Sunday, January 9, 2011

Analysis of the Monetary Reform Act — Part I

Analysis of the Monetary Reform Act — Part I
Thomas Allen

This is the first part of a paper analyzing the “Monetary Reform Act” as it appeared on November 3, 2010. This Act and a description of it can be found at

Footnote 1 identifies Patrick Carmack as the principal author of the proposed Act. For my analysis, the authorship is irrelevant. I am analyzing the Act and not its author. For convenience I refer to the proposed Act as Mr. Carmack’s proposal and use his name.

I have italicized words of the Act and its footnotes and my paraphrases and summaries of their words. My commentary is in roman letters.

The Act presents a two-step plan to national reform and recovery:

Step 1: Directs the Treasury Department to issue U.S. Notes (like Lincoln’s Greenbacks; can also be in electronic deposit format) to pay off the National debt.

Step 2: Increases the reserve ratio private banks are required to maintain from 10% to 100%, thereby terminating their ability to create money, while simultaneously absorbing the funds created to retire the national debt.
Mr. Carmack states that “These two relatively simple steps, which Congress has the power to enact, would extinguish the national debt, without inflation or deflation, and end the unjust practice of private banks creating money as loans (i.e., fractional reserve banking). Paying off the national debt would wipe out the $400+ billion annual interest payments and thereby balance the budget.”

His proposed Act “would stabilize the economy and end the boom-bust economic cycles caused by fractional reserve banking.” As shown below, the proposed Act fails to achieve most of these objectives, and in some instance makes matters worse.

The preamble of the Act reads:

To restore confidence in and governmental control over money and credit, to stabilize the money supply and price level, to establish full reserve banking, to prohibit fractional reserve banking, to retire the national debt, to repeal conflicting Acts, to withdraw from international banks, to restore political accountability for monetary policy, and to remove the causes of economic depressions, without additional taxation, inflation or deflation, and for other purposes.
As shown below, the Act does not stabilize price level, retire the national debt, or remove the causes of economic depression. It is merely another fiat monetary attempt to get something for nothing.

Section 3, Definitions, defines U.S. notes. “United States Notes as used herein shall mean Treasury issue United States currency notes (as defined in 31 U.S.C. Sec. 5115) not bearing any interest, being lawful money and legal tender for all debts, public and private, and which term as used herein shall include Treasury Department Deposits (a.k.a. Treasury Deposits or Treasury book entries) convertible to United States Notes, which may be substituted therefor at the discretion of the Secretary of the Treasury.”

Mr. Carmack intends to flood the country with noninterest bearing debt. Moreover, this debt is nonpayable. According Webster’s New Collegiate Dictionary (1977), a “note” is “3c (1): a written promise to pay a debt (2): a piece of paper money.” Thus, Mr. Carmack’s money, U.S. notes, is a debt circulating as money. As a note is a debt, it implies that something is due the holder. However, Mr. Carmack’s notes are redeemable in nothing. The holder cannot redeem them in anything. All he can do is pass this debt to another person in exchange for some good or serve. Consequently, his notes are noninterest bearing and nonpayable debt.

The Act’s definition of U.S. notes declares them to be legal tender for all debts. By declaring them legal tender, Mr. Carmack is convinced, and rightly so, that people will not accept his U.S. notes as payment unless the government forces them to. Unlike gold and silver, which can stand on their own merits, the military might of the government is necessary to force these U.S. notes on the people.

Based on the footnotes to the Act, Mr. Carmack, unlike most fiat monetary reformers, seems to have some confidence in a market economy — except for money. He does not trust the markets, i.e., the people themselves, to provide a high quality money in an adequate quantity. He is convinced, and correctly so, that his irredeemable fiat paper money cannot compete against real money like gold and silver. If he really believes that government fiat paper money is the superior form of money, he would not need to declare it legal tender. If he believes in monetary freedom, he would let the markets choose what they want for money. He knows that if given a choice, the free market would most likely choose gold and probably silver. It would not choose government fiat paper money. Thus, legal tender laws are needed. Gold must never be allowed to become money.

Moreover, the U.S. constitution does not authorize the U.S. government to issue any kind of paper money or to declare any kind of money legal tender. (See my book Reconstruction of America’s Monetary and Banking System, pages 72-82, for a discussion on this prohibition.) By implication, legal tender laws reside with the States. It prohibits the States from “making anything but gold and silver coin a tender in payment of debts” (Article I, Section 10). Thus, an honest court would declare Section 3 of this Act, along with most of the rest of it, unconstitutional.

Section 4, One Hundred Percent (100%) Reserve Requirement, requires 100 percent reserves. It sets forth a procedure to achieve this requirement. This is one of the few redeeming features of this Act. Its language does not clearly distinguish between checkable deposits (checking accounts) and savings deposits (savings accounts). Banks receive savings deposits to lend. Unlike money in savings accounts, money in checking account is immediately available to the account holder to use. If a bank lends money from checking accounts, it is borrowing short and lending long — a recipe for disaster. If it uses money in checking accounts for the basis of loans, it is giving multiple parties access to the same money simultaneously — a recipe for disaster. Because fractional reserve banking gives multiple parties access to the same money simultaneously, it is a form of fraud. It should be prohibited.

Section 5, Retiring the National Debt, sets forth procedures for retiring the national debt. The Secretary of the Treasury is to buy all outstanding federal debt held by the public using U.S. notes. In essence, Mr. Carmack proposes to replace interest-bearing debt that is eventually discharged with noninterest bearing debt that is never discharged.

Under the current monetary system and Mr. Carmack’s proposed replacement, debt can never be extinguished. When a debt instrument is paid off with another debt instrument, that debt is discharged by transferring the debt to another. Until a debt is paid off with a commodity like gold or silver that is no one else’s obligation, it can never be extinguished short of bankruptcy.

In Footnote 3, Mr. Carmack does recognize that without ending fractional reserve banking using U.S. notes to buy federal debt would be hyperinflationary — thus, the need to end fractional reserve banking. He is correct in this assessment. However, contrary to his assertion otherwise, his Act would be highly inflationary for two reasons: (1) the large and increasing quantity of money that it creates and (2) the poor and declining quality of that money.

Also, in Footnote 3, he refers to extinguishing the national debt. As discussed above, his scheme does not and cannot extinguish the national debt. It only changes the form of that debt.

Section 6, Stable Money Supply, requires the Secretary of the Treasury to buy with U.S. notes or Treasury Deposits U.S. government debt securities held by the public at the rate of the reserve requirement ratio under Section 4. Section 6 asserts that by buying at this rate, the money supply will be kept constantly stable. It allows the Secretary to buy other U.S. government agency securities with U.S. notes if necessary to provide funds to increase bank reserves to 100 percent.

This Section is primarily a transitional section from the current system to 100- percent reserves. Mr. Carmack is assuming that most of the U.S. notes used to buy U.S. government securities from the public outside of banks will be deposited in banks instead of being spent. If most of this money is not deposited in banks or used to pay loans, some banks may be unable to meet the 100-percent reserve requirement. Even if all of it were deposited in banks, it would not necessarily be deposited proportionally. Thus, some banks still would not meet the reserve requirement and would have to call in loans. This transitional period could cause a recession.

Section7, Future Monetary Growth, requires the Treasury Department to increase the quantity of U.S. notes (outstanding currency plus Treasury deposits) outstanding by 3 percent per year. It accomplishes this goal by paying U.S. notes into economy “first to retire (or purchase) any future war bonds (issued pursuant to section 8. hereof), then any remaining marketable and non-marketable federal debt (e.g., Federal government agency securities, intra-governmental debt, and fully guaranteed obligations of the government), then, pursuant to appropriation by Congress, to pay for goods, services, or interest.” Any new money that Congress does not appropriate is rebated to individuals via the income tax system. This Section also prohibits the sell of U.S. government debt securities except during war.

Mr. Carmack exhibits a childlike trust in the politicians who control Congress. That Congress would fail to appropriate the full 3 percent is highly unlikely. That it would appropriate more than the 3-percent allotted growth is highly likely. With all this apparent free money without the resistance of raising taxes, how could they restrain themselves? By statute, Congress can change the 3 percent to a much higher percentage. It probably would not even have to raise the limit formally. If it appropriates more than the 3-percent limit, the Department of the Treasury has to create additional U.S. notes to pay for the excess. It cannot borrow. That a court would object to exceeding the 3-percent limit is highly unlikely. (Although some federal judges have undertaken the task of writing budgets and appropriating funds for local governments, I am unaware of any judge assuming this authority to write the budget for the entire U.S. government. It would have to do this if it wanted to hold appropriations to 3 percent. If it sent the budget back to Congress, Congress could retaliate by abolishing all federal courts below the Supreme Court — a good first step to reducing expenditures to the 3-percent level.)

He attempts to cover this loophole under Section 10. As discussed below, Section 10 is ineffective at achieving this goal and offers only a weak resistance.

According to Footnote 5, the 3 percent comes from Milton Friedman’s recommendation that money supply should grow at a steady rate year after year. Prof. Friedman recommended a growth rate between 3 and 5 percent. Mr. Carmack’s approach should be more capable of achieving a steady growth rate than Prof. Friedman’s approach. Mr. Carmack’s approach monopolizes money issuance and places it under the control of one, the U.S. government. Prof. Friedman proposed attaching his scheme to the current system with the Federal Reserve administering it with fractional reserve banking. Thus, under Prof. Friedman’s scheme, money creation is dispersed. Unlike Mr. Carmack’s scheme, Prof. Friedman’s scheme continues to allow fractional reserve banking.

Mr. Carmack supports Prof. Friedman’s proposed constitutional amendment to limit the growth of money. This amendment is in Footnote 14. Prof. Friedman’s amendment does two things. First, it authorizes Congress to issue “non-interest-bearing obligations of the government in the form of currency or book entries.” Second, “the total dollar amount outstanding increases by no more than 5 percent per year and no less than 3 percent.” At least the amendment gives constitutional support to Mr. Carmack’s proposal of the Department of the Treasury issuing U.S. notes. However, his requirement for banks maintaining 100-percent reserves is questionable. A strict constitutionalist would insist that the regulation of reserve requirements for banks lie with the States.

Footnote 14 gives Mr. Friedman’s introduction to his proposed amendment. He correctly notes that the Constitution does not authorize Congress to issue paper money. “[T]he power given to Congress ‘to coin money, regulate the value thereof, and of foreign coin’ referred to a commodity money: specifying that the dollar shall mean a definite weight in grams of silver or gold.”

In defense of his selection of 3 percent, Mr. Carmack writes in Footnote 5:
With population growth and productivity increases averaging approximately one percent (1%) each per year for the last thirty years, a three percent (3%) growth figure will insure stable prices within a vary narrow range and would allow for price-level or cost-of-living adjustments (COLAs) in contracts with a predictable effect to address any slight variation in economic activity from the three percent (3%) monetary growth rate. Further, as perfect fine-turning of monetary growth in a complex economy is not possible, to err on the side of a very slight inflation would at least relieve those burdened by debt of some of the effects of the prior inequity caused by private money creation, whereas to err on the side of deflation would exacerbate such inequity.
He believes that “a fixed rate of growth will provide the needed stability so long lacking [in] monetary policy.”

Mr. Carmack admits that his proposal is inflationary. He is correct. His proposal has no direct relationship with the demand for money or the economy’s need for money. Basing the growth of the money supply on a 30-year average population growth and productivity increases is ridiculous. These numbers, especially population growth, relate only indirectly to the need for monetary growth. Some years more money is needed. Some years less money is needed. Then to avoid the possibility of deflation, he triples these growth rates to derive his monetary growth rate. He prefers money whose purchasing power (quality) is in a perpetual state of decline to money whose purchasing power is generally stable or increases. If he did not intend to destroy the currency, he would not need to discuss allowing price-level and cost-of-living adjustments.

He is right about the lack of stability with the current monetary policy. Unfortunately, his proposal will not bring the stability that he claims to desire.

Inflation is primary cause of instability under the current system. It will cause instability under his proposal. Inflation distorts the economy. It leads to malinvestments. It causes excessive speculation. Savings, and, therefore, investments, decline because it penalizes savers. All these distortions cannot continue indefinitely. Eventually they cause an economic contraction that leads to a panic, recession, or depression.

Apparently, Mr. Carmack, following Prof. Friedman’s lead, is trying to achieve the stability achieved under the gold and silver standards without their discipline to keep governments and bankers in line.

Furthermore, Mr. Carmack’s proposed Act appears to contain a flaw in common with the 100-percent gold standard. It does not automatically adjust the money supply to match the high seasonal demand for money that occurs in December and in rural areas at harvest time. Thus, the system must carry an unused excess of money for most of the year to cover these peak demand periods.

Unlike many fiat money reformers, Mr. Carmack is not proposing, at least in this Act, to eliminate the income tax. Without the income tax system, he would need another mechanism to rebate deficiencies in appropriations to individuals. He is not proposing to replace the income tax with printing press money as some fiat money reformers do.

Section 8, War Exception, allows Congress to exceed the 3-percent limit if Congress formally declares war. It also allows the U.S. government to borrow when Congress formally declares war. The authorization to exceed the 3-percent limit and to borrow ends each year unless Congress extends them for another year. In any event, they end when the war ends.

Anyone who believes that this Section provides any restraint on Congress or the President should not be taken seriously. If this law had been in effect since 1950, only the childishly naive would believe that it would have provided any restraint on Presidents Truman, Kennedy, Johnson, Nixon, Regan, Bush the Elder, Clinton, Bush the Younger, or Obama in their undeclared wars.

If Congress authorized exceeding the 3-percent limit or borrowing to fund these undeclared wars, such law itself would be interpreted as nullifying Section 8. Section 8 is merely a hollow feel-good provision. It restrains Congress no more than Section 7 or 10.

Section 9, Full Reserve Banks, restricts the lending and investing activities of any institution calling itself a “bank.” A bank cannot lend any more than its owners’ capital. All money deposited in a bank is held in trust by the bank for the depositor. For every dollar deposited, the bank must have a dollar in U.S. notes in its vaults or invested in a Treasury Department Deposit account. All deposits in banks are in demand (checking) accounts. “Only bank deposits may be transferable by check, credit card, electronic transfer or any substitute therefor.” Banks may charge fees for their services and may pay interest on deposits.

As banks cannot lend deposits or otherwise use to them to generate revenue except to deposit them in Treasury Department Deposit accounts, it is highly unlikely that they would pay interest on deposits. To the contrary, they will charge fees: fees to hold the money, and fees to transfer the money.

In Footnote 6, Mr. Carmack remarks, “Absent massive fraud or theft, full reserve banks cannot fail, rendering insurance such as F.D.I.C. and F.S.L.I.C. unnecessary.” At least his proposal gets rid of these two agencies.

He is correct in that 100-percent reserves for checking accounts goes along way toward eliminating bank failure. The other component is prohibiting the lending of money in savings account for periods longer than the depositor has surrendered control of his money. That is, if a saver deposits his money in an account from which he cannot withdraw the money for 30 days, the lending institution, as Mr. Carmack calls it, could lend that money for no more than 30 days. Thus, prohibiting borrowing short and lending long also goes along way toward eliminating bank failure. The Act covers this prohibition under Section 12.

Bank failure can be virtually eliminated if banks met these two criteria. First, banks cannot lend or use as the basis for loans moneys in checking accounts — 100-percent-reserve banking. Second, banks cannot lend savings deposits for periods longer than it has full control of the savings — ending borrowing short and lending long.

Copyright © 2010 by Thomas Coley Allen.

Part 2 

More articles on money.

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