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Saturday, March 5, 2011

Building an Economy on a System of Debt, Part Three

Dissident Voice: a radical newsletter in the struggle for peace and social justice

Finance Sector Bilks the People

Memo to Congress: Show Us the M-O-N-E-Y! Part 3 of 3.

To examine the question posed in Part 2 (namely how can the Federal Reserve, as the nation’s designated monetary authority, balance the internal needs of the world’s largest economy with the inevitable impact that that economy has on the global economy, all through a monetary system precariously built on debt?) let’s begin at the beginning by describing quantitative easing as follows (underlining mine):

a monetary policy used by central banks to increase the supply of money by increasing the excess reserves of the banking system. This policy is usually invoked when the normal methods to control the money supply have failed, i.e the bank interest rate,discount rate and/or interbank interest rate are either at, or close to, zero.

A central bank implements QE by first crediting its own account with money it has created ex nihilo (“out of nothing”)… It then purchases financial assets, including government bonds, mortgage-backed securities and corporate bonds, from banks and other financial institutions in a process referred to as open market operations. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money, and thus a hopeful stimulation of the economy, by the process of deposit multiplication from increased lending in the fractional reserve banking system… The Fed is simply electronically swapping assets with the private sector, mostly swapping deposits with an interest bearing asset.1

Yes It Is True: Bank Credit Is Not Money

In other words, the “money” that the Federal Reserve creates in order to purchase securities is really a form of credit that forms the reserves through which the banks “create new money.” How do the banks do this? By extending loans to businesses, local governments and ordinary people as well as investors, large corporations and financiers, using fractional reserve expansion.

This is why private debt outstrips federal debt by a factor of roughly five to one. Federal debt in turn is the justification used to allow foreign entities to buy up government debt and private debt is the method by which foreign entities, various investment funds and the wealthier of our citizens are able to purchase U.S. assets for a “dime on the dollar.”

It should be noted that paper currency, printed at the Treasury upon Fed request, represents only a tiny portion of our nation’s money supply, most of which is digitized as “checkbook” money. Moreover, paper currency so printed – together with digitized money – makes up the reserves through which the banking system creates new money (or more accurately credit serving as money) through the fractional reserve system. Thus credit is widely seen as the lifeblood of the economy.

In the strictest sense, the Fed does not “print” new money, although it does authorize the printing of new currency. The banking system in effect creates new money – most of which is “checkbook” or digitized money – once the Fed has initiated the money/credit creation chain through creation of reserves. Generally speaking it is the big commercial banks which soak up new reserves first, because it is in those banks where the sellers of securities always deposit their electronic checks from the Fed. Some reserves eventually can trickle down to mid-sized and small banks, often without their even knowing it – provided the big banks cooperate through credit creation for use within the national economy, and not for investments abroad, and provided consumers and businesses spend as well as borrow.

This tiered system not only enables the big banks to funnel massive amounts of “cheap” money toward the purchase of assets and debt of nations around the world but it also enables them to secure the lion’s share of fees associated with these various transactions. This in turn has enabled the big banks to acquire a “unique degree of leverage over government” through sheer financial clout coupled with a carefully nurtured “revolving door” employment policy that enables select individuals to move almost seamlessly from the financial sector to government and back again.2 As one measure of what is happening, six mega banks – Goldman Sachs, JP Morgan Chase, Bank of America, Morgan Stanley and Citigroup – have grown to the point where they now control assets totaling more than 60% of the national GDP. Meanwhile smaller banks are being squeezed out of business.3

This feature notwithstanding, and in order for new money (that is credit serving as money) to be created through reserve accounts, both banks and borrowers need to participate by creating new loans to serve as money. With some $1 trillion of the $1.7 trillion of QE1 still sloshing around in the reserve accounts of major banks, Fed Chair Bernancke is hoping that additional reserves from QE2 and beyond will eventually help some of these big bank reserves to trickle down to the smaller banks who should in turn provide much needed credit/money to local economies. There is at least some indication that this might be happening – but it may not be nearly enough to arrest the downward momentum of an economy in free-fall.

In addition to the propensity to create monopolies – and as correctly discerned by Thomas Jefferson – our monetary system is a mathematical impossibility because when “money” is created as loans there is no money created to pay the interest and all associated fees on those loans. In essence we are trying to make 2 + 2 = 5 instead of 4.

The ONLY way to pay the interest on our money-as-credit is for additional loans to be made, a phenomenon which not only encourages a culture of “waste, fraud and abuse” but sets in motion a money shortage as soon as we try to pay the interest and fees due on our money-as-credit. The shortage of money relative to debt is further exacerbated by the “extinguishment” process, whereby the “money-as-credit” supply is decreased as loan principals are paid down, or “extinguished.” It should be noted that this differs slightly in the case of Treasury bonds: when they mature the reserves they represent goes away, leading to “credit contraction” unless new Treasury debt replaces them.

This shortage of money relative to debt in turn breeds a climate of greed which becomes worse over time due to the universal law of exponential debt growth. Today, our debt outstrips our money supply by a factor of at least 4 to 1, due to this mathematical law. The debt-load so expanded becomes worse over time, making it increasingly difficult to pay even the interest on the debt thereby incrementally squeezing government, business and household budgets alike. Indeed, the credit-as-money squeeze is quite possibly a major motivating factor pushing governmental entities toward profit-driven financial structures that siphon money away from the local community and into the financial arena.

Periodic – and painful – corrections are required in order to maintain system stability, and that is what we are going through now. These downturns, or corrections, inevitably lead to wealth being redistributed upwards into fewer and fewer hands, as those who “have” buy up troubled assets for the proverbial dime on a dollar. In this way, excess debt is wrung out of the system. Without question, our debt-based fractional reserve system is the primary underlying reason for the kind of extreme income inequality and widespread unnecessary poverty that we see today – something foreseen by many of our founding fathers, including William McClay, John Taylor, James Madison and Thomas Jefferson.

Overall, market corrections – whether by sector, locality or generally – exacerbate the inherent money shortage caused by creating money-as-credit by forcing further reductions in the supply of credit (or bank credit serving as money) that is needed to pay wages, produce products and otherwise fuel the local and national economies. Moreover, the more debt that gets paid down or cancelled through default, the less money-as-credit is left in the economy – creating in effect an escalating money shortage which then leads to a deflationary spiral.

Since lending activity is below what it was in 2007, we know that insufficient money (as new loans) is being created by the banking system for use by those citizens, local businesses and local governmental entities most in need. This is why Bernanke was so worried about deflationary trends – the grim scenario for which is spelled out in this online definition:

Deflation: A decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy, opposite of inflation.

The Fed’s latest effort is clearly aimed at countering the deadly deflationary trend of falling prices and wages here at home. Moreover, as Bernancke himself details: “Even absent such risks [of deflation and stagnation] low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating…. Easier financial conditions will promote economic growth.” [Emphasis my own] That considerable spare capacity signifies a shortage of money which Mr. Bernancke hopes can be corrected through “easier financial conditions.”

That is the hope anyway, but banks are still deleveraging their way out of bad debts, borrowers are fewer and farther apart – and Congress is leaning heavily toward a healthy dose of what it calls “austerity” despite its recent hefty tax cut bill, which despite its presumed stimulative effects, represents yet another massive addition to the nation’s liability column.

Meanwhile highly credentialed economists are reading something slightly different into Bernancke’s plea for Congressional help in repairing a broken economy – setting off a renewed debate over calls for austerity as well as exactly what kind of stimulus can be considered cost effective. For example, Joe Stiglitz maintains that “anybody that says, ‘I’m going to only look at one side of the balance sheet, the liabilities; I’m not going to look at the other side, the assets,’ is really not understanding economics… if we spend the money on investments—investments in education, technology, infrastructure—you grow the economy in the short run from the stimulus, you grow the economy in the long term because of the returns that you get on these investments.”

Currency plays

In seeking to raise asset prices, the Fed is doing what it can to level out both sides of the nation’s balance sheet. This is to say, increased asset prices will help balance the liabilities that the Fed and the banking system together create through money/credit creation. This is important because the value of both our assets AND our liabilities are the two key features embedded within our monetary system, and hence the dollar.

The Fed is in effect helping us to inflate our way out of debt, irrespective of how that may affect the global economy or whether that endeavor may in effect force others to pay for our profligate ways. Although other factors serve as counterweights, the temptation to inflate away at least some of the debt is of course magnified by the fact that some 48% of public debt is held by foreigners. And so the unintended consequences begin.

For example, low interest rates – which are encouraged by QE measures as well as Fed Fund rates effectively held at zero – “cheapen” the dollar while excess reserves have the effect of weakening, or lowering the value of, the dollar because excess reserves have the potential to allow the creation of too much credit serving as money. A cheap dollar is a two-edged sword, punishing savers even as it provides strong incentives to engage in speculation. Those who have access to capital, whether stored in savings accounts or elsewhere, are able to leverage that capital into newly created, “cheap” dollars with which to venture forth into the world in search of speculative opportunities that promise big returns.

At the same time, a weakened dollar causes our exports to become cheaper and imports more expensive, reducing consumer demand for imports – arguably a good thing for the national GDP, not so good for importing countries who have depended on our purchases. In both cases, national economic indicators are emphasized; small, local producers across the globe fall farther down the totem pole where devalued, “cheap” dollars produce the harshest impact – albeit via different routes.

The Fed has made its choice clear, regardless of the extent to which “[t]he competitive devaluation orchestrated by the U.S. has consequences for all its trading partners. In essence, the U.S. is manipulating its own currency, while accusing China of doing the same…. The U.S. dollar is both the centre piece of the world financial system, and the national currency of a country with a stagnating economy, which is losing manufacturing capacity and well-paying jobs. One role gets in the way of the other. When faced with a choice between acting on its own behalf, or helping out the world financial system, the U.S. does not hesitate. It looks to itself.”

Those pessimistic about America’s future, and therefore the dollar, believe the day of reckoning is at hand due to what they say – not without some justification – is essentially unpayable U.S. debt. Because “both East and West now find themselves on the edge of a growing deflationary sinkhole created by the sequential collapse of two large US bubbles, the dot.com and US real estate bubbles” there appears to be no viable way left to borrow, spend and inflate our way out. Credit expansion has in other words been overtaken by debt deflation, and the inevitable result is collapse of the dollar.

Meanwhile some experts argue that U.S. debt levels are NOT unsustainable and that commonly used debt-to-GDP charts used to support doomsayers are “technically wrong and analytically meaningless.” Dollar “bulls” also see things a bit differently than the bears, going so far as to say that added debt via QE2 and beyond is bullish for the dollar and for America’s future. One analyst explains:

The Fed’s verbal commitment to support asset prices coupled with its ability to buy assets should provide support in the US financial markets. Moreover, while yields may move slightly higher due to inflationary expectations, the US stock market will remain relatively attractive as compared to bonds. Therefore, from an investor’s perspective, US assets become attractive. The “Goldilocks” environment the Fed is attempting to create could result in foreign investor interest in the US markets as relatively low rates and the Bernanke “put option” make the US a safer place to invest. This foreign investment interest would be supportive of the US dollar. Moreover, as other countries attempt to weaken their currency, the US dollar will strengthen, making US investments even more attractive.

Another “dollar bull” with a similarly positive outlook for America’s future poses the intriguing question of how it is that dollar bears can be so certain that this country is finished:

[S]omeone claiming the dollar is worth nothing clearly carries the burden of proof. The dollar is backed by a $14.59 trillion competitive and innovative economy. Yes, $13.4 trillion in US federal debt is quite far from ideal … [but] Debt/GDP was over 120% in 1940 [when] we accepted the accidental Keynesian spending that was required to fight WWII. Imagine if we ran up to 120% now but did it on infrastructure spending and alternative energy investment within the United States? Think the economy would recover dramatically and ultimately lower the only ratio that really matters: debt/GDP? Japan has a debt/GDP ratio of over 200% yet the yen has not collapsed to zero. In fact, the Japanese Central Bank recently intervened to halt the rally in the yen but to no avail as the yen/dollar is right back to highs in just under 3 weeks…

Currency plays aside, currencies are not stocks, as the afore-mentioned dollar bull later points out. To the extent that a country’s currency reflects the productive and consumptive capacities of its people, and to the extent that such a currency is supported by appropriate monetary policy, said currency can maintain stable value.

This was the main point around which the contentious debate between our founding fathers, most notably Thomas Jefferson and Alexander Hamilton, revolved. In other words, “We’ve been here before. The confrontation between financial power and democratically elected government is as old as the American Republic.”3

Despite Hamilton’s well-known affinity for financial power, it was in fact Hamilton as creator of modern financial policy, who confirmed that “It is immaterial what serves the purpose of money, whether paper or gold and silver; that the effect of both upon industry is the same; and that the intrinsic wealth of a nation is to be measured, not by the abundance of the precious metals contained in it, but by the quantity of the productions of its labor and industry.”4

Money, in other words, represents what people create. Its sole function is to facilitate the exchange of goods and services in such a way as to maintain relative balance between the creative and consumptive capacities of the people. The great sticking point between the Jeffersonians and Hamiltonians was how money was to be created, or brought into circulation. That division remains with us to this day.

To Jefferson’s great and everlasting consternation, Hamilton devised a plan by which bank credit would serve as money and be brought into circulation by the monied elite. Paying homage to gold advocates – and in direct contradiction to his own assertion about how a nation’s wealth should be measured – Hamilton’s credit/money system was nominally backed by gold and expanded through the fractional reserve system.

In an especially poignant letter written to George Washington on September 9, 1792 Jefferson writes that Hamilton’s

“system flowed from principles adverse to liberty, & was calculated to undermine and demolish the republic, by creating an influence of his department over the members of the legislature.

I saw this influence actually produced, & it’s first fruits to be the establishment of the great outlines of his project by the votes of the very persons who, having swallowed his bait were laying themselves out to profit by his plans: & that had these persons withdrawn, as those interested in a question ever should, the vote of the disinterested majority was clearly the reverse of what they made it. These were no longer the votes then of the representatives of the people, but of deserters from the rights & interests of the people: & it was impossible to consider their decisions, which had nothing in view but to enrich themselves…”

Jefferson not only correctly warned of the political threat posed by Hamilton’s financial plan, but he correctly foresaw that perpetually expanding debt would become a major national problem. Most importantly Jefferson knew that “a reliance on bank notes would create economic instability and a permanent creditor faction dependent on the taxpayer, while, in contrast, [properly managed] government paper money would prevent both evils.”5 Not only was government-issued currency that was paid into circulation far more stable and dependable than credit-as-money loaned into circulation but it was far more “democratic.”

The Hamilton contingent, though smaller, was better organized and incentivized than the Jefferson/Madison/yeoman farmer contingent. As soon as the ink was dry on the Constitution, the Hamilton contingent introduced the argument that implied powers allowed the new government to hand over its money power to what was essentially a private corporation. The argument was accepted, Hamilton’s plan won out and its essential elements continue to the present day.

Today the accuracy of Jefferson’s insights are in full view of any who cares to look. As he predicted, debt – together with corruption – has become a systemic problem, albeit far less bothersome for Wall Street and government than it is for savers and producers on Main Street, most of whom are being crushed under the weight of both government taxes and personal debt.

It’s high time to demand that Congress show we the people – and not the banks – the m-o-n-e-y by doing what it is instructed by the Constitution to do: “coin (as in create) Money and regulate the Value thereof.”6 ,7 ,8

  • Read Part 1 and 2.
    1. See also “Modern Money Mechanics,” a publication of the Federal Reserve. []
    2. The Quiet Coup” by Simon Johnson. []
    3. See 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson and James Kwak. Pantheon Books, New York, c2010. [] []
    4. Hamilton’s Works, published by order of the Joint Library Committee of Congress, ed by John C. Hamilton, author of The Life of Hamilton, vol 3, page 18. []
    5. “Bank Notes Will Be But as Oak Leaves” by Donald Swanson. The Virginia Magazine of History and Biography, Vol. 101, No. 1, “In the Modest Garb of Pure Republicanism”: Thomas Jefferson as Reformer and Architect (Jan., 1993), pp. 37-52 Published by: Virginia Historical Society. []
    6. A proposal prepared by The American Monetary Institute is along the lines of Jeffersonian thought because it takes the monetary authority away from private hands and places it in the hands of government, where it is created as money and not bank credit, similar to the manner in which the most successful of colonial money was created, particularly in Virginia, for which colony Jefferson served as governor. []
    7. In a scholarly article titled “Paper Money and the Original Understanding of the Coinage Clause” author Robert Natelson, a recognized expert on the framing and adoption of the United States Constitution, draws upon Founding Era jurisprudence and original source material to discuss in detail the origins of the “coinage clause” as it appears in the U.S. Constitution. Published in 31 Harvard J.L. & Pub. Policy 1017 (2008). []
    8. A new bill submitted by Congressman Dennis Kucinich last December 17 and to be reintroduced in the 112th Congress includes many important elements of monetary reform as defined and advocated by the American Monetary Institute. []

    Geraldine Perry is co-author of The Two Faces of Money and creator of its related website which includes recent reviews. This website also has an abundance of related material and links, along with a free, down loadable slide presentation describing the two forms of money creation and the Constitutional solution, which is not the gold-backed dollar as popularly believed. As a means of imparting accurate information on health and nutrition to as broad an audience as possible she developed the web site The Health Advantage. Read other articles by Geraldine, or visit Geraldine's website.

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