1979, 406.) Further, Keynes assumed as a given that "everything" consists exclusively of existing inventories of wealth. (John Maynard Keynes, General Theory of Employment, Interest, and Money, 1936, II.7.v.) This is a logical conclusion from the assumption that existing accumulations of savings are absolutely necessary to finance new capital formation. Von Hayek and the other members of the Austrian School, along with the Monetarists and virtually every economic school today, accept this assumption almost as a religious dogma.

The shared concept of "forced" or "involuntary" savings illustrates this acceptance of the presumed necessity for existing accumulations of savings to finance capital formation. Binary economists have, in the past, used "forced" and "future" savings as equivalent terms. This may have engendered as much confusion within the limited scope of this and similar discussions as has the term "capitalism" in the wider world outside the narrow confines of political economy.

We will therefore from now on try to describe the saving that results from using the future stream of income to finance capital formation as "future savings," and restrict the terms "forced" or "involuntary" savings to the sense used in so-called "mainstream economics." This should be useful, for the concept of future savings as used by Kelso and Adler is a beneficial process, while the idea of forced or involuntary savings, as described by, e.g., Keynes (Keynes, General Theory, op. cit., II.7.iv; IV.14.i; V.21.i; VI.22.iii.) and von Hayek, (Friedrich von Hayek, Monetary Theory and the Trade Cycle. New York: Augustus Kelly, Publishers, 1966, 218-226.) describes what can only be described as massive theft. As demolished by Moulton, however, the concept loses all credibility:
Many economists have contended that the use of bank credit for purposes of capital expansion does not obviate the necessity for concurrent saving — using the term saving in the sense of restricting consumption. They argue that instead of voluntary saving for the purpose of accumulating funds for capital expansion, the use of bank credit for the purpose forces involuntary saving. It is held that the result of the expansion of bank credit is merely to raise the general level of prices, and that since money wages and most other income remain the same, the real purchasing power of the masses is restricted. The expansion of capital thus appears still to have been at the expense of consumption.

This analysis completely overlooks the dynamics of the process. It fails to note that the rate of capital formation would be less rapid if business enterprisers had to wait until money savings were first accumulated. It thus fails to see the effects of accelerating capital expansion upon productivity and the volume of national income. Thus it is possible to increase the supply of capital goods without an antecedent or concurrent restriction of consumption. The truth is that the accelerated capital expansion and increased productivity result in an increased output of both capital goods and consumer goods. Thus real wages are increased. The history of capital expansion and wage and price trends in the United States affords no support for the theory that bank credit expansion merely means involuntary saving. Nor do the facts support the thesis that savings in the sense of positively reducing consumption is essential to the formation of capital. (Note in quoted text: "See Moulton, The Formation of Capital, pp. 37-43."), (Harold G. Moulton, Capital Expansion, Employment, and Economic Stability. Washington, DC: The Brookings Institution, 1940, 26.)
The key sentence in this passage, and the most concise statement of the concept of "forced savings," is, "It is held that the result of the expansion of bank credit is merely to raise the general level of prices, and that since money wages and most other income remain the same, the real purchasing power of the masses is restricted." That is, there are two beliefs as fixed as they are false of the Currency School and its many heirs that Moulton addresses:
1. Investment in new capital can only take place after saving has occurred. (Moulton, The Formation of Capital, op. cit., 47-48.)

2. Saving is narrowly defined as cutting consumption. (Moulton, Capital Expansion, loc. cit.)
Since these two fixed beliefs are considered absolutes, virtual religious dogmas, in fact (dissent from which is considered "heresy"), (Joseph A. Schumpeter, The Theory of Economic Development. New Brunswick, New Jersey: Transaction Publishers, 1993, 96-97.) they cannot, and, indeed, are not questioned. New capital formation can thus be financed (according to Keynes) by inflating the currency. Consistent with the quantity theory of money, inflating the currency drives up the price level. Adherents of the Austrian School claim that this process takes place even if there is no increase in the price level. (Friedrich von Hayek, Monetary Theory and the Trade Cycle, loc. cit.) Because wage incomes tend either to remain at the same level or lag behind the price level, people reduce consumption as their wage purchasing power and the value of their savings evaporate. This meets the definition of "saving" used by economists today.

"Somewhat Comprehensive Socialisation"

To make certain that just enough new capital is financed, the State also needs to set the rate of return to capital — the interest rate — and the allocation of resources to production. As Keynes explained,
The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways. Furthermore, it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of compromises and of devices by which public authority will co-operate with private initiative. But beyond this no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community. It is not the ownership of the instruments of production which it is important for the State to assume. If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary. (General Theory, V.24.iii)
"It is not the ownership of the instruments of production which it is important for the State to assume." In other words (as Henry George pointed out), legal title is irrelevant as long as the State exercises absolute control. Despite the apparent mildness of the words, what Keynes proposed was not "somewhat comprehensive socialization" — "somewhat comprehensive"? — but socialism, period. As lawyer-economist Louis Kelso pointed out, "Property in everyday life, is the right of control." (Louis O. Kelso, "Karl Marx: The Almost Capitalist," American Bar Association Journal, March 1957.)

Both Right and Wrong

Ironically, both the Austrians and the Keynesians are right — and both are wrong.

The Austrians are correct that, in a democracy based on natural rights and sovereignty of the person, the State has no business telling people how much return they can receive on their savings — that is, in setting the interest rate, whether low to encourage investment, or high to inhibit capital formation. Neither does the State have any business manipulating the currency to restrict or inhibit either consumption or saving. All these are outrages against human dignity and a violation of personal sovereignty by interfering with the natural mechanism of the free market. Interfering with nature causes the drastic swings in the business cycle.

The Keynesians are correct that, assuming a system in which capital formation is financed exclusively out of existing accumulations of savings (a false assumption), and capital is rapidly becoming increasingly productive relative to labor as technology advances, effective demand can decline catastrophically unless the State steps in and redistributes purchasing power. Similarly, if people are consuming too much, there will presumably not be sufficient savings in the system to finance the new capital formation essential to job creation. That being the case, the chief economic — and political — goal of the State is to reach full employment. This requires careful manipulation of interest rates, the quantity of money, and tax policy to ensure that the State, working together with the central bank, achieves exactly the right mix to reach full employment: Keynesian "fine tuning."

Thus, from the Keynesian perspective, the only hope for people within a system enslaved to existing accumulations of savings is for the State to seize control of the central bank, and manipulate the interest rate and allocate resources to try and reach full employment. This is intended to put as many people as possible into wage system jobs, or maintain them on welfare by inflating the currency to fund transfer payments. Ultimately, nothing matters except pumping enough liquidity into the economy to redistribute sufficient effective demand to stimulate new capital formation and thereby create jobs. (Vide Keynes, General Theory, op. cit.,

Yes, both the Austrians and the Keynesians are right — given their basic assumption about the necessity of existing accumulations of savings to finance capital formation. To the Austrians, freedom is more important than the laws of economics, although they assert that the laws of economics would, presumably, operate properly if the State would stop interfering. To the Keynesians, the laws of economics are more important than freedom, although they tend to believe that if people would act rationally instead of insisting on natural rights such as liberty (freedom of association) and private property, the most basic right of all, the right to life, would presumably be secured by adequate provision for humanity's material needs supplied via a wage system job.

It does not appear to occur to either the Keynesians or the Austrians that it is possible to reconcile both the laws of economics — based on human nature — with humanity's natural rights, also based on human nature. The only thing necessary for such a reconciliation is for adherents of both schools (to say nothing of virtually all the other modern schools of economics) to surrender their dogmatic belief that capital formation can only be financed by cutting consumption, saving, then investing.

Capital Financing Under Past Savings Assumptions

As far as von Hayek was concerned, the question of how investment in new capital was to be financed answered itself. All that is necessary is for the State to step aside and let the free market function properly. If there are insufficient savings in the system to finance new capital, a rise in interest rates will bring new savings into the market, either by encouraging more saving, bringing in marginal savers, or through capital movement into the country. If there is too much, a naturally lower rate of interest will discourage additional saving, promote dissaving (consuming more than is currently being produced), or force savers to seek better investment opportunities outside the country. The ownership of all new capital is thereby concentrated in the hands of whoever has been able to refrain from consuming to a degree sufficient to generate the savings necessary to finance the new capital.

The Austrian analysis recognizes the importance of the market, and the fact that when the State sets interest rates or manipulates the quantity of money, it violates the very rights it was established to protect. The Austrian analysis does not, however, recognize that there are barriers that exist to entry into the market, so that it cannot truly be called "free" even if the State leaves the market strictly alone.

The chief barrier to free entry into and participation in the market is the restrictive definition of money on which the Austrians as well as the Keynesians insist. Defining money solely in terms of specie or State-issued purchase orders restricts entry into the market to those who either already have existing accumulations of savings, anyone who receives a redistribution of wealth from the State, or who is able to persuade others to let them use existing accumulations belonging to those others. Given the erroneous assumption that it is impossible to monetize the present value of existing and, especially future marketable goods and services, and that "money" consists exclusively of State-issued coin, banknotes, demand deposits, and some time deposits (i.e., M2), State control of money and credit, as well as allocation of resources would, the Keynesians assert, solve the problem.

Neither the Austrians nor the Keynesians recognize commercial banks and central banks as institutions that can create money out of a borrower's private property interest in the present value of existing and future marketable goods and services. Instead, both schools consider a bank to be an institution that exists solely to lend out existing accumulations of savings. Given this assumption, when either a commercial or central bank prints banknotes or creates demand deposits in excess of deposited savings, purchasing power is transferred through an increase in the price level.

When the increase in the money supply goes to people who previously had nothing to spend, there is an increase in effective demand — income. Consumption increases because people who previously had no money, now have money and are able to consume. When units of the devalued money go to people in payment of their wages, the increase in the price level forces wage earners to consume less. This decrease in consumption "forces" savings that can be used to finance new capital formation. The ownership of all new capital is thereby concentrated in the hands of whoever has been able to refrain from consuming to a degree sufficient to generate the savings necessary to finance the new capital, or who has been granted a State subsidy financed by inflating the currency or confiscatory taxation.

Thus, according to both Keynesians and Austrians, because ordinary people cannot afford to cut consumption and save in appreciable amounts, economic growth absolutely requires a class of extremely rich individuals — the richer, the better — who not only can afford to save, but are actually forced to save because they cannot possibly consume their enormous incomes. Only in this manner will there be sufficient savings in the system to finance new capital formation and the system function properly.

This is because the rich reinvest their unconsumed income in additional new capital, thereby creating wage system jobs for the rest of humanity, with the State taxing away any excess for redistribution. As Keynes declared, "The immense accumulations of fixed capital which, to the great benefit of mankind, were built up during the half century before the war, could never have come about in a Society where wealth was divided equitably." (John Maynard Keynes, The Economic Consequences of the Peace, 1919, 2.iii) In other words, unless most people are deprived of their natural right to own a capital stake (
Leo XIII, Rerum Novarum ("On Capital and Labor"), 1891, § 46) large enough to generate a secure income sufficient to meet common domestic needs adequately (Pius XI, Quadragesimo Anno ("On the Restructuring of the Social Order"), 1931, § 71), the economy will not function properly.

Reality Check

That's the theory, anyway. As even Keynes admitted, however, matters don't work out that well in practice. The problem is that since "power naturally and necessarily follows property" (Daniel Webster in the Massachusetts Constitutional Convention of 1820), what happens is that private interests inevitably take over the State and operate it to their advantage. Walter Bagehot described this process in The English Constitution (1867) and the result of the process in Lombard Street (1873). To Bagehot, "democracy" meant that England was ruled by an economic oligarchy,
i.e., the financial and moneyed classes ran the British Empire by controlling parliament through the "rotten borough" system. The rest of the people were too stupid ("not quick of apprehension") to run their own lives, much less the Empire.  These "real" rulers of England were not to be confused with the "the Upper Ten Thousand," who, with the Queen at their head, ruled society.

Inevitably, the State has to step in and either create or control (i.e., "own") the economy in place of the "despotic economic dictatorship." (Pius XI, Quadragesimo Anno ("On the Restructuring of the Social Order"), 1931, §§ 105-106.) By this means the State is supposed to encourage the rich to save more, thereby reducing effective demand. To offset the decrease in effective demand, the State is forced to regulate the interest rate — the rate of return to capital — and otherwise manipulate the financial system, inflating or deflating the money supply in order to achieve just the right mix to ensure full employment or low inflation, whichever seems more desirable to the politicians at any given point in time.

Both the Austrians and the Keynesians are therefore in fundamental agreement that the system works this way. The only real conflict between the two is whether a "free" market that prevents most people from entering or participating in any meaningful sense, is superior to a market in which the State attempts to ensure that, regardless of their inputs to the production process or degree of participation in the market, everyone has an adequate and secure income through a wage system job.

From the standpoint of the Just Third Way, both the Austrians and the Keynesians are wrong. This is not because the market would not function in the manner described given that existing accumulations of savings are the sole source of financing for new capital formation. On the contrary, it is because the market does not function in the manner described, for the simple reason that existing accumulations of savings are not the sole source of financing for new capital formation. That being the case, the interest rate — specifically the return on existing accumulations of savings as opposed to the return on capital — artificially manipulated or set by the market, might not be as critical a factor in financing the formation of new capital as either Keynesians or the Austrians believe.