Louis O. Kelso, inventor of the ESOP, was a professional investment banker by trade, and the insights this gave him into the origins of wealth and capital ownership can be seen throughout his writings. It is hardly surprising to find that one of his most controversial proposals targets the heart of his own industry: the Federal Reserve. The Federal Reserve (or "Fed"), as the central bank of the United States, is responsible for regulating the country’s money supply, ensuring that there is neither more nor less money than is required for the sustainable growth of the economy. The Fed’s current practice is to introduce newly created money into the money supply by lending directly to banks, charging interest at what is known as the Discount Rate. By raising or lowering the Discount Rate, the Fed is able to increase or decrease the cost of borrowing for banks, and thus businesses and consumers, which then contributes to the deceleration or acceleration of economic activity (and accompanying inflationary pressures) throughout the country.
While this is (arguably) an important function, Kelso’s attention was drawn to the fact that by lending money directly to commercial banks, the Fed contributes to the concentration of capital ownership within the American economy. Because banks still insure against potential default on loans through collateralization, the current practices of the banking industry ensure that only the wealthy are able to borrow the newly created funds for investment in new productive capital. Since the Fed usually creates significant amounts of new money each year (author William Greider uses the figure $30-40 billion annually in One World, Ready or Not, p.422), Kelso felt that there was potential to advance the democratization of capital ownership by altering how the Fed introduced that money into the economy.
Stated simply, Kelso proposed that the Fed should "discount" capital investment loans made by commercial banks to ESOPs (and other yet-to-be implemented capital democratization vehicles). This translates as the Fed loaning funds to banks at a Discount Rate (usually described as between ˝% and 1%, the estimated administrative overhead on a Fed loan) to cover the value of previously approved loans to ESOP trusts, with the understanding that the bank will pass the reduced interest rate along to the ESOP, thus drastically easing the ESOP’s repayment of the loan. This would not necessarily require any changes to existing law, as the Fed was originally designed to add money to the economy through discounting of "eligible" loans. However, it is likely that some form of legislative action would be required to force the Fed to change its practices; various members of the Federal Reserve Board have been aware of this proposal over the years, but it has never received any significant support within the Board as a whole.
Inertia on the part of the Fed aside, this idea is not without its critics. Objections to Fed discounting of loans generally fall into one of three categories: economic concerns; questions of usefulness; and political worries.
Economic: The most common concern is that forcing the Fed to concentrate on something besides the rise and fall of the Discount Rate will undercut the Fed’s ability to control inflation. While this begs the question of whether inflation control is the most important public policy goal which the Fed could be pursuing, there are several steps which could be taken to minimize the impact of Federal Reserve discounting, such as setting the reserve requirements on discounted funds to 100%: banks generally operate with a reserve requirement of 20%, which means that for every $5 worth of loans they make, they must keep $1 on hand in their cash reserves, which means that every newly introduced dollar tends to expand the money available for loans, and thus potential inflationary pressures, by significantly more than $1. A 100% reserve requirement on discounted funds would prevent this "multiplier effect", and tend to minimize any inflationary impact.
Usefulness: While in theory directing $30-$40 billion in credit per year through capital democratization vehicles would do a great deal to improve the distribution of ownership in the American economy, there is some question of whether it could be utilized effectively under current conditions. Corey Rosen, Executive Director of the National Center for Employee Ownership (http://www.nceo.org) argues that the demand for additional capital financing for ESOPs is simply not there at the moment:
"The underlying assumption here is that companies would change their ownership structure in return for a lower interest rate… In fact, we can prove this is not the case, because the tax-deductibility of principle on ESOP loans amounts to a subsidy much, much larger than the lower interest rates. Yet there are almost no cases of public ESOP companies, and only a small number of private ones, who have used ESOPs to borrow money to acquire new capital… rather than to repurchase shares." (From personal e-mail communication)
This is certainly a very real concern, and it may be that the capital democratization movement, as exemplified by the thousands of ESOP companies throughout the country, is still not mature enough that the significant expansion of capital credit could be usefully exploited. However, this could very well change; between the continuing growth of ESOPs and the potential that additional capital democratization vehicles (such as Consumer and Community Share Ownership Plans) will be legally established in coming years, the day when Fed dollars are in fact desperately needed may not be all that far off.
Political: Any change of Fed policy away from direct allocation of newly created money to commercial banks, whether partial or total, would undoubtedly impact the economic interests of certain groups (including sectors of the financial industry, large corporations, and wealthy individuals) who benefit from the current patterns of credit allocation. All of these groups would presumably oppose any move to democratize access to the money creation powers of the Fed. Adding to this the historical opposition of the Fed itself to this policy, it is fair to ask whether the massive political resources required to win a legislative battle to open the Fed would be better spent elsewhere. Once again, however, it is important to remember that increases in ESOP participation, "conversion" of influential politicians, and any number of potential agenda-setting "crises" could change the political calculus drastically in a matter of years. Given the volatility of American politics in the last decade, it would be premature to permanently discard the idea due to the realities of the moment.
It seems fair to say that while now may not be a particularly auspicious time to push "opening the Federal Reserve discount window" in the public agenda, it shows promise as a means to promote democratic patterns of capital ownership. As such, it is important to continue discussing the idea even as we work and wait for the time when it is more necessary and more viable politically. As Norman Kurland, President of the Center for Economic and Social Justice (http://www.cesj.org) puts it,
"If there is indeed a basic defect or injustice in our economic system… we should not be afraid to attack the disease at its roots, rather than merely twiddle with the tax system. If a fundamental social institution such as our monetary and banking system is erecting barriers to [economic] participation for the majority of our citizens, should we not exercise our political will and do something about it? Ignoring an injustice, or failing to organize with others to correct it, is a cop-out." (From personal e-mail communication)
Personal Blurb:
David Spitzley received his Masters in Public Administration in 1996. He is currently working as a database developer for the State of Michigan, but plans to begin a PhD in Economics in the Fall of 2000. He may be contacted by e-mail at optimist@io.com.