Sunday, February 01, 2009

Saving Part 3: The Banks

Last week, I asked, where does the new money come from? Where does the wealth it procures go? I'll start with something I think all agree is not a beneficial practice: outright counterfeiting.

It's simple: just print something which can pass for the things printed up at the US Bureau of Printing and Engraving, and then use it to buy stuff. Who loses? If it's a particularly bad forgery and they spend it in through particularly foolish marks, probably that first victim: this person then takes it to the grocery store or something, which uses their methods for detecting counterfeit bills, and they refuse to take it. The counterfeiter has conned only one person, and stolen from only that one person.

But there are very likely better counterfeiters whose creations might circulate through considerably more hands before they are discovered... if ever. No one person is defrauded in this case, though obviously, someone has been. In truth, everybody has been; the ill-gotten wealth is taken not from any individual particularly, but from the common stock of wealth generally. Every false bill that enters circulation withdraws something from this stock, without first adding anything to it. Every false bill that enters circulation makes everyone else just that much poorer.

Fact: the number of "dollars" circulating through the economy in one form or another (mostly electronic) increases over the long term, and it very rarely decreases in the short term. Where do the new dollars come from? In the following paragraphs, I will describe the mechanics of monetary expansion, and leave the judgment as to whether or not this is justified to the reader.

One agency that introduces new money is the banks. Banks are permitted by law to loan out more money than they have on deposit. The amount the bank must have either in their vault on on deposit with a Federal Reserve Bank is determined by the Federal Open Markets Committee, but for the purpose of this illustration I will assume a 10% reserve requirement. What this means is that if you deposit $100 at the bank, they are now allowed to loan out an additional $900. They do this by simply creating an account that says "I have $900 in me." There is, of course, only safe if the depositors do not attempt to withdraw more than 10% of the amount the bank owes them... which is what happened to IndyMac last July. There was a time when such a failure would destroy not only the bank, but the money the depositors thought they had. These days the FDIC, backed by tax dollars should they run out of money, ensures that the depositors do not lose their money.

Now, the banks' contribution to monetary expansion is not uniformly upward, but rather somewhat cyclical. Were it not for the business cycle (economic growth and recession), the money supply would grow, plateau, and then not grow any more. Who would benefit from this growth? The answer is that those who borrowed and spent money earlier in this growth would benefit more than those who borrowed and spent it later, with those not borrowing getting the shaft. Much like the counterfeiter, the early borrower gets to spend the money before knowledge of the existence of this new money is dispersed through the market... that is to say, before prices rise (or slow their decrease) in response to this new money being spent in. Unlike the counterfeiter, the borrower has to pay interest on this new money, and must pay it back, but he gets to spend it when it is worth more, and pay it back when it is worth less... meaning he gets more out of it than he puts back in. He gets it from later borrowers to a later extent, and non-borrowers to a greater extent. Additionally, the banks themselves get to collect another portion of the increased productivity that can result from additional investment in the form of interest, some of which goes to depositors, some of which goes to the bank's investors.

Note that this serves, during the increase, as an incentive to borrow and a disincentive to save.

The reality of the business cycle, however, ensures that the banks' contribution doesn't plateau, but rather cycles. During the boom, they lend out more money. During the recession, they concern themselves primarily with getting loans paid back, and are less inclined to loan (because people seem less likely to pay them back). And just as lending against a fractional reserve adds more money to the economy, that same loan being paid back removes it. So long as loans are being made and paid back at the same rate, the overall quantity of money does not increase. But the reality is that there are times when there is more lending than repayment (the boom), and times when there is more repayment than lending (the bust, or "recession"). (I won't be talking about the cause of the business cycle here, but for my preferred explanations google "Austrian Business Cycle Theory" and "Land Market Cycle".)

So our economy goes (or rather would go, if the Federal Reserve allowed it) through periods where the banks expand the money supply, and periods where they contract it. Those who exploit this system wisely can profit from increased money, and avoid the dropping prices that result from reduced money (as those who got out at the top of the recent housing boom did) at the expense of those to whom they sold it. It's rather like an exceptionally successful counterfeiting ring who manage to unload large quantities of exquisitely crafted fake money onto suckers, enjoy what they've already bought as everyone else's prices rise in response... then sell their stuff for real money right as the forgeries begin to to be discovered and removed, but before the prices begin to return to their original levels in response... and THEN buy yet again, at the lower prices.

These days, however, the money supply is rarely allowed to truly decrease (though money is continually injected into and removed from this speculative market or that as the fads change, causing volatile price changes over the short term... as was the case when the banks significantly loosened criteria for lending against real estate... and then suddenly tightened them again). The Federal Reserve System also has ways of manipulating the money supply, by manipulating the base against which the banks lend. And while, given a fixed base, the banks could theoretically plateau at a new level and never increase again; the Federal Reserve has ways to constantly increase the base... and does, to the benefit of a different set of parties.

The Federal Reserve's role will be next week's topic.

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