Conversely, when the Fed wants to reduce the money supply—it does so much less frequently than it increases the money supply—it conducts an “open market sale” in which it sells some of its own large holdings of Treasury securities. Perhaps your bank buys from the Fed one of those Treasury notes to increase its holdings of relatively safe investments for, say, $10,500. (The price would rise a little higher if market interest rates had fallen a little lower.) The $10,500 your bank pays essentially vanishes from the money supply—it is extinguished, annihilated—when it returns to the Federal Reserve. (Think of a $10,000 bill and a $500 bill being thrown into the furnace in the Fed’s basement, or the bookkeeper highlighting the entry for $10,500 in your bank’s account and hitting “Delete.”) In this manner the money supply is reduced. Your bank still has the Treasury note, with its promised interest and principal payments, but there is $10,500 less money in the economy.
By removing money from circulation in this way, open market sales increase the fed funds rate. The $10,500 your bank pays for the Treasury security comes out of its reserves. Having fewer reserves on hand now, your bank would naturally require a slightly higher interest rate, other things remaining equal, of another bank seeking to borrow some of its now-reduced reserves. In supply and demand terms, the decrease in the supply of reserves leads to a higher price—interest rate—for reserves.
What is described here is the Fed’s primary means of altering the money supply and thereby affecting interest rates. In recent years (as of 2013), the Fed has used other means of expanding the money supply and keeping interest rates lower than they would otherwise be, including rounds of “quantitative easing.” The term means that it has “eased”—increased—the quantity of money in circulation. Among other means, it has done so by purchasing huge quantities of mortgage-backed securities. (See Chapter 12 for a discussion of these.) The process is essentially the same as what is described here; the only meaningful difference is in the kind of securities the Fed purchases with the new money it creates.
Appendix B
Bank Capital and “Leverage”
Bank capital can be understood as the net value of the bank or how much stockholders own after all obligations are paid off. It’s the difference between the bank’s assets (what the bank owns, mostly loans it has made) and its liabilities (what it owes). It functions as a cushion against loans that might go bad. To see the importance of having a good capital cushion, imagine that you, the reader, are a simplified bank that you have established with $20 million of stockholders’ money. That’s your capital as you begin to do business. Your balance sheet (which always balances, by the nature of the reckoning) looks like this:
Assets
Liabilities + Capital
Cash in reserve $20 million
Capital $20 million
At this point, your capital ratio—your ratio of capital to assets—is 100% ($20 million in capital/$20 million in assets); but because cash is essentially riskless, your ratio of capital to risky assets is infinite ($20 million in capital/$0 in risky assets). Cash also earns no interest, so you are really not in business as a banker yet. You could earn some interest by lending out some of this cash you have from stockholders. If you were to lend, say, a quarter of it, your balance sheet would look like this:
Assets
Liabilities + Capital
Cash in reserve $15 million
Loans $5 million
TOTAL $20 million
Capital $20 million
TOTAL $20 million
Still you would not be operating like a real bank because you are notyet taking deposits and lending out some or all of them. Doing so involves “expanding your balance sheet”—increasing its length, so to speak, by taking on additional liabilities in the form of checking or savings deposits, and using those to increase your interest-earning assets. For example, instead of lending out your capital, you might take in $100 million worth of deposits. Those deposits are liabilities because you have effectively borrowed that money from your depositors, and you are responsible for (“liable” for) paying it back when depositors want it. Now your balance sheet has expanded from $20 million to $120 million:
Assets
Liabilities + Capital
Cash in reserve $120 million
TOTAL $120 million
Capital $20 million
Deposits $100 million
TOTAL $120 million
Your capital ratio (capital/assets) is now technically $20 million/$120 million = 16.66%, but your ratio of capital to risky assets is still infinite because your cash is riskless.
You want to make money, however, and in order to do that you have to take some risks, so you might hold, say, 10 percent of your deposits ($10 million) in reserve and lend out your remaining cash. Your balance sheet then looks like this:
Assets
Liabilities + Capital
Cash in reserve $10 million
Loans $110 million
TOTAL $120 million
Capital $20 million
Deposits $100 million
TOTAL $120 million
Your ratio of capital to risky assets (your loans) is now $20 million/$110 million = 18.18%.
If all your loans pay off at, say, 7 percent interest on average, then you earn $7.7 million on your loans in a year, and that amount, less all your expenses, gets added to capital. You will be happy, having earned a return on capital of $7.7 million/$20 million = 38.5% before expenses. That’s a decent return that can earn you a nice profit, depending on how well you keep expenses down.
Your capital meanwhile serves as a reserve against possible loan losses. Suppose instead of a good year you have a bad one in which ten percent of your loans go bad. (For simplicity’s sake, let’s suppose the other loans earn just enough to cover your expenses). Will your $20 million in capital keep you out of bankruptcy? Ten percent losses on $110 million in loans is $11 million lost, leaving you with loans worth only $99 million. The deposits for which you are liable have not changed; so on the right-hand side of your balance sheet, that $11 million loss reduces your capital by an equal amount. (Too bad!) Your balance sheet has shrunk by the amount of the loss as follows:
Assets
Liabilities + Capital
Cash in reserve $10 million
Loans $99 million
TOTAL $109 million
Capital $9 million
Deposits $100 million
TOTAL $109 million
You have taken a grievous loss, but you are still solvent: your assets ($109 million) are greater than your liabilities ($100 million of deposits), so you are able to pay what you owe. Your losses have wiped out more than half of your capital; therefore your ratio of capital to risky assets is now down to $9 million/$99 million = 9.09%, but you had enough capital to weather the storm.
By contrast, consider what would have happened to you, the bank, if you had been a lot more aggressive, expanding your balance sheet ten times more—to $1 billion—on the basis of that same $20 million in capital. Here is the sequence:
Assets
Liabilities + Capital
Cash in reserve $20 million
Capital $20 million
You begin as before, but this time, in order to make more money from loans, you take in not a million, but a billion dollars’ worth ($1000 million) of deposits. That is, you borrow a billion from depositors, whom you must pay back. Before you make any loans, your balance sheet looks like this:
Assets
Liabilities + Capital
Cash in reserve $1020 million
TOTAL $1020 million
Capital $20 million
Deposits $1000 million
TOTAL $1020 million
This kind of increased borrowing as a proportion of one’s capital is called “leveraging” or “increasing leverage.” In the first example above, your leverage was only $100 million in deposits to $20 million in capital or 5:1. In the present example, your leverage would be $1 billion in deposits
to $20 million in capital, or 50:1; you are borrowing from depositors fifty dollars for every one dollar you have in capital. The point of doing so is to earn more income by lending out the borrowed money, although doing so is risky, as we’ll see.
Suppose that, willing to take a lot of risk in hope you’ll make a lot of money, again you hold back 10% of your deposits in reserve (that’s $100 million now) and lend out the rest. Your greatly expanded balance sheet now looks like this:
Assets
Liabilities + Capital
Cash in reserve $100 million
Loans $920 million
TOTAL $1020 million
Capital $20 million
Deposits $1000 million
TOTAL $1020 million
Now your ratio of capital to risky assets (your loans) is $20 million/$920 million = 2.17%. If all goes well, that frighteningly low ratio will mean high profits (known as return on equity or ROE) for you and the bank’s other shareholders; but if things go badly, it will mean disaster. Let’s do the arithmetic:
If, as before, all your loans pay off at 7 percent interest on average, then you will earn 7 percent of $920 million on your loans in a year (less all your expenses). That is $64.4 million. You would have hit the jackpot, having earned a return on equity capital of $64.4 million/$20 million = 322% (!) before expenses. That’s the payoff from expanding your balance sheet with such tremendous leverage when things go well.
But what if things go badly? Your $20 million in capital is all you have as a reserve against possible losses on $920 million worth of loans. Suppose you have a mildly bad year in which, say, three percent of your loans go bad. Three percent of $920 million is $27.6 million, so your remaining loans would now be worth only $920-$27.6 = $892.4 million. You still owe your depositors $1000 million, so you are in bad trouble. On the right-hand side of your balance sheet that $27.6 million loss completely wipes out your capital and leaves you $7.6 million deep in insolvency and shame, as shown here:
Assets
Liabilities + Capital
Cash in reserve $100.0 million
Loans $892.4 million
TOTAL $992.4 million
Capital (-$7.6 million)
Deposits $1000.0 million
TOTAL $992.4 million
The increased likelihood of insolvency is the downside of shooting for high returns by using high leverage (maintaining a small ratio of capital to risky assets): a small decrease in the value of its assets can pitch a bank that does so into insolvency.
This is the problem the Basel capital adequacy rules were supposed to prevent. They didn’t.
Notes
Notes to the Introduction
Frederic Bastiat’s The Law, first published in France in 1850, is widely available in English translation. The Dean Russell translation which the Foundation for Economic Education (FEE) gave me at my first seminar is available online at the Library of Economics and Liberty at http://econlib.org/library/Bastiat/basLaw.html. The quoted passage is in paragraphs 64 and 65. FEE provides a PDF file for download at http://www.fee.org/library/books/the-law-by-frederic-bastiat-free-download/.
Jennifer Roback’s illuminating article on racial segregation in the South describes the way many streetcar owners resisted segregation because it would be costly to do so. They would not segregate their streetcars voluntarily, so others who favored segregation had to force segregation on them with governmental force. See “The Political Economy of Segregation: The Case of Segregated Streetcars,” published in December, 1986, in the Journal of Economic History, Vol. XLVI, No. 4. It is available on JSTOR, a digital library of academic journals, books, and primary resources, at http://www.jstor.org/discover/10.2307/2121814?uid=3739704&uid=2129&uid=2&uid=70&uid=4&uid=3739256&sid=21101128768711.
The quotation from Adam Smith’s The Wealth of Nations comes from Book IV, Chapter IX, paragraph 51, available from the Library of Economics and Liberty at http://www.econlib.org/library/Smith/smWN19.html#B.IV. The whole sentence and the next bear quoting:
All systems either of preference or of restraint, therefore, being thus completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord. Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men.
The full text of Thomas Jefferson’s first inaugural address is available on the web at http://jeffersonpapers.princeton.edu/selected-documents/first-inaugural-address-0.
Part I: Principles of Spontaneous Economic Order
Notes to Chapter 1 “Prices Communicate Knowledge”
Leonard Read was the founder of the Foundation for Economic Education (FEE). His classic essay “I, Pencil” is available in an attractive pamphlet from FEE at http://feestore.myshopify.com/products/i-pencil, and online at the Library of Economics and Liberty at http://www.econlib.org/library/Essays/rdPncl1.html. Read put this footnote after the very first sentence of “I, Pencil”: “My official name is ‘Mongol 482.’ My many ingredients are assembled, fabricated, and finished by Eberhard Faber Pencil Company, Wilkes-Barre, Pennsylvania.”
The Price of Everything, a short novel by Russell Roberts available from Princeton University Press (2009), provides an engaging exploration of this chapter’s point about prices.
Ludwig von Mises’ statement that socialists without prices would be “groping in the dark” comes from “Economic Calculation in the Socialist Commonwealth,” in Collectivist Economic Planning, F.A. Hayek, ed., George Routledge & Sons, 1938, p. 110.
The term “the knowledge problem,” as applied to central economic planning was probably coined by Don Lavoie, or possibly his teacher at New York University, Israel Kirzner. Don was my beloved instructor, dissertation advisor, colleague and friend at George Mason University. He used this term to identify the main problem the scholars of the Austrian School of economics found with central planning in the famous Socialist Calculation Debate. Don’s book on the subject is Rivalry and Central Planning, The Socialist Calculation Debate Reconsidered, Cambridge University Press, 1985.
Hayek’s essay, “The Use of Knowledge in Society,” was originally published in the American Economic Review XXXV, No. 4 (September, 1945), pp. 519-30. It was reprinted in Individualism and Economic Order, University of Chicago Press, 1948. It is available online at http://www.econlib.org/library/Essays/hykKnw1.html. The famous quotation about “knowledge of the particular circumstances of time and place” is in paragraph H.9 of this online version. The quoted passage giving the example of the market for tin is from paragraph H.21, and the quotation about “the economy of knowledge with which [the price system] operates” is from paragraph H.22.
Hayek’s discussion of the tacitness of knowledge is in “Socialist Calculation II: The State of the Debate,” in Individualism and Economic Order, University of Chicago Press, 1948, p. 155.
Details on the punishment for violating the price controls in Charleston after Hurricane Hugo come from the microeconomics textbook I use, Gwartney, Stroup, Sobel, and Macpherson’s, Microeconomics: Private and Public Choice, Thomson-Southwestern, 2005, p. 87.
Tyler Cowen and Alex Tabarrok’s wonderful statement that “a price is a signal wrapped up in an incentive” comes from their textbook, Modern Principles: Microeconomics, 2nd Edition, Worth Publishers, 2013, p. 113.
Professor Russ Sobel’s story about using scarce generators to power a blow-dryer and an electric shaver is from an email he sent me on July 30, 2008.
Notes to Chapter 2 “Profit and Loss Guide Innovation”
The work to which I am most indebted for my understanding of the ideas in this chapter is Ludwig von Mises’ “Profit and Loss,” available online at http://library.mises.org/books/Ludwig%20von%20Mises/Profit%20and%20Loss.pdf. The book containing my copy is Planning for Freedom, and Sixteen other Essays and Addresses, published in 1980 by Libertarian Press. The first quotation fr
om Mises in this chapter is from page 23 of the online version and page 123 of the printed version. The second quotation is from page 13 of the online version and page 113 of the printed version.
For my understanding of the role of the entrepreneur and the entrepreneur’s “propensity for alertness toward fresh goals and the discovery of hitherto unknown resources,” I am most indebted to the work of Israel Kirzner, especially his Competition and Entrepreneurship, The University of Chicago Press, 1973. The quotation in the previous sentence is from page 34.
A short, clear story that illustrates the source of profit is Fred I. Kent’s “Letter to his Grandson,” available in Free Market Economics, A Reader, edited by Bettina Bien Greaves and available at https://mises.org/store/Product2.aspx?ProductId=393.
The complete interdependency between market prices and profit (or loss) deserves note. Entrepreneurs base their actions on profit-and-loss projections, which are themselves based on expected market prices. Entrepreneurs’ actions then determine actual market prices, and actual market prices determine actual profits and losses. Both the projected and the realized profits and losses help entrepreneurs discover what to do with scarce resources to create the most profit for themselves by creating the most new value for others.
The quotation from Adam Smith’s Wealth of Nations comes from Book I, Chapter V, paragraph 17, available from the Library of Economics and Liberty at http://www.econlib.org/library/Smith/smWN2.html#B.I, Ch.5, Of the Real and Nominal Price of Commodities.
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