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     Jan 30, 2008
Page 2 of 5
THE ROAD TO HYPERINFLATION, Part 2
A failure of central banking
By Henry C K Liu

The issue of centralized private banking was part of the Sectional Conflict of the 1800s between America’s industrial North and the agricultural South that eventually led to the Civil War. The South opposed a centralized private banking system that would be controlled by Northeastern financial interests, protective tariffs to help struggling Northeast industries and federal aid for transportation development to open up the Midwest and the West for investment intermediated through Northeastern money trusts backed by European capital.

Money as political instrument
Money, classical economics' view of it notwithstanding, is not



neutral. Money is a political issue. It is a matter of deliberate choice made by the state with consequential implications in support of a strategic political and geopolitical agenda. In a democracy, that choice should be made by the popular will, rather than by a small select group of political appointees. The supply of money and its cost, as well as the allocation of credit, have direct socio-political implications beyond finance and economics. Policies on money reward or punish different segments of the population, stimulate or restrain different economic sectors and activities. They affect the distribution of political power. Democracy itself depends on a populist monetary policy.

Economist Joseph A Schumpeter (1883-1950) observed that in the first part of the 19th century, mainstream economists believed in the merit of a privately provided and competitively supplied currency. Adam Smith differed from David Hume in advocating state non-intervention in the supply of money. Smith, an early advocate of progressive taxation, argued that a convertible paper money could not be issued to excess by privately owned banks in a competitive banking environment, under which the Quantity Theory of Money is a mere fantasy and the Real Bills doctrine was reality.

Smith never acknowledged or understood the business cycle of boom and bust. He denied its existence by proposing to forbid its emergence by the use of governmental powers. The policy of laissez-faire, or government non-intervention in trade, broadly attributed by present-day market fundamentalists to Adam Smith who himself never used the term, nor did any of his British colleagues such as Thomas Malthus and David Ricardo, requires government intervention to be operative.

The anti-monopolistic and anti-regulatory Free Banking School found support in agrarian and proletarian mistrust of big banks and paper money. This mistrust was reinforced by evidence of widespread fraud in the banking system, which appeared proportional to the size of the institution. Paper money was increasingly viewed as a tool used by unconscionable employers and greedy financiers to trick working men and farmers out of what was due to them in a free market.

A similar attitude of distrust is currently on the rise as a result of massive and pervasive corporate and financial fraud in the brave new world of banking, fueled by structured finance in the under-regulated financial markets of the 1990s though not focused on paper money as such, but on electronic money used in derivative transactions, which is paperless virtual money built on debt.

The $7 billion loss cause by alleged fraud committed by a low-level trader at Societe Generale, one of the largest and most respected banks in France, was shocking not because it happened but because for a whole year, the fraud was not discovered while the unauthorized trades were profitable. It would not be unreasonable for the counterparties that had suffered losses in these unauthorized trades to sue SoGen for recovery.

Andrew Jackson, who in 1835, managed to reduce the federal debt to only $33,733, the lowest it has been since the first fiscal year of 1791, vetoed the bill to renew the charter of the Second Bank of the United States. In his farewell speech in 1837, Jackson addressed the paper-money system and its natural association with monopoly and special privilege, the way Dwight D Eisenhower in 1961 warned a paranoid nation gripped by Cold War fears against the domestic threat of a military-industrial complex at home. The value of paper, Jackson stated, "is liable to great and sudden fluctuations and cannot be relied upon to keep the medium of exchange uniform in amount."

In his veto message, Jackson said the bank needed to be abolished because it concentrated excessive financial strength in one single institution, exposed the government to control by foreign investors, served mainly to make the rich richer and exercised undue control over Congress.

"It is to be regretted that the rich and powerful too often bend the acts of government to their selfish purposes," wrote Jackson. In 1836, Jackson issued the Specie Circular, which required government lands to be paid in "specie" (gold or silver coins), which caused many banks that did not have enough specie to exchange for their notes to fail, leading to the Panic of 1837 as the bursting of the speculative bubble threw the economy into deep depression. Jacksonian Democrat partisans to this day blame the severe depression on bank irresponsibility, both in funding rampant speculation and by abusing paper money issuance to cause inflation. It remains to be seen if the credit crisis of 2007 will cause the elections of 2008 to revive the Jacksonian populism that founded the modern Democrat Party.

Jackson's farewell message read:
.... The planter, the farmer, the mechanic, and the laborer all know that their success depends upon their own industry and economy and that they must not expect to become suddenly rich by the fruits of their toil. Yet these classes of society form the great body of the people of the United States; they are the bone and sinew of the country; men who love liberty and desire nothing but equal rights and equal laws and who, moreover, hold the great mass of our national wealth, although it is distributed in moderate amounts among the millions of freemen who possess it. But, with overwhelming numbers and wealth on their side, they are in constant danger of losing their fair influence in the government, and with difficulty maintain their just rights against the incessant efforts daily made to encroach upon them.
It is clear that the developing pains of the credit crisis of 2007 are not evenly borne by all, with a select few who had caused the crisis walking away with millions in severance compensation, and the few who are selected to restructure the financial mess no doubt will gain millions, while the mass of victims are losing homes, jobs and pensions, with no end in sight. The trouble with unregulated finance capitalism is not just that it inevitably produces boom and busts, but that the gains and pains are distributed in obscene uneven proportions.

Merit of central banking overstated
The monetary expansion that preceded and led to the recession of 1834-37 did not come from a falling bank reserve ratio but rather from the bubble effect of an inflow of silver into the United States in the early 1830s, the result of increased silver production in Mexico, and also from an increase in British investment in the United States. Thus a case could be made that the power of central banking in causing or preventing recessions through management of the money supply is overstated and oversimplified.

Libertarians hold the view that the state has neither the right nor the skill to regulate any commercial transactions freely entered into between consenting individuals, including the acceptance of paper currency. Thus all legal tenders, specie or not, are government intrusions. Yet the key words are "freely entered into", a condition most markets do not make available to all participants. Market conditions invariably compel participants to enter into disadvantaged transactions for lack of alternatives because of uneven market power.

For example, a family must buy food regardless of the price set by agribusiness, since inflation is not a matter that the average consumer can control. When it comes to money, a medium of exchange based on bank liabilities and a fractional reserve system and/or government taxing capacity is essential to an industrializing economy. But today, when bank liability can be masked by off-balance sheet securitization, the credibility of money is threatened. Back in 1837, instead of eliminating abuse of the fractional reserve system, the hard-money advocates had merely unwittingly removed a force that acted to restrain it.

After 1837, the reserve ratio of the banking system was much higher than it had been during the period of the Second Bank of the United States. This reflected public mistrust of banks in the wake of the panic of 1837, when out of 850 banks in the United States 343 closed entirely and 62 failed partially. This lack of confidence in the paper-money system led to the myth that it could have been ameliorated by central-bank liquidity, which would have required a lower reserve ratio, more availability of credit and an increase of money supply during the 1840s and 1850s.

The myth contends that with central banking, the evolution of the US banking system would have been less localized and fragmented in a way inconsistent with large industrialized economics, and the US economy would have been less dependent on foreign investment. This did not happen until 1913 because central banking was genetically disposed to favor the center against the periphery, which conflicted with democratic politics.

President Martin Van Buren was harshly judged and lost reelection because of his ideologically commitment of keeping the government out of banking regulation. Many economic historians feel Van Buren extended the effects of the Panic, which lasted until 1843, while others consider his approach to have minimized potentially destructive interference.

This problem continues today with central banking in a globalized international finance architecture. It remains a truism that it is preferable to be self-employed poor than to be working poor. Thus economic centralism will be tolerated politically only if it can deliver wealth away from the center to the periphery to enhance economic democracy. Yet central banking in the past two

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