Could Fed Style Banking Save California?

As was mentioned in this column last week, given the defeat of tax hike propositions in California, the state is in a real quandary to find $24 billion dollars by July to close its budget gap.  Without those funds or new debt guaranteed by the federal government, California will face insolvency by mid-summer.  Unlike Washington, Sacramento cannot just print money out of thin air to put off paying its bills indefinitely.  Even that technique of monetary policy is about to catch up with the entire country soon when people begin spending and prices hit the roof.  No, it seems the only way for the Gold Plated State to settle its fiscal woes is to cut payrolls and services.

Not so fast you doomsayers, Ellen Brown, author of Web of Debt, and blogger on the leftist Huffington Post believes she has come up with a scheme to keep the socialistic gravy train in the state rolling without interruption.  She admits California cannot print its own money, but it can open a state owned bank that can create money through credit entries on its books.  To explain how it would work she quotes the webpage for the Federal Reserve Bank of Dallas:  

“Banks actually create money when they lend it. Here’s how it works: Most of a bank’s loans are made to its own customers and are deposited in their checking accounts. Because the loan becomes a new deposit, just like a paycheck does, the bank…holds a small percentage of that new amount in reserve and again lends the remainder to someone else, repeating the money-creation process many times.”

Pretty neat huh, new money is created by a simple accounting entry and then loaned out again.  Because it owns the bank, the state could afford itself a sweetheart deal by giving itself rates below market value and then roll those loans over as needed until revenues had been generated to pay them off.  Brown credits the state owned bank in North Dakota for that state being one of only 3 currently that are solvent.  She also believes North Dakota’s GNP and personal income growth is directly related to the bank’s operation.  One can have their cake and eat it too in the Peace Garden State.

Now, on the surface, Brown’s assertion that the difference between North Dakota’s solvency and the 47 states that are insolvent in this economic crisis is the state owned bank seems legitimate.  However, upon closer inspection this is proven inaccurate.  First of all, North Dakota is the 3^rd least populous state in the union.  It doesn’t even have a million people.  There is little crime, hardly any costs associated with illegal immigration, and much less of a need for social programs.  It is after all a conservative Midwestern farming state.  

Indeed, it is probably because of the state’s two biggest industries, agriculture and petroleum, that North Dakota is doing so well.  These industries have done very well in recent years and would account for the huge growth in the state’s GNP and personal income.  Incidentally, the exclusion of food and energy costs from the consumer price index has contributed to moderating the national inflation rate at a time when both commodities’ costs have been relatively high.  As far as the solvency of the state is concerned, North Dakota is not a low tax state and given the prosperity of the two aforementioned industries it’s no wonder the state’s coffers are overflowing.

Secondly, what Brown is suggesting is responsible for North Dakota’s prosperity is really just fractional reserve banking albeit through a state run bank instead of the private system.  Fractional reserve banking is nothing new and in fact is what the Federal Reserve System is based on (hence the quote from the Dallas Fed).  It is a monetary scheme whereby banks keep only a portion of all its deposits (currently approximately 10 percent) in reserve and loan out the remainder while at the same time maintaining their obligation to pay on demand all deposits to savers.  There are two problems with fractional reserve banking: Loss of liquidity and inflation.  The Fed maintains what is called a discount window for banks to use to borrow short term from the Fed when their liquidity is insufficient.  Fed chairman Ben Bernanke has been asked several times by Congress to divulge the names of banks that utilize the discount window.  He refuses on the grounds that the information would unnecessarily cause a lack of confidence in those banks and put them at risk of real insolvency.  However, it is more likely that the number of banks utilizing the discount window is immense primarily because of fractional reserve banking and to make that information public would destroy all confidence of Americans in the banking system.  Think about it, when a bank writes down a bad loan it is also writing down a deposit it must eventually make good on.  How many banks have written down bad loans in the current crisis?

But fractional reserve is a funny money scheme for another reason.  It is a hidden tax because it leads to general price inflation.  It probably is more responsible for the increase in money supply than low interest rates.  As banks create new money through creating credit out of thin air the value of every dollar is decreased.  It then takes more dollars to purchase the same goods if the supply of those goods has not increased.  More research would be needed, but the Bank of North Dakota’s inflationary policies are probably being offset by the high market prices of their two main industries – food and petroleum.  In any event, besides Alan Greenspan’s artificially low interest rates of the early 2000s, fractional reserve banking also contributed to the housing bubble and will be a contributing factor to the inflation the U.S. will face in the future.

Statists are good at devising schemes to prolong their wasteful policies.  Ellen Brown’s funny money scheme is just the latest.  It won’t work for California because it hasn’t worked for America.  A bailout of the state should be out of the question.  The voters have spoken and they have said no new taxes!  The only thing left for the benevolent politicians in Sacramento to do is to free thousands of non-violent drug offenders, lay off thousands of state workers, and end welfare as they know it.  Maybe then California can be known again as the Golden State.

Let California Fail

It is ironic that the federal government is substantially meddling in the financial affairs of other entities given the dilapidated state of Washington’s own finances.  First, there were the banks, investment houses and insurance companies – the most notorious being AIG.  Then the auto companies weighed in getting their piece of bailout funds from Uncle Sam.  Now, it seems the states will be next to tap the national treasury for funds that do not exist. 

There is a saying, “As California goes, so goes the rest of the nation.”  How true these words have become since both are completely bankrupt.  With the defeat this week by voters in the Golden State of ballot initiatives that would have drastically raised taxes to close a $24 billion budget gap, the state is on course for a complete financial collapse by July.  Unlike the national government, California can’t print money to buy more time either – no pun intended.  It must find a way to raise the funds otherwise millions of Californians will not receive checks.

But, not to worry, Governor Schwarzenegger, Senator Boxer and other Golden Staters are putting the squeeze on Treasury Secretary Tim Geithner to guarantee emergency loans that California needs to meet its obligations.  With the state’s credit rating in the toilet, some analysts believe federal backing is California’s only hope to secure the loans it needs to pay its bills.   The proposal would collateralize U.S. taxpayer funds to guarantee private lenders that they would be repaid if California defaulted.  The concept is to take the risk out of lending to California for banks and place it squarely, again, on the shoulders of American taxpayers.

Of course the leverage state officials are using on Geithner is that California is “too big to fail.”  They claim if the state were to go belly up it would send ripples through the rest of the country and even the world.  Further, if Washington allowed the collapse to take place imagine what that would do to the confidence the rest of the world has in us to lead economically.

Clearly the feds are in a totally unenviable position.  If they don’t bail Sacramento out they will look really bad given their enormous generosity towards unscrupulous bankers, and inept carmakers.  Since most of the money California needs to borrow will go to ordinary folks, teachers, cops, government workers, Washington can’t be seen again to favor the interests of Wall Street over Main Street.  Thus, I believe there is no question that the Obama Administration will bailout California.  Naturally, this is a big mistake.

In the first place, if Washington succumbs to the “too big to fail” ploy with California, then what happens if say Wyoming asks for bailout funds.  Can it be denied because its economy is not nearly as important as California’s to America’s health?  Is it proper to favor one group of Americans over another simply by virtue of where they live?  I realize we do that now with things like highway funds, but saving one state and letting another go is a horse of a different color.  What about Wyoming’s portion of the federal bailout funds for California?  If Washington submits to Schwarzenegger’s request it will open up an array of ethical and legal questions pitting states against each other.

Then there is the “moral hazard” that would result with a California bailout.  Given that politicians are not very courageous when it comes to making touch choices, state bailouts by the feds would allow state officials to manage state funds even more irresponsibly.  California is a perfect example.  The statist politicians there have overpaid public employees, spent generously on social services, and overregulated business and the environment.  Bankruptcy is the perfect solution to their reckless spending.  It is what ended socialism in Eastern Europe; it should be used to end socialism in California.  Without it, politicians of all stripes will believe that Uncle Sam will catch them when they fall.  This will impede economic recovery and perpetrate the myth that Washington has a bottomless bank account or a bank account at all.

Which brings us to the question of where does California think the feds are going to get this money anyway?  Our leaders have become oblivious to our financial condition.  When you can’t pay your bills you are bankrupt.  Washington has been bankrupt for a long time, but again has had the means (printing press) to put it off.  And put it off the politicians have.  That is why we now face the economic situation before us – a lower standard of living, mountains of debt both personal and national, and a gigantic task of rebuilding our industrial base so that we can compete again.  You see the politicians since at least 1971 have mortgaged our future; those bills have come due; and we don’t have the money to pay them.

So, California is not alone.  “As California goes, so goes the rest of the nation.”  Both entities are broke.  Perhaps instead of groveling to Washington to bail them out with funds Washington doesn’t have, the politicians in Sacramento can set an example for Washington to follow – deregulate, end the welfare state, disband public unions, and live within your means as a society.  Wouldn’t it be nice if California led the nation in a positive way for a change?

Rothbard as Prophet – Part 2

As documented in Rothbard’s classic piece America’s Great Depression, the similarities of the 1920s and 2000s did not end with the beginnings of each crisis in 1929 and 2008 respectively.  It gets much scarier than that.  Washington responded in very similar ways to both crises.  As we know, Hoover/Roosevelt policies made the recession of 1929 into a depression and prolonged recover for at least a decade.  Time will only tell how bad Bush/Obama policies will make our current economic depression.

So, just what were the policies of the Hoover/Roosevelt administrations that exacerbated the U.S. economy into the 1930s and resemble the policies of the Bush/Obama administrations today?  For one, a blatant misinformation scheme to make Americans believe that the excesses of laissez-faire capitalism were to blame for the economic downturns was launched.  In both cases, this was used to deflect any culpability of the U.S. government for the crisis.  But, also and more importantly, it was used as the rationale for heavier government intervention in the economy.  It is ridiculous that then and now the American public has fallen for this deception.  We did not in the 1920s and we did not earlier in this decade have a laissez-faire economy in the United States.  As Rothbard points out, just prior to the 1920s America went through the so called Progressive Era.  This era introduced enormous regulations on our economy.  There was price fixing, a full blown agricultural policy and interstate commerce regulation through the Interstate Commerce Commission and other government agencies.  Let’s not forget that the Federal Reserve Bank began operations in 1913 with the expressed mission to prevent economic downturns through currency regulation.

Of course, many regulations and regulatory agencies founded during the Great Depression are still with us today.  Because we are no longer on the gold standard, the Federal Reserve has even more power today than in the 1920s to regulate our money supply.  The bottom line is that laissez-faire means no government interference in the economy, but Washington has had its grubby big hands on our financial system for a long time.  Therefore, Washington’s attempt to blame laissez-faire for economic troubles in this country, ever, is highly disingenuous.

But, the politicians have used this pretense since the Great Depression to step in and “rescue” our economy from the “greedy capitalists.”  After the stock market crash of October 1929, the Federal Reserve pumped $300 million into the reserves of the nation’s banks.  It expanded its balance sheet by purchasing $1 billion of government securities and provided $200 million more to banks at discounted rates.  Sound familiar?  These numbers are nothing compared to what the Fed and treasury have spent on the current crisis ($12 trillion), but they were a lot given the nation’s GDP at the time was $100 billion.  The scary thought is that by the time Hoover left office his attempt to re-inflate the bubble produced a 25 percent unemployment rate.  What will $12 trillion produce?

Additionally, government works projects were used by Hoover/Roosevelt and are about to be used by Obama.  Hoover raised taxes on the rich and Obama has threatened to do the same by allowing Bush’s tax cuts to expire. Fortunately, a major policy difference between then and now is that Washington has not passed (came close with “buy America” clauses in the stimulus bill) protectionist measures in the current crisis.  Nonetheless, the comparisons in policy are startling given they didn’t work the first time.

Beyond the policy similarities, there are at least two chilling coincidences between then and now.  In 1931, almost two years after the crash, the unemployment rate was only 9 percent.  One and a half years after the current crisis began unemployment is 8.9 percent.  But, more ominously, given Hoover’s inflating of the money supply banks didn’t lend and consumers were not spending in 1932.  Naturally, the short term deflation that resulted improved the economy for a while since it began to deflate the credit bubble which the economy needed to recover.  However, it was only a matter of time before all the new money hit the economy and caused havoc.  One year later, the unemployment rate soared to 25 percent.

Again, today, in spite of the Fed’s pumping of new money into the economy, banks have been slow to lend and consumers slow to spend.  Prices have declined over the past 12 months – for the first time since 1955.  You might say the economy is showing signs of improvement – the stock market is up 25 percent in the last two months.  However, since government intervention caused the Great Depression don’t be too hopeful that Washington’s current intervention will have any different outcome this time.

It is amazing that in both crises the same folks who caused the problem were called upon to solve it.  The easy money policies of the Fed have been responsible for both the Great Depression and our current economic crisis.  After the 1929 stock market crash, the Fed’s re-inflating policies did not allow the economy to rid itself of the malinvestments caused by its previous inflating.  The economy sank into a deep depression.  According to Rothbard’s writing, we are headed for a similar if not worst fate.  If only Ben Bernanke had read Rothbard as a part of his study of the Great Depression.