How the Banks Use Government

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There are many ways in which human beings have created means of exchange (currency, means of payment, money) that have worked successfully over long periods of time. There is the way that Menger explained, through discovery of a highly marketable commodity. This is the way in which precious metals gained ascendancy. Another way is through banks that have intermediated short-term (90-day) bills of exchange and provided bank notes. This was common for many centuries. Another way is through the deposits of goldsmiths at a bank in exchange for certificates that circulate. Fourth, governments have created tax certificates good for paying taxes, and these have functioned as means of exchange. We should not forget also that there have been many commodities that have been used as means of exchange.

This is not an exhaustive list. It is enough to suggest that the private economy is perfectly capable of generating a variety of means of exchange that solve the economic challenge of low-cost exchange without barter. It is also enough to suggest that even a government can devise a legitimate means of exchange without imposing an illegitimate forced currency, that is, legal tender.

None of these listed methods can cause an economy to malfunction, properly used. None can cause unemployment, properly used. None of them ever has, not unless banks or governments broke certain rules that fundamentally changed the means of exchange into something illegitimate or improper or not fitted to the purpose and to the economizing behavior of human beings.

I have particularly in mind such improper acts as the following:

  1. Governments taxing freely-developed means of exchange so as to disadvantage them.
  2. Governments forcing citizens to use a currency by legal tender restrictions.
  3. Banks issuing notes against assets that were not short-term or were not liquid, assets such as term loans, real estate, stocks and mortgages.
  4. Banks using financial leverage, usually excessive, to borrow money to buy illiquid and/or long-term assets and mixing this activity with the issuance of notes against short-term self-liquidating bills.
  5. Banks rolling over short-term bills and improperly converting them into longer-term obligations.
  6. Governments making their own bonds the basis of issuing bank notes.
  7. Governments insuring bank deposits when the banks were using the funds to buy long-term and/or illiquid assets.
  8. Governments setting up central banks with special privileges such as making their notes legal tender.
  9. Central banks with the power to bail out illiquid banks and other financial institutions that have purchased illiquid assets and become insolvent.
  10. Governments and central banks that favor large banks.
  11. Central banks with the power to purchase government bonds with its government-forced means of payment.
  12. Governments that seize gold, outlaw gold contracts and issue irredeemable money.
  13. Governments that issue certificates or bills of credit far in excess of what they can collect in taxes.
  14. Governments that prevent or restrict their citizens from buying foreign currencies or foreign assets.
  15. Central banks with a monopoly on note issue and the concurrent phasing out of notes issued by individual banks.

This too is not an exhaustive list.

Here we have the opposite situation. Every one of these improper and illegitimate activities has historically been used. Not only can they cause large economic problems, they have caused such problems.

Even prior to the Great Depression, thousands of banks failed in America. This was not because they were unit banks or undiversified, it was because they had invested in long-term illiquid assets, such as farm land and mortgages tied to farm land, whose prices declined. They declined because they had been driven up by World War I and the accompanying excessive creation of means of payment by the central bank (the FED). During the 1920s, the FED created funds that flowed into stocks financed by loans issued, improperly, by banks, since stocks are long-term assets. History shows again and again that banks cannot safely issue redeemable bank notes against long-term assets. Indeed, the stock market crash in 1929 triggered bank failures in America and worldwide.

The large-scale bank failures in the 1930s caused a currency famine, much as in 1893, but the banks in this case did not create a currency of clearinghouse certificates as they had in 1893. The FED now controlled base money. The result was a large-scale deflation and depression.

With the private creation of currency by proper means and a proper system of governing law, this could not have happened.

When banks employ improper practices and when governments make improper laws that shape the banking industry and the entire monetary system, what are the results? We get inflation, deflation, stagflation, booms and crashes, unemployment and, very often, needless wars. We get frictions with other nations, trade interruptions, and excessive volatility of asset and commodity prices. We get resources diverted into efforts to protect against this system. We get failures in accounting. We get excessive frauds and rampant speculation. We get malinvestment. We get extremely unhealthy alliances between financial institutions and governments.

We the ordinary people get a great deal of needless suffering.

Improper practices and laws are the rule, not the exception. It is absurd to blame the 2008 crash and the subsequent deep recession and continuing economic difficulties on the free market or on capitalism. When it comes to the monetary system, these are nowhere in sight.

The current financial system issues that surfaced with a vengeance in 2007-2008 and have not yet been resolved are no different from any others in the past in the sense that the causes of them are the same as always: improper banking practices and improper government laws shaping financial institutions and the monetary system.

Major banks and investment banks borrowed short and lent long. They bought long-term assets with short-term deposits that, under the central banking system, are treated as money or close to it. They broke the economic rule that banks should only properly invest such deposits in self-liquidating loans of 90 days or less while also keeping liquid reserves. They broke the other rules as well. The long-term assets were and are related to the housing industry, in which prices were inflated both by the FED's easy money and government encouragement in various ways. When those assets fell in price, the dominoes began to fall. By providing loans and creating huge amounts of base money, the FED prevented widespread failures of these fundamentally flawed and mismanaged institutions that are working within a fundamentally flawed government-created system of laws and regulations.

The FED postponed fixing the system, but this simply continues and worsens the suffering. The basic problems and issues have not been resolved in the intervening 4 years. They have literally been papered over or, more accurately, digitized over. The system is now operating in "pretend" mode. In some countries in Europe, pretending is no longer possible.

There are those who think — and those who are being instructed to think — that the direct printing of forced currency (politely called legal tender and colloquially called greenbacks) by the U.S. Treasury is better than the printing of forced currency by the FED and will solve the nation's problems. Move the printing press a few blocks down the street, we are told by Ellen Brown, and all will be well. Why? Because those nasty banks that charge interest will be deleted from the picture.

Yes, there are those who think that replacing the central bank's (forced) currency monopoly by the Treasury's (forced) currency monopoly will ameliorate the nation's economic difficulties. These people are so confused that they do not realize that a money monopoly by any other name is still a money monopoly. The currency forced upon the nation that is called the Federal Reserve Note will not be improved by relabeling it a U.S. Note and forcing it upon the nation. In both cases, we the people are not in a position to produce our own currencies because a central institution has forced its own currency upon us as legal tender and monopolistically disallowed other currencies or created insurmountable barriers to their use. It is a farce to think that a government's forced currency is the people's free market currency.

Greenbackism in the form of the printing of forced currency by the U.S. government is totally futile as a method of monetary reform.

Equally futile is another movement spurred on by the evidently energetic Ms. Brown. This is for individual states to start up their own state banks. These banks will, in certain important respects, be much like all other banks. They will adopt the same flawed practices now in evidence everywhere of making long-term loans against deposits, and they will be under the same flawed government laws that exist now that prevent monetary freedom. Their currency will be the same. The states will guarantee deposits.

This movement is much ado about nothing, because it changes nothing fundamental. The hopes and promises articulated by the true believers in this solution are bound to be disappointed. We need not even stop to analyze the many paths by which such government-run banks will fail to operate efficiently, distort economies, and/or cause a decline in the banking within their states. The main point is that the proposed institutions do absolutely nothing to bring about monetary freedom, proper banking practices and proper government laws that must underpin a decent monetary system. State banks that use the national currency and work within the central banking system and the national laws do nothing to rid us of inflation, deflation, stagflation, booms and crashes, unemployment, needless wars and all the other ill effects mentioned above.

The most important message that I can deliver as the bottom line is that a great deal of economic hardship and suffering today is directly related to and caused by improper banking practices and a flawed monetary system created by bad government laws. To reduce this suffering, these must be changed.

This requires far more radical changes in thinking and action in this nation's and the world's monetary system than are commonly mentioned in the main stream media. The radical changes have to be the right changes and effective changes. They can't be dithering around with greenback ideas that are non-starters.

Until we make government make these foundational changes, the current system is going to deliver continued needless suffering.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire: Liberty vs. Domination and the free e-book The U.S. Constitution and Money: Corruption and Decline.

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