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On the financial crisis

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.

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.

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