The public pronouncements of those who occupy leadership positions
and of their so-called economic experts is that we are experiencing an
economic crisis comparable to that which produced the Great Depression
of the 1930s.
The central concern of economists active in those Depression days was
why the predicted forces of equilibrium that economic theory attributed
to the free market economy did not materialize. The formidable John
Maynard Keynes invented the "critical aggregate demand" concept as an
explanation. He postulated that if aggregate demand fell below some
critical level, the equilibrium forces of the free market would be
incapable of restoring equilibrium.
KEYNESIAN REVOLUTION
That being the case, government fiscal programs funded by deficit
spending should be introduced to boost economic activity to the level
required to reactivate the free market forces. This became the
Keynesian revolution adopted worldwide establishing the now normal
practice of using government deficit spending in recessionary periods
to be offset (conceptually) by deficit reduction through government
surpluses achieved in economic boom-times.
Lost, and now totally ignored in this enthusiastic support for the
Keynesian solution, was another line of enquiry that attracted the
attention of a number of other prominent economists of those dreary
economic times, most notably Irving Fisher of Yale, John Commons of the
University of Wisconsin, and Henry Simons of the University of Chicago.
Their focus was on the nature of the fractional reserve system by which
the money needed to sustain a growing economy was loaned into existence
by the commercial banking system.
They were acutely aware that the dramatic collapse of the money supply
following the crash of 1929, which itself was responsible for the
Depression, was an inherent property of this fractional reserve system.
They understood that because the money supply was provided by
authorizing banks to leverage their loan portfolios well beyond their
cash reserves in accordance with the fractional reserve requirements
set by the Federal Reserve, that any repudiation of such debt would
produce the same leveraged decline in the money supply.
Further, if debt was massively repudiated, as happened after the crash
of 1929, their reserves would be so depleted as to challenge their
survival and, at the same time, catastrophically deplete the money
supply.
Today, we are witness to these exact same consequences of the
fractional reserve system, even more leveraged than was the case in
1929. The only difference is that the Keynesian revolution has made
orthodox the government deficit spending that was taboo in 1929, and so
rather than experience the massive bank failures that characterized the
post-1929 economy, the government is now bailing out the banking system
by restoring their greatly depleted cash reserves. What is not
happening is any revival of the question as to whether the fractional
reserve system itself needs to be reformed.
Such a revival would reconsider the questions raised by Fisher, Commons
and Simons and more recently by Hickson, as to the wisdom of the
current arrangement by which our government has largely surrendered its
constitutional authority to create the money supply required to support
a dynamic economy by maintaining in place the fractional reserve system
of money creation.
FRACTIONAL RESERVE SYSTEM
This fractional reserve system is based on a belief amply supported by
historical evidence that governments are incapable of the discipline
needed to ensure that newly created money is not excessive to the needs
of the economy.
The inflationary consequences of the arbitrary and excessive creation
of money by governments are exemplified by the horrific hyperinflation
in Germany that paved the way for Hitler's accession to power, by the
serious bouts of inflation characteristic of many developing countries
and that is being played out today in Zimbabwe.
The historic solution was to transfer most of the money creation task
to commercial banks through the fractional reserve system. The idea was
that the money supply should increase based on demand from the
marketplace rather than the whim of government, and banks could best
supply this by providing the credit needed to meet this demand. Over
time, this fractional reserve system was organized under the control of
a central bank under rules created by central governments.
Governments through central banking and the treasury can inject new
money into the economy, typically by purchasing securities. These
injections can then be multiplied many times as they work their way
through the fractional reserve system of commercial banks. This system
requires banks to retain cash reserves at a central bank that are a
small percentage of their allowed loan portfolio -- thus a small
injection of government-created money will support a much larger bank
creation of money by allowing the expansion of their loan portfolios.
CASH RESERVE PERCENTAGE
The cash reserve percentage (fraction) figure was one of the variables
that governments at one time employed to assist their "control" of the
money supply. Increasing the reserve requirements would require banks
to reduce their loan portfolio and thus the money supply, while
reducing reserve requirements would encourage banks to increase their
loan portfolio and thus the money supply. Today, governments
principally manipulate a particular basic interest rate to encourage or
discourage borrowers.
That is, governments have abandoned the use of a tool that directly
affects the supply of money loaned into existence in favor of one that
does so only indirectly by affecting the demand for new loans -- a
practice most advantageous to the financial community.
The question not being revisited today has to do with the inevitability
by which the fractional reserve system guarantees that tendencies for
economic slowdowns will automatically be exaggerated for no other
reason than that the money supply is so intimately connected to debt.
This necessary correlation also accounts for the massive contraction of
the money supply when debt is massively repudiated, as is happening now.
If governments, instead of creating only a small amount of the new
money required by the economy, produced at least the major portion if
not all of this money, by directly spending or loaning it into
existence, such money could enter the economy as "debt-free" money.
That is, the Gordian knot connecting the money supply to debt would be
severed, and a slowdown in the economy would cease to trigger the
contraction of the money supply that is such a prominent feature of
modern-day recessions.
Obviously posing such questions assumes that modern governments have
the capacity (a) to authorize a technical means free of political
meddling, for determining allowable annual "new money" spending, (b) to
sever their intimate connections to a financial community that would
bitterly oppose such a loss of entitlement, and (c) to safely
transition the financial industry to functionality in a post-fractional
reserve economy. Upon these assumptions rest the case for revisiting
the last Depression's unanswered question.
Cowan lives in Moretown.
