Financial Literacy: How Fractional Reserve Banking Multiplies the Money Supply

One of the reasons why so few people show an interest in economics is that in today’s world the subject is complex and defies simplistic definitions.  But that is so true of much of our modern society.  It is not uncommon these days for older folks to refuse to learn e-mail and to shake their heads in wonderment at their grandchildren deftly manipulating electronic hand-held games totally beyond the grasp of their elders.  What IS of grave concern is the fact that the achievements of our scientists and engineers have aided and abetted the dumbing down of successive generations.  We have heard much of the income gaps in our society; we hear much less about the widening chasm between the educational level of the designers and engineers of our world and the end-users of our world.  Not to mention the grade inflation of our educational system.  Hence we sometimes find students in Advance Placement who still cannot read and write well.  I would be remiss in my duty to you, my reader, to imply that you can understand the economic world you live in without effort.  There are times when you will still have to reach for the dictionary, and hopefully you have several in your home, and even more hopefully, they are well worn and used!  Or more likely, you have an online dictionary marked as a favorite.  Even though I exert considerable effort to simplify and clarify an otherwise arcane and difficult subject, I would suspect that my articles have little appeal to those addicted to instant gratification.  I simply do not know how to reduce some concepts to a sound byte level.  Take for example, the concept of the money supply. 

The money supply is a very important concept with those entrusted with the well-being of our macro-economy (the BIG picture).  There are, for example, endless arguments among economists about what properly constitutes the money supply.  We’ll skip most of that stuff and stick to essentials.  Let’s start with the fact that in the profession and in the media, the money supply is referred to as M.  Yep, that’s it, M as in Mickey Mouse, Mars bars, or of course, M&Ms.  To me, the latter connotes Money and Masochism, which sort of go together.  Of course, economists talk of M1, M2, M1a, etc.  That is largely to impress us.  Or maybe to impress themselves.  It has absolutely no effect on the accuracy of their predictions.    But it seems to be a requirement imposed upon all financial advisors and analysts to use jargon composed of largely a minimum of four or more syllables per word to convince us that, like all priesthoods, they know what we cannot possible grasp with our feeble minds.  But let us bravely press on . . .

The money supply is important, because money is a commodity like everything else, and is therefore subject to the laws of supply and demand.  You no doubt have a firm handle on the concept of money supply in your micro-economy.  You hopefully know how much money is in your wallet, and in your checking account, and under your mattress.   You intuitively know how much money to count, and you intuitively know how liquid it is.  The green stuff in your wallet is very liquid; the money in your checking account is immediately accessible through your debit card, and the $100 Uncle Fred owes you, well, probably better not count that.   And you know you can’t touch that CD of yours for at least another 45 days without a severe penalty.  Not liquid.  You’ve got it.  You do know the importance of counting all this stuff, and on any given day you have a pretty good idea what’s there. 

You may have noticed that the money whips in and out of your wallet (and your life) pretty quickly.  That’s called the velocity of money.  If you think velocity isn’t important, think about how you’d feel if your employer delayed your paycheck a week or two—just because he wanted to slow time down a little.  Why does velocity matter to you?  Because you have bills to pay and commitments to keep, and time is of the essence.  You may have noticed that your creditors share this obsession of yours with time.  That’s another important concept, that there is a time value to money.  You’re getting it.  You’re almost an economist now!  Now have you ever wondered how many different people have used the same twenty dollar bill you just spent at the grocery store?  What does the grocery store do with it, and who gets it next, and how many times will it change hands over and over again in, say, the next week?  month?  year?  That twenty dollar bill is part of the money supply, and the speed with which it changes hands is called its velocity.  Economists try to total up all such money in circulation, and they try to predict the likeliest outcome if it grows or shrinks.

Just as with you, the money supply in the macro-economy changes with dizzying rapidity.  There are things that governments can do with the money supply that make it grow or shrink.   Governments and politicians think voters will love them more if they can control what an economy does, or at least make it look like they are controlling it.  Mostly they try to control what people think they are doing.  They get very good at taking the credit for good things that happen, and passing the buck on bad things that happen.  They practice looking statesman-like a lot.  After a while, people get to thinking that government people are responsible for everything, good and bad, that happens to them.  Politicians know this, and they don’t want to lose their jobs.  Because of their jobs they get invited to the best parties, and sometimes get free trips to strange places.  And they get great benefits.  Sometimes it frightens politicians that some of their voters might understand some of this economic stuff a little better than they do.  It doesn’t present well before the cameras.  Have you ever noticed how photogenic most of our politicians are?  We want our politicians to look statesman-like.  Even if they were a C- student in school. 

Now let’s add another term to our economics vocabulary:  fractional reserve banking.  This means exactly what it looks like.  The banks are required to keep back, in reserve, a percentage of all the deposits they take in.  Banks make their money by taking other people’s money in, and then loaning it out with interest.  They are not allowed to loan everything out that they took in.  They have to keep part of it in the back room, out of use.  They know (most of the time) that everyone is not going to walk in and ask for all of their money at one time.  So if they keep 10% or so back, that is usually enough to cover the withdrawals by their depositors at any given time.  Not everyone who takes out a loan actually repays it.  Some default on their loans.  If someone defaults on a $10,000 loan, fractional reserve banking works in reverse.  That $10,000 belonged to depositors, and now that it is gone, it reduces the bank’s ability to loan by ten times that amount, or $100,000!  Remember all those foreclosures?  Those were all bad loans.  But the banks don’t want to write them off as bad loans on their books.  Each of those bad loans reduces the banks ability to loan by a multiple of ten!  As a matter of fact, when the bank adds up all the bad loans and multiplies by ten, it may discover it doesn’t have enough in reserve now to cover its good loans.  That means the bank is insolvent and by all rights should go out of business.

Those bad mortgages have collateral, the properties against which the money was borrowed.  But the market price of real estate has dropped precipitously, and the properties are now worth 1/4 or 1/3 less than what was borrowed in many cases.  No one really knows what those properties are worth until they are sold on the market.  Buyers and Sellers together set the price.  But once the property is sold, the bank has no choice but to use the sale price of the property as the number they have to use to determine how much money they lost on the loan.  If they loaned $100,000 against a property, and it sells for $60,000 at auction, the bank has to write off the difference, or $40,000.  That means the bank has to either shrink their outstanding loans by $400,000 (factor of ten), or they must increase their reserves by $40,000.  Since nobody knows how many bad loans are out there, and nobody knows how much money will be lost on each one of them, no one really knows how many banks, or which banks, will be insolvent and go out of business.  The government gave the banks (some banks) a lot of money, but the banks are keeping that money in the back room to add to their reserves.  That means they can’t use that money to increase lending.  And if the banks aren’t lending, credit is more or less frozen, and if businesses and households cannot borrow, the economy freezes up, unemployment goes up, and voters get very unhappy and nervous.

The banks, and the government, have found some solutions.  One is to deny.  They do this by simply changing their accounting rules.  Instead of calculating what the properties are  worth at current sale prices (called marking to market) they write down the loans based on these properties to an artifically selected number that is less painful than the market numbers.  In other words its a game called Pretend.  If we pretend we didn’t lose that much money, we didn’t.  And if we didn’t lose that much money, then our bank doesn’t have to raise our reserves quite so much.  Secondly, the government decides which banks get to go out of business.  Friends and big campaign contributors get special, preferential treatment.  Third, the government will buy the toxic assets (bad loans).  They will sell Treasury Notes (how the government borrows) and also print money to pay for the toxic assets.  The money that is printed increases the money supply.  As that new money finds its way into the economy, it grows through the fractional reserve system of banking.  Listen to an explanation of how that works here:  http://www.youtube.com/watch?v=d-vYzQvfAAs.

We are going to talk a lot more about the money supply,  because the Federal Reserve tries to control the economy by manipulating the money supply.

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