Absent a Monetary Rule, Fiscal Cliffs Will Be the Norm

Story Stream
recent articles

In the February 29, 1908, edition of New York Outlook magazine, Andrew Carnegie penned an article in which he lamented that the, "Americans have many advantages upon which we may plume ourselves as being in advance of other nations, but we have at least one humiliation to lessen self-glorification. Our banking system is the worst in the civilized world." The timing of Mr. Carnegie's missive complaint was not coincidental, as the US banking system, our national humiliation, was being thrust into the spotlight for having endured another panic. On October 14, 1907, five bank members of the New York Clearing House and three other outside banks put out notices for liquidity assistance as they were having desperate trouble meeting demands for currency from depositors. That led only a week later to liquidity imbalances at Knickerbocker Trust in New York, then the third largest New York Trust, that had credit relationships with these other banks and which led in very short order to a suspension of operations. A wider panic ensued two days after Knickerbocker suspended.

By early 1908, posturing began for the inevitable political intrusion into banking. A sentiment that would resurface more than a century later, crises were often used as excuses for drastic changes. After having survived and recovered from a nearly "lost decade" in the 1890's, made so in no small part to uncertainty over the monetary position of the United States relative to the global trade system, there was no patience for a return to what had been the worst economic downturn. Banking "needed" to evolve lest damnable bank panics continuously ruin economic prosperity.

Mr. Carnegie, for his part, advised a new system of currency that would allow for far more flexibility in times of panic and illiquidity. The growing sentiment for "elasticity" of a national currency had already begun to crystalize in numerous political and economic conventions as early as that depressed decade of the 1890's. At the American Banker's Association Convention of 1894 in Baltimore, MD, a plan was put forth that changed the restrictions on bank issued currency away from government bonds to bank assets. While that plan never found serious political backing, it certainly influenced philosophies and frameworks that followed.

In 1898, the Indianapolis Monetary Commission proposed phasing out the bond-backed currency with an asset-backed currency over a five-year period. After the 1907 panic, several Congressional bills were sponsored to accomplish exactly that, including the much debated Fowler Bill in the House and Aldrich Bill in the Senate. Andrew Carnegie's article in Outlook was written in the context of that debate.

What may be truly surprising to denizens of the 21st century was Mr. Carnegie's ultimate appeal toward a larger monetary solution:

"Men have railed, against gold as if it had received some adventitious advantage over other articles. Not so; gold has made itself the standard of value for the same reason that the North Star is made the North Star-it is the nearest star to the true north, around which the solar system revolves. It wanders less from, and remains nearer to the center than any other object. It changes its position less. To object to gold as the standard of value, therefore, is as if we were to refuse to call the star nearest of all stars to the true north, the North Star. Man found that gold possessed many advantages as a metal and was the one that fluctuated least in value; therefore its merits have made it the standard of value. That is all. If another metal appears that keeps truer to uniform value, it will displace gold and make itself the standard, as Lyra, under present conditions, will finally displace the present North Star."

For those not intimately familiar with the inner workings of nineteenth century American banking, this appeal to gold seems completely out of place. After all, as most people may be aware, there was a gold standard in place at that time. Why would Andrew Carnegie in 1908 need to be singing the praises of gold?

The answer lies in the financing of the Civil War and what actually constituted "money". "Currency" was nothing more than bank-issued notes. "Money" was gold coins or bullion. Currency was a claim on money, created through fractional lending. That meant that paper currency was decidedly non-uniform throughout the country, and therefore the only real "risk-free" tradable asset was gold coin. That, of course, imposed a distance restriction on paper money. Bank notes would often trade at discounts the greater the distance those notes traveled away from the issuing bank. Because of this disparity between money and currency, there had always been an undercurrent of desire for a national system of claims on real money, or what we call currency.

Enter the government. Financing for the Civil War required any and all new ideas, including Greenbacks. Realizing the potential locked up in this craving for uniform currency, the Lincoln administration created the National Banking System which chartered banks federally. This would allow for a uniform national currency, but it was cleverly paired with restrictions. The amount of currency (bank notes) that national banks could issue was tied to the amount of government bonds on those national bank's books. In other words, these new national banks were required to purchase government bonds in proportion to the amount of currency they felt they needed to issue. It solved two problems simultaneously by creating uniform bank currency (the Greenback) and tying that currency to financing government war deficits.

Some four decades later, however, bank currency was still tied to government bond assets. The problem for banks was that government debt was largely static outside of wars and was therefore generally inelastic. In times of crisis, banks could not increase their note issuance (currency) to meet the general public's panicked, emotional demand for currency.

Because the public had grown very comfortable with currency backed by government bonds, Andrew Carnegie and his intellectual compatriots were forced to knock government bonds by comparing them to gold. In fact, this growing acceptance of currency as a substitute for gold money was directly related to that banking panic of 1907, and the far larger panic that would nearly destroy the American system in the early 1930's. In 1860, the public held about $1.20 in deposits for every $1 in currency. By 1880, the public's growing comfort with banking allowed the deposit/currency ratio to rise to about $2 in deposits for every $1 in currency. By 1907, the deposit/currency ratio was nearly 7 to 1!

That meant, in terms of elasticity, banks were essentially short currency, due in no small part to the limitation imposed by the government bond security requirement. By October 1929, for example, just in time for the stock market crash, the deposit currency ratio had ballooned to nearly 12 to 1. In a bank panic, that is the essential liquidity transformation as the public's growing mistrust of banks causes the desire to reacquire bearer instruments (currency in hand) rather than remote claims on currency (deposits). With a smaller currency ratio, the ability to absorb that changing preference is severely constrained.

The irony here is a function of political history. In 1908, bankers were decrying the fact that the US government was not running enough of a deficit, chronically, to allow for an expansion of currency (what we now call the money supply). The first answer to rectify this government-imposed inelasticity was not a change in the government bond/currency standard as Carnegie argued, rather in May 1908 the Aldrich-Vreeland Act was passed and implemented. This bill provided a private issuance of currency by groups of private banks that passed what amounted to an asset test. In other words, the "good" banks would be putting up "good" currency in a pool that suffering and illiquid, but otherwise solvent, banks could access in times of crisis. This is the familiar, modern sense of central bank policy in a crisis, and this eventually led to the creation of the Federal Reserve System.

But there is another important point that is perhaps lost in the modern translation. As ironic as it is for Andrew Carnegie to argue against a fiscally responsible government, the entire concept and program of elasticity loses or discolors the idea of financial responsibility. The ultimate irony here may be that Andrew Carnegie was using gold as the club to bash government bonds as anything other than "risk-free" because he, as a banker, wanted to be free from any exogenous restraint on his own ability to expand bank operations. Currency issuance was always a limiting factor in the expansion of bank credit in the depository system, so removing the tether of government bonds from currency issuance was vital toward a more robust (and more profitable) inflation of bank credit. Carnegie essentially wanted gold to reassert risk-free primacy so that he could inflate the currency with far less restraint.

That twisted and tortured picture tells us a lot about the state of monetary affairs as the "evolution" of money progressed wildly through the late nineteenth and early twentieth centuries and into the modern, wholesale "money" banking system. It also refutes some of the myths about bank panics and the role of the assumed gold standard. Let's not forget that the reason bank panics arose is directly related to those deposit/currency ratios, meaning the public was not always wrong to panic. We can argue and debate about what to do with "good" banks caught in the maelstrom of illiquidity during such periods, but there should be no doubt as to where that dysfunction arises. Bankers, including Andrew Carnegie, will always and through any means possible seek to obtain political power to inflate credit to the highest degree possible.

Modern central banks, including the Federal Reserve born in 1913 out of the concepts contained in the Aldrich-Vreeland Act, are first and foremost political agents that seek to foster that inflation without interruption. Elasticity, this progressive concept, is enshrined as the first stated task in the Federal Reserve Act itself, directly in the title, "An Act to provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes."

What was never fully contemplated at the time, especially by the voting American public, was how elasticity would function without a monetary "North Star". Absent the foundational specie of real money, gold, elasticity takes on many new facets that are neatly contained in that final, open-ended clause of the Federal Reserve Act's title phrase - "for other purposes".

In 1963, Milton Friedman and Anna Schwartz observed of the Federal Reserve in the monetary vacuum of currency without money:

"One result [in the absence of the gold standard] was a conscious attempt, for perhaps the first time in monetary history, to use central bank powers to promote internal economic stability as well as to preserve balance in international payments and to prevent and moderate strictly financial crisis. In retrospect, we can see that this was a major step toward the assumption by government of explicit continuous responsibility for economic stability."

Friedman and Schwartz use that compliment to describe the Fed's actions in the 1920's, which they call the "High tide of the Reserve System". This was exactly the period where the deposit/currency ratio expanded to heights not seen before or since. In other words, Carnegie got his wish without ever destroying the elevated stance of government bonds that grew out of Civil War-era contingencies. In fact, in another twist to the monetary evolution saga, it could have only come in an age where gold was conspicuously absent.

What has really changed throughout this progression of monetary arrangements is the ultimate authority of not just money and credit, but economic direction. Monetary policy used to mean exactly that - management of real money and flows in international trade and seasonal fluctuations. The gold standard answered many of the routine issues surrounding trade and seasonal flows, so a central bank or bank cartel's monetary job was to simply manage the transportation of money and currency on a timely basis.

In the 1923 Annual Report to the Federal Reserve Board, the idea of the modern economic manager was essentially adopted. Without an international gold standard to create a monetary foundation for economic flow, the Federal Reserve found itself perplexed as to how to conduct even routine monetary affairs (the gold standard in most developed countries, notably Britain and France, was discarded in World War I as combatants sought to "pay" for their war expenditures through inflated currency, akin to the US Civil War, with the idea that they would use their assumed victory to repay and restore monetary imbalances). The Fed in the absence of global gold stability intended to adapt policy to cyclical fluctuations as well as the normal seasonal variations. Further, it was intended that such an adaption to policy would not simply be reactionary, particularly in the cases of "extreme" inflation or deflation.

Once the political link was severed between currency and exogenous constraint, the path to central planning was essentially opened. What is also very conspicuous is that there is no positive role for American democratic citizens in the monetary course. As the concept of elasticity gained wide acceptance, it essentially relegated the public to scapegoat for any bout of illiquidity. If elasticity is the cure to the bank panic disease, the virulent infection of panic is not the indiscretion and intentional maximization of bank/currency inflation, it must be the unsophisticated public's "irrational" desire to resort to "hoarding" currency in bearer form. So while elasticity is a cure for that assumed disease of public free will, that still left unresolved a softer limitation on currency expansion that at least became recognized in a panic.

After the extreme inflation of the 1920's (including a relatively new outlet for widespread monetary inflation - asset prices), the political focus again shifted, this time to removing any remaining public check on the banking system's ability toward inflation. Currency itself is increasingly removed from physical possession - ledger "money" has taken over. We have not moved completely to a cashless society, but in many important respects particularly with regard to bank inflation, we have been there for decades (eurodollars, repos, balance sheet accounting rules, both on and off). Where ledger money still contains a minor connection to public-held limitations (since deposit holders can still withdraw physical, bearer currency), wholesale money has completely removed any final connection between the public and currency/money. Operationally, the Federal Reserve can, in the ultimate fit of elasticity, "fund" any bank in the world with "dollars" through nothing more than computerized figments of electronic transactions. There is no link between currency and anything - the North Star simply faded into the darkness of a banking dominance.

From the perspective of this new era of QE-driven malaise, Carnegie's appeal to gold to remove limitations is far more than just quaint, ironic history. It demonstrates that the debate about gold, as such that any should seriously exist today, is not fundamentally a financial or economic question. It takes on even more weight given the dramatic role reversal that has taken place in the hundred years since. The profligacy of the federal government is now directly tied to the ability of the banking system to inflate "currency", an ability bequeathed by both the failure of Carnegie to supplant government bonds and the success of Carnegie's ideals of unlimited expansion. The government had to set the banking system free from the chains of currency restraint first so that it could be set free to borrow theoretically unlimited sums of something that should never be called money.

And this is not just an American problem as it is no longer a "humiliation to lessen self-glorification". Rather, this banking system evolution is a global blight in that the absence of the North Star, or fixed monetary point, is far more than just relevant to the existential crises of the day - from Washington and New York to Madrid and Brussels. It is and should be the focal point. Fiscal cliffs simply would never appear in financial systems where free-thinking citizens hold real monetary authority.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

Show commentsHide Comments

Related Articles