Guest Post: 7 Questions About Public Banking

By Washington.  Note: I can’t get the videos to embed. Please click here to see videos.

This is an open letter to the economics, finance and banking communities. I don’t have any dog in the fight, other than to figure out and then publicize what is best for the greatest number of people. People I greatly respect advocate for federal-level public banking, state public banks or a return to the gold standard. I am simply attempting to start a high-level debate about what the best option is.

Please see responses posted by economists and others below.  I will update the responses as I receive them.

How Is Credit Created?

I pointed out in September:

As PhD economist Steve Keen pointed out recently, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:

The model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about 4 periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Kydland and Prescott observed at the end of their paper that:

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

In other words, if the conventional view that excess reserves (stemming either from customer deposits or government infusions of money) lead to increased lending were correct, then Kydland and Prescott would have found that credit is extended by the banks (i.e. loaned out to customers) after the banks received infusions of money from the government. Instead, they found that the extension of credit preceded the receipt of government monies.

Keen explained in an interview Friday that 25 years of research shows that creation of debt by banks precedes creation of government money, and that debt money is created first and precedes creation of credit money.

As Mish has previously noted:

Conventional wisdom regarding the money multiplier is wrong. Australian economist Steve Keen notes that in a debt based society, expansion of credit comes first and reserves come later.

This angle of the banking system has actually been discussed for many years by leading experts:

“[Banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers’ transaction accounts.”
– 1960s Chicago Federal Reserve Bank booklet entitled “Modern Money Mechanics”

“The process by which banks create money is so simple that the mind is repelled.”
– Economist John Kenneth Galbraith

“[W]hen a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit; it was not previously paid in to the bank by anyone. It’s new money, created by the bank for the use of the borrower.
– Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

“Do private banks issue money today? Yes. Although banks no longer have the right to issue bank notes, they can create money in the form of bank deposits when they lend money to businesses, or buy securities. . . . The important thing to remember is that when banks lend money they don’t necessarily take it from anyone else to lend. Thus they ‘create’ it.”
-Congressman Wright Patman, Money Facts (House Committee on Banking and Currency, 1964)

The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented.”
– Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920s.

“Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created — brand new money.”
– Graham Towers, Governor of the Bank of Canada from 1935 to 1955.

I’ve also noted:

In First National Bank v. Daly (often referred to as the “Credit River” case) the court found that the bank created money “out of thin air”:

[The president of the First National Bank of Montgomery] admitted that all of the money or credit which was used as a consideration [for the mortgage loan given to the defendant] was created upon their books, that this was standard banking practice exercised by their bank in combination with the Federal Reserve Bank of Minneaopolis, another private bank, further that he knew of no United States statute or law that gave the Plaintiff [bank] the authority to do this.

The court also held:

The money and credit first came into existence when they [the bank] created it.

(Here’s the case file).

Justice courts are just local courts, and not as powerful or prestigious as state supreme courts, for example. And it was not a judge, but a justice of the peace who made the decision.

But what is important is that the president of the First National Bank of Montgomery apparently admitted that his bank created money by simply making an entry in its book …

Moreover, although it is counter-intuitive, virtually all money is actually created as debt. For example, in a hearing held on September 30, 1941 in the House Committee on Banking and Currency, then-Chairman of the Federal Reserve (Mariner S. Eccles) said:

That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.

And Robert H. Hemphill, Credit Manager of the Federal Reserve Bank of Atlanta, said:

If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is. It is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.

This must-see 47 minute video provides details:

So here are the first two questions:

Do you agree that banks create credit by initiating loans, and then obtaining deposits subsequently, to comply with depository requirements? I’m not talking about the coins which governments create (in America, coins represent less than 5% of the total money in circulation).

Do you agree with Eccles and Hemphill that money is debt, in that new credit normally comes into existence when a new loan is issued?

Government Alternative

William Greider is a former Washington Post and Rolling Stone editor, and now writes for the Nation. Greider has written numerous books and articles on the economy over the course of many decades, including one of the leading books on the Federal Reserve, Secrets of the Temple.

In an article in the Nation, Greider argues that the government could solve the economic crisis by taking back the power of money creation from the banks and the Federal reserve:

For the first time in generations, [the Fed is] now threatened with popular rebellion.

During the past year, the Fed has flooded the streets with money–distributing trillions of dollars to banks, financial markets and commercial interests …

Where did the central bank get all the money it is handing out? Basically, the Fed printed it, out of thin air. That is what central banks do. Who told the Fed governors they could do this? Nobody, really–not Congress or the president. The Federal Reserve Board, alone among government agencies, does not submit its budgets to Congress for authorization and appropriation. It raises its own money, sets its own priorities.

Representative Wright Patman, the Texas populist who was a scourge of central bankers, once described the Federal Reserve as “a pretty queer duck.” Congress created the Fed in 1913 with the presumption that it would be “independent” from the rest of government, aloof from regular politics and deliberately shielded from the hot breath of voters or the grasping appetites of private interests–with one powerful exception: the bankers…

Banks are the “shareholders” who ostensibly own the twelve regional Federal Reserve banks…

The Federal Reserve is the black hole of our democracy–the crucial contradiction that keeps the people and their representatives from having any voice in these most important public policies. That’s why the central bankers have always operated in secrecy, avoiding public controversy and inevitable accusations of special deal-making. The current crisis has blown the central bank’s cover…

Altering the central bank would also give Congress an opening to reclaim its primacy in this most important matter. That sounds farfetched to modern sensibilities, and traditionalists will scream that it is a recipe for inflationary disaster. But this is what the Constitution prescribes: “The Congress shall have the power to coin money [and] regulate the value thereof.” It does not grant the president or the treasury secretary this power. Nor does it envision a secretive central bank that interacts murkily with the executive branch…

If Ben Bernanke can create trillions of dollars at will and spread them around the financial system, could government do the same thing to finance important public projects the people want and need? Daring as it sounds, the answer is, Yes, we can.

The central bank’s most mysterious power–to create money with a few computer keystrokes–is dauntingly complicated, and the mechanics are not widely understood. But the essential thing to understand is that this power relies on democratic consent–the people’s trust, their willingness to accept the currency and use it in exchange. This is not entirely voluntary, since the government also requires people to pay their taxes in dollars, not euros or yen. But citizens conferred the power on government through their elected representatives. Newly created money is often called the “pure credit” of the nation. In principle, it exists for the benefit of all];

In this emergency, Bernanke essentially used the Fed’s money-creation power in a way that resembles the “greenbacks” Abraham Lincoln printed to fight the Civil War. Lincoln was faced with rising costs and shrinking revenues (because the Confederate states had left the Union). The president authorized issuance of a novel national currency–the “greenback”–that had no backing in gold reserves and therefore outraged orthodox thinking. But the greenbacks worked. The expanded money supply helped pay for war mobilization and kept the economy booming. In a sense, Lincoln won the war by relying on the “full faith and credit” of the people, much as Bernanke is printing money freely to fight off financial collapse and deflation.

If Congress chooses to take charge of its constitutional duty, it could similarly use greenback currency created by the Federal Reserve as a legitimate channel for financing important public projects–like sorely needed improvements to the nation’s infrastructure. Obviously, this has to be done carefully and responsibly, limited to normal expansion of the money supply and used only for projects that truly benefit the entire nation (lest it lead to inflation). But here is an example of how it would work…

Instead, Congress should create a stand-alone development fund for long-term capital investment projects (this would require the long-sought reform of the federal budget, which makes no distinction between current operating spending and long-term investment). The Fed would continue to create money only as needed by the economy; but instead of injecting this money into the banking system, a portion of it would go directly to the capital investment fund, earmarked by Congress for specific projects of great urgency. The idea of direct financing for infrastructure has been proposed periodically for many years by groups from right and left…

This approach speaks to the contradiction House Speaker Pelosi pointed out when she asked why the Fed has limitless money to spend however it sees fit. Instead of borrowing the money to pay for the new rail system, the government financing would draw on the public’s money-creation process–just as Lincoln did and Bernanke is now doing.

The bankers would howl, for good reason. They profit enormously from the present system and share in the money-creation process. When the Fed injects more reserves into the banking system, it automatically multiplies the banks’ capacity to create money by increasing their lending (and banks, in turn, collect interest on their new loans). The direct-financing approach would not halt the banking industry’s role in allocating new credit, since the newly created money would still wind up in the banks as deposits. But the government would now decide how to allocate new credit to preferred public projects rather than let private banks make all the decisions for us.

Here are my third, fourth and fifth questions:

Do you agree with Greider that the American Constitution and/or the inherent right of sovereign nations gives the government the power and authority to itself create credit?

Do you agree with Greider that such government creation of credit need not be inflationary so long as only as much credit is created as is needed by the economy – in other words, the amount actually needed to buy goods and services?

Several monetary commentators have said that – if credit is created primarily by the government instead of private banks – that it would save the government trillions of dollars in interest. Specifically, they claim that private banks charge interest to the government to fund the government’s debt, but that the government would owe no debt on credit it creates itself.

Is that true?

What Is the Best Public Banking Option?

As I wrote in November:

AFL-CIO president Richard Trumka told Congress last week:

If the Federal Reserve were made a fully public body, it would be an acceptable alternative.

The American Monetary Institute proposes the following alternative:

Incorporate the Federal Reserve System into the U.S. Treasury where all new money would be created by government as money, not interest-bearing debt; and be spent into circulation to promote the general welfare. The monetary system would be monitored to be neither inflationary nor deflationary.

Second, halt the bank’s privilege to create money by ending the fractional reserve system in a gentle and elegant way.

All the past monetized private credit would be converted into U.S. government money. Banks would then act as intermediaries accepting savings deposits and loaning them out to borrowers. They would do what people think they do now. This Act nationalizes the money system, not the banking system.

Bloomberg News columnist Matthew Lynn writes:

The U.K. government needs to start thinking about what it will do with all the banks it now owns. The answer is simple: Hand them to the people…

Instead of selling the stakes it acquired in the financial system to other banks, or listing the shares on the stock market, it could create mutually owned societies. Royal Bank of Scotland Group Plc could be a people’s bank, owned by everyone.That would ensure more diversity, competition and stability, all goals just as worthy as getting back the money Prime Minister Gordon Brown’s government spent on bank rescues…

Sovereign nations such as the U.S. and England have the power to create credit and money (and see this, this and this). Taking the credit-creation power away from the banks and giving it back to the nation would ensure that credit is freed up for people’s use, and the stranglehold over the economy is taken away from the too big to fails.

State Public Banks

Many people argue that – given its actions – people don’t trust the federal government to create money.

Fair enough. Why not let the states do it?

Michael Moore recommends that the American people demand:

Each of the 50 states must create a state-owned public bank like they have in North Dakota. Then congress MUST reinstate all the strict pre-Reagan regulations on all commercial banks, investment firms, insurance companies — and all the other industries that have been savaged by deregulation: Airlines, the food industry, pharmaceutical companies — you name it. If a company’s primary motive to exist is to make a profit, then it needs a set of stringent rules to live by — and the first rule is “Do no harm.” The second rule: The question must always be asked — “Is this for the common good?” (Click here for some info about the state-owned Bank of North Dakota.)

As Moore notes, the state of North Dakota already has such a bank, and – because of that – North Dakota is just about the only state which is not running a huge deficit.

PhD economist and candidate for Florida governor Farid Khavari wants to create a Bank of the State of Florida, to create credit without burdening the state and its citizens with high interest charges by private banks.

See this for details.

Local Public Banks

An alternative to federal or state public banking is local public banks, as proposed by Edward Kellogg and others.

As summarized by Adrian Kuzminski:

During this time of financial and economic crisis, it is worth recalling that credible alternatives to our current financial system exist, if largely unrecognized, and deserve serious consideration…

The now-neglected 19th-century American proto-populist, Edward Kellogg … was a kind of godfather to the later populist movement on monetary issues. Perhaps the most profound of American writers on monetary issues, Kellogg advocated a decentralized but nationally regulated monetary system based on non-usurious, low-interest public loans to individuals. His vision inspired 19th-century century mutualists, greenbackers, populists, and others who sought to restructure the monetary system to redistribute wealth.

In our own day, when usurious credit in the form of private finance capital remains the dominant force in economic life, and is largely taken for granted even by educated people, the alternative Kellogg offers is more important than ever. Indeed, I suggest that Kellogg’s theory of money is the best monetary alternative we have to the baleful system under which we suffer…

Edward Kellogg (1790-1858) was a New York City businessman whose losses in the crash of 1837 led him to examine the business cycle, monetary policy, and debt. In a series of writings, Kellogg developed the idea of … having the government provide very-low-interest loans to the general public. These loans would have a uniform, fixed interest rate, established by law. They would be issued locally through a system of public credit banks he called the Safety Fund. Once issued, these low-interest loan notes would circulate as currency, replacing the privately issued banking notes of his day (which today take the form of Federal Reserve Notes)…

In his day Kellogg seems to have influenced even Abraham Lincoln who, according to historian Mark A. Lause, ” . . . had his own copy of Kellogg’s book, Labor and Capital [sic] advocating the government issuance of paper currency as a just means of redistributing wealth, and he corresponded with the author’s son-in-law.” Kellogg’s public currency was intended to end the monopoly over the discretionary issuance of money at interest, which was held then (and now) by the private banking and investment system…

Kellogg proposed to establish local public credit banks, and we might imagine one in each community. These local public credit banks would be part of the Safety Fund. Instead of money being issued (as it is now) through a privatized and centralized money-management system on a top-down basis, primarily as loans at increasing rates of interest from a central bank to major commercial banks, and then to regional and local banks, and then to the public, money in his system would be issued by local federal banks as loans directly to citizens at nominal interest on the basis of their economic prospects. Once lent out, Kellogg’s public credit notes would flow into circulation, providing the basis for a new currency backed by the assets of individual borrowers…

A centralized national currency would be replaced, in Kellogg’s system, by a locally issued currency. But that currency would everywhere be subject to common national standards, ensuring that each local public credit bank reliably issued equivalent units of currency. A dollar issued by one local public credit bank of the Safety Fund, Kellogg intended, would be worth the same as, and be freely interchangeable with, one issued by any other. The independence of local branches would be guaranteed by the discretionary power reserved to them as a local monopoly actually to loan money; the compatibility of their monies would be ensured under federal law by fixing the value of the dollar by law at 1.1 percent/year – that is, by lending money everywhere to citizens at that rate…

The goal is to establish and preserve economic decentralization. Amounts of money lent in Kellogg’s system would vary considerably from place to place, with some areas needing and creating more currency than others. The solvency of local federal public credit banks would be guaranteed by collateral put up by borrowers, and the money supply would be stabilized by repayment of loans as they came due. The interchangeability of public credit bank notes would ensure a wide circulation for the new money…

To achieve a stable currency, Kellogg insisted that this rate be fixed by law; perhaps today it would take a constitutional amendment.

Michael Hudson (Distinguished Research Professor at the University of Missouri, Kansas City, who has advised the U.S., Canadian, Mexican and Latvian governments as well as the United Nations Institute for Training and Research. He is a former Wall Street economist at Chase Manhattan Bank who also helped establish the world’s first sovereign debt fund) and Congressman Dennis Kucinich both support the federal public banking option:

On the other hand, California considered creation of a state bank modeled after North Dakota’s bank in 1977. And the Massachusetts state Senate is currently considering creation of a state public bank, and other states are currently considering creating their own state banks.

So here is my sixth question:

Do you think a federal, state or local public banking option is best?

What About Gold?

Advocates for a return to the gold standard point out that – when a currency is pegged to a hard asset such as gold – it imposes fiscal discipline. Specifically, the government cannot simply run its “printing press” if its currency has to maintain a set ratio to a hard asset, and this prevents funding of endless wars and other misadventures.

Advocates for public banking, on the other hand, point to the numerous depressions which have occurred during periods when the gold standard was in place.

See these short videos (I don’t necessarily agree with the conspiracy theories alleged in the first video, but only with the general question of whether we can assure that the quantity and quality of gold can be assured):

Here is my seventh and final question:

Is there any way to have a hybrid monetary system which provides the benefits of public banking with the fiscal discipline which something like a gold standard imposes?

Responses to This Essay

Steve Keen is an Associate Professor in economics and finance at the University of Western Sydney. He identifies as post-Keynesian, criticizing both modern neoclassical economics and (some of) Marxian economics as inconsistent, unscientific and empirically unsupported. The major influences on Keen’s thinking about economics include Hyman Minsky, Piero Sraffa and Joseph Alois Schumpeter. His recent work mostly concentrates on mathematical modeling and simulation of financial instability. Keen writes at DebtDeflation.com/blogs

Keen responds:

I obviously see the need to reform the financial system, but my analysis of how credit is created (see my “Roving Cavaliers of Credit” post: http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/) makes me sceptical that any new system will “hold” so long as financiers can make money by financing asset-price speculation. I believe the experience of history should tell us that every system we’ve tried to far has finally succumbed to a debt-financed asset-price bubble, whose bursting has brought in at best a recession and at worst a Depression.

I have therefore developed proposals to tackle the root problem from the other side of the ledger: if financiers can always be expected to exploit the desire of borrowers to speculate on rising asset prices, then we have to remove that desire in the first place.

The most effective way to do this would be to redesign assets in a manner that still encouraged individual ownership and enterprise, but made the prospects of leveraged gains on asset speculation much less likely.

My two proposals are: to modify shares so that once they are on the secondary market they expire after a predefined period (say 25 years); and to limit the maximum leverage that can be secured against a property to some multiple (say 10) of the property’s annual rental income.

Explaining these in more detail:

Shares

Shares purchased in an initial public offering or float would last indefinitely while held by the original purchaser. But once these shares were sold, they would have a defined life of (say) 25 years.

This would have several benefits over our current system:

(1) Purchasers of shares on the secondary market would be forced to do what the Capital Assets Pricing Model (the delusional neoclassical theory that dominated academic finance prior to the GFC) pretended they do now: to value shares on a sensible valuation of expected future dividend earnings. You would only buy a share under this system if you expected a reasonably good stream of dividends from it, because in 25 years it would expire; and

(2) It would encourage the act of providing finance to new ventures. At present, the share market does a very poor job of providing new finance, with over 99% of the transactions being secondary market sales in search of capital gains. With my change, the only way to secure an indefinite stream of revenue from a new venture would be to provide it with some of its initial capital. This proposal would drastically shift the balance in favour of raising initial capital, which is the only truly socially beneficial role of the stock market.

Property

The great danger with the current system is that there is a positive feedback loop between property prices and leverage. An increase in leverage allows a purchaser to bid a higher price for a property, which encourages other purchasers to come in with higher leverage again with the intention of profiting from selling on a rising market. This is the basic mechanism that led to the Subprime Crisis.

If instead there were a maximum allowed level of leverage based on the income-earning potential of the property being purchased, then an increase in price would cause a reduction in leverage: if a purchaser truly wanted a given property and was willing to pay more than ten times the annual rental income to secure it, then he/she would necessarily have to use unleveraged funds to do so, and the increase in price would cause a reduction in leverage.

Stability

The real problem with other proposals–such as government-created credit, etc.–is that without reform to the way we define capital assets, this money can still be used to speculate on asset prices. This can lead to asset bubbles, and those who are successful in them will gain money and the power that comes with it. They will then be in a position to lobby for the unwinding of the reforms that were enacted during the crisis–as we have seen in our own lifetimes with the abolition of almost all the Great Depression era legislation in the leadup to the GFC.

This proposal would limit that prospect by preventing the formation of the class of Ponzi Financiers in the first instance. This to me is the real lesson of financial history: every crisis is caused by debt, the debt is taken on by Ponzi Financiers who then accumulate the economic and political power to reshape the system to suit themselves, leading to its inevitable collapse. We have to stop the Ponzis at the source, and the source is the potential for leveraged gain on asset prices.

Print Friendly, PDF & Email
This entry was posted in Guest Post on by .

About George Washington

George Washington is the head writer at Washington’s Blog. A busy professional and former adjunct professor, George’s insatiable curiousity causes him to write on a wide variety of topics, including economics, finance, the environment and politics. For further details, ask Keith Alexander… http://www.washingtonsblog.com

37 comments

  1. Inspector Asset

    For some comic relief go to http://www.WallSTOnion.blogspot.com

    Tim Geithner announces the new and improved monetary policy for U.S. that was hammered out over the weekend with Lawerence Summers and received a two-thumbs up from the Obama administration. The new policy comes as a result of the new tough reforms coming out of DC against Wall Street due to the crisis in 2008. Tim Geithner, speaks excitedly about the new policy and states “unlike the past, this new reform package, and new monetary has plenty of transparency and oversight.”

    In fact the new policy is so simple that oversight may not be needed at all, as pointed out by Congress member Maxine Walters. It is better known on the hill as “The 3 rule system.”

    Rule # 1. If the investment is worthless (toxic) the Treasury shall buy it and pay full price. If a price is not known, then we shall make up a price.

    Rule # 2. If the investment has any value at all, or has the potential to show value in the future than the Federal Reserve shall buy it.

    Rule #3. If you not sure, call Goldman Sachs and let them decide. Give them a little time so they can make their investments, as needed, before the herds stampede in looking for a deal.

    Geithner admits the plan may seem to simple, but argues “that sometimes complex problems require simple solutions, and oversight.” “This plan being so simple, allows for that oversight that was lacking before.”

    When asked what happens when the FED balance sheet gets so big, would it pose a risk of being “To Big To Fail?” Geithner sniped back,

    “Don’t you worry about the FED, they will take care of themselves.” “Long after America is bankrupted, just an example of course, the FED will still be here standing. Get it? They are a separate entity! ”

    Geithner closed out the interview saying “we should be more concerned about the actions of our own government, than snooping around the FEDS business.”

    When asked, by Congress Maxine Walters, “which government, do you work for?: Geithner lit up like an alien, seemed confused, and then left the room. He was unable to answer the question.

  2. john

    Hard money sticks in your teeth.

    It is easy to theorize about money form a high level, like Harry Lime in The Third Man sitting atop the ferris wheel in VIenna, “would anyone notice if there were one or two fewer of those ants (people) down there”.

    The world has evolved off of hard money not because of the fecklessness of politicians, not that they don’t tend toward fecklessness, but because no one wants to be in charge of a self induced famine.

    As industrialization organized society around the division of labor, day to day sustenance became increasingly dependent on credit. Today we, the 90% of us who live in urbanized areas, get our food from industrialized producers who industrially ship to industrial processors who manufacture and industrially package and ship through industrial wholesalers to mostly corporate franchise retailers. Every one of these commercial entities is dependent on credit flows for their commercial sustenance.

    Faced with credit seizure, this essential distribution stops. It doesn’t matter how rich you are when this happens you starve. This recognition is why Geithner and Paulson opened the sluices at the Treasury, it wasn’t their innate communist tendencies.

    The impossibility of liquidity a gold standard would define would have frozen commerce in goods as well as finance. Without recourse to liquidity the mother of all collectivist centrally planned interventions would have been the only tool to attempt to prevent mass starvation. I don’t know anyone who thinks that effort could succeed.

    It would be nice if we could put our politicians under the discipline of gold without risking our lives to their competence, but we can’t. We’ll have to do the hard work of managing our national accounts politically rather than with a technical fix. Either that or all go back to the farm. When Mellon said “liquidate labor, liquidate stocks, liquidate the farmers…” we were recently a farming nation and in his lifetime had been in a position where the economy could have survived that shock. That is no longer the case.

  3. Steve Keen

    Dear George,

    I obviously see the need to reform the financial system, but my analysis of how credit is created (see my “Roving Cavaliers of Credit” post: http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/) makes me sceptical that any new system will “hold” so long as financiers can make money by financing asset-price speculation. I believe the experience of history should tell us that every system we’ve tried to far has finally succumbed to a debt-financed asset-price bubble, whose bursting has brought in at best a recession and at worst a Depression.

    I have therefore developed proposals to tackle the root problem from the other side of the ledger: if financiers can always be expected to exploit the desire of borrowers to speculate on rising asset prices, then we have to remove that desire in the first place.

    The most effective way to do this would be to redesign assets in a manner that still encouraged individual ownership and enterprise, but made the prospects of leveraged gains on asset speculation much less likely.

    My two proposals are: to modify shares so that once they are on the secondary market they expire after a predefined period (say 25 years); and to limit the maximum leverage that can be secured against a property to some multiple (say 10) of the property’s annual rental income.

    Explaining these in more detail:

    Shares

    Shares purchased in an initial public offering or float would last indefinitely while held by the original purchaser. But once these shares were sold, they would have a defined life of (say) 25 years.

    This would have several benefits over our current system:

    (1) Purchasers of shares on the secondary market would be forced to do what the Capital Assets Pricing Model (the delusional neoclassical theory that dominated academic finance prior to the GFC) pretended they do now: to value shares on a sensible valuation of expected future dividend earnings. You would only buy a share under this system if you expected a reasonably good stream of dividends from it, because in 25 years it would expire; and

    (2) It would encourage the act of providing finance to new ventures. At present, the share market does a very poor job of providing new finance, with over 99% of the transactions being secondary market sales in search of capital gains. With my change, the only way to secure an indefinite stream of revenue from a new venture would be to provide it with some of its initial capital. This proposal would drastically shift the balance in favour of raising initial capital, which is the only truly socially beneficial role of the stock market.

    Property

    The great danger with the current system is that there is a positive feedback loop between property prices and leverage. An increase in leverage allows a purchaser to bid a higher price for a property, which encourages other purchasers to come in with higher leverage again with the intention of profiting from selling on a rising market. This is the basic mechanism that led to the Subprime Crisis.

    If instead there were a maximum allowed level of leverage based on the income-earning potential of the property being purchased, then an increase in price would cause a reduction in leverage: if a purchaser truly wanted a given property and was willing to pay more than ten times the annual rental income to secure it, then he/she would necessarily have to use unleveraged funds to do so, and the increase in price would cause a reduction in leverage.

    Stability

    The real problem with other proposals–such as government-created credit, etc.–is that without reform to the way we define capital assets, this money can still be used to speculate on asset prices. This can lead to asset bubbles, and those who are successful in them will gain money and the power that comes with it. They will then be in a position to lobby for the unwinding of the reforms that were enacted during the crisis–as we have seen in our own lifetimes with the abolition of almost all the Great Depression era legislation in the leadup to the GFC.

    This proposal would limit that prospect by preventing the formation of the class of Ponzi Financiers in the first instance. This to me is the real lesson of financial history: every crisis is caused by debt, the debt is taken on by Ponzi Financiers who then accumulate the economic and political power to reshape the system to suit themselves, leading to its inevitable collapse. We have to stop the Ponzis at the source, and the source is the potential for leveraged gain on asset prices.

    1. Rory

      Thank you for this comment. I know little about finance, but I’ve always been puzzled that we in the public are expected to show great respect for the social utility of stock markets when so little of the buying and selling which goes on in them actually puts investment funds in the hands of productive enterprises. Your proposals, especially the first one, are intriguing.

    2. Fed Up

      Steve Keen said: “I have therefore developed proposals to tackle the root problem from the other side of the ledger: if financiers can always be expected to exploit the desire of borrowers to speculate on rising asset prices, then we have to remove that desire in the first place.

      The most effective way to do this would be to redesign assets in a manner that still encouraged individual ownership and enterprise, but made the prospects of leveraged gains on asset speculation much less likely.”

      What about getting interest rates higher than the expected rate of return on the financial asset?

      For example, if an asset is expected to rise 7% a year and it costs 8% to borrow, it seems to me the investor will lose money. No asset bubble with debt???

    3. run75441

      Thank you for this comment:

      “makes me sceptical that any new system will “hold” so long as financiers can make money by financing asset-price speculation.”

  4. Farrar

    It’s clear that the Constitution gives the Federal Government monopoly power to create money, and therefore to make loans. Of course, the founding fathers didn’t have this in mind when they wrote that hallowed instrument. But that hasn’t bothered the Supreme Court when considering gun control, or, most recently, free speech for corporations.

    National Banks are therefor subcontractors, and lenders which do not have National charters are all operating illegally. This situation obviously needs to be regularized, preferably by nationalizing the illegals, and bringing existing subcontractors under tighter control.

    IMHO any system which does not allow fractional reserve lending, would be too inflexible. And I can’t really imagine the government owning all banks, but a “public option” in banking has long seemed to me to be a great idea.

  5. steve from virginia

    Steve Keen hits the nail on the head; no system is better than its participants. Our problem is simple; we refuse to live within our means and have refused to do so for too long.

    Our bottom problem isn’t monetary. We have the most fabulous and sophisticated forms of money and credit, derivatives and exchange media. What we don’t have is a money- substitute for energy which is the foundation of our productivity.

    What is needed is not another (irrelevant) system but a revaluation of work. The bias toward machine work against human work is coming to an end. This is so ironically because of the success of machine work which efficiently devours the capital required to run it.

    What must replace capital destroying machine work, automation and industrialization is human work. This must be done within the means that nature provides for us. The outcome is an escape from the inhuman scale and drear of machine work and machine economics – one serves the other – and from pointless, wasteful consumption.

    There is no choice; an outgrowth of resource depletion is the strengthening relation between the US dollar and crude oil. The current peg may be – or may not be – supported by the swing producer Saudi Arabia. Nevertheless, the peg makes the dollar a hard currency. Hey gold bugs! You are getting what you wish for! You and your families will regret it! The value of all other currencies and debt derivatives is shifting in relation to the dollar as the required intermediary between darling industrial ‘production’ and the fuel that powers it.

    A depreciated dollar really isn’t possible as the price of fuel will leap upward as a consequence, causing a business cardiac arrest leading to demand destruction and a return to a low fuel price. As fuel demand increases, it will reach the price level where the dollar/oil peg is reestablished. The interim volatility cycle will collapse thousands of more businesses and put millions more into the streets.

    The outcome of the Niewe Hard Dollar is going to be hard for most to bear; deflation without pity or mercy in the developed world as the demand for dollars becomes intense. As dollars disappear, dollar arbitrage along with fuel speculation will become the entire world’s economy – just as gold arbitrage was all the world’s economy back in the early 1930’s. The consequence will be identical save for one, tiny, little difference.

    Since ours is an energy rather than a credit crisis, there will be no exit from our suffering as we embrace are beloved machines to the bitter end. Until countries ‘go off oil’ as they ‘went off gold’ in the mid- 1930’s there is no exit from the deepening malaise. It’s an ‘easy way’ or ‘hard way’ situation. The world will go off oil regardless.

    The other ingredient which is not addressed by monetary diddling is the requirement to put people to meaningful work; teach hand labor, artistry and skill to remake the human environment as interesting and humane as possible. This is hard because machine- thinking (advertising( has made most people stupid and uncreative ‘consumers’ rather than citizens who have creative demands made upon them.

    There is clearly work for multitudes … to change America first from an automobile habitat to something more pleasant.

    Regardless os what happens to money – there will always be something – America can become ruined Detroit from Sea to Shining Sea or it can become Florence or Sienna or Kyoto or …

    1. theroach

      Hi steve from virginia… you my friend, hit the nail on the head haha.

      Money is a fundamentally a claim on energy and nothing besides. That energy allows man to extract and consume natural resources.

      Given that our present world system creates money from debt, and that the interest upon that debt must be serviced with exponential economic growth/debt (more energy therfore resource consption) our future becomes all too clear.

      We are heading for disaster and, three billion new finite energy/resource thirsty consumers guarantee that.

      We already had a taste of the near future when oil was $147/barrel and is it is no coincidence that the world financial system is now on its death bed today. Low interest rates, credit derivatives etc are only the symptoms of an economic model that id fueled by finite energy resources in a finite planet.

      The answer is a global carbon trading economy and it will create wealth equality throughout the world via free market capitalism so don’t despair, you can look forward to a slower paced, low quantity high quality future, just gotta survive the collaspe haha ;-)

  6. theroach

    In answer to your seventh question, Yes. Its called cap and trade.

    We do not require a gold standard to limit the creation of money beyond what is required to maintain economic stability and currency purchasing power.
    When a government caps emissions, it monetizes them effectively taking back the ability for banks to create the initial money supply.

    Once governments cap CO2 emissions and allow emissions to be made only though purchasing credits from the market, the given nations currency is effectively on a carbon standard. That is, every dollar buys you the right to emit a given ammount of CO2 from the limited (capped) supply.

    When cap and trade is enacted, profit is created through CO2 (energy) efficiency gains and sustainability. Those gains become “offsets” that are sold for profit into the market.

    Therefore in a carbon economy, profit is energy/resource efficiency gains.
    As technology innovation and individual carbon consumption behavior changes and less CO2 is emitted, the government tightens the cap to maintain the currencys purchasing power or loosens the cap if the need arises (which cannot be done with gold).
    In other words, governments will also control interest rates which under emissions trading is the ammount of available CO2 that a nation can emit.

    This is the model for the new global carbon economy and its right around the corner.
    Unsustainable finite resource (energy) consumptin is given a realistic economic value that makes resource sustainability the only way to create wealth saving the world from death by unsustainable consumption at the same time.
    Killing two birds with one stone. Pure genius!!!

  7. EmilianoZ

    But if banks create the money they lend you on the spot, why are they hurting if you default? It’s not like they’re losing something. They didn’t have it to start with! This is just incomprehensible.

    1. theroach

      EmilianoZ…

      In objective reality, money is purely subjective (haha, thats a mind teaser), its only numbers on paper backed by laws on paper.

      Banks must hold assets with value that maintain the required capitalisation under national laws. This is fractional reserve banking.
      When banks for example, create easy credit through low interest they can create bubbles like the housing bubble to name one.

      When credit (debt) exspansion goes beyond what can be supported by sound economic fundamentals, the bubble collapses and in turn, asset prices (supply and demand)

      Now the banks are in the shit, so they put a gun to the governments head and threaten to blow up the world (which is almost true) if they do not receive enough cash to maintain capital requirements.

      As this has been done to many times in the past, the banks have lost the ability to blow another asset bubble and so we find ourselves in the position we are in today.

      Our economys are on life support with no chance to maintain any dignified life other to keep on the life support machine (print money) but even that wont last.

      But maybe there is one last bubble left, and that is gold so please do not buy any despite the consensus view.

      The people that are saying buy gold are the ones who did not see the housing bubble coming. With a few exceptions like Peter Shiff. Of course, gold may go to infinity depending only upon the $$$ supply but come time for a new currency, gold will be worth only as much as dental crown and bling bling supply and demand dictates.

      If you want to invest in the future, buy some seeds and books and learn how to grow veggies ;-)

    2. Adam

      The problem is those loans EVENTUALLY become a deposit and a deposit at the bank is a liability. The bank still owes the depositor their money even is the loan goes bad.

  8. Fed Up

    “So here are the first two questions:

    Do you agree that banks create credit by initiating loans, and then obtaining deposits subsequently, to comply with depository requirements? I’m not talking about the coins which governments create (in America, coins represent less than 5% of the total money in circulation).”

    See this link for a LONG comment by JKH November 29, 2009 at 05:32 PM

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/money-banks-loans-reserves-capital-and-loan-officers.html

  9. John Merryman

    Money has two current functions; as a store of value and medium of exchange.

    What it really is, is drawing rights on community productivity.

    Much of this bubble mentality is about creating ever greater stores of value by creating ever more demand for the supply and thus greater supply. More debt is more wealth. This is the cancerous part of the problem.

    We first have to recognize the basis of monetary value; the productive capacity of the economy, not any subset or commodity.

    This means recognizing the fungibility of money makes it a form of public utility, or commons. One which must be used to sustain the long term health of the economy and the society as a whole. Given the political dynamics of group demands, it might seem unlikely that a system could be established, but one primary effect of recognizing the monetary system as a public medium would be to refine and define its applicability. People would be far more restrained in how much value they would drain out of personal resources to convert to money in the first place. It would open up the space for all manner of social and economic networking to evolve; health, retirement, education, insurance, etc. Quite simply it would force all of us into a far more complex and healthy economic environment than this monetary monoculture we have now. It would also take significant power away from large banks and large governments.

    We all like having roads, which are another form of public medium, but there is little inclination to pave more than we must.

    Remember that central banking grew out of private bankers taking over control of monetary systems from monarchies in their declining stages. Monarchists used to rail against “mob rule,” but democracy works by pushing the responsibility of power down to the levels it is most responsive, so if we are to recognize money as a public utility and now make banking a public function, it would be a bottom up model of local community banks investing in local communities and serving as the board for larger regional banks, in a parliamentary type system.

    As for government spending, this system is designed to overspend by buying votes for enormous bills that can only be passed or vetoed. This serves to create debt in order to store capital.

    In the spirit of actual budgeting, a possible solution would be to break these bills down to their constituent items and have every legislator assign a percentage value to each one and then re-assemble them in order of preference. The president would draw the line at what would be funded. This would divide responsibility, allowing the legislature to prioritize, while giving the president final authority over total spending. Since making the cut would be graded on a curve, there would be much less incentive to trade favors and the percentage system would allow legislators to fine tune their granting of favors to other legislators and lobbyists. Since this would reduce spending on the local level, a system of local community banks funding their own communities would fill this need.

    Remember that growth is always bottom up, not top down.

  10. Fed Up

    “Do you agree with Eccles and Hemphill that money is debt, in that new credit normally comes into existence when a new loan is issued?”

    Not really.

    “That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.”

    By my definitions, currency is a type of money. So, no.

    “If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is. It is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.”

    I don’t see any reason why an all-currency-no-debt economy isn’t possible.

    I don’t see any reason why I can’t deposit currency at a bank, and they hold it as a bank deposit that I can withdraw at any time.

    1. NotTimothyGeithner

      Sure, you just have to pay for that service. They aren’t going to build a secure facility for holding your money for free. You might as well just bury your money.

    2. joebhed

      I rarely disagree.
      But if you don’t think that currency (FR notes) are lent into existence then I think we need to compare some points in the Modern Money Mechanics paper.
      Only coins are spent into existence.
      Both Hemphill and Eccles are exactly right, but you are correct on your conclusion about depositing any form of REAL money and it being re-lent.
      respectfully.

      1. Fed Up

        I’m not sure I got that. I’ll say it this way, and I’ll try to sum up some of JKH’s idea(s) from the link above.

        It seems to me that currency denominated debt is lent into existence based on capital, not based on reserves. In most cases, there is a time difference and risk difference.

  11. Doug Terpstra

    Excellent eye-opening article on money creation (free money for banksters versus true wealth creation).

    Moore’s prescription for public banks is overdue, as is Greider’s point: “If Congress chooses to take charge of its constitutional duty, it could similarly use greenback currency created by the Federal Reserve as a legitimate channel for financing important public projects–like sorely needed improvements to the nation’s infrastructure.”

    But Steve Keen from down under clearly understands the dynamism of well-governed free enterprise versus the hyper-leveraged casino capitalism in play now with its endlessly recurring Hindenburg Ponzi bubbles.

    Current obscene concentration of (unearned) wealth encourages gambling, produces spurts and stops, booms and busts—and worse, military adventurism—that squelch true dynamic wealth creation. Re-leveraging that same reckless system with public funds is nothing less than leveraged insanity. Our banking system must evolve away from financial pirates toward public commonwealth. Let the banksters howl; it’s music to our ears. It is time for a evolutionary new model; neoclassical economics is clearly an inevitable dead end.

  12. maniam

    “..the are 2 ways to control and enslaved a nation.One is by the sword .The other is by debt”John Adams
    “…When through the process of the law, the common people have lost their homes, they will be more tractable and easily governed through the influence of the strong arm of the government applied to a central power of imperial wealth under the control of the leading financiers. People without homes will not quarrel with their leaders.”-bankers manifesto 1892.
    “..Slavery is likely to be abolished by the war power and chattel slavery destroyed. This, I and my European friends are glad of, for slavery is but the owning of labor and carries with it the care of the laborers, while the European plan, led by England, is that capital shall control labor by controlling wages. This can be done by controlling the money. The great debt that capitalists will see to it is made out of the war, must be used as a means to control the volume of money. To accomplish this, the bonds [government debt to the bankers] must be used as a banking basis. . . . It will not do to allow the greenback, as it is called, to circulate as money any length of time, as we cannot control that.”-hazard circular 1862.

  13. zanon

    You barely understand this Washingon.

    And be careful of getting too much of your information from Steve Keen. He sort-of understands private credit, but does not understand Govt credit at all.

    When Govt deficit spends, it creates private sector net financial assets (equity). Note that private sector cannot do this. So Govt ALREADY has ability to create credit and does so every time it deficit spends.

    We want private sector to direct investment though, and not Govt sector, so we want to recognize that banks are public-private partnership and have them focus on making loans, with private capital in first-loss position. This means that 95% of bank activity today is meaningless and should be regulated out of existance.

    Obama never needed to bail out banks. He could simply have recapitalized households and let banks fail.

  14. jerry denim

    Nice to see a post concerning monetary reform on Naked Capitalism. Its the most important debate concerning our economy that almost no one is having outside of the far right wing world of conspiracy theorists and other people who are dismissed and discredited. I would love to see this topic become a popular source of debate among serious minded thinkers from the world of finance.

  15. Tom Crowl

    Great post! And reform in the processes by which money and credit are created is vital.

    I’m not an economist but I’ve found it helpful to look at civilizations as the product of “social energy”. Essentially that’s countless decisions (Decision= An Idea + an Action) by individual’s and groups operating within physical conditions.

    Money, I believe, is more aptly seen as a rather flawed technology for the store and allocation of ‘social energy’ rather than as a store of value. However its an inefficient and incomplete mechanism at best…

    And is subject to inherent bias in favor of its creators which is difficult, if not impossible to avoid (in this case, as you state… bankers).

    So, since bias is inevitable the solution has to lie in democratizing (with important checks and balances) the process. This inherent bias also makes the Feds claim of independence ridiculous on its face.

    After all… who has the right to create and than allocate YOUR ‘social energy’ without your input?

    That’s worse than taxation without representation… that’s potentially multi-generational enslavement without having an ounce of input into that allocation of your life’s energy.

    The thought process that rationalizes it for the ‘credit creator’ and those most closely benefitting is tied to a problem of scaling biological altruism but that’s a separate essay.

    I believe this inherent bias may suggest that more than one type of credit creation may be desirable. For example local currencies geared to local products and services to function alongside one or more global currencies… in an attempt to overcome a ‘proximity’ bias which goes along with a social bias.

    Your prescriptions are right on it seems to me in regards state banks, etc!

    This approach can encourage asset-based-community-development and economic and financial resiliency while preserving the advantages of global trade and markets as well.

    Again, I’m not an economist but it seems to me these are ideas worth investigating.

    A brief post on some of this here:

    On Social Energy, Enterprise & Expanding the Technology of Money
    http://culturalengineer.blogspot.com/2010/01/on-social-energy-enterprise-expanding.html

    I also believe the Individually-controlled / Commons-dedicated Account facilitating the microtransaction in Commons focussed activities (politics and charity) is an essential piece of this puzzle.

    Opinion and influence are also aspects of ‘social energy’ which money powerfully conveys(though we might wish it weren’t so). Current money technology inhibits the free flow and networking of this energy which distorts opinion markets.

  16. joebhed

    My answers are:
    Yes
    Yes
    Yes
    Yes
    Yes
    Federal
    Yes

    Greider correctly identifies the private debt/credit creation flaw as the black hole of economic democracy, and the systemic government solution. It is Zarlenga that identifies the superior method to implement that government system.
    The American Monetary Act and related proposals take care of both Steve Keen’s capital marketing concerns as well as the need for the ultimate stability that something like a silver standard could accomplish.

    On Keen’s points re capital markets and continuing speculative bubbles, the fact is there would/could be no financial ‘leveraging’ with created debts based on Zarlenga’s proposal.
    All money would exist as real money.
    What depositor would allow bubble-speculation with their own monies?
    Investments? Yes. But not debt-bubbled speculation.
    Depositors would OWN the banking system, not the other way around.

    As to the necessary standard.
    What is really needed is ‘something’ that can engender the trust and confidence of the capital markets operating exclusively with real money.
    No metal standard capable of manipulation is called for.
    The “trust” answer is a transparently operating monetary authority at work in every country of the world.
    It is time to tear down the curtain, Dorothy.
    Either honest, open monetary operations engender trust, or they are changed accordingly.
    Bankers get back to banking, lending people’s real monies, like everyone thinks they do now.
    The American Monetary Act.
    The Money System Common.

    Thanks for this posting, Yves and Washington

  17. akr884

    If we already have something like the Earned Income Tax Credit, why not just use money creation (say 3-5% a year) as a direct subsidy as a form of wealth/income redistribution to the poorest in our society (with some relatively simple formula based on average income and standard deviations to determine who receives cash payments and for how much), which would also completely eliminate the overhead for administering public banks and would cut out all the corruption that we see in public pension funds where bankers bribe the politicians/administrators of the funds in order to defraud the public. Thus, the inflation tax would become an automatic stabilizer against income inequality.

  18. paul

    Wow. Things have changed radically when Congress is being put up as more efficient and effective at monetary priorities than the Fed. (I remember a group of US economists laughing sometime in the 70s when visitors from a bunch of 3d-world countries said, “We can’t understand why your central bank isn’t under the direct control of the legislature.”)

    The funny thing about Bernanke saying he won’t print money, of course, is that he already has, in the multiple trillions. But what the stimulus bill showed already is that we don’t have the political will to spend money on the things we really need, even when it is free.

  19. PJ

    “Incorporate the Federal Reserve System into the U.S. Treasury where all new money would be created by government as money, not interest-bearing debt; and be spent into circulation to promote the general welfare. The monetary system would be monitored to be neither inflationary nor deflationary.”
    Monitored by whom? Mr. Tim Geithner, Mr. Lawerence Summers or Goldman Sachs? All that any monetary system requires in honest government being operated by honest people; unfortunately that is much more rare than gold.

  20. anon

    Washington, thank you for this article. The links were very interesting. I also enjoyed the comments and Fed Up’s link to the Worthwhile Canadian Initiative and JKH’s comments. Keen’s observations about debt/credit creation preceding reserve creation makes sense.

    Re: Keen’s proposals
    “I believe the experience of history should tell us that every system we’ve tried to far has finally succumbed to a debt-financed asset-price bubble, whose bursting has brought in at best a recession and at worst a Depression. . . . My two proposals [to prevent this] are: to modify shares so that once they are on the secondary market they expire after a predefined period (say 25 years); and to limit the maximum leverage that can be secured against a property to some multiple (say 10) of the property’s annual rental income.”

    I’m not an economist. I’m reading here to try to learn more because I realize that this is all over my head. It seems to me that debt-financed bubbles are a big problem that needs to be addressed.

    However, I don’t understand how Keen’s proposal would work with assets like copper, corn, or oil. How would we prevent banks from using borrowed money (or borrowed money in excess of the prescribed ratio) obtained from the Fed (e.g., discount window) to buy such assets? For that matter, how would we prevent the average Jo/e from using her/his credit card to buy such assets with essentially free money by charging all her/his other expenses on the CC and paying off the CC by the end of the month so no interest was charged? How does one determine the annual rental income of assets like minerals, agricultural products, energy sources, etc.?

    WRT Keen’s proposal as it applies to RE, it seems to me that the proposal would essentially ignore the value of the land in favor of determining value almost exclusively by the value of the structure(s) on it. I.e., by tying financing to rental value, it ignores all value that is outside the RE’s current uses to a renter. In the extreme case of raw land with no current economic use (e.g., an empty residential lot with water, sewer, etc. and a development plan available), it seems to me that no financing would be available because one probably could not rent the property for anything more than a very small sum. But this makes no sense because the value of the lot is often > 80% of the value of the home one buys, with the value of the structure being worth < 20% of the price. In a less extreme example, if there were two identical adjacent houses, one on a 0.5 acre lot and the other on a 10 acre lot, the rents would probably be similar and, under Keen’s model, their prices would probably be almost identical because few people could pay cash for the extra land. In fact, the house on the home on the 10-acre lot might rent for less if the respective lessees were required to take care of the rented lot (and, therefore would tend to sell for less under Keen’s proposal because potential buyers could borrow less to buy that home). But for most buyers, the home on the 10-acre lot would be much more valuable than the home on the 0.5-acre lot (especially if the land could be subdivided or rezoned but even if it could not). I think that’s because the land itself (and its potential uses far into the future) has little value to renters but a great deal of value to buyers. It seems like Keen is ignoring land’s “store of value” function (to use a gold analogy) and incorrectly valuing it based solely on the current use from the perspective of a renter.

    It seems to me that this would encourage urban sprawl. Land is cheap in outlying areas. Many more people can afford to buy it with cash (as would be necessary under Keen’s model). Furthermore, land in outlying areas is worth a much lower percentage of a home’s price than land in cities. Since the amount buyers could finance would be based almost entirely on the value of the structure, even fewer buyers would be able to afford homes in cities, driving them to buy at the fringe of metro areas. This seems to be undesirable to me because it would add to pollution and traffic (neither of which would be paid for by those who bought in the outlying areas but would instead be externalized) as well as taking commuting time that could be used in better ways. Maybe home prices in cities would eventually fall but it would take quite a bit of time. In the mean time, most buyers would be forced to buy in the outlying areas where they could obtain financing. (Further, it seems like it would cause a great deal of deflation in “pricier” neighborhoods and tend to cause the whole metro area to be pretty close to the same price. It would basically eliminate neighborhood disparities in cost, which you may see as a good thing but I see as misallocation and price skewing. I also see it as tending to price the poor and working class out of every area, even those areas that are now cheaper because the rents in those areas are a much higher proportion of a buyer’s cost than rents in the pricier areas.)

    It also seems like this proposal would make it economically unfeasible to have planned communities/neighborhoods that have a large proportion of open space. E.g, a neighborhood in my area is required to keep about 7/8 of the land (1,400 acres) as open space. That open space doesn’t include the sports fields, pool, land dedicated to city offices, etc, which are also required. While this open space is very valuable to some buyers (who, e.g., may plan for their grandchildren to hike there in 15 years or even live there in 50 years), it will have far less value to renters.

    Am I missing something or misunderstanding Keen?

    Fed Up @ March 14 @ 9:37 pm: It seems to me that your proposal hinges on assets rising uniformly. How would that work if, e.g., oil was rising @ 10%/yr and soybeans were rising @ 5%/year? How well can we predict asset price fluctuations? Would the 8% cost of borrowing affect the price of assets? How?

    Thanks again for the article and the thought-provoking comments.

    1. Fed Up

      anon said: “Fed Up @ March 14 @ 9:37 pm: It seems to me that your proposal hinges on assets rising uniformly. How would that work if, e.g., oil was rising @ 10%/yr and soybeans were rising @ 5%/year?”

      It seems to me that making 2% (10% minus 8%) isn’t worth it. The other thing that could be done is to raise the margin rate (like a down payment with a home). Also and under most scenarios, 10% per year price gains won’t last long because demand will go down and supply will rise leading to possible losses along with volatility in prices that might lead to margin calls.

      And, “How well can we predict asset price fluctuations? Would the 8% cost of borrowing affect the price of assets? How?”

      Predicting asset price fluctuations is tough.

      When people borrow and spend (debt), it brings quantities forward from the future for something. If quantities brought forward from the future meet not enough supply in the present, prices rise whether goods or assets. Higher interest rates discourage this bringing quantities forward from the future thru debt.

  21. K Ackermann

    This was an outstanding post, George, and it was nice to see Mr. Keene add his comments.

    I forgot what all your questions were. I was enjoying the read too much.

    Thanks

  22. Brooks G

    The 25 year expiration of shares in the secondary market makes no sense. If I bought at IPO, then holding the shares until the end would entitle me to all those dividends, indefinitely. Why sell to the secondary market, the originally held shares would be much more valuable without an expiration date.

    Worse, companies would die after 25 or so years of paying out dividends–as the stockholders would demand this rather than seeing no returns on their purchase of soon to expire shares. Do we really want every company to go out of business at a pre-determined time when their shares would expire?

    The whole idea is nuts. If you want to end speculation, you need to use tax policy to get it–high capital gains taxes on sales from one shareholder to another, but no capital gains taxes from sales from an original investor to the secondary market.

Comments are closed.