On October 13, 2015, Robert Reich writes on Salon:
Giant Wall Street banks continue to threaten the wellbeing of millions of Americans, but what to do?
Bernie Sanders says break them up and resurrect the Glass-Steagall Act that once separated investment from commercial banking.
Hillary Clinton says charge them a bit more and oversee them more carefully.
Most Republicans say don’t worry.
Clearly, there’s reason to worry. Back in 2000, before they almost ruined the economy and had to be bailed out, the five biggest banks on Wall Street held 25 percent of the nation’s banking assets. Now they hold more than 45 percent.
Their huge size fuels further growth because they’ll be bailed out if they get into trouble again.
This hidden federal guarantee against failure is estimated be worth over $80 billion a year to the big banks. In effect, it’s a subsidy from the rest of us to the bankers.
And they’ll almost certainly get into trouble again if nothing dramatic is done to stop them. Consider their behavior since they were bailed out.
In 2012 JPMorgan Chase, the largest bank on Street, lost $6.2 billion betting on credit default swaps tied to corporate debt – and then publicly lied about the losses. It later came out that the bank paid illegal bribes to get the business in the first place.
Last May the Justice Department announced a settlement of the biggest criminal price-fixing conspiracy in modern history, in which the biggest banks manipulated the $5.3 trillion-a-day currency market in a “brazen display of collusion,” according to Attorney General Loretta Lynch.
Wall Street is on the road to another crisis.
This would take a huge toll. Although the banks have repaid the billions we lent them in 2008, many Americans are still living with the collateral damage from what occurred – lost jobs, savings, and homes.
But rather than prevent this by breaking up the big banks and resurrecting Glass-Steagall, Hillary Clinton is taking a more cautious approach.
She wants to impose extra fees on the banks, with the amounts turning not on the bank’s size but how much it depends on short-term funding (such as fast-moving capital markets), which is a way of assessing riskiness.
So a giant bank that relies mainly on bank deposits wouldn’t be charged.
The following explanation is largely credited to Michael Greaney, my colleague at the Center for Economic and Social Justice (www.cesj.org). It is important to distinguish the three types of banks and what banks deal with existing “money savings,” mortgages, and bills of exchange. Following the repeal of Glass-Steagall, what occurred was a conglomeration of the financial services industry, whereby most banking institutions combined the different types of banks under one roof. That has lead to massive confusion as people assume that the proper functioning of one type of bank is a crime because it is different from the way another type of bank operates.
The three types of banks are 1) Banks of Deposit, 2) Banks of Issue (also called Banks of Circulation), and 3) Banks of Discount. Causing confusion is that a commercial or mercantile bank is a combination of discount and issue banking, to which is usually added deposit banking features.
Banks of Deposit. A bank of deposit is defined as a financial institution that takes deposits and makes loans. This is what most people think of as a bank. A bank of deposit does not have the power to create money. It merely serves as an intermediary between savers and borrowers. The most common banks of deposit are credit unions, savings and loans, and investment banks.
Banks of Issue. A bank of issue is defined as a financial institution that takes deposits, makes loans, and issues promissory notes intended for use in the community as a medium of exchange. Strictly speaking, a bank of issue does not create money. It only accepts deposits of existing wealth and issues promissory notes backed by the deposited wealth or the bank’s capitalization.
Banks of Discount. A bank of discount is defined as a financial institution that accepts bills and notes at a discount and issues promissory notes backed by the present value of the bills and notes accepted.
Commercial or Mercantile Banks. In today’s financial services sector there are no “pure” banks of issue or banks of discount, i.e., that perform only that function. Commercial or mercantile banks combine the functions of banks of issue and banks of discount. Many usually add personal banking services for consumers, which (while convenient) helps confuse the roles of the different types of banks to the public and the politicians.
Commercial or mercantile banks combine the features of discount and issue banking because otherwise a business seeking a loan based on its creditworthiness would have to take its bill of exchange and offer it to a bank of discount. If the bank of discount accepted the bill and issued a promissory note, the business would then take the promissory note issued by the bank of discount and take it to a bank of issue to convert it into the promissory note(s) of the bank of issue that the business could then use as money.
It simply makes more sense for a single institution to accept a bill of exchange and issue a promissory note, and then use that promissory note to back a new issue of banknotes (very rare these days) or create a new demand deposit (almost always), on which the borrower can draw.
Central Banks. Contrary to popular and political thought, central banks were not invented to finance government. The fact that they have developed as the primary source of government funding today is the result of an accident of history and political expedience. Most simply put, a central bank is a commercial bank for commercial banks. A central bank is sort of a reinsurance company for bills and notes accepted by commercial banks that are then rediscounted at the central bank.
At the same time, a central bank has the power to initiate transactions by going to the open market and buying and selling qualified private sector bills and notes issued by commercial banks, businesses, and individuals. Again, today’s almost exclusive use of open market operations to deal in secondary government securities is an accident of history combined with political expedience, and was never intended as a function of a central bank.
How does the amount of money increase in the system? By making loans by discounting (accepting) bills of exchange. A bank of deposit cannot do this. Neither can a bank of issue. Only a bank of discount, or a bank with discounting power such as a commercial or mercantile bank, can create money by making loans.
Banks do not make loans out of reserves. “Reserves” are a minimum amount of cash in the form of the reserve currency that a financial institution is required to keep on hand. A bank can only lend out money that is in excess of reserve requirements. It can’t loan out reserves, or it has violated its charter by exceeding the amount it is permitted to loan out. This goes for all types of banks.
Banks do not “create money” by re-depositing reserves. This is explained by
Dr. Harold G. Moulton in The Formation of Capital. As Moulton explained:
“Suppose now that Mr. A writes a check for $98,000 in favor of Mr. B. Suppose also that B desires to be a customer of this bank, and upon receipt of the check presents it at the bank and asks that an account be opened in his name and that the $98,000 check be deposited to this account. It is evident that the result of this operation, so far as deposits are concerned, is merely to deduct $98,000 from A’s account and add $98,000 to B’s account. The total deposits owed by the bank remain unchanged. While B’s deposit account comes over the counter in the form of a check presented to the bank, it is obvious that it is still indirectly the result of the loan that was made to A.
“Since it is more convenient for B to meet his obligations by means of checks rather than in the form of actual cash, we may assume that he will write checks to those to whom he is indebted. Let us assume that he writes four checks of $24,500 each; and that Messrs. C, D, E,and F, desiring to do business with this bank, in turn present these checks for deposit. The net result still is to leave the total of deposits unchanged; though instead of being credited to A or B the deposits are now credited to the accounts of other individuals. In their turn C, D, E, and F may write checks against their deposit accounts for varying amounts and to the order of sundry persons. If all the people receiving such checks in turn present them to this bank for deposit to their respective accounts, it is obvious that, while there would be an ever-shifting personnel among depositors, the total deposits would remain at $98,000.” (Dr. Harold G. Moulton, The Formation of Capital. Washington, DC: The Brookings Institution, 1935, 79-80.)
Thus, when B deposits A’s check, the bank transfers $98,000 from A’s account to B’s account. When C deposits B’s check, the bank transfers $96,040 to C’s account, and so on down the line. As Moulton noted, there is no increase in the money supply, just a shifting around of who holds the original money.
To gain a better understanding of banking principles, it is critical that the difference between the Currency School and the Banking School is understood. To oversimplify:
Currency School economists and politicians believe that “money” is itself a thing of value (a commodity), while Banking School economists and politicians (assuming you can find any) believe that “money” is a symbol of a thing of value (a contract).
To an adherent of the Currency Principle, the issuer of money transfers wealth, while to an adherent of the Banking Principle, the issuer of money transfers a claim on wealth.
In the Currency School, money is a medium of exchange, while in the Banking School money is the medium of exchange: “all things transferred in commerce” — anything that can be accepted in settlement of a debt.
The three mainstream schools of economics (Keynesian, Monetarist/Chicago, and Austrian) are all Currency School. The differences among the Currency Principle schools of economics are:
In Keynesian economics, money is a general claim on the existing wealth of the economy issued by the State, making the State the real owner of everything in the economy. The amount and value of the currency may be adjusted to achieve political and economic goals (“Chartalism,” or “Modern Monetary Theory”). Ultimately (merging the concepts of private and collective property), the money supply is a non-repayable debt the nation owes itself. The amount of government debt outstanding is irrelevant, because issuing or retiring money simply increases or decreases the number of claims on existing wealth. Interest rates are subject to change to discourage or encourage investment.
In Monetarist/Chicago economics, money is a general claim on the existing wealth of the economy, which may be issued either by private sector banks or the public treasury. In either case, the amount of money issued must equal the value of existing wealth of the economy. If too much money is issued, there is inflation, which erodes private property. If too little money is issued, there is deflation, which inhibits economic growth. The amount of government debt outstanding, and the activities of private sector banks must be strictly regulated to avoid issuing money is excess of the existing wealth in the economy, thereby causing inflation. Interest rates are the price of money and must be set by the market.
In Austrian economics, money is a commodity with generally recognized value and acceptability (formerly silver, now gold) that serves as a medium of exchange to facilitate commerce and that can be used as a standard to measure all other things of value. If the needs of an economy require an increase in the money supply, either the natural increase in the supply of gold through mining or commerce, or a rise in the price of gold as it becomes scarcer relative to other things of value in the economy will bring in more gold and stabilize prices at their natural, real level. Any increase in the money supply from other sources is thus inflationary as it interferes with the real price level established by parity with gold, whether or not the price level rises, and any decrease in the money supply by artificially controlling the price of gold is deflationary for the same reason, whether or not the price level falls. Interest rates are the price of money and must be set by the market.
Obviously, if you use a “bank” — a financial institution based on the Banking Principle — as if it were a financial institution based on the Currency Principle, you’re misusing a very powerful tool.
Banking Principle economics is a little more straightforward than Currency Principle economics. This may be because there is only one surviving school of Banking Principle economics: binary economics, what its principal developer, lawyer-economist Louis O. Kelso, called “the economics of reality.”
In binary economics, money is simply a means to measure value and facilitate exchange — it’s a contract, nothing more, nothing less, a symbol, not the thing itself. As Kelso explained it,
“Money is not a part of the visible sector of the economy. People do not consume money. Money is not a physical factor of production, but rather a yardstick for measuring economic input, economic outtake and the relative values of the real goods and services of the economic world. Money provides a method of measuring obligations, rights, powers and privileges. It provides a means whereby certain individuals can accumulate claims against others, or against the economy as a whole, or against many economies. It is a system of symbols that many economists substitute for the visible sector and its productive enterprises, goods and services, thereby losing sight of the fact that a monetary system is a part only of the invisible sector of the economy, and that its adequacy can only be measured by its effect upon the visible sector.” (Louis O. Kelso and Patricia Hetter, Two-Factor Theory: The Economics of Reality. New York: Random House, 1967, 54-55.)
In binary economics, all money is a contract, just as (in a sense) all contracts are money. This is strictly in accordance with Say’s Law of Markets, which is based on Adam Smith’s first principle of economics from The Wealth of Nations (1776): “Consumption is the sole end and purpose of all production.”
That being the case (and all other things being equal), the only way to consume is to produce; you cannot consume what has not been produced. You must, therefore, either produce goods, products and services for your own consumption, or to trade to others for what they have produced so that you can consume it. The means by which we exchange goods, products and services we call by the general term “money.” As Jean-Baptiste Say explained,
“All those who, since Adam Smith, have turned their attention to Political Economy, agree that in reality we do not buy articles of consumption with money, the circulating medium with which we pay for them. We must in the first instance have bought this money itself by the sale of our produce.
“To a proprietor of a mine, the silver money is a produce with which he buys what he has occasion for. To all those through whose hands this silver afterwards passes, it is only the price of the produce which they themselves have raised by means of their property in land, their capitals, or their industry. In selling them they in the first place exchange them for money, and afterwards they exchange the money for articles of consumption. It is therefore really and absolutely with their produce that they make their purchases: therefore it is impossible for them to purchase any articles whatever, to a greater amount than those they have produced, either by themselves or through the means of their capital or their land.
“From these premises I have drawn a conclusion which appears to me evident, but the consequences of which appear to have alarmed you. I had said — As no one can purchase the produce of another except with his own produce, as the amount for which we can buy is equal to that which we can produce, the more we can produce the more we can purchase. From whence proceeds this other conclusion, which you refuse to admit — That if certain commodities do not sell, it is because others are not produced, and that it is the raising produce alone which opens a market for the sale of produce.” (Jean-Baptiste Say, Letters to Malthus. London: Sherwood, Neely, and Jones, 1821, 2.)
Nor is this some kind of wild and crazy innovation by Smith and Say. Other political economists advanced the same theory before Smith. For example, in a passage that clearly viewed coin and bullion as a substitute for marketable goods, products and services (not the other way around), John Conduitt, Member of Parliament and Master of the Mint (who married Sir Isaac Newton’s niece), explained,
“When we cannot pay in goods, what we owe abroad, on account of the balance of trade, or for the sale or interest of stocks belonging to foreigners, or for foreign national services, our debts must be paid in gold or silver, coined or uncoined; and when bullion is more scarce or more dear than English coin, English coin will be exported, either melted or in specie, in spite of any laws to the contrary.” (John Conduitt, Observations Upon the Present State of our Gold and Silver Coins, 1730. London, T. Becket, 1774, 1.) [Emphasis added.]
If any doubt remains, we can go to an authority, Dr. Harold G. Moulton, President of the Brookings Institution from 1928 to 1952:
“It is important to bear in mind that the thing loaned (on credit) may be either commodities or funds. Goods sold on time involve credit; indeed, we usually say that they are sold ‘on credit.’ Such merchandise may be paid for by a return of goods in kind; though under modern conditions the obligation is usually settled by money payments. Loans of money by a bank or other financial institution, or by one individual to another, similarly involve a future payment, the credit consisting in allowing the individual to have the use of funds which he is to return at a later time.” (Moulton, Financial Organization and the Economic System. New York: McGraw-Hill Book Company, Inc., 1938, 99.)
Thus, as Henry Dunning Macleod, another lawyer-economist, observed, “Money and Credit are essentially of the same nature; Money being only the highest and most general form of Credit.” (Henry Dunning Macleod, The Theory of Credit. Longmans, Green and Co., 1894, 82.)
What’s all this got to do with restoring Glass-Steagall?
Today we’re looking at one of the “causes behind the causes”: lack of internal control in the financial services industry. With an all-powerful State and a Keynesian economy, who needs internal, systemic controls for the financial system? If something has to be done, the State will order it, and it will be done — external control. Won’t it?
That was the reasoning behind the repeal of Glass-Steagall (certain provisions of the Banking Act of 1933, (Pub. L. 73–66, 48 Stat. 162), anyway. Who needs the system to be set up to operate properly when we have the government to tell people what’s right and wrong? People will do the right thing naturally, and if they get out of line, the government will fix it.
The fact is that all forms of external control only work effectively if the system itself is structured properly, i.e., has the right kind of internal controls. This is basic accounting.
For example: in a business (or anywhere else) you don’t want the same people authorizing disbursements who issue and sign the checks. Why? Because it is too easy for a dishonest person to authorize a payment to him- or herself, and then issue the check, with no one the wiser until checks start bouncing all over the map because someone cleaned out the business’s accounts and moved to Andorra, a tiny principality in the Pyrenees, which has no extradition treaty with the U.S.
How does this apply to the financial system? Before the Crash of 1929, commercial and investment banking were linked. That meant that stock brokers in an investment bank could go to the related commercial branch and have the commercial branch create money to loan to an investor, sometimes with as little as 3 percent down.
This resulted in massive money creation that fueled speculation on Wall Street, driving up the prices of shares to unheard-of heights. When people realized there was nothing behind the rise in share values except private sector debt backed by the rise in share values, the stock market crashed.
To correct this and prevent it from happening again, Senator Carter Glass of Virginia (who had been instrumental in the passage of the Federal Reserve Act of 1913) and Representative Henry B. Steagall of Alabama insisted on provisions in the Banking Act of 1933 that separated commercial and investment banking. There were, unfortunately, some loopholes, especially those that permitted money creation backed by government securities (or, more accurately, didn’t prohibit it), but by and large Glass-Steagall effectively instituted solid principles of internal control into the financial services industry.
In the 1980s efforts began to repeal Glass-Steagall, which was accomplished in two phases. The first resulted in the savings and loan debacle, and the second led directly to the home mortgage meltdown.
The current wild fluctuations in the stock market are, in a sense, not directly related to the repeal of Glass-Steagall, as they are funded largely by government instead of private sector money creation. The lack of separation of function between investment and commercial banking makes this easier, but that is all. Commercial banks are channeling funds to speculation instead of using their money creation powers backed up by the Federal Reserve to finance private sector investment in new capital asset formation.
That is why sound principles of internal control would mandate not merely a separation of investment and commercial banking again, but also mandate that financial institutions of all types stick strictly to the purpose for which they were instituted. A commercial bank would make commercial loans, a savings and loan would make consumer loans, an insurance company would offer only insurance, an investment bank would mediate between stock issuers and stock purchasers, and so on.
Above all, there would be no creation of money backed by government debt. If a government borrows, it must be out of existing savings. The only reason the Federal Reserve was permitted to deal in government securities on the open market was to retire the debt-backed United States Notes, National Bank Notes, and Treasury Notes of 1890, and replace them with Federal Reserve Notes backed with private sector hard assets.
The bottom line here is that if proper internal controls are in place, it is no longer a question whether the government or the banks are creating too much or not enough money for non-productive spending and speculation. The question answers itself, because the system would prohibit ALL new money creation except that which is backed by non-speculative, private sector hard assets. Governments, like the rest of us, would have to learn to live within their means, meaning what can be raised by taxation, not issuing government debt-backed funny money.
To ensure the viability of such a move, it would have to be linked to an aggressive program of expanded capital ownership, such as entailed in the Just Third Way’s proposed Capital Homestead Act, increasing the number of capital owners, rebuilding the tax base, and decreasing the need for massive government entitlements. See the Capital Homestead Act at http://www.cesj.org/learn/capital-homesteading/, http://www.cesj.org/learn/capital-homesteading/capital-homestead-act-a-plan-for-getting-ownership-income-and-power-to-every-citizen/ and http://www.cesj.org/learn/capital-homesteading/capital-homestead-act-summary/. See http://www.cesj.org/learn/capital-homesteading/ch-vehicles/.
