By Stephen Rodenbeck, CEO of 4th Street LLCAs every pundit and politician debates the merits and shortcomings of the bank bailout and the government spending bill, they seem to all miss the root cause of what got us here. All of our current problems regarding the economy have their roots in the Federal Reserve Act of 1913. From that point forward, it became law that all money would be created out of debt. To look at it another way, if all debt (be it government, corporate, or individual) in our current economic system were paid off, there would be no money. But paying off all debt is impossible because of the effect of interest. For example, let's assume that the entire economy is 10 people. In order for the 10 people to get money to start a business, they have to borrow $1 million each from the Federal Reserve at 10% interest per annum. So a total of $10 million is injected into our new economy. In 10 years, on interest alone, the Federal Reserve is going to have all $10 million back. But since the entire economy at the start of this example was $10 million, those 10 people (or businesses) will have to borrow more money in order to have any money. In other words, debt begets more debt. The only way for these 10 people not to go immediately back to the Fed to borrow more money is to find other markets to sell their goods and services into. This enormous flaw -- money being created from debt with interest -- has been masked by the fact that our population has more than tripled since 1913 and our economy has become massively intertwined with the other economies of the world.
In other words, our economy has expanded almost as fast as our debt levels; or at least fast enough for most not to notice the flaw in the system. However, the recent grossly irresponsible expansion of leverage in our banking system has left it essentially insolvent and has forced our government to come to the rescue. How is this rescue being done? Answer: by borrowing more money from the Federal Reserve with interest. We are now running debt levels in the double digits as a%age of total GDP. The question is how do we get ourselves out of this ever expanding vortex of debt? Before we answer that question, let's refresh ourselves on the mechanics of how money is created. The US government needs money so it goes to the Fed and issues U.S. Treasury Securities (bills, notes, and bonds). In exchange for the Treasury Securities, the Fed creates money (a.k.a. Federal Reserve Notes) out of thin air. The Fed then can either hold the Treasury securities until maturity and collect the interest or sell the securities through its registered broker dealers such as JPMorgan Chase ( JPM), Citigroup ( C) or Goldman Sachs ( GS). Either way, the government has to borrow the money it needs and thus the money is created out of debt with interest. The U.S. government takes the money it gets from the Fed and deposits it in a bank. Through fractional reserve banking, that bank can now lend up to 10 times the amount deposited by the U.S. government to businesses, individuals, etc. In this way the bank is now creating money out of debt (with interest).
The answer to how we relieve our government of this expanding vortex of debt is quite simple and dates back to our founding fathers and the real reason we fought the Revolutionary War, but more on that later. The solution consists of three steps: 1. Replace Federal Reserve Notes with U.S. Government Notes. As the current debt comes due, the U.S. government will pay it off with U.S. Government Notes (as opposed to Federal Reserve Notes). The government notes will look exactly like our current money except that the government will not have to borrow the money from the Fed and as a result will not have to issue any more debt (U.S. Treasury Securities) to the Federal Reserve. 2. Repeal the Federal Reserve Act of 1913. Use the Federal Reserve to clear checks and to provide other back-office functions, but repeal the Federal Reserve Act of 1913 and the National Bank Act of 1864. 3. Eliminate Fractional Reserve Banking. Now that there will be no more U.S. Treasury debt to purchase, investors will be flooded with U.S. Government Notes. A lot of that money will find its way into the banking system in the form of deposits. As that money finds it way into the banking system, the government will continually and proportionally raise the reserve requirements until the time when there is no more government debt in existence; at that time fractional reserve banking will no longer exist. In other words, when all government debt is paid off, a bank with $1 million in reserves will be able to make $1 million in loans, not $10 million like the current system.
Not much else needs to be done. The government will continue to tax the population and pay for the military and other essential programs. The difference is that when it spends more than it takes in, our government will just add more currency (i.e. U.S. Government Notes) to the economy. (Hopefully our government will be able to do this responsibly and add currency to the economy at the rate of population growth). Banks will still lend money with interest like they always have, but remember, without fractional reserve banking, they will not be creating any new money. They will simply be lending out what they have in deposits. One obvious benefit to the average American is that his or her taxes will come down as he or she will not be financing the government debt -- as it will no longer exist. This system would obviously hurt all of the registered broker dealers as the U.S. government securities market would no longer exist -- my guess is that the average American probably wouldn't lose too much sleep about this consequence. For those who say that our government would just be counterfeiting money, I have two responses. One, the Federal Reserve essentially does the same thing but with interest. Two, our founding fathers did it. They printed Continental currency and the economy flourished. Back in those days, the central banking interests of Western Europe would not stand for this debt-free currency and before too long the Continental was banned and the colonies were forced to use British currency that they had to borrow from the Western European banks with interest. It was for this reason, the Revolutionary War was fought. In fact it says in our Constitution that Congress is the branch that controls the currency -- not the Fed, which is a private bank and not a government agency. Given that our current system of money is exactly what our founding fathers were trying to free themselves from, they must be rolling in their graves. PLEASE ABOLISH THE FEDERAL RESERVE AND THE WHOLE NOTION OF CENTRAL AND FRACTIONAL RESERVE BANKING NOW. Stephen Rodenbeck is the CEO of 4th Street LLC, owner of Krome Vodka . He worked on Wall Street for 14 years as an institutional listed equity sales trader for Smith Barney and Prudential Securities. He has a B.A. in Economics from Bucknell University.