Professional Documents
Culture Documents
January, 2009
(preliminary version, not for general distribution)
c
Cover art: “Gold Standard” !2004 by Damon A. H. Denys
Used with the artist’s permission and with the cooperation of
Quent Cordair Fine Art, Napa, CA
www.cordair.com
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Contents
1 What is Money? 1
1.1 Spontaneous Order . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Indirect Exchange and the Emergence of Money . . . . . . . 4
1.3 Subsidiary Functions of Money . . . . . . . . . . . . . . . . . 14
1.3.1 Unit of Account . . . . . . . . . . . . . . . . . . . . . 14
1.3.2 Store of Value . . . . . . . . . . . . . . . . . . . . . . . 16
1.3.3 Standard of Deferred Payment . . . . . . . . . . . . . 17
1.4 Credit Cards, Debit Cards, and Smart Cards . . . . . . . . . 18
1.5 Where is Money? . . . . . . . . . . . . . . . . . . . . . . . . . 19
1.6 The cashless society . . . . . . . . . . . . . . . . . . . . . . . 20
1.7 Money in modern society . . . . . . . . . . . . . . . . . . . . 20
1.8 Important terms and concepts . . . . . . . . . . . . . . . . . . 20
1.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
iii
iv CONTENTS
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CONTENTS v
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vi CONTENTS
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CONTENTS vii
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viii CONTENTS
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List of Figures
5.1 Amazon.com had negative net worth during its early growth
years. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
5.2 The flow of funds . . . . . . . . . . . . . . . . . . . . . . . . . 80
5.3 Supply and demand of loanable funds . . . . . . . . . . . . . 82
5.4 Transaction costs drive a wedge between interest paid and
interest received. . . . . . . . . . . . . . . . . . . . . . . . . . 85
6.1 Gold bullion stored in the warehouse of the SPDR Gold Shares
Trust. The bars each contain 400 ounces of gold, valued at
about a third of a million dollars. . . . . . . . . . . . . . . . . 94
6.2 Federal Reserve assets for year-end 2007 and 2008. . . . . . . 105
6.3 Federal Reserve liabilities for year-end 2007 and 2008. . . . . 107
6.4 Gold note issued by a private bank, 1874 . . . . . . . . . . . . 108
ix
x LIST OF FIGURES
9.1 Traders on the floor of the New York Stock Exchange . . . . 157
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List of Tables
xi
xii LIST OF TABLES
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Some basic principles of
economics
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xiv Some Basic Principles
are scarce, meaning we cannot get some without giving up something else.
Opportunity cost is what we give up to acquire a scarce good or ser-
vice.
Subjective value is a corollary of human actions that the value of a
good or service does not inhere in that good or service but rather in the mind
of the person evaluating it. The same good or services are valued differently
people, and for by the same person at different times. Values are revealed
by action and are ranked, so that only ordinal numbers can be applied to
them. Market prices, by contrast, are objective and measured by means of
money prices.
Coercion is the use or threat of violent action, usually directed against
another person in order to induce an action which that person would not
freely choose. Two forms of coercion may be distinguished: initiated and
retaliatory.
A government is a group of people that holds a monopoly of the use of
force in a particular territory, which monopoly is at least passively accepted
by the majority of the inhabitants of that territory.
Market failure, government failure. Market failure is the idea that
free markets produce outcomes that are undesirable by some standard, and
must be corrected by government action. Government failure is the idea
that such programs may fail to achieve the intended result or even make
things worse.
Normative and positive statements: a positive statement is a state-
ment about what is, or what would be in some situation. The statement
may be correct or not, but it is at least open to objective analysis. A nor-
mative statement is a statement about what should be in some situation,
and is presumed to be exempt from objective analysis.
Gains from trade stem from the recognition that people choose to act
because they expect to be better off, and therefore when we observe people
trading without coercion, we must assume that both expect to gain from
the trade.
Law of demand, law of supply. Each additional unit of a good or
service that we acquire is used to satisfy the most urgent unfulfilled need
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LIST OF TABLES xv
which that good can satisfy. From this follows the law of demand which
says that as the price of a good increases, the quantity demanded decreases,
other things being equal. Likewise, supplier supply more of a good as the
price increases.
Elasticity refers to the price sensitivity of buyers and sellers in a par-
ticular market. When many buyers leave a market in response to a price
increase, their demand is said to be elastic. If most continue to buy in spite
of price increases, their demand is inelastic. The same concepts apply to the
responsiveness of sellers to price changes.
Stock and flow. The stock of a good is the amount that is present
some place and some particular time, while the flow of that good is the rate
at which the stock is increasing or decreasing. One’s assets, for example,
are a stock, while one’s income is a flow. Because the flow of goods is not
nearly as continuous as the flow of fluids in physics, economic flows are often
expressed as amounts which have flowed during a particular time period.
Interest payments, for example, are usually understood to be amount that
flows in one year, as are GDP and many other flows.
Public interest, public choice. The public choice viewpoint of the
actions of government agents emphasizes the incentives that such people face
and how those incentives are likely to influence their actions. By contrast,
the public interest point of view is the popular but naive assumption that
government agents always adhere to “the public interest.’
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xvi Some Basic Principles
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Part I
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Chapter 1
What is Money?
1
2 Spontaneous Order
must understand what money is and how it came about. It may seem strange
to ask what money is, since most of us use some every day and therefore
we know it well. Or do we? Clearly the bills and coins we carry are money.
But are checks money? Credit cards, debit cards? Stocks and bonds? Gold
jewelry? The answers are not obvious, and we will defer classification of the
kinds of money until Chapter 8 at the end of Part II. In the three chapters
of Part I we will explore how money evolved out of barter, identify the
defining characteristic of money and its subsidiary functions, study how its
purchasing power is determined by the interaction of supply and demand,
and see how and why governments have acquired a monopoly of the business
of supplying money.
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Chapter 1: What is Money? 3
speare wrote. Even today, new words and phrases or new uses for old ones
stream into our language from technology (input, hacker, on-line) or from
youth (chill out, “bad” meaning “good”). Words take on new meanings –
“silly” once meant “sacred,” while “network” has become a verb meaning
to have a conversation. These changes regularly fill the columns of such
language gurus as William Saffire, who pronounce judgment on them. The
changes go on, however, whether Saffire approves or disapproves. Indeed,
how do you suppose language originated? Undoubtedly the same sponta-
neous process, since words are just commonly accepted sounds.
Spontaneous order contrasts with planned order. The building in which
you attend your college class is an example of a planned order. An architect
drew up plans that structural engineers amplified, and unless the contrac-
tors who constructed the building adhered very closely to the specifications
given in the plans, the building would have been incomplete or deficient.
Someone did actually attempt a planned language. In 1887 one L.L. Za-
menhof invented a totally new language called Esperanto, but despite its
simplicity and consistency compared with other languages, hardly anyone
speaks it.
We all, of course, individually make our own planned choices about lan-
guage. We personally decide what linguistic innovations to use or avoid.
Governments and other institutions may try to influence those choices. The
French government, for instance, is engaged in an ongoing but generally fu-
tile attempt to prevent the penetration of English words and phrases into
the French language. Often differences over language can result in bloody
conflicts, as the history of Eastern Europe amply attests. But languages
still spontaneously evolved without the guidance and beyond the direction
of a single, conscious plan. They are too complex, and remain essentially
spontaneous, decentralized, and often voluntary creations.
Consider the metaphor that Adam Smith used in his 1776 masterpiece,
An Inquiry into the Wealth of Nations for the concept of spontaneous order?
An individual pursuing his own private interest, wrote Smith, “generally,
indeed, neither intends to promote the public interest, nor knows how much
he is promoting it . . . he is led by an invisible hand to promote an end which
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4 Indirect Exchange and the Emergence of Money
was no part of his intention [emphasis added].” If you ponder the idea of an
invisible hand as spontaneous order, you can probably come up with several
more examples. For instance, what about the checkout lines in grocery stores
or the flow of traffic in multi-laned freeways? Does any central planner keep
the lines fairly even in length or the lanes fairly equally busy? Money, as we
will see, is another, major example of spontaneous order.
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Chapter 1: What is Money? 5
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6 Indirect Exchange and the Emergence of Money
the same thing, the number of apples someone may want in exchange for the
CD may far exceed the subjective value to our Oingo-Boingo fan of listening
to it. If the authors of this text had to trade their economics lectures directly
for food, they would probably go hungry. The transaction costs associated
with direct exchange are so severe that economists have given them a special
name: the problem of the double coincidence of wants. In order for direct
exchange to take place, both parties must want what the other is offering.
But finding such a double coincidence of wants is usually very difficult.
Introducing a third person into this picture could overcome this problem.
Jeff wants the Oingo-Boingo CD and has extra apples he would like to sell.
Ajax owns the CD but hates apples, so there is no double coincidence of
wants. But Penelope it turns out has a large endowment of chocolate chip
cookies that she would like to dispose of in exchange for some apples, and
Ajax loves chocolate chip cookies.
Has Wants
Jeff Apples CD
Penelope Cookies Apples
Ajax CD Cookies
There are now two potential ways of capturing some gains from trade. The
most elegant is to assume a benevolent bureaucrat-god, who can orchestrate
a multilateral exchange by ordering Jeff to give Penelope the appropriate
number of apples, ordering Penelope to give Ajax the appropriate number
of cookies, and ordering Ajax to give Jeff the CD. Everyone is better off. But
even though benevolent bureaucrat-gods do not exist, in small economies,
with sufficient face-to-face interaction and mutual trust, such multilateral
trade has sometimes arisen voluntarily.
A far less elegant but more practical solution depends upon one of the
three parties having some knowledge about both of the others. If that person
is Jeff, he could take his apples and trade with Penelope for chocolate chip
cookies, after which he exchanges the cookies with Ajax for the CD. The
three parties have reduced transaction costs and captured the gains from
trade. But in the process, they are no longer engaged in direct exchange.
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Chapter 1: What is Money? 7
Jeff instead has conducted indirect exchange. He traded for the cookies
not in order to eat them but to sell them, making the cookies a medium
of exchange. A medium of exchange, something acquire not because you
want to use it directly in consumption or production but only to trade it
for something else you want. The process seems complicated, but it realizes
the benefits of multilateral exchange without recourse to a central planner.
Many goods could theoretically serve as a medium of exchange. We
could rework the example in the previous paragraph using apples as the
medium or using the CD. But which of the three goods would you expect
to be least likely to serve in that capacity? Probably the Oingo-Boingo
CD, because people prefer to use as media of exchange goods that are more
marketable. Marketability is a measure of the extent to which a good or
service is desired in trade in a particular economy; the larger the market,
the more marketable the good. Apples and cookies have a larger market
than Oingo-Boingo CDs. And the more marketable the good, the lower
the transactions costs associated with buying or selling it. Yet the fact that
people are already using a particular good as a medium of exchange enhances
its marketability. As a result, people will spontaneously gravitate toward
one or two media of exchange that are commonly or routinely accepted
throughout the economy. When a medium of exchange becomes commonly
accepted, it has become money.
Observe that there are two elements to this definition of money: “com-
monly accepted” and “medium of exchange.” That makes monetary ex-
change a subset of indirect exchange. All moneys are media of exchange,
but not all media of exchange qualify as money. A modern example of in-
direct exchange without money occurred when an American firm, Pepsico,
began exporting Pepsi-Cola to the Soviet Union before its collapse. Because
of exchange rate barriers, rubles could not be easily converted into money
that could be spent outside the Soviet Union. So Pepsico, after selling Pepsi
for rubles, used its rubles to buy Russian vodka, which it then sold in the
United States for dollars. Vodka served Pepsico as a medium of exchange,
but it was not commonly accepted and therefore not money. (Some writers a
bit confusingly refer to indirect exchange without money as indirect barter.)
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8 Indirect Exchange and the Emergence of Money
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Chapter 1: What is Money? 9
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10 Indirect Exchange and the Emergence of Money
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Chapter 1: What is Money? 11
actly the same (although both metals are often alloyed with copper to make
them harder). Money is convenient when it is portable, which is why the
stone wheels of Yap did not catch on internationally. And finally, money
should be easily recognizable, so it can be easily verified in trade. A relative
scarcity that gives money a convenient value-to-weight ratio greatly facili-
tates the last two properties. If the monetary commodity is too abundant
then the amounts required for normal transactions cease to be portable.
If on the other hand the monetary commodity is too scarce, like platinum
(coined in Russia between 1828 and 1845), a gram or two of platinum, which
might suffice for a small purchase, would be to small for convenient handling
or even recognition. None of these characteristics is absolutely essential for
money, and we have observed historical commodity moneys that lacked one
or more of them. But all of these characteristics gave gold and silver an
advantage because they reduced transactions costs.
Initially, gold, silver, and other monetary metals circulated by weight.
Hence, several units of weight—the shekel, the talent, and the pound—also
became units of money. But there were significant transaction costs in the
form of both weighing and also assaying (determining the purity of) these
metals. This led to the invention of coins. Coinage developed independently
in several locations, but the location about which we know the most was
the Kingdom of Lydia, in Asia Minor, in the seventh century B.C. Lydia’s
commodity money was electrum, a naturally occurring alloy of gold and
silver (Figure 1.1). Prominent merchants with established reputations began
stamping lumps of electrum with identifying marks or images, and these
electrum coins then circulated as a more convenient form of money. Bronze
coins in the shapes of tools and shells arose in China at about the same
time. Silver coinage may have originated in India as much as a hundred
years earlier, although such an early independent, origin is contested, and
gold and silver coins appeared in Persia a few hundred years later. Together
gold and silver coins eventually became known as specie.
The earliest coins probably specified only the fineness and purity of the
metal, but eventually coins specified the weight. Because coins could then
circulate by “tale” (tally, or count) rather than by weight, they further re-
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12 Indirect Exchange and the Emergence of Money
duced transaction costs. Knowing the number of coins and the weight of
each makes it easier to tally the total amount of gold or silver. Coins there-
fore commanded a slight premium over the equivalent weight of raw metal
in the form of bullion or dust. In long-run equilibrium, the premium tends
to equal the costs of minting the coins (called brassage), making coinage a
viable business on the market. Private manufacture, for instance, character-
ized the earliest Chinese coins as well as later coinage off and on throughout
Chinese history. Private mints successfully competed in the United States
until they were suppressed during the Civil War. Wherever domestic mints
proved insufficient, it was profitable to import coins from abroad. Foreign
coins circulated widely in the U.S. during its early years, while most of the
ancient Greek city-states, including Sparta, had no mints of their own and
relied upon coins minted elsewhere. A particularly intriguing example of
a second-generation coinage that was mostly private occurred in Mamluk
Egypt at the end of the thirteenth century. Miscellaneous coins of various
origins, both gold and silver, new as well as old, would be handled in sealed
purses. The exact value was indicated on the outside, bearing the mark-
ing of a well-known merchant, banker, money changer, or infrequently a
government official. This parallels the modern practice of selling high-grade
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Chapter 1: What is Money? 13
collectible coins in sealed packages labelled with the coin’s grade (condition).
In short, money constantly evolves and changes. Observe that every
step in this evolution, from barter through indirect exchange and primitive
commodity moneys, up to gold and silver and the minting of coins, low-
ered transaction costs and expanded enormously the gains from voluntary
exchange. Driven by the mutual benefits for all who traded, the origin and
development of money stands as a dramatic demonstration of spontaneous
order, with little conscious coordination and no necessary government in-
volvement. Of course, this evolution did not stop with the emergence of
specie, but continued forward to present-day forms of money in ways that
upcoming chapters will investigate in great detail. We will see how and why
governments became intimately involved with money. Yet money’s funda-
mental function as a commonly accepted medium of exchange that reduces
transaction costs and facilitates specialization and trade has remained fixed
and fundamental.
Despite the triumph of monetary exchange in modern economies, direct
exchange still survives in a few unique markets. Workers, for instance, do
not always exchange their labor solely for money wages. Because of an ex-
emption in the U.S. tax code, many employers offer their employees fringe
benefits such as health insurance. While health insurance has a monetary
value, it is not money per se, and this form of barter, where labor is ex-
changed directly for medical care, goes a long way toward explaining the
high transaction costs and enormous efficiencies in the American medical
market. Indeed, one way of avoiding taxes altogether is with barter trans-
actions in the underground economy.1 People also often trade-in their used
automobiles for new ones, rather than for money, probably because this
helps to overcome some of the transaction costs associated with asymmetric
information in the used-car market.
One major non-monetary market in modern economies is not conven-
1
Employers generally provide health insurance to their employees but not, for example,
car insurance because the income tax code makes these provisions tax-deductible for the
employer and tax-free to the employee, whereas most non-cash forms of remuneration are
considered taxable.
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14 Subsidiary Functions of Money
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Chapter 1: What is Money? 15
one apple? 1/100th of an Oingo-Boingo CD The fact that prices are ratios
is clearest in the case of exchange rates, which are the prices of one money
in terms of another. Thus if you are an American traveling in the United
Kingdom, you may be want to know the dollar price of pounds or the pound
price of dollars.
In a barter economy, every good potentially exchanges for every other.
Where n distinct items are traded, there would be n(n-1)/2 distinct ratio
prices, counting CDs per apples and apples per CD as a single price. So if
there were 1,000 goods in an economy, there could be 499,500 prices. Such
a multitude of prices hinders economic calculation. Imagine manufacturing
CDs that are traded for apples, chocolate chip cookies, rubies, and other
assorted goods or services, and when your workers and vendors are paid in
the same assortment. Now try to calculate your profit or loss.
Once a good becomes a commonly accepted medium of exchange, it
establishes comparable prices for all other goods and services. Although
some texts describe this role as a common denominator for all prices, it
actually is the common numerator: dollars per CD; dollars per apple; dollars
per chocolate chip cookie; or dollars per ruby. That is why economists
sometimes refer to the commodity providing the unit of account with the
French word numéraire. In the economy with 1000 different goods, one
of which is money, the number drops from 499,500 to only 999 prices. But
more importantly, it greatly facilitates economic calculation by allowing easy
comparison of various goods and services. Businesses can sum up their costs
and their revenues and see whether the business is earning profits or suffering
losses.3
3
Suppose I am running a business that requires two tons of coal, 500 kw-hrs of electricity
and 100 hours of labor per month. Output consists of 1,000 widgets. How do I know
whether this is a worthwhile undertaking? Money accounting will tell me:
Expenses Revenues
Two tons of coal @ $40 $80 1,000 widgets @ $1.50 $1,500
500 kw-hrs electricity @ $0.12 $60
100 hrs labor @ $12 $1,200
Total expenses $1,340 Total revenues $1,500
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16 Subsidiary Functions of Money
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Chapter 1: What is Money? 17
today and then use the money to buy food or clothing later. During the
time you hold the money, it is a temporary abode of generalized purchasing
power. Thus money provides a convenient way of saving and accumulating
wealth, though by no means the only way. People can use any relatively
durable good as a store of value, such as cans of tuna fish or valuable paint-
ings. Some anthropologists contend that several of the primitive commodity
moneys listed in Table 1.1 did not actually circulate as commonly accepted
media of exchange but instead were only held as stores of value. Yet holding
wealth in the form of your medium of exchange reduces transaction costs.
You can readily spend the money on other available goods and services at
any time, whereas you usually have to convert the tuna cans or paintings
into money first.
While using money as a store of value lowers transaction costs, it can
introduce other opportunity costs that are sometimes significant. To the
extent that you hold any commodity as a medium of exchange you cannot
use it up in consumption or production. Thus hanging on to commodity
entails an opportunity cost. As some writers put it, commodity money
is “barren.” But they are seeing only the opportunity cost and not the
subjective benefit that people gain – the confidence that commodity money
will retain its purchasing power. When the economy is poor and markets
are thin, with few people buying or selling, individuals may find it less
costly to hold what little wealth they have in goods other than money. This
was apparently the situation in early medieval Europe between the fall of
Rome and the eleventh century. Although coins existed and were used in
some exchanges, the expense of holding them was so prohibitive that barter
remained common. Money’s convenience as a store of value can also diminish
over extended periods or when prices are rising rapidly. Severe inflation may
therefore separate money from its store of value function as effectively as is
separates money from the unit of account.
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18 Credit Cards, Debit Cards, and Smart Cards
This means that money becomes not only the preferred way of paying back
loans (because it is the medium of exchange) but also the preferred way
of specifying the amount repaid (because it provides the unit of account).
Notice that loans do not necessarily have to be paid back in money. One of
the authors sometimes loans his pickup truck to his neighbor, who usually
returns it with a full tank of gasoline. Early economies, even after the evo-
lution of commodity money, often continued to rely on debts denominated
in other goods, such as loans of seed repaid out of the crop, or a loan of
breeding animals repaid with animals. And here again, if prices are rising
rapidly, money may cease to be the standard of deferred payment even be-
fore it ceases to serve as a store of value or provide the unit of account.
Although loans may continue to be repaid with money, the exact amount is
no longer set in advance in monetary units but determined at the time of
repayment based on some index number.
Often texts omit this third subsidiary function because it follows from
money’s other roles. Yet it bears mentioning because the price at which
money loaned today exchanges for money in the future gives rise to an
interest rate. If you borrow $100 and repay $110 a year from today, the
interest rate on that loan is 10 percent, in terms of money. Although the
interest rate for money is the one that people almost exclusively deal with,
it is not the only interest rate in the economy. Even if no one directly
loans apples today in exchange for apples in the future, there is still an
implicit interest rate on apples, and one on chocolate chip cookies, and
perhaps another one on pickup trucks. Those interest rates need not equal
each other or the interest rate on money. The significance of this seemingly
subtle observation will become clearer once in Part 2.
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Chapter 1: What is Money? 19
transfers money to the merchant and that amount is added to the balance
which you owe the bank. Later on you transfer money from your checking
account or another source to the bank to pay down or pay off the loan. So
credit cards are a convenient means of gaining access to money, but they
are not in themselves money. Likewise debit cards are a convenient means
of transferring money from your checking account to a merchant.
Your university may issue a card that you can use to make purchases on
campus and perhaps at off-campus stores as well. Such cards are sometimes
called “smart cards,” or they may go by a brand name such as an “Access
Card.” You establish an account at the campus office and transfer an initial
balance into the account, as you would with a bank checking account. You
make purchases by swiping the card through a point-of-sale terminal which
deducts the amount of your purchase from your account, and may show the
remaining balance on an electronic display attached to the terminal. These
cards reduce transaction costs, but are a temptation for some students to
over-indulge, and are a privacy concern to some, since the administrators
may be able to track what you buy, where, and when.
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20 The cashless society
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Chapter 1: What is Money? 21
1.9 References
Friedrich A. von Hayek discusses spontaneous order in The Constitution of
Liberty, (University of Chicago Press, 1960, p. 159-161. Hayek acknowledges
that the concept goes back at least to the time of Adam Smith.
Discussions of money as a solution to the problems with barter are ubiq-
uitous throughout economic principles and money and banking texts and can
be traced all the way back to Aristotle. But a step-by-step economic expla-
nation of how money could spontaneously originate first appeared in chapter
8 of Carl Menger’s Grundsätze der Volkswirtschaftslehre (1871), translated
as Principles of Economics (New York: New York University Press, 1981).
Ludwig von Mises elaborates upon this explanation in his Theory of Money
and Credit (Irvington NY: Foundation for Economic Education, [1912]1971).
More recent writers who elucidate the Mengerian approach in their open-
ing chapters include J. Huston McCulloch, Money and Inflation: A Mone-
tarist Approach, 2nd ed. (New York: Academic Press, 1982), David Glas-
ner, Free Banking and Monetary Reform (Cambridge: Cambridge University
Press, 1989), and Lawrence H. White, The Theory of Monetary Institutions
(Malden, MA: Blackwell, 1999).
A more technical and therefore more sterile presentation that empha-
sizes information costs is Armen Alchian’s article, “Why Money?”, reprinted
in his collection, Economic Forces at Work (Indianapolis: Liberty Press,
1977). The standard list of money’s desirable properties and its functions
(using slightly different terminology) was not originated by Alchian but owes
its popularity to William Stanley Jevons’ economic classic, Money and the
Mechanism of Exchange, 23rd ed. (London: Kegan Paul, 1910), first pub-
lished in 1875. A famous article on money in P.O.W. camps is R. A. Radford,
“The Economic Organization of a P.O.W. Camp,” Economica, 17 (Novem-
ber 1945): 189-201.
Unfortunately there is no recent historical or anthropological survey of
the origin of money that is really good. Jack Weatherford, The History
of Money: From Sandstone to Cyberspace (New York: Three Rivers Press,
1997), is too popular and simplistic to be of much use except for anec-
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22 References
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Chapter 1: What is Money? 23
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24 References
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Chapter 2
We acquire money for purchase of goods and services. It is natural to ask how
much we can purchase with a unit of money at a particular time. Clearly, the
answer depends on what we wish to purchase. Yet it is helpful to have some
estimate of the general purchasing power of money even though such an
estimate must cross over differences in what we want to buy. Having such
estimates allows us to separate price changes due to changes in money’s
overall purchasing power from price changes due to real factors. It also
helps us study factors that may degrade or enhance the purchasing power
of money, as well as factors that might seem to influence purchasing power
but do not.
25
26 Estimating the Purchasing Power of Money
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Chapter 2: The Purchasing Power of Money 27
goes by, the contents of the basket may become less representative of what
consumers actually buy. For example, people generally consume less of items
whose relative prices have risen, either by finding substitute products or just
by cutting back or eliminating their purchases of that item. To see why this
is a problem, imagine that we are in a period of rising prices and that the
price of cabbages has risen a lot due to an insect infestation in the cabbage
fields, so that the price of cabbages rises. People will shift to lettuce or
do without cabbages in order to stay within their budget. But if the CPI
continues to assume the same quantity of cabbages, the higher price p1 will
push up the CPI figure more than if that q1 had been reduced to reflect
consumer cutbacks. This problem is called substitution bias.
A similar problem occurs when new products enter the marketplace or
old ones disappear. Personal computers and cellular telephone service are
now important to most consumers but they did not exist 20 years ago. Items
are added to the CPI or deleted from it from time to time as a result.
Personal computers raise another issue that has bedeviled the managers
of the CPI: changing quality. The power of personal computers has increased
dramatically since they were first introduced. Some adjustment to reflect
this fact seem in order, especially for PC’s but for other goods as well.
The BLS solution to this problem is “hedonic adjustments” from the Greek
word for “pleasure”. Hedonic adjustments attempt to capture the increase
in services provided by products such as personal computers. This is a very
difficult estimate to make: how much more valuable is a one-GHz processor
than a 250-MHz processor? Nowhere near four times as valuable for the
average user, writing a book or checking the internet. It is estimated that
during recent times when the CPI was running at an average annual increase
of 3%, this figure would have been about 6% without hedonic adjustments.1
This is a very significant difference because many payouts, notably social
security payments, are raised automatically in line with the CPI. People
drawing social security benefits tend not to own personal computers so one
could argue that hedonic adjustments negatively impact them.
In addition to the consumer price index (CPI), the BLS calculates a
1
www.shadowstats.com
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28 Estimating the Purchasing Power of Money
“producer price index” (PPI), which purports to represent the costs faced
by typical producers. A third index is the “GDP deflator” which attempts
to measure the prices of all the goods and services produced in the entire
national economy, its “gross domestic product.” As Figure 2.1 shows, these
indices typically move together, but not always. The fact that they generally
correlate well with each other gives us some confidence in their usefulness.
The price one basket of goods and services, however it may be consti-
tuted, is the price level P , in units of dollars per basket. When the price
level rises, the purchasing power of a unit of money declines. The purchasing
power of money, abbreviated PPM, is defined as the reciprocal of the price
level, 1/P , in units of baskets per dollar. The absolute price level at any
given time is not as interesting as changes in P that are observed over time.
A rise in the price level is called price inflation (or just inflation). A decline
is called price deflation (or just deflation). A slowing of price inflation is
called disinflation.
It is important to keep in mind the distinction between relative prices and
the price level. If all money prices in an economy were to rise by 5%, the price
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Chapter 2: The Purchasing Power of Money 29
level would also rise by 5% while relative prices would remain unchanged.
Conversely, it is possible for some relative prices to rise and others to fall in
such a way that the price level remains unchanged. The ocean provides a
metaphor for prices which may be helpful. Think of the average level of the
water as the price level and the waves as relative prices. (Do you see why it is
logically impossible for all relative prices to rise simultaneously?) Between
1973 and 1980, for example, the CPI rose by 85% while heating oil rose
170% and clothing rose 40%. Thus the relative price of clothing expressed
in terms of units of heating oil actually fell even though its nominal dollar
price, along with most other prices, increased.
Price indices enable us to adjust observed prices – nominal prices – so
as to eliminate the effects of price inflation which as we shall see, results
primarily from increases in the money stock, or monetary inflation. Such
adjusted or “real” values attempt to remove the distortion that price infla-
tion brings, a distortion that is like a shrinking measuring stick. Think of
price indices as estimates of the shrinkage of the measuring stick that allow
us to eliminate the shrinkage from our observations. If nominal wages dou-
ble during a time period when the price level also doubles, real wages – the
purchasing power of those wages – are unchanged. Economists often denote
nominal magnitudes by upper-case letters and real magnitudes by lower-case
letters. If nominal wages are W, then real wages are w = W/P . Nominal
output Y , real output y = Y /P . Real GDP is nominal GDP divided by P .
Table 2.1 shows the GDP deflator for each year from 1959 to 2007.2
This particular index is set up so that the value for a particular year, called
the “base year,” is 100. You can see that the year 2000 was chosen as the
base year in this case, but selecting a different base year would not change
any calculations based on this index. Now suppose one of your authors,
in a fit of nostalgia, recalls that the movie admission price for adults was
50 cents in 1960 and had risen to $9.00 in 2007. How much of this price
increase is real and how much is due to the declining purchasing power of
2
The high precision implied by the display of three digits beyond the decimal point is
highly misleading to say the least, given all the gross approximations that underlie these
figures.
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30 Estimating the Purchasing Power of Money
the dollar? Multiply each price by 100 and divide by the index value for
that year, resulting in prices expressed in year 2000 dollars. In this case,
$0.50× 100/21.0 = $2.38; $9.00× 100/119.8 = $7.51. The movie price in real
terms has risen approximately threefold, from $2.38 to $7.51, a substantial
increase but much less than the nominal price, which rose nearly forty-fold.
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Chapter 2: The Purchasing Power of Money 31
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32 The Demand for Money
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Chapter 2: The Purchasing Power of Money 33
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34 The Demand for Money
events. We will work toward this tool by expressing this accounting identity
algebraically as the “equation of exchange.”
To understand the expense side of the equation, consider the role of one
particular dollar during a year. If that dollar is part of five transactions
during the year, it accounts for $5 of spending. Total spending is therefore
the number of dollars (M ) times the average number of transactions (V ).
We now have the product M V on one side of the equation.
On the other side of the equation, we represent the total amount of goods
and services purchased during the year by the symbol y. Recall that in
macroeconomics we attempt to aggregate all the various goods and services
produced by an economy into “baskets.” y is then the number of baskets
that are traded in a given year, also called “real output.” The price level is
the price of one basket, P . The total dollar value of the goods supplied is
the value per basket times the number of baskets, P y. Equating aggregate
income and expenses yields the equation of exchange
MV = Py
∆M + ∆V ≈ ∆P + ∆y
3
If you are familiar with calculus, you can follow this derivation using differentials:
d(M V ) = d(P y)
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Chapter 2: The Purchasing Power of Money 35
This form of the equation would tell us, for example, that if real output
were to rise by 3% in a given year (∆y/y = 3%), velocity remained constant
(∆V = 0), and if the money supply were to increase by 5% (∆M/M = 5%),
then we could determine the change in the price level, ∆P by substitution:
5% + 0% = ∆P P + 3%
or
∆P P = 2%
Later we will see how economists have used assumptions about which of the
four variables is more changeable and which can be considered constant to
develop theories about how ∆M effects ∆P.
Dividing the left side by M V and the right side by P y (which we can do because these
two are equal), and rearranging yields
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36 The Demand for Money
P ↑⇒ M d ↓ y ↑⇒ M d ↑ V ↑⇒ M d ↓
which merely says that the demand for money goes down when the price
level rises, up when real output rises, or down when velocity rises. The
demand for money is one of the most studied and controversial topics in
macroeconomics, and our limited discussion is intended only to provide you
with a general grasp of the concept.5 It is fair to say that changes in money
demand are usually quite small and rarely account for more than a small
portion of the changes in price level.
“Hoarding” is sometimes cited as an exceptional kind of demand for
money. A dictionary definition of hoarding is “to collect or lay up for the
sake of accumulation.” Hoarders of money, like the comic book character
4
We omit occasional accidental losses of currency. Also, central banks can increase or
decrease the supply of money, but we will reserve these changes for study in Chapter 16.
5
The appendix to this chapter explains three theories of the demand for money: Fisher’s
quantity theory, Keynes’ liquidity preference theory, and Friedman’s permanent income
theory.
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Chapter 2: The Purchasing Power of Money 37
Scrooge McDuck, seem to be doing so just for the pleasure of holding them
and not for any service they might render in the immediate or distant future.
To identify an acquisition as hoarding, we must guess the motives of the
acquirer, which is always difficult. Perhaps the hoarder derives pleasure
just from contemplating the cash in his possession, his bank balance, or his
stash of canned food. In any event, there is no good reason to suppose that
a significant number of people behave this way, except perhaps in times of
emergency. Even then, people must consume, and time preference cannot
be obliterated.
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38 The Supply of Money
PPM = 1/P
s
M
d
M
M Money supply, M
1
ply. We must emphasize that relationships like the law of demand and the
law of supply assume that other factors remain unchanged. The law of de-
mand for money was not invalidated by the experience of the 1920’s. Its
effects were masked because other things were not unchanged: supply was
rising. So both supply and demand curves rose (moving equilibrium from
point A to B in Fig. 2.3, leaving the purchasing power unchanged while the
quantity in circulation increased noticeably).
When we study central banks in Chapter 16 we will encounter a pol-
icy proposal that central banks should adjust the supply of money so as to
maintain a steady price level. This would imply an upward-sloping supply
curve for money, since the quantity supplied would rise with its purchasing
power (fall with the price level). However we prefer to show vertical sup-
ply curves for money to emphasize the monopoly power that central banks
currently have over the money supply (Chapter 16).
Our models show that PPM and P are determined solely by M d and
M s , with M s usually predominant. Any effect that does not influence the
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Chapter 2: The Purchasing Power of Money 39
PPM
A B
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40 The Supply of Money
PPM=1/P
Ms
Md
Figure 2.4: Secondary effect on the demand for money following an OPEC
supply shock.
any other good or service, but now we come to the crucial difference. Most
goods and services are used up in consumption or production. Once they
have been put to use they cannot be reused, at least not in total. Money, on
the other hand, is never used up.7 We acquire money not for its own sake but
for the goods and services we can buy with it, now or in the future. Increases
of ordinary goods and services make people better off. Most of us are better
off when there are more apples, more economics lectures, more telephones.
In sharp contrast, increases in the money supply confer no overall benefit on
society? Why is this? The answer lies in the distinction between real and
nominal magnitudes. People want money for what they can buy with it.
They care about the real value of their money, the inflation-adjusted value.
Following our convention, we denote real money demand by a lower-case
symbol, md = MD /P . If P falls, PPM rises, and each dollar is worth more.
7
Worn-out bills and coins are constantly being replaced. This does not constitute a
change in the money stock.
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Chapter 2: The Purchasing Power of Money 41
If you as an individual want to hold more money, you will try to increase
your nominal cash holdings. But as we have said, all money is in someone’s
possession at any point in time: M S = M D . If the nominal money supply
remains fixed, we cannot all increase our money holdings.
We have now been led to the important conclusion that any stock of
money is as good as any other supply; increases or decreases confer no so-
cial welfare. We must qualify this statement somewhat by noting that in
the case of commodity money, the supply must provide practical amounts.
Thus platinum would not be practical for small purchases since no one would
want to purchase a newspaper for a few milligrams of platinum. At the other
extreme, no one would want to buy an economics text with a half ton of
sand. In thinking about increases in the money stock in the context of a
gold standard, we must remember that increases gold as intended for con-
sumption or production increase total wealth but increases in gold intended
as money do not. This important distinction lies in the intentions of those
who possess the gold, not in the physical metal.
Another qualification is that while one money stock is as good as another
(within the aforementioned limits), a transition from one stock to another
could have serious economic repercussions if such a change were large or
sudden.
We must also be aware of how any new money enters the economy.
Economists like to imagine helicopters flying overhead and dropping money
to people in proportion to their current holdings. But this never happens.
Some people always get the new money first, and only slowly, as it is spent
over and over, does it make its way to other people. Early recipients gain at
the expense of the later recipients. Although the new money will cause the
overall price level do rise (other things being equal), this does not happen
immediately. Those who first receive the new money are faced with the
existing array of prices. Prices rise gradually as the new money is spent
and re-spent. Those who get the money last are losers, because by the time
the money reaches them, prices have already risen. We thus have a net
transfer of wealth from those who get the money last to those who get it
first. This is called the “distribution effect” or “ripple effect” of monetary
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42 Important Terms and Concepts
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Chapter 2: The Purchasing Power of Money 43
2.5 References
Irving Fisher, The Purchasing Power of Money (1911)
2.6 Questions
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44 Questions
Appendix to Chapter 2:
Theories of the Portfolio Demand for Money
Here we go into more detail about the demand for money M d ?. We sum-
marize three theories: Fisher’s quantity theory, Keynes’ liquidity preference
theory, and Friedman’s modern quantity theory, also known as the perma-
nent income hypothesis.
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Chapter 2: The Purchasing Power of Money 45
i ↑⇒ mD ↓ y ↑⇒ mD ↑
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46 Questions
Md
= f (Yp )
P
which is very much like Fisher’s quantity theory equation given above. Also,
while velocity is not strictly constant in Friedman’s theory, it takes the form
Y
V =
f (Yp )
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Chapter 3
Government Control of
Money
47
48 Legal Tender Laws
monetary institutions may feed these appetites directly, the primary benefit
to governments is the revenue they are able to secure through debasing or
inflating the money supply. As Nobel Prize winner Friedrich Hayek put it,
“History is largely a history of inflation, and usually of inflations engineered
by governments for the gain of governments.”1
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Chapter 3: Government Control of Money 49
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50 Monopoly Mints
Edward VI, Queen Mary, and Queen Elizabeth. Gresham’s Law deals with
a special case of price controls. It is often summarized as “bad money
drives out good,” but this is an oversimplification that can easily lead one
to conclude that something about free choice of money that would lead the
“bad” kinds predominating.
To see how Gresham’s law works, suppose the equilibrium price is 15.5
ounces of silver per ounce of gold. If the government decrees a higher price
such as 16, there will be a surplus of silver so that people will not want
to use silver for money. It will be converted to candlesticks, exported to
other countries, or hoarded by people who hope the government intervention
will end. Gresham’s Law might better be stated as “artificially over-valued
money will circulate; under-valued money will not.” If the price decreed is
below the equilibrium price, 15 to one for example, the reverse situation will
arise. Silver will circulate and gold will disappear from circulation.
Three instances of this sort of intervention in the United States were
the Mint Act of 1792, which set a 15 to 1 ratio and drove out gold, the
Coinage Act of 1835 which set a 16 to one ratio and drove out silver, and
the Coinage Act of 1873, which effectively demonetized silver, whereupon
the market ratio fell to 30 to 1.
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Chapter 3: Government Control of Money 51
arrangement was to insure the quality of coinage and reduce fraud. A bet-
ter explanation would point to the profits that government mints enjoyed.
Like any monopolist, they were able to increase revenues by restricting out-
put. Whenever they were able to mint coins whose face value exceeded the
value of the metal plus production costs (brassage), they enjoyed enhanced
revenue, called seignorage. On the other hand, some mints engaged in free
coinage. The U. S. Mint did this for a number of years, offering coins with
one ounce of gold in exchange for one ounce of gold dust, with no charge for
production.
Governments soon realized that they could raise seignorage revenue still
higher by issuing fraudulent coins themselves. One way to do this was to
simply issue smaller coins and decree that their value was the same as the
larger predecessor coins. One hundred of the old gold coins might be melted
down to make 150 newer and smaller coins. They were thereby enjoying the
same kind of benefit that a successful counterfeiter enjoys. But of course
government agents did not have to worry about being caught and punished
for their activities.
The impacts of coin debasement were threefold. First, there was an
increase in the money supply M s which caused the price level to rise. Then
Gresham’s Law came into play as old and more valuable coins were hoarded,
and this often prompted governments to “call in” these coins and forbid
hoarding of them. Third, there were distribution effects. The new money
was spent by the government into a market where the price level had not yet
risen, and many people did not see their incomes rise until well after prices
had risen, the net result being a transfer of real wealth to the government.
This transfer is very much like a tax. John Maynard Keynes, the prominent
twentieth-century economist summed up the situation well when he said
that issuing money allows governments to impose pseudo-taxes “in a manner
which not one man in a million is able to diagnose.”
The Roman denarius was a silver coin that was debased over the years.
In the year 54 A.D. this coin contained 94% silver. By 218 A.D. it was
down to 43%, and by 268 A.D. it stood at 1%, simply a silver wash over
a copper coin. It is no surprise that between 200 and 300 A.D. prices rose
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52 Fiat Money
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Chapter 3: Government Control of Money 53
In recent times we have seen the public reject the Susan B. Anthony and
Sacagawea dollar coins even though they are fully legal tender. Evidently
people prefer dollar bills, even though they are dirty and ugly, to dollar coins
which are relative heavy and awkward. So how can governments persuade
people to use its fiat money?
The answer lies in linking fiat money to pre-existing commodity money.
At first, the new money may be temporarily redeemable. This was the case
with Federal Reserve notes when they were first issued in the U.S. Second,
as we have indicated, governments make taxes payable in fiat money. Third,
legal tender laws are enacted. If you examine a dollar bill, you will find the
inscription “This note is legal tender for all debts, public and private.” In
other words, any private debt can be extinguished by payment of federal
reserve notes.4 Once people become accustomed to the paper money, they
accept it simply because they know others will accept it, and they forget
about its prior link to gold or silver.
The entire world today operates with fiat money, but in almost every
case, that money arose from prior commodity money. Pure fiat standards
have prevailed only since 1971, at which time the last link between the U.S.
dollar and gold was severed, and that is not enough time for us to estimate
how well this system can continue to work. Milton Friedman, perhaps the
most influential economist of the late twentieth century said, “it remains
an open question whether the temptation to use fiat money as a source
of revenue will lead to a situation that will ultimately force a return to
a commodity standard – perhaps a gold standard of one kind or another.
The promising alternative is that over the coming decades the advanced
countries will succeed in development of monetary and fiscal institutions
that will provide an effective check on the propensity to inflate and that will
again give a large part of the world a relatively stable price level over a long
period of time.5
4
Tecnically, checks drawn on commercial banks are not legal tender. However, a check
with sufficient funds behind it is so readily convertible into currency that it serves as de
facto legal tender.
5
Milton Friedman, “Money Mischief” p. 259.
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54 Fiat Money
Coins can be fiat money, not just paper money. Iron tokens circulated
in ancient Byzantium, for example, and their value as iron was much less
than their face value. The current U.S. coins are made of metal whose
value is unrelated to their face value plus brassage. A quarter, for example,
costs about five cents to make, including labor and capital in addition to
metal. At one time in the 1970’s, the price of copper rose high enough that
it almost became profitable to melt down pennies. 1982, the Mint started
making pennies out of zinc, with a copper wash. In 2008, however, the price
of zinc had risen to the point where pennies again cost more than one cent to
make. Pennies seem to disappear from circulation almost as fast as they can
be minted – people throw them into jars or simply discard them. Annual
proposals to abolish the penny are invariably defeated by the zinc lobby.
The American colonies were among the first to issue paper money. Wars
are the most expensive of all government activities, but this particular war
was in large part a revolt against taxation. In fact, the Continental Congress
had no powers of taxation. How, then, to finance the war? Here is what
they did: 6% ($5.8 million) by taxation in the form of requisitions on the
individual colonies 19% was borrowed ($11 million from domestic lenders,
$7.8 million from abroad) 78% was newly issued money
Six million dollars was issued in 1775, $19 million in 1776, and after
that new issues began to appear every fortnight. Predictably, the value of
the currency, called Continentals, fell sharply against specie: by 1/3 as of
October 1775, to 30-to-one in 1779, and 167-to-one in 1781. The Continen-
tal currency became worthless and the phrase “not worth a Continental”
entered the American language.
The Continental episode was the first modern instance of hyperinflation,
which is the name for extreme rates of inflation, often defined as rates ex-
ceeding 50% per month. More technically, hyperinflation is a situation where
prices rise even faster than the money supply because of falling demand for
money. In fact, expectations play a key role in the degree to which inflation
of the money supply translates into price inflation. We can discern three
stages:
1. When people first see price increases, they often believe they are tem-
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Chapter 3: Government Control of Money 55
porary. “I’ll wait and buy after prices have fallen back to normal.”
Demand for money increases slightly, and price inflation lags behind
money inflation.
3. As inflation races ahead, people are eager to get rid of their money.
“I’ll buy anything just to get rid of this depreciating currency.” In
effect, people are trying to avoid the implicit inflation tax. Demand
for money falls rapidly and price inflation races ahead of monetary
inflation.
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56 Fiat Money
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Chapter 3: Government Control of Money 57
reduced costs can be had where gold and silver certificates replace coins
in daily transactions. Such money substitutes have been offered by private
banks. A weightier argument in favor of fiat money is based on the resource
cost of commodity money. As we have seen, commodity money is money
that is embodied in some physical form that has consumption or production
use that parallels its use as money. Every ounce of gold that is used as
money is an ounce that will not be worn on a lady’s wrist, not fill a decayed
tooth, not coat the connectors of a printed circuit board. Paper money frees
up these precious resources for use in satisfying important human wants.
And yet, this is not what has happened in the U.S. since it went on a pure
fiat money standard in 1971. Shortly after that time, the price of gold was
freed from its prior official fixed price of $42 per ounce. The market price
began to rise, slowly at first, an then in a frenzy hit $850 per ounce in
1980. People were acquiring gold as a hedge against rising inflation, so if
anything there was less gold available for consumption. Furthermore, the
U.S. government continues to hold its stock of gold even though no longer
has any monetary function. If you check the balance sheet of the Federal
Reserve System online or in a financial publication such as Barron’s you will
find 263 million ounces listed as an asset, valued at the pre-1971 price of
$42.22 per ounce.7
Fiat money can be compared to paper bicycle locks. As long as thieves
respect these “locks” or believe they are unbreakable, they will function
without the expenses of hardened steel and keys. As long as people believe
in fiat money, it will serve its purpose without the resource costs of com-
modity money: the opportunity cost of commodities that sit in vaults and
therefore cannot be consumed. Defenders of fiat money point out that it
allows government to control the money supply. This control constitutes a
macroeconomic tool at the disposal of policy-makers for the purpose of coun-
tering the inherent instability that some economists, particular followers of
John Maynard Keynes, see in free markets. We will consider counter-cyclical
7
The market price of gold was about $850 per ounce in 2008. “Troy ounces” are used
to measure weights of gold and silver, and these are different from the ounces used in most
commerce, called “Averdupois ounces.” One troy ounce equals 31.1035 grams.
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58 Socialism and the Abolition of Money
3.7 References
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Part II
59
Chapter 4
We are now ready to study credit and saving. Later we will combine these
concepts with the basics of money which we have just covered. This will
give us a foundation for understanding financial systems.
The word credit comes from the Latin credare, to trust. When we extend
credit to someone, we provide money, goods, or services in the present and
trust that they will return money, goods or services to us later. You may
therefore feel flattered when someone by extends credit to you, but from an
economic point of view, when you accept credit you assume an obligation
to pay later. That obligation is not an asset but in fact the opposite of an
asset: a liability, as we shall see in the course of this chapter.
A person who provides credit is saving. Exchange can provide enormous
gains in wealth, and saving adds to the benefits of exchange by providing
the capital that is so necessary economic growth and prosperity. Saving, as
we use the word in ordinary conversation, calls to mind bank accounts or
jars of pennies, but we need a more fundamental understanding. Just as we
developed the concept of money beginning with a primitive barter economy,
we will develop the concept of saving starting from a primitive example.
Robinson Crusoe, alone on his desert island, faces some stark choices.
He can stay alive by picking berries but he would prefer to add some fish to
his diet. He needs a net to catch fish, but in order to make one, he has to
take time and energy away from picking berries. He might accumulate some
61
62
berries before starting work on the net or he could give up some leisure by
taking fewer naps. However he proceeds, he will have to give up something
valuable in the present for the sake of increased future production. He will
be saving.
This simple example shows that leisure is a consumption good. When
we choose to take naps, play games, watch movies, or grow roses, we reap
direct pleasure from time and energy that we devote to these activities,
and this time and energy could have been devoted to producing goods and
services. Foregone production is thus an opportunity cost of leisure. The
benefits of leisure, like the benefits we get from any kind of consumption,
are entirely subjective. All we can say when we see someone taking leisure
time is that he prefers to devote this particular hour (his marginal hour)
to leisure rather than alternative productive uses of his time. Leisure also
illustrates the diversity of people’s choices. Some people use leisure time
to sleep, some play golf, some even read tracts on economics for pleasure.
These activities acquire the status of leisure only from the attitudes of the
people who engage in them. Some people hate golf, economics, or even sleep!
Crusoe also reminds us of the fundamental fact of scarcity that underlies
all economics. Whenever we acquire scarce goods we must forgo opportu-
nities to acquire other goods. The opportunity cost of saving is present
consumption and this tradeoff involves a time element. Time preference, a
basic fact of human life, explains the cost of saving. Time preference refers
to our preference for consumption in the present over the same consumption
in the future, other things being equal. We therefore choose to forgo present
consumption only when we expect to receive more in the future than we have
to give up in the present. How much more is a subjective matter, varying
from one person to another and varying over time for a particular person.
There is a name for this “how much more:” interest. How much more is
today’s ten dollars worth to us versus ten dollars next week? Or to put it
differently, how much compensation do we require to persuade us to wait? If
we require an additional dollar to persuade us to delay for a month receiving
$10 that is owed to us, that dollar is interest. Some people might want $2
for that delay while others might settle for fifty cents, and that same person
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Chapter 4: The Significance of Saving 63
might settle for forty cents next week, when circumstances change. We say
someone with a relatively strong preference for present satisfaction, like the
one who requires an extra $2 persuasion to wait, has high time preference.
A person with very high time preference is pejoratively called a spendthrift
and a savings fanatic a miser.1 Notice that although interest is usually
accounted for and paid in terms of money, it need not be. I might accept
one additional apple as interest to induce me to wait a month for payment
of ten apples that are owed to me. Notice further that interest does not
give rise to time preference, just the reverse. Time preference is a basic
fact of human life. How is it that there is only one rate of interest, given
that we all have differing degrees of time preference?2 For the same reason
that there is only one market price for apples even though some of us like
apples better than others. As a person buys more apples, the marginal
subjective value of each apple declines, and with it, the price he is willing
to pay. When that price has declined to the market price, he stops buying
apples. Similarly, a person whose time preference exceeds the average time
preference as reflected in the market rate of interest will borrow more (or
loan out less) until the marginal value of the last loan is equal to the price
paid, at which point he will stop borrowing. Conversely, someone whose
time preference is below average will borrow less (or loan out more).
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64 Capital Goods
the emergence of money which avoids the problem of the double coincidence
of wants. Savers face a more severe form of the problem of the double
coincidence of wants. Compared to someone who wants to exchange present
goods, a borrower in a barter economy – someone who wants to acquire
present goods in exchange for future goods – not only has to find someone
willing to provide those particular goods, but also someone who agrees to
the duration and terms of the loan. Again, money solves the problem. It
is safe to say that money amplifies the benefits of saving even more than it
amplifies the benefits of exchange of present goods. One can save money and
loan it to a borrower who wants to buy present goods. When the loan term
expires, the borrower can sell goods and settle the loan with money. When
Robinson Crusoe gathers vines to make a fishing net, we identify that act
as both saving and investing. But saving in money form opens a conceptual
separation of the acts of saving from the act of investment: the creation of
capital goods. Suppose I have been buying a daily $3 latte but decide to
accumulate that money in a jar instead. After a year I loan the money to
my neighbor so he can buy some tools for his machine shop. I have saved
and my neighbor has invested. If all goes well, his investment enhances his
income. At the end of another year he returns my money plus interest.
We will now examine the various forms of saving in a monetary economy
and how savings are used for investment and consumption.
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Chapter 4: The Significance of Saving 65
with the understanding that the equation applies to a specific time period
such as a month, a quarter, or a year. Note the ∆ indicates change in cash
balances because whereas income, consumption and investment are flows
(amounts specific to some time period), one’s cash balance is a stock.
The most direct form of investment is the purchase of a capital good –
a physical asset that is a tool of production. A wealthy investor buying a
factory, an oil well, or a TV station would be purchasing a capital good. A
proprietor who owns a restaurant might buy kitchen equipment. Even people
who work for wages sometimes make capital investments. Suppose you buy
an automobile for $15,000 and suppose 60% of the miles you drive are for
transportation to work and the rest for family purposes. You are buying
a car partly for production (driving to work) and partly for consumption
(family uses). You have made a $9,000 investment in a production good (60%
of $15,000) and a $6,000 consumption purchase. If you borrow the $15,000
you would categorize $9,000 as an investment and $6,000 as dis-saving, a
concept we will discuss later.4 Our example shows that cars cannot be
classified as production goods or consumption goods except by reference to
the plans of the particular individuals who drive them. In fact, no economic
aspects of any goods and services are intrinsic to those goods or services.
These aspects always depend upon the desires and plans of the person who
is putting them to use in service of some goal, or contemplates doing so.
term “market economy.”
4
However, the Internal Revenue Service will not allow you go claim a deduction for
this or any other expenses of a car you drive to work!
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Chapter 4: The Significance of Saving 67
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68 Direct Finance
make payment until they received the goods. In other words, neither party
wanted to own the tobacco while it was in transit. Some imaginative person
saw this unmet need as a profit opportunity and invented bills of exchange.
Merchants in England issued these bills in the form of written promises to
pay for the goods at some specified future date. Tobacco growers acquired
these bills and sold them to a financier, who in essence made a loan that
enabled the farmers to be paid immediately and the merchant to pay later.
Financiers engaged in this trade came to be called factors. The bills were
secured by the tobacco, meaning that if the merchant failed to pay at the
specified time, the factor would acquire title to the tobacco. The bills paid
interest in the form of a discount. This means that a farmer might be paid
only £98 for a bill which would be worth £100 when it reached England,
the difference being the interest earned by the factor. That interest would
cover the opportunity cost of fronting the money, the risk of default, and
profit. Of course, all parties gained from this arrangement. To the farmer,
the benefit of being paid immediately exceeded the £2 he had to give up.
To the factor, those £2 were worth more than the interest income his funds
might have earned elsewhere plus the risk of occasional default.
A factor holding a bill could remit it to England in exchange for specie.
However, transportation of gold and silver across the ocean was expensive
and risky. More often, holders of bills would sell them to importers who
needed money to purchase English goods for sale in America. As such
arrangements became more common, goods flowed back and forth across
the ocean as did bills of exchange, but there was very little transportation
of specie. Thus bills of exchange resulted in a more efficient clearing system
which increased net social welfare, and as we have seen, reduced the demand
for money.7
Notice that the story of the emergence of bills of exchange is an example
of spontaneous order. Somebody saw a profit opportunity, tried the idea
7
We might ask whether bills of exchange achieved the status of money since they were
widely used as a medium of exchange. They did not, because although they circulated
fairly widely among merchants, they were not used by the general public. They were not
a generally accepted medium of exchange.
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Chapter 4: The Significance of Saving 71
be clipped and redeemed for interest payments. The bond promises to pay
principal and interest in “gold coin of the United States of the present stan-
dard of weight and fineness.” Gold contracts such as this were unilaterally
abrogated by President Roosevelt during the Great Depression.
When a corporation is formed, shares of stock are sold to investors. For
example, 50,000 shares may be sold for $2 each, providing the corporation
with $100,000 in capital. Some shares of corporate stock can be resold in
markets that have developed for that purpose. These are called secondary
markets. The best-known secondary markets in the United States are the
New York Stock Exchange, where some trading still takes place in a build-
ing in lower Manhattan although most is now done electronically, and the
NASDAQ exchange which is all electronic. In addition to shares of stock,
bonds and limited partnership units are also traded on these exchanges.
When people buy and sell shares of a particular company, that company is
not a party to the trade.9 This is called secondary trading, and while the
volume of secondary trading (the number of shares traded per day) dwarfs
the volume of new issues of stocks or bonds, new issues are economically the
most important aspect of capital markets. Capital markets generally, which
include markets for initial shares of stock and new bond issues, provide the
financial “fuel” that powers the great engines of innovation and productiv-
ity that drive free market societies. The market prices of these instruments
arise out of the judgments of the buyers and sellers as to (1) the productive
value of the collection of capital goods that the shares represent and (2) how
other traders are likely to appraise the shares.
The emergence of joint ownership as represented by partnership units
and shares of stock enables us to distinguish business firms from households.
Both can be thought of as property-managing units, but whereas the primary
function of households is to manage consumption for a single person, a family
or perhaps a commune, the function of a business firm, be it a corporation, a
9
This is not to say that corporate managers are indifferent to the market price of their
company’s stock. First, they themselves may hold large amounts of stock. Second, they
may lose some of their salary or even be fired if the company’s stock performs poorly.
Third, a high market price makes it easier for companies to issue new shares of stock –
secondary offerings – to finance new activities or to buy other companies.
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Chapter 5
We now introduce a basic tool of finance which is the balance sheet. A firm’s
balance sheet is a snapshot of its financial position in time which lists all its
assets and all its obligations, and the sum of each category must be the same
– they must balance. Balance sheets are often depicted as a “T account”
where lines like the letter T are used to separate assets from liabilities. Here
is a very basic balance sheet for a company we will call ABC Manufacturing.
ABC Manufacturing
Assets Liabilities and net worth
Machines & bldgs $5 million Credit instruments (debt) $2.5 million
Shares of stock (equity) $2.5 million
Total $5 million Total $5 million
As you can see, the total assets are $5 million as are the total of liabilities
($2.5 million credit instruments) and net worth ($2.5 million shareholder
equity). Credit instruments (bonds or loans) usually have a fixed nominal
face value and pay a fixed nominal amount of interest. Thus, the holder of
a five-year $1,000 bond bearing 5% interest will receive five annual interest
payments of $50 (or more likely ten bi-annual $25 payments) plus a lump-
sum payment of $1,000 at the end of five years. Shareholders are called
“residual claimants” because they are entitled to the residual – whatever is
left over after all other liabilities have been subtracted from assets. This
75
76
follows from the basic rule of accounting which says that assets must always
be equal to the total of liabilities and shareholder equity. Net worth – the
equity of the stockholders – is calculated last and is the number that makes
the total on the right-hand column equal to the total on the left.
Now suppose a year has passed and ABC has prospered. Its earnings
(income) can be used only three ways, much like an individual’s earnings.
An individual can use cash income for consumption, saving, or addition to
cash balances. Since businesses are not organized for the purpose of con-
sumption, we would substitute distributions to shareholders or partners for
consumption and write the equation and instead of saving, add reinvestment
in the business (acquisition or replacement of capitals goods) plus repayment
of any debt
Again we must note that each term in the equation is totaled over a specified
time period such as a month, a quarter or a year. In this case, assume our
company’s machines and buildings have depreciated to a value of $4 million
because they have aged and suffered wear and tear. It has also accrued
earnings (accounting profits), some of which have been retained in the form
of cash balances and some used to pay down debt. The balance sheet now
looks like this:
ABC Manufacturing
Assets Liabilities and net worth
Machines & bldgs $4.0 million Credit instruments (debt) $2.0 million
Cash $3.5 million Shares of stock (equity) $5.5 million
Total $7.5 million Total $7.5 million
Shareholder equity (assets minus liabilities) has more than doubled, from
$2.5 million to $5.5 million. In addition, the company has accumulated $3
million in cash. This cash could be used to expand the business or it could
be paid out to shareholders in the form of dividends.1
1
Because of distortions caused by tax laws, corporations sometimes buy some of their
own shares in the open market, and then retire those shares in lieu of declaring dividends.
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Chapter 5: The balance sheet 77
ABC Manufacturing
Assets Liabilities and net worth
Machines & bldgs $4 million Credit instruments (debt) $5 million
Shares of stock (equity) -$1 million
Total $4 million Total $4 million
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78
Figure 5.1: Amazon.com had negative net worth during its early growth
years.
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Chapter 5: The balance sheet 79
course an asset to shareholders, and would appear on the asset side of their
personal balance sheets. Stated differently, shareholder equity is the amount
that makes assets balance liabilities.
Our examples show that stockholders take on more risk than bondholders
but can also reap greater rewards. Stockholders’ equity can increase without
any limit when a company prospers or can be wiped out when it performs
poorly. Bondholders’ returns are more certain but they do not benefit from
the company’s prosperity except in the sense that default becomes less likely.
If the company should face bankruptcy or liquidation, bondholders are paid
off before shareholders get anything.
A great variety of hybrid financial instruments have arisen that are nei-
ther pure bonds nor pure equity. Convertible bonds are bonds with attached
warrants that entitle holders to purchase shares of stock at a specified price.
Preferred stock is a class of stock that pays a fixed dividend and is usually
redeemable by the company at some specified date and price. The claims
of preferred stockholders precede those of the common stockholders in case
of bankruptcy or liquidation but are inferior to the claims of bondholders.
And if you check the stock exchange listings, you will find a host of hybrid
issues identified by whimsical acronyms like TIGRS, MIPS, and QUIBS to
name a few.2
Despite their differences, debt and equity perform the same basic eco-
nomic function. Both are securities or financial instruments. Each is the
holder’s asset and the company’s liability. Both provide pooling of resources
to purchase capital goods and labor. Both are claims to capital goods,
though the details vary as we have seen. But their economic function – to
convert savings to capital – is identical.
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80 The Flow of Funds
bottom of the diagram we see the most important flow, which is households’
use of disposable personal income for consumption. Consumption is, after
all, the ultimate purpose of all economic activity. Gross domestic product
(GDP) consists of this consumption plus investment, which is provided by
capital markets, as well as government expenditures.3 Some government
expenditures flow directly to individuals in the form of transfer payments
(Social Security, welfare programs, etc.). Most government funds are spent
for salaries, materials, weapons, etc. Government funding comes from indi-
viduals and corporations in the form of taxes. Corporations and households
both provide savings to the capital markets. Complex as it may appear,
this diagram leaves out many details. For example, net borrowing by gov-
ernments, businesses, and individuals is not shown. Also, we are considering
3
Gross domestic product figures are meant to provide an indication of the economic
welfare of a nation. Some authors consider the inclusion of government expenditures in
GNP problematic, either because (1) they consider them intermediate goods or (2) because
such expenditures are coercively funded and therefore do not necessarily reflect the desires
of the people who were taxed to provide the funds.
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82 The Flow of Funds
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84 Indirect Finance
reversed: savers would demand these instruments and companies would sup-
ply them. While this would have been valid, the market for loanable funds
lets us see directly the role of a composite interest rate since that is what
is shown on the vertical axis. In a market for stocks and bonds, the role of
interest rates would be somewhat obscured.
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Chapter 5: The balance sheet 85
P
3
0
0 2 4 6 8 10 12 14 16
Q
Figure 5.4: Transaction costs drive a wedge between interest paid and in-
terest received.
nesses: scrap iron, restaurant supplies, musicians for hire. Many of them
now operate on the internet, with greatly reduced transaction costs. In
the financial world, brokers and dealers match buyers and sellers of stocks,
bonds, mortgages, and other financial instruments. Mortgage brokers, for
example, find home buyers who want mortgage loans and match them with
banks and other institutions that have funds to loan. Stock brokers, oper-
ating through various stock exchanges, match buyers and sellers of stocks.
Costs of stock transactions, which were once fixed by the government, have
fallen dramatically while service has improved. Customers using stockbro-
kers’ web sites now routinely see their trades completed in seconds, paying
perhaps $10 for a transaction that might have cost $100 (not adjusted for
price inflation) prior to the 1975 deregulation of brokerage commissions. In
addition, customers now get free access to vast quantities of research data
which was difficult to get in 1975.
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86 Indirect Finance
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Chapter 5: The balance sheet 87
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88 Indirect Finance
markets in the form of interest rate ceilings. There are many laws that
forbid a willing lender and a willing borrower to complete a transaction in
various circumstances if the interest rate exceeds the legal ceiling. Like all
price ceilings, these limits gave rise to shortages, provided they are binding,
i.e., that they are set below the market-clearing rate.
We have said that all income goes to consumption, increased cash bal-
ances, and/or investment. Investment in turn can be divided into acquisition
of capital goods (real investment), direct finance, and indirect finance. Flow-
of-funds diagrams can be used to track these flows on a national level, as in
Figure 5.2.
Thus far we have maintained an analytical distinction between demand
and supply of money versus the supply and demand for saving or for loanable
funds. Banks, however, blur this distinction through what is called fractional
reserve banking, which we will take up next.
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Chapter 6
6.1 Origins
Gold warehouses began to appear in England in the 17th century, although
deposit banking existed in China as early as 1000 AD. As a direct outgrowth
of the emergence of specie (gold and silver) as money, merchants began to
deposit their gold and silver with goldsmiths for safekeeping. This was a
natural extension of the goldsmiths’ business since they were familiar with
the various forms of specie, had good reputations, and were equipped with
storage vaults. When customers left their gold or silver, the goldsmith is-
sued a paper receipt which could be used later to redeem the goods. These
receipts, like any credit instrument, were an asset of one party (their holder)
and a liability of another (the goldsmith). These instruments had no speci-
fied maturity, but the assets in storage were redeemable on demand, meaning
the holder of a receipt could go to the goldsmith at any time during business
hours and demand to exchange it for gold or silver. The goldsmith charged a
fee for his services which the customers were willing to pay for the benefits of
increased convenience and security. A T-account for a goldsmith (ignoring
equity) might look like this:
89
90 Origins
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Chapter 6: Fractional reserve banking 91
Now William the Goldsmith was in the credit business – he has become a
financial intermediary or more briefly, a banker.
Our goldsmith’s assets and liabilities balance in terms of amounts, but
the T-account fails to show an important imbalance: their time structure.
The goldsmith’s liabilities are all payable in gold on demand, but his loans
could not usually be called in quickly or easily. In short, he was “borrowing
short and lending long,” and this became an important problem of bank
management. His reserves – the gold actually remaining in his warehouse
– were only a fraction (in this case, half) of his liabilities. Here we have
a rudimentary form of fractional reserve banking. Goldsmiths’ warehouse
receipts came to be called bank notes like the one shown in Figure 6.3.
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92 Effects of fractional reserve banking
net benefit. This gain is permanent, but the cost is a temporary dislocation
during the time that money substitutes are expanding relative to reserves,
as purchasing power shifts from holders of money to bankers.
As an aside, notice that in our modern economy many businesses have
adopted policies similar to fractional reserve banking. Airlines, for example,
typically “overbook” their flights. They sell more seats than are available
on a flight, knowing that a few passengers usually don’t show up. If they all
show up, the airline company offers compensation to anyone willing to give
up his seat. Companies that provide services over the internet – including
banks! – do not provide sufficient server capacity to accommodate all their
online customers simultaneously, knowing that it is most unlikely that they
all will try to log in at once. Roads, telephone systems, and cafeterias offer
further examples which are at least partly analogous to fractional reserve
banking. To be sure, these examples are not perfect analogies because they
are examples of flows whereas bank deposits are stocks. They are not com-
pletely analogous because they represent services, which are flows, whereas
bank deposits are stocks.
We have listed the benefits of fractional reserve banking, now what about
its drawbacks? The primary hazard of fractional reserve banking is the
possibility of a run on the bank. A run is usually a sudden and dramatic
event and therefore quite difficult to anticipate. If for some reason, some
critical number of depositors begin to doubt the ability of the bank to honor
its redemption obligations, other depositors will notice this and join in with
demands for redemption. The bank may actually have sufficient assets to
cover its liabilities to the depositors, but since some of those assets are in the
form of long-term loans which cannot easily or quickly be converted to cash,
it may be unable to satisfy a crowd of depositors clamoring for redemption.
This situation is called illiquidity. Bank runs have historically featured long
lines of anxious depositors waiting to get into the bank. The first people
in line get all their money and the last get none, and this of course is the
source of the urgency.2
2
The classic Jimmy Stewart movie “It’s a Wonderful Life” includes a dramatic bank
run scene.
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94 Effects of fractional reserve banking
Figure 6.1: Gold bullion stored in the warehouse of the SPDR Gold Shares
Trust. The bars each contain 400 ounces of gold, valued at about a third of
a million dollars.
first loan, the money stock went up by £2,500. You may see this more
clearly if you envision the bank loaning out its own notes instead of loaning
out gold – the result is identical. If banknotes are lent out, some will be
returned for redemption in gold, and if gold is lent out, some of it will be
deposited in exchange for banknotes. Either way, the market will approach
the same equilibrium in which some of the new money is in banknote form
and some is in specie form.
Consider now a hypothetical economy in which gold in circulation as
money amounts to £1,000,000.4 Suppose banks hold £100,000 of that sum
and have issued banknotes 100% backed by that gold. The aggregate balance
sheet for these banks (excluding capital which will be discussed later) is
Now banks as a whole reduce their reserve ratio from 100% to 20% – they
issue new loans until they reach a point where the gold they hold equals to
4
£ is the symbol for the British pound sterling. In our example we assume a pound
stands for a certain weight of gold, as it once did.
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Chapter 6: Fractional reserve banking 95
The aggregate reserve ratio for these banks is equal to the gold in reserve
divided by total notes outstanding, or £100,000/£500,000 = 20%.
What has happened to the total money stock? It was £1,000,000 prior to
the expansion and was then increased by £400,000 – the amount of the newly
issued notes. We can get the same sum by observing how much money is in
circulation after the expansion: £900,000 in specie and £500,000 in notes for
the same total of £1,400,000. Note that reserves are not counted as part of
the money stock, since they are not available for use as a general medium of
exchange. Also note that 100% reserve banking does not increase the money
stock since under this rule, all deposits are converted to reserves. The lower
the reserve ratio, other things being equal, the greater the amount of new
money that is created when new deposits are made.
We have now uncovered an important insight: in a fractional reserve
system, private banks create money. Private banks create money when they
increase their deposits and loan out all but a fraction of those funds. Some-
one who deposits $100 in a bank counts that $100 as part of his money
stock. If $90 of that deposit is loaned out, the borrower counts that $90
as part of his money stock. $100 has been converted to $190 through the
bank’s fractional reserve practice.
Private banks cannot, however, create money on a whim as government
central banks can. They can only do so when they attract new deposits and
choose to loan out some of these deposits rather than adding them all to
reserves. Banks usually do not hold much in the way of “excess reserves”
which are reserves above and beyond the statutory minimum, because they
forgo interest income on these funds if they do. Furthermore, when deposits
shrink and and there are no excess reserves, banks must call in some loans
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96 Effects of fractional reserve banking
in order to maintain required reserves, and when they do so they shrink the
money stock.
What happens to the price level when fractional-reserve banking replaces
100% reserve banking? The increased money stock causes a rise in the price
level and a decline in the purchasing power of money. Under a gold standard,
the PPM is the price of gold. But since gold, or any commodity money,
is used for consumption as well as for money, the rise of fractional-reserve
banking frees up some gold for consumption that otherwise would have been
used as money. Users of gold – jewelers, dentists, electronics firms – face
declining costs, and competitive pressures transfer some of that benefit to
consumers. In other words, society as a whole benefits. Recall that we are
posing a situation where fractional reserve banking arises spontaneously on
the market without any government involvement. Profit-seeking bankers
have discovered a way to reduce the cost of the monetary system and enjoy
enhanced profits, at least for the short run. Everyone benefits. Of course,
if a transition to fractional-reserve banking were sudden, it could be very
disruptive. However, institutions that arise via spontaneous order, as we are
assuming here, usually do so gradually.
Now we might ask whether private banks enjoy gains from money cre-
ation comparable to the seignorage that governments and central banks en-
joy when they create money. The answer lies in the fact that private banks
operate in a competitive market. The difference between the interest they
charge on loans and the interest they pay on deposits, called their spread,
is the primary source of banks’ profits. If a single bank were to introduce
fractional-reserve banking in a formerly 100% reserve market, it would en-
joy a one-time boost in profits. But competing banks would follow suit, and
spreads would tend toward an equilibrium level of zero economic profits.5
Subsequent increases in loan volume would yield approximately this same
level of profits.
There is another way to look at the benefits of fractional reserve banking.
Recall that commodity money entails resource costs. The resource cost of
gold sitting idle in banks is an opportunity cost because that gold cannot
5
That is, conventional accounting profits equal to the going rate of interest.
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Chapter 6: Fractional reserve banking 97
be used to adorn women, fill teeth, or coat the connectors of printed circuit
boards. Gold released from bank vaults can of course fulfill these functions.
The paper and ink used to create money substitutes constitute very small
resource costs and electronic transfer systems are even more efficient.
Notice that the advent of fractional reserve banking is yet another ex-
ample of spontaneous order, not involving government action. However,
governments have interjected themselves heavily into the banking industry
as we shall see in subsequent chapters.
Banknotes have several features that make them attractive as money.
First, they are redeemable. Though they are mere paper and ink, they rep-
resent a promise to pay specie on demand, much as the receipt you get from
the dry cleaner represents your ownership of the suede jacket you left there
for cleaning. Second, they are negotiable, meaning they can be exchanged
from one person to another without any noticeable transaction costs. Fi-
nally, paper is more convenient than gold because it is lighter in weight and
can be folded. Banknotes are not, however, the last word in convenience.
If you carry large amounts of negotiable banknotes you may find their bulk
to be inconvenient, and worse, you may be robbed. Profit-motivated banks
began to offer a solution to this problem in the form of checkable deposit
accounts. The holder of such an account can write checks, sometimes called
drafts, that entitle the person receiving the check to redeem it for money at
the bank on which the check was drawn. The check can be drawn in any
amount that is less than the check-writer’s current account balance.
The first checks were made out to the “bearer,” meaning whoever physi-
cally possessed the check. Bank notes are also spendable by their bearer, but
bearer checks have one important distinction vis-a-vis banknotes. Whereas
a banknote is a liability of the bank of issue and will always be redeemable
as long as the bank has sufficient specie in its vault, a check is a liability of
the account holder and is only redeemable as long as the bank is liquid and
the account holder has sufficient funds in his checking account. Thus there
is a greater risk of not getting your money when you accept payment in the
form of a check rather than banknotes. In the past, checks were generally
accepted only by payees who knew the payer’s reputation or had some con-
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98 Effects of fractional reserve banking
tinuing relationship with the payer such as an electric utility has with its
customers. Fifty years ago, stores did not accept checks in payment for pur-
chases. Now electronic check validation systems have been invented to make
this form of payment much more attractive. Also, banks have also instituted
steep penalties for “bouncing” checks, i.e., returning checks for which the
account holder has insufficient funds. These penalties tend to discourage
people from writing bad checks (colloquially called “rubber” checks).
Nowadays we almost always make checks payable to a particular person
or business firm, not to the bearer. Such checks can only be redeemed by
the person or firm to whom they are made out and this makes it relatively
safe to send checks in the mail. Technically such checks can be negotiated
somewhat like bearer checks. If Smith writes a check payable to Jones, Jones
can write “pay to the order of Brown” on the back and sign his name and
then use the check to pay Brown. Brown then takes the check to the bank
for redemption. Or Brown could endorse the check over to Green, and so on.
But this seldom happens because the amount Jones wants to pay Brown is
not likely to be equal to the amount of the check that Smith wrote the check
for. We will discuss modern mechanisms for clearing checks in Chapter 12.
Could unregulated fractional-reserve banks create new money without
limit? Could they cause hyperinflation – a collapse in the value of money
and a runaway acceleration of price inflation? Absent government inter-
ference, the answer is almost certainly no, not as long as their notes and
deposits remain redeemable. There are two sources of redemption that tend
to “discipline” banks against excessive issues of new liabilities, whether in
the form of bank notes or deposits. The first is that in the long run banks
would not be able to issue more notes and deposits than the public wants to
hold. Consider Bank A, a note-issuing bank that maintains fractional gold
reserves. Anyone holding a note issued by Bank A can take it to that bank
and demand gold. Anyone holding a check drawn on Bank A can likewise
present it for redemption in gold, provided the account on which the check
is drawn has sufficient funds. People will increase their redemptions of Bank
A’s notes or hasten to cash checks drawn on Bank A if they have doubts
about its liquidity or worse, its solvency. As we have seen, such doubts can
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Chapter 6: Fractional reserve banking 99
spread like a virus from person to person, causing a run on the bank. Sec-
ond, people may deposit banknotes and checks from Bank A into another
banks, such as Bank B. Bank B will take these to Bank A and present them
for redemption, again raising the possibility of a bank run.6
Banks are in business to make a profit. If they suffer a run and they
have no insurance or other strategy for mitigating the run, they go out of
business and the bank owners lose their investment and the employees likely
lose their jobs. So fractional-reserve banks have an incentive to hold an
optimal level of reserves. If that level is too high, their profits will suffer. If
it is too low, they risk a run. The banks whose managers are most skilled at
reducing the risk of a run will be able to reduce reserves and thereby increase
profits.7 Those who are most successful over time acquire a reputation which
enhances their prospects of continued success.
So the willingness of customers to hold banknotes and deposits plus the
competition of other banks and the possibility of adverse clearings serve
to restrain banks against excessive increases of the money stock. We must
emphasize that these are purely market phenomena, as we have not yet
introduced government into the picture. This arrangement – competitive
issue of banknotes and deposits by private unregulated banks – is called free
banking, and its viability is upheld by historical episodes in Scotland, Swe-
den, Canada and elsewhere. Historically, nearly all such banks functioned
as fractional reserve banks. While the price level is necessarily higher un-
der fractional-reserve banking than under 100% reserve banking, fractional
reserve banking, once established, does not lead to sustained price inflation
6
In the normal course of business Bank A will have some of Bank B’s notes and checks
that it wants to redeem, and vice versa. These redemption activities are called clear-
ing, and in order to increase the efficiency of clearing operations, clearing houses arose
which specialized in offsetting the obligations among the various banks within a particular
geographic area.
7
Do not confuse reserves with reserve requirements. The latter are minimum amounts
of reserves that governments force banks to hold. While reserve requirements are imposed
on some kinds of accounts at U. S. banks, there are no government-imposed reserve re-
quirements in Canada or Switzerland. We will say more about reserve requirements in
our study of central banking in Chapter 12.
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100 Effects of fractional reserve banking
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Chapter 6: Fractional reserve banking 101
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102 The Government Central Bank
mand. Such banknotes thereby ceased being true bank notes and became
fiat money instead. Through this process, the central bank becomes a de
facto government agency, gaining for governments a second way to issue fiat
money in addition to direct issues of fiat money by the government Treasury,
such as that shown in Figure 6.2. All the nations of the world now have
fiat money systems and notes issued by central banks constitute almost the
entire money stock.
Let us examine simplified and rounded-off versions of the balance sheets
of the central bank, the Fed, and private banks using 2005 figures. We will
add complications later.
Currency belongs on the liability side of the central bank’s balance sheet, but
it is unlike any liability of a private firm. This is because fiat money cannot
be redeemed or exchanged for anything but more fiat money. The central
bank may accept your fiat money and give you different denominations in
exchange, or it will trade worn-out bills for new ones, but that is all. Reserves
are assets of private banks and liabilities of the central bank. In a purely fiat
money system, reserves are simply bookkeeping entries rather than currency
or specie.
Now assume the private banking system is represented by this highly
simplified balance sheet, which omits vault cash, physical assets and equity
capital:
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Chapter 6: Fractional reserve banking 103
In this situation the total money stock9 consists of $750 billion in deposits
plus $760 billion in currency in the hands of the public (the $5 billion in
vault cash does not count) for a total of $1,525 billion. The diagram below
shows that fiat money consists of currency plus reserves, and that deposits
are a multiple of reserves. Note a potential source of confusion here in that
reserves are a form of fiat money but they are not part of the money stock.
They are not part of the money stock because they cannot be spent; they
are not a medium of exchange.
This shows that when a central bank issues more fiat money under fractional
reserve banking, there is a multiple expansion of the money stock since some
of the new money makes its way into banks, where it is multiplied by the
process we have seen. Recall that under a gold standard, a fractional-reserve
policy reduces resource costs. Under a fiat money standard, fractional re-
serves do not entail any such saving because there are no resource costs.
Hence there is no wealth effect or welfare gain from money creation, but
there are nevertheless distribution effects.
Central banking can exist without fiat money. What happens if a central
bank promises to redeem some or all of its notes for specie? Early in its
history, the Federal Reserve System did in fact issue redeemable gold notes,
and the Treasury redeemed its notes for silver prior to 1933. Thus silver and
gold continued to play a diminishing role in the U.S. money system between
9
Some authors, particularly financial journalists, use the term “money supply.” We
prefer “money stock” because we are referring to the total existence at any particular
time, and we reserve “supply” to denote flows.
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104 The Government Central Bank
the Fed’s 1916 inauguration and the 1971 severing of the last link between
U.S. money and gold. In this intermediate situation there were actually
three tiers or levels of money. At the top level, we have the Fed’s simplified
balance sheet looking like this
Central bank
($ billion)
Assets Liabilities
Gold 1.5 Fiat money 4.0
Loans 2.5
Total 4.0 Total 4.0
Notice the reserve ratio is reserves divided by loans = 3/39 = 7.7% (not
the ratio of reserves to total assets which would be 3/42). Finally, we have
the money stock represented by these figures (refer to the diagram on the
previous page for the source of these numbers):
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Chapter 6: Fractional reserve banking 105
Figure 6.2: Federal Reserve assets for year-end 2007 and 2008.
Figures 6.2 and 6.3 present consolidated Federal Reserve balance sheets
for 2007 and 2008. We have chosen not to use the usual T format, so as
to highlight the drastic changes that took place during 2007 and 2008. The
most significant items are these
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106 The Government Central Bank
of these securities.
• Three LLC’s have been set up under the name “Maiden Lane.” The
first advanced funds to JPMorgan to acquire Bear Stearns, an invest-
ment bank that was on the brink of failure. The second was used
to purchase mortgage-backed securities from American International
Group, an insurance company that had expanded into this and other
forms of derivative securities. The third purchase collateralized debt
obligations from AIG.
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Chapter 6: Fractional reserve banking 107
Capital accounts
Capital paid in 21,076 21,071
Surplus 21,076 16,846
Other capital accounts 0 4,600
Total capital 42,152 42,517
Figure 6.3: Federal Reserve liabilities for year-end 2007 and 2008.
Another interesting Fed asset is its gold stock, valued at $11,041 million.
This is a holdover from the time prior to 1965 when some Federal Reserve
notes were redeemable in gold. This gold reserve is valued at $42.22 per
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108 The Government Central Bank
ounce which was the arbitrary price that the government fixed just prior to
severing the last link between the dollar and gold in 1971. The government
is holding about 261 million which at today’s market price of about $485 per
ounce, would be worth about $126.8 billion rather than a paltry $11 billion.
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110 The Government Central Bank
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Chapter 7
111
112 Fiat Money Versus Commodity Money
will use the term currency to refer to these two forms collectively, although
some writers reserve the term currency for paper money, in contrast to coins.
In the U.S., our paper money, as we have said, is issued by the Federal Re-
serve while coins are minted by the Treasury. Since it costs a little over
three cents to produce and distribute a new quarter, for example, the Trea-
sury gains about 22 cents in seignorage revenue for every quarter.2 This
seignorage revenue is remitted to the Treasury by the Bureau of the Mint,
and the Fed’s only involvement is in the distribution of coins to banks. In
the U.S. today, banks issue deposits but they are not allowed to issue either
banknotes or coins.3 The closest thing we have to private banknotes are
travelers’ checks. These are issued by American Express and other private
companies and are used by people who plan to travel to foreign countries
where their U.S. money is not accepted. Travelers’ checks are essentially
unregulated and unlike traditional banknotes, they are only spent once. As
we shall see, travelers’ checks are counted as part of the money stock, but a
very small part.
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Chapter 7: The Varieties of Money: a Critical Comparison 113
retained its stash of gold at Ft. Knox that was once required as legal back-
ing for Federal Reserve notes. This hoard, amounting to some 261 million
ounces, seems to serve no purpose. One can speculate that the American
public still views this gold as some sort of indirect assurance of the value
of its money. When asked in a Congressional hearing why the government
continued to hold gold given that it was no longer need to back the money
stock, Fed chairman Alan Greenspan answered, “in times of extreme eco-
nomic crisis gold has been the only means to settle accounts.” Greenspan
was evidently saying that the U.S. gold stock still served as some sort of
emergency reserve or implicit backing.4 Whatever the reason, the market
value of that gold at this writing is about $126 billion. That gold could pre-
sumably be sold and the proceeds distributed to taxpayers or used to pay
down the national debt. Another important distinction is that money pro-
vides the government with a tool to control the economy which it lacks under
a commodity money standard. Your appraisal of this situation will depend
on whether you believe government control of the economy is desirable or
even possible.
Sustained inflation is unlikely under a gold standard, since gold mining
is a very laborious and expensive process, requiring years of exploration,
permitting, mining operations, and environmental restoration. By contrast,
fiat money can be created in any quantity at virtually no cost so that there is
no limit to the amount of price inflation that is possible under a fiat money
standard. Of course, if someone should find an economical way to convert
base metals into gold – the age-old goal of alchemy – there could be high
inflation under a gold standard, and gold might lose its position as a favored
medium of exchange.
Why is sustained inflation undesirable? We have said that any reasonable
stock of money will serve as well as any other, but problems arise during
the transition to a different (usually larger) money stock. If money were
4
In 1966 Alan Greenspan published an essay, “Gold and Economic Freedom,” in which
he stated that “gold and economic freedom are inseparable” and “in the absence of the
gold standard, there is no way to protect savings from confiscation through inflation.” He
recently stated that he stands by this essay.
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114 Distribution Effects
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Chapter 7: The Varieties of Money: a Critical Comparison 115
precious metals rises under inflation since many people see them as financial
havens.
Depreciation is an important item in accounting for any business firm.
Buildings and equipment wear out and have to be replaced or refurbished.
Accountants must estimate the yearly decline in the value of buildings and
equipment as they age. The loss in value (depreciation) appears on the ex-
pense side of a firm’s income statement. At best, estimating depreciation is
a tricky proposition. When prices are rising, the nominal replacement cost
of a particular machine may be much higher than was estimated when its de-
preciation schedule was established. The result is that some business firms’
reported income may be overstated because of the failure to adequately ac-
count for price inflation in the depreciation schedules. That exaggerated
income will be fully subject to corporate income tax, which amounts to a
stealth tax increase caused by inflation.
Inflation gives rise to an implicit tax on cash balances. Under a fiat
standard, some of the value of the cash in your pocket essentially leaks out
and is lost or transferred to other market participants or to the government
just as if it had levied a tax on that cash.
A further effect of inflation is price distortions or changes in relative
prices. When new money is created, it is not distributed uniformly to
all prior holders of money, as if it were dropped by helicopters, to use a
metaphor favored by economists. Some people get the new money first.
They can spend the money before prices have risen. The next people to
get it face only a small rise in prices, but the last people get it only after
prices have fully adjusted upward. This phenomenon is sometimes called
the “ripple effect” of new money; it is also known as the Cantillon effect
after the 18th Century economist of that name.
If people correctly anticipate inflation, they can dodge its effects in some
circumstances. Creditors, as mentioned, can build inflation hedges into the
terms of their loans. “Fixed” incomes can be adjusted for inflation. De-
preciation schedules can be adjusted appropriately. People can divert their
savings into precious metals. Of course, such strategies will have mixed
success, and substantial resources may be consumed in the process of devis-
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116 Net Welfare Effects of Inflation
ing and carrying out such strategies. Furthermore, some effects cannot be
avoided even if they are fully anticipated. The drop in purchasing power of
cash balances is unavoidable, and virtually everyone must hold some cash
balances. Distortions due to the ripple effect are very difficult to avoid since
the ripple process is nearly invisible. As Lord Keynes put it,
Lenin is said to have declared that the best way to destroy the
Capitalist System was to debauch the currency. By a continu-
ing process of inflation, government can confiscate, secretly and
unobserved, an important part of the wealth of their citizens.
By this method they not only confiscate, but they confiscate ar-
bitrarily; and while the process impoverishes many, it actually
enriches some. As the inflation proceeds and the real value of
the currency fluctuates wildly from month to month, all per-
manent relations between debtors and creditors, which form the
ultimate foundation of capitalism, become so utterly disordered
as to be almost meaningless; and the process of wealth-getting
degenerates into a gamble and a lottery.
Lenin was certainly right. There is no subtler, no surer means
of overturning the existing basis of society than to debauch the
currency. The process engages all the hidden forces of economic
law on the side of destruction, and does it in a manner which
not one man in a million is able to diagnose.
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Chapter 7: The Varieties of Money: a Critical Comparison 117
Even industrial materials such as copper, nickel and zinc may be held as
inflation hedges. And in fact during hyperinflation, people may acquire al-
most any asset with some durability just to get rid of their money: paper
towels, canned foods, pencils, etc.5
Inflation has serious effects on productive activity. When an expansion
of the money stock is unanticipated, it will generate a temporary decline
in interest rates. Business people can easily be fooled into thinking this
decline represents an overall drop in time preference (though they may not
use that exact term) and will respond by shifting assets away from consumer
goods toward producer goods, and most especially into projects that take
the most time to mature and are therefore most sensitive to interest rates.
Later, when the monetary expansion is recognized and interest rates reverse
course, it is seen that there has been no change in time preference at all and
the investments made on this assumption are revealed to be unsustainable.
A recession results.6
When inflation is anticipated, people sometimes add clauses to contracts
to attempt to compensate for it. Business owners’ attention is partly di-
verted away from managing their business and into inflation-watching. Be-
cause it is very difficult to anticipate inflation over long periods of time, long-
term contracts are avoided or negotiated at higher costs. Projects which by
their physical nature require long startup times are more difficult to finance.
An ironic example of such a project would be a new gold mine. A new gold
mine requires many years of exploration, permit seeking, assembling equip-
ment and workers, digging and processing ore, and finally environmental
restoration after the lode has been exhausted. With financing for long-term
ventures hard to come by, the supply of new gold may drop just as inflation
has pushed up demand for it.
Some people get rich by successfully anticipating inflation. A gambling
mentality begins to crowd out the focus on production that is more preva-
5
The time and money that people spend in efforts to avoid the effects of price inflation
are sometimes called shoeleather costs, a phrase which we believe tends to trivialize a quite
serious issue.
6
This is a brief sketch of Austrian business cycle theory.
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118 Benefits of Inflation
lent under a stable monetary regime. People eagerly anticipate the latest
announcements of “money supply” figures, gold prices, or whatever indicator
has captured the public’s attention. This was the case in 1980, when much
chatter at cocktail parties was about gold, silver, and diamonds. Inflation
was halted soon after that and the prices of inflation hedges collapsed.
We should not lose sight of the benefits people accrue from holding
money for unexpected purchases or as a way of saving. People hold less
money when they anticipate inflation. They thereby lose some of the con-
venience of money holdings, whether cash or demand deposits, that they
would otherwise enjoy.
Relative price changes are important and sometimes subtle signals that
guide a market economy. In an inflationary environment, it can be hard to
tell whether the rise in a particular price simply reflects the overall price
level or whether there has been a relative price change. This is because
business people are most closely attuned to prices in their own specialty
than to overall prices. Relative price changes call for a different responses
– basically, shifting of assets to different lines of production. General price
inflation carries no such implication.
How significant are these effects? Under mild inflations such as we have
experienced in the U.S., these costs are low. One estimate puts the figure at
$15 billion per year, which is about $50 per person. Under hyperinflation,
savings are wiped out and monetary calculation becomes very difficult. The
German hyperinflation of 1920-23 virtually destroyed the middle class in
that country and helped pave the way for the rise of Hitler and the Nazis.
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Chapter 7: The Varieties of Money: a Critical Comparison 119
federal individual income tax schedule for a married couple filing jointly was
as follows
Income up to $16,050 10%
From $16,050 to $65,100 15%
From $65,100 to $131,450 25%
From $131,450 to $200,300 28%
From $200,300 to $357,700 33%
Above $357,700 38%
These ranges of income are called tax brackets. As nominal incomes in-
crease, people drift into higher income brackets and thus pay higher rates,
even though the real value of their income may be unchanged. This is called
bracket creep. Actually, the tax codes have been modified so that most of
these brackets are indexed to inflation. The $16,050 bracket boundary for
2008 was $15,650 in 2007, for example. A major exception is the alternative
minimum tax. The AMT is a separate parallel income tax regime which
takes effect when one’s income reaches a certain level, and its effect is to
partially eliminate some deductions like charitable contributions. The AMT
is fiendishly complex and makes planning very difficult for high-income in-
dividuals. With the progress of inflation and because the AMT brackets are
not indexed for inflation, more middle-income Americans have been snared
in the AMT net. There have been proposals to eliminate or reform the AMT
but nothing has been done as of this writing, although Congress has passed
a last-minute one-year patch in each of the last several years.
In the short run, a burst of inflation can reduce unemployment and lower
interest rates, and while these effects may seem positive, they do not endure
and in fact are almost always reversed in the long run. They are a lot
like the effect of a dose of cocaine – a temporary high followed by painful
consequences. We will have more to say on this topic in subsequent chapters.
It should be no surprise that the record shows more inflation under fiat
money than under commodity money. Although the U.S. has not suffered
hyperinflation since the Revolution (excluding the Confederacy), its price
level history demonstrates fiat money’s inflationary bias. Figure 7.4 shows
the decline in purchasing power of the U. S. dollar since 1959 as measured by
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120 Benefits of Inflation
both the Consumer Price Index and the Producer Price Index. As you can
see, a 1959 dollar has lost all but about 15 to 20 cents of its value since that
time. Note also that most of these years were years of advancing productiv-
ity. This means that had there not been any increase in the money stock,
we would have expected continuing gradual declines in the price level. That,
in fact, is exactly what happened during much of the nineteenth century in
the U.S.
Compare England under commodity money during the period from 1650
to 1914. While price levels can only be estimated roughly for these early
years, the best figures we have show an approximate rise in the price level
for those 264 years of approximately zero!
The costs of the inflations we have experienced following the transition to
fiat money must be weighed against the resource cost of commodity money.
Resource costs, though real, may be a small price to pay avoid the devasta-
tion of inflation.
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Chapter 7: The Varieties of Money: a Critical Comparison 121
Fiat money can be compared to paper bicycle locks. Paper locks will
work just as well as steel locks as long as everybody believes in them. Fiat
money can work well as long as people believe in it, and on the whole it
did work rather well during the Greenspan era. Both inflation and interest
rates were relatively low during his tenure as Fed chairman. But paper
bicycle locks don’t usually work in the long run and fiat money may not
either. Gold and silver sitting “idle” in vaults may be the sort of monetary
restraint necessary to protect us from our rapacious politicians.
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122 A Future Gold Standard
Of course, the market would ultimately pick a winner from among these or
other as yet unforeseen possibilities. Resource costs would be driven down
to the point where the marginal benefit of one more unit of reserves would
approximately equal the marginal benefit realized in terms of increased con-
fidence or marketability.
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Chapter 7: The Varieties of Money: a Critical Comparison 123
7.7 References
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124 References
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Part III
125
127
9
While markets in the United States are some in respects the freest in the world, our
financial sector is one of the most heavily regulated – more so than Japan’s, for example.
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128
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Chapter 8
Financial instruments
All financial instruments, with the exception of outside money, are someone’s
asset and someone else’s liability. If I have a checking account at Citicorp,
the account balance is my asset and the bank’s liability. If I own a U.S.
Treasury bond, it is my asset and the Treasury’s liability. The one-dollar
silver certificates the authors used in 1960 were their asset and the Treasury’s
liability. But if you hold contemporary one-dollar bill, which is a Federal
Reserve note, it is your asset but nobody’s liability.1 Federal Reserve notes
are outside money as are Treasury coins.
Money is the most basic financial instrument. Although its definition –
a generally accepted medium of exchange – is conceptually simple, it is not
so easy to identify just what particular instruments fit that definition in a
give time and place. We will now look carefully at what actually constitutes
money in our present economy, and how its various forms are summarized
in standard monetary aggregates.
1
Notwithstanding the fact that outstanding currency appears on the liability side of
Federal Reserve’s balance sheet. It appears there simply as a formality; the Fed is not
obligated to redeem its notes for anything except more notes.
129
130 Components of the monetary aggregates
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Chapter 8: Financial instruments 131
tary base, M1, and M2. Other variations on these categories are sometimes
used.2
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132 Components of the monetary aggregates
8.1.2 M1
The next category of money is called M1. It consists of (1) currency in cir-
culation (i.e., excluding vault cash), (2) travelers’ checks, and (3) so-called
transaction deposits. Travelers’ checks are sold to people who plan overseas
travel, and have one attractive feature which is the ability to replace them
if they are lost or stolen. Traveler’s checks that have been issued but not
yet used are counted in M1. But they have lost market share to credit cards
in recent years and therefore constitute only a very small part of M1, hav-
ing peaked at about $10 billion in the 1990’s and since dropped below $6
billion. Transaction deposits consist primarily of demand deposits (check-
ing accounts) but also include certain interest-bearing checking accounts
that, although technically not redeemable on demand, are actually directly
spendable. This minor category includes NOW accounts (“notice of with-
drawal”), an early form of interest-bearing checking account that appeared
in the 1970’s, ATS accounts (“automatic transfer service”) and Credit Union
share draft accounts, which are almost identical to bank checking accounts.
We lose very little if we streamline our definition of M1 to include just
1. Currency in circulation
3. Travelers’ checks
Notice that M1 and the monetary base overlap since both include currency
in circulation. Reserve balances are part of the monetary base but not M1;
checking account balances are part of M1 but not the monetary base.
8.1.3 M2
The next category is M2 which includes everything in M1 and four more
items: (1) savings deposits, (2) small certificates of deposit, (3) retail money-
market mutual funds, and (4) money-market deposit accounts. Each of these
requires some explanation.
Savings deposits consist of bank passbook accounts and statement ac-
counts. In the past, people who opened savings accounts were given a little
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Chapter 8: Financial instruments 133
book with blank pages called a passbook. They would take their passbook
to the bank and the teller would accept deposits or pay out withdrawal re-
quests and write the amount of the transaction and the new balance in the
passbook. Passbook accounts have all but vanished, but they remain in the
definition of M2. Statement savings accounts are like passbook accounts
except they substitute a written periodic statement to the saver instead of
a passbook.
Certificates of deposit are bank savings instruments with specified ma-
turities such as six months, one year, five years, etc. Originally, these were
represented by paper certificates, but now many savers buy them through
brokerages and hold them in their accounts without any paper document.
They are not intended to be redeemed before maturity but they usually can
be, with a penalty typically in the form of a partial loss of interest. Only
certificates of deposit in amounts of $100,000 or less are counted in M2.
$100,000 was until recently the the largest deposit that is covered by FDIC
insurance (more about which later).
Money-market mutual funds are funds run by mutual fund companies
like Vanguard or Fidelity. They accept customers’ money and use it to buy
debt instruments having maturities of 90 days or less. The term “retail”
means that they are marketed to individuals rather than to large institutions.
These funds are discussed more fully in Section 8.2.5
Money-market deposit accounts are similar to money-market mutual funds
except that they are offered by banks and they are insured by a federal
agency.
The common attribute of the four asset classes that M2 adds to M1 is
that they are not negotiable but are redeemable.6 Negotiability means they
can be exchanged from person to person; redeemability means the issuer
will provide outside money or a different form of inside money in exchange
for the asset on demand. Thus a holder of an M2 asset can exchange it for
spendable money at any time. The fact that one can write checks on the
assets in a money market fund make them seem like spendable money but
6
Even small CD’s bought through brokers are sometimes negotiable. Bid and ask prices
are available and a sale can be effected very quickly.
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134 Components of the monetary aggregates
Monetary base:
Currency $800
Reserves $571
Total $1,371
M1:
Currency: $800
Demand deposits: $410
Other checkable deposits: $300
Traveler’s checks: $6
Total $1,516
M2
Savings deposits $4,007
Small time deposits $1,350
Retail money market funds $1,054
M1 $1,516
Total $7,927
To repeat, the first two categories which together constitute bank reserves
are not really money since they are not generally accepted media of ex-
change. This could be a source of confusion since they are counted in dollars
and otherwise may give every appearance of being money. But if we are to
adhere to our definitions and categories, we should consider them potential
money, not actual money.
While the table above might seem to include every asset that could con-
ceivably be proposed as money, there are other fairly liquid assets that might
appear to be candidates for classification as money but are not. Treasury
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Chapter 8: Financial instruments 135
bills trade in a very liquid market. They are available in huge quantities
and have short maturities which means that their market values fluctuate
only slightly and hence they are very liquid. But Treasury securities, while
they are highly liquid, are never considered a form of money, even in its
broadest sense.7 Likewise if you hold shares of stock that are listed on a
major exchange, you can sell them and get your money in three days, but
the price you will receive may vary a lot and you have to pay a brokerage
fees. Shares of stock are therefore even farther from money on a liquidity
scale. In summary, if you hold Treasury securities or shares of stock, they
are certainly part of your wealth and are a lot more liquid than your house
but they are still not part of your personal money stock.
Money stock figures are not easy to calculate in practice. The Fed issues
weekly estimates of the value of each of the monetary aggregates, but these
are only estimates for a variety of reasons. To calculate the monetary base,
the Fed also needs to know how much currency is in circulation (not in bank
vaults) and the levels of member bank reserve holdings at the Fed. The
latter figure is easy to come by, but currency moves in and out of bank
vaults all the time, which means that estimates must be used. To estimate
M1, the Fed needs to find the level of bank deposits, and here again money
is constantly flowing in and out of these accounts, so estimates must be
used. As we move into M2, the figures are even more difficult to come by.
Because of all this uncertainty, the Fed issues weekly preliminary estimates
along with revised figures for previous periods.
In addition to revised figures, seasonally-adjusted figures are often is-
sued. There are certain times of year when people demand more currency –
Christmastime in particular. Sometimes it is desirable to eliminate these sea-
sonal fluctuations from the data in order to bring into better focus changes
that might be caused by other factors. This is done by computing a normal
seasonal variation and then subtracting that variation from the raw figures.
Money stock figures can be found in Barron’s, the Wall Street Jour-
nal, and numerous web sites. Note that financial publications use the term
7
Yet money-market fund balances, which often invest in Treasury bills, are counted in
M2.
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136 Other marketable instruments
“money supply.” We prefer the term “money stock” because “supply” im-
plies a flow instead of a stock. However, it is safe to assume that “money
stock” and “money supply” mean the same thing.
Which is the true money stock: the monetary base, M1, M2, the former
M3 or some other variety? There is no one definition that is best for all
situations. M3 is no longer available, and there was a time when a lot
of money was moving out of M1 into M2. This would have distorted any
calculations based on M1, but not M2 since M2 includes everything in M1.
So generally speaking M2 may be preferable but in many situations it doesn’t
much matter.
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138 Other marketable instruments
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Chapter 8: Financial instruments 139
to residents of that state who then enjoy full exemption from state as well
as federal income tax on the dividends paid by these funds. There are even
muni money market funds – funds that buy only muni bonds due in 90 days
or less, so as to maintain a one dollar share price.
Muni bonds vary widely in quality. State and local governments can get
in local difficulty, as when the City of Vallejo, California declared bankruptcy
in 2008. Rating agencies rate muni bonds, and local governments often find
that it pays to provide purchasers of their bonds with insurance which they
can obtain from private firms, thereby raising the quality of their issues and
lowering the interest that they pay.
In theory, high-quality muni bonds should yield less than Treasury secu-
rities because interest on the latter is subject to federal income tax while the
muni bond interest is tax exempt to borrowers who live in the state where
the bond is issued. Yet such was the magnitude of the “flight to quality”
at year end 2008 that short Treasuries were paying essentially zero for the
shortest maturities out to about 3% on 20-year bonds, while munis were
yielding 4% or more.
Outstanding municipal bond securities amounted to nearly $2 trillion at
year-end 2008, with about 50,000 separate issuing agencies ranging in size
from tiny school districts to the State of California.
Nearly all state and local capital projects are financed by bond issues.
It is probably safe to say that the average voter does not think about the
interest cost of the bond issues that he votes on. Total interest payments on
a 30-year bond paying 3% per annum will add up to more than the entire
principal, meaning that projects are essentially paid for more than twice
over.
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142 Other marketable instruments
• Others
Some of these agencies in this partial list were created during the Great
Depression. The conditions of the time may or may not have justified their
creation. Regardless of the fact that conditions have changed greatly since
that time, it seems these agencies can only grow larger over time.
The two largest government-sponsored enterprises, Fannie Mae and Fred-
die Mac, started out life as government agencies but then were privatized,
while retaining their special mission to support the housing market. The
dual loyalties of these institutions, to their stockholders on the one hand and
to their special mission on the other hand, may have been the key to their
failure. In particular, foreign holders of their debt and equity securities as-
sumed that they enjoyed the backing of the federal government even though
there was no such explicit guarantee. Fannie and Freddie spent heavily on
lobbyists and campaign contributions so as to help deflect any questions
about the lavish salaries paid to their executives or the high leverage ratios
that they employed.
In 2008 Fannie and Freddie suffered massive losses as the housing market
began to unravel, taking down mortgage-backed securities with it. In July
Fannie and Freddie saw their stock prices fall by almost half. In response, the
Treasury announced an increase in the GSE’s line of credit at the Treasury
and other measures. These measures proved inadequate, and on September
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Chapter 8: Financial instruments 143
7 of that year, the regulator of Fannie and Freddie announced his intention
to place them under a “conservatorship.” The Treasury pledged up to $100
billion for each organization in return for $1 billion in senior preferred stock
yielding 10% per annum. A cap on the size of their portfolio of mortgage-
backed securities was also imposed. The extent of future taxpayer losses, if
any, is unknown at this time. Fannie Mae stockholders, however, saw their
shears plunge to less than $1 per share from %80 in January, 2007. Preferred
stockholders fared somewhat better.
The Government National Mortgage Association was never privatized
and did not suffer from the problems that brought Fannie Mae and Freddie
Mac to grief.
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144 Other marketable instruments
like 98:30 which means the bond trades for 98 and 30/32 cents per dollar of
face value, which as a decimal is 0.98375. Thus a bond with a $10,000 face
value is quoted at 98:30 and thus is trading for $9,837.50. Stock prices were
switched from fractions to decimals a few years ago but the bond markets
have yet to follow suit, perhaps because there is much less public awareness
of bond trading as compared to stock trading.
Commercial paper (part of the money market) is a relatively new type of
financial instrument. Large corporations with good credit such as General
Electric can bypass banks and borrow money directly thus reducing their
transaction costs. Commercial paper is not backed by collateral, and paper
whose maturity is less than 270 days, they are not subject to government
regulation. Yet defaults or other problems were very rare in this market
prior to the crisis of 2008, when the Fed stepped in to buy up distressed
commercial paper.
Bankers’ acceptances (part of the money market) are bank-guaranteed
bills of exchange. A banker’s acceptance is simply a piece of paper that
announces the bank’s willingness to guarantee a debt instrument of a busi-
ness firm. Banker’s acceptances are actively traded and are widely held by
money market funds. They are a contingent liability of the bank that issues
them.
Mortgage-backed securities are a relatively new development. Mortgages
are not very marketable since they represent such a wide variety of properties
and borrowers. This provides a strong incentive to securitize these assets.
Nowadays if you take out a mortgage, chances are it will be securitized, which
means it will be purchased from the institution that created the mortgage
and bundled with other mortgages into a fund that is financed by issuing
shares, i.e., securitized. Government guarantees are an additional advantage
of mortgage-backed securities.
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Chapter 8: Financial instruments 145
banking.
Money market mutual funds (MMMF) appeared in the U.S. financial
world around 1970, a time when interest rates were rising but Regulation Q
prevented banks from offering competitive rates on savings accounts. At the
same time, the Treasury raised its minimum for purchase of Treasury Bills
from $1,000 to $10,000, putting them out of reach of small savers. Clever
entrepreneurs stepped into this breach and invented money market funds
which had several new and attractive features. They offered rates of return
comparable other short-term rates, a high degree of safety, low minimum
balances, and most importantly, a constant one-dollar share price. Most
funds later added check-writing privileges, usually with a minimum amount
like $100 or $250, intended to limit the expense associated with clearing
many small checks. Efficient and affordable computer systems enabled the
operators of successful funds to meet expenses and clear a profit by charging
shareholders a fraction of one percent of their fund balances. These charges
were not levied directly, but were subtracted from the fund’s income prior
to distributions to shareholders. Technically, shareholders were owners of
equity stakes in a mutual fund, but for all practical purposes, and mainly
because of the constant one-dollar share price, the check-writing privilege,
and in recent years, online transfer privileges, they began to view these
balances as part of their personal money stock. Indeed, small money-market
fund balances were added to the definition of the M2.
How is it that MMMF share prices are kept at exactly $1.00; no more,
no less? The answer lies in the short maturity of the instruments that
MMMF’s hold. The value of such a security, which could be commercial
paper, Treasury Bills, or municipal securities such as revenue anticipation
notes, depends on two things (assuming unchanging risk): their maturity
and the prevailing short-term interest rate. Short term securities are issued
in discount form, meaning that purchasers buy the security at a discount
from par. Thus if you buy a $10,000 3-month Treasury bill for a quoted
price of 99.6, you pay $9,960 and the $10,000 you receive three months later
consists of your $9,960 principal plus $40 representing interest. The rate of
interest is thus $40 divided by $9,960, multiplied by four to make an annual
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146 Other marketable instruments
This security’s value will march in nearly a straight line toward $10,000. But
suppose the short-term rate of interest jumps from 3% to 3.5% overnight.
The next day’s value will be
$10, 000
PV = = $9, 972.70
(1 + 0.035)29/365
This would be a problem because of the way MMMF’s keep their share price
at $1.00 They do so by computing the value of their holdings at the close of
business each day and crediting the increase to the shareholders in the form
of additional shares. Thus if a fund has ten million shareholders and the
market value of its holdings has increased from $10,000,000 to $10,001,000
overnight, it will credit 1,000 new shares to its shareholders. Although new
shares are issued nightly, they are not typically not reported until a monthly
statement issued or the account is closed. An overnight drop as illustrated
above would be a problem because technically the funds cannot take shares
away from shareholders. But because such an event is exceedingly unlikely
and because management would very likely step in to cover such a temporary
loss, it is essentially a non-issue.
The failure of a MMMF to maintain a one-dollar share price is called
“breaking the buck.” During the entire history of MMMF’s, there had been
only one instance of breaking the buck until 2008 when a second instance
occurred. Most MMMF’s are managed by large firms that offer a range
of mutual funds, ETF’s, and other financial products. Breaking the buck
would be a severe blow to the reputation of such firms, perhaps because
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Chapter 8: Financial instruments 147
many MMMF shareholders are at best dimly aware that they are equity
investors in a fund whose fortunes can rise and fall. Therefore, firms will
absorb losses in their MMMF for some period of time in order to avoid
breaking the buck.
The Reserve Primary Fund held short-term securities issued by Lehman
Bros. Holdings, whose September 2008 bankruptcy caused the market for
those securities to dry up, whereupon the Reserve Fund marked their value
to zero on their books. One of this firm’s MMMF’s dropped to 97 cents on
the dollar, and the firm imposed a seven-day waiting period for redemptions.
Another stood at 91 cents on the dollar – hardly a catastrophic loss at a time
when the stock market averages were dropping by larger larger percentages
in one day.
Perhaps the biggest threat to MMMF’s is sustained ultra-low interest
rates, such as those that prevailed at the end of 2008. For example, in early
January the yield on Schwab’s $34 billion Treasury Money Market fund
had sunk to an astonishing 0.02% after operating expensese of 0.6% were
deducted.9 The yield was sure to drop because with an average duration of
55 days, the fund’s portfolio didn’t yet reflect the recent drop in Treasury
rates to essentially zero. This left Schwab with a choice of waiving fees,
which would cut into its earnings, or phasing out the fund.
All money market funds share the structure outlined above but within
those confines there are several varieties. Most invest in a mix of corpo-
rate and government securities, typically commercial paper and short-term
notes. Others invest solely in U.S. Treasury securities, and their sharehold-
ers are exempt from state income taxes on the dividends they receive. Sill
others invest in short-term municipal securities and their shareholders enjoy
exemption from both state and federal income tax10
In Chapter 6 we discussed the phenomenon of bank runs. We might
ask whether MMMF’s are run-proof. They certainly are not subject to the
first-come-first-serve aspect of a classic bank run, wherein those first in line
may get all their bank deposits converted to cash, leaving others to get little
9
Wall Street Journal, Jan. 15, 2009
10
Provided the reside in the state where the securities are issued.
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148 Present value and yield to maturity
or none. In the case of a MMMF failure, all shareholders would receive the
same percentage of their funds, e.g., 92 cents per dollar invested.
Still, a run on a particular MMMF or all funds as a whole could pro-
duce a great deal of distress as funds rushed to dump securities in order to
meet redemptions. In fact, in September 2008, the the failure of the Re-
serve Primary funds to maintain their $1.00 share price, the Lehman Bros.
bankruptcy, along with general market unrest led many investors, including
one of your authors, to move their MMMF fund assets either to insured
bank accounts or to MMMF that invest solely in Treasury securities. In
response, the Treasury announced it would guarantee most money market
funds against losses up to $50 billion for a period of one year. It is likely
that this guarantee will be extended after the year is up.
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Chapter 8: Financial instruments 149
where the interest i must of course be a decimal value. Thus for a $100
three-year loan or bond at 5%,
We have assumed that the interest for each year is not paid until the
end of the year. Suppose instead of 5% paid annually, you get paid 2.5%
twice a year? This is called semi-annual compounding and we use the same
formula but set i = 0025 and n = 6 for six 6-month periods instead of n = 3
for three years:
F V = $100 × 1.0256 = $115.97
These differences are trivial in today’s low interest rate environment, but in
1980 when interest rates were approaching 15%, banks offered more frequent
compounding to be competitive.11
The yield to maturity of a bond or other debt instrument is important
when its market value has risen or fallen. Yield to maturity reflects both
the stream of future interest payments and the rise or fall in the value of
the bond as it reaches maturity. In the example above, suppose our $10,000
5% bond has three years to run but market rates of interest for bonds of
this duration and quality are now 6%. What market value for this bond will
make its yield to maturity equal 6%? We calculate the present value of the
three remaining interest payments plus the present value of the principal,
using not the 5% bond coupon but the 6% prevailing rate:
$500 $500 $500 $10, 000
PV = + 2
+ 3
+ = $9, 632.70
1.06 1.06 1.06 1.063
11
The limiting case is called continuous compounding for which the formula is F V =
P V ∗ ein where e is the base of natural logarithms. $100 × e0.05×3 = $116.183
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150 Present value and yield to maturity
So the bond should sell for something close to $9,632. If you repeat this
calculation using a 4% going rate of interest you should come up with a
present value that is greater than $10,000.
Mortgage loans are structured somewhat differently than bonds. While
they typically have a fixed maturity date, conventional mortgages have a
fixed monthly payment which is part interest and part principal. The pay-
ments are computed so that after the last monthly payment has been made
(the 360th on a 30-year loan), the principal has been reduced exactly to
zero. Applying the present-value formula to a stream of 360 fixed monthly
payments P, we would have a loan value of
P P P P
LV = + 2
+ 3
+ ··· +
(1 + i/12) (1 + i/12) (1 + i/12) (1 + i/12)360
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Chapter 8: Financial instruments 151
As you can see, the 30-year bond declines very steeply as the market interest
rate rises and the one-year bond is not very sensitive at all. In fact, a rise of
the market interest rate from 5% to 10% has knocked almost half the value
off a 30-year bond. Why is this? The total return from a 30-year bond is
made up mostly of interest payments so its present value is very sensitive to
interest fluctuations. Such extreme price fluctuations can be a problem for
people who are risk-averse but they are an opportunity for people who want
to speculate on changes in interest rates. In contrast, a one-year bond’s
return consists primarily of principal so it is not much affected by interest
fluctuations.
Consider again the present value of a steam of interest payments, leaving
aside the present value of the principal. Assuming a constant annual interest
payment P , what happens to the present value of the stream of payments
as the maturity of the bond increases? It goes up, obviously. What if
the payments extend to infinity? Such bonds actually exist, though they
are now rare. They are called perpetual bonds or consols.12 If the bond
matures in N years with annual interest i, we can write the present value of
the payment stream as
!N
P
P VN =
n=1
(1 + i)n
Now let N become infinitely large. Doesn’t the sum of an infinite number
of terms have to be infinite? No, this is one of many infinite series that
converges to a finite value which is easily shown to be
!
∞
P P
P V∞ = n
=
n=1
(1 + i) i
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152 Risk and maturity factors
N P VN
10 $1,840.02
20 $2,867.48
50 $3,940.47
100 $4,154,39
∞ $4,166.67
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In 2008 these organizations came under fire for some questionable ratings
and for allegedly improper relationships with some of the institutions they
were evaluating.
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154 Risk and maturity factors
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Chapter 9
Financial institutions
Savers are very different in terms of time preference, risk preference or aver-
sion, income, wealth, age, etc. In response to the wide variety of savers’
needs, financial entrepreneurs have developed a vast array of financial ser-
vices, institutions, and markets. As in markets generally, innovators have
devised products that no one anticipated, such as money markets or junk
bonds, but which found favor with investors once they became known. We
will take a broad look at the categories of institutions that server savers and
investors.
155
156 Brokers, dealers and underwriters
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Chapter 9: Financial institutions 157
Figure 9.1: Traders on the floor of the New York Stock Exchange
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158 Brokers, dealers and underwriters
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Chapter 9: Financial institutions 159
Brothers was allowed to fail and other investment banks were allowed to
convert to deposit banks.
Just as banks have been allowed to start brokerage operations, stock-
brokers can now offer most of the services of banks. For example, Charles
Schwab owns a bank that issues insured deposits and offers mortgages and
other loans. Schwab also issues credit cards, runs money market funds, and
provides cash withdrawals from ATM’s. Wells Fargo is an example of a
bank which has expanded into brokerage and insurance. These two firms
have almost completely overlapped each other’s markets. Notwithstanding
all this expansion, we must bear in mind the conceptual difference between
dealers and brokers.
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160 Depository Institutions and Pure Intermediaries
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Chapter 9: Financial institutions 161
gaps usually open between their net asset value per share and their market
value per share. That is, the shares either trade and a premium or a discount
to their net asset value. Premiums and discounts reflect market judgments
of the future values of the fund’s holdings, and these spreads can get as high
as 25%; 10% one way or the other is not unusual.
Exchange-traded funds are very much like closed-end mutual funds, ex-
cept that ETFs typically buy a fixed basket of assets, such as those included
in the Standard & Poors 500 Index. Initially ETFs were focused on common
stocks but a vast array of new ETFs have arisen to track specific industries,
commodities, foreign securities, etc. Like closed-end mutual funds, ETFs do
not issue new shares in small amounts, but they do issue “creation units,”
large blocks of shares, to insititutional investors who wish to acquire them.
Recently, regulators authorized actively managed ETFs, all but eliminat-
ing the distinction between ETFs and closed-end mutual funds. ETF’s now
outnumber closed-end funds.
Real estate investment trusts (REIT) were formed for the purpose of
providing some of the tax advantages of real estate investing to small savers,
whereas before only wealthy investors could enjoy these benefits. Unlike
corporations, REITs can only hold real property (apartments, commercial
buildings, and retail buildings) or mortgages. They pay no corporate income
tax provided they distribute most of their income to shareholders.
We have already discussed money-market mutual funds which buy short-
term debt instruments, keep their share price at $1, and offer conveniences
like check-writing and on-line transfers.
Yet another class of financial firms are those that provide consumer fi-
nancing such as car loans or personal loans. Household Finance Corporation
is one of the largest such companies. Firms have also been set up to provide
working capital to small start-up companies. Allied Capital is such a firm,
making loans to hundreds of small businesses and paying high dividends to
its shareholders.
Depository institutions are distinct from other financial institutions in
three important ways. Of course, depositories accept deposits, but what
are deposits and how do they differ from other financial instruments? They
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162 Depository Institutions and Pure Intermediaries
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Chapter 10
Market Determination of
Interest Rates
163
164 The Loanable Funds Market
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Chapter 10: Market Determination of Interest Rates 165
Interest rate
D
Loanable funds
we know from observation (or can imagine knowing) where they intersect,
but we have no grounds to attempt precise descriptions of the curves them-
selves. Second, there are many other influences on the supply and demand
for loanable funds that are exogenous to this picture – they are assumed
to remain unchanged so that we can isolate the interaction between price
(interest rate) and quantity. While that is a legitimate and useful tactic,
we must not lose sight of all the other hidden variables that influence in-
terest rates. Among these might be price inflation, changes in tax laws,
or increased wealth. Also, we have seen that credit quality and maturity
are major determinants of interest rates, but rather than treating these as
exogenous to a single supply/demand graph we would segment the mar-
ket for loanable funds into many markets, each representing a particular
combination of maturity and quality.
The loanable funds approach may seem counter-intuitive. We could
turn the market for apples upside down and look at the supply of apple-
purchasing funds in terms of the price that those funds command, which
would be the number of apples per dollar. Then the supply of loanable
funds would become the demand for bonds and vice versa. This is a le-
gitimate approach which some authors follow, but we adopt the loanable
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166 The Loanable Funds Market
funds point of view because we are trying to explain how interest rates are
determined by market forces and a loanable funds diagram shows interest
rates explicitly on the vertical axis. With loanable funds diagram in front of
us we can imagine how changes in exogenous variables shift the curves and
move the equilibrium point. An increase in the demand for loanable funds,
when more people want to borrow, would shift the demand curve to the
right, resulting in more loans at a higher interest rate. More savers offering
their funds will shift the supply curve to the right, resulting in more loans
at a lower interest rate.
Of course, this analysis leaves unanswered the question of what causes
shifts in the demand for money. We will have more to say about that in
later chapters. We will also examine the supply of money under a fiat money
regime such as we have now as well as a free banking regime.
If we bear in mind that interest arises from time preference we see in-
terest not just in the loanable funds market but in almost any economic
activity that spans a significant amount of time. Think of capital goods:
goods capable of producing consumption goods in the future. The prices of
those capital goods that require the most time to bear results will be most
sensitive to interest rates. Stated differently, if people in the aggregate are
highly oriented to the present, they will strongly prefer consumption and
will require high interest to persuade them to save. The prices of durable
consumer goods which mete out their services over a long span of time are
also interest-sensitive. Another example would be the relationship between
the sale price and the rental price of a house.
The tendency of the loanable funds market to move toward equilibrium,
but never reaching it because of ever-changing circumstances, is no different
from the function of other free markets. Lenders seek the highest returns for
their funds consistent with their time horizon and risk tolerance. Borrowers
seek low rates. When a temporary shortage of loanable funds arises, a rise
in interest rates induces lenders to lend who were not quite willing to lend at
the old rates. Conversely, borrowers who were only marginally interested in
borrowing leave the market. These responses tend to eliminate the shortage.
The concept of profit can be a source of confusion. This is especially true
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Chapter 10: Market Determination of Interest Rates 167
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168 The Loanable Funds Market
way, so time preference is one way, and interest derives from time preference.
Saving requires that we forgo present consumption for the sake of in-
creased consumption. When we save money and loan it out, who gets the
present consumption that we forgo? In the case of a consumer loan, the bor-
rower gets the present consumption. You loan your brother-in-law money to
buy a Chevy which he pays you back after five years, plus interest. You take
the money and buy a Cadillac and park it next to his five-year-old Chevy.
It is convenient to subtract consumer loans from total lending in order to
study the connection between saving and investment.
In the case of business investment, it is not so obvious who gets the
present consumption that you as a lender forgo. So let us trace it through.
You buy a life insurance policy for $5,000. The life insurance company,
if we neglect expenses, buys a $5,000 corporate bond. The bond issuing
company buys $5,000 worth of capital goods – machine tools, for example.
The machine tool manufacturer pays its workers $2,500 and its suppliers
$2,500. The suppliers pay for materials and labor. And so on with their
suppliers. Ultimately, most of the money goes to workers who use their
wages for present consumption. Some goes to owners as profits and they
consume those profits. Of course, workers and stockholders could invest
part of their income in which case we would further trace their savings and
ultimately find workers and owners consuming, bearing in mind that the
end purpose of all production is consumption.
A key aspect of this little analysis is the fact that workers are paid at the
conclusion of each work period, typically two weeks or half a month. But
the owners must wait until the goods are sold before receiving any income.
If workers were willing to wait for their pay until the goods had been sold,
there would be no need for a capitalist to provide savings because the workers
would have done so and they would earn the interest. Of course, workers who
are so inclined can often buy stock in the company they work for. However,
financial advisors discourage too much of this since if the company fails, a
worker who has substantial savings invested in company stock will not only
lose his job but those savings as well. Many Enron employees bought stock,
having been encouraged to do so by management just months ahead of the
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Chapter 10: Market Determination of Interest Rates 169
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170 Deflation versus inflation
or 1.82%. With an inflation rate that is much less than 100% (p << 1), it
is reasonable to drop the 1 + p in the denominator leaving the approximate
formula
r ≈i−p
which gives 2% instead of 1.82% for the example – close enough. When in-
terest rates are high, the precision of the exact formula is misleading because
price inflation is typically changing rapidly in such circumstances, making
calculations all the more problematic.
Calculation of real interest rates for past periods is inexact because price
indices are inherently imprecise. They are, after all, based on arbitrarily cho-
sen baskets of goods and services. Projection of real interest rates into the
future is even less exact because we must rely on estimates of future price
inflation rates, which even expert prognosticators have difficulty with. Nev-
ertheless, this is a problem facing anyone who contemplates lending money
in an inflationary environment – some estimate must be used. Fortunately,
the money markets distill the collective estimates of all the market partici-
pants and this collective wisdom is about as good as it gets. In particular,
futures contracts on interest rates provide this information.
• People who hold cash or bonds see the real value of their holdings
increase, also the reverse.
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Chapter 10: Market Determination of Interest Rates 171
One major difference is that deflation is rarely both severe and sustained.
If sustained, it is usually mild. If severe, it is usually sudden and sharp. In
the first case people don’t need to worry much about it and in the second
case there is not much they can do about it since it hits almost without
warning. But if you see deflation coming and want to protect yourself, the
obvious strategy is to hold more money since the purchasing power of money
is rising.
Let us return to the concept of the real rate of interest. To compensate
for inflation, lenders demand higher interest rates. To compensate for de-
flation, borrowers demand lower interest rates. But nominal interest rates
cannot go lower than zero. Why not? Suppose someone wants to borrow
$100 from you and proposes to return $99 after one year – interest at neg-
ative one percent per annum. No matter what happens to the purchasing
power of money and no matter how much you trust the borrower, what could
possibly induce you to accept such a deal, as opposed to simply keeping the
$100 in your pocket during the whole year?1 Thus if nominal interest rates
should fall very close to zero, people would lose all reason to make financial
investments. The incentive to save would evaporate and money would cease
to function as a standard of deferred payment. Moreover, this situation can
be temporarily self-reinforcing. Assume that price deflation is the result of
a declining money supply. In response, people increase their portfolio de-
mand for money. In other words, the velocity of circulation declines. This
increases price deflation further. This is just the opposite of the inflation-
ary situation where expectations cause velocity to rise which in turn makes
prices increases run ahead of money supply increases, at least for a time.
Although the dire consequences of deflation as we have sketched them
are theoretically possible, in reality they almost never happen. To begin
with a gold standard regime, it is difficult, though not impossible, to en-
vision a situation where the stock of monetary gold would fall steeply and
1
For a brief intraday period in late 2008, the interest rate on certain Treasury bills
dipped ever so slightly into negative territory. Some investors were obviously willing to
forgo all interest on such bills, but why would they pay the borrower to hold their money?
The very slight negative rate could be considered a fee paid for safekeeping of funds for
which there was no better alternative, e.g., funds above the bank insurance limit.
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172 Deflation versus inflation
suddenly. Suppose, for example, someone discovered a cure for cancer that
required significant amounts of gold. There are two possibilities. First, the
process might require a significant one-time transfer of gold to new machines
that effected the cure. Or it might involve ongoing injections of gold into
cancerous tumors. In either case, a deflationary shock would occur as gold
was converted from monetary uses to clinical uses suddenly and in signif-
icant quantities. But equilibrium would return as new mines opened up
or as people figured out how to recycle some of the gold used in the new
treatment. Also note that under a gold standard, some of the gold required
by the new cancer cure would be drawn out of non-monetary stocks of gold
(such as meltdown of jewelry) and some would be diverted from supplies
that would otherwise flow to consumption. In either case, the existence of
a consumption market would soften the effects of the new demand on the
market for monetary gold.
Deflationary shocks under a government fiat money regime are even more
difficult to imagine, since governments do not ordinarily have anything to
gain from contractions of the money supply. Recall that when they increase
the money stock, governments gain seignorage revenue and devalue their
outstanding debt. Both of these effects would reverse themselves under a
situation where the government was deliberately reducing the money stock.
In order to reduce the stock of money, the Treasury or the central bank
would essentially have to burn some of its incoming tax revenue. Also,
outstanding debt would have to be paid off with more valuable money, which
would further strain the Treasury.
We must not confuse declines in the overall price level – price deflation
– with declines in particular relative prices. Prices of personal computers
have plummeted in recent years in both real and nominal terms, especially
when adjusted for the power of those computers.2 Very few people complain
about this situation. And while many early computer manufacturers have
been driven out of the business as a result of fierce competition (even IBM
2
Computer engineers like to say that if automobile manufacturing had progressed at the
rate at which computers have progressed, a Rolls Royce would cost $1 and get 1,000,000
miles per gallon!
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Chapter 10: Market Determination of Interest Rates 173
sold its personal computer operation in 2004), most of those that remain,
such as Dell, continue to earn respectable profits in spite of rapid price
declines.
10.5 Marketability
Some bonds are more marketable than others, meaning it is easier to find
buyers for them. Bonds issued by IBM, for example, are actively traded
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174 Tax Treatment
and their prices are easy to obtain from brokers, though not quite as easily
as stock prices. In contrast, consider a bond issued by a small and obscure
company. Such a bond would not be as marketable, perhaps not marketable
at all, and therefore even if that company’s prospects were just as sound
as IBM’s, its bonds would pay higher interest as compensation for lack of
marketability.
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Chapter 10: Market Determination of Interest Rates 175
conversion. Most mortgages can be (and usually are) paid off in advance of
their maturity without any penalty to the borrower. This is a kind of put
option, meaning the mortgage holder has the right to “put” it back to the
lender (or more likely, the firm to which the mortgage was sold) at any time.
Some bonds are accompanied by warrants which entitle their holders to buy
shares of the company’s stock at a certain price. Warrants are a kind of call
option. They grant their holder the right to call away shares of stock from
the writer of the option (which is the company in the case of warrants).
Sometimes bonds (and more commonly, preferred stocks) are callable.
This means that after some specified date, the issuer has the right to re-
purchase the bonds at some specified price, i.e., call them in. For example,
preferred stocks are usually issued at $25 per share, and may be callable by
the company at 25, starting five years after their issuance. Such provisions
are a benefit to the company and thus require somewhat more interest to
make them attractive to buyers.
10.8 Maturity
As we have indicated, a bond’s maturity date is the date when its principal
is to be returned to the lender (or maturity may refer to the time remaining
until this date). As a rule, people require higher interest rates to induce
them to lend for a longer period of time, assuming other factors are equal.
Active markets for bonds of various maturities give rise to a yield curve,
which is a plot of interest rate versus maturity. A particular yield curve is
specific to bonds of a certain, tax treatment, etc. and should be thought of
as a snapshot at any particular time. Yield curves are most commonly show
interest rates on Treasury securities. The yield curve shown in Figure 10.8
for Treasury securities as of January of several recent years is based on rates
quoted for bills, notes, and bonds. Note that these are not time history
plots. Rather, each curve is a snapshot taken in different years and showing
the yields available on securities due in three months, one year, etc.
The yield curve for 2007 slopes down slightly. This situation is called an
inverted yield curve, where short-term rates exceed long-term rates, These
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176 Maturity
6%
5%
4%
Interest rate
3%
2%
2009
1% 2008
2007
2006
2005
0%
3 mo 6 mo 2 yr 5 yr 10 yr 30 yr
Maturity
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Chapter 10: Market Determination of Interest Rates 177
different maturities are only imperfectly substitutable. The theory says that
on the whole, people slightly prefer shorter maturities and require higher
interest rates to induce them to go longer. That is, the short end of the
maturity spectrum is their “preferred habitat.”
The liquidity premium theory says that lenders will accept lower interest
rates for shorter maturity. This explains the normal upward-sloping yield
curve but not inverted curves.
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178 Interest Rate Controls
and some were lost altogether. Thus if intermediation increases the efficiency
of the flow of funds, disintermediation does just the opposite.
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Part IV
Commercial Banking:
History and Practice
179
181
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182
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Chapter 11
The U. S. Experience
183
184 Pre-Civil War: From Chartered Monopoly to “Free” Banking
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Chapter 11: The U. S. Experience 185
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186 Pre-Civil War: From Chartered Monopoly to “Free” Banking
taxes (i.e., they held public legal tender status), In addition, the government
provided part of the Bank’s equity capital. It was, in its time, America’s
largest corporation. As of 1809, its simplified balance sheet was as follows:
This balance sheet provides some insight into banking practice at the time.
For example, the reserve ratio, equal to the amount of gold and silver re-
serves divided by the sum of notes and deposits outstanding, was 5/13 =
38% and the ratio of capital to equity was 10/23.5 = 42%. Although this
reserve ratio is high by present-day standards, other banks used these notes
as a basis for further expansion, the result being a 72% rise in the price level
between 1791 and 1796. Thus the ratio of private banks’ aggregate liabilities
to the reserves held by the second bank would be a much smaller number.
The term pyramiding is used for such situations, where a bank’s liabilities
are a multiple of its reserves, and those reserves are in turn a multiple of
another bank’s reserves (Figure 11.1).
Banking was a divisive political issue at this time. The Federalists, led
by Washington and Hamilton, were the pro-bank party, and they stood
for a powerful central government, tariffs, internal taxes, a large standing
army and a large national debt. The Republicans,5 led by Thomas Jeffer-
son and James Madison, wanted frugal government, free trade, no internal
5
Sometimes called the Democratic Republican Party and unrelated to the modern
Republican Party
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Chapter 11: The U. S. Experience 187
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188 Pre-Civil War: From Chartered Monopoly to “Free” Banking
payments. Thus the War of 1812 was financed mainly through privately
issued fiat money as the U. S. continued to borrow and pay out unredeemable
private bank notes. After the war it was generally agreed that banks must
return to making specie payments but it was difficult to see how this might
be done in light of the great expansion of credit during the war, in addition to
a great deal of credit extended to purchasers of public lands, many of whom
could no longer make their installment payments. With specie payments
suspended, the notes of many banks began to trade at a discount. This
was especially problematic for the Treasury which received payments from
public land purchasers largely in depreciated currency, but had to make its
purchases mainly in the East where the money had depreciated much less.
In response to this situation, the Second Bank of the United States was
formed in 1816, much like the First Bank only bigger. Its balance sheet as
of 1832 was as follows:
Here we see a lower reserve ratio than in the First Bank, 7/44 = 16%.
The primary justification for the Second Bank was to help state banks
resume specie payments. During its first three years of operations it did
so, but only by expanding its own notes which state banks then used as
reserves, with actual gold obtainable only from the Second Bank – another
instance of pyramiding. Only the Second Bank’s notes were receivable in
payment of taxes.7
7
Tariffs were the only federal taxes levied at the time, and very few people paid these
taxes.
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Chapter 11: The U. S. Experience 189
It was not long before America’s first modern bank panic hit, the Panic
of 1819, which was also a period of economic contraction.8 Specie payment
was suspended, but because the government’s control of the economy was
quite limited, the panic ended fairly soon and specie payment was soon
resumed. But the episode left a bad taste and opposition to the Second
Bank mounted. So important was the issue that it led to a new political
alignment. The Whigs replaced the Federalists as defenders of banking
and government intervention; prominent Whigs included Henry Clay, John
Quincy Adams and Daniel Webster. In opposition, Martin van Buren of
New York forged a new Democratic party to carry on the tradition of laissez
faire. Van Buren recruited war hero Andrew Jackson to run for President,
and Jackson won a sweeping victory over incumbent John Quincy Adams
in the pivotal Presidential election of 1828.
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190 Pre-Civil War: From Chartered Monopoly to “Free” Banking
John Marshall on the bank’s payroll. But Jackson was even more skillful at
the game of patronage. When Congress re-authorized the Second Bank in
1832, four years in advance of the expiration of its charter, Jackson vetoed
the bill. In his veto message he denounced the bank as a “hydra-headed
monster.” In response, Biddle called Jackson’s veto statement “a manifesto
of anarchy.” The veto stood but the Bank’s charter still had four years to
run. Jackson was re-elected in 1832 and in 1833 he withdrew federal funds
from the Second Bank (firing two Secretaries of the Treasury in the pro-
cess) and deposited them in various state banks which critics called his “pet
banks.” After the expiration of the Bank’s charter in 1836, it struggled on
for a while as a private bank, finally failing in 1841.
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Chapter 11: The U. S. Experience 191
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192 Pre-Civil War: From Chartered Monopoly to “Free” Banking
like bankers’ banks, places where bankers could take notes of other banks
and exchange them for their own notes or, occasionally, for coins.
A notable example of a clearinghouse operation was the Suffolk Bank
clearing system which operated from 1819 to 1859. Boston was the hub
of commercial and cultural life in Massachusetts and consequently a large
volume of banknotes from banks outside Boston – “country banks” – were
spent in the city. These notes circulated at a discount not only because the
soundness of those banks was uncertain but also because the transporta-
tion costs associated with redeeming them for specie were substantial. This
was especially problematic for merchants who did not want to alienate their
country customers by refusing or discounting their notes. Seeing a profit op-
portunity, the directors of the Suffolk Bank offered a service whereby they
would accept the notes of country banks at par, provided those banks would
maintain funds on deposit without interest. The Suffolk Bank earned income
from this arrangement primarily by loaning out the deposited funds at inter-
est. The system worked so well that many years later the U.S. Comptroller
of the Currency, John J. Knox, commented in a moment of candor that the
Suffolk Bank did its job “as safely and much more economically than the
same services can be performed by the government.”9
Clearinghouses evolved to provide more services than just note exchange.
Some of them cleared checks and guaranteed note values. They provided
incentives for banks to honor their redemption obligations while at the same
time reducing the transaction costs and resource costs of banking – the
amount of specie that had to be maintained as “idle resources” in support
of redemption obligations. In general, clearinghouses, whether organized for
profit or as non-profit associations of member banks, increased the overall
efficiency and stability of the banking system.
In some cities there were no clearinghouses, and note brokers took on
the job of exchanging the notes of various private banks, much like the es-
tablishments in today’s airports that exchange foreign currencies. Brokers
were much less efficient and less convenient than clearinghouses, and some
have criticized free banking on this ground. But we must remember that
9
John Jay Knox, “A History of Banking in the United States,” New York, 1903.
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Chapter 11: The U. S. Experience 193
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194 Pre-Civil War: From Chartered Monopoly to “Free” Banking
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Chapter 11: The U. S. Experience 195
which extended the central banking powers of the Bank of England to Scot-
land as well. Ironically, Peel’s act was a result of hard money sentiments.
And under the new system there were two serious bank failures, in 1857 and
1878.
Perhaps the U.S. banking system would have evolved in the direction of
Scottish free banking. We will never know, because U.S. free banking was
ended abruptly by the biggest crisis in the entire history of the Republic:
the Civil War.
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The Civil War (1861-1865)
196 and National Banking
$415 million in 1864, a stupendous sum relative to the size of the economy.
The National Banking Acts of 1863, 1864, and 1865 effectively monetized
this war debt, transforming it into a government-managed paper currency.
It established a system of nationally chartered banks, unique in that no other
business firms were federally chartered. While this system used general in-
corporation and was nominally open to free entry, in fact each proposed new
bank had to gain the approval of the Comptroller of the Currency,11 whose
office administered regulations and restrictions on their activities. National
banks could not issue their own notes, but instead were required to dis-
tribute U.S. Bank Notes supplied to them by the Comptroller. These notes
had to be backed by government bonds and were guaranteed at face value.
This system created a market for national debt which, by the end of the
War, had reached the staggering sum of $2.8 billion. With limitations on
federal power still taken seriously, Congress did not see fit to outlaw notes
issued by state-chartered banks, but it accomplished this end by impos-
11
Pronounced “controller.”
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Chapter 11: The U. S. Experience 197
ing a prohibitive 10% tax on such notes. This set an ominous precedent
for taxing something into oblivion that could not be explicitly prohibited.
The National Banking Acts established a currency monopoly, but instead
of a central bank, it created a system of many tightly regulated national
banks. Still no branching was allowed with the exception of some estab-
lished branches that were “grandfathered” in. And while state-chartered
banks could no longer issue notes, they could still accept deposits. Thus
a dual banking system was established in which national banks could issue
notes and accept deposits while state banks could only accept deposits.
The new national banking system did not eliminate financial instability
and the banks did not fully return to specie payment until 1875 – ten years
after the end of the war – at which time Greenbacks were made fully con-
vertible into gold. Panics continued under the new system. The years 1873,
1893 and 1907 all saw bank panics, the last a severe episode in which banks
were once again permitted to suspend specie payment.
Among other regulations, national banks were required to maintain min-
imum levels of reserves to back their deposits. Reserve requirements became
a fixture of banking regulation in the twentieth century. The presumed ben-
efit of reserve requirements was to improve the soundness of banks, but a
cost had to be paid in terms of reduced liquidity. And in fact, an entirely
new source of illiquidity arose. Notes were now fully insured but conversion
of deposits into notes involved a contraction of the money stock which had
not been the case with private note issue. That is because U.S. notes served
as reserves, and have we have seen, private deposits were pyramided on top
of those notes so conversion of deposits to notes involved a reversal of the
pyramiding which does not happen when deposits are converted to private
notes, both of which pyramid on top of specie.
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198 Creation of the Federal Reserve System
to monopoly big business. And while academics and intellectuals lent sup-
port, much of the Progressive movement was actually led by big business,
particularly the Wall Street firm of J. P. Morgan, in an attempt to establish
monopoly cartels and escape the harsh discipline of free-market competition.
Control of the banking system was a key element of their plans. Support for
a central bank was drummed up at a series of well-publicized conferences.
A draft bill for the new Federal Reserve System was worked out at a secret
meeting of top business and banking leaders in 1910 at a private island off
the coast of Georgia. It took longer than expected to line up support for the
bill, partly due to Democratic victories in the 1910 congressional elections,
but the Federal Reserve Act was passed by Congress in December 1913.
The primary justification for the new central bank was the need for
an elastic currency, one that could respond to seasonal fluctuations in the
demand for cash holdings, particularly at harvest time. The new Federal
Reserve System was also to act as a “lender of last resort,” providing a safety
net that would preclude disastrous bank runs and bank panics.
There was substantial lingering distrust of central banking in the minds
of the public at the time. To allay suspicions, the System was organized as a
network of semi-autonomous regional banks. Each regional bank issued its
own notes, all superficial variants of a single national currency.12 National
banks were required to join the System and state banks were given the option
to join. Joining meant purchasing shares of “stock” which paid a six percent
annual dividend. But to say that these arrangements made the Fed, as it is
commonly called, a private institution is a mistake. The member banks did
not own the Fed in any real sense because they could not sell their shares
and they exercised no real control of its policies or operations.
As the Fed ramped up its operations, national banknotes were phased
out. The new Federal Reserve Notes could be used as bank reserves along
with gold, silver and Greenbacks. Thus Federal Reserve Notes provided
a new basis for money creation since private banks could pyramid their
assets on top of them. In addition, the Fed took over the functions of the
12
Until recently, Federal Reserve notes were marked with a letter indicating the branch
that theoretically issued them, e.g., A for New York or L for San Francisco.
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Chapter 11: The U. S. Experience 199
many private clearinghouses that had arisen since the Civil War. The Fed
provided a national clearinghouse function which had not evolved privately
mainly because of the prohibition of interstate branch banking.
The Fed came upon the scene just in time to facilitate U.S. participation
in World War I. International gold payments were suspended and the money
stock was expanded substantially. Predictably, a severe wartime price in-
flation resulted – the worst since the Revolution. This was followed by an
equally severe business depression in 1921-22. There were no bank panics
during this time, and the depression ended quickly. Credit for the recov-
ery is perhaps due to the inability or unwillingness of either the Fed or the
Harding Administration to step in with macroeconomic remedies.
As the 1920’s drew to a close, the country was about to experience its
worst depression ever. The Great Depression of the 1930’s would make prior
business cycles seem trivial by comparison.
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200 The Great Depression of the 1930’s
permeated the economy and led businesses into systematic errors. That sig-
nal could only come through money because money permeates the economy
like nothing else. We must look to money to find answers to the mystery of
the Great Depression.
Recall the distinction between relative prices and the price level. Changes
in the money stock only affect the price level in the long run but in the short
run they affect relative prices as well. One relative price permeates the entire
economy: the interest rate, which is the price of loanable funds.
Let us begin with the levels of the U.S. money stock prior to the Great
Depression. Following the inflation of World War I, the M2 money stock
stood at about $32 billion. It shrank by about 10% during the Depres-
sion of 1921-22. Over the next decade it grew at an annual rate of about
4.6%, standing at $46 billion in 1929. Yet prices remained roughly constant.
This was because output increased substantially during the Roaring Twen-
ties due to new technology and a rising population, resulting in increased
demand for money that roughly matched the increased supply (Figure 2.3.)
As Figure 2.3 shows, the price level remained roughly constant because of
increasing demand to hold money. This increase was due to the healthy
gains in real output that occurred during that decade, due in large part to
technological advances such as automobiles and radios.
Figure 11.3 shows the tremendous rise of the Dow Jones Industrial Aver-
age from about 1929 to 1929, followed by the reversal that took the average
all the way down to 1914 levels during the depths of the Depression, followed
by a substantial recovery to 1937 and then another reversal. Not until the
1950’s did the DJI exceed its 1929 highs.
The stock market boom worried many observers including Fed policy-
makers, who throttled back on the money supply during 1928-29. The stock
market crashed in October 1929, but in the following months the crash began
to look like a one-time event with no great significance for the economy as
a whole, much like the crash of 1987 which was steeper than that of 1929
but had few long-term consequences. The economy might have recovered
starting in 1930, but in October of that year the first of three massive
waves of bank failures struck. During each of these waves, panic spread
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Chapter 11: The U. S. Experience 201
contagiously and by the end of the Great Depression fully 9,000 banks had
failed – a truly astonishing number.
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202 The Great Depression of the 1930’s
liquid some assets at “fire sale” prices. It could easily have been saved by a
merger or other means but a plan to do so fell through at the last minute.13
The waves of bank failures that swept the U.S. during the Great Depres-
sion amounted to the worst bank panic in U.S. history and indeed in world
history. The problems climaxed with a “bank holiday” declared by Presi-
dential fiat on March 6, 1933 and confirmed retroactively by Congress a few
days later. During this time banks were not only forbidden from honoring
withdrawal requests, but had to stop all operations and literally close their
doors. Although the holiday lasted just six days, more than 5,000 banks did
not reopen their doors right away and over 2,000 of these never reopened.14
The main consequence of all these bank failures, aside from countless
personal tragedies, was a one third collapse in the M2 money supply, from
about $45 billion to $33 billion in 1933. This breathtaking fall, and the
government’s response to it, was the key element in the Great Depression.
Several questions suggest themselves. Why was the commercial banking
system, after 20 years of operation under the Federal Reserve, so vulnerable?
What was the trigger that started the chain of failures? And what was the
response of the Fed, the banks’ lender of last resort? Basically – nothing!
Said President Hoover, “I concluded [the Reserve Board] was indeed a weak
reed for a nation to lean on in time of trouble.”
A comparison with Canada is instructive, since Canadian culture and
institutions are quite similar to those of the U.S. Canadian banks enjoyed
much more freedom than their U.S. counterparts. There were only a handful
of banks in that country, most of them nationwide in scope, since there were
no restrictions on branch banking. There no reserve requirements and there
was no central bank. While Canada also suffered from the depression, it
experienced a relatively mild 13% contraction of its money supply, and most
notably there were no bank failures. (Recall there were some 9,000 failures
in the U.S.) The Canadian story provides strong evidence of the ill effects
of the U.S. prohibition of branch banking, a policy nearly unique among
13
Milton Friedman & Anna Jacobson Schwartz, “A Monetary History of the United
States, 1857-1960,” Princeton, 1963, p. 309.
14
Friedman and Schwartz, op. cit., p. 330.
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204 The Great Depression of the 1930’s
was getting underway. This act raised tariff rates to their highest level in
American history. Predictably, international trade fell by 60% from 1930 to
1932, wiping out a great deal of the mutual gains from trade. While U.S.
exports amounted to only about 5% of its domestic GNP, that figure was
about 14% in the U.K., Germany and France. The Smoot-Hawley tariff had
more drastic effects on these countries than on the U.S., effectively spreading
the depression world-wide and helping to sew the seeds of fascism and war
in Europe.
In response to earlier depressions, government policy had been to do es-
sentially nothing but cut its own expenditures. This tradition was reversed
during the Great Depression and the reversal began not with Franklin Roo-
sevelt who took office in March, 1933 but with his Republican predecessor,
Herbert Hoover. It is ironic that Hoover is often condemned as a do-nothing
president. Campaigning for President in 1932, Hoover said,
We might have done nothing. That would have been utter ruin.
Instead we met the situation with proposals to private business
and to Congress of the most gigantic program of economic de-
fense and counterattack ever evolved in the history of the Re-
public.
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Chapter 11: The U. S. Experience 205
1839-43 1929-33
Money stock -34% (M2) -36%
(M1) -34%
Prices -42% -31%
Number of banks -23% -42%
Real gross investment -23% -91%
Real consumption +21% -19%
Real GNP +16% -30%
Notice that prices fell sharply during the 1839-43 episode, more so than in
the Great Depression. In other words, there was no government interference
to make prices rigid downward. Not only was there full employment dur-
ing this depression but output actually increased by 16%, notwithstanding
declines in the money stock and in investment. This is indicative of the
fact that contractions are not uniform but hit the loan market first, and
then later lead to business failures. Note that a full-employment depression
of 1839 to 1843 was something that could not be explained by Keynesian
theory.
In summary, the Great Depression was a prolonged maladjustment to
deflation that resulted from monetary contraction. So how did it end? World
War II began, and the military draft absorbed fully 22% of the pre-war labor
force. The good news was that many men were no longer unemployed. The
bad news was that they were forcefully employed in the business of getting
shot at. The true end to the Great Depression came only with the partial
freeing of the economy after the war’s end.
Let us examine some of the financial consequences of the Great Depres-
sion. First, the U.S. went off the gold standard when Roosevelt, using patri-
otic exhortations, forced all citizens to surrender their personal holdings of
gold. Thereafter, possession of gold, with some industrial and numismatic
exceptions, was made a crime punishable by ten years in jail and a $10,000
fine. New contracts denominated in gold were forbidden and those already
in effect were abrogated. The price of gold for international settlements
was arbitrarily raised from $20 to $35 per ounce. The prohibition of gold
ownership remained in effect until 1974.
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Chapter 11: The U. S. Experience 207
• Federal deposit insurance has not eliminated bank failures, but has
rendered them harmless to most bank depositors. However, this does
not mean that the risks of bank failures have been eliminated; rather,
they have been socialized.
• Thus far the 2008 recession has been nowhere near as severe as the
Great Depression. Unemployment, in particular, is still in single digits,
in contrast to the peak figure of 25% during the 1930’s.
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208 The Great Depression of the 1930’s
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Chapter 12
Banking Practice
209
210 The Regulatory Structure.
example, products that many large banks now offer through affiliates or sub-
sidiaries. Bank mergers are subject to review by their regulatory agencies,
and sometimes by the Anti-Trust Division of the Justice Department.
We have already commented on branch banking restrictions and how
they weakened the U.S. banking system relative to countries like Canada.
Originally no interstate branching was allowed and many states restricted
or prohibited branch banking entirely. In 1900, out of 12,427 banks in the
country, only 87 had any branches at all. One one occasion a bank in
Texas built a tunnel under a street so it could set up operations on the
other side without technically establishing a branch. In Ohio, banks at one
time could establish branches only within a single county, and as a result
the smaller of the state’s 88 counties were stuck with small and inefficient
banks. These restrictions have been almost entirely eliminated and so we
now have several large nationwide banks including Citicorp, Wells Fargo,
Bank of America and Wachovia. Small branches have been established in
retail stores, airports, and other previously unthinkable locations. Stand-
alone automated teller machines are also common.
The disestablishment of many regulations came about largely as a result
of successful efforts to sidestep them. Bank holding companies, established
to control the stock of individual banks, were the most common tactic.
Texas with its outright prohibition had many of them, First Interstate Ban-
corp being the largest. Single-bank holding companies also arose as a way
of avoiding prohibitions on non-bank activities such as insurance and stock
brokerage. Citicorp, which merged with Travelers’ Insurance to form Citi-
group, was the largest of these.
So-called “non-bank banks” were organizations that took advantage of
the definition of a bank as a business offering both commercial loans and
deposits. By omitting one or the other of these activities, “non-bank banks”
were able to avoid regulations on interstate banking. At one time, American
Express, First Nationwide, Merrill Lynch, Sears Roebuck and J.C. Penney
all took advantage of this loophole, which was closed by Congress in 1987.
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212 The Regulatory Structure.
12.1.1 Assets
Following standard accounting practice, assets are listed on the left-hand
column and liabilities on the right. Since assets exceed liabilities, as they
must for any solvent bank, there is positive equity capital and the sum of
liabilities and equity capital equals total assets. “Vault cash” consists of
cash in the bank’s vaults, teller drawers, and automated teller machines.
Vault cash plus “balances at the FRB” (Federal Reserve Banks) constitute
the bank’s legal reserves. “Checks in the process of collection” are checks
on their way to the Fed where they will be added to the bank’s deposits.1
“Balances at correspondent banks” arise when banks open demand deposit
accounts at other banks. The Dartmouth Bank has no branches in Boston,
for example, so it might maintains deposits at the Bank of Boston to facili-
tate check clearing.2 The Bank of Boston would record Dartmouth’s deposit
account as a liability.
Cash items are reserves in an economic sense since they pay no interest.
Until recently, reserve balances at the Fed paid no interest either, but that
changed in 2008. Notice that required reserve balances at the Fed differ
from the ordinary reserves that households or businesses might maintain –
“rainy day” funds that we might tap in an emergency. Bank reserves cannot
be tapped for any reason other than a decreased deposit base.
While bank regulators mandate minimum levels of reserves for certain
types of deposits, but banks are free to maintain higher levels. “Excess re-
serves” are thus the difference between actual and required reserves. Some-
times banks hold excess reserves out of prudence – anticipation of larger
withdrawals than the minimum level of reserves would reasonably support.
But in recent years, banks have tended to loan their excess reserves to other
1
Starting in 2004 it was no longer necessary to physically transport paper checks to the
Federal Reserve. Electronic images could be transmitted instead, resulting in much a much
speedier clearing operation and correspondingly lower assets in this category. However
some consumer groups objected to this change because it meant that recipients of checks
were no longer required to physically forward checks for clearing but could directly debit
the writer’s account via electronic means.
2
This is a form of pyramiding and raises the question as to whether such inter-bank
deposits should be counted in the money stock.
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Chapter 12: Banking Practice 213
banks whose reserves were temporarily inadequate. This market for inter-
bank loans is called the “Federal funds” market, a somewhat misleading
name since neither the Federal government nor the Federal Reserve System
is directly involved. At the time this snapshot of Dartmouth’s finances was
taken, it had loaned out (“sold”) $7 million of fed funds to other banks.
This sum appears as an interest-earning asset on the bank’s balance sheet.
Another bank with net Fed Funds borrowings would record a liability in the
appropriate amount.
The fed funds rate is a very sensitive interest rate indicator, and it was
until very recently the target that the Federal Reserve used in conducting
its open market operations, as we will see in Chapter 16.
Bank assets generally fall under one of two broad categories: instruments
with secondary markets, called investments, and those that are directly ne-
gotiated and carry unique features. Secondary reserves are liquid assets
like CD’s purchased, treasury bills, commercial paper and banker’s accep-
tances. Other investments include treasury securities, government agency
issues (mainly bonds), municipal bonds (issued by states, counties, cities,
sewer districts, etc.), mortgage-backed securities, and some corporate debt,
but not corporate stocks. The “corporate stocks” mentioned on the Dart-
mouth balance sheet are actually shares in the Federal Reserve, which the
bank was required to buy when it became a member of the Fed, and shares
of “stock” in the Student Loan Marketing Association, a quasi-government
agency. Banks are not allowed to hold ordinary common stocks as assets.
Dartmouth’s loan portfolio appears as a single line item, but bank loans
generally fall into one of several categories. Business loans (commercial and
industrial) are the most important category. Other categories include loans
to financial institutions, agricultural loans, real estate loans (mortgages)
and margin loans (loans advanced through brokers to their customers for
stock purchases). A Federal Reserve regulation limits margin loans 50% of
the value of the stocks purchased. All of these loans bear different interest
rates. A bank’s lowest advertised rate is called its “prime rate.” However,
this term is less meaningful than it once was as competition has driven some
banks to advertise “sub-prime” rates.
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214 The Regulatory Structure.
Finally, the item labeled “bank premises and other assets” captures the
current depreciated value of Dartmouth’s land, buildings, furniture, etc.
12.1.2 Liabilities
Now we consider liabilities, the sources of funds for the bank. Demand
deposits are the bank’s checking account liabilities. NOW accounts were
an early form of interest-bearing checking accounts that are now obsolete.
Government deposits are another form of demand deposits, though they can
pay interest. All of these items are counted in the M1 money stock.
Savings deposits (passbook and statement varieties) are time deposits
with fixed interest and variable maturities. Small time deposits (under
$100,000) have a fixed maturity. Money market deposit accounts pay vari-
able interest and have varying maturities. All of these count as part of the
M2 money stock.
The remaining types of liabilities can be called managed liabilities in that
management can control them directly rather than relying on customers to
open accounts.
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Chapter 12: Banking Practice 215
a large number of banks, hoping this would keep them solvent and active
in the loan market until the crisis somehow ended and the Treasury could
redeem its investments.
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216 Asset vs. Liability Management
($ million)
Citigroup (New York) $2,199,848
Bank of America Corp. (Charlotte, NC) 1,743,478
JPMorgan Chase (Columbus, OH) 1,642,862
Wachovia Corp. (Charlotte, NC) 808,575
Taunus Corp. (New York) 750,323
Wells Fargo (San Fransisco) 595,221
HSBC North America Inc. (Prospect Heights, IL) 493,010
U.S. Bancorp (Minneapolis) 241,781
Bank of the New York Mellon Corp. (New York) 205,151
Suntrust, Inc. (Atlanta) 178,986
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Part V
217
Chapter 13
Survey of Non-bank
Intermediaries
• Savings & loan institutions and savings banks such as Downey Savings
(1,400). Collectively, S&Ls and savings banks are called “thrifts.”
219
220 Savings and Loan Associations and Savings Banks
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Chapter 13: Survey of Non-bank Intermediaries 221
the bank. It was a commercial bank with its deposits insured by the FDIC
and its shares traded on the New York Stock Exchange.
A crisis struck the savings and loan industry in the 1980’s which took
many years and a great deal of tax money to solve. We tell this story below.
Partly as a result of that crisis, the number of savings and loan associations
has declined from around 6,300 in 1960 to about 1,000 currently.
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222 Life Insurance Companies
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224 Investment companies
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Chapter 13: Survey of Non-bank Intermediaries 225
buying their shares. Front-end loads are fees charged at the time shares are
purchased and back-end loads are charged when shares are sold. Competi-
tion has driven loads out of the market for the most part, so that with the
exception of a few specialized funds, most are no-load funds, i.e., funds that
do not levy any direct sales charges.4 They are left with management fees
as their income source, and these vary widely from fund to fund.
Individual investors typically lack the time or motivation to research
stocks, which is one of the reasons they are led to mutual funds which have
full-time professional managers. Ironically, however, most broadly based
stock mutual funds do not perform as well as the averages. As a result,
index mutual funds have gained in popularity. Many of these are based on
the Standard & Poor’s index of 500 stocks (the S&P 500) meaning that
they hold all 500 of those stocks in their portfolio, weighted the same as
they are weighted in the S&P 500: by market capitalization. Not only do
these funds out-perform most actively managed funds, but they also have
very low expenses since they have no need for research departments or active
managers.
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226 Investment companies
by supply and demand and is not necessarily equal to the fund’s net asset
value. Deviations of 10% above and below NAV are common and 20% or
25% deviations are not unknown. The deviations may be in part a reflection
of investors looking beyond the NAV and discounting the future prospects
of the fund’s holdings.
An advantage of closed-end funds is that the managers do not have to
worry about redemption requests. They do not need a cash buffer to meet
redemptions nor do they have to worry about possible short-term unpopu-
larity of their investments. A minor advantage to investors is the ability to
buy and sell them throughout the day, not just once a day as with open-end
funds. They can also be sold short, unlike open-end funds. However, the
total value closed-end funds has always been a small fraction of the total of
open-end mutual funds. The spread between market price and NAV may be
one deterrent to these funds.
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228 Investment companies
commercial buildings, and land). REITs, as they are called, were created so
that small investors could enjoy the same advantages. REITs operate under
special restrictions and in return enjoy favorable tax treatment. They are
restricted to two categories of investments: real property and mortgages on
real property. Many funds hold only real estate or only mortgages although
some hold both. They operate like closed-end mutual funds and are traded
on the stock exchanges, They must stay nearly fully invested and must
distribute at least 90% of their earnings in the form of dividends. As long
as they conform to these restrictions, they are not subject to any corporate
income tax, just as mutual funds pay no corporate income tax. REIT’s
usually provide above-average rates of return but they vary widely in quality
and some can be quite volatile.
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Chapter 13: Survey of Non-bank Intermediaries 229
the T-Bill minimum to $10,000, thus shutting out most small investors. At
this time smart entrepreneurs conceived of a mutual fund that invested only
in very short-term debt instruments. Recall that bond prices vary inversely
with yields, and bonds with shorter maturities experience lower variations.
Because of their ultra-short maturity, it would be extremely unlikely that
the market value of MMMF assets could drop enough to generate negative
yield to maturity which made it possible to maintain the share price at
exactly $1.00, while the MMMF yield would vary with market conditions.
MMMF dividends are always paid in the form of new shares credited to each
shareholder’s account.
The $1.00 share price, while not guaranteed, has almost never been vi-
olated. Only one or two instances of “breaking the buck,” as this is called,
have been recorded, and it is likely that management malfeasance was to
blame in these isolated instances. For all practical purposes, MMMF bal-
ances can be treated like bank accounts and in fact, most funds allow share-
holders to write checks on their accounts (subject usually to a minimum
amount of $100 or $250 per check and a limited number of checks per
month). Most also offer on-line transfers to and from commercial banks
free of charge. Retail MMMF balances are so liquid that they are counted
as part of the M2 money stock. Money-market mutual funds are subject to
regulations with regard to maturities (90 days or less) and credit quality.
Typical MMMF assets include commercial paper, bankers acceptances and
government securities.
There are now several hundred money-market mutual funds, totaling
over $2 trillion in assets. About $1.7 trillion of this is in funds whose pay-
ments are fully taxable. The rest is in funds that specialize in very short-
term muni bonds (see Section 8.2.2) which makes their dividends exempt
from federal income taxes. Most muni MMMF’s specialize in issues of a
single state which makes their yield exempt from state income taxes in that
particular state.
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230 Investment companies
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Chapter 13: Survey of Non-bank Intermediaries 231
tion much like IRA or 401K accounts. The proposal got nowhere and is
unlikely to receive serious consideration in light of the stock market melt-
down of 2008, which took down many people’s 401-k or other retirement
investment accounts..
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232 Investment companies
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Chapter 14
233
234 Innovation Fosters Deregulation
• Thrifts were allowed to pay higher interest on their time deposits and
savings deposits under Regulation Q (although prior to 1966, interest
paid by thrifts was not constrained).
• Thrifts were highly regulated as to their asset mix. They were confined
mainly to mortgage loans.
• Banks had higher capital requirements, and thrifts enjoyed some tax
advantages.
This arrangement persisted for a number of years, but the rising interest
rates of the 1970’s knocked them out of this happy equilibrium. All deposi-
tories were hit by disintermediation – withdrawal of deposits by savers eager
to find higher rates to compensate for price inflation. These were times of
serious price inflation, first hitting double digits (11%) in 1974, easing off in
1976, but rising again in 1979-81 to a peak of around 15%. Clearly, anyone
earning 3% in a bank account when purchasing power was declining at a
10% or 15% rate was suffering substantial losses.
Banks, but especially S&Ls, were losing business to foreign banks, the
new money market mutual funds, junk bonds, gold and silver, diamonds,
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Chapter 14: The Changing Regulatory Environment 235
collectibles, real estate, canned goods, and just about anything that peo-
ple thought might hold its value against the ravages of inflation. Finding
regulatory loopholes became a matter of survival for depository institutions.
One of the authors disintermediated some of his savings during that
time. Though a resident of California, he opened an account at the Coolidge
Bank in Boston. This bank and others in Massachusetts and New Hamp-
shire had won permission from the courts to issue what were for all intents
and purposes interest-bearing checking accounts, called NOW (Notice of
Withdrawal) accounts. The author had an account on which he could write
checks, with the remaining balance earning 5% or more per annum. This in-
novation let the proverbial cat out of the bag. Commercial banks and S&Ls
in New England were incensed. Congress and the regulators listened, and
soon they too were allowed to issue NOW accounts, followed soon thereafter
by the same permission in New York State. These developments precipitated
massive regulatory overhaul.
In 1980, Congress enacted the Depository Institutions Deregulation and
Monetary Control Act (DIDMCA), consisting of three parts
• The monetary control part was in part a response to the Fed’s declin-
ing control over the M1 money supply, as depositors fled from M1 to
M2 assets. Furthermore, banks were withdrawing from the Federal
Reserve – 300 of them in the prior six years. In response, the Act
provided these powers:
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236 Innovation Fosters Deregulation
But DIDMCA did not solve all the problems of depositories. Money
market mutual funds had entered the picture and were sapping the deposits
away from traditional institutions. As we have seen, these funds had come
seemingly out of nowhere to provide safe, convenient market-rate returns
to small and large savers. (NOW and ATS interest rates were subject to a
5.25% ceiling until 1986.)
In addition to disintermediation woes, S&L’s were suffering from interest-
rate risk. Like banks, S&Ls borrow short and lend long. This is a special
problem when interest rates are rising because they must offer higher rates to
new depositors while stuck with low-interest long-term rates. The problem
was particularly acute for S&Ls because they were making mostly mortgage
loans of up to 30 years’ duration.1 Variable-rate mortgages, which can
largely overcome this problem, were prohibited until 1979.
This led to the first S&L crisis. By 1982 fully three quarters of S&Ls
were insolvent and the industry as a whole had a negative net worth of
about $150 billion, assuming assets marked to market. Regulators, instead
of closing them down, decided to exercise forbearance, giving them time to
The Garn-St. Germain Act was passed in 1982. This act allowed sav-
ings and loans and savings banks to make loans other than mortgages, such
as commercial loans and consumer loans and even “junk” bond finance.
DIDMCA had phased out Regulation Q and raised deposit insurance from
$40,000 to $100,000 per customer. This was an explosive mix. To begin
with, most S&L managers lacked expertise in these areas. The agency that
provided insurance to S&L’s, the Federal Savings and Loan Insurance Cor-
poration (FSLIC) had insufficient personnel and insufficient expertise to
oversee these new activities. To make matters worse, a severe recession hit
the country in 1981-82, one that had been engineering by the Federal Re-
1
Prior to 1934, most mortgages were written for only three to five years.
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Chapter 14: The Changing Regulatory Environment 237
serve in order to choke off the inflation that reached historic levels. As a
result, many S&L assets turned sour, especially in Texas. Losses mounted
to the point where over half of the S&L’s, by some estimates, were insolvent
by the end of 1982.
Hesitating to close insolvent S&L’s, FSLIC regulators chose further reg-
ulatory forbearance. They loosened capital requirements and stretched ac-
counting principles. The situation was allowed to worsen so that by 1989 it
had reached crisis proportions. A half-hearted measure called the Compet-
itive Equality in Banking Act was passed in 1987. The real bailout came in
1989 with the passage of the Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 (FIRREA). The Federal Home Loan Bank Board
and the FSLIC were abolished and a new Office of Thrift Supervision was
established as a bureau of the Treasury Department. The FDIC became
the sole provider of deposit insurance, but with one fund for banks (the
Bank Insurance Fund) and one for thrifts (the Savings Association Insur-
ance Fund). The Resolution Trust Corporation (RTC) was set up to clean
up the wreckage of insolvent S&L’s. It seized assets of about 750 S&L’s and
sold about 95% of these assets, receiving an average of 85 cents on the dollar.
The cost of his bailout was approximately $150 billion, some of which came
from the assets of the Federal Home Loan Banks but mostly from the sale
of new government debt. Finally, FIRREA tightened capital requirements.
By 1991, FIRREA was making progress but the FDIC was running out
of funds. In response, Congress enacted yet another piece of legislation,
the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in
1991. The FDIC was given greater authority to borrow and was told to
raise insurance premiums with a goal of achieving an insurance fund equal
to 1.25% of insured deposits. p. 279.
What can we learn from the S&L crisis? Was it a market failure? Lax
regulation? Too much regulation?
Moral hazard was a direct and inevitable consequence of deposit insur-
ance. Without it, bank managers would have been much more circumspect
in their operations. Of course, they might have sought private deposit in-
surance, but the providers of this insurance would have incentives to watch
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238 Innovation Fosters Deregulation
their insured banks carefully and to withdraw insurance from banks that
went too far. (Just the threat of withdrawal would be sufficient in many
cases.) In contrast, the FDIC and FSLIC insured all banks and S&L’s with
little or no attention to the risks they were taking.
Private insurers face moral hazard problems. They deal with them by
various means: deductibles, co-insurance, risk-based premiums, and regu-
lations that purchasers of insurance must agree to. Government insurance,
being politically motivated, lacked many of these sound principles. First, de-
positors were relieved of all responsibility for seeing to the soundness of the
people who invested their money – all they had to do was locate the FDIC
sticker on the door. Further, management was partially protected form bad
consequences of heavy risks. The FDIC charged a uniform premium of 1/12
of one percent per year on insured deposits. Thus, while deposit insurance
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Chapter 14: The Changing Regulatory Environment 239
solves the liquidity problem – insuring that depositors can get their funds –
it creates a solvency problem.
After the passage Garn-St. Germain, thrifts seemed to recover and the
forbearance strategy seemed to be working. Interest rates eased, and asset
values seemed to rise. But many of these assets were dubious, high-risk
assets.
This led to the second thrift crisis. One commentator labeled the worst
institutions “zombie S&L’s,” technically insolvent institutions that were still
in business, with little to lose, facing incentives to increase risks dramatically.
They offered high interest on insured deposits thus putting pressure on their
solvent competitors. On the other side of the balance sheet, they increased
this pressure by making loans at low rates. To add a new metaphor, the
zombie S&L’s were like black holes sucking solvent S&L’s toward oblitera-
tion. Some were paying high interest rates with new deposits – a quasi-Ponzi
scheme. Factors exacerbating the situation included brokered deposits, gen-
erous accounting principles, the too-big-to-fail idea, and, as so often happens
in regulatory regimes, regulators who too close to the institutions they were
supposed to be regulating – not necessarily corrupt, but perhaps emotionally
invested in saving them.
When governments set regulatory standards for banks or any other in-
dustry, an inevitable consequence is that the customers and stockholders
cease worrying about the regulated aspects of those businesses. Thus min-
imum standards tend to become maximum standards because the lack of
consumer oversight removes incentives to do any better than the minimum.
“The government will take care of it,” becomes the general attitude. When,
as in the case of the FSLIC, a regulator is unable or unwilling to do its
job, you have the kind of disastrous situation that gave birth to the zombie
S&L’s and precipitated the general collapse. It is certainly possible that
better management of the FSLIC might have lessened the damage. But it
is also possible that market oversight would have prevented the crisis from
getting started at all.
These three aspects of the situation, deposit insurance, Regulation Q,
and the FSLIC failure, all suggest that the S&L crisis was a massive gov-
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240 Innovation Fosters Deregulation
• Modified the regulatory structure once again. The FSLIC was abol-
ished and its functions were taken over by the FDIC, which established
a separate insurance fund for S&Ls called the Savings Association In-
surance Fund (SAIC). Also, the Federal Home Loan Bank Board was
abolished and its regulatory functions were turned over to the new
Office of Thrift Supervision, part of the Treasury Department and
analogous to the Comptroller of the Currency, which is also under
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Chapter 14: The Changing Regulatory Environment 241
• Harsh penalties were meted out to some of the more notorious players,
including prison terms of up to twenty years.
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242 Innovation Fosters Deregulation
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Part VI
243
Chapter 15
245
246 How Base Money Gets Multiplied
B base money
C currency
R bank reserves
D deposits
M1 M1 money stock
rr required minimum reserve ratio r = D/R
r banks’ average actual reserve ratio, r ≥ rr
Now base money B consists of currency C and reserves R; B = C + R.
As we have seen, reserves are accounts kept at the Federal Reserve for the
benefit of commercial banks. Banks are required to maintain reserves in the
amount of at least 10% of their demand deposits.1 We will call this 10%
figure (which as we will see is set by the Fed) rr .
Consider three cases:
2. With multiple depositories but still no currency, the result is the same
3. Currrency is introduced.
We now develop the latter assumption. Assume that banks hold no ex-
cess reserves, i.e. their actual reserves are equal to the minimum required
reserves. Call the currency/deposit ratio k = C/D. Then
C+D
km =
B
1
Actually no reserves are required for the first $6.6 million in demand deposits, 3% for
amounts from $6.6 to $45.4 million, and 10% above that. Since most banks of any size
hold demand deposits far in excess of $45.4 million, the average reserve requirement is
very nearly 10%.
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Chapter 15: The Money Multiplier:
How Banks Create Money 247
C D
= +
B B
C+D
=
C+R
C/D + D/D
=
C/D + R/D
k+1
=
k+r
so that
k+1 k+1
M1 = B ∆M 1 = ∆B
k+r k+r
Thus we see that the money stock is a function of three variables:
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248 How Base Money Gets Multiplied
This bank-to-bank loan market is called the federal funds market. Fig-
ure 15.1 shows an estimate of the M1 multiplier which has been declining
steadily in recent years.
Clearly the Federal Reserve does not have complete control of the M1
money stock since the money multiplier which converts base money into M1
contains terms that are outside the Fed’s control. The currency/deposit ratio
is entirely determined by the preferences of the public. Currency is becoming
less important in ordinary daily transactions as people find credit cards and
debit cards increasingly convenient. But demand from drug dealers and
others eager to hide their transactions, along with overseas demand for U.S.
currency, have led to increasing demands for currency in recent years.
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Chapter 16
16.1 Origins
In the United States, the Federal Reserve System, commonly called “the
Fed,” is the central bank. The Fed commenced operations in 1913, fol-
lowing legislation passed in 1912. The public interest justification for the
creation of the Fed was the need for an “elastic” currency, one whose sup-
ply could expand during times of greatest need, such as harvest time or
Christmastime, and contract at other times. While legally authorized by
Congress, the decision to start a central bank was probably reached at a
secret conference organized by J. P. Morgan, arguably the most powerful
Wall Street financier of his time, held in 1910 at his private island off the
coast of South Carolina. A public choice viewpoint of the creation of the
Fed would point to the private interests of the House of Morgan and his
allies in business and politics.
16.2 Organization
The legal structure of the Federal Reserve is not economically important and
we explain it here partly because some people on the fringes of economics
use it as a basis for silly conspiracy theories. Legally, the Fed is owned by
private member banks like Citicorp or Bank of America. These banks are
249
250 Organization
required to buy shares of Federal Reserve stock and that stock pays them
a fixed 6% yearly dividend. But this stock bears little resemblance to the
shares of private corporations. Member banks may not sell their shares of
Fed stock and the dividend cannot be changed. While the Fed earns profits
on its operations, it cannot distribute those profits to its “owners” except
through the 6% “ dividend.” The member banks’ ownership of “ stock” does
not give them the right to vote out the management as the stockholders of
an ordinary corporation could. From an economic point of view, the Fed
should be thought of as a government agency, albeit an agency with some
very special obligations and privileges as we shall see.
Let us now focus on the functioning of the Fed. Fiat money issued by
the Fed or any other central bank, rather than being spent directly by the
government, is loaned out. The Fed does not actually lend money directly
to the Treasury. Instead, through its open-market operations, the Fed buys
Treasury securities from New York bond dealers. These are typically Trea-
sury Bills that were first purchased by a commercial bank or other private
party. When it does so, it reduces the supply of these bonds in the private
market, thereby making it easier for the Treasury to issue new bonds into
the market.
As of 2006, the Fed held about $800 billion worth of Treasury securities,
and this constitutes about one sixth of the total federal debt (not counting
debt in the hands of Federal agencies like the Social Security Administra-
tion). This $800 billion worth of debt is said to have been monetized, because
in essence it has been taken off the market and replaced with newly created
money.
We must emphasize that the Fed really does create new money “out of
thin air.” When buys bonds in the New York bond market, the Fed pays
with money that never existed before. This activity is some ways similar
to counterfeiting which is of course illegal. We shall return to the effects of
new money on the economy subsequently.
What does the Fed do with the Treasury securities that it acquires? It
holds them and collects interest on them from the Treasury and it presents
them for redemption when they come due. The interest on $800 billion worth
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Chapter 16: The Federal Reserve System 251
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252 Organization
Francisco. The earliest Federal Reserve notes showed the district of origin
quite prominently as you can see in Figure 6.3.
Under our present system, issuance of Federal Reserve notes does not
in itself represent creation of new money. The money that the Fed creates
in open-market operations is in electronic form. Some of this money is
converted to notes as requested by private banks in response to customer
demands. These banks can request shipments of fresh bills from the Fed at
any time, and the Fed deducts the amounts from the private bank’s account
at the Fed. The bills are actually printed by the Bureau of Engraving and
Printing, a separate government agency. Private banks also return worn
bills to the Fed for replacement with fresh bills. One-dollar bills typically
wear out in less than two years, but higher-denomination bills last somewhat
longer.2
We have seen that the Fed can create new money at will through its
open-market operations. But we must remember that private banks also
create money via the fractional reserve system. Moreover, they now use
the central bank’s notes as reserves because these notes usually enjoy the
government’s legal tender sanction, which you will recall requires that all
taxes be paid in that money, and in a stronger form, requires in addition
that all holders of all debts, public and private, accept central bank money
in payment of these debts.3 We can envision two tiers of money creation.
First, the central bank issues new money and then private banks pyramid
2
One-dollar bills have been a headache for the monetary authorities for a number of
years. New Susan B. Anthony one-dollar coins, smaller than the silver dollars of earlier
years, were issued in 1979, but the public did not accept them because they were easily
confused with quarters. Then in 1997 the Mint tried issuing brass-colored coins bearing
the likeness of Sacagawea, but these have also failed to catch on and are generally appear
only as change returned by government-owned vending machines in post offices, train
stations, etc. Canada solved its one-dollar problem by simply discontinuing its one-dollar
bill. However, it had a two-dollar bill in circulation which was not plagued by superstitious
rejection as U.S. two-dollar bills were. These stories show that even when governments
monopolize the issuance of money, they cannot force the public to accept particular forms
of it.
3
Thus we see printed on all our paper currency, “This note is legal tender for all debts,
public and private.”
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Chapter 16: The Federal Reserve System 253
The Fed has three powers that influence the money supply. We have already
discussed open-market operations in which the Fed buys Treasury securities
using newly created money, or sells them and effectively destroys the money
it receives. For the last several years the Fed has announced target Fed
Funds rates, and these targets are widely publicized. But the public is less
aware of the fact that the Fed achieves its targets by manipulating the money
stock through open market operations.
Discount Rate
The Fed’s other two monetary control powers are not much used. One is
the discount rate, which is the rate at which the Fed stands ready to loan
reserves to member banks. Unlike the Federal Funds rate, the Fed actually
sets the exact discount rate that it wants. But the Fed prefers that member
banks obtain needed reserves by borrowing them from other commercial
banks, that is, in the Federal Funds market. As a result the discount rate
does not play a direct role in the conduct of monetary policy. It is generally
set at a rate somewhat higher than the Federal Funds rate. For example, as
this is written, the Fed Funds target rate is 5.25%, the average rate for recent
transactions is 5.24% and the discount rate is 6.25%. The discount rate does
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254 Instruments of control
Reserve requirements
The third discretionary power that the Fed wields is the reserve requirements
for demand deposits. This has been set at 10% for many years and while
reductions in this requirement could increase the money supply, and vice
versa, this tool is considered rather blunt in comparison to open market
operations.
Margin requirements
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Chapter 16: The Federal Reserve System 255
Regulation Q
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256 Instruments of control
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Chapter 17
17.1 Pre-1929
Prior to 1929, the quantity theory of money held sway, and it was thought
that the price level would rise in concert with the money supply. How-
ever, there was disagreement about other aspects of banking. The Cur-
rency School of thought of mid-nineteenth century England was dedicated
to hard money and opposed to fractional-reserve banking. The Banking
School thought that limited fractional-reserve banking was acceptable. This
school also advocated the “real bills” doctrine which held that short-term
loans for productive business purposes should be the basis of currency.
257
258 Monetary policy options
ing, which is not widely known or discussed but which has theoretical and
historical underpinnings that we believe merit examination.
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Chapter 17: Targets of monetary policy 259
values of price inflation and real output growth. Four terms are added to
get the desired fed-funds target rate:
1. The long-term target real fed funds rate (2% is usually selected)
3. Half of the “inflation gap” which is the difference between the actual
rate of price inflation and the target rate.
4. Half of the “output gap” which is the difference between potential and
actual output.
This rule implies that both price inflation and output growth are important
and should play a role in the target formula. during the period from 1960
to 2003, the Taylor Rule tracks fairly well with the Fed Funds rate. Some
have suggested that Chairman Alan Greenspan has been following this rule
although there has been no public commitment to do so. And if the Taylor
rule were ever to be enshrined as official policy, there would be substantial
political pressure to modify or abolish it in recessions or inflationary periods.
There would also be pressure from economists who think their proposed
improvements on the Taylor rule should be written into policy.
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260 Monetary policy options
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Chapter 17: Targets of monetary policy 261
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262 Monetary policy options
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Part VII
263
Chapter 18
265
266
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Chapter 19
267
268 Monetary nationalism
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Chapter 20
269
Index
270
INDEX 271
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272 INDEX
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INDEX 273
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