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chapter 15 money banking and central banking

“I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.” Thomas Jefferson

Chapter 15 Money, banking, and Central Banking
short history of monetary policy

Under advocacy by the 1st Treasury Secretary, Alexander Hamilton, Congress chartered the First Bank of the United States. They failed to renew the charter in 1811. There was no Central Bank during the War of 1812 and US credit suffered significantly. A Second Bank of the United Sates was then chartered in 1816 and closed in 1836 under the Administration of Andrew Jackson.

Short history of monetary policy
jacksonian monetary policy

For approx. 25 years the US had what was called the “free banking” system. States chartered banks and wrote the regulations. There were a handful of federally chartered banks, but the period was basically a banking free-for-all. Depressions were frequent and severe and bank notes were routinely worth less than their face value. Depositors would deposit specie into a bank in the form of gold or silver coin, and the bank would issue bank notes, notes printed by the bank as an indication of deposit. Counterfeiting was common. The big book.

Jacksonian monetary policy
national bank acts of 1863 1864

Congress started taxing the bank notes provided by state banks at a rate of 10%. This encouraged state banks to take on a national charter and submit to federal regulations regarding financial transactions and banking activities.

During the Civil War the US had been issuing a fiat currency (not backed by gold or silver) and efforts were made to return the currency to one backed by gold.

In 1873, the US converted to currency backed by gold alone. By the 1890s persistent recessions and periods of deflation had widened the gap of the haves and the nave-nots. The gold was all held in banks and there was insufficient currency circulating in the economy for conducting commerce. Deflation benefits creditors (those holding all the gold) and harms debtors (nearly everyone else).

National bank acts of 1863 & 1864
free silver

The political firestorms of the late 19th century centered around the concept of introducing silver as an additional base for currency in order to grow the money supply.

Throughout the 19th Century, banking crises were commonplace, occurring about once a decade.

Free silver
the federal reserve system

The Panic of 1907 produced the political will for the US to set up a central bank similar to those in other countries, many of which dated back to the 17th century. In 1913, Woodrow Wilson signed the Federal Reserve Act of 1913 to prevent the problem of illiquidity and runs on banks.

In the 1920s, there was a popular belief that the Federal Reserve System had fixed the problems associated with inflation, deflation, and economic crises. What was not realized at the time is that monetary policy cannot fix everything. A failure to adequately regulate the banks would lead to one more spectacular failure in the Great Depression.

It all started when banks started issuing mortgage-backed securities which generated a bubble in the real estate market that burst in 1926. In 1926, banks were closing at a rate of 2.7 per day.

The federal reserve system
the new deal

In his 1st Inaugural speech, FDR stated “there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people’s money, and there must be provision for an adequate but sound currency.”

In developing a sound banking system that was more attuned to the needs of society than the needs of the bankers, many safeguards were put into place. Glass-Steagal (repealed in 1999), the Federal National Mortgage Association (Fannie Mae, privatized in 1968), the FDIC, and stricter banking regulations (many of which disappeared in The Depository Institutions Deregulation and Monetary Control Act of 1980) all kept the US economy humming along until the oil crises of the 1970s.

The new deal
why the history lesson

There have been calls from the far right to do away with the Federal Reserve System, for states to start printing their own currency, or for the US to go back to a gold standard (this last would be heavily advocated for by those holding a lot of gold like Glenn Beck and his sponsors).

There are historic reasons why countries have central banks. They can be a good thing. However, most countries have their central banks being run by the government, not the banks.

Why the history lesson?

An audit at this point would probably be a good idea.

milton friedman and monetarism

In 1963, Milton Friedman published A Monetary History of the United States, 1867-1960. In his book he passed off the issues of the 1920s as either good things (mortgage-backed securities), or nothing to be concerned about (banks closing at a rate of 2.7 per day. In his analysis, the Great Depression had nothing to do with accumulated capital and income disparity, but rather, failed monetary policy. Between this book and his Capitalism and Freedom (1962), he became the darling of supply-side economics and is considered the father of monetarism.

Milton friedman and monetarism
monetarists vs keynesians

Think of a scale at a doctor’s office. There are two weights, a big weight and a small weight. The big weight takes you to the closest 50 pounds while the smaller weight takes you to the exact weight. Unless the big weight is at the right level, you can never get the right weight.

This would be a good analogy of how a Keynesian (demand-side) economist looks at the relationship of fiscal and monetary policy. If you do not get your fiscal policy right, you can monkey with monetary policy all you want and not get anywhere. If, on the other hand, you get your fiscal policy right, monetary policy is a great way to dial in the needs of the economy over the short term without requiring an act of Congress.

To a monetarist, fiscal policy is all but irrelevant. Monetary policy is the primary driver in ensuring economic growth and stability. This also takes economic policy out of the hands of government and politicians and puts it in the hands of economists and bankers.

Monetarists vs Keynesians
the functions of money

Medium of exchange: You don’t have to be Radar O’Reilly. Barter and coincidence of wants.

Unit of accounting: Measure of value. If a widget is worth $1 and a superwidget is worth $10, then 10 widgets = 10 superwidgets.

Store of value: A farmer has a surplus of 100 bushels of wheat from his harvest. He stores the wheat in a barn. 10% is eaten by rats, 25% rots, and the rest is burned in a fire. Had he have sold the wheat he would still hold the complete value of his surplus. Note that many of the types of money in the chart are perishable items, those items would not meet this function of money.

Standard of deferred payment: Makes contracting possible. If I were to contract to provide a service for 100 bushels of wheat, I could not be assured of the value of those bushels when the job was finished.

tHe functions of money
properties of money

Money is a liquid asset. If you have cash in your hand you have the form of payment that is most readily accepted. If you walk in to a liquor store and try to buy a bottle of Wild Turkey with an antique humidor you will probably be laughed out of the store.

Other forms: Transactions deposits are the bulk of our fiduciary monetary system. We accept paper of little intrinsic value and money that exists solely on the balance sheets of banks. We accept the value of currency only if we have faith in the rules that determine its value. Fiduciary = trust or confidence.

Acceptability of transaction deposits and currency are based on past performance. In other words, the acceptability of our currency is based on predictability. If you have never had a problem by accepting payment via credit card, you have faith that there will be no problems accepting it in the future.

Properties of money
venezuelan private currencies

Not unlike the free banking system of the Jacksonian era. The textbook seems to see the regulation of these private currencies as being overbearing. What kind of effect would these private currencies have on monetary policy in Venezuela if they were unregulated? How would the government be able to prevent counterfeiting? These were the problems of the US free banking system; it is why we abandoned it.

Venezuelan private currencies
money supply m1 and m2

There is nowhere near sufficient currency and coin to represent what we call the money supply. The majority of our money supply exists merely as numbers on a ledger or bits of data in a dataset (or however you would say that in computer speak)

If you have $1000 in a checking account, that does not mean there is $1000 sitting in a vault waiting for you. You write a check to someone who deposits the cash in their bank and the money is transferred digitally. There is no exchange of currency between the two banks, just adjustments of their ledgers based on agreed upon rules of conduct.

Lately, there has been increased discussion regarding returning to the gold standard to limit the amount of money that can be “created” by banks. The problem with the gold standard is that you become limited in your ability to enact monetary policy. Unless you can find more gold to grow with your economy, deflation is guaranteed. Deflation freezes up the credit markets and is extremely harmful to borrowers.

Money supply: M1 and M2
m1 an m2

M1: Currency and coins, traveler’s checks (how long is this going to last?), and transactions deposits (checks and debit cards, or checking accounts)

M2: M1, Savings deposits, small-denomination time deposits, and money market mutual fund balances. Besides M1, M2 includes money that is still relatively liquid, but not as liquid as M1. To spend from your transaction deposit you just whip out the old debit card and shazam, the magic money card does its thing. With a savings deposit you must first contact the bank to either transfer funds to the transaction deposit account or physically go to the bank to withdraw cash. Still pretty liquid, but just a touch less so.

M1 an M2
central bank

Central banks institute monetary policy. Only Andorra, Monaco, and the Vatican City have no central bank. To suggest that the US (the largest economy in the world) eliminate the Federal Reserve is ludicrous.

The IMF has recently called for central banks to retain independence in monetary policy, but that there should be significantly more government supervision of the regulatory functions of the central banks.

Central bank
financial intermediation

This is where the savings of millions of middle class households becomes investment.

Where direct financing would be the purchase of bonds or direct infusions of cash from the investor to the business, the banking system plays an important role as middle man to consolidate the cash from many different households to provide loans to businesses and other households. The expectation is that the bank will provide due diligence to determine the risk of the loan and decline those loans that are too risky.

Financial intermediation
benefits of financial intermediation

Reduces the effects of asymmetric information, adverse selection, and moral hazard.

Larger scale and lower management costs. Returns to scale.

Specialization in liabilities and assets.

The textbook looks to a future of insurance companies, banks, S&Ls, etc. all being treated as a more generic financial intermediary. This would be a position that would be taken by someone who believes that all regulation is counterproductive.

Differentiation between different forms of financial intermediaries is key to the protection of consumers, and ultimately, the economy. The repeal of Glass-Steagall and the subsequent failure of the economy should provide sufficient evidence of that fact.

Benefits of financial intermediation
important terms to understand in economics

Asymmetric information: When one party to a contract or transaction has information that the other party lacks. For example, an insurance company knows all about your health history. In filling out the paperwork you indicate no preexisting conditions. They take your premiums for years but when you get sick they indicate that you failed to report a yeast infection 7 years prior and deny coverage. They know everything about you, but you know very little about the quality of the insurer or the policy you are paying for until you need it and then it is too late.

Important terms to understand in economics

important terms

Adverse selection: High risk individuals are more likely to seek insurance. This is one of the potential problems that the PPACA could run into. If only those who already have a pre-existing condition sign up and the young and healthy decline to, the system could run into serious problems with more being paid out in benefits than are taken in in premiums.

Important terms
important terms1

Moral hazard: Indulging in risky behavior because you are shielded from the costs of the risks. IE A person with good health insurance indulges in daredevil sports because the cost of broken bones will be taken on by the insurance company.

Important terms
the process of financial intermediation

Before the repeal of Glass-Steagall, there could be no relationships between commercial banks and securities firms (or investment banks) This was a problem leading into the Great Depression. Glass-Steagall was a set of regulations intended to prevent the negative externalities produced by mortgage-backed securities which lead to the real estate boom and bust of the 1920s and ultimately brought down the entire economy. When a bank makes a loan they can do one of two things, keep the loan and service it or sell it in the secondary market.

The process of financial intermediation
previous scenario

During the Keynesian era, Fannie Mae held a near monopoly in the secondary market of purchasing mortgages. Fannie Mae had stringent policies regarding the quality of loans they would accept. Nobody qualified for a loan that they could not afford to pay off. These mortgages could then be bundled and sold to investors as high quality securities. This would free up banks to make more loans.

Previous scenario
fast forward to repeal of glass steagall

Banks could now bundle and sell their own mortgage-backed securities. They no longer had to worry about borrowers paying back the loan or being found acceptable by Fannie Mae. Fannie Mae also loosened its standards in order to compete. Some banks would also insure these securitized bad loans against losses. Not only were they protected from losses, they actually made more money when the asset failed. From what we know about asymmetric information, adverse selection, and moral hazard, we see the three combined here in a way that brought down the economy in much the same way as they had in the 1920s.

Fast forward to repeal of glass-Steagall
2008 economic crash

While the textbook seems to want to emphasize the FDIC as being the cause of moral hazard and adverse selection, and that depositors failed to hold the banks accountable, there is a story here that makes more sense. Banks found a way to get rich with little or no risk to themselves. The government allowed it through deregulation and we all have suffered from the negative externalities.

2008 economic crash
independent central bank

As indicated previously, the IMF has called for central banks of the world to retain independence in terms of setting monetary policy, but at the same time calling for more government oversight in the other functions of central banks. This is in result of the abuses of worldwide banking systems over the past few decades.

Independent central bank
functions of the fed

Supplies the economy with currency

Provides payment-clearing systems

Holds depository institutions’ reserves

Acts as the government’s fiscal agent

Supervises depository institutions

Conducts monetary policy (the one thing the IMF believes should remain independent of government oversight and influence)

Intervenes in foreign currency markets

Acts as “lender of last resort”, thing of the past.

Functions of the Fed
fed in crisis

Lender of last resort was intended to be to fix problems of temporary illiquidity.

With a truly progressive tax structure that becomes prohibitive at a certain point, businesses produce spin-off companies to reduce tax liabilities. By breaking a single entity into numerous smaller companies:

More profits are taxed at a lower tax rate

Shareholders are happy as they now hold more shares of stock

Consumers benefit through increased competition

No business becomes “too big to fail” and poses a threat to taking down the entire economy.

IE General Motors breaks up into Cadillac, Chevrolet, GMC, and Buick, Ford spins off Lincoln and Mercury, and Chrysler spins off Dodge, Jeep, and Ram.

Fed in crisis

Many of these businesses depicted were actually stand alone companies before they were bought up by larger companies.

the fed fed the banks

“the Fed exerts too much control over the distribution of funds throughout the banking system and the broader economy.”

When we consider the hierarchical structure of the Federal Reserve System with the majority of funds and staffing coming from the banking system, is it any wonder that the Fed continues to distribute money to the banks and not the broader economy.

Systemic risks: Too big to fail has gotten worse, and a central bank independent of government oversight but not independent of member banks. Remember the quote by Jefferson earlier.

The fed fed the banks
fractional reserve banking

This is how banks “create” money.

Reserves: currently a minimum of 10% of transactions deposits to be held in reserve as vault cash or held with the federal reserve

Reserve ratio: Percentage of deposits held as reserves.

Open market operations: Buying (contractionery) and selling (expansionary) US government securities.

Fractional reserve banking
money multiplier

Potential money multiplier = 1/reserve ratio

Do not confuse the multiplier (Keynesian theory) with the money multiplier.

Banks play a key role in expansionary monetary policy, however, it is the responsibility of the Fed and regulators to make sure the banks behave responsibly.

Money multiplier
why not eliminate open market operations

This section brings up an interesting issue. The Fed COULD simply raise the reserve requirements of banks. Currently it varies between 0 and 10% depending on the size of the institution. 1992 change in reserve requirements from 12% to 10%.

The Fed has opted to pay banks interest to hold more in reserves. This is consistent with free market doctrine and is very good for the banks.

What is actually happening is that the banks are borrowing money from the Fed at .25% and either holding reserves at interest or buying government securities (lending it to the government) at 3-4%.

Why not eliminate open market operations?
bank runs and the fdic

Clearly, if a bank holds only 10% in cash in reserves (or even 50%) a bank run can be disastrous for even a healthy, responsibly run bank. The FDIC has prevented the bank runs that were so disastrous through the 1920s and 30s.

When the Great Depression first hit, Herbert Hoover followed the economic advice of his Treasury Secretary, Andrew Mellon and let the banks fail to “purge the rottenness out of the system”. This is a non-interventionest approach supported by faith in the infallibility of markets to correct themselves. The credit markets froze and severe deflation set in.

Bank runs and the FDIC
the fdic

The FDIC made savers (many who had already been burnt by a bank failure) more willing to take their money out of their mattresses and put it back into the banks.

The FDIC was one of many New Deal policies that kept the US economy stable and strong for 50 years prior to deregulation.

The textbook points to the FDIC as providing adverse selection and moral hazard leading to the greater risk being taken by banks.

The FDIC as the government-run insurer of deposits has a fiduciary responsibility to taxpayers and depositors to oversee the banks. With deregulation, the FDIC and other bank regulators have lost the authority to question bank practices.

2008 crisis

Not as many banks failed because they were bought up by other banks. Making the “too big to fail” banks even bigger.

2008 crisis
fdic asleep at the wheel

Insurance without paying premiums.

Higher capital requirements required following S&L crisis (response to a negative externality). Standards weakened.

Text suggests that it is the responsibility of depositors to monitor bank activities, this idea completely ignores the concept of asymmetric information. This fiduciary responsibility belongs with the FDIC. The FDIC needs to do its job.

Fdic asleep at the wheel
fdic entrepreneurs

This is an example of what political scientists call the revolving door. Former government officials utilizing their knowledge of loopholes in laws and rules they helped to write to grow wealthy.

They are charging a premium for taxpayer provided insurance. It is legal.

FDIC entrepreneurs
research project private insurers

AIG was a private insurer whose activities fueled the flame of the economic crisis through credit default swaps. Moral hazard exists when individuals working for an organization face no consequences as a result of their decisions. Executives at AIG made millions with no risk to themselves by selling credit default swaps. When it all unraveled, they kept their millions.

With the government depository insurance there is not a similar conflict of interest between the insurance organization and its employees.

Research project – private insurers