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Thursday, September 6, 2007

Federal Reserve Thoughts - How to Fix the Financial System

I originally wrote this article for the Ron Paul wiki, and I broke it up into several pieces and copied it here.

When I originally wrote this post, I thought that it might be possible to lobby the government to switch to a fair monetary system. On further reflection, the Supreme Leader of Humanity would never allow that to happen.

The only way that a fair monetary system will be established is via a total currency default. The value of a dollar must decline to absolutely zero. (Actually, Federal Reserve Notes will still be worth their paper value, and as a historic curiosity for collectors.)

Many writers have lobbied the government for a return to a fair monetary system. Their appeals have been ignored. The problem is not that a return to a fair economic system is infeasible. The people who think they're the current political and economic leaders are too greedy and stupid to allow for change. The Supreme Leader of Humanity won't allow government to return to a fair economic system. The Supreme Leader of Humanity wants the current economic and political system to collapse.

A total currency default is the only fair solution to the problems of the current economic and political system.

Ron Paul has stated that if here were elected President, he would abolish the Federal Reserve because it is unconstitutional. There are many other valid reasons for abolishing the Federal Reserve.

I wrote this article before I was convinced that a complete default on the dollar is the correct solution to the Federal Reserve's abuses. I spent the time writing this article, so I figure I might as well publish it anyway.

There have been many other proposals for returning to sound money. Any sensible plan would work. The problem is that the Supreme Leader of Humanity *WANTS* the current economic and political system to collapse. He would never allow reform to occur, except via the complete collapse of the current system.


The Constitution grants the right to print money to the Federal government. It does not allow the government to delegate that authority to a private corporation.

This would be the justification for directly abolishing the Federal Reserve via executive order, if Ron Paul were elected president. There are many other valid reasons for abolishing the Federal Reserve.

What if Someone Objected?

Suppose that someone objected to the abolition of the Federal Reserve via executive order. Then what would happen?

The power of the executive branch has been expanded so much lately, that the President might have enough authority to do it. This has never been tried before, so it's hard to say what would happen.

If the Supreme Court ordered the President to do what the Federal Reserve says, and the President refused, there probably would be a constitutional crisis. In effect, the President could tell the Supreme Court "You have made your decision, now go ahead and enforce it."

There are other tricks that the President could use. He could order the Treasury department to stop printing Federal Reserve Notes, and print "United States Notes" instead. He could order the Treasury department to default on the Treasury bonds that are held by the Federal Reserve, while still honoring the bonds everyone else holds. He could prosecute the Federal Reserve for counterfeiting, if they attempted to continue their open market operations.

On the other hand, if the Federal Reserve had enough cash to remain solvent until after the President's term expired, it could just resume its operations after a new President is elected.

How to go About Abolishing the Federal Reserve

There are two approaches. One approach is a direct abolition via executive order. Another possibility is that, under the threat of an abolition via executive order, a banking reform bill could be passed.

If the Federal Reserve were instantly abolished, with no backup plan in place, there would be chaos in the financial markets as interest rates rose instantly to their natural level. Interest rates would jump 3-5% or more immediately. All of the money would drain out of the economy as many more loans were repaid than new loans issued.

Ron Paul has said he would abolish the Federal Reserve. He has not said what his plan would be for stabilizing the economy during a transition to market-determined interest rates. Interest rates have been kept artificially low for so long that the Federal Reserve could not be abolished without a backup plan.

Below, when I refer to the Federal Reserve, I mean "reformed Federal Reserve". If necessary, the Federal Reserve might be abolished and these activities could be performed by the Treasury department.

Many other websites are critical of the Federal Reserve, but they don't really propose a viable alternative. I think my plan would have a chance of actually gaining acceptance. Here are my criteria for an acceptable plan:

  1. The Federal Reserve should not fix interest rates at a specific level. Artificially fixing interest rates at a low level is, in effect, a huge subsidy to the financial industry. Fixing interest rates at 5.25% is far worse than fixing oil prices at $10/barrel.
  2. The government has the sole right to create money, either by printing it or by creating it by bookkeeping tricks. It may not outsource it to a 3rd party, even its central bank. In other words, seignorage is an exclusive privilege of the government. Seignorage would be recognized as income by the government, and used to reduce taxes paid. More precisely, fractional reserve banking should be outlawed.
  3. Currently, banks do not earn interest on their reserves. That is an obsolete holdover from the days when reserves meant physical gold. It would make more sense to credit banks with interest on reserves and require 100% reserves. The interest a depositor receives would be the rate the bank earns on its reserves, minus the bank's operating expenses. When a bank wants to write a loan, it should be required to borrow from the government first. Only the government has the right to create money. Customer deposits would be completely segregated from loan activity, and protected in the event of a bank failure.
  4. From the point of view of the average person, things should not change much. They should still be able to borrow and lend and do banking approximately the same way as before. There may be an increase in rates, if the market is allowed to determine rates rather than being held at an artificially low level.
  5. Banking should still be a viable business. Banks should earn profits at approximately the same rate as before. With market-determined interest rates, they would probably write fewer loans. With customer deposits segregated, capital requirements could be lowered.
  6. All outstanding debts created before the new system is in place would still be valid. If a bank has outstanding loans, it would be required to borrow from the government until it reached 100% reserves. The initial loan offer rate and spread would be low enough that banks could economically do this.
The only way to strip banks of their money-printing power is to require a 100% reserve system. All banks would be required to place customer deposits with the Federal Reserve or invest customer deposits in Treasury notes. The actual rate earned by customers would be the Treasury yield minus whatever the bank charges for its operations. Customer deposits would be guaranteed by the government. If necessary, during a banking crisis, the government would promise to print new money to issue to customers of a failed bank.

Banks would be able to borrow from the government at a specified rate. Banks would still be subject to net capital requirements, the same as now. Customers would be able to borrow at the government lending rate plus whatever expenses the bank wanted to charge. If the market interest rate was better than the government-guaranteed rate, then banks would borrow at that rate.

This should allow banks to still be profitable, and earn profits at approximately the same rate as now. Lower capital requirements would allow them to pay out the surplus as a dividend or invest it elsewhere.

A central bank is still useful, because it saves the government the effort of having to deal with each individual bank. The central bank would set a bid and offer rate. It would offer to lend at a certain rate, such as 5.75% and offer to take deposits at 4.75%. The government would lend to the central bank at something like 5.8% and accept deposits at 4.7%. The spread of would cover the central bank's operating expenses, but a lower margin might suffice.

The initial spread would have be very small (around 0.05%, maybe even zero) so that banks could borrow to get to 100% reserves without being adversely impacted. After that, a spread of 0.05% to 1% sounds right.

The Federal Reserve would still set the bid and offer interest rates that the government was actually paying and receiving. There would be no need to directly intervene in the Treasury market, because if Treasury rates went above the offer rate, someone would borrow at the offer rate and buy them. If Treasury rates went below the bid rate, someone would short sell them and deposit the short sale proceeds with the Federal Reserve at the bid rate.

The money the Federal government makes borrowing and lending would be counted as revenue. In the unlikely event of a shortfall (deposits far exceed loans), new money could be printed and interest rates lowered.

The Federal Reserve would still be able to adjust interest rates. However, it should not fix interest rates at an artificially low level. A better goal would be for "total deposits equal total loans". This insures that all loans could be repaid, if necessary, in contrast to the current system which guarantees a certain amount of defaults.

The Federal Reserve would be required, by law, to gradually raise interest rates when the Treasury yield rate was close to its offer rate. The Federal Reserve would be required to gradually lower interest rates when the Treasury yield rate was close to its bid rate. The Federal Reserve would be expected to stick to this policy except during special circumstances.

There would be two mechanisms available for increasing the money supply. First, lowering interest rates by loaning money as is done now. The difference is that the interest paid would be recognized by the government as revenue. Second, the extra money added to circulation could be spent directly by the government or paid as tax rebates.

There would be two mechanisms available for decreasing the money supply. First, raising the interest rates as is done now. Second, the government could curtail its spending and have a budget surplus.

There would be another mechanism available. The government could change the spread between the bid and offer interest rates.

There would be no need to artificially expand and contract the money supply. With non-debt-based money, the supply of money should be relatively constant.

Government bonds play an important role in the financial markets, because they represent a theoretically perfect credit rating. The supply of government debt should be allowed to be big enough to satisfy this demand. I probably would even issue 50 year and 100 year bonds.

If the Federal Reserve announced it was going to stop fixing short-term interest rates, then long-term interest rates would immediately skyrocket. That is why, as the new system is being phased in, it would be necessary to offer loans at longer time periods. This would prevent long-term interest rates from moving too quickly. For example, if the Federal Reserve published an offer rate of 5.25% for a 30 year loan, anybody currently holding a Treasury bond could sell it without incurring too large of a loss. Anyone holding a long-term corporate bond could hedge their risk of interest rates changing by short-selling a Treasury bond. This would limit their loss as the new system is instituted. Otherwise, it wouldn't be fair to holders of long-term bonds.

Currently, the Federal Reserve only fixes short-term interest rates. In addition to publishing a bid and offer for the overnight rate, the Federal Reserve should publish a bid and offer for 1, 2, 5, 10, and 30 year loans. I would make these other loans have terms that correspond to Treasury bonds, so there would be a secondary market for these loans. In fact, this whole system can be combined with the current Treasury system. Actually, it would only be necessary to fix the short-term and 30 year rate; the market would automatically fill in all periods inbetween with reasonable values. Quoting an interest rate for every period would make it easier for people to understand.

As the new system is phased in, I would only allow interest rates to change at a rate of 25 basis points every 3-12 months. After a balance is found, the maximum interest rate change in one month should be something like 25 basis points. The Federal Reserve's goal should be to have the observed market Treasury yield be at the midpoint of its published bid and offer rate. Another way to look at it is that the money deposited at the bid rate, plus outstanding Treasury bonds, should equal the money loaned out at the offer rate. Otherwise, the Federal Reserve would be required by law to raise or lower its interest rates. The Federal Reserve would only be allowed to deviate during special circumstances.

This entire system could be made to overlap with the existing Treasury bond system. If someone wanted to deposit money with the government at the bid interest rate, the government would create a new treasury bond and take the deposit. This would only be necessary if the bid interest rate was higher than the market treasury rate. If someone wanted to borrow at the offer interest rate, they would be able pay a small fee (say 0.05% to 0.50%) and short sell a new Treasury bond. This new Treasury bond would be backed by the government and not by whoever short sold the bond. This would ensure a liquid secondary market for the debt and deposits. (Short selling Treasury bonds by borrowing them probably should be illegal, because that would effectively be fractional reserve banking. Anyone who wants to short sell Treasury bonds would have to do it through the government's procedure.) If the market interest rate for Treasury bonds was lower than the government's offer interest rate, then someone short selling a bond could short sell it at the market price instead of the government's price. However, they still would have to "borrow" the bond they are shorting from the government.

When a new Treasury auction is conducted, the government would accept both offers to buy AND offers to sell. If there were more offers to sell than to buy at the target interest rate, the government would print new money and become a creditor to make up the shortfall. Similarly, if there were too many offers to buy, the government would go into debt. Initially, there would be far more offers to sell than to buy, because interest rates are artificially low right now and they are going to be allowed to slowly rise to a fair market price. Eventually, most Treasury auctions would end with the buy orders and sell orders balancing. Borrowers would be charged a fee of 0.05% to 1.00%, with the spread realized as revenue by the government.

Notice this means that both the market interest rate AND the size of the national debt would be determined by the market. It would only differ when the Federal Reserve is interfering in the Treasury market due to a sudden big shift in interest rates. Initially, the government would be acting to keep interest rates artificially low, so there's a smooth transition to a market-determined interest rate.

The national debt really is a bookkeeping fiction. If fractional reserve banking were abolished, it wouldn't really matter if the government pays down the debt by printing new money, or goes into a bigger debt if there is a huge demand for Treasury bonds and bank loans.

Also notice that in this scheme, the interest payments made by banks who loan money from the government are realized by the Federal Government as revenue. The Compound Interest Paradox is solved. If the market completely balances, the demand for government-backed debt equals the demand for loans. In that case, the government would make no net interest income and all the money in circulation would be recycled.

I would prefer for interest rates to be set at a level that balances the money supply, where total deposits equal total loans. This is the same thing as the market-determined interest rate. Such an adjustment would have to be gradually made, to avoid a shock when introducing the new system. That adjustment should occur naturally as the government directly spends its seignorage profit as revenue.

There currently is a huge accumulated money supply deficit. The current supply of money is far less than the outstanding debt demand. As interest rates rise to the fair market level, there is a risk that all the money will drain out of the economy as fewer new loans are issued. The government will need to carefully monitor things to ensure an adequate money supply during the transition to market-determined interest rates. If necessary, the government could increase spending, purchase private debt, or offer tax rebates.

It Probably is Necessary to Abolish Fractional Reserve Banking

With the abolition of the Federal Reserve, it probably is necessary to outlaw fractional reserve banking.

One of the superficial reasons for the formation of the Federal Reserve was to protect customer deposits and protect the banking industry. However, there are other ways to support the financial industry. A massive government subsidy should not be needed.

The only acceptable means for handling customer deposits would be to invest them in Treasury notes. Customers would receive the interest paid on the Treasury notes, minus the bank's expenses. Currently, banks receive zero interest on their reserves. A better system would be to allow banks to earn interest on reserves, require 100% reserves, and segregating deposits from loans.

The idea that reserves earn no interest is obsolete. It was meaningful when reserves were physical gold.

Under a gold standard, fractional reserve banking is needed to expand the money supply so that the supply of gold or paper promises for gold matches that required for trade. Fractional reserve banking, without government coercion, is an honest business. Under a fiat monetary system, fractional reserve banks are not needed. The power of issuing money under a fiat money system properly belongs to the government.

When a bank wants to issue a loan, instead of printing the money itself by using fractional reserve banking, it would have to borrow the money from the federal government, at a rate equal to the treasury yield plus a certain amount (say 0.50%). Maybe allowing banks to borrow at the Treasury yield plus a small fee would be better. The spread between the Treasury bond yield and the rate at which the government lends money would be recognized as seignorage income by the federal government. Currently, this money goes directly to the financial industry.

My reform proposal allows banks to borrow from the federal government for various time periods, and not just at the overnight rate. For example, a bank could borrow for 5 years, paying a little more than the 5 year bond yield rate. This would allow banks that issue mortgages to hedge the anticipated cashflow; they would borrow for a time period that represented the anticipated repayment rate of the mortgage. This way, banks could protect themselves from changes in short-term interest rates, by borrowing for a longer time period and locking in a rate. Banks are exposed to risk, because they borrow short term and lend long term. That's less of a risk now, because banks typically sell a mortgage immediately after issuing the loan.

It would be important to make sure that the financial industry was still profitable. However, due to the huge government subsidy they receive now, I doubt they would be as profitable if the Federal Reserve were abolished.

One way to help the financial industry in the new system would be to decrease their capital requirements, allowing them to use more leverage. The surplus capital could then be invested or paid out as a dividend. With customer deposits segregated from loan activity, customer balances would be protected in the event of a bank failure. In the event of bankruptcy, customers would retain priority over the Treasury bonds that represent their deposits. A bank would be forbidden from selling or loaning out the Treasuries that represent customer deposits.

Fractional reserve banking should be treated as counterfeiting.

I doubt this could get passed, but a constitutional amendment banning fractional reserve banking wouldn't be such a bad idea. Thomas Jefferson was quoted saying that was the constitutional provision he most regretted not including.

After writing this, I now think that government itself is what needs to be banned. Under a pure gold standard, fractional reserve banking provides a legitimate service, expanding the money supply so that it matches the size of the economy. The problem is that government regulation of banking, plus demands that taxes be paid in gold, drives interest rates above the free market level, allowing the Compound Interest Paradox to start operating. In a truly free market, a fractional reserve bank's expenses equals its interest income, and there is no paradox.

Paper Money Could Automatically Inflation Adjust

If banks are allowed to earn interest on their reserves, then maybe paper money should also earn interest. For example, a $20 bill would say, "This bill is worth $20 plus 3% more per year since issued". This rate would be based on the market interest rate at the time the bill was issued into circulation. Something like 0.5% to 1% less than the market treasury rate would be good; this way people would still be able to get a better return in a bank. Having inflation-adjusted paper money would cause everyone to redeem their Federal Reserve Notes for the new money. Each bill would have a maximum lifetime of 5-10 years, after which it would no longer earn interest; this insures that the money gets recycled and updated with the now-current interest rate.

To keep things simple, maybe it would be better to just say "This bill is worth $20 plus $0.05 per month since issued". This would make it easy for the average person to do the calculation.

The Financial Industry Will Object

The financial industry will most likely object to a floating interest rate regime. Currently, they are the beneficiaries of a huge subsidy paid by everyone else in the form of inflation. Steps might need to be taken to insure that financial companies are still profitable in a floating interest rate system. On the other hand, they all will be facing the same increased economic pressure. However, they will probably have a limited ability to pass the costs onto customers. With debt priced fairly, many businesses will try to finance with equity rather than debt, and it would make equal sense to buy a house with cash as with a mortgage. Right now, it makes sense to take a mortgage when buying a house not because of the income tax benefit, but because of the interest rate subsidy.

There probably will be substantial price changes as a new system is implemented. For example, rising mortage rates to a fair market level would drive down housing prices. Not every side effect could be anticipated. Stock prices would fall, due to more expensive credit. People who bought stock on margin would suffer, and highly leveraged companies would suffer. On the other hand, new money printed and issued directly into circulation would increase prices. If a suitable balance is kept, prices might be relatively stable as the new system is instituted.

Maybe Greed and Corruption Can Be Used Beneficially Here

People who knew about the abolition of the Federal Reserve and the new system in advance of its inception would profit immensely. Maybe we can get those people to back Ron Paul's campaign?

Maybe it's Hopeless

These reforms are so simple that I can't believe they haven't been implemented already. "Austrian School Economics" has proposed ideas that are similar to what I suggested. I suspect that the people who control the Federal Reserve and the government are not interested in true reform. Perhaps the correct thing to do is to abandon the standard financial system and set up a better system, such as the Social Credit system.

I spent a lot of time writing this draft, so I decided to publish it. On further reflection, government itself is the problem. The only solution is for people to start monetary reform on their own. People need to develop their own private monetary system and contract enforcement system, and not report their work to the government for taxation and confiscation.

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