Basic Economics

by Sowell, Thomas

  Many individuals also transfer their own money more directly to businesses by buying stocks and bonds. But that means doing their own risk assessments, while others transfer their money through financial intermediaries who have the expertise and experience to evaluate investment risks and earnings prospects in a way that most individuals do not.

  What is evaluated by individual owners of money that is transferred through financial institutions is the riskiness and earnings prospects of the financial institutions themselves. Individuals decide whether to put their money into an insured savings account, into a pension plan, or into a mutual fund or with commodity speculators, while these financial intermediaries in turn evaluate the riskiness and earnings prospects of those to whom they transfer this money.

  Banks also finance consumer purchases by paying for credit card purchases by people who later reimburse the credit card companies and the banks behind them, by paying monthly installments that include interest. The banking system is thus a major part of an elaborate system of financial intermediaries which enables millions of people to spend money that belongs to millions of strangers, not only for investments in businesses but also for consumer purchases. For example, the leading credit card company, Visa, forms a network in which 14,800 banks and other financial institutions provide the money for purchases made by more than 100 million credit card users who buy goods from 20 million merchants around the world.{600}

  The importance of financial intermediaries to the economy as a whole can be seen by looking at places where there are not enough sufficiently knowledgeable, experienced, and trustworthy intermediaries to enable strangers to turn vast sums of money over to other strangers. Such countries are often poor, even when they are rich in natural resources. Financial intermediaries can facilitate turning these natural resources into goods and services, homes and businesses—in short, wealth.

  Although money itself is not wealth, from the standpoint of society as a whole, its role in facilitating the production and transfer of wealth is important. The real wealth—the tangible things—that people are entitled to withdraw from a nation’s output can instead be redirected toward others through banks and other financial institutions, using money as the means of transfer. Thus wood that could have been used to build furniture, if consumers had chosen to spend their money on that, is instead redirected toward creating paper for printing magazines when those consumers put their money into banks instead of spending it, and the banks then lend it to magazine publishers.

  Modern banks, however, do more than simply transfer cash. Such transfers do not change the total demand in the economy but simply change who demands what. The total demand for all goods and services combined is not changed by such transactions, important as these transactions are for other purposes. But what the banking system does, over and beyond what other financial intermediaries do, is affect the total demand in the economy as a whole. The banking system creates credits which, in effect, add to the money supply through what is called “fractional reserve banking.” A brief history of how this practice arose may make this process clearer.

  Fractional Reserve Banking

  Goldsmiths have for centuries had to have some safe place to store the precious metal that they use to make jewelry and other items. Once they had established a vault or other secure storage place, other people often stored their own gold with the goldsmith, rather than take on the cost of creating their own secure storage facilities. In other words, there were economies of scale in storing gold in a vault or other stronghold, so goldsmiths ended up storing other people’s gold, as well as their own.

  Naturally, the goldsmiths gave out receipts entitling the owners to reclaim their gold whenever they wished to. Since these receipts were redeemable in gold, they were in effect “as good as gold” and circulated as if they were money, buying goods and services as they were passed on from one person to another.

  From experience, goldsmiths learned that they seldom had to redeem all the gold that was stored with them at any given time. If a goldsmith felt confident that he would never have to redeem more than one-third of the gold that he held for other people at any given time, then he could lend out the other two-thirds and earn interest on it. Since the receipts for gold and two-thirds of the gold itself were both in circulation at the same time, the goldsmith was, in effect, adding to the total money supply.

  In this way, there arose two of the major features of modern banking—(1) holding only a fraction of the reserves needed to cover deposits and (2) adding to the total money supply. Since all the depositors are not going to want their money at one time, the bank lends most of it to other people, in order to earn interest on those loans. Some of this interest they share with the depositors by paying interest on their bank accounts. Again, with the depositors writing checks on their accounts while part of the money in those accounts is also circulating as loans to other people, the banking system is in effect adding to the national money supply, over and above the money printed by the government. Since some of these bank credits are re-deposited in other banks, additional rounds of expansion of the money supply follow, so that the total amount of bank credits in the economy has tended to exceed all the hard cash issued by the government.

  One of the reasons this system worked was that the whole banking system has never been called upon to actually supply cash to cover all the checks written by depositors. Instead, if the Acme Bank receives a million dollars’ worth of checks from its depositors, who received these checks from people whose accounts are with the Zebra Bank, the Acme bank does not ask the Zebra Bank for the million dollars. Instead, the Acme Bank balances these checks off against whatever checks were written by its own depositors and ended up in the hands of the Zebra Bank. For example, if Acme bank depositors had written a total of $1,200,000 worth of checks to businesses and individuals who then deposited those checks in the Zebra Bank, then the Acme Bank would just pay the difference. This way, only $200,000 is needed to settle more than two million dollars’ worth of checks that had been written on accounts in the two banks combined.

  Both banks could keep just a fraction of their deposits in cash because all the checks written on all the banks require just a fraction of the total amounts on those checks to settle the differences between banks. Since all depositors would not want their money in cash at the same time, a relatively small amount of hard cash would permit a much larger amount of credits created by the banking system to function as money in the economy.

  This system, called “fractional reserve banking,” worked fine in normal times. But it was very vulnerable when many depositors wanted hard cash at the same time. While most depositors are not going to ask for their money at the same time under normal conditions, there are special situations where more depositors will ask for their money than the bank can supply from the cash it has kept on hand as reserves. Usually, this would be when the depositors fear that they will not be able to get their money back. At one time, a bank robbery could cause depositors to fear that the bank would have to close and therefore they would all run to the bank at the same time, trying to withdraw their money before the bank collapsed.

  If the bank had only one-third as much money available as the total depositors were entitled to, and one-half of the depositors asked for their money, then the bank ran out of money and collapsed, with the remaining depositors losing everything. The money taken by the bank robbers was often far less damaging than the run on the bank that followed.

  A bank may be perfectly sound in the sense of having enough assets to cover its liabilities, but these assets cannot be instantly sold to get money to pay off the depositors. A building owned by a bank is unlikely to find a buyer instantly when the bank’s depositors start lining up at the tellers’ windows, asking for their money. Nor can a bank instantly collect all the money due them on 30-year mortgages. Such assets are not considered to be “liquid” because they cannot be readily turned into cash.

  More than time is involved when eva
luating the liquidity of assets. You can always sell a diamond for a dime—and pretty quickly. It is the degree to which an asset can be converted to money without losing its value that makes it liquid or not. American Express traveler’s checks are liquid because they can be converted to money at their face value at any American Express office. A Treasury bond that is due to mature next month is almost as liquid, but not quite, even though you may be able to sell it as quickly as you can cash a traveler’s check, but no one will pay the full face value of that Treasury bond today.

  Because a bank’s assets cannot all be liquidated at a moment’s notice, anything that could set off a run on a bank could cause that bank to collapse. Not only would many depositors lose their savings, the nation’s total demand for goods and services could suddenly decline, if this happened to enough banks at the same time. After all, part of the monetary demand consists of credits created by the banking system during the process of lending out money. When that credit disappears, there is no longer enough demand to buy everything that was being produced—at least not at the prices that had been set when the supply of money and credit was larger. This is what happened during the Great Depression of the 1930s, when thousands of banks in the United States collapsed and the total monetary demand of the country (including credits) contracted by one-third.

  In order to prevent a repetition of this catastrophe, the Federal Deposit Insurance Corporation was created, guaranteeing that the government would reimburse depositors whose money was in an insured bank when it collapsed. Now there was no longer a reason for depositors to start a run on a bank, so very few banks collapsed, and as a result there was less likelihood of a sudden and disastrous reduction of the nation’s total supply of money and credit.

  While the Federal Deposit Insurance Corporation is a sort of firewall to prevent bank failures from spreading throughout the system, a more fine-tuned way of trying to control the national supply of money and credit is through the Federal Reserve System. The Federal Reserve is a central bank run by the government to control all the private banks. It has the power to tell the banks what fraction of their deposits must be kept in reserve, with only the remainder being allowed to be lent out. It also lends money to the banks, which the banks can then re-lend to the general public. By setting the interest rate on the money that it lends to the banks, the Federal Reserve System indirectly controls the interest rate that the banks will charge the general public.

  All of this has the net effect of allowing the Federal Reserve to control the total amount of money and credit in the economy as a whole, to one degree or another, thereby controlling indirectly the aggregate demand for the nation’s goods and services.

  Because of the powerful leverage of the Federal Reserve System, public statements by the chairman of the Federal Reserve Board are scrutinized by bankers and investors for clues as to whether “the Fed” is likely to tighten the money supply or ease up. An unguarded statement by the chairman of the Federal Reserve Board, or a statement that is misconstrued by financiers, can set off a panic in Wall Street that causes stock prices to plummet. Or, if the Federal Reserve Board chairman sounds upbeat, stock prices may soar—to unsustainable levels that will ruin many investors when the prices come back down again. Given such drastic repercussions, which can affect financial markets around the world, Federal Reserve Board chairmen over the years have learned to speak in highly guarded and Delphic terms that often leave listeners puzzled as to what they really mean.

  What BusinessWeek magazine said of Federal Reserve chairman Alan Greenspan could have been said of many of his predecessors in that position: “Wall Street and Washington expend megawatts of energy trying to decipher the delphic pronouncements of Alan Greenspan.”{601} In 2004, the following news item appeared in the business section of the San Francisco Chronicle:

  Alan Greenspan sneezed Wednesday, and Wall Street caught a chill.

  The Federal Reserve chairman and his colleagues on the central bank’s policy-making committee left short-term interest costs unchanged, but issued a statement that didn’t repeat the mantra of recent meetings about keeping rates low for a “considerable period.”

  Stunned traders took the omission as a signal to unload stocks and bonds.{602}

  The Dow Jones average, Nasdaq, and the Standard & Poor’s Index all dropped sharply, as did the price of treasury bonds{603}—all because of what was not said.

  This scrutiny of obscure statements by the Federal Reserve Board was not peculiar to Alan Greenspan’s tenure as chairman of that board. Under his successor as chairman, Ben Bernanke, the Federal Reserve was purchasing large amounts of U.S. government bonds, thereby pouring new money into the American economy. But when Chairman Bernanke said in May 2013 that, if the economy improved, the Federal Reserve Board “could in the next few meetings take a step down in our pace of purchases,” the reaction was swift and far reaching. The Japanese stock market lost 21 percent of its value in less than a month and total losses in stock markets around the world in that brief time totaled $3 trillion{604}—which is more than the value of the total annual output of France, or of most other nations.

  In assessing the role of the Federal Reserve, as well as any other organs of government, a sharp distinction must be made between their stated goals and their actual performance or effect. The Federal Reserve System was established in 1914 as a result of fears of such economic consequences as deflation and bank failures. Yet the worst deflation and the worst bank failures in the country’s history occurred after the Federal Reserve was established. The financial crises of 1907, which helped spur the creation of the Federal Reserve System, were dwarfed by the financial crises associated with the stock market crash of 1929 and the Great Depression of the 1930s.

  BANKING LAWS AND POLICIES

  Banks and banking systems vary from one country to another. They differ not only in particular institutional practices but more fundamentally in the general setting and historical experiences of the particular country. Such differences can help illustrate some of the general requirements of a successful banking system and also to evaluate the effects of particular policies.

  Requirements for a Banking System

  Like so many other things, banking looks easy from the outside—simply take in deposits and lend much of it out, earning interest in the process and sharing some of that interest with the depositors, in order to keep them putting their money into the banks. Yet we do not want to repeat the mistake that Lenin made in grossly under-estimating the complexity of business in general.

  At the beginning of the twenty-first century, some post-Communist nations were having great difficulties creating a banking system that could operate in a free market. In Albania and in the Czech Republic, for example, banks were able to receive deposits but were stymied by the problem of how to lend out the money to private businesses in a way that would bring returns on their investment, while minimizing losses from money that was not repaid. The London magazine The Economist reported that “the legal infrastructure is so weak” in Albania that the head of a bank there “is afraid to make any loans.” Even though another Albanian bank made loans, it discovered that the collateral it acquired from a defaulting borrower was “impossible to sell.” An Albanian bank with 83 percent of the country’s deposits made no loans at all, but bought government securities instead, earning a low but dependable rate of return.{605}

  What this means for the country’s economy as a whole, The Economist reported, is that “capital-hungry enterprises are robbed of a source of finance.” In the post-Communist Czech Republic, lending was more generous—and losses much larger. Here the government stepped in to cover losses and the banks shifted their assets into government securities, as in Albania.{606} Whether such problems will sort themselves out over time—and how much time?—is obviously a question for the Czechs and the Albanians. But it will take time for private enterprises to acquire track records and private bankers to acquire more experience, while the legal system adapts to a
market economy after the long decades of a Communist economic and political regime. However, for the rest of us, their experience illustrates again the fact that one of the best ways of understanding and appreciating an economic function is by seeing what happens when that function does not exist or malfunctions.

  As with Britain several centuries earlier, foreigners have been brought in to run financial institutions that the people of the former Communist bloc nations were having great difficulty running. As of 2006, foreigners owned more than half of the banking assets in the Czech Republic, Slovakia, Romania, Estonia, Lithuania, Hungary, Bulgaria, Poland and Latvia. The range of the bank assets owned by foreigners was from 60 percent in Latvia to virtually all in Estonia.{607}

  In India, a very different problem exists. While the country’s rate of saving, as a percent of its economy’s output, is much higher than that in the United States, its people are so distrustful of banks that individuals’ holdings of gold are the highest in the world.{608} From the standpoint of the country, this means that a substantial part of its wealth does not get used to finance investment to create additional output. Of those savings which do go into India’s largely state-dominated banking system, 70 percent are lent to the government or to government-owned enterprises.{609}