Economics for Democrats

The Monetary Solution:

"Funding Progressive Economics"

By Mark Pash, CFP

Monetary Policy is the power to create (print) money out of thin air. This is called “fiat” money. The major source of this creation is the commercial banks such as Bank of America, JP Morgan and Wells Fargo. Their regulation, oversight and control are by the central banks. In the United States this is called the Federal Reserve.

Here is a very simple explanation of how new money is created by these commercial banks. When you make a deposit in your bank for $1000, the banking system can loan out a multiple of this figure-$7000. The size of this multiple, which is called the reserve requirement, is regulated by the Federal Reserve. This $6,000 difference, new money, is placed in the checking accounts of its borrowers. Therefore, the bulk of the new money is not created by printing, it is a simple book entry in the personal and business accounts of borrowers.

When your review monetary history, every country, and I mean every country has gone thru significant monetary crisis. The most recent one is right here in the U.S. with the sub prime collapse. WHY?

The general reason is that we are human. We make errors. It does not matter how good the regulators are. These errors in judgment will happen. The specific reason is that we have mainly one system and one instrument (loans) to create and distribute new money into the economy (monetary supply). A single system can not come close to delivering the appropriate amounts of new capital to the appropriate diversity of projects. When this single system makes an error (sub prime), it puts the entire system in jeopardy and shuts off or substantially reduces the stream of new money (credit) into the economy causing extreme economic down turns. Why can’t this single banking system delivery the appropriate new money into the economy??

The main reason is most loans can only be received if you don’t need them or you already have all the capital (collateral) you can use. Therefore new money is not allocated enough by market forces, need or quality of the investment but according to the financial girth of prospective borrowers. Even if they do not need it! Monetary history, both nationally and internationally, depicts this over concentration of lending. This leads to a boom-and-bust scenario, not only in entire economies but in specific industries.

The second reason is new money is infused into the economy solely through the use of debt instruments with a variable-short term interest charge. Besides the psychological effect of increasing debt, a rising interest rate environment again hurts the borrowers with less financial girth and those enterprises that you use debt rather than equity as a means of financial operations.

What is the solution? The answer is to create a diversity of delivery systems of new money under the central bank using both long and short term interest rate charges and equity participation in its financial instruments. Don’t worry. The commercial banking system will still remain as the major source of new money.

The following reasons will convince you that we need this diversification:

1. Diversification reduces banking favoritism, nepotism, bribes, political cronyism, shoddy management and criminal activity.

2. The boom-bust scenario we see in various assets, industries and countries will be greatly reduced by not over lending in successful industries and individuals. It makes managing risks less difficult.

3. Diversification gives more capitalistic opportunities to others-creating more capitalists (business owners) and increasing competition. Diversity spreads the new money around-creating other capitalistic opportunities at the same time reducing human hardship.

4. The major reason for business failure is still lack of capital, not competition or mismanagement.

5. Diversification expands credit based on the ability to succeed and not just on the ability to repay. Distribution of new money should also be based on the quality of your talent and need for your enterprise not just the quantity of your collateral.

6. Diversification dilutes the power that any one system brings to monetary creation. Absolute power corrupts absolutely. Why should only one financial industry system of commercial banking have the monopolistic power of monetary creation and infusion?

7. Diversification reduces the effects of any errors of monetary distribution during expansion or contraction. This means that the central bank can divert new money from industries that do not need it to those who do. This allows for errors on the monetary expansion/inflation side of the equation rather than the contraction side. The end result is a lesser chance of recession/depression.

8. Excessive wide range defaults and bankruptcies will not hurt the new money delivery systems as much, because it’s spread among many systems rather than a single banking system. Therefore, the monetary system will have less stress due to economic volatility.

9. Diversity of systems allows decision makers to more effectively reduce the over-lending to a particular individual, company, industry or geographical area. The current dilemma of regulation is that it’s very hard to deal with things when life is good. Who tells the banks not to lend to real estate when real estate is the hottest part of the economy and running up great profits? Or shipping? Or oil and gas? Having other systems with different objectives will more effectively control over-lending, thereby reducing boom/bust scenarios within an industry or an entire economy.

10. Diversity also helps control the amounts used for aggregate demand (consumer loans) stimulation and supply creation (business loans), depending on the needs of each. Having more control of the quality and quantity of new money being issued results in less of a chance of an over-expansive money supply creating a bubble economy.

11. Diversity can provide more capital to areas with high need, such as low tech industries and lower income areas.

12. Monetary policy is an art not a science! Monetary policy requires judgment at every stage of the process, form the initial formulation to the final implementation. Judgment is susceptible to human error. If there is an error in one major system it can lead to tragic consequences. But several errors in a multiplicity of systems can be much more easily overcome. The more diversified the delivery system, the less a judgment error by central banking management will result in a catastrophe.

13. The fiscal system operates on a much diversified level. There are many governments in the fiscal system – federal, state, county, city. Within those governments are many delivery systems – military, Medicare, social security, education, welfare (social and corporate). Also old money operates at a much diversified level. Why shouldn’t new money?

14. Credit risk formulas and models of commercial banks, which are inherently flawed, will be reduced in consequence because money creation is moved to other institutions. Improving and increasing regulation and risk models can help – but it’s not the answer. Reckless lending will be scattered and there will be fewer defaults especially with the use of an equity component rather than all debt.

15. A key element in the art of monetary policy is coping with change. The current, most important change that central banks face is the globalization of monetary policy. Again, with more decision makers and more diversified delivery systems, the monetary authorities will find it easier and safer to cope with these changes.

16. We need diversity to reduce the negative effects of excess greed.

17. The central banks have many checks and regulations to offset factors of self-interest and other human frailties. But with the delivery basically in one system, any errors that do get by are certainly overly accentuating the negatives to the economy (sub prime).

18. Our single banking system is less and less willing to share risk. Yet, risk is critical to the progress of the private sector and hence economic growth. Our single system has lost the ability to foster the development of novel or non standardized – in short, risky private enterprise. This means that economic development slows and future generations are disadvantaged.

19. Banking crisis will not be as detrimental to the overall economy and other financial systems because these crises will not be as large as influential in the monetary specter. Consequently, human hardships will be greatly reduced.

20. In actuality, the current disciplinary system of high interest rates punishes the weakest, smallest players first and most severely, while the largest and more powerful enterprises are able to dodge the bullet.

21. Reduces the 'herd behavior' of financial institutions and investors in whatever country or market is fashionable at the moment. This can lead into excessive bank lending and over-borrowing in a particular country, or group of countries, with each lender paying insufficient heed to the extent of their collective total commitment.

I believe I have listed more than enough reasons to support a diversity of monetary systems. I am sure you can see that these reasons both overcome the negatives of a central bank operating-regulating many systems and validate the need to be implanted in national economies.

The next addition, besides system diversification, is investment vehicle change. (This was the root of the current crisis.) Where is it written that new money is created only by debt (loans)? By the way we cling to our old, antiquated system; you would think using debt to create money was one of the ten commandments. There is no reason why we can’t establish institutions to partially fund new money through equity (common stock) structures, or a combination of debt and equity.

There is precedence for this. Believe it or not, Middle East (Islamic) banking provides equity return rather than just interest return. Because of religious beliefs, a mutual risk and a goal of non-clashing interests has developed into shared risk banking. There is less adversarial relationship between lenders and borrowers. Actually, our big banks and insurance companies currently make these types of participation loans to large commercial real estate projects!

Any equity-new money system still yields return and may be even greater return – but it occurs upon sale, gifting or refinancing.

Many things happen when there is no or less debt service. Business survival is heightened, competition increases, production is improved, and consequently prices are kept lower. There is less displacement of employers and employees. Even when interest rates rise, industries will continue to grow. The housing industry usually the first hit by rising interest rates (sub prime), will stay healthier. When mortgage payments are lowered by participation returns, more folks can get into housing and sustain themselves.

When business survival is heightened by lower loan payments, there are fewer defaults which cause less train on the entire financial system.

In an effective monetary creation program, in order to reduce the extreme negative effects of interest rate fluctuations and the reluctance of private enterprise to invest especially in economic down turns, equity structures become an absolute necessity.

The following is a list of potential systems for new money creation. All are under the control of the Federal Reserve! Commercial banking will still be the major source of new money but at a reduced amount. Some will have equity returns only, others will have combination equity and interest charges, others will be the standard interest only charges. They have to have a return; otherwise they should be funded on the fiscal side of government. Also, certain programs that are favored for national interest will have longer maturities and lower charges like student loans. I will not describe each one. You can order my book or ask for more detail on my blog.

1. Venture Capital Banking – equity as main source of return.
2. A Land Bank – collateral with return upon sale only.
3. Environmental Bank (see blog)-long term, low interest loans
4. Local Government Bank – to aid states and cities.
5. Community Bank – for lower income areas with equity participation.
6. Infrastructure – Capital expenditures.
7. Financial Services Banks
8. Real Estate-Home Bank – not outside the central bank control.
9. Nonprofit Bank.
10. Student Loan Banks
11. Microfinance Banks

These are some of the different type systems that can be created to provide diversified infusion of new money. Many of these systems depend on partnership of public and private capital and can be implemented by private enterprise. Of course implementation has to start with only a few and gradually introduced. The Congress should have more direct oversight with appointments still by the Executive branch.

The cost of funding on the monetary side is minimal except for inflationary pressures. I am not talking about increasing the money supply causing excess inflation. This is another topic, I can discuss on my website/blog. But the results can be more commerce, bringing in more tax revenue and more fiscal programs funded on the monetary side which makes it much easier to balance the fiscal budget, even with lower marginal tax rates.

The World needs capital to fund, expand, explore, invest, research and to create goods and services. Private capital (old money) can not  do it alone. Let’s start the debate to improve are monetary systems. This is the answer to fund the future, not the usual tax and spend debate!

There are other proposals to restructure the monetary system. The American Monetary Institutes (www.monetary.org) wants to move the Federal Reserve back to the Treasury. They want to eliminate the reserve banking system in the creation of money. Considering their failures over the last several centuries, I tend to agree. I am more concerned with what and how they distribute new money to create a more diverse, expansive and fairer economy without excess or hyper inflation.