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 3rd 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.

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