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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