Understanding the flow of Funds System

and the Financial Crisis of 2008
David Nawrocki and Fred Viole
Villanova University and OVVO Financial Systems

This paper describes a logical approach for understanding the flow of funds
system linking surplus to deficit, lender to borrower, by way of financial
intermediaries. Through a cascading series of mismanagement by
government regulators and the financial institutions, we see where the flow
of funds system broke down causing the financial crisis of 2008 and the
current “Great Recession.”

The financial flow of funds system is the operating system of our financial
markets and is a true national resource. An understanding of that system is crucial
to business students, educators and the general public. While there can be an
extended debate on the exact cause of the “Great Recession,” the cessation of the
flow of funds system resulted from the freezing of the credit markets in September
2008, resulted in the high employment rate and bailouts. People do not realize that
their jobs evaporated partly because the flow of funds system was not properly
managed by the financial industry and government regulators.
Having an efficient flow of funds system is essential to maintaining our current
level of production and one of the critical services provided is that it unlocks the
liquidity of illiquid assets. Markets and the flow of funds allow us to have liquid
access to the economic value that is stored in very illiquid assets such as homes,
farms, and equipment. Debt markets in particular provide access to this illiquid
wealth and improve the standard of living for everyone by transferring funds from
surplus units to deficit units. It is the transfer of funds that allows our financial
market system to do its job. Once the flow of funds system is presented, then we
can look to where the breakdown between lenders and borrowers occurred within
the flow of funds, contributing to the current “Great Recession.”
Discussion Point – Ask the students to name an individual or business not
connected to the modern banking system. This will illustrate the
interconnectedness of the entire population throuh this system, and its



Table 1. A Functioning Flow of Funds System with Two Economic Units
Household A

Household B

Income (Y)
Consumption (C)
Savings (S)
Flow of Funds





The economic system in the United States consists of millions of economic units
that are typically grouped into three large sectors: households, businesses, and
governments. As these economic units go about their day-to-day business, they
make decisions to lend and to borrow. As a result, in order to facilitate these
decisions, we have to move funds from lenders to borrowers.
Each economic unit has a decision to choose between future consumption and
present consumption.1 Milton Friedman (1980) called this “free to choose”.2 By
giving each economic unit this choice, each unit has the ability to maximize its
economic happiness (utility). This freedom to choose is the real beauty of the
(capitalist) financial market system. However, for the benefits of this freedom to
accrue, we must have a mechanism to move claims to goods and services from
savers (surplus units) to borrowers (deficit units). Essentially, we have surplus and
deficit units looking as follows:

(Surplus unit)
(Deficit unit)

where Y is the unit’s production of goods and services (income), C is the unit’s
consumption of goods and services, and S is the savings (+) or dissavings (-) of the
economic unit.
Let’s assume a two economic unit system with two households A and B.3 In
Table 1, we see that Household A has produced $1,000 in income and wishes to


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Table 2. Flow of Funds are Blocked

save $200 to defer consumption to the future. Household B also with $1,000 income
would like to move future consumption to the present and would like to consume
$1,200 now. In order for both households to be happy, A has to lend $200 to B
which is the flow of funds from surplus units to deficit units. Later when A wishes
to consume $1,200, B will repay the $200 loan and only consume $800. Both are
happy because A has chosen to defer consumption and B has moved future
consumption to the present.
If the flow of funds system does not exist for whatever reason, then funds cannot
move from the surplus unit to the deficit unit, then B cannot borrow the required
surplus. This is shown in Table 2 as the funds are blocked from moving from A to
B. A still wishes to consume less this period but the $200 of savings remains with
A in the form of unconsumed goods. B in the meantime is unable to consume
$1,200 and has to make do with only $1,000 in consumption. We no longer have
both economic units satisfied, and utility not maximized.
A major problem for the economy may now occur if Household A decides to
hold its consumption at $1,000 in the next period. Because of the leftover savings
(or inventory) of $200, A may decide to only produce $800 worth of goods in the
next period. This has the unfortunate result where the production of goods and
services declines from $2,000 to $1,800 providing us with our first recession in our
little economy (Table 3).4
As we can see, providing the freedom to choose to the economic units but not
allowing them to move the claims to goods and services from the surplus to deficit
units may result in a decrease in production. In order to maintain a given level of
production of GNP, it is imperative that the flow of funds system is efficiently
matching borrower and lender.



Table 3. Household A Reduces Production to Work Off Excess Inventory

The flow of funds system plays an important role in the growth of an economy
but it is not the source of economic growth. Economic growth requires increases in
resources, labor, and technology. However, once this growth has occurred, financial
markets and the flow of funds system provide the means to maintain the increased
levels of production.
Discussion Point – Compare today’s demographics to the 1960s and 1970s when
the baby boomers were entering their prime consumption age for demographic
effects on the flow of funds system.
Matching Borrower and Lender
When we have only two economic units, it is quite easy to put A and B together
for the $200 loan and have the flow the funds work to maintain the current level of
production. However, the task of putting millions of lenders and borrowers together
in order to maintain production levels in our economy is not simple. This is the
primary role of our current financial markets and financial institutions.
In Figure 1, we see a systems chart of the flow of funds system with three types
of financial institutions: financial markets, monetary institutions, and nonmonetary
institutions.5 First, financial markets are organized around broker/dealers who bring
lenders and borrowers together into transactions with each other. Because of
economies of large scale operation, monetary and nonmonetary institutions can
provide lower risk and lower return financial instruments to the surplus units. These


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Figure 1. The National Flow of Funds System

economies of scale include the pooling of information costs, transaction costs, and
analysis costs across large investments. Funds flow into financial institutions in
small denominations and flow out in large denominations. Funds also flow into
financial institutions in short-to-intermediate termed maturities and flow out in long
maturities. Finally, because funds are continually flowing in and out of financial
institutions, we have liquidity intermediation as well. Through diversified
investment pools, institutions can provide specialized financial instruments to
surplus units more efficiently at a lower cost and lower risk than surplus units can
achieve by themselves.
Financial Institutions
As shown in Figure 1, there are three types of financial institutions – financial
markets, monetary institutions and nonmonetary institutions participating in the flow
of funds system. Financial markets match surplus and deficit units for lending and
borrowing. Monetary institutions lend to deficit units and borrow from surplus units
by issuing money to the surplus units. This process is known as monetizing debt,
whereby the debt of deficit units is converted to money that is then used within the



economy. Monetary institutions supply money in the form of paper bills, coins, and
checkable deposits. A nonmonetary institution also borrows from surplus units and
lends to deficit units. However, the securities provided by the nonmonetary
institution to the surplus units do not act as money but rather are indirect securities
issued as a liability of the financial institution. These securities meet specialized
needs of the surplus units by providing insurance, pensions, mutual funds, trust
accounts, etc. These indirect securities also help provide a rich and diverse set of
investments to the surplus units to encourage them to participate in the flow of funds
by lending to deficit units. The flow of funds has to attract all of the savers and
dissavers to participate in order to maintain the current level of production. Using
credit money provides savers with a diverse menu of securities ranging from noreturn, low-risk, high-liquidity (money) to high-return, high-risk, low-liquidity
(equity). It is crucial that the flow of funds system maintains the confidence of all
of the economic units within an economy. If confidence erodes, people will leave
the system and drops in the production of goods and services will ensue (recession
and depression).
In Figure 1, surplus units transfer their claims to goods and services to the
deficit units and in return, they receive debt and equity instruments from the deficit
units. These instruments can be acquired through the financial markets or they may
be transformed into money through monetary institutions and indirect securities
through the nonmonetary institutions.
In Table 4, we see an overview of the financial institution system with a
summary of their balance sheets that result from lending to deficit units while
borrowing from surplus units. The institutions are divided into monetary institutions,
broker/dealers, and nonmonetary institutions and the various instruments being
offered to surplus units may be seen.6
Discussion Point – Discuss how by investing into a retirement account at a
pension fund, an individual is participating in the flow of funds system.
We need another piece of information in order to understand the business cycle
and the flow of funds system. The quantity theory of money (MV=OP) was finalized
by Irving Fisher in 1911.7 Money times the Velocity of money is equal to the
Output of goods and services times Prices (inflation/deflation). Essentially the four
factors have to remain in balance over time. As we increase the money supply (M),
the number of transactions increases within the economy which leads to increases
in the output (O) of goods and services. Unfortunately, we will eventually run out
of the resources required to produce more output (O) and if the money supply keeps
growing while the output (O) stagnates at the maximum level of production, then
inflation (increases in the price level P) will result. One result of inflation is that we
will decrease the money supply (M) which will decrease the output (O) which will


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Table 4. Operations of Financial Institutions in US Flow of Funds System
Panel A: Operations of Monetary Institutions
Taxing Power
U.S. Treasury
Treasury Debt
Consumer Loans,
Commercial Loans,
Mortgages, Call Loans,
Credit Cards
Commercial paper, CDs,
T-bills, Acceptances,

Federal Reserve
Commercial Banks
Savings and Loans
Mutual Savings Banks
Credit Unions
Money Market Mutual

Panel B: Operations of Broker/Dealers

Issue Liabilities
Token coins, US Notes,
Treasury Securities
Federal Reserve Notes
Checkable Deposits,
CDs, Acceptances

Mutual Fund Shares
Checkable Deposits

Issue Liabilities
Call Loans

Panel C: Operations of Nonmonetary Institutions
Real Estate

Mutual Funds
Life Insurance Co.


Property Insurance Co.
Pension Funds

Securities, Real Assets
Mortgages, Ins.Reserve
Securities, Loans,
Credit Cards, Mortgages

Trust Departments
GNMA Mutual Fund
Non-Bank Finance

Issue Indirect
Mutual Fund Shares
Mutual Fund Shares
Cash Deposits
Insurance Reserves
Insurance Reserves
Cash Deposits
Trust Accounts
FNMA Bonds
Insurance Reserve
Insured GNMA Bonds

reduce the inflation. Unfortunately, we usually have to experience a recession
(decrease in output) in order to bring things back into balance.8
Therefore, in order to prevent inflation as we reach the full employment of
resources (maximizing output), we need a central monetary authority to influence



the money supply.9 In the U.S., we did not have a true central monetary authority
until the Federal Reserve was created in 1913. Many people do not understand that
the value of credit money is obtained from the production of goods and services in
our economy. Money has value because it may be exchanged for goods and services.
If we do not produce any goods and services, then the money has no value. Money
and Credit are generated through the production of goods and services and the flow
of funds from surplus units to deficit units. The demand for money from the
economy is determined by the need to make transactions and to maintain liquidity.
Fractional Reserve Banking System
The framework that enables the quantity theory of money is the fractional
reserve banking system. Household A deposits money at a bank and only a portion
of this is kept as reserves by the bank. The amount that is not maintained for
reserves is used to make loans to other individuals. The loan from Household A’s
deposit is used by Household B. Household B will then create a new deposit,
enabling new loans to be constructed to subsequent individuals. Thus Individual
A’s initial deposit has succeeded in multiplying the money supply to an amount
greater than the original deposit. By changing the required reserve ratio on deposits,
the Federal Reserve influences the multiplication of deposits throughout the banking
system. The problem at the macro level is that no single bank increases the money
supply. Each bank takes a deposit, sets aside the reserve requirement and lends the
remainder. As the multiplication of deposits work their way through the banking
system, we have an expansion of the money supply. Thus, there has to be a central
monetary authority such as the Federal Reserve to prevent an oversupply of money
and credit.
While we are accustomed to this multiplier being positive, it can and does turn
negative at times. Since the bank does not keep all of Individual A’s deposit as
reserves, if Individual A decides to withdraw the deposit, the bank must liquidate
whatever activity they have done with the money. If the bank has purchased
securities, they must sell them. If the bank has made a loan, they must call the
borrower and have them repay that loan. These actions force similar actions from
other parties creating a negative multiplier. The negative cascading event decreases
the amount of money and credit, resulting in deflation. If these actions cause many
individuals to withdraw their deposits from the bank, a bank run may ensue where
more deposits are withdrawn than the bank can liquefy assets by calling in loans.
The Federal Reserve was not created to influence the money supply, but rather
we discovered, the need for a lender of the last resort. In the 1800s, the U.S.
economy was exceptionally volatile. Banks would expand loans to include marginal
loans to borrowers (subprime lending is the modern term) thus increasing the money


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supply. When the economy stalled, banks would continue to expand loans to
marginal borrowers. Finally, the banks experienced increased defaults, leading to
the public’s loss of confidence in the safety of their money in the banks. A bank run
would result where everyone runs to the bank to withdraw their deposits. When the
banks failed, there was nobody to make commercial (working capital) loans to
companies and factories would start to close, precipitating recession and high
unemployment. These periods were often accompanied by violent worker riots. By
the 1890s, J.P. Morgan discovered that if you could stop the bank run at the first
bank, you could stop the panic and avoid the collapse in bank lending and the
resulting recession. We needed a lender of the last resort whose credit is so
impeccable that it is able to stop bank runs. Morgan’s bank was the de facto central
bank of the United States in the 1890s.
In the aftermath of the Bank Panic of 1907, Congress held hearings and learned
about the lender of the last resort from J.P. Morgan and from a tour of European
central banks. As a result, they passed the Federal Reserve Act of 1913. The
Federal Reserve (a.k.a. The Fed) was set up with the legal power to be the lender of
the last resort within our flow of funds system.
Bagehot and the Lender of the Last Resort
Bagehot (1873) wrote the following during the 1870s: “very large (domestic)
loans at very high rates are the best remedy for the worst malady of the money
market when a foreign drain is added to a domestic drain.10 Walter Bagehot’s
principle is over a century old. He identifies the need for a central bank with the
language “very large (domestic) loans.” Also, he identifies the need to maintain the
flow of funds with the language “best remedy.”
The “best remedy” is to provide liquidity to the flow of funds to facilitate the
role of markets and institutions in matching borrower and lender. Congress realized
the magnitude of this need, and they created the Federal Reserve to implement this
sound principle of a central monetary authority that can make very large domestic
loans in order to maintain liquidity within the banking system (Lender of the Last
Resort). Unfortunately, it is more of an art than a science when determining the
structure of those “very large loans” and the “very high rates”.
Federal Reserve Mandates
The Employment Act of 1946 was an attempt by the federal government to
develop macroeconomic policy. The act encourages the federal government to
“promote maximum employment, production, and purchasing power.” The
Humphrey-Hawkins Act of 1977 specifically made these mandates the goals of the
Federal Reserve. This is currently reflected in the Federal Reserve’s role in
attempting to maintain price stability and maximum employment.



Figure 2. GDP Price Deflator from 1790–2011

The modern era of the Federal Reserve maintaining price stability began with
the Federal Reserve-Treasury agreement in 1951 that allowed the Fed to operate
independently of the Treasury. In Figure 2, note the volatility of the GDP price
deflator prior to 1951 and the relative stability since 1951. The stability of prices
after 1951 illustrates the important role that the Fed plays in our economic flow of
funds system. However, the over-arching requirement from the 1913 Congress is
for the Federal Reserve to be the lender of the last resort for the banking system.
Section 13 of the Federal Reserve Act of 1913 provides the mechanism for the Fed
to discount commercial and industrial paper in order to lend to banks. Section 13(3)
was added in 1932 and was amended in 1935, 1991 and 2010. Under Section 13(3),
the Fed is allowed to lend directly to any individual, partnership or corporation
under unusual and exigent circumstances.
Discussion Point – Would we be better served with a single mandate as per the
European Central Bank with inflation targeting? Will this reduce volatility
from a reduction of uncertainty about central bank policies?
Currently, Section 13(3) is where the Fed’s lender of the last resort powers resides
after being rewritten by the Dodd-Frank Act of 2010.


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Section 13(3) of the Federal Reserve Act
3. Discounts for Individuals, Partnerships, and Corporations
In unusual and exigent circumstances, the Board of Governors of the
Federal Reserve System, by the affirmative vote of not less than five
members, may authorize any Federal Reserve bank, during such periods as
the said board may determine, at rates established in accordance with the
provisions of section 14, subdivision (d), of this Act, to discount for any
participant in any program or facility with broad-based eligibility, notes,
drafts, and bills of exchange when such notes, drafts, and bills of exchange
are indorsed or otherwise secured to the satisfaction of the Federal Reserve
bank: Provided, That before discounting any such note, draft, or bill of
exchange, the Federal Reserve bank shall obtain evidence that such
participant in any program or facility with broad-based eligibility is unable
to secure adequate credit accommodations from other banking institutions.
All such discounts for any participant in any program or facility with broadbased eligibility shall be subject to such limitations, restrictions, and
regulations as the Board of Governors of the Federal Reserve System may
This new language provides a clear specification of the procedures and
conditions for Federal Reserve intervention into the flow of funds by lending to
individuals, partnerships, and corporations.
The Fed has used its lender of the last resort (LOLR) powers numerous times
during the past 60 years. It has intervened in the Penn Central crisis in 1970
(commercial paper), Franklin National Bank in 1974, the Lombard Wall/Drysdale
crisis in 1982, Continental Illinois Bank in 1985, the stock market crash of 1987
(dealer call loans), Y2K in 1999-2000 and during 9/11 in 2001.11
The primary explanation for specific areas of the flow of funds that needed
Federal Reserve intervention as the LOLR in 2008 has been deregulation during the
past 30 years. The savings and loan (S&L) crisis in the late 1980s-early 1990s was
the result of a sequence of events. The high inflation of the 1970s resulted in very
high interest rates brought about by the Fed’s fight against the high inflation. Banks
and S&Ls held large amounts of low interest fixed income securities and the high
interest rates significantly reduced the value of these assets. They had a severe
asset/liability mismatch in that their assets had long maturities and their liabilities
had short maturities. As a remedy, the Depository Institutions Deregulation and
Monetary Control Act of 1980 (DIDMCA) was passed by Congress.12 It removed
some of the restrictions placed on depository institutions by the Glass-Steagall Act



in 1933 which introduced the concept of separating financial institutions according
to their business lines (commercial, consumer, and investment banking). The
DIDMCA removed restrictions on what assets could be held by a financial
institution. The immediate trigger to the S&L crisis in the late 1980s resulted from
savings and loans being allowed to enter the commercial lending market. As
newcomers to the market, they only had access to marginal loans and when the real
estate market contracted, they were left with serious losses in commercial and
residential real estate loans.13 All financial institutions were deregulated when the
last vestiges of the Glass-Steagall Act were repealed through the Gramm-LeachBliley Act of 1999. The 1999 act allowed non-bank financial institutions like
brokerage, insurance, and investment bankers to merge with other financial
institutions. In addition, the Commodity Futures Modernization Act of 2000 failed
to regulate the credit default swaps (CDS).14 The Treasury eliminated a proposal
to regulate mortgage backed securities in 1998 and, in 2004, the SEC removed debt
limits on the five largest investment banks. Before their failures in 2008, Bear
Stearns’ debt to equity ratio was 33 to 1. Merrill Lynch was as high as 40 to 1.
Lehman Brothers was 30 to 1. On January 13, 2010, John Mack testified in
Congress that Morgan Stanley's debt-equity ratio was 33 to 1 in December 2007.
When they realized the extent of their exposure, they worked it down to 16 to 1 by
September 2008.15
Discussion Point – Note the uniform endgame of deregulation – increased
leverage in that non-bank financial sector.
Moral Hazard and the Lender of the Last Resort
The Lender of Last Resort then raises the question of “moral hazard”. Kuttner
(2008) said, a moral hazard is created when the flow of funds system cannot be
allowed to collapse and market participants know it. A central bank’s job as lender
of last resort is never an easy one. Bagehot’s guiding principle—to lend freely at a
penalty rate against good collateral—is clear, but its application is inevitably messy.
Distinguishing good collateral from bad is difficult, and determining how good is
“good enough” requires considerable judgment. Moreover, the lender of last resort
function confronts the central bank with an awkward credibility problem. To
encourage prudent behavior, the central bank would like to convince financial
institutions that it will not intervene in a crisis, knowing full well that the
consequences of non-intervention may be catastrophic. Realizing this, the private
sector can rationally expect a central bank rescue.16
The Financial Crisis of 2008
By examining the nonmonetary institutions shown at the bottom of Table 4, the
reader can see the relationship between the start of 2008 financial crisis and the


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Figure 3. The Structure of a Collateralized Loan Obligation (CLO)
tructured Financial Product

Source: Business Week, October 26, 2006.

offering of specialized Collateralized Debt Obligations (CDOs).17 The debts
backing these securities can be mortgages (CMO), commercial loans (CLO), credit
card balances, car loans, etc. This process is known as asset securitization. In
Figure 3, a Collateralized Loan Obligation (CLO) structure is defined. The
nonmonetary institutions expanded total credit (and money) by issuing these
structured products effectively acting like a fractional reserve multi-bank system
with no fractional reserve requirement since each successful sale of a CDO issue



Figure 4. Annual U.S. Money Supply Growth

Courtesy of ShadowStats.com


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to investors provided the funds for the next CDO structure sold to investors.18 We
witness the effect of this explosive expansion of credit in the M3 money supply plot
in Figure 4. The M1 money supply consists of money: coins, paper money, and
checkable deposits. The M3 money supply consists of money and near money
instruments that are created through transactions in the flow of funds system. Two
of the roles of money are: (1) medium of exchange to facilitate transactions, and (2)
store of value. M3 results from transactions while M1 acts as a store of value. In
Figure 4, we see a large run up of transactions in 2006 and 2007 due to the CDOs
while M1 remained stable. After the crisis, cash is king and the M1 balances
increase drastically as banks and corporations hold cash to stabilize their balance
sheets. Transactions, or M3 drops drastically from 2008 through 2010. Even today,
we have companies like GE ($90 billion) and Apple ($50 billion) holding large sums
of cash. The banking system is holding $1.5 trillion on their balance sheets as a
hedge against loans going bad. This is why the increase in M1 has not resulted in
inflation over the past three years.
We also see the prelude to an old fashioned bank run from the 1800s. In 2003,
these CDOs usually had less than 15% subprime (junk) loans in them. By 2006,
they were 100% junk as shown in Figure 3 and now highly sensitive to default risks
of the underlying loans. All of the available prime loans were gone and only the
marginal subprime loans were available to construct a CDO. Just as the M3 money
supply increased with the introduction of these products, M3 then decreased when
default rates on the underlying loans increased. When these securities were used as
collateral to other banking activities, the decrease in value required more collateral
to be posted from other sources, setting off the negative cascade in other asset prices
witnessed in 2008.
Discussion Point – Circle back to the pension funds and discuss how these
structured financial products can affect household retirement funds in the 2008
The trick of turning garbage into gold (Figure 3) was made possible by
diversification of the loan portfolio by including a large number of loans into the
pool of commercial loans. However, when 100% of the assets are subprime,
thinking that diversification can produce 75% AAA securities is somewhat wishful.
This was made even worse when investment banks bundled unsold B, BB, and BBB
tranches into CDO Squares. When defaults rose, these tranches defaulted at close
to 100% rates.19
Unfortunately, these instruments are so complicated that they are almost
impossible to restructure through a Resolution Trust Corporation as we did in the
1990s (See Scott and Taylor, 2009). While these CDOs were at the heart of the
financial market collapse in 2008, CDOs perform a crucial role in matching
borrowers’ (corporations) and lenders’ (banks and other financial institutions)
preferences. The lenders’ desire to obtain exposure to the commercial loan market



in a diversified manner facilitated the ability of the borrowers to obtain commercial
loans of varying maturity dates and interest rates. This was all possible through
asset securitization. The greed and predatory purveyance of these securitized
products was enabled through the deregulation we discussed earlier (as well as
ratings agencies failures). Unfortunately for the flow of funds system, the financial
institutions involved in asset securitization made a very serious mistake, i.e., the
institutions assumed that the ability to diversify remained stationary over time. As
the economy moves through the business cycle, the ability to diversify changes. As
a result, the structured finance products (CDO) were not built to survive a large
downward change in the business cycle. The bigger problem occurred when the
CDOs started their explosive growth in 2004-2006, financial institutions had less
than a decade of experience developing and selling the CDOs. The securities had
never gone through a period of decreasing prices in residential and commercial real
estate, and, more importantly, external liquidity demands.20 The resulting crisis was
centered on the non-bank financials located in the non-monetary institutions which
were beyond the purview of the Federal Reserve (See Cooper, 2008).21
The Treasury and Federal Reserve’s actions in response to the 2008 crisis were
as innovative as the products responsible for the crisis. The Troubled Asset Relief
Program (TARP) was initially designed to purchase the toxic assets from the market
participants. This highlights an important analogy – the ‘Lender of Last Resort’ is
synonymous with the ‘Counterparty of Last Resort.’ TARP was eventually altered
to direct capital injections into troubled institutions in exchange for equity stakes.
While TARP did buy time, preventing a major collapse of the banking system, it did
nothing to take the toxic assets off the banks’ balance sheets as the Resolution Trust
did in the early 1990s. The results are “zombie” banks unable to fully participate
in the flow of funds system.
The vexing problem for the Fed in 2008 was how to help multiple market
participants. Facilitating the transactions for virtually the entire nonmonetary
institution universe was very difficult. This is a symptom of the deregulation
mentioned earlier. The blurring of distinction from monetary and nonmonetary
institutions resulted in similar exposures on both balance sheets, thus making a large
bailout like Resolution Trust impossible to replicate.
The results of the 2008 crisis are reflected in the flow of funds system. Table
5 provides Table F.4 found in the Federal Reserve Flow of Funds Report for the
Second Quarter of 2012. The Fed’s report shows the current state of health for the
flow of funds system. In 2009, net credit market borrowing fell by $607 billion (all
numbers are seasonally adjusted annual rates). However, private sector borrowing
fell by almost $2 trillion. After increasing $694 billion in 2008, bank loans dropped
by $775 billion in 2009. The U.S. Treasury borrowed at a $1.239 trillion annual rate
in 2008, at a $1.434 trillion annual rate for 2009, at a $1.58 trillion annual rate in
2010 and at a $1.06 trillion annual rate in 2011 to make up for the decline in private


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Table 5. Federal Reserve Table F.4 from
Federal Reserve Flow of Funds Report of 9-20-2012

In Table 6, the numbers in Table 5 are aggregated into private sector borrowing.
We see that net private borrowing was $2.1 trillion in 2006. By 2009, private
borrowers were deleveraging at a $2 trillion annual rate. In 2010, private borrowing
de-levered at a $1 trillion rate. The U.S. Treasury countered this private sector
maneuver by borrowing $1.239 trillion in 2008, $1.444 trillion in 2009, $1.58
trillion rate in 2010, $1.06 trillion in 2011 and $1.30 trillion annual rate in the first
two quarters of 2012. When private borrowing stops deleveraging, only then can
the U.S. Treasury return its borrowing to 2006-07 levels. The Treasury and the Fed
will have to reduce their borrowing quickly so that when private borrowing returns
in full force, it will not be “crowded out” of the market. The dislocation between
borrower and lender evidenced in the flow of funds system in 2008 coincides with
decline in GNP (-3.24%) and the increase in unemployment (5.43% to 10.50%).
The anemic growth in GNP and no real drop in unemployment since mid-2009
results from the continued lack of borrowing demand from the private sector. Until
private borrowing demand recovers from its deleveraging cycle, there will be no real
recovery in GNP. The reader should note that deleveraging in the private sector has
been slowing down in 2010 with bank loans finally increasing by $30 billion in the
fourth quarter of 2010 and returning to a $132 billion annual rate in 2011 and a $150



Table 6. Flow of Funds Summary and the Economy from 2006 through 2012Q2




% Real


* The unemployment rate for the first 9 months of 2008 was 5.43%. For the last
three months of 2008, it was 6.97%. All rates are seasonally adjusted annual rates.
Private Borrowing is the summation of Lines 2, 7, 8, 9, and 10. All numbers in
billions of dollars. The quarterly GDP growth rates are annualized.

billion annual rate in the first two quarters of 2012. The slightly late good news is
that private borrowing finally turned positive for the first time since 2008 during the
second quarter of 2012 (at an anemic $136 billion annual rate). Finally, in Figure
4 note that M3 is peeking above a zero growth rate starting in April 2011 through
August 2012.22 However, it hasn’t recovered to the growth rates of 2003-2004. The
results of these data indicate that the recovery of private sector borrowing has been
very slow.
The financial crisis of 2008 may be seen in the magnitude of the collapse in
2008 of private sector borrowing relative to total borrowing in the U.S. since 1971
as shown in Figure 5. This collapse is unprecedented in recent history as crises in
1974-75, 1981-82, 1990-1992, 2000-2002 do not begin to compare to 2008. As we
show in our examples in Tables 1, 2, and 3, if the flow of funds system is disrupted
a recession will follow (2008 to 2009Q2 in this case).


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Figure 5. Understanding The U.S. Economy Through Credit Flows
(Annual through 2008, Quarterly 2009-2012 Q2)

Studying the flow of funds system offers a level of detail not available from
other aggregated economic data, such as GDP. Reported changes in individual
markets’ supply and demand characteristics can be quite useful in addressing any
dislocations identified in historical crises and especially the Financial Crisis of 2008.
One result of the crisis is a movement to re-regulate the financial markets. However,
trying to control these markets through rigid regulations is futile as the financial
institutions historically have discovered ways to adapt around the best intentioned
regulations. Government regulation has to lay out a level playing field and learn to
adapt as participants counter the regulations. Overall credit exploded in the mid
2000’s because of non-bank financial institutions that were beyond the Fed’s control
due to deregulation. We need to be able to control total credit through
credit/leverage rules for all financial institutions in order to prevent a similar crisis



and there should be suitable punishment if your bank’s policies create a bank run
and subsequent panic. Former Federal Reserve Chairman William McChesney
Martin best described the Fed’s role in the economy. The Fed’s job is “to take away
the punch bowl just as the party gets going.”
The financial flow of funds system is one of mankind’s greatest
accomplishments;23 however, the capital markets which the flow of funds depend
upon are not efficient because of many frictions inherent in the markets. Efficient
markets don’t collapse three times in a decade – their natural state should be a stable
equilibrium. Financial markets are operationally and allocationally more effective
than any alternative system available, i.e. they will allocate resources more
effectively and at a lower cost than any alternative. Yet, markets (and our flow of
funds system) also have to attract people and their surplus claims to goods and
services into participating in the markets. Markets have to continuously earn the
confidence of the people who participate in them. When a sufficiently large enough
group of people lose faith in the markets, their withdrawal will lead to the
dislocation of borrowers and lenders within the flow of funds system; resulting in
recession and unemployment.24
Financial innovations are wonderful additions to the flow of funds system.
They provide financial products that make it more attractive to participate in the
flow of funds. In the mortgage market, we have the GNMA, CMO and RMBS
securities which brought a standardized financial product to market that’s more
liquid and more marketable than individual mortgages. By itself, the mortgage
market never competed effectively against the other capital markets until these
instruments were developed. Unfortunately, we did not watch them carefully
enough to avoid the abuse of these innovative products that led to the 2008 crisis.
Debt markets represent a major advance in our economic systems. They allow
us to have liquid access to the economic value that is stored in very illiquid assets
such as homes, farms, and equipment. Debt markets provide access to this illiquid
wealth and improve the standard of living for everyone. We simply need to
maintain the stability of this system and not allow the periodic dislocation of
borrowers and lenders due to an over-extension of credit (re: bubble). As Richard
Bookstaber (2007) concludes in his overview of financial markets, “It’s the
liquidity, Stupid”.25

See “Irving Fisher: Out of Keynes’s Shadow,” The Economist, February 12,
2009 for a coverage of Fisher’s many contributions to economics.
Friedman did a wonderful job explaining these concepts in his PBS TV Series,
“Free to Choose”.
We will assume a zero real rate of interest on loans.
Changes in consumption may also occur due to the aging consumer. An aging
population segment will reflect an aggregate decrease in production while


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maintaining some consumption. This is due to the fixed income that this population
segment will be living on, such as Social Security and pension payments. The
retiring “baby boomers” are the most prescient example today. This negative effect
to the flow of funds can only be offset by increased production/consumption from
the younger generations.
A very similar chart appeared in Polakoff (1971) and Durkin and Polakoff
(1982). Over the years, it has been adapted to its current form.
The only counter-argument to the flow of funds system over the years is that
it is out of date with the increase in international transactions. This argument is
countered by the fact that the flow of funds system is an open system and therefore,
is a subsystem of the international flow of funds system. The international flow of
funds is covered in the appendix.
“Irving Fisher: Out of Keynes’s Shadow,” The Economist, February 12, 2009.
In the long term, Velocity is affected by technological change but it does tend
to decline going into a recession and expand coming out of the recession because of
liquidity preferences during recessions. Output, long term, is affected by technology,
energy, and demographics. However, in order to maintain a level of output, we have
to have enough money supply to support the amount of transactions required by that
level of output.
The Federal Reserve can only influence the money supply by increasing or
decreasing bank reserves. Decreasing reserves reduces the banking system’s ability
to expand the money supply. However, the overall amount of money is created by
the transactions demand for money within the economy. We see this currently with
the massive increase in the monetary base (bank reserves plus currency in
circulation) and the Federal Reserve balance sheet the past few years while the broad
money supply growth has stayed low because of the collapse of the credit markets
and the reduction in output of goods and services.
In 1999, the Fed was concerned that computer crashes resulting from the turn
of the century would result in the shutdown of many electronic funds transfer
systems in the U.S. The Fed responded by increasing the currency in circulation
during the last four months of 1999. In 2001, the attack on the World Trade Center
closed a number of New York financial markets for a few days. In order to ensure
a smooth reopening of the markets, the Fed provided banks with additional reserves
to provide the necessary credit.
The S&L crisis was resolved through the Resolution Trust Corporation that
purchased loans from failing savings and loans and worked out the loans. Between
1989 and mid-1995, the Resolution Trust Corporation closed or otherwise resolved
747 thrifts with total assets of $394 billion. The final tab for the bailout was $220.32
billion. Of that total, taxpayers were responsible for about $178.56 billion; the
private sector covered the rest. http://www.propublica.org/special/bailoutaftermaths#penncentral




Neil Bush’s Silverado S&L (1988) and Charles Keating’s Lincoln Savings
and Loan (1989) were two of the more spectacular failures due to bad commercial
loans. Keating’s failure was more along the lines of a Ponzi scheme, a fraud
encouraged by the deregulation of S&Ls.
The lack of regulation in the Credit Default Swap (CDS) market created
another moral hazard. Tett (2009) illustrates the problem with credit default swaps,
i.e., banks do better if borrowers fail. A Kazakhstan bank, BTA, was tipped into
partial default because American banks would do better collecting on the CDS than
trying to work out the loan. We have the same problem in the mortgage market.
Very few lenders seem to want to restructure existing mortgages because they will
make more money on fees collected from foreclosure and CDS insurance if the
borrower defaults than if they restructure the loan. The problem is analogous to
insuring your neighbor’s house and then burning it down to collect the insurance.
Francis (2009).
Protess (2008). Goldman Sachs was over a 30 to 1 debt/asset ratio as well.


Collateralized Loan Obligations (CLO), Collateralized Debt Obligations
(CDO), Collateralized Mortgage Obligations (CMO), Residential Mortgage-Backed
Securities (RMBS), Commercial Mortgage-Backed Securities (CMBS), and Credit
Default Swaps (CDS).
This cycle of credit expansion was made even more dangerous when CDOsquares were developed. Under these new structures, the unsold subprime
components of an existing CDO were bundled together into a new CDO.
Lewis (2011), The Big Short.
The last great decline in real estate prices was in 1989-1992. In 1991-92, real
estate prices in Southern California declined by over 30%. In recent years,
California is also one of the major sources of the sub-prime mortgage lending
problem. (The Case-Shiller real estate price index for the entire U.S. declined by
6% in 1991-92 missing the major damage done in California.)
Letting Lehman Brothers go bankrupt in September 2008 will always be
subject to discussion. Through Section 13(3), the Fed had the legal authority to lend
to Lehman and to work out a smoother transition towards recovery. A large number
of economists believe that letting Lehman fail was a major mistake that resulted in
the credit markets freezing up. First, short-term credit froze up and later it extended
to long-term credit. When credit freezes up consumption and production shut down.
One very likely result of the credit market freeze is that the unemployment rate
increased from 6.2% in September 2008 to 10.2% in October 2009 (and over 17%
in the U6 unemployment number) which directly hurt households. See Kaletsky
(2010) and Krugman (2009).
This analysis could also be expanded to an international level. In fact, the
flow of funds report includes an international report, “Rest of the World” F.107.
The appendix will expand this notion.


Advances in Financial Education


The evolution of financial markets over the last three centuries financed the
technological revolution raising per capita real income in the U.S. from $175 in
1775 to over $30,000 today. Compare this outcome to the per capita real income of
$150 in ancient Greece around 500 B.C. These estimates developed by J. Bradford
DeLong. They are available at www.j-bradford-delong.net
See Minsky (2008) about financial instability and the economy.
Bookstaber (2007) Chapter 10.
Bagehot, Walter (1873), “Lombard Street: A Description of the Money Market,”
London: H.S. King & Co.
Bookstaber, Richard (2007). A Demon of Our Own Design, Hoboken, NJ: John
Wiley and Sons, Inc.
Cooper, George (2008). The Origin of Financial Crises, New York: Vintage Books.
“Danger – Explosive Loans,” Business Week, October 23, 2006.
Durkin, Thomas, A., Murray Polakoff Et al. (1982). Financial Institutions and
Markets, Houghton Mifflin Co.
“Efficiency and Beyond,” The Economist, July 16, 2009.
Francis, Theo (2009). “Washington Revives the Mortgage Cramdown,” Business
Week, October 8, 2009. http://www.businessweek.com/magazine/ content/
“Irving Fisher: Out of Keynes’s Shadow,” The Economist, February 12, 2009.
Friedman, Milton (1980). Free to Choose, PBS Television Series.
Kaletsky, Anatole (2010). Capitalism 4.0: The Birth of a New Economy in the
Aftermath of Crisis, Public Affairs.
Krugman, Paul (2009), “How Did Economists Get It So Wrong?” New York Times,
September 2, 2009. http://www.nytimes.com/2009/09/06/magazine/
Kuttner, Kenneth (2008). “The Federal Reserve as Lender of Last Resort during the
Panic of 2008.” Report prepared on behalf of the Committee on Capital Markets
Regulation. (www.capmktsreg.org).
Lewis, Michael (2011). The Big Short: Inside the Doomsday Machine. W.W. Norton
& Co.
Minsky, Hyman P. (2008). Stabilizing an Unstable Economy, McGraw Hill.
Polakoff, Murray and others (1971). Financial Institutions and Markets, Cengage



Protess, Ben (2008). “Flawed’ SEC Program Failed to Rein in Investment Banks,”
ProPublica, October 1, 2008. http://www.propublica.org/article/flawed-secprogram-failed-to-rein-in-investment-banks-101
Scott, Kenneth and John Taylor (2009), “Why Toxic Assets Are So Hard to Fix,”
Wall Street Journal, July 2009. http://online.wsj.com/article/
Tett, Gillian (2009), “Kazakh Bank Falls Foul of CDS,” Financial Times, April 30,
2009. Reprinted: http://gata.org/node/7399

Appendix A: The International Flow of Funds System
With the increase of globalization, financial markets are increasingly
interconnected. Witness the “Asian flu” with the collapse of Thailand’s currency
in 1997, the Russian bond default in 1998 (and the subsequent Long Term Capital
Management collapse), and the American real estate bubble in 2008. All had major
effects beyond their countries’ borders through the international flow of funds.
The International Flow of Funds
The international flow of funds consists of all of the national flow of funds
systems throughout the world and operates on the same principles of the national
flow of funds, i.e. moving funds from surplus units to deficit units; in this case
In the following example, we will ignore capital flows between countries and
look at the basic foundation of the international flow of funds. In the international
arena, there is the one economic law that exports (E) equals imports (I). If we
export $100 worth of software to Germany, it represents a $100 import to Germany.
Generally, countries would prefer to run a surplus as exporting more than you
import means that your country’s wealth is increasing. But that means somebody
has to run a deficit. Therefore, surplus countries have to lend to deficit countries in
order to maintain the level of international (World GDP) trade. Failure to maintain
this flow of funds will result in the reduction of world trade.
In Figure A.1, we see the international flow of funds chart. Monetary institutions consist of the International Monetary Fund (IMF), national central banks, and
commercial banks. The broker/dealer system is dominated by commercial banks.


Advances in Financial Education

Figure A.1. The International Flow of Funds from
Surplus Countries to Deficit Countries

The nonmonetary institutions start with the World Bank (IBRD) and mutual funds,
insurance companies, etc. that operate internationally. The IMF issues a credit
money known as a special drawing right (SDR) that is used as a reserve currency by
the central banks.
The national flow of funds, as shown in Figure A.1, for each country represents
a surplus or deficit unit in the international flow of funds. As such, the national flow
of funds systems are subsystems of the international flow of funds system.
The central banks of each country represent the monetary authority in that
country and have the responsibility of maintaining the convertibility of the country’s
currency. Convertibility means that any bank throughout the world will accept a
currency in exchange for another country’s currency. In Table A.1, we see the
major international institutions.
Discussion Point – Discuss the US deficit and the offsetting surpluses of other
countries such as China and the Gulf oil states.
United States (Dollar) that result from the daily business of exporting and
importing goods and services. The central banks are the Federal Reserve for the U.S.



Table A.1. Monetary and Nonmonetary Institutions in the
International Flow of Funds
Bonds, Loans,

Monetary Institutions
International Monetary

Bonds, Loans

Commercial Banks

Bonds, Loans

Central Banks


Issue Liabilities
SDRs, Quotas
Currency Denominated

Non-Monetary Institutions
IBRD – World Bank

Indirect Securities


Mutual Funds

Mutual Fund Shares


Insurance Companies

Insurance Reserves


Pension Funds


Dollar and the European Central Bank (ECB) for the Euro. Starting at the top, we
see an American company exporting a computer to Germany. The business in
Germany writes a check in Euros to pay for the computer. The American company
deposits the check in its bank which credits the American company’s account in US
dollars. The Euros remain within the American banking system for the time being.
Next, a German company exports a car to the United States. The customer in the
U.S. pays the German company with a check denominated in US dollars. The
German company deposits the check in their bank which credits their account in
As the banks accumulate foreign currencies, they only need so much foreign
currency for day-to-day business and will trade the excess to their central bank for
domestic currency. Therefore, US dollars will accumulate in the ECB and Euros
will accumulate in the Federal Reserve. At some point, the ECB and the Fed will
swap currencies sending the dollars back to the U.S. and Euros back to Europe. As
long as exports and imports balance out between the two countries, then the central
banks need to only swap currencies less frequently. Let’s examine the ramifications
if the United States runs a trade deficit with Germany, i.e. imports more from
Germany than it exports to Germany?
The result is that the supply of US dollars in Germany will start to increase. The
ECB is not receiving enough Euros from the Federal Reserve to take these excess


Advances in Financial Education

Figure A.2, Currency Flows between United States and
Germany Given a Trade Balance between the Two Countries

US dollars off of the German market. If this pattern continues, the value of the
dollar will start to decline through supply and demand. In this case, the United
States will have to respond in order to defend the value of the US dollar. There are
several responses that can be made by the United States:
1. Transfer Reserves – The Federal Reserve holds foreign currency of other
countries and also holds the Special Drawing Rights for the United States.
The Fed can use these reserves to purchase U.S. dollars in Germany through
the ECB.
2. Finance the Deficit – The United States Treasury can sell Treasury bonds
to Germany which allows the Fed to buy U.S. dollars from the German
markets. As long as Germany buys the bonds, the U.S. can maintain a trade
deficit with Germany. At this point, we see capital flows between countries
entering into the international flow of funds system.
3. Devalue the Dollar – The Fed can allow the value of the dollar to decline
on the German market. This helps to reduce the trade deficit as German
imports become more expensive while U.S. exports become cheaper.



4. Suppress the Deficit – The U.S. government can make German imports
more expensive by increasing tariffs (import taxes) on German goods and
services. By making German imports more expensive, we should import
less from Germany. Another strategy is to create quotas that allow only so
many German goods and services into the U.S. An example would be a
quota that allows a fixed number of cars to be imported.
The problem with the last alternative is that Germany may retaliate with higher
tariffs and quotas on the U.S. goods and services. Protectionist tariff wars are
destructive to world trade in that they reduce the amount of world trade or world
GDP. One of the lessons of the Great Depression is that increasing tariffs will cause
other countries to retaliate thus drastically reducing the amount of trade between
countries. In 1930, the United States passed the Smoot-Hawley Tariff Act which
raised tariffs on 20,000 products resulting in the second highest level of tariffs in
U.S. history. Retaliation by U.S. trade partners reduced American exports by 50%
thus exacerbating the Great Depression.
Discussion Point – Reiterate the general purpose of this section by showing how
the national flow of funds system is integrated into the international flow of
funds system and how globalization has taken central bankers’ once peripheral
concerns into direct focus. One central idea is that currencies internationally
are backed by the production of goods and services of a country’s economy.


Advances in Financial Education

Appendix B: The Real “Too Big to Fail” or the Flow of Funds as a Public Good
The one term that we heard during the 2008 financial crisis was that certain
financial firms were “too big to fail” meaning that the failure of a “too big to fail”
firm would bring down the whole financial market system. As a result of the recent
crisis, the ten largest banks in the United States represent 77% of the banking assets.
Well, they were a bit late worrying about “too big to fail” after letting the Lehman
failure bring down most of the fixed income markets in the U.S. A lot of the
subsequent bailouts were justified by the “too big to fail” argument.
There is a basic misunderstanding here. “Too big to fail” needs to apply to the
flow of funds system. One of the lessons of the 2008 financial crisis is that we
cannot let the flow of funds system fail. In order to maintain the flow of funds
system, the lender of the last resort has to stop a “run” at the initial point. It cannot
allow the run to gather momentum and spread to the rest of the flow of funds
system. As we have seen, the flow of funds system has the important role of
maintaining the level of production of goods and services within the economy and
if we wish to avoid recessions, we need to keep the flow of funds system
functioning. Whenever people lose confidence in the flow of funds, they will stop
participating and the economy will decline soon thereafter because of the lack of
surplus units lending to deficit units.
The savings and loan crises of the late 1980s started with the failure of the
Home States Savings Bank in Ohio in March 1985. Since the deposit insurance
fund in Ohio was not large enough to stop the run on this S&L, the governor of Ohio
declared a bank holiday and closed all Ohio S&Ls. This was followed by the failure
of S&Ls in Maryland in May 1985 which overwhelmed the state deposit insurance
fund in Maryland. By January 1987, the federal insurance deposit fund for S&Ls
(FSLIC) was declared insolvent. These failures ended the idea of a state-run deposit
insurance fund and in August 1989, all deposit insurance was turned over to the
FDIC. The final tab to taxpayers was almost $180 billion.
It doesn’t take a “too big to fail” institution to start a “run” on the flow of funds
– it can start anywhere but we have to realize that the flow of funds system itself is
too big to fail. Since we don’t live on an island isolated from the rest of human
civilization, the failure of our flow of funds system will have a ripple effect
throughout the international flow of funds system.
Because the failure of the flow of funds system has such a major impact on
people’s lives, we might need to consider it to be a public good like defense
spending, education, public utilities, etc.



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