Contemporary Economic Issues LECTURE 4: 19 MARCH 2017

Preventing Depressions If the government’s proper policy during a depression is laissez faire, what should it do to prevent a depression from beginning?

Since credit expansion necessarily sows the seeds of later depression, the proper course for the government is to stop any inflationary credit expansion from getting under way. This is not a very difficult injunction, for government’s most important task is to keep itself from generating inflation. For government is an inherently inflationary institution, and consequently has almost always triggered, encouraged, and directed the inflationary boom.

Preventing Depressions Government is inherently inflationary because it has, over the centuries, acquired control over the monetary system. Having the power to print money (including the “printing” of bank deposits) gives it the power to tap a ready source of revenue. Inflation is a form of taxation, since the government can create new money out of thin air and use it to bid away resources from private individuals, who are barred by heavy penalty from similar “counterfeiting.”

Private banks, it is true, can themselves inflate the money supply by issuing more claims to standard money (whether gold or government paper) than they could possibly redeem. A bank deposit is equivalent to a warehouse receipt for cash, a receipt which the bank pledges to redeem at any time the customer wishes to take his money out of the bank’s vaults. The whole system of “fractional-reserve banking” involves the issuance of receipts which cannot possibly be redeemed.

Preventing Depressions Instead of preventing inflation by prohibiting fractional-reserve banking as fraudulent, governments have uniformly moved in the opposite direction, and have step-by-step removed these free-market checks to bank credit expansion, at the same time putting themselves in a position to direct the inflation. In various ways, they have artificially bolstered public confidence in the banks, encouraged public use of paper and deposits instead of gold (finally outlawing gold), and shepherded all the banks under one roof so that they can all expand together. The main device for accomplishing these aims has been Central Banking, an institution which America finally acquired as the Federal Reserve System in 1913.

Preventing Depressions Central Banking permitted the centralization and absorption of gold into government vaults, greatly enlarging the national base for credit expansion: it also insured uniform action by the banks through basing their reserves on deposit accounts at the Central Bank instead of on gold. Upon establishment of a Central Bank, each private bank no longer gauges its policy according to its particular gold reserve; all banks are now tied together and regulated by Central Bank action. The Central Bank, furthermore, by proclaiming its function to be a “lender of last resort” to banks in trouble, enormously increases public confidence in the banking system.

Preventing Depressions The government assured Federal Reserve control over the banks by (1) granting to the Federal Reserve System (FRS) a monopoly over note issue; (2) compelling all the existing “national banks” to join the Federal Reserve System, and to keep all their legal reserves as deposits at the Federal Reserve;

and (3) fixing the minimum reserve ratio of deposits at the Reserve to bank deposits (money owned by the public). The establishment of the FRS was furthermore inflationary in directly reducing existing reserve-ratio requirements.

Preventing Depressions The Reserve could then control the volume of money by governing two things: the volume of bank reserves, and the legal reserve requirements. The Reserve can govern the volume of bank reserves (in ways which will be explained below), and the government sets the legal ratio, but admittedly control over the money supply is not perfect, as banks can keep “excess reserves.” Normally, however, reassured by the existence of a lender of last resort, and making profits by maximizing its assets and deposits, a bank will keep fully “loaned up” to its legal ratio.

The clearest way of preventing inflation is to outlaw fractional-reserve banking, and to impose a 100 percent gold reserve to all notes and deposits.

Banker to Commercial Banks

commercial banks are required to hold more cash on hand and are less able to increase the amount of loans to give consumers and businesses. This reduces the money supply, economic growth, and increases interest rates.

commercial banks are required to hold less cash on hand and are able to increase the amount of loans to give consumers and businesses. This increases the money supply, economic growth, and reduces interest rates.

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Conducting Monetary Policy

Open Market Operations

Preventing Depression What, then, was the proper government policy during the 1920s? What should government have done to prevent the crash?

Its best policy would have been to liquidate the Federal Reserve System, and to erect a 100 percent gold reserve money; failing that, it should have liquidated the FRS and left private banks unregulated, but subject to prompt, rigorous bankruptcy upon failure to redeem their notes and deposits

Preventing Depression Failing these drastic measures, and given the existence of the Federal Reserve System, what should its policy have been?

The government should have exercised full vigilance in not supporting or permitting any inflationary credit expansion. We have seen that the Fed—the Federal Reserve System—does not have complete control over money because it cannot force banks to lend up to their reserves; but it does have absolute anti-inflationary control over the banking system. For it does have the power to reduce bank reserves at will, and thereby force the banks to cease inflating, or even to contract if necessary. By lowering the volume of bank reserves and/or raising reserve requirements, the federal government, in the 1920s as well as today, has had the absolute power to prevent any increase in the total volume of money and credit.

Preventing Depression It is true that the FRS has no direct control over such money creators as savings banks, savings and loan associations, and life insurance companies, but any credit expansion from these sources could be offset by deflationary pressure upon the commercial banks.

This is especially true because commercial bank deposits (1) form the monetary base for the credit extended by the other financial institutions, and (2) are the most actively circulating part of the money supply.

Preventing Depression Given the Federal Reserve System and its absolute power over the nation’s money, the federal government, since 1913, must bear the complete responsibility for any inflation. The banks cannot inflate on their own; any credit expansion can only take place with the support and acquiescence of the federal government and its Federal Reserve authorities. The banks are virtual pawns of the government, and have been since 1913. Any guilt for credit expansion and the consequent depression must be borne by the federal government and by it alone.