Reprinted from The Commercial and Financial Chronicle, June 7, 1956
An increasing number of articles and speeches have been devoted to the question of whether we should give the Federal Reserve Board standby controls over installment credit. One need not look far to find the reason we are being asked to sanction these ever-increasing government controls. W. McChesney Martin, Chairman of the Federal Reserve Board, stated the reason very clearly as follows:
"It should be borne in mind that expansion in commercial banking operations creates new supplies of money, in contrast to other financial institutions which lend existing funds." (Testimony before Senate Banking Committee.)
In other words, we must distinguish between the lending of credit, i.e., "new supplies of money," and the lending of "existing funds." If all loans were made with existing funds, there would be no valid reason for any government interference, regulation, or control of the lending of those funds. The lending of bona fide savings is merely the lending of a surplus. That is a civilized process that should be encouraged. It should not be controlled and regulated by the government. Nor should there be any fear over the volume of debt arising from such lending. It is desirable that all our resources--including bona fide savings--be put to maximum use.
Why, then, do we tolerate government interference in the money market? Why all these "credit controls?" Why all this concern over the volume of debt? Because--as Mr. Martin pointed out--when our commercial banking system expands its operations, it does so by lending "new supplies of money" (bank credit), rather than by lending existing funds.
The importance of this fact cannot be over-emphasized. Our entire price structure today is in terms of bank credit originating from earlier expansions of commercial bank operations. Over 90% of what we are using as money is nothing but bank credit. And because our past experience with bank credit has shown that it is highly unstable, and that undue fluctuations in its supply can have disastrous effects upon our economic system, we have been forced to accept ever-increasing government controls of our banking system.
Need we fear these controls? Yes. No man or group of men should have the power to arbitrarily manipulate the supply of money or to determine the channels into which savings should flow. The power to change the supply of money is a tremendous power. It is the power to force debtors into slavery; it is the power to dispossess people of their property; it is the power to rob people of the value of their savings. And the power to determine the channels into which savings should flow is the power to control the entire economic system. The existence of such powers is totally incompatible with the survival of freedom--both economic and political. And yet, under the existing banking system, if we do not grant these powers to the Federal Reserve Board, a semi-public agency, then they will remain in the hands of our commercial banks and market forces which in the past produced such violent fluctuations in the supply of money (bank credit) as to nearly destroy our free enterprise system.
Dilemma Confronting Us
That is the dilemma that confronts us. How can we preserve the monetary stability that is needed for the proper functioning of a free economic system without being forced into a financial dictatorship that is incompatible with the survival of our free economic system?
If we keep in mind the basic cause of our dilemma, we should have no trouble figuring a way out of it. If the basic justification for government controls of banking stems from the fact that an expansion in commercial banking operations creates new supplies of money, then why not convert our commercial banks into institutions that can lend only existing funds? If this could be done without unduly upsetting our financial markets, and if some provisions can be made for additions to the supply of money as needed to serve an expanding population, then we could enjoy monetary stability without the threat of a financial dictatorship.
Why Change Banking?
There are many good reasons why we should seriously consider making such a change in our banking system. In the first place, this reform is the next logical step in the evolution of banking. Over 100 years ago--after the era of wildcat banking--it was recognized that banks should not have the power to issue their own notes. That power was taken away from the banks. What we failed to realize at that time was that the power to create "deposits" subject to check is equivalent to the power to issue notes. So although one-half the weakness in our banking system was corrected, the other half remained--as has been amply demonstrated by the many bank panics suffered since that time.
Now that almost all students of the subject agree that there is no basic difference between notes and checks, we should complete the reform of our banking system by making it unlawful for banks to create deposits--taking care to first monetize the existing volume of bank credit (now being used as money) so as to prevent a severe deflation.
A second important reason for making such a change is that bank credit is a fundamentally dishonest type of money. The lending of bank credit is tantamount to the lending of an imaginary surplus. The bank deposits so created are fictitious. The banker--by lending his credit payable in money on demand--places himself in the position of promising to do something that is physically impossible to do. And the further bank credit is extended, the more precarious the position of the banker becomes--until finally confidence is lost and the whole flimsy structure of bank credit collapses.
Bank Credit Causes Inflation
A third important reason for making such a change is that the use of bank credit as a substitute for money is a most unsound procedure. The commonly accepted definition of money is that it is a medium of exchange and a standard of value. Bank credit--even though used as money--is merely a promise to pay money. This is a very important distinction that is too often overlooked. Bank credit is a shortsale of money. And like shortsales of anything else, shortsales of money upset the true value relationship between money and the goods and services to be exchanged for money. In other words, bank credit causes inflation. Prices are inflated whenever they are higher than they ought to be. And if our money is diluted with bank credit, then prices are higher than they ought to be. This concept of inflation is a little different from the orthodox conception of inflation--but it is far more meaningful. No understanding of the cause of deflations (depressions) is possible unless we have a correct understanding of what causes inflation.
There are those who believe that once bank credit has been allowed to expand, nothing can be done to prevent a collapse (that is, nothing economically sound and consistent with a free economic system). The Austrian school--best represented by the writings of Ludwig von Mises--takes this stand as evidenced in the following statement:
Ludwig von Mises
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." (Human Action, p. 570). Dr. von Mises believes that the expansion of bank credit causes malinvestment and a squandering of scarce factors of production that will inevitably lead to a crash and ensuing depression. But a more plausible theory is that all economic activity is continually reaching a new equilibrium between the total circulating medium of exchange and the goods and services offered for it. In other words, an expansion of bank credit leads to a collapse not because of mis-directions in production but rather because of Gresham's Law. The use of bank credit as a medium of exchange gives us what Bishop Berkeley called a "double money." Even though bank credit is supposedly convertible into money on demand, nevertheless it is not as good as money. It is a shortsale of money. And as the volume of these shortsales increases, it is inevitable that Gresham's Law will eventually operate, i.e., the undervalued money (gold or legal tender 'fiat' money) will be exported or hoarded--thus causing a collapse of bank credit.
According to this theory, it is possible to avoid a collapse following a period of credit expansion simply by converting the existing volume of bank credit into actual money having an existence independent of debt, and at the same time take away the banking system's privilege of creating any more credit, i.e., force banks to confine their lending operations to the lending of existing funds.
100% Reserves and Savings Bonds
Is there a practical way of making such a reform today without causing any disruption to our economic system? Yes. It involves validating the existing volume of bank credit (which is now being used as money but which has no actual existence except as bookkeeping entries). This can be done by backing bank deposits subject-to-check with actual currency, while at the same time taking away the banks' privilege of creating any more bank credit. In other words, each commercial bank must be divided into two separate and distinct sections--a Deposit Section and a Savings and Loan Section. The function of the Deposit Section should be that of a warehouse, pure and simple. Deposits would be accepted for safekeeping. The bank would not be allowed to use these deposits--but would merely facilitate the transfer of claims to these deposits by means of checking accounts. All checks drawn against such deposits would therefore be backed 100% by actual money.
The function of the Savings and Loan section would be to obtain the savings of the community for the purpose of making loans to the community. The ideal toward which we should strive is a Savings and Loan section that obtains lendable funds by selling the banks' bonds. The Savings and Loan Section of a bank should have a bonded indebtedness to the public rather than deposits that are withdrawable on 30 days' notice. And, of course, all the banks' loans should mature on or before [the maturity dates of] its outstanding bonds. When operating this way, the bank is free to lend all the savings of the community that have been placed with it--rather than having to retain a cash reserve to honor requests for withdrawals. And the person holding a bank bond always has a liquid asset that can be sold in the event of an emergency.
It is not possible, of course, to attain this ideal overnight. But as a start, the Savings and Loan section of a bank should be set up much the same as existing Savings and Loan Associations. It should have a minimum cash reserve of 5% to honor occasional requests for withdrawals. Then, as its outstanding loans are paid back, it should approach the savings depositors one by one and tell them that their savings can no longer be held as deposits that can be withdrawn within 30 days. Each depositor would have to decide how long a period he wished to make his money available for lending and buy a bond for that period of time. Eventually all savings deposits held by banks at the time the reform is made would be converted into bonded indebtedness of these institutions to the public.
To clarify the mechanics of such a reform, let us take an actual bank statement and analyze it (see table).
| Cash: | |||
| On hand and with Federal Reserve Bank | $105,538,077.17 | ||
| With Other Banks | 24,401,994.59 | $129,940,071.76 | |
| Investments(at not exceeding market value): | |||
| U.S. Government Securities | 200,563,124.32 | ||
| Other Bonds | 34,451,435.16 | 235,014,559.48 | * |
| Stock and Other Securities | 600,004.00 | ||
| Loans: | |||
| Loans and Discounts | 109,323,696.98 | ||
| Loans on Real Estate | 31,638,601.53 | 140,962,298.51 | |
| Customers' Liability for Credits and Acceptances | 7,126,629.09 | ||
| Bank Premises, Furniture and Fixtures | 2,079.706.91 | ||
| Other Real Estate Owned | 5.00 | ||
| Other Assets | 763.99 | ||
| $515,724,038.74 | |||
| LIABILITIES | |||
| Deposits: | |||
| Demand | $332,395,486.71 | ||
| Time (Saving and Commercial) | 114,160,858.07 | ||
| Public Funds | 34,857,221.87 | $481,413,566.65 | |
| Letters of Credit, Credits and Acceptances | 7,126,629.09 | ||
| Reserved for Taxes | 1,580,729.93 | ||
| Other Liabilities | 749,704.83 | ||
| Capital Paid In | 9,000,000.00 | ||
| Surplus | 11,000,000.00 | ||
| Undivided Profits | 4,853,408.24 | 24,853,408.24 |
This bank has total demand deposits of $332,395,486.71. These are the deposits against which checks are being drawn and which should therefore be in the newly formed Deposit Section backed dollar for dollar by actual currency. The bank already has cash reserves of $129,940,071.76. (Although these cash reserves include deposits with other banks, the entire amount can be treated as actual cash if all banks go through a similar change at the same time.) To bring the cash reserves of the Deposit Section up to 100% of its deposits would require an additional $202,455,414.95. However, the newly formed Savings and Loan Section will also need $7,450,904.00 to give it a 5% reserve behind its deposits (which total $149,018,079.94). So the bank would need a total of $209,906,318.95 in order to split itself into a Deposit Section with 100% reserves and a Savings and Loan Section with a 5% reserve.
Print Money to Retire Bonds
The government should print the required amount of money and lend it to the bank. (Although this money is being loaned into existence, its repayment to the government will not cause it to be retired from circulation. All money paid back to the government will be earmarked for retirement of government bonds. It should be clear, therefore, that this new money will have an actual existence independent of debt.) Since the government already owes this bank $200,563,124.32 (U.S. Government Securities held by the bank), the government could advance the entire $209,906,318.95 to the bank, cancel the government securities held by the bank, and accept the bank's bonds in the amount of $9,343,194,63 to cover the difference.
The above plan for converting a particular bank into a deposit bank may not be perfect in all details. Doubtless minor adjustments will have to be made so that each bank is assured adequate funds to tide it over during the change from one system to the other. For example, some of the "Other Liabilities" and "Credits and Acceptances" may be considered as demand liabilities--in which case the bank would have to borrow still more from the government in order to maintain a 100% reserve behind its demand deposits and a 5% reserve behind its savings deposits. Enough of the details of the plan have been given here to indicate the general idea of how our credit banking system can be converted into a deposit banking system.
Once having stabilized the banking system so that it could no longer be the source of changes in the supply of money, it would then be necessary to protect ourselves from arbitrary manipulation of the supply of money by the government. That raises the question: What should determine changes in the supply of money?
How to Change Money Supply
Such well-known economists as Bradford Smith (U.S. Steel Corp.), C. A. Phillips, F. A. Bradford, Carl Snyder, and James Angell have suggested that the supply of money should vary directly as population, i.e., as our population increases, our supply of money should be increased proportionately. Then the supply and demand relationship between population and money will result in a dollar of constant value. Such a dollar would buy more physical goods as techniques of production improve and costs are therefore going down. But this would not be deflationary, because prices would not fall faster than costs--except in those industries suffering from a shift in consumer demand. And prices should fall faster than costs in such industries, in order to facilitate a shift in the basic factors of production from "less wanted" forms of wealth into "more wanted" forms of wealth.
Such a dollar would also always do justice between debtors and creditors, because it would always be equally difficult to obtain.
No Inflation or Deflation
Were we to adopt such a system at this time, we would remove the threat of inflation and deflation while at the same time removing the necessity for any government controls of the lending operations of banks. We could henceforth cease to worry about the amount of consumer debt. All savings should be loaned so as to keep money in circulation. Debts that arise from the lending of actual savings are perfectly sound so long as ordinary caution is used by the lender. It is debts that arise from the lending of bank credit that cause our price level to become inflated. And the threat of deflation that faces us today is due to the fact that our price level is in terms of bank credit rather than in terms of money having an existence independent of debt. By converting that bank credit into money, we will have removed the threat of deflation.
Perhaps the most important result of such a change would be that our bankers and our businessmen could now rely on the stability of the per capita supply of money. Neither our banking system nor our government would have the power to expand or contract the per capita supply of money. Keep in mind that no new purchasing power would be given to, nor would any be taken from, any person who doesn't already have access to that purchasing power today. We would merely be putting actual money where people now think money is;--merely converting credit (which is now being used as money) into money that has an actual existence.
Non-Collapsible Money Market
Bankers would now be free to make the savings of the country readily available for loans without the fear of a possible collapse of the money market. That's not true today. At present, bankers are fully aware of the instability of bank credit. Therefore a conservative banker--anxious to protect his depositors as much as possible--is reluctant to lend credit on long term during a boom because his deposits are withdrawable on demand or at most on 30 days' notice. And the government--also aware of how unstable the banking system is--has surrounded bankers with a mass of red tape, rules, and regulations in a vain effort to protect the public from this essentially unsound operation.
Under this new system, the bankers and the government would know that the money market had a solid, non-collapsible base. They would know that the basic cause of bank panics had been removed. The only restriction on the banks now would be that they would not have the right to create credit as they did formerly. They could only lend savings, i.e., money obtained by sales of their bonds.
This plan has been discussed at length with several bankers. A few, who see the threat of a nationalized banking system, or continued inflation, unless a reform of this sort is made, are strongly in favor of this change. Those who react against it do so for a variety of reasons. Some don't like the prospect of losing the income on all the government bonds they are now holding. But a large part of the income the banks have received from government securities has been passed on to their depositors in the form of lower service charges on checking accounts. These charges should be raised. The full cost of safeguarding money and facilitating the transfer of titles to that money (by means of checking accounts) should be borne by each person or company for whom that service is rendered.
Some bankers will call the plan "inflationary" and some will call it "deflationary." But it should be clear that neither accusation is valid. No additional purchasing power would be added to the system--nor would any be taken out of the system. We would merely be stabilizing at the existing per capita supply of dollars. We would merely be converting bank credit--which is now being used as money--into actual money. This new money will be money that ought to be in the banks today, but isn't. It is money that belongs to those who have checking accounts. Checks are continually being drawn against those deposits. But at present those deposits have no existence except on the books of the banks. And because that situation prevails with all our banks, our price structure is not on a firm basis. By putting a 100% reserve behind all checking accounts, we will be putting our price structure on a sound basis.
Include All Lending Institutions
A banker may say that it would not be fair to force him to rely on sales of his bonds in order to obtain money for lending, when other lending institutions such as Savings and Loan Associations are not required to operate that way. And here the banker is perfectly right. At the time each of our credit banks is split into two sections as previously outlined, all lending institutions should be required to gradually convert their obligations to the public into bonded indebtedness. The public should recognize that it is not proper or sound for them to have the right to withdraw their savings on demand, or on 30 days' notice, when those savings have, in fact, been borrowed by others from the lending institutions for a much longer period than 30 days. It is not sound for the simple reason that it is physically impossible for a lending institution to pay all its depositors in 30 days. But it would be sound for a lending institution to sell its bonds and then make loans that would mature on or before the bonds' maturity dates. And I understand that Swiss banks make use of this principle to some extent--as well as the British Building Societies in England (they are the equivalent of our Savings and Loan Associations).
The banker may then ask: "What happens if everybody wants to sell these new savings bonds at the same time?"
Would Eliminate Hoarding
Buried in the answer to this question is one of the most powerful arguments against credit banking--as well as one of the most powerful arguments for reform. Variations in the volume of money-hoarding are inherent in (because of Gresham's Law), and have a very disturbing effect upon, a system of credit banking. The prime examples of this are the many bank panics which have rocked the system ever since it started. By converting our system of credit banking into a system of deposit banking and stabilizing the per-capita supply of dollars, we will have removed the basic cause of variations in the volume of money-hoarding.
However, if for the sake of argument, we assume that the public suddenly did wish to hoard money (by selling their bank bonds), there would be a healthful counteracting force to prevent such action from reaching excessive proportions: the price of bank bonds would fall.
Contrasts Two Systems
Now contrast the two systems: Under credit banking, there is a justifiable reason for a periodic increase in the desire to hoard money, and there is no deterrent to a withdrawal of money from the banking system for hoarding purposes. Indeed, the justification for the desire to hoard--as well as the actual hoarding itself--is encouraged by the fact that hoarding will cause a contraction of bank credit and therefore an appreciation in the value of money.
Under the new system there is no justifiable reason for a periodic increase in the desire to hoard money. However, if we should assume that an increase in the desire to hoard money should occur, there will be a natural deterrent that will operate to prevent the increase from becoming excessive, i.e. , the price of bank bonds will fall.
This does not mean, however, that a bank bond would be a poor investment. It should be obvious that any commodity or security will fail in price if everyone holding it decides to sell it. Bank bonds--under the new system--would be one of the safest investments that a person could make. The security behind these bank bonds would certainly be all that could be asked for--loans secured by collateral, the dollar value of which is not subject to collapse. Contrast this with the present system in which the dollar value of a bank's collateral collapses whenever bank credit collapses.
Aid Debt Retirement
When it is realized that the conversion of our credit banks into deposit banks automatically reduces the national debt by over $50 billion (the amount of government bonds now held by the banking system), some people may think that a sleight-of-hand trick is being played. But there is nothing tricky about it. The banking system acquired those bonds by literally creating deposits on their books to that amount. As a result of that creation of deposits, as well as the creation of other deposits, our price structure is not on a sound basis. By putting a 100% reserve behind deposits subject to check, we're merely accepting the situation the bankers have put us into and stabilizing it so that it can't collapse. We would merely be putting money where it ought to be but isn't.
It might appear that if we stop using bank credit as money, there will be a great reduction in the liquidity and transferability of wealth. That would be true if we did not monetize the existing volume of bank credit. Bank credit is nothing but a substitute for money--and a very poor substitute at that. One of the functions of money is to make wealth liquid and facilitate the transfer of wealth. The curse of using bank credit as money is that when bank credit collapses, the liquidity of wealth is destroyed. That's why we have depressions. If we furnish ourselves with an adequate supply of money--and stabilize that money by making credit banking illegal--we will then be assured of continuous liquidity.
Population vs. Gold Standard
The question arises: Would it be wise to have such a currency convertible into gold? Certainly not. That would make it credit currency--the very thing that has caused so much trouble. The time has come to cut ourselves loose from the gold standard altogether. The stability of international trade depends primarily upon the stability of the currencies used in international trade. And by abandoning the use of credit as money--thereby stabilizing the dollar--we will be doing the most that can be expected of us toward the establishment of conditions that would make possible an expansion of world trade on a sound basis. (This subject has been thoroughly dealt with in the excellent book International Monetary Issues by Charles R. Whittlesey.)
There are some people who look with distrust upon "printing press" or "fiat" money. But they overlook one of the basic facts about money. It is true that we need a "hard" money. But we should not make the mistake of associating "hardness" with convertibility into gold. The essence of a hard money is not determined by the material of which it is composed--or the material into which it is convertible. The essence of a hard money is that its supply is fairly stable and there are precise limits to it. In other words, gold itself is a comparatively hard money because the supply of gold is inelastic. Bank credit convertible into gold is a very soft money because it is elastic and there are no precise limits to its supply, i.e., it expands and contracts. And a purely paper or "fiat" money can be a hard money if we set precise limits to its supply, or it can be a soft money if we set no precise limits to its supply. A population standard, as described above, would obviously give us a much harder money than the orthodox gold-credit system gave us prior to 1933--and certainly a much harder currency than the money-managers are giving us today.
The time is ripe for a thorough study of the principles upon which our monetary system ought to operate. To do that, we must first clear our minds of the erroneous theories that have been devised to support the use of gold and gold-credit as money. We must think solely in terms of sound economic principles.
It's a challenge--a very great challenge. If we face it, and solve the problem, we will be taking the first constructive step back toward sanity in national and international relations. If we fail to accept the challenge, we will continue sinking into the mire of Collectivism--hopelessly weighted down by the ever-increasing problems arising from an economic system that can't regulate itself because it lacks a stable and reliable standard of value.