Financial Literacy: When a Bank Collapses

There has been so much debate about bank bailouts, and most people have nothing more than uninformed, generalized opinions on the subject, usually based on personal philosophies about the proper role of government in our nation’s economy. Bernanke and the Fed have maintained that the bailout was absolutely necessary in order to stop the economy from charging over a cliff. Is this what really happened? Or are the big banks an informal extension of the government already, and the taxpayers are routinely called upon to bail them out due to their poor business judgments? And if the latter is true, then surely such government “protection” creates a moral hazard in that the banks know  no matter how foolhardy or careless they may be,  when push comes to shove their survival is assured, i.e.  Big Business always gets saved by Big Government! Exactly how did the banks, particularly the Big Banks, get in so much trouble? How exactly was this related to the real estate bubble? Get part of the picture in this short video: Financial Literacy: When a Bank Collapses at

Financial Literacy: Deflation: When an Economy Implodes on Itself

As I have discussed in other posts, every good, service, and commodity has a value, and that value is denominated, or measured in terms of the national currency; in our case the value of anything is measured in dollars.  (Go to Billionaires Who Can’t Afford a Loaf of Bread  Even money has a value that fluctuates, and there are events that trigger changes in the value of money.  Money is measured by it’s purchasing power, and economists spell this with capital letters Purchasing Power (PP).  Money by itself has no value; it is only a symbol and a medium of exchange, so the real question is how much of anything can you exchange a dollar for??  I have covered what happens during a period of inflation, and the costs of everything as measured in dollars goes up, which means the value of the dollar (or its purchasing power) goes down.  People think they are better off with rising wages, but factoring in the decreased ability of those wages to purchase, they are actually worse off. 

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Deflation is the opposite.  During a period of deflation there is not enough money in circulation to buy the goods and services available.  Ironically one of the reasons for this could be that the population is nervous about their financial future and they start saving their money instead of spending it.  The money is there, but it is not in circulation, because people (and companies) are not in a mood to take risks.  When people aren’t buying, companies lay off employees, which contributes to the overall feeling of insecurity.  Because people aren’t buying, companies slow down manufacturing, and the amount of product they keep in inventory in their warehouse and distribution centers goes down and is not replaced.  In order to improve sales, they lower prices.  Since wages are the price of labor, that means the wages gradually go down also.  That means there is less money to spend, and the cycle feeds on itself.  In this way an entire economy can implode on itself.

Something needs to be said about the effects of inflation and deflation on debt at this point.  During times of inflation, prices (including wages, the price of labor) are going up; the purchasing power of those dollars is going down.  If you owe fixed-interest debt during a period of inflation, your wages will inflate with the rest of the economy, but your debt, which is fixed by contract with your creditor, remains the same.  That means you will be paying your debt back with cheap dollars, dollars that are worth less than they were when you incurred the debt.  During inflation, debt can be your friend, and the enemy of your creditor.

During deflation, however, debt is your enemy.  Your debt is once again, fixed by contract to a certain amount of dollars, but your wages, along with the rest of the economy, are deflating, or going down.  Your debt can hang you during a time of deflation.

Hear more about this at

Financial Literacy: Measuring the Mood of the Mob by the Price of Gold

At various times throughout history money, or currency, has been based on metals, usually silver or gold.  This created an objective value to the currency of the period.  A dollar, for example, was worth an ounce of gold, or 1/10 of an ounce of gold, or 1/20 of an ounce of gold.  Governments and rulers, who always want to spend more money than they take in, either for their own enrichment or in order to bribe voters, usually try to debase their currency.  Kings about once a generation used to re-mint their coins (paper currency wasn’t invented yet), using the need to have their own image on the coin as the excuse, and they would dilute the gold content by mixing other metals with the gold, or slightly downsize the coin itself, but calling it by the same name as its predecessor.  When governments became well established, they usually did a ‘bait and switch’ routine and substituted printed money for metal coin, and again called it by the same name attached to a unit of its metal predecessor.  So a gold dollar was now called a paper dollar, as if their value were the same!

Once governments discovered the delights of the printing press, they would print as much money as they felt they could slip past their gullible and unaware subjects.  Acceptance by the herd was essential, and when the debased currency was widely rejected, it was not uncommon for a ruler to create stiff penalties, including the death penalty, for not accepting the paper currency as legal tender.  The reason governments prefer to print money is first of all so they are not bound by the usual principles of fiscal discipline (Don’t spend more than you make) but also every time they print money, they are actually lowering the unit value of that currency, reducing its purchasing power.  They are actually picking the pockets of their citizens, especially the most conservative ones who save.  The money these citizens save will not buy as much when it is finally spent as it would have immediately upon their having received it.

When citizens get nervous about the stability of the banking system, their political system, or their own personal safety, they are inclined to buy gold.  Gold does not pay interest, and it is still only worth what a buyer is willing to pay for it, but because there is a fixed quantity of it at any given point in time, its value tends to be very stable.  This is why nervous people buy gold as a hedge against inflation.  Gold is not without risk, however.  At times when the madding crowd is enamored of another of its periodic manias, interest in gold will wane as the herd stampedes in a new direction.  When demand falls off, the price of gold drops, like anything else.  Even in times of rising price of gold, there is always the possibility of the government confiscating it (that has been done by OUR government, as well as many others.)  Ultimately the government has the guns, and whatever we have is pretty much by permission.  A democracy, as I have written many times, is no guarantee of anything more than mob rule.  All people, in any period of history, need protected most from those they elect over themselves.  Inevitably their public servants become their masters.  Even here, the freest nation on earth, the Constitution guaranteeing both individual rights and the limitation of government’s powers, has been under steady attack for well over a hundred years by many activists who resent its restrictions.  They want to harness the coercive power of government to an endless list of programs to protect us from ourselves, and of course, with them at the levers of distribution and power.

For a short video on how the price of gold is a measure of the mood of the mob, go to

Financial Literacy: Why Governments Secretly Like Inflation

The dirty secret of all governments is that contrary to popular opinion, they do not hate inflation.  All governmental corruption begins when they discover the power of the purse, and that they can use the public purse to perpetuate their power, privilege, and benefits.  Over time all legislators and power brokers arrogate to themselves the means to stay in office and the luxuries it affords at the general taxpayer’s expense.  So of course we hear how the purpose of the Federal Reserve and Congress is to maintain a strict control over inflation, that the Fed is independent of the government, and that it is immune to political influence.  At best this is a Trojan horse.  Inflation is the primary tool used by every government to live beyond its means, and by its “means” we mean its ability to tax.  For taxation is the Achilles heel of all governments, for carried to excess it inspires armed revolution and fall from power.  Governments raise taxes at their peril.  Inflation, however, is a hidden tax, for it is how the government spends and borrows beyond its ability to repay.  By printing money and increasing credit, thereby increasing the money supply, the government creates inflation.  How does this happen?

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When there is X amount of money in circulation in an economy chasing Y amount of goods and services, and you increase X to 2X chasing the same Y amount of goods and services, you have increased demand for those goods and services, but you have not changed the supply of them.  When demand outstrips supply, the general price level rises.  The rise in prices is a result of manipulating the money supply, NOT by an increase in productivity.  In other words, the increase in the money supply is NOT the same thing as an increase in wealth.  It is an artificial increase that may give everyone a case of the warm fuzzies, until they realize their pockets have been picked while they were celebrating!  This is what happened in the last ten years during the “real estate bubble’.  Millions were celebrating their rapid rise in wealth, and we were saturated with boastful claims of “instant equity”.  What we had was hyperinflation of real estate prices but no increase in underlying wealth.  It was a bubble, and it contained only air, no wealth.  Taxing authorities were flush with new revenue from the inflated values of real estate, and the money poured in.  Politicians were ecstatic, and plans for distributing  the tax revenue to friends and benefactors proliferated.  Everyone was having a great time at the party.  The last ones to leave got stuck with the clean-up.  Governments went from riches to rags over night.  The Fed cranked up the printing presses as their only resort.  People weren’t spending, the taxable base was shriveling like a late-harvest grape in the hot sun, and governments everywhere started warning about necessary cut-backs in services.  And the homeowners, well they have inflated mortgages and inflated property taxes, and deflated value.  They were taxed all right, but by stealth.

If the government had tried, during the peak of the bubble, to raise comparable amounts of revenue through increases in taxation, there would have been riots in the streets.  But the inflation they created by expanding credit markets, was in fact a very clever, hidden tax.  Incredibly, the governments response to the crisis has been,  once again, to expand the money supply.  The inflationary impact of all the newly printed money they have injected into the system is muted, for the moment, by the lag in spending and the poor demand for goods.  But the expanded money supply is out there, lurking comfortably in the books of the banks afraid to acknowledge and write off all the toxic loans of the boom years.    The banks have used the money to shore up their sagging balance sheets, just in case, and the public has decided to save rather than spend.  The economy is lurching like a schizophrenic paranoid between euphoria and deep depression.  The surface temperature of the economy says we are recovering, but further analysis says the virus is still with us.  The government maintains,  like a modern gestalt therapist, that if we all believe we are well, we can transform belief into reality.  Therefore we all need to put on a happy face and spend, spend, spend our way out of the malaise.  The money supply is the lifeblood of our economy.  Believing that we are hoarding the money supply like bad children  the government has applied leeches to relieve the pressure, and to get the excess blood out and into circulation.  So it has borrowed and printed money for bailouts for banks and tax payers, cash for clunkers, and nationalizing whole industries.  Like a drunk conductor at the wheel of a runaway train, there is nothing that Big Government cannot do, cannot fix.  Why didn’t anyone ever think of this before—when there is a downturn due to previous bad policy, the solution is to print your way to prosperity.  Remember twenty years ago when it was “The economy, stupid!”; well, now its “The money supply, stupid!”

The good news is the bad news.  As the economy staggers uncertainly toward a seeming full recovery, the excess money that has been pumped into the system and has been lurking out of sight in the banks will finally have its much delayed impact when it finds its way into the economy.  The Fed operation was a success; unfortunately the patient died.  As the government lurches  madly between transfusions and leeches, between the silent killer of inflation and the bludgeon blows of direct taxation and deflation, eventually in frustration and exhaustion and confusion we will do what all very ill patients do–put our lives and our destinies in the hands of the doctor.  For after all, the doctor knows best, right?  And at the end of the day, there won’t even be any ambulance chasers to file malpractice lawsuits.  It’s illegal to sue your government.  Why?  For starters, they have the guns.

For a brief video on why inflation permits the government to “repay” the national debt at a huge discount, go to

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 . . .

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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:

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.

Financial Literacy: The Origins of Banking

Financial Literacy: The Origins of Banking

Financial Literacy: Billionaires who can’t afford to buy a loaf of bread.

by on August 3, 2009
in Economics, money

Everything has a “trading value” and it is expressed as a price.  This includes the value of human labor, regardless of whether it is of the menial type, such as hammering nails, or intellectual labor, such as a performing rock star or a concert pianist or a novelist or a scientist.  The value of any given labor is determined by those who purchase the product of that labor, i.e. a newly constructed house, a repaired dishwasher, going to a movie, or a new prescription drug developed through scientific research.  The value of all labor is expressed as a price.  The price of labor is its compensation, whether in the form of hourly wages, salary, commissions, royalties, percentages of sales or profits, or whatever.

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Even money has a value, and like every other traded commodity, the price of money fluctuates.  The reason for this is that money has no intrinsic value; it has no value in, and of, itself.  The only value of money is in its function as a medium of exchange.  The value of money is measured by its Purchasing Power (PP).  Obviously there is a big difference between a dollar that will buy you a whole loaf of bread and a dollar that will only buy you two slices of bread. 

The value of money, i.e. it’s Purchasing Power, goes down as prices go up.  Again, if the price of a loaf of bread went from $1 to $2, one dollar now only has the ability to purchase 1/2 loaf of bread.  This is called inflation.  Inflation debases, or reduces the Purchasing Power of the dollar.  When the price of labor inflates, wages go up, but the wage earners standard of living does not go up, because the Purchasing Power of every dollar of his wages went down.  Continually increasing wages is always a part of an overall inflationary spiral, where the price of everything goes up, and the value or purchasing power of the currency goes down.

The key to improving the overall standard of living is not by raising wages, but by raising productivity.  Then the cost of everything goes down in real terms, and every dollar trades for greater amounts of goods and services.  An increase in productivity results in raising the Purchasing Power of your dollar.  This is not inflation.  This is real growth.  Increases in productivity are achieved, not because people work harder, but because technology automates more and more activities.  Human labor is still required, but more goods are produced for every hour of input.

A grasp of this concept will help you to appreciate why government’s insistence on periodically raising the minimum wage does not improve anyone’s lot in life.  It temporarily and artificially inflates the price of labor without any matching rise in productivity.  It raises wages as measured in dollars, but without raising the Purchasing Power of those dollars, it only succeeds in devaluing or cheapening those dollars.  Minimum wage legislation is nothing more than a cheap, symbolic gesture to buy votes, and it contributes to an inflationary spiral.  Legislating an increase in the price of labor is no different than legislating a lower price of bread; they are efforts to force trading at fixed prices, rather than letting the prices fluctuate according to the agreements arranged between two or more free trading partners.  When governments attempt to force trading and fix prices, they create “black markets” which is where people do what they really want to do anyway.  When governments legislate minimum wages, one of the unanticipated results is frequently people buying and selling their time and services “under the table”.  This is a form of a “black market”.

So remember, when dollars go up, productivity must also go up, or your dollars become worth less in their ability to purchase.  How rich would you feel with a wheelbarrow load of dollars that didn’t have enough purchasing power to buy a single loaf of bread?  This type of thing has already happened!  Listen to it here

Financial Literacy: The Money Supply and Inflation

Financial Literacy: The Money Supply and Inflation

Financial Literacy: Good Money, Bad Money

Financial Literacy: Good Money, Bad Money

Financial Literacy: How Big is a Trillion?

Financial Literacy: How Big is a Trillion?

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