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The seventh reform is financial markets. First, personal finances must be stabilized. Second, the financial and economic crisis must be managed. The Federal Reserve must cease additional purchases of questionable securities. Taxpayers should not be stuck with overpriced toxic assets. Economic stimulus should consist of implementing this and other reforms. As for stimulus, it must be remembered that bigger is not necessarily better. Third, capital markets regulation must be reformed. Financial markets must be better regulated by erecting financial firewalls between different types of financial activities; protecting against conflicts of interest; instituting and enforcing uniform financial principles; managing risk; ensuring competition – no “too big to fail”; creating rules for the orderly disposition of all insolvent financial institutions; setting limits on financial “innovation”; requiring that all major derivatives trade on an exchange or clearinghouse; banning credit default swaps; and requiring independent, segregated custody of securities whenever possible. The mortgage market must be fixed by fixing the institutional and legal infrastructure; strengthening residential mortgage lending standards; and by getting the federal government out of the mortgage market as soon as possible. Predatory practices must be reined in; for example, enforcing existing restrictions on short selling. Fourth, monetary and currency reforms must be implemented by adopting banking reform; periodically auditing the Fed; cleaning up the Fed’s balance sheet; taxing gold and silver at capital gains rates; improving confidence in floating exchange rate currencies and fighting manipulation through currency reform; and, in the long-term, considering a return to the gold standard and rescinding legal tender laws. Fifth, the federal government should enact a “balanced” budget amendment.
The key principle for financial markets reform is that risk and reward must be properly related. Two nonmarket institutions were instituted to manage fractional reserve banking. First, the central bank, in its role as “lender of last resort,” lends cash to inherently illiquid fractional reserve banks against good collateral. Second, deposit insurance maintains confidence in banks so depositors don’t withdraw their money from the banking system altogether. Both institutions transferred much of the risk of banking to society. The quid pro quo was heavy regulation. Deregulation upset this balance by allowing financial firms to reap the rewards while society kept the systemic risk. America must choose one and only one option: either a truly free market that eliminates the socialization of risk by eliminating the Federal Reserve’s role as “lender of last resort” and government deposit insurance. Or, a truly regulated financial market.
This book chooses the free market reform. Several reforms are needed to accomplish this. First, nationalize the Federal Reserve System and make it an independent federal agency. This is not unprecedented. For example, the Bank of England is government-owned. Second, require demand deposits to be 100% backed by cash and Federal Reserve deposits. Third, savings deposits shall be legally separate from other funds like demand deposits. There can be many separate savings trusts. Fourth, require maturity matching. The length-to-maturity of savings deposits must equal or exceed the length-to-maturity of loans. Savings must be in the form of negotiable time deposits that cannot be redeemed before their maturity date. This eliminates the chance for a run-on-the-bank and, therefore, the need for a lender of last resort. The federal government should authorize and foster a secondary market for time deposits to allow investors to sell their time deposits to other investors before maturity. Fifth, bank capital will be required for all loan assets except publicly offered debt and will cover “first losses” up to a certain percentage of deposits. Private deposit insurance will cover “second losses” up to an additional percentage of deposits. One possible formula: Total bank capital plus private insurance must be at least 5% of which at least 3% is bank capital and at least 2% is private insurance. Private insurers will be motivated to monitor risk when they have capital at risk. After full implementation of the new capital requirements, public deposit insurance will be eliminated. Depositors will have priority claim on assets but can suffer losses. Finally, repeal bank regulations required because of the current fractional reserve banking system. Use ordinary civil – that is, commercial – and criminal law instead.
The current banking system derives its profits from seigniorage, intermediation and the spread between short-term and long-term interest rates. Intermediation will be the source of profit after banking reform. In the current banking system, central bank reserves serve as reserves for all bank deposits. The commercial banks extend several times the credit that the central bank extends to them. After the reform, central bank credit will back demand deposits only. Demand deposits will be truly payable on demand, backed up 100% by cash and Federal Reserve deposits. The banks will be able to issue as much credit as they wish via time deposits. Time deposits can be traded on the secondary market. Private deposit insurance will help protect depositors by keeping a close eye on the quality of the bank’s assets, but losses above that of bank equity plus private deposit insurance will be borne by the depositors. Because demand deposits are backed by cash and deposits at the Federal Reserve, demand deposits will not suffer losses.
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