Alvin Hansen establishes early in his work, Monetary Theory and Fiscal policy that the power to create money is a force to be reckoned with. In the nineteenth century in the U.S.the private banks at the behest of their business clientele and owners arranged for the monetization of the credit notes they had issued to their customers. Privately issued bills of exchange were exchanged for bank notes. By this process Hansen explains the banks were set up to manufacture money. As the American economy expanded and the frontier pushed westward this private source of money expanded as banks were created under the free banking movement. As such, it became clear that there was a need to create a supply of money but not to create so much that it would lose most of its value. some degree of regulation was required. however, ‘extreme monetary conservatives (were)as mistaken as the monetary cranks….what (was) required (was) temperance -the pursuit of Aristotle’s golden mean applied to monetary management…. Money is an invaluable , but nonetheless dangerous invention. The trick was to permit enterprise through privately owned banks to manufacture its own money, yet to hold the privilege within bounds.” (p.18) Hansen goes on to explain this is how the right to issue money which was clearly a governmental perogative was delegated in the nineteenth century by the federal government to the private banks. Still paper money and check book money became the subject of a debate as to how much of it should be issued in order to ensure that the economy could expand but an inflationary bubble could be avoided. Gold and silver coining was not viewed in the same sort of way because of the difficulty of increasing supplies through the mining process. (p.19)
There was a search on the part of experts including those in the business community for some sort of automatic formula that could control the supply of paper money so that enough was issued but not too much. Over time a formula developed that linked the supply of paper money to that that was necessary to finance current production through bills of exchange and loans for production of goods.”Only the monetization of private credit could supply the efficient circulating medium needed to effect the transactions arising from an expanding economy.” In such a fashion it was thought the banking or commercial loan system could be self regulating and also supply the right amount of money.
Over time out of the debate between the banking principle school and the currency school the principle of convertibility arose whereby it was considered necessary that the banks stood ready to exchange standard bank notes for bank created money. (p.22) This then evolved with creation of a central bank into the principle that the banks would stand ready to pay out ”currency central bank notes and Treasury currency to any depositer.” Over time a convention arose that the banks could pay out currency in some multiple of their holdings of gold and legal tender on deposit with the central bank.
Until the modern and debatable innovation of capital adequacy and risk rules as a substitute for fractional reserves central banks like the Federal Reserve required commercial banks to maintain a legal ratio of reserves on deposit with the Federal Reserve banks. This ratio imposed a limit upon the expansion of bank credit and money issuance. Hansen then discusses the 100 % money controversy . This was a proposal to prohibit the commercial banks from issuing money. Instead under the scheme only the Federal Reserve would have the power to issue money. Demand deposits would always have to be precisely balanced by member bank reserves and vault cash.Time and savings deposits would no longer be considered cash.
Milton Friedman at one point supported the notion of 100 % money because he believed it would ensure that the Fed and the treasury together could then ensure an adequate supply of currency in the system . But 100 % money is controversial , and clearly not favoured by the banking community. The Fed delegates the power to create money by allowing the banks to loan out deposits which for the overall system leads to a multiple on balance of the deposit base being created as money. The Fed stands at the base of this system.
Hansen acknowleges this fact but his discussion of 100 % money demystifies the process.More importantly he demonstrates that there is ample justification for the Fed to purchase government debt when the circumstances demand it.
”Under the 100 % plan individuals and business firms could not acquire new money by borrowing from commercial banks. But the monetary authorities(meaning both the Federal reserve System and the Treasury) could put new money in their hands (1) by Federal Reserve purchases of U.S. securities in the open market, and (2) by creating a government deficit financed by the Federal Reserve banks.”( P.27) This is an important insight into the evolution of the money creation process and its relationship to fiscal policy even if we reject the 100 % money system.
The latest numbers on unemployment are disappointing in the U.S. and confirm what I and others have been saying about the foolishness of austerity as a policy choice in the period after a crash and deep recession. Unemployment rose in Europe to 11.9 % in the euro zone but fell in Germany to 5.4 %. In the U.S. it rose by a tenth of a percent as more discouraged workers rejoined the labour force. It now stands at 8.2 % . More on these events tomorrow.