Weaknesses of Fractional Reserve Lending

There are some negative features in this system.

  1. It is not stable. The banks say your money is safe and it is your money, so is available to you, but that is not fully true. Banks lend out a sizable amount, so do not have all of your money available to you. The government does not have direct control over the money they issue, but can implement some rules to somewhat manage the money.                                  Say one of the banks makes a bad investment, or worse, some money is embezzled, so now they cannot pay out the money you ask for.  You do not have faith in the bank anymore, you read about it in the newspaper and other people start to demand their money, too. Even though the other banks are solid, people start to question those and start taking out money from there as well. That is where the FDIC comes in. It is a government agency which steps in and provides insurance to banks. The money a bank client asks for, will ultimately be provided through this insurance policy.
  2. Bad incentives. Because the bank is insured by this FDIC policy, the customer is not too concerned with how the bank invests its money, so there is no accountability necessary toward the customer, as to whether the bank is making good loans or bad loans.             Banks can issue sub-prime loans to people who cannot really afford that house. It is not just the sub-prime loans that cause financial problems, but more so the ease with which the banks “offer” all kinds of incentives so people will buy whether it is wise or not.
  3. Lending money. The banking system has a lot of control over the money. When the economy is doing well the banks will distribute more money into the lending supply. The opposite is true as well: when the economy is weak it can turn into a recession. Businesses will ask for less money in the form of loans, etc. But in a recession the economy really needs more money so people will buy more again. The Federal government will print more money. However, that is only half of the equation, when in fact, the banks provide less lending, being scared because of the recession. In reality, when you want to get more money into circulation the opposite is happening. When there is a boom and you want to slow down the economy, the opposite is also happening. Because of the boom, more money is entering the market place. To temper an overheated economy, the government can sell more securities and take the money it receives for them, out of circulation.

This is not some law of economics. It is a system, but not the only system, although the most common in many countries.

Sal really explains this very well with a diagram in The Monetary System class of the Khan Academy:

weaknesses-reserve-banking

My challenge to you:    Take time to study this diagram, and see if you can explain it to a friend!

Fractional Reserve Banking

How does our banking system work, and why bring that up? The most common banking system used by most countries is the Fractional Reserve System. This is explained very well in the Khan Academy class of the monetary system. It is not a perfect system but needs to be explained for understanding because national debt is related to it. Here is a diagram again from the Khan Academy:

overview-reserve-banking

How does the money, that the Central Bank prints, get circulated? For simplicity, say the Central Bank prints three dollars, or three units, if you will. We have a system whereby the government sells securities, often in the form of bonds. Whoever has those securities can sell them and deposit that money in a bank. The money can also physically or electronically be transferred to a bank. Say, someone owns securities (the 3 yellow rectangles on the borrow left), sells those and deposits the money in a bank, or the bank obtains dollars from the Central Bank. I will skip the details of that process for now. The bank, let’s say receives $3 (the green rectangles in the diagram) from someone who sells securities. So now the individual can access his / her money from the bank (the “bank” with the 3 dollar bills). But the bank does not keep all $3, because it assumes the individual will not access all $3 at once, so it reinvests most of that money, even though it will tell the depositor that his money is safe and will be accessible. In reality a bank only has to keep about 10% available to its customers. This % fluctuates.

Whoever buys those securities may not use all of it, or buy a car and the dealership deposits that money in a bank. This is shown as the second “bank” with two dollar bills. That bank reinvests, say, $1 and the same thing happens all over again. So, the three dollars, or units, printed by the Central Bank now have multiplied to six dollars (fractional).

The bank issues checks. Say I want to buy an apple which costs $1. I can write a check for $1 (Yellow rectangle left of the apple) and give that to the vendor, who in turn deposits that back in the bank into his account. Only a paper transaction has taken place: my account has been reduced by $1 and the apple vendor’s account, increased by $1. So the original $1 printed by the Central Bank does not even come into play!

The point of this exercise, is to show that the government has limited control over the money it prints. To reduce the $$ in circulation, the government can sell the securities, and keep the money they receive out of circulation to reduce the money supply, thus reducing the amount of lending by the banks. The government can also buy securities and take that money and put it into circulation, so the banks can increase their lending portfolio.

There are also some drawbacks about the system, but that will be for another blog.

 

Emotional Economics

The business cycle can also be expressed in an emotional format. The Khan Academy came up with the diagram below:

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When we believe things are looking up economically, we get a sense of optimism which gives us confidence everything will be all right. That turns into excitement when things keep going well. Gas prices drop, we hear that there is less unemployment, and other factors. That turns our excitement into thrill and that increases our confidence. We start looking what our contribution may have been to this movement, or how we can contribute. Now we can buy that dining room set we always wanted, or maybe even that car as advertised on TV! Our thrill turns into euphoria. Companies start investing capital in more tools and machines to expand production. Then we see prices rising, first because production cannot keep with demand, followed by an overheated economy. The Fed already has reduced interest rates to almost 0% and now is redirecting it upwards again to take the steam out of the economy. People are laid off here and there, causing some anxiety among the rest of us. It becomes clear that we have an overproduction and people are getting into more debt. Industry and governments are still in denial if we have to believe the fervent advertisements: “Now is the time to buy your dream house before interest rates go up again!” is the slogan. “Don’t worry if your mortgage payments are a bit high, your home value will only go up, so you’ll be ok.” But more people are losing their job and gas prices are creeping up. The population is getting  fearful. People are pulling back and delaying that couch set purchase. Production is decreasing a bit more with all the consequences that come with it. People who lost their job can barely keep up with their mortgage payments and are becoming desperate. Banks are starting to issue notices for those who are 2-3 months behind in their mortgage payments. All of a sudden housing values are not so important anymore because no one can afford to “upgrade.”  The richer among us also stop paying mortgages, because those prices “were ridiculous to begin with”. The banks don’t dare evacuate them for fear of property being destroyed or stolen so they can stay in their “castle” even if they do not pay the mortgage for 6-8 months, or longer!  Panic sets in, interest rates drop to zero % and housing prices start to drop. More foreclosures. Some capitulate, just leave their home and drop off the key at their bank. Despondency sets in and the homeless are becoming more visible. The editorial pages have more articles about depression. The Fed buys up mortgages to keep the economy going, banks get all kinds of relief. No matter that the banks contributed to this mess in the first place by offering mortgages to just anyone at the peak of the cycle, they are not held responsible; no CEO’s are fired!

Gradually we see a glimmer of hope. Companies have cut back enough to survive the recession, Wall Street is showing some growth again and international markets are following. We may not like it, but China’s economy is surging because they don’t want to lose the dollar value, since they have a lot of them. They can now invest them in California properties 🙂 Relief sets in followed by optimism, and the cycle starts all over again.

 

booming-new-home-sales

      Realtors are telling us the housing market is “booming” again. The graph on the left of new housing construction does not seem to support that. Ever since coming to the USA in 1967, realtors always say: “Now is the best time to buy!”

What emotional stage do you believe we are in, at the end of 2014?

Principle I: Teach your children the difference between (National) Debt and cultural habits.

That is easy to say, but how do we do it in a society where we are bombarded with offers to buy, and where many households are far in debt, teaching children that debt does not matter?

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Before 2009 48% of households carried debt. Then it dropped and came back up again to 47%. The average debt dropped from $29,000 to $25,480 but not because people were paying off debt at a faster pace, but because banks closed out accounts. With these kind of statistics, how do we have a chance of teaching children the difference between debt and cultural habits?

By teaching our children economics, and how politics plays a role.

 Let me recap where we have been so far in the search of whether national debt is a big issue or not:

  1. Is debt a bad thing? I have given examples of debt in business, government, and individual debt.
  2. Government debt is twofold: a city can go bankrupt and so could a state, but the national government can stay afloat a bit longer by printing money.
  3. Social Security is not part of the budget, but is an entity of its own, getting financed separately. But it is an entitlement, which puts it high on the moral list in the American culture.
  4. I touched on aggregate demand, and where foreign exchange fits in.
  5. A business cycle is not very difficult to understand. It is based on how confidence in the market (Wall Street) and government fluctuates.
  6. How National Debt has  been on an astronomical increase, regardless of which political party was in office, either the Presidency and / or Congress.
  7. How culturally we have changed to the price-someone-is-willing-to-pay from cost-plus-reasonable-profits-to-stay-in- business, and regarding personal debt as being “normal” without worrying too much about the consequences.

I’ve described the business cycle, but not yet how emotions follow that.

What kind of banking system do we use? Are there more than one?

More about all that in the next weeks!