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We propose four points the G20 needs to institute to (quite literally) save the world :
1. First, the so-called “capital adequacy” system has to go. It was the child of Milton Friedman’s eccentric flip-flop from being an advocate of 100% cash reserves, that he learned from his mentors from the original Chicago school of the 1930s, to his later advocacy of zero percent reserves. The system is basically uncontrollable because all the yardsticks are subjective.
2. The second requirement is to re-instate the cash reserve system that is an objective regulator of the rate of money creation without the wild fluctuations in interest rates that have had such horrific consequences on the real world.
3. Third, bank leverage has to be reduced from the current twenty to one to a level that the banks themselves would consider prudent if they were making a loan to industry. After much thought, a ratio of three to one appears to be most appropriate. That leaves them with more than enough money creation power to meet their legitimate objective while denying the reckless latitude to finance leveraged buyouts, hedge funds, the purchase of stocks on margin and the casino-like activities that have become addictive.
4. Fourth, and of profound significance, the proportion of government-created money (GCM) should increase to 34% of the total while the banks are reduced to 66% from about 95%. If the GCM is created as debt free money it will be possible to reverse the curve for sovereign debts everywhere in relation to Gross Domestic Product.
Banking Past, Present, and (Hopefully) Future:
The purpose of this document is to help understand the need for banking reform that is unquestionably the most important issue facing the world today. It is, regrettably, a subject that is only well understood by about one person in a hundred.
The story of banking is almost as old as the hills but for the sake of brevity we will begin in the mid-seventeenth century in England.
Until 1640 wealthy London merchants deposited their surplus gold and silver at the government mint in the Tower of London for safekeeping. In that year, Charles I seized the privately-owned money and destroyed the Mint's reputation as a safe place.
This action forced the wealthy to look elsewhere and they decided to store their excess coins with the goldsmiths of Lombard Street who already had strongboxes for their own valuables.
The goldsmiths paid 5% interest on their customers' deposits and gave them receipts for their money on the condition that they could lend out the money until it was needed. Wealthy Londoners soon found that it was more convenient to use the receipts, which became known as goldsmiths' notes, than to carry around a bag of coins. So the goldsmiths' notes became the predecessors of bank notes.
The goldsmiths soon learned that they could lend more money than they actually had in their vaults. The reason they could get away with this is because depositors never all came to cash their certificates at one time. Thus began the fractional reserve system. It was to become the most profitable scam in all of history.
What the goldsmiths were doing was certainly illegal but the scam received official tolerance when the Bank of England was chartered to help finance King William's War 1688-1697. The rich people of London subscribed 1,200,000 pounds sterling in gold and silver and the bank lent it all to the government at 8% interest (which seems like a pretty good rate of interest for government guaranteed bonds.)
The government showed its appreciation by allowing the Bank to print 1,200,000 pounds in bank notes and lend it to their wealthy customers at high interest rates. In effect, the Bank was allowed to lend the same money twice.
Bank lending ratios have increased dramatically over the years due to the avarice of the banks and the collusion of the politicians. In the early years of the 20th century federally chartered United States banks had to maintain 25% gold reserves against their deposits. In other words they were allowed to lend the same money four times. For many years Canadian banks had to maintain 8% cash reserves which means they were allowed to lend the same money 121/2 times.
Today, U.S. cash reserves on chequing accounts are 3%, zero percent on savings accounts, and zero percent on Eurodollar accounts. In Canada the reserve requirement is zero percent, period! With no legal requirement to keep any cash you are lucky if your bank has a cent or a cent-and-a-half in legal tender for every dollar you think you have in the bank - just the minimum to meet the day-to-day needs of their customers.
Under the current system, known as "capital adequacy," Canadian and most U.S. banks are allowed a leverage of twenty to one, an absolutely ridiculous bonanza that can justly be described as legalized fraud. It is comparable to a landowner being able to rent a pasture to twenty farmers simultaneously and collecting rent from each one.
What it means for the banks, however, is that if the average market value of their assets (stocks, mortgages, etc.) falls 5% or more they are technically bankrupt; and that is what happened to many of them in 2008. Without government assistance a significant number would have gone under, including some of the biggest ones.
Friedmanism
The magnitude of the catastrophe in 2008 can be traced to the economics of Milton Friedman and his colleagues at the University of Chicago, whose ideas were adopted by central banks in 1974.
Friedman, who at one time advocated 100% cash reserves switched to zero reserves when he concluded that the former was politically impossible. One has to wonder about the judgment of a man who jumped from one extreme to the other.
In any event his ideas led to the virtual abandonment of the partial reserve system and the substitution of what is called (ironically) a capital adequacy system. This is a misnomer because it has proved to be a capital inadequacy system. Risk assessment is entirely subjective. For example, bonds of sovereign governments were considered to be risk free but that has proved not to be the case.
Our concern is profound when we note that leaders of the G20 group of nations appear to be blithely unaware that radical and fundamental reform is required. The bill being considered by the U.S. Congress is worse than useless because it purports to be reform when in fact it is nothing more than an attempt to patch up the existing system within a thicker layer of bureaucracy. I have described it as comparable to welding a few patches of boiler plate on a rusty old ship in the hope it will stay afloat.
One thing is certain. The current system will not give governments the financial flexibility necessary to finance essential services, subsidize the changeover from a fossil fuel economy to a clean fuel economy within the next ten years or so that we have available before reaching the point of no return on global warming, and still balance their budgets. It is mathematically impossible under a system where privately-owned banks create about 95% or more of the new money printed each year.
The principal problem with bank-created money (BCM) is that it is all created as debt, debt on which interest has to be paid. So what happens if no one creates any money with which to pay the interest? You have to borrow more and go deeper and deeper in debt without any viable means of escape.
The system is like a balloon being pumped full of debt. The balloon keeps getting larger and larger until the debt load is too heavy to carry and then it's like a balloon with a pin stuck in it. A recession or depression wipes out a lot of the debt so the whole process can start over again.
At this point it may be useful to review briefly how banks create so many billions of dollars of virtual (debt) money. They like us to believe that when we go for a loan the money they lend us is some that somebody else deposited the day before. But the chances of that being true are infinitesimal.
The way it works is like this. Should you want to borrow $35,000 to buy a car you visit your friendly banker. He or she will ask for collateral. Once that has been provided you will be asked to sign a note repayable with interest. When the note is signed the banker will tap their computer keys and, presto, $35,000 will be deposited to your account. The important point is that just seconds earlier that money did not exist. It was created out of thin air, so to speak.
The system is a kind of double-entry bookkeeping where your note becomes an asset on the bank's books and the new deposit becomes a liability. The banks make their money on the spread, the difference between the rate of interest you have to pay on your note and the infinitesimal rate, if any, they pay you on the deposit in the event you keep the money in your account for a few months until the new car model comes out, or for some other reason.
The 34% Solution
What we are proposing today for consideration by the G20 is that we learn from the experience of the last 72 years and apply the lessons.
First, the so-called capital adequacy system has to go. It is based on terribly skewed academic theory and is fundamentally uncontrollable.
Second, the cash reserve system must be restored to provide direct control over the money supply without resorting to wild fluctuation in interest rates that have such horrific consequences in the real world.
Third, bank leverage has to be reduced from the current twenty to one to a level that the banks themselves would consider prudent if they were making a loan to industry. After much thought we have settled on three to one.
Fourth, and of profound significance, the proportion of government-created money (GCM) should increase to 34% of the total while the banks are reduced to 66% from about 95%. If the GCM is created as debt free money it will be possible to reverse the curve for sovereign debts everywhere in relation to Gross Domestic Product.
Of course the 34% cash reserve should be phased in over a period of several years in order to give the banks time to adjust to the new reality. Still the benefits of the transition would be immediate.
Canadian banks had considerably more than two trillion in assets and probably not much more than 1% of it in cash at the end of last year. Increasing the cash requirement to 4% at once would allow the federal government to create enough money to eliminate its budgetary deficit for the year. Another three percent would allow a balanced budget in the coming year. A couple of additional percent would provide enough cash to allow the federal government to assist the hard-pressed provinces and still have enough left over to provide additional stimulus to help create jobs for some of the people who lost theirs as a direct result of the banking crisis.
The benefits for the United States of introducing the same system would be as great if not greater. The problem of financing their new health care benefits would be instantly resolved. All countries would gain the financial flexibility required to seriously and urgently address the crucial problem of global warming. All of this benefit is possible if we learn from the success of an earlier generation. The model we are proposing is based on the Canadian experience from 1939 to 1974 when Canada joined the mob and opted for the monetarist counter-revolution of the Friedmanites.
A Canadian Precedent
In 1938 there were no jobs in Canada - none. Then war broke out in 1939. Pretty soon everyone was working. Some people joined the armed forces, others built factories or made munitions. So, you might ask, where did they get the money necessary to do all this?
The Bank of Canada printed it! P R I N T E D It!
The system worked this way. The Bank of Canada printed money to buy government of Canada bonds. The government paid the Bank interest on the bonds. The Bank paid the interest back to the government as dividends because the government owned the Bank. So the net cost to the government (read taxpayers) was just a little more than zero percent. Just the cost of administration deducted.
The cash that the government got from the sale of its bonds was spent into circulation and wound up in the private banks where it became what the economists called high-powered money. That became the monetary base (cash reserves) for private banks to expand their lending capacity and make loans for building factories, buying war bonds, etc.
In effect, the money creation function was shared between the government of Canada, through the Bank of Canada, and the private banks. This was the system that got us out of the Great Depression, helped finance World War II, helped finance post-war infrastructure and assisted in laying the foundation for our social security system. It was the system that gave us the best 25 years of the 20th century!
The system remained in effect until 1974 when the Bank of Canada, in concert with other central banks, adopted the ideas of Milton Friedman and his colleagues at the University of Chicago. It has been downhill ever since.
One Important Variation on the Canadian Precedent
During the golden years the government of Canada gave the Bank of Canada interest-bearing bonds in exchange for the money it printed. The government paid the Bank interest on the bonds and the Bank paid it back in dividends. So it was near zero cost money. But it wasn't debt free money in the sense that the bonds were shown as debt on the government books.
There is an easy solution to this bookkeeping problem. Governments can give central banks non-redeemable, non-convertible shares in the country in appropriate nominal denominations. This will allow the central bank to balance its books by recording the nominal value of the shares as an asset. The money created in exchange would be, for all practical purposes, debt free.
The infusion of substantial sums of debt free money would end the tsunami of debt that has put the whole world financial system in peril and paralyzed governments from taking the essential steps to solve the problems of the real world as opposed to the demands of the money-changers.
Of course not all countries are as fortunate as Canada with its 100% publicly owned central bank. Public ownership of the printing presses is a problem that each country will have to address so that the benefits of the 34% seignorage will accrue 100% to the people who rightfully own the patent to create money.
We think that adoption of our plan would be enough to create a modern miracle.
P.S. But if you plan to ask the opinion of bank or other orthodox economists concerning its merits, you should take the trouble to check their bona fides. Ask them for their plan to enable sovereign governments to stimulate their economies until full employment is restored, replace aging infrastructure, assist poor countries and help pay down their debt, as well as spend the large sums required to change from an oil-based economy to a clean fuel economy within a few years - all without an increase in taxes (that would decrease aggregate demand and slow the economy) or taking on more debt, or both.
One thing is absolutely certain. You can kiss the world goodbye as a hospitable habitat for the human species unless governments take back a substantial slice of their money creation powers. Otherwise the nations of the world will not have the financial flexibility to convert from fossil fuels to clean energy before it is too late! The stakes could not be higher.
Is to too much to ask of the leaders of the G20 that they put the interests of their electors and of future generations ahead of the interests of an elite few?