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Friday, December 26, 2008

A Progressive Program for Monetary Reform?

Examination of William F Hixson's book A Matter of Interest: Reexamining Money, Debt, and Real Economic Growth. Foreword by John H Hotson (Praeger, 1991).

by Robert Pollin

Monthly Review (October 1993)

"The Casino Society" is the apt term that came to characterize the US economy in the 1980s - the speculation driven free for all symbolized by three of the wealthiest convicted felons in history: Charles Keating of Lincoln Savings and Loan infamy, junk bond kingpin Michael Milken, and arbitrage operator Ivan Boesky.

Boesky captured the spirit of the period with his famous "greed is good" declaration as the 1986 University of California-Berkeley Commencement speaker. Some observers have attempted to explain the 1980s as simply due to an unprecedented and overzealous embrace of Boeskyism. But could one seriously argue that there were significantly fewer greedy people in previous decades? Understanding the casino society of the 1980s rather demands that we search deeply toward an understanding of the contemporary financial system, and in particular that we explore the links between the contradictions in the financial sector and the broader structural problems of contemporary US capitalism.

William F Hixson's A Matter of Interest is a stimulating effort at providing an explanation for the economy's fundamental financial difficulties. It is also a serious attempt at advancing policy ideas for overcoming these problems. Hixson's analysis is notable for his creative use of simple statistical indicators to support his arguments.

In addition, an especially striking feature of both Hixson's theoretical and policy ideas is the way he has drawn fruitfully upon disparate intellectual influences in developing his line of thought. These influences range from Monthly Review editors Paul Sweezy and Harry Magdoff to John Maynard Keynes and the leading free-market "monetarist" Milton Friedman. Perhaps Hixson's greatest affinity is with Henry Simons, a University of Chicago economist of the generation preceding Milton Friedman.

According to Hixson, the basic problem with the US economy is that, over the post-Second World War period, it has become increasingly dependent on debt to finance government. For example, Hixson shows that in the mid-1960s about eight cents of every dollar of total national spending came from borrowed funds. By the mid 1980s, sixteen cents of every dollar of spending came from borrowed funds. As Hixson shows, this rise in debt financing also means that interest payments as a share of total spending have increased dramatically. Observing these postwar trends, he writes that the only possible conclusion is that from 1947 to 1987 the economy was operated in a way in which there is no hope whatsoever that it can continue to operate for many more decades, and quite possibly for many more years. (page 177).

What are the forces that have produced this unsustainable trend? Hixson cites two main factors. The first is the Federal Reserve's use of high interest rates as a policy tool for maintaining price stability - that is, its policy of raising interest rates for the purpose of slowing the economy's growth and thereby weakening inflationary pressures. The second factor is the increasing reliance on borrowed funds by the public and private sectors to finance both their long-term investments and their ongoing operating costs.

Hixson argues that the logic underlying each of these developments is seriously in error. In his view, using high interest rates to slow price inflation only produces higher interest payments and higher prices. This follows from the obvious point that higher interest payments must be absorbed by nonfinancial firms as a cost. When these firms' interest burdens rise, in Hixson's view, they will aim to mark up their prices to reflect their additional cost, just as they would want to mark up prices due to an increase in wages. Hence, the Federal Reserve's use of high interest rates as an anti-inflationary tool has the perverse effect of both increasing prices and maintaining interest rates at an excessively high level.

With respect to private debt financing, Hixson draws on the work of Henry Simons to argue that, to the maximum possible extent, corporations should be financed through equity rather than debt. Simons argued that debt financing creates a danger of "pervasive, synchronous, and cumulative maladjustments", while also providing excessive revenues to rentier bondholders. Simons thus favored "making a risk-taker and equity investor out of the rentier" and Hixson endorses the idea. Actually, Simons believed that corporations should be fully financed through equity funds. But recognizing the impracticality of this idea under modern circumstances, he proposed drastic simplifications in the types of debt and equity instruments that corporations could issue. As Hixson emphasizes, one crucial result of such a restructuring of corporate financing would be to substantially reduce the ratio of interest payments to national income.

Hixson's most dramatic and fully argued proposals concern government financing. Hixson contends that the federal government should not engage in deficit financing at all. Rather, governments should exercise the power they possess to be the sole creators of new money. In periods of high unemployment when the economy needs stimulus through government spending, the government should therefore finance its spending entirely through money creation rather than borrowing. This way, the return on government projects are essentially infinite: employment and income will increase at no cost, since the government has the power to create money costlessly through its central banking operations. Moreover, the government would be free of debt, and we the taxpayers would no longer be paying fifteen cents on every dollar of our federal taxes to cover interest payments on the debt.

There is an important corollary to this proposal, discussed at length by Hixson. This is that the private banking system should be completely stripped of the power it now has to create money. The way the banks create money is through the system of fractional reserve banking. In this system, banks accept private deposits with the understanding that depositors are able to get their money back when they want it. Therefore such "demand deposits" are as good as money, and in all standard measures, are counted as a portion of the money supply. However, under fractional reserve banking, the banks also have the right to lend out most of the deposit funds they have received. If they receive $10 in deposits, they can, for example, lend out $9 in loans. This increases the money supply from $10 to $19, since the loans can be spent by borrowers just like cash or a check of a depositor. The beneficiaries of this money growth are the banks, who receive interest on the loans they made.

Note that this whole system is premised on the idea that the original depositor is unlikely to come back to the bank and demand her $10, even though she has the fight to do so. If a high proportion of depositors did, at the same time, decide they wanted to convert their deposits to cash, the bank would simply be unable to accommodate this demand, and financial panic would ensue. The Federal Deposit Insurance Corporation - deposit insurance that is government guaranteed and thus underwritten by taxpayers - was created in the 1930s precisely to avoid such panics, and thus maintain the viability of a fractional reserve system.

Under Hixson's proposal, banks would be obligated to maintain 100 percent of the deposits they receive in their vaults. In other words, they would no longer be lending institutions, and as such, they would no longer have the power to create money through privately profitable activity. This would also eliminate the need for taxpayer supported deposit insurance.

Lending institutions in Hixson's scenario - providing credit primarily for mortgages and small businesses - would make loans with the deposits they accept. But a substantial waiting period would then be required before depositors could withdraw their funds from these institutions. This would make deposits from these institutions essentially illiquid: they could not serve as a source of money or "near money" alternative to that supplied by the government.

Overall then, Hixson's proposals aim to promote far less reliance on debt, fewer opportunities for speculation, and, most broadly, drastic simplification of the US financial system. These are obviously desirable ends. The question is whether Hixson's proposals are a viable vehicle for achieving them.

At the level of theory, Hixson has overstated his case on some crucial points. One example concerns his claim that a Federal Reserve policy of raising interest rates is actually inflationary, rather than deflationary, as standard theory would hold. In fact, either case is possible, depending on whether interest rates are pushed up high enough to stifle borrowing and spending. Certainly, during former Federal Reserve Chair Paul Volcker's famous "monetarist experiment" of 1979-1982, raising short-term interest rates to nearly twenty percent did manage - albeit at tremendous human costs in both the US and in particular the Third World - to wring inflationary pressures out of the economy, just as he intended.

At the level of policy, an immediate question about his approach is whether, in the contemporary highly innovative and flexible global financial market, it is realistic to assume the US government, or any government, could successfully thwart the creation of highly liquid deposit funds - that is, substitute forms of money or near money - generated by the private financial system. A central goal of financial innovators over the past thirty years has been precisely to create assets for depositors that are at once highly liquid but that also provide their holders with positive rates of return.

A formidable act of political mobilization would be needed, in other words, to return to a financial environment that is not driven by innovation and circumvention of government regulations. And even assuming that such a political mobilization were attainable, we would then have to question whether its efforts should be concentrated, as a first priority, on a Hixson-like agenda of reform.

One basic problem with his approach is something that monetarists would pounce on, and here with some reason. There is a real danger of excessive inflation ('too much money chasing too few goods') if government relies exclusively on creating money to finance its projects beyond a level supported by its tax base. The first way to prevent excessive inflationary pressures is the monetarist alternative, which is to strictly limit the growth of money. This obviously would inhibit government spending, which is exactly what monetarists favor. The other, more difficult, but also more politically progressive option would be to ensure that the government projects funded by the newly created money are bringing productive assets onstream at a rate equivalent to that of money growth (goods and money growing together). In other words, a crucial component - even more central than the financing mechanism itself - of a progressive financial agenda would be to create an effective system of credit allocation for channeling funds into projects that promote productive activity and sustainable development.

Once the issue is posed in this way, we are then forced to consider what would be the best institutional forms for promoting a more rational allocation of credit. Who should be in control of the central bank? How might we change the allocation of pension funds - which now supply more than half the total funds to the US capital market - so that this money is used to promote the overall well-being of workers, not merely the highest short-term rates of return for the funds? In my view, progressives need to resolve such questions first before taking on a financing mechanism that could, in the absence of a rational credit allocation plan, degenerate into a monetarist tight money regime or a similarly unsatisfactory condition of unproductive spending and excessive inflation.

Given the ongoing irrationality of our financial system, a program of progressive restructuring could become politically feasible in the foreseeable future. Regardless of how one responds to the details of Hixson's proposals, A Matter of Interest is a serious attempt to grapple with the issues before us. As such, it should become a useful resource in building both the economic understanding and political will necessary for constructing a more equitable and viable financial system.

Copyright (c) 1993 Monthly Review Foundation, Inc.
Copyright (c) 2004 Gale Group

Bill Totten


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