Banks and the Economy

Banks are a safe place to store money and get loans. What isn’t well understood is banks’ role in preventing depressions and pulling us out of recessions. Consequently, there is a great deal of misunderstanding about the 2008 Troubled Asset Relief Program (TARP) that bailed out big banks.

Historical background

The rationale for the TARP goes back to the 1930’s and the Great Depression. The stock market crashed in late 1929 and in four days lost 25% of its value. By early July 1932, the market lost 90% of its original value.

Franklin Roosevelt was elected in November 1932 and assumed office in January 1933. He and his Democratic majorities in Congress redefined government’s role in the US economy with their New Deal programs ranging from the Works Progress Administration to Social Security. A plethora of government programs sprang up and put many US citizens back to work. Unemployed workers got government jobs and spent money on food and other essentials. They theorized the people they bought from would spend the money restocking their stores and the cycle would continue and revitalize the economy.  These programs improved life for many in the US, yet unemployment remained in double digits until World War II engulfed us.

Table 1; US Unemployment Rate During the Great Depression

Year                 Unemployment Rate

1930                            8.7%

1932                            23.6%

1934                            21.7%

1936                            16.9%

1938                            19.0%

1940                            14.6%

1942                            4.7%
Source: Department of Labor

Banks to the rescue

Two economic mysteries that dumbfounded economists are:

  • What caused the Great Depression of 1929-1942
  • Why Roosevelt’s programs failed to end it.

Understanding the causes is important for preventing another devastating depression.  The most plausible explanation came from Milton Friedman, a conservative University of Chicago Nobel prize-winning economist who with Anna Jacobson Schwartz wrote A Monetary History of the United States, 1867-1960.

Friedman argued inept Federal Reserve Bank monetary policy was a major factor causing the Great Depression. When $30 billion in stock market value disappeared in 1929, the Federal Reserve should have acted to increase the money supply in our economy. Instead Fed policies lowered the money supply. The Depression became global because England, with the world’s second largest economy at the time, was on the Gold Standard. The Gold Standard, championed by the Chancellor of the Exchequer Winston Churchill in 1925, required all British currency be backed by gold. This made it impossible for Britain to increase their money supply.

While many think government increases the money supply by printing more currency, cash in the US only represents about 6 percent of the US money supply. In March 2014, the Federal Reserve estimates $1.19 trillion of cash in circulation. Approximately 1/2 to 2/3 is outside the US. The total amount of cash, checkable deposits and CDs is about $11.2 trillion. For a bit more perspective, the current stock value of all US companies is $18.7 trillion.

How banks increase the money supply

Banks and the Federal Reserve are the primary means to increase the amount of money in our economy. Following is a simple example of how this works. Banks are required to keep reserves. A bank with over $89 million of accounts must maintain 10% in reserves. Therefore, if they have loans outstanding of $100 million, they must have $10 million of reserves either in the bank or deposited with the Federal Reserve. (The Fed pays interest to the bank on reserves.)

Taking a hypothetical example, if a banker turns on her computer in the morning and finds an extra $2.5 million in deposits above the reserve requirement, she is anxious to generate more income from this money than the interest rate than the Fed is paying. By coincidence, one of the bank’s better customers walks in with a proposal to borrow $25 million for an expansion. If our banker decides to make the loan, she applies to the Federal Reserve and upon approval, the Fed deposits $25 million in the bank’s account. The bank now owes the Federal Reserve $25 million.

In this process, the Fed just created $25 million that did not exist a day earlier. No cash is printed. The bank deposits the newly created $25 million in the customer’s account. The customer will likely make electronic payments or use checks to pay contractors. No cash ever changes hands.

Start with this
Banks start out with this…

In the real world, our friendly banker might not have the necessary reserve on hand. Still wanting to make the loan, she would coordinate with a larger bank that would provide the extra reserve. In another case, she might have the reserve and want to make the loan, but this customer might be at the point where he represents a large part of the bank’s loan volume. Even though

Dollar-bills_4
Overnight Federal Reserve miracle.

this is an excellent customer, the large share of loans to one entity represents extra risk. Again, the local bank may ask a larger bank to help make the loan.

For the bank customer getting the loan, he will make principal and interest payments to the bank. The local bank will pay off their loan to the Federal Reserve and keep interest income above what the Fed charged them.

History repeating itself?

From June 2007 to March 2009, the stock value of US companies on the New York Stock Exchange dropped almost 50 percent translating into an $8 trillion loss for investors. In addition, US households saw the value of their homes drop $6 trillion.

The banking system was in shambles since the mega banks had taken huge financial hits with derivatives and other risky investments. They were in no position to make loans.  Consequently, the Fed’s ability to inject more capital into the economy was paralyzed.

The TARP funds provided mega banks the liquidity to make large loans and assist smaller banks in making their loans. The evaporation of $14 trillion of equity seemed eerily like 1929 repeating it self. The inability of banks to do anything in 2007 without the TARP was also reminiscent of the inactivity of 1929-30.

It is impossible to say TARP saved us from a financial meltdown or a depression. However, the risk was real and since the TARP money has all been repaid with interest, the downside risk of TARP turned out to be very small.

Fiscal and monetary policy

The US government can use fiscal or monetary policy to stimulate the economy. Roosevelt’s fiscal policy was large government spending programs. Fiscal policy also includes tax cuts. Research on this site, using data from 1980 forward, finds neither of these is particularly effective. (Tax Cuts and Budget Deficits, Not the AnswerSpending increases, the problem not the solution)

Monetary policy involves the Federal Reserve System and banks. The Federal Reserve can cut interest rates they charge banks to make borrowing more attractive for the customer contemplating getting a loan. Doing this more aggressively increases the money supply.

Summing-up

While liberals expect government to solve economic downturns (and all the other problems we have), the reality is much different. Fiscal policies, such as government spending increases, have limited impact. Tax cuts that cause bigger budget deficits are counter productive and slow economic growth and increase unemployment.

Banks and the Federal Reserve System play a vital part in keeping our economy healthy.  However, there are limitations. While more effective than fiscal policy, monetary policy can’t work miracles. At the height of the recession, even with interest rates near zero, companies were very hesitant to expand because demand was down for their products. Without loan demand, the Federal Reserve and banks can’t generate much increase in the money supply.

The bottom line here is the reality of the limitations of government power. The most effective tools to pull us out of recessions are truly conservative government fiscal management, banks and people optimistic enough about the future to borrow.


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