How Lincoln Might Fix Our Economic Mess

     As America grapples with the worst economic chain-reaction since 1929 —— and as President-Elect Obama takes time to consider more closely the methods of Abraham Lincoln —— it is time to reconsider a monetary method that Lincoln and the Civil War Republicans used, a monetary method that America’s leading economists attempted to revive in the 1930s.  It’s a method that could work right now, but with a critical revision to adapt it to the methods and techniques of the Federal Reserve.

     Extortionate bank interest rates caused Lincoln and his fellow Republicans to think more creatively about finance.  They decided to supplement the revenue from taxes and bonds with direct creation of money —— the Civil War greenbacks —— via the Legal Tender Act of 1862.  Though many recommended the continuation of the method in subsequent decades —— the Greenback Party in the 1870s, the National Farmers’ Alliance in the 1880s, “Coxey’s Army” of the unemployed in 1894, the contemporaneous Populist Party, and the Democratic Congress in 1933, which included in the act that created the Agricultural Adjustment Administration (AAA) presidential authority to print and issue greenbacks —— the experiment has never been repeated.  Private financial interests joined at the hip with political insiders have thwarted the idea at every turn.

     The conventional wisdom would have us believe that the use of what some call “printing press money,” which the government creates out of nothing and spends directly into use, leads to ruinous hyperinflation.  The usual exhibit is Confederate money, which depreciated so disastrously that it was worthless.  At its worst, the rate of Confederate inflation was 9,000 percent.  But consider in comparison the rate of inflation in the Union:  80 percent.  That’s of course double-digit inflation, but the difference reveals a very interesting fact:  a wide variety of economic factors can mitigate the side-effects of governmental money creation.  And since the Civil War, new institutions have developed, like the Federal Reserve, that are well equipped to fight inflation.

     A general ignorance about money obscures the fact that “printing press money” is created right now by the Federal Reserve.  In a 1939 guidebook, The Federal Reserve System: Its Purposes and Functions, published by “the Fed” and written principally by economic historian Bray Hammond, this pithy revelation appears:  “Federal Reserve Bank Credit . . . does not consist of funds that the Reserve authorities ‘get’ somewhere in order to lend, but constitutes funds that they are empowered to create.”  This stunning revelation was deleted from subsequent editions of the volume.

     How can such a thing be possible?  In the history of money and banking, it’s a long and complicated story.  But the gist of it is this:  over time, the financial term “credit” evolved from the legal/economic denotation of a “promise to pay” to the functional/dynamic equivalent of actualpayment.  That’s how our money supply can expand at any time through the lending activities of banks.  Want proof?  Grab an Econ 101 textbook and look up “fractional reserve banking.”

     Americans in general know absolutely nothing of this; even presidents have been in the dark.  The financial journalist William Greider once observed that the process of money creation is “a powerful mystery to most citizens.”  In his book Secrets of the Temple:  How the Federal Reserve Runs the Country, he quoted the head of the Federal Reserve Bank of New York as follows:  “No President really understands these things.”

     In the Great Depression of the 1930s, America’s leading economists tried to explain it all to FDR and the American people.  They urged Congress itself to supplant both the Federal Reserve and its member banks as the fundamental source of new money.  In 1934, John R. Commons, co-founder in the 1880s of the American Economic Association, wrote that “in order to create the consumer demand, on which business depends for sales, the government itself must create . . . new money and go completely over the head of the entire banking system by paying it out directly to the unemployed, either as relief or for construction of public works.”  Henry C. Simons of the University of Chicago condemned “the usurpation by private institutions (deposit banks) of the basic state function of providing the medium of circulation.”  Irving Fisher of Yale wrote that “the government should take away from banks all control over money creation.”  In recent years, such maverick economists as John H. Hotson and William F. Hixson have continued this tradition.

     But the chances of essentially “toppling” the Federal Reserve in a frightening economic environment such as this one are nil.  And rightly so.  Even in normal times, the massed forces of Wall Street would make the idea truly dead on arrival in Washington.

     But here’s a different idea.  Let Congress create new money, but this time do it in a way that would employ all the tools of the Federal Reserve and its member banks to counteract inflationary pressures.  Here’s the recipe:  Congress creates the new money (“out of nothing”), then spends it through direct electronic deposit into the bank accounts of government employees and vendors.  Once the government money has been spent into the banks, it would be (1) instantly convertible to cash through the methods of the Federal Reserve, and (2) subject to all the major monetary tools through which the “Fed” can now counteract inflation.  These include not only the obvious tool of raising interest rates —— inadvisable now when the economy needs a great stimulus —— but also the method of raising the “reserve requirements” as Paul Volcker did in the eighties.  As the bank deposits increased —— as new government money poured into the banks, thus expanding the money supply —— the Fed could require all the member banks to put equivalent funds “on reserve,” off-limits for lending.  And this could nip inflation in the bud.

Think it over:  the result could be essentially a “wash,” an almost perfect offset.  As the banks received the new deposits (thus expanding their capacity to lend) their reserves would be adjusted accordingly.  This would not necessarily inhibit the private-sector market.  It could do the reverse:  with government spending increased, more Americans would now have the cash to be vigorous customers again.  Our “economic pie” would get bigger.

Meanwhile, our government could spend many hundreds of billions on public necessities without higher taxes, without more deficit spending, and without any serious inflation.

     It’s time for this idea to be discussed in a national debate.  Desperate times call for innovative measures.