Brown Web of Debt The Shocking Truth about our Money System (3rd ed)

Chapter 41 - Restoring Natonal Soverignty

And there was the rub: in London, banking is very big business. If the banks were to move en masse to the Continent, the British economy could collapse like a house of cards.

The 100 Percent Reserve Solution

A proposal similar to the Robertson plan was presented to the U.S. Congress by Representative Jerry Voorhis in the 1940s. Called “the 100 Percent Reserve Solution,” it was first devised in 1926 by Professor Frederick Soddy of Oxford and was revived in 1933 by Professor Henry Simons of the University of Chicago. The plan was to require banks to establish 100 percent reserve backing for their deposits, something they could do by borrowing enough newly-created money from the U.S. Treasury to make up the shortfall.

“With this elegant plan,” wrote Stephen Zarlenga in The Lost Science of Money, “all the bank credit money the banks have created out of thin air, through fractional reserve banking, would be transformed into U.S. government legal tender – real, honest money.” The plan was elegant, but like the later Robertson proposal, it would have been quite costly for the banks. It died when Representative Voorhis lost his seat to Richard Nixon in a vicious campaign funded by the bankers.6

The 100 Percent Reserve Solution was revived by Robert de Fremery in a series of articles published in the 1960s.7 Under his proposal, banks would have two sections, a deposit or checking-account section and a savings-and-loan section:

The deposit section would merely be a warehouse for money. All demand deposits would be backed dollar for dollar by actual currency in the vaults of the bank. The savings-and-loan section would sell Certificates of Deposit (CDs)ii of varying maturities – from 30 days to 20 years – to obtain funds that could be safely loaned for comparable periods of time. Thus money obtained by the sale of 30-day, one-year and five-year CDs, etc., could be loaned for 30 days, one year and five years respectively – not longer. Banks would then be fully liquid at all times and never again need fear a liquidity crisis.

ii	Certificate of deposit (CD): a time deposit with a bank which bears a specific

maturity date (from three months to five years) and a specified interest rate, much like bonds.

396

Web of Debt

The liquidity crisis de Fremery was concerned with came from “borrowing short and lending long” -- borrowing short-term deposits and committing them to long-term loans -- a common practice that exposes banks to the risk that their depositors will withdraw their money before the loans come due, leaving the banks short of lendable funds. Just such a liquidity crisis materialized in the summer of 2007, when holders of collateralized debt obligations or CDOs (securities backed by income-producing assets) discovered that what they thought were triple-A investments were infected with “toxic” subprime debt. The value of the CDOs crashed, making banks and other investors either reluctant or unable to lend as before; and that included lending the money market funds relied on by banks to get through a shortterm shortage. The other option for banks short of funds is to borrow from the Fed, which can advance accounting-entry money as needed; and that is what it has been doing, with a vengeance. Recall the $38 billion credit line the Fed made available on a single day in August 2007. (See Chapter 2.) This “credit” was money created out of thin air, something central banks are considered entitled to do as “lenders of last resort.”8 The taxpayer bailouts that used to cause politicians to lose votes are being replaced with the hidden tax of a massive stealth inflation of the money supply by the “banker’s bank” the Federal Reserve, inflating prices and reducing the value of the dollar.

DeFremery’s 100 percent reserve solution would have avoided this sort of banking crisis and its highly inflationary solution by limiting banks to lending only money they actually have. The American Monetary Institute, an organization founded by Stephen Zarlenga for furthering monetary reform, has drafted a model American Monetary Act that would achieve this result by imposing a 100 percent reserve requirement on all checking-type bank accounts. As in de Fremery’s proposal, these accounts could not be the basis for loans but would simply be “a warehousing and transferring service for which fees are charged.” The Federal Reserve System would be incorporated into the U.S. Treasury, and all new money would be created by these merged government agencies. New money would be spent into circulation by the government to promote the general welfare, monitored in a way so that it was neither inflationary nor deflationary. It would be spent on infrastructure, including education and health care, creating jobs, re-invigorating local economies, and re-funding government at all levels. Banks would lend in the way most people think they do now: by simply acting as intermediaries that accepted savings deposits and lent them out to borrowers.9

397

Chapter 41 - Restoring Natonal Soverignty

A model Monetary Reform Act drafted by Patrick Carmack, author of the popular documentary video The Money Masters, would go even further. It would impose a 100 percent reserve requirement on all bank deposits, including savings deposits. Recall that most “savings deposits” are still “transaction accounts,” in which the money is readily available to the depositor. If it is available to the depositor, it cannot have been “lent” to someone else without duplicating the funds. Under Carmack’s proposal, banks that serviced depositors could not lend at all unless they were using their own money. If banks wanted to make loans of other people’s money, they would have to set up separate institutions for that purpose, not called “banks,” which could lend only pre-existing funds. Banks making loans would join those other lending institutions that can lend only when they first have the money in hand. “Deposits” would not be counted as “reserves” against which loans could be made but would be held in trust for the exclusive use of the depositors.10

How to Eliminate Fractional Reserve Banking

Without Eliminating the Banks

If the power to create the national money supply is going to be the exclusive domain of Congress, 100 percent backing will have to be required for any private bank deposits that can be withdrawn on demand, to avoid the electronic duplication that is the source of growth in the money supply today. But like the Robertson plan proposed in England, proposals for requiring 100 percent reserves have met with the objection that they could bankrupt the banks. We’ve seen that when a bank makes a loan, it merely writes a deposit into the borrower’s account, treating the deposit as a “liability” of the bank. This is money the bank owes to the borrower in return for the borrower’s promise to pay it back. Under a 100 percent reserve system, all of these bank liabilities would have to be “funded” with real money. Federal Reserve Statistical Release H.8 put the total “loans and leases in bank credit” of all U.S. banks as of April 2007 at $6 trillion.11 Since banks today operate with minimal reserves (10 percent or even less), they might have to borrow 90 percent of $6 trillion in “real” money to meet a 100 percent reserve requirement. Where would they find the money to service these loans? They would have to raise interest rates and reduce the interest they paid to depositors, shrinking their profit margins, squeezing their customers, and driving them into the arms

398

Web of Debt

of those non-bank competitors that have already usurped a major portion of the loan market. Just the rumor that the banks were going to have to incur substantial new debt could make bank share values plummet.

William Hummel is not actually in the money reform camp, but in a December 2006 critique of the 100 percent reserve solution, he raised some interesting issues and alternatives. Rather than borrowing from the government, he suggested that the banks could sell their existing loans to investors, getting the loans off their books.12 That is not actually a new idea. It is something the banks have been doing for a number of years. In 2007, “securitized” mortgage debts (mortgages sliced into mortgage-backed securities) were reported at $6.5 trillion, or about one-half of all outstanding mortgage debt (totaling $13 trillion). “Securitized” debt is debt that has been off-loaded by selling it to investors, who collect the interest as it comes due. In effect, the banks have merely acted as middlemen, bringing investors with funds together with borrowers who need funding. This is the role of “investment banks” – putting together deals, finding investors for projects in need of funds. It is also the role played by bank intermediaries in “Islamic banking.” The bank sets up profit-sharing arrangements in which investors buy “stock” rather than interest-bearing “bonds.”

Where could enough investors be found to fund close to $6 trillion in outstanding bank loans? Recall the nearly $9 trillion in bond money that would be freed up if the federal debt were paid off by “monetizing” it with new Greenback dollars. People who had previously stored their savings in government bonds would be looking for a steady source of income to replace the interest stream they had just lost. Investment fund managers, quick to see an opportunity, would no doubt form funds just for this purpose. They could buy up the banks’ existing loans with money from their investors and bundle them into securities. The investors would then be paid interest as it accrued on the loans. In this way, the same Greenback dollars that had “monetized” the federal debt could be used to monetize the $6 trillion in bank loans created with accounting entries by the banks.

Investors today have become leery of buying securitized debt, but this is due largely to lax disclosure and regulation. If the securities laws were strengthened so that all risks were known and on the table, at some price investors could no doubt be found; and if they couldn’t, the banks could still turn to the Fed for an advance of funds -- which is just what they have been doing, accepting a lifeline from the Fed in the form of massive bailouts with highly inflationary accounting-entry money. The difference under a 100 percent reserve system would be

399

Chapter 41 - Restoring Natonal Soverignty

that the Federal Reserve would actually be federal, operating its bailouts in a way that benefited the people rather than just inflating their dollars away. (More on this in Chapter 43.)

The Banking System Is Already Bankrupt

To the charge that imposing a 100 percent reserve requirement could bankrupt the banks, the Wizard’s retort might be that the banking system is already bankrupt. The 300-year fractional-reserve Ponzi scheme has reached its mathematical end-point. The bankers’ chickens have come home to roost, and only a radical overhaul will save the system. Nouriel Roubini, Professor of Economics at New York University and a former advisor to the U.S. Treasury, gave this bleak assessment in a November 2007 newsletter:

I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets . . . ; massive losses on money market funds

. . . ; ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages . . . ; severe problems and losses in commercial real estate . . . ; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed’s lender of last resort support; [and] a sharp increase in corporate defaults and credit spreads . . . . 13

The private banking system can no longer be saved with a stream of accounting-entry “reserves” to support an expanding pyramid of “fractional reserve” lending. If private banks are going to salvage their role in the economy, they are going to have to move into some other line of work. Chris Cook is a British market consultant who was formerly director of the International Petroleum Exchange. He observes that the true role of banks is to serve as guarantors and facilitators of deals. The seller wants his money now, but the buyer doesn’t have it; he wants to pay over time. So the bank steps in and

400

Web of Debt

advances “credit” by creating a deposit from which the borrower can pay the seller. The bank then collects the buyer’s payments over time, adding interest as its compensation for assuming the risk that the buyer won’t pay. The glitch in this model is that the banks don’t create the interest, so larger and larger debt-bubbles have to be created to service the collective debt. A mathematically neater way to achieve this result is through “investment banking” or “Islamic banking” -- bringing investors together with projects in need of funds. The money already exists; the bank just arranges the deal and the issuance of stock. The arrangement is a joint venture rather than a creditor-debtor relationship. The investor makes money only if the company makes money, and the company makes money only if it produces goods and services that add value to the economy. The parasite becomes a partner.14

Businesses and individuals do need a ready source of credit, and that credit could be created from nothing and advanced to borrowers under a 100 percent reserve system, just as is done now. The difference would be that the credit would originate with the government, which alone has the sovereign right to create money; and the interest on it would be returned to the public purse. In effect, the government would just be serving as a “credit clearing exchange,” or as the accountant in a community system of credits and debits. (More on this later.)

A System of National Bank Branches to Service Basic Public Banking Needs?

Hummel points out that if private banks could no longer lend their deposits many times over, they would have little incentive to service the depository needs of the public. Depository functions are basically clerical and offer little opportunity for income except fees for service. Who would service the public’s banking needs if the banks lost interest in that business? In How Credit-Money Shapes the Economy, Professor Guttman notes that our basic banking needs are fairly simple. We need a safe place to keep our money and a practical way to transfer it to others. These services could be performed by a government agency on the model of the now-defunct U.S. Postal Savings System, which operated successfully from 1911 to 1967, providing a safe and efficient place for customers to save and transfer funds. It issued U.S. Postal Savings Bonds in various denominations that paid annual interest, as well as Postal Savings Certificates and domestic money orders.15 The U.S. Postal Savings System was set up to get money out of hiding,

401

Chapter 41 - Restoring Natonal Soverignty

attract the savings of immigrants accustomed to saving at post offices in their native countries, provide safe depositories for people who had lost confidence in private banks, and furnish more convenient depositories for working people than were provided by private banks. (Post offices then had longer hours than banks, being open from 8 a.m. to 6 p.m. six days a week.) The postal system paid two percent interest on deposits annually. The minimum deposit was $1 and the maximum was $2,500. Savings in the system spurted to $1.2 billion during the 1930s and jumped again during World War II, peaking in 1947 at almost $3.4 billion. The U.S. Postal Savings System was shut down in 1967, not because it was inefficient but because it became unnecessary after private banks raised their interest rates and offered the same governmental guarantees that the postal savings system had.16

The services offered by a modern system of federally-operated bank branches would have to be modified to reflect today’s conditions, but the point is that the government has done these things before and could do them again. Indeed, if “fractional reserve” banking were eliminated, those functions could fall to the government by default. Hummel suggests that it would make sense to simplify the banking business by transferring the depository role to a system of bank branches acting as one entity under the Federal Reserve. Among other advantages, he says:

Since all deposits would be entries in a common computer network, determining balances and clearing checks could be done instantly, thereby eliminating checking system floatiii and its logistic complexities. . . .

With the Fed operating as the sole depository, payments would only involve the transfer of deposits between accounts within a single bank. This would allow for instant clearing, eliminate the nuisance of checking system float, and significantly reduce associated costs. Additional advantages include the elimination of any need for deposit insurance, and ending overnight sweepsiv and other sterile games that banks play to

iii Float: the time that elapses between when a check is deposited and the funds are available to the depositor, during which the bank is collecting payment from the payer’s bank.

iv The overnight sweep is a tactic for maximizing interest by “sweeping” funds not being immediately used in a low-interest account into a high-interest account, where they remain until the balance in the low-interest account drops below a certain minimum.

402

Web of Debt

get around the fractional reserve requirement.17

In Hummel’s model, the Fed would be the sole depository and only its branches would be called “banks.” Institutions formerly called banks would have to close down their depository operations and would become “private financial institutions” (PFIs), along with finance companies, pension funds, mutual funds, insurance companies and the like. Some banks would probably sell out to existing PFIs. PFIs could borrow from the Fed just as banks do now, but the interest rate would be set high enough to discourage them from engaging in “purely speculative games in the financial markets.” Without the depository role, banks would no longer need the same number of branch offices. The Fed would probably offer to buy them in setting up its own depository branch offices. Hummel suggests that a logical way to proceed would be to gradually increase the reserve ratio requirement on existing depositories until it reached 100 percent.

The National Credit Card

A system of publicly-owned bank branches could also solve the credit card problem. Hummel notes that imposing a 100 percent reserve requirement on the banks would mean the end of the private credit card business. Recall that when a bank issues credit against a customer’s charge slip, the charge slip is considered a “negotiable instrument” that becomes an “asset” against which the bank creates a “liability” in the form of a deposit. The bank balances its books without debiting its own assets or anyone else’s account. The bank is thus creating new money, something private banks could no longer do under a 100 percent reserve system. But the ability to get ready credit against the borrower’s promise to pay is an important service that would be sorely missed if banks could no longer engage in it. If your ability to use your credit card were contingent on your bank’s ability to obtain scarce funds in a competitive market, you might find, when you went to pay your restaurant bill, that credit had been denied because your bank was out of lendable funds.

The notion that money has to “be there” before it can be borrowed is based on the old commodity theory of money. Theorists from Cotton Mather to Benjamin Franklin to Michael Linton (who designed the LETS system) have all defined “money” as something else. It is simply “credit” – an advance against the borrower’s promise to repay. Credit originates with that promise, not with someone else’s deposit of something valuable in the bank. Credit is not dependent on someone

403

Chapter 41 - Restoring Natonal Soverignty

else having given up his rights to an asset for a period of time, and “reserves” are not necessary for advancing it. What is wrong with the current system is not that money is advanced as a credit against the borrower’s promise to repay but that the interest on this advance accrues to private banks that gave up nothing of their own to earn it. This problem could be rectified by turning the extension of credit over to a system of truly national banks, which would be authorized to advance the “full faith and credit of the United States” as agents of Congress, which is authorized to create the national money supply under the Constitution.

Credit card services actually are an extension of the depository functions of banks. The link with bank deposits is particularly obvious in the case of those debit cards that can be used to trigger ATM machines to spit out twenty dollar bills. When you make a transfer or withdrawal on your debit card, the money is immediately transferred out of your account, just as if you had written a check. When you use your credit card, the link is not quite so obvious, since the money doesn’t come out of your account until later; but it is still your money that is being advanced, not someone else’s. Again, your promise to pay becomes an asset and a liability of the bank at the same time, without bringing any of the bank’s or any other depositor’s money into the deal. The natural agency for handling this sort of transaction would be an institution that is authorized both to deal with deposits and to create credit-money with accounting entries, something a truly “national” bank could do as an agent of Congress. A government banking agency would not be driven by the profit motive to gouge desperate people with exorbitant interest charges. Credit could be extended at interest rates that were reasonable, predictable and fixed. In appropriate circumstances, credit might even be extended interestfree. (More on this in Chapter 42.)

Old Banks Under New Management

The branch offices set up by a truly federal Federal Reserve would not need to be new entities, and they would not need to take over the whole banking business. They could be existing banks that had been bought by the government or picked up in bankruptcy. As we’ll see in Chapter 43, the same mega-banks that handle a major portion of the nation’s credit card business today may already be insolvent, making them prime candidates for FDIC receivership and government takeover. If just those banking giants were made government agencies, they

404

Web of Debt

might provide enough branches to service the depository and credit card needs of the citizenry, leaving the lending of pre-existing funds to private financial institutions just as is done now.

Note too that the government would not actually have to run these new bank branches. The FDIC could just hire new management or give the old management new guidelines, redirecting them to operate the business for the benefit of the public. As in any corporate acquisition, not much would need to change beyond the names on the stock certificates. Business could carry on as before. The employees would just be under new management. The banks could advance loans as accounting entries, just as they do now. The difference would be that interest on advances of credit, rather than going into private vaults for private profit, would go into the coffers of the government.

The “full faith and credit of the United States” would become an asset of the United States.

A Money Supply That Regulates Itself?

Hummel points to another wrinkle that would need to be worked out in a 100 percent reserve system: the extension of credit by private banks plays an important role in regulating the national money supply. Public borrowing is the natural determinant of monetary growth. When banks extend credit, the money supply expands naturally to meet the needs of growth and productivity. If a 100 percent reserve requirement were imposed, the money supply could not grow in this organic way, so growth would have to be brought about by some artificial means.

One alternative would be for the government to expand the money supply according to a set formula. Milton Friedman suggested a fixed 4 percent per year. But such a system would not allow for modifying the money supply to respond to external shocks or varying internal needs. Another alternative would be to delegate monetary expansion to a monetary board of some sort, which would be authorized to determine how much new money the government could issue in any given period. But that alternative too would be subject to the vagaries of human error and manipulation for private gain. We’ve seen the roller-coaster results when the Fed has been allowed to manipulate the money supply by arbitrarily changing interest rates and reserve requirements. The Great Depression was blamed on Fed tinkering.

Why does the money supply need to be manipulated by the Federal Reserve? Consumer loans are self-liquidating: the new money they

405