Ellen Brown
November 1, 2011
There is much to like in the National Employment Defense Act (NEED) introduced by Representative Dennis Kucinich on September 21, 2011. For one thing, it includes a mechanism for transforming the national debt back into what it should have been all along—a debt-free national money supply composed of non-interest-bearing government-issued notes. The Act also contains the seeds of what could be a viable cure for credit crises, in the form of a national monetary authority empowered to create money and advance credit to banks. The terms and conditions for these advances are not specified, but assuming they are at reasonable rates and are equally available to all banks on demand, the system could prevent the bank liquidity crises and remedy the tight credit conditions we are experiencing today.
Where the NEED Act seems to go awry is in the attempt to impose a 100% reserve requirement on the banks, and to force banks to turn over the proceeds of their existing loans to the federal government. This money is already a liability on the banks’ books; it is owed to somebody else. Requiring it to be paid again to the federal government would be a form of double jeopardy that could bankrupt the banks.
That said, the Act has potential. Bills are usually modified before they get passed, and this one contains some creative solutions that are worth developing.
“Fractional Reserve” Lending Is an Obsolete Model
The NEED Act assumes that banks create money “out of thin air” by “fractional reserve” lending, and that this practice is fraudulent and unfair. To remedy this, the Act would establish an independent U.S. Monetary Authority that had the sole power to create “new” money and inject it into the economy. Before banks could lend, they would be required either to borrow the money from the U.S. Monetary Authority, or to issue interest-bearing securities, or to raise capital from their earnings or from their investors (Sec. 402(1)(e)).
The NEED Act would also require banks to turn over the proceeds from their existing loans to the federal government. The Act provides at Sec. 402(a)(2):
OUTSTANDING CREDIT- Any asset [or loan] of a depository institution that results from credit extended against . . . [deposits in transaction accounts] shall, as of the effective date—
(A) be a liability of the depository institution to the Federal Government; and
(B) as the outstanding balance is repaid pursuant to its terms, shall be paid over to
the Federal Government.
The problem with paying the proceeds of outstanding loans to the federal monetary authority is that this money is already owed to someone else—the banks’ own depositors, another bank, or the money market. The balance sheet for all U.S. depository institutions detailed on the website of the FDIC shows total collective assets of $13.6 trillion and total liabilities of $12 trillion. (The banks’ capital makes up the difference—their own money.) The largest category of bank assets are outstanding loans, totaling more than $7 trillion. The $12 trillion in liabilities is all money that is owed to someone else. On top of this $12 trillion, the NEED Act would require banks to repay $7 trillion to the federal government, a burden that would render them insolvent.
This provision of the Act appears to be based on a misapprehension concerning how banking works today. Banks DO lend money before they have it in hand, but they have to borrow the money later to clear their checks and balance their books. Current banking practice is described in a textbook by Peter Rose and Sylvia Hudgins titled Bank Management & Financial Services (New York: McGraw-Hill, 8th edition 2010). They write at pages 419-20:
Managers of lending institutions learned over the years that turning down a profitable loan request with the usual excuse—“We don’t have enough deposits or other funds sources to support the loan”—is not well received by their customers. Denial of a credit request often means the immediate loss of a customer account and perhaps the loss of any future business from the disappointed customer. . . .
The financial community learned long ago the importance of the customer relationship doctrine, which proclaims that the first priority of a lending institution is to make loans to all those customers from whom the lender expects to receive positive net earnings. . . . If enough deposits are not immediately available to cover these loans and investments, then management should seek out the lowest-cost source of borrowed funds available to meet its customers’ credit needs. . . .
During the 1960s and 1970s, the customer relationship doctrine spawned the liquidity management strategy known as liability management . . . . Liability management consists of buying funds, mainly from other financial institutions, in order to cover good-quality credit requests and satisfy any legal reserve requirements on deposits and other borrowings that law or regulation may require. A lending institution may acquire funds by borrowing short term, such as in the domestic Federal funds market or borrowing abroad through the Eurocurrency market.
Other sources of funds listed by the authors include repurchase agreements (“repos”), loans from Federal Reserve Banks, advances from Federal Home Loan Banks, sales of large negotiable CDs (certificates of deposit), the commercial paper market, and long-term non-deposit funds (mortgages, capital notes, debentures, etc.).
This system insures not only that the bank retains its customers but that its customers can draw on their credit lines when needed. To extend open-ended credit lines to businesses, banks need to know they have a stable, certain, inexpensive source of funds.
Unfortunately, that certainty is lacking today for the small local banks that are the principal lenders to local businesses, for reasons detailed in an earlier article here. A sovereign federal monetary authority of the sort envisioned by the NEED Act could provide this stable source of funds.
That is not, however, the focus of the NEED Act, which is bent on imposing a 100% reserve requirement on the banks. The drafters of the Act have waged an aggressive campaign against the growing movement for state-owned banks, contending that this alternative merely perpetuates the fractional reserve system. But “fractional reserve banking" as it is done today is merely the extension of bank credit and is not bad in itself. Businesses need ready access to credit, without waiting on the vagaries of the capital markets. The best way to ensure that it is advanced responsibly, honestly, and efficiently is through publicly-owned banks with a mandate to serve the public. A large body of precedent demonstrates that banks can be run not only equitably but quite profitably, when owned and operated by the people themselves.
A Comparison with the Public Bank Option
In a December 2010 article titled “100-percent Reserve Banking and State Banks,” Bill Mitchell, Professor of Economics at the University of New Castle in Australia, critiqued the 100% reserve approach and compared it to the public banking alternative. He wrote:
Clearly, under a 100-percent reserve system, all credit granting institutions would have to acquire the funds in advance of their lending. There would be the equivalent of a gold standard imposed on private banking which could invoke harsh deflationary forces. Further, the 100-percent reserve banking system does not eliminate credit risk, so that crises could still occur if there were significant defaults . . . .
. . . [T]here is nothing intrinsically wrong with private credit. The private sector should be able to borrow and banks create credit under the strict conditions noted below. . . . [T]he only useful thing a bank should do is to facilitate a payments system and provide loans to credit-worthy customers. . . . I would ban all financial risk-taking behaviour that does not advance public purpose (which is most of it).
What is wrong with the existing scheme is not that banks create credit on their books but that this process is under the monopoly control of private financial institutions, which have the ability to turn the credit spigots on and off at will and can charge an extortionate toll for using what should be a public utility. Banks have become so powerful that they have been able to evade regulatory control and now use their credit privileges not just for making loans but for a whole range of speculative investment activities that have jeopardized the stability of the financial system. This flaw in the scheme could be corrected by making credit creation a public service, overseen by public servants who return the profits to the public purse. Mitchell writes of the public bank alternative:
I definitely see the creation of public banks (or in Australia – the return to public banks – which were all privatised in the halcyon days of neo-liberalama!) as a way forward in a new banking system.
A public bank can discipline the cost structure of the private banks. For example, in Australia commercial banking is run as a cartel and they screw customers with all sorts of charges that having nothing to do with their own costs. A public bank with access to sovereign funds could offer very low charges.
. . . Having a strong public banking system to compete against the private banks will achieve mostly the same ends [as bank nationalization] and is more likely to be politically acceptable in the current climate.
Aiming for the Politically Feasible
It may be a while before a radical monetary overhaul is pulled off at the federal level, given the current political climate. In the meantime, the Federal Reserve itself could serve the function of universal sovereign lender to banks. Today, not all banks have access to the Fed’s discount window, and its loans are priced higher than other sources of liquidity. Warren Mosler, author of The 7 Deadly Innocent Frauds of Economic Policy, maintains that the Fed could eliminate bank liquidity problems simply by lending Fed funds to all banks at the Fed funds rate as needed.
A stable source of liquidity could also be provided to local banks by publicly-owned banks at the state level. This option is not only politically feasible right now but has a long and proven track record, as Prof. Mitchell observes with respect to the Australian experience. In the U.S., the established model is the Bank of North Dakota (BND), the nation’s only state-owned bank. North Dakota is the only state to have escaped the credit crisis, boasting a significant budget surplus every year since 2008. It has the lowest unemployment rate in the country, the lowest default rate on loans, and no government debt at all. Viable state bank models are also available from other countries.
Publicly-owned banks are a natural ally of the NEED Act and its stated aim of “employment defense.” Small businesses, according to Fed Chairman Ben Bernanke, account for about 60 percent of gross job creation. In a National Small Business Association survey, 56% of small businesses having problems finding available credit reported having to lay off employees as a result. In North Dakota, the stated-owned BND keeps credit flowing to the local economy by providing liquidity and capital guarantees to the banks that service local business.
We need banks in some form. Businesses need to be able to get ready credit, and state and local governments need somewhere to park their revenues. Banks with a mandate to serve the public are obviously a safer and more cost-effective alternative than banks serving private greed.
