Global Financial Market Outlook for 2008

The single most important factor affecting personal investing and thus the global outlook for finance and development for 2008 is democratic access to the means of acquiring and possessing private, income-generating property: money and credit.

The secondary equity and debt markets have been used improperly since at least the 1920s. Economic policymakers and others view them as a barometer measuring the overall health of the economy and an indication of whether there is a sufficiency or insufficiency of liquidity in the system. The Federal government and the Federal Reserve System, keeping an eye on the demands of Wall Street, typically act in concert in determining how much money should be in the system. The Federal Reserve Board of Governors then engages in open market operations to set the price of money and regulate the supply.

This economic symbiosis is ingrained in the basic assumptions that underpin today’s financial systems. The general idea is that money only enters the system initially via the purchase and sale of government bonds, with additional funds for business generated through the multiplier effect. When bonds are purchased, more money enters the system and is available to lend for business and consumer purposes. When bonds are sold, money is removed from the system and available sources of financing evaporate.

With the recent disasters on Wall Street, the picture for local banks being able to provide sufficient funds to lend to business has dimmed considerably. When added to concerns expressed previously that the money supply was in danger of “disappearing” as the Federal government reduced its load of debt, the outlook appears even bleaker. The problem is intensified to an almost unbearable degree when we add the latest wave of corporate scandals.

These have been driven, as most analysts admit, by the misguided focus on share values in the secondary markets instead of returns based on production. The result is that the whole process of financing economic growth through the extension of bank credit becomes substantially more risky as investors hesitate to entrust their savings to commercial banks, and commercial banks begin to shy away from all lending to protect their good names.

It may be time to consider a previously overlooked source of new money. This is embodied in Section 13 of the Federal Reserve Act of 1913. Providing a “flexible currency” was, in fact, the original reason for setting up a central bank for the United States. A flexible currency is one that expands and contracts in direct response to the needs of commerce, agriculture and industry.

Prior to 1913 there had been two attempts to establish a central bank for the United States. Both of these failed largely due to general distrust of centralized financial power. The need became acute to establish a central banking and clearing house system for the United States as a result of the “Panic of 1907.” The 1913 Pujo Committee decided that the effective monopoly of New York City over the control of the creation of money and credit should be broken up.

Consequently a “decentralized central bank” was established under the name “Federal Reserve System,” avoiding even the word “bank.” The stated purpose was to provide a flexible currency for the needs of commerce, industry and agriculture. The money supply was to be expanded by creating money to purchase qualified short term agricultural, industrial and commercial paper through the discount window. The money supply was to be reduced by restricting the extension of credit.

An extremely important provision of the Federal Reserve Act was the strict prohibition still in effect against dealing in primary issuances of government securities. This was intended to prevent the government from gaining access to the discount mechanism and thereby having the ability to monetize its deficits, bypassing the allocation process. The fear was that allowing the central bank to monetize government deficits instead of relying on taxes would render the legislature less accountable to the electorate.

The Federal Reserve System was, however, permitted to deal in secondary issuances of government securities. Because the Panic of 1907 was precipitated when a commercial bank got into trouble speculating in shares of public companies, commercial banks were forbidden to hold anything other than cash or government securities as reserves. The central bank needed the power to affect reserve requirements, which meant that it had to be able to buy and sell government securities on the secondary market.

When the United States entered the First World War the need surfaced to finance the war effort. Congress was faced with the choice of raising taxes to a level much higher than ever before, or borrowing. It chose to borrow. The First Liberty Loan Drive, however, drained all available liquidity out of the system without satisfying the government’s need for cash.

When the Second Liberty Loan Drive was initiated, commercial banks patriotically stepped forward and purchased the bonds. In order to obtain more funds to purchase additional bonds and provide for the loan needs of their customers, the commercial banks discounted the war bonds at their local Federal Reserve. The Federal Reserve printed money and created demand deposits to purchase the bonds. This process permitted the central bank to monetize government deficits while, at the same time, keeping within the letter of the law by not dealing in primary issuances of government securities.

It became a dictum of monetary and fiscal policy that only a limited amount of money could be created. This was based on a careful balancing of the needs of business, commerce and agriculture against the needs of government. The problem was that virtually all new money creation originated in open market operations concerned exclusively with the purchase and sale of government bonds. This gave the government a monopoly on the creation of money and credit, the very thing the Federal Reserve was established to eliminate.

Another downside associated with current policy is using the discount rate to manipulate the cost of capital. Typically the Federal Reserve denies that changes in the discount rate has any affect on the prime rate, but the claim is, at best, disingenuous. There is no direct link, true, but the link is there, nonetheless.

This means that the Federal Reserve, in effect, sets interest rates for the United States. This is supremely ironic under a free market advocate like Alan Greenspan, former Chairman of the Federal Reserve. If we understand interest as the price of money, then an application of free market principles would dictate that interest rates should respond to the market cost of capital, not the other way around.

What the Federal Reserve does, however, is not sell money or even lend money, but monetize a borrower’s ability to repay. An interest rate at or near the cost of capital is legitimate only when a loan is made out of existing pools of savings, that is, through intermediation. This allows an investor or saver a return based on the value of what is being supplied capitalization.

When the Federal Reserve monetizes government paper or, in the past, qualified commercial, industrial and agricultural paper, it is not lending existing savings. It is, instead, creating new money by turning a borrower’s ability to repay or “credit worthiness” into currency. The Federal Reserve is not, therefore, due a return based on the cost of capital, but a return based on the value of the service provided.

A rational discount rate for the Federal Reserve should thus be a service fee designed to recapture the costs associated with carrying out the process of monetizing a borrower’s credit worthiness, rather than a means of raising or lowering the market cost of capital. As a quasi-governmental agency, it is debatable, to say the least, whether there should be a provision for profit built into the discount rate.

Understanding how the current system came about, we can see how to solve the current financial crisis without recourse to the secondary market. This makes sense, if only because the crisis in confidence in the secondary market renders it inadvisable to continue to allow the secondary market to exercise the degree of control that has been imposed since the formalization of open market operations in the 1930s.

The supply of money for business, commerce and agriculture can be made to match the demand for it exactly thus avoiding the dangers of both inflation and deflation by opening up the discount window to qualified industrial, commercial and agricultural paper as originally intended. This would provide commercial banks, especially the smaller independents, with a pipeline to a source of loanable funds restricted only by the net present value of financially feasible projects brought to the bank for financing. As Mr. Greenspan pointed out, advances in technology have fueled the economic preeminence of the United States. Opening up the discount window to qualified, financially feasible projects would enhance America’s ability to compete in this area.

Only a few amendments would be necessary to make this return to the original purpose of the Federal Reserve System financially sound and politically pragmatic. First, of course, would be the elimination or severe restriction of the power of the central bank to deal even in secondary government issues. How politically feasible this might be is a separate issue. The current situation, however, is clearly untenable from an economic standpoint. It is also not politically sound to permit Congress to continue to finance its operations without direct accountability to the taxpayer.

The power of the central bank to affect reserve requirements could be rendered moot by implementing something similar to the “Chicago Plan” proposed in the 1930s. This is also known as a “100% reserve requirement.” A commercial bank would be required to keep on hand the full amount of cash necessary to cover all its demand deposits.

The 100% reserve requirement would, of course, eliminate the multiplier effect. The multiplier effect would be unnecessary as all loanable funds could be obtained directly from savings or via the discount window. Realistically, of course, the amount of loanable funds available through intermediation would shrink drastically.

The government, cut off from access to the money creation powers of the Federal Reserve, would be forced to go to the public to borrow money. This would rapidly dry up the pool of existing savings, just as it did in the First World War, a time when government expenditures were nowhere near as large a part of the economy as now. As Dr. Norman Kurland of the Center for Economic and Social Justice (“CESJ”) in Washington, DC has hypothesized in his recent paper on prices and money (“A New Look at Prices and Money” The Journal of Socio-Economics, 30:495-515), this would result in the formation of a “two tier” interest rate. A rate linked to the current cost of capital would be in effect for existing pools of savings, while a rate set to cover only the cost of monetizing a borrower’s creditworthiness would be in effect for new money (plus the ordinary markup for a commercial bank).

One important aspect of a reform of the central bank is the necessity of an intensive program of expanded ownership of the means of production, whether commercial, industrial or agricultural. With direct ownership of the means of production spread out among the population, more if not all of the earnings on capital would be spent on consumption, thus clearing production at market prices. As the discount window would be available to finance the formation of capital, retained earnings could be paid out to the shareholders who own them by right of property anyway. Other than the “forced savings” required to service the debt incurred to form capital, saving to finance economic growth would be eliminated.

The effect of the proposal briefly outlined here would not affect large commercial or investment banks to any significant degree. The greatest impact would be on the smaller independent commercial banks. As business enterprises switched from financing growth with retained earnings to using new money provided through the discount window, business would increase dramatically. The increased consumer demand generated by distribution of earnings instead of retaining them to finance growth would spur additional capital formation and enhance the profitability of existing productive capacity. As Dr. Harold Moulton noted in the 1930s, the demand for capital is derived from consumer demand, not the other way around.

A substantial increase in the numbers of independent banks would be noted, due to increased competition, lower overhead and equality of access to the discount window. The higher level of personal service generally associated with smaller banks would enhance their competitive stance and lure more financial service providers into the market to meet the demand for financing capital growth through the discount mechanism and the creation of new money.

The most significant improvement, however, would be breaking the monopoly over the control of the creation of money and credit now held by the secondary and governmental markets. The United States and, eventually, the world, would change from the current emphasis on speculation that characterizes much financial activity. There would be a gradual yet dramatic switch to emphasis on the productive sector, the genuinely critical sector of any economy and the one served most efficiently by independent commercial banks.