7

Money, Banks, and Finance

A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain.

Robert Frost

It is ironic that money and banks top the list of economic subjects that most baffle students. Money is just a clever invention to save time, and bankers, contrary to their stodgy reputations, substitute bigamy for proper marriages between borrowers and lenders – with predictably disastrous consequences when both wives press their legal claims. Once the financial industry is understood for what it is, the Savings and Loan crisis of the 1980s, international financial crises of the 1990s, and the biggest global financial crisis since 1929, triggered when Lehman Brothers went bankrupt on September 15, 2008, are not difficult to understand. After which the logic of monetary policy and quantitative easing and tapering are easy to understand as well.

Money: A Problematic Convenience

It is possible to have exchange, or market economies, without money. A barter exchange economy is one in which people exchange one kind of good directly for another kind of good. For instance, I grow potatoes because my land is best suited to that crop. My neighbor grows carrots because her land is better for carrots. But if we both like our stew with potatoes and carrots, we can accomplish this through barter exchange. On Saturday I take some of my potatoes to town, she takes some of her carrots, and we exchange a certain number of pounds of potatoes for a certain number of pounds of carrots. No money is involved as goods are exchanged directly for other goods.

Notice that in barter exchange the act of supplying is inextricably linked to an equivalent act of demanding. I cannot supply potatoes in the farmers’ market without simultaneously demanding carrots. And my neighbor cannot supply carrots without simultaneously demanding potatoes. Having learned how recessions and inflation can arise because aggregate demand is less or greater than aggregate supply, it is interesting to note that in a barter exchange economy these difficulties would not occur. If every act of supplying is simultaneously an act of demanding an equivalent value, then when we add up the value of all the goods and services supplied and demanded in a barter exchange economy they will always be exactly the same. No depressions or recessions. No demand pull inflation. It’s enough to make one wonder who was the idiot who dreamed up the idea of money!

Sometimes ideas that seem good at the time turn out to cause more trouble than they’re worth. Maybe finding some object that everyone agrees to accept in exchange for goods or services was just one of those lousy ideas that looked good until it was too late to do anything about it. But let’s think more before jumping to conclusions. Barter exchange seemed to do the job well enough in the above example. But what if I want potatoes and carrots in my stew, as before, but my carrot growing neighbor wants carrots and onions in her stew, and my onion growing neighbor wants onions and potatoes in her stew? We would have to arrange some kind of three-cornered trade. I could not trade potatoes for carrots because my carrot-growing neighbor doesn’t want potatoes. My carrot-growing neighbor could not trade carrots for onions because the onion grower doesn’t want carrots. And the onion-growing neighbor could not trade her onions for my potatoes because I don’t want onions. I could trade potatoes for onions which I don’t really want – except to trade the onions for carrots. Or, my carrot-growing neighbor could trade carrots for potatoes she doesn’t want – except to trade the potatoes for onions. Or, my onion-growing neighbor could trade onions for carrots she doesn’t want – except to trade for potatoes. But arranging mutually beneficial deals obviously becomes more problematic when there are three goods, much less thousands.

There are two problems with barter exchange when there are more than two goods: (1) Not all the mutually beneficial, multiparty deals might be discovered – which would be a shame since it means people wouldn’t always get to eat their stew the way they want it. And (2) even if a mutually beneficial multiparty deal is discovered and struck, the transaction costs in time, guarantees, and assurances might be considerable. Money eliminates both these problems. As long as all three of us agree to exchange vegetables for money there is no need to work out complicated three-cornered trades. Each of us simply sells our vegetable for money to whoever wants to buy it, and then uses the money we got to buy whatever we want.

Simple. No complicated contracts. No lawyers needed. But notice that now it is possible to supply without simultaneously demanding an equivalent value. When I sell my potatoes for money I have contributed to supply without contributing to demand. Of course, if I turn around and use all the money I got from selling my potatoes to buy carrots for my stew I will have contributed as much to demand as I did to supply when you consider the two transactions together. But money separates the acts of supplying and demanding making it possible to do one without doing the other. Suppose I come and sell my potatoes for money and then my six-year-old breaks his arm running around underneath the vegetable stands, I take him to the emergency room, and by the time we get back to the vegetable market it’s closed. In this case I will have added to the supply in the Saturday vegetable market without adding to the demand. Nobody is seriously concerned about this problem in simple vegetable markets, but in large capitalist economies the fact that monetized exchange makes possible discrepancies between supply and demand in the aggregate can be problematic. Once a business has paid for inputs and hired labor they have every incentive to sell their product. But if the price they must settle for leaves a profit that is negative, unacceptable, or just disappointing, the business may well wait for better market conditions before purchasing more inputs and labor to produce again. The specter of workers anxious to work going without jobs because employers don’t believe they will be able to sell what those workers would produce is a self-fulfilling prophesy that tens of millions of victims of the Great Depression, and now the Great Recession, can attest is no mere theoretical concern!

Banks: Bigamy Not a Proper Marriage

What if there were no banks? How would people who want to spend more than their income meet people who wish to spend less? How would businesses with profitable investment opportunities in excess of their retained earnings meet households willing to loan them their savings? If banks did not exist there would be sections in the classified advertisements in newspapers – or listings on ebay – titled “loan wanted” and “willing to loan.” But matching would-be borrowers with would-be lenders is not a simple process. These ads might not be as titillating as personals, but they would have to go into details such as: “Want to lend $4,500 for three years with quarterly payments at 9.5% annual rate of interest to creditworthy customer – references required.” And, “Want to borrow 2 million dollars to finance construction of eight, half million dollar homes on prime suburban land already purchased. Willing to pay 11% over thirty years. Well known developer with over fifty years of successful business activity in the area.” But this entails two kinds of transaction costs. First, the creditworthiness of borrowers is not easy to determine. In particular, small lenders don’t want to spend time checking on references of loan applicants. Second, not all mutually beneficial deals are between a single lender and borrower. Many mutually beneficial deals are multiparty swaps. Searching through ads to find all mutually beneficial, multiparty deals takes time – more than most people have – and guaranteeing the commitments and terms of multiparty deals takes time and legal expertise. One way to understand what banks do is to see them as “matchmakers” for borrowers and lenders. But it turns out they are more than efficient matchmakers who reduce transaction costs by informational economies of scale.

Perhaps banks could perform their service like the matchmaker in Fiddler on the Roof – collecting fees from the lender and borrower when they marry – but they don’t. Banks don’t introduce borrowers and lenders who then contract a “proper” marriage between themselves. Instead, banks engage in legalized bigamy. A bank “marries” its depositors – paying interest on deposits which depositors can redeem on demand. Then the bank “marries” its loan customers – who pay interest on loans which the bank can only redeem on specified future dates. But notice that if both the bank’s “wives” insist on exercising their full legal rights, no bank would be able to fulfill its legal obligations! If depositors exercise their legal right to withdraw all their deposits, and if loan customers refuse to pay back their loans any faster than their loan contracts requires, every bank would be insolvent every day of the year. It is only because not all wives with whom banks engage in bigamy choose to simultaneously exercise their full legal rights that banks can get away with bigamy – and make a handsome profit for themselves in the process.

Many depositors assume when they deposit money in their checking account the bank simply puts their money into a safe, along with all the other deposits, where it sits until they choose to withdraw it. After all, unless it is all kept available there is no way the bank could give all depositors all their money back if they asked for it. But if that is what banks did they could never make any loans, and therefore they could never make any profits! To assume banks hold all the deposits they accept is to think banks offer a kind of collective safety deposit box service for cash. But that is not at all what banks offer when they accept deposits. Banks use those deposits to make loans to customers who pay the bank interest. As long as the bank collects interest on loans that is higher on average than the interest the bank pays depositors, banks can make a profit. But to realize the potential profit from the difference between the loan and deposit rates of interest, banks have to loan the deposits. And if they loan even a small part of the deposits obviously not all the deposits can be there in the eventuality that depositors asked to withdraw all their money.

Which leads to a frightening realization: Banks inherently entail the possibility of bankruptcy! There is no way to guarantee that banks will always be able to honor their legal commitments to depositors without making it impossible for banks to make profits. That is, no matter how safe and conservative bank management, no matter how faithfully borrowers repay bank loans, depositors are inherently at risk. But the logic of banking is even worse, which is why every government on the planet – no matter how laissez faire – regulates the banking industry in ways no other industry is subjected to.

How can a bank increase its profits? Profits will be higher if the differential between the rates of interest paid on loans and on deposits is larger. Every bank would like to expand this differential, but how can they? If a bank starts charging higher interest on loans it will risk losing its loan customers to other banks. If it offers to pay less on deposits it risks losing depositors to other banks. In other words, individual banks are limited by competition with other banks from expanding the differential beyond a certain point. Another way of saying the same thing is that the size of the differential is determined by the amount of competition in the banking industry. If there is lots of competition the differential will be small, if there is less competition the differential will be larger. But for a given level of competition, individual banks are restricted in their ability to increase profits by expanding their own differential. The other determinant of bank profits is how many loans they make taking advantage of the differential. If a bank loans out 40% of its deposits and earns $X in profits, it could earn $2X profits by lending out 80% of its deposits. Since there is little an individual bank can do to expand its interest differential, banks concentrate on loaning out as much of their deposits as possible.

Which leads to a second frightening realization: When stockholders press bank officers to increase profits, bank CEOs are driven to loan out more and more of bank deposits. Since insolvency results when depositors ask to withdraw more than the bank has kept as reserves, the drive for more profits necessarily increases the likelihood of bankruptcy by lowering bank reserves. It is true that stockholders should seek a trade-off between higher profits and insolvency since shareholders lose the value of their investment if the bank they own goes bankrupt. But stockholders are not the only ones who lose when a bank goes bankrupt. While stockholders lose the value of their investment, depositors lose their deposits. So when stockholders weigh the benefit of higher profits against the expected cost of bankruptcy they do not weigh the benefits against the entire cost, but only the fraction of the cost that falls on them. And even with regulations requiring minimum capitalization, it is always the case that the cost of bankruptcy to depositors is much greater than the cost to shareholders. This means that bank shareholders’ interests do not coincide with the public interest in finding the efficient trade-off between higher profitability and lower likelihood of insolvency. Hence the need for government regulation.

This was a lesson that history taught over and over again during the eighteenth and nineteenth centuries as periodic waves of bankruptcy rocked the growing American Republic. Early in the twentieth century Congress charged the Federal Reserve Bank with the task of setting and enforcing a minimum legal reserve requirement that prevents banks from lending out more than a certain fraction of their deposits. In 1933 Congress also created a federal agency to insure depositors in the eventuality of bankruptcy in its efforts to reassure the public that it was safe to deposit their savings in banks during the Great Depression. Today the Federal Deposit Insurance Corporation (FDIC) will fully redeem deposits up to $200,000 in value if a bank goes bankrupt.

But federal insurance has created two new problems. First of all, as we discovered in the Savings and Loan Crisis of the 1980s, any substantial string of bankruptcies will also bankrupt the insuring agency! When the Savings and Loan Crisis was finally recognized there were roughly 500 insolvent thrift institutions with deposits of over $200 billion. The Federal Savings and Loan Insurance Corporation, FSLIC, had less than $2 billion in assets at the time. While the Federal Reserve Bank was anxious to shut the insolvent Savings and Loan Associations down to prevent them from accepting new deposits and creating additional FSLIC liabilities, neither Congress, led by Speaker Jim Wright from Texas, nor the Reagan White House wanted to declare the thrifts bankrupt because that would have required massive additional appropriations for FSLIC. Many of the insolvent thrifts were in Texas and they convinced Wright to lobby for delay of bankruptcy procedures. Owners of those insolvent thrifts had everything to lose from bankruptcy, whereas they could continue to collect dividends as long as they were permitted to accept new deposits and make new loans – regardless of whether or not there was any likelihood they would be able to overcome insolvency by doing so. The Reagan administration was not anxious to accept responsibility for the consequences of its financial deregulatory frenzy, and didn’t want to have to raise taxes or cut defense spending to come up with the appropriations necessary to fund FSLIC sufficiently to pay off $200 billion to depositors – which the Gramm-Rudman Act limiting deficit spending would have required at the time. As a result the crisis was swept under the carpet for three more years, by which time the deposit liabilities of the insolvent thrifts had doubled. In other words, the politics of partially funded government insurance cost the American taxpayer additional hundreds of billions of dollars. Besides the $200 billion plus bailout itself, the Resolution Trust Corporation established by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 to sell, merge, or liquidate insolvent thrifts, offered huge tax breaks as inducements to solvent financial institutions to take over failed institutions, thereby reducing tax revenues for many years and making it impossible to ever calculate what the total loss to taxpayers was from the S&L crisis of the 1980s.

Federal insurance also aggravates what economists call moral hazard in the banking sector. Bank owners and large depositors essentially collude in placing and accepting deposits in financial institutions that pay high interest on deposits which are used to make risky loans that pay high returns – as long as the borrowers don’t default. But when there are defaults on risky loans neither depositors nor shareholders are the major victims of insolvency and bankruptcy. Lightly capitalized shareholders lose little in case of bankruptcy, while fully insured depositors lose nothing. Meanwhile both have been enjoying high returns while running little or no risk in the process. So government insurance compounds the problem that bank officers cannot be counted on to pursue the public interest in an efficient trade-off between profitability and risk by no longer making it necessary for depositors to monitor the lending activities of the financial institutions where they place their deposits. Apparently depositor fear of insolvency was an insufficient restraint on bank lending policy even before the advent of public deposit insurance since all governments had already found it necessary to charge their Central Bank with regulating minimum reserve requirements and monitoring the legitimacy of bank loans. Deposit insurance has the unfortunate effect of further weakening depositor incentives to monitor bank behavior.

Finally, notice that the existence of banks means the functioning money supply is considerably larger than the amount of currency circulating in the economy. If we ask how much someone could buy, immediately, in a world without banks the answer would be the amount of currency that person has. But in a world with banks where sellers not only accept currency in exchange for goods and services, but accept checks drawn on banks as well, someone can buy an amount equal to the currency they have plus the balance they have in their checking account(s). This means the “functioning” money supply is equal to the amount of currency circulating in the economy plus the sum total balances in household and business checking accounts at banks. For decades checking account balances in banks have been larger than the amount of currency in circulation, more than doubling the functioning money supply.1

Which leads to our last frightening realization. Most of the functioning money supply is literally created by private commercial banks when they accept deposits and make loans. But as we have seen, when banks engage in these activities, and thereby “create” most of the functioning money supply, they think only of their own profits and give nary a thought to the sacred public trust of preserving the integrity of “money” in our economy.

Monetary Policy: Another Way to Skin the Cat

In Chapter 6 we studied three fiscal policies: changes in government spending, changes in taxes, and changing both spending and taxes by the same amount in the same direction. While they had different effects on the government budget deficit (or surplus) and on the composition of output, in theory, any one of them was sufficient to eliminate any unemployment or inflation gap. The alternative to fiscal policy is monetary policy which, in theory, can also be used to eliminate unemployment or inflation gaps. If the Federal Reserve Bank changes the money supply it can induce a rise or fall in market interest rates, which in turn can induce a fall or rise in private investment demand, which in turn will induce an even larger change in overall aggregate demand and equilibrium GDP through the “investment income expenditure multiplier.” Just like fiscal policies, monetary policy can be either expansionary – raising equilibrium GDP to combat unemployment – or deflationary – lowering equilibrium GDP to combat demand pull inflation.

While fiscal policy attacks government spending directly, or household consumption demand indirectly by changing personal taxes, monetary policy aims indirectly at the third component of aggregate demand, private investment demand.² As explained in the previous chapter investment demand depends negatively on interest rates. The micro law of supply and demand tells us that changes in the money supply should affect interest rates, which are simply the “price” of money. Just as the price of apples drops when the supply of apples increases, interest rates drop when the supply of money increases. The Federal Reserve Bank – called the Central Bank in other countries – can change the money supply in any of three ways. It can change the legal minimum reserve requirement. It can conduct “open market operations” by buying or selling treasury bonds in the “open” bond market. Or it can change something called “the discount rate.” By changing the money supply the Fed can induce a change in market interest rates to stimulate or retard business investment demand.

When the Fed lowers the legal minimum reserve requirement some of the required reserves held by each bank are no longer required and become excess reserves the banks are free to loan. As we saw, when banks make loans this has the effect of increasing the functioning money supply. By increasing the required reserve ratio the Fed can cause a decrease in the functioning money supply. Interestingly, changing the reserve requirement changes the money supply without changing the amount of currency.

The Fed has its own budget and its own assets, which in March 2013 included roughly 12% of all outstanding US treasury bonds in an assortment of sizes and maturity dates. So instead of changing the reserve requirement the Fed could take some of its treasury bonds to the “open” bond market in New York and sell them to the general public who, for simplicity, we assume pays for them with cash. The market for treasury bonds is “open” in the sense that anyone can buy them, and anyone who has some can sell them. While new treasury bonds are sold by the Treasury Department at what are called “Treasury auctions,” previously issued treasury bonds are “resold” by their original purchasers who no longer wish to hold them until they mature, to purchasers on the “open bond market.” When we talk about the Fed engaging in “open market operations” we are talking about the Fed buying or selling previously issued treasury bonds, that is, we’re talking about the bond “resell” market rather than Treasury Department auctions of new bonds. When the Fed sells bonds this isn’t a transfer of wealth from the Fed to the private sector or vice versa. It is merely a change in the form in which the Fed and private sector hold their wealth, or assets. Whereas the Fed used to hold part of its wealth in the form of the bonds it sells, now it holds that wealth in the form of currency it was paid for the bonds it sold. Whereas the private sector used to hold part of its wealth in currency, now it holds that wealth in the form of treasury bonds. When the Fed engages in open market operations it does change the amount of currency in the economy – increasing currency in the economy by buying bonds and decreasing currency in the economy by selling bonds.

So-called quantitative easing is a slight variation on this theme. As part of its attempts to rescue banks from insolvency in the aftermath of the financial crisis of 2008 the Fed under Chairman Ben Bernanke dramatically increased Fed purchases of assets from banks, thereby providing banks with more money and relieving them of troublesome assets. The policy was also intended as expansionary monetary policy, making it easier for banks to make loans to businesses and thereby stimulate the stagnant economy. Tapering refers to a reduction in the amount of quantitative easing the Fed engages in each month. Tapering, which was postponed several times when new data revealed that the economy was still sputtering, was the eventual response of the Fed to diminished fears of a recessionary relapse in 2013. Except for the fact that the Fed is purchasing assets from banks, rather than treasury bonds in the open market, quantitative easing and tapering are similar to traditional open market operations.

Finally, the Federal Reserve Bank loans money to private commercial banks that are members of the Federal Reserve Banking System.3 If these commercial banks borrow more money from the Fed and then loan it out, the money supply will increase. If they borrow less from the Fed the money supply will decrease. Just like any other lender, the Fed charges interest on loans – in this case loans it makes to private banks that are members of the Federal Reserve System. And just like any other borrower, these banks will borrow more from the Fed if the interest rate they have to pay is lower, and less if the interest rate they pay is higher. The name for the interest rate the Fed charges banks who borrow at its “discount window” is the discount rate. So by lowering its discount rate the Fed can induce commercial banks to borrow more money, thereby increasing the currency circulating in the economy, and by raising the discount rate the Fed can discourage borrowing, thereby decreasing the amount of currency circulating in the economy.

In sum, the logic of monetary policy is as follows: The Fed can increase or decrease the functioning money supply, M1, by changing the minimum reserve requirement, through open market operations, including so-called quantitative easing, or by changing its discount rate. By changing the money supply the Fed can induce changes in market interest rates, leading to changes in investment demand, leading to even greater changes in aggregate demand and equilibrium GDP. When monetary authorities fear economic recession they increase the money supply, as then Chairman Alan Greenspan and the Fed did from mid-1999 through early 2002 when they regularly lowered the discount rate by a quarter and sometimes half percent every month or two, further aggravating a housing bubble Greenspan vehemently denied existed; and as Chairman Bernanke and the Fed did from 2008 through 2013. International Monetary Fund conditionality agreements, on the other hand, routinely insist that monetary authorities reduce their functioning money supply in exchange for emergency IMF bail out loans, for reasons we explore next chapter.

Since neither increasing nor decreasing the money supply affects government spending or taxes directly, monetary policy has no direct effect on the government budget. Of course if expansionary monetary policy lowers unemployment and thereby decreases government spending on unemployment compensation and welfare programs, it will indirectly lower G. And if expansionary monetary policy increases GDP and GDI, and thereby increases tax revenues collected as a percentage of income, it will indirectly raise T. So monetary policy does have an indirect effect on the government budget. But unlike fiscal policy, changing the money supply has no direct impact on the government budget. As far as the composition of output is concerned, expansionary monetary policy increases the share of GDP going to private investment, I/Y, and decreases the shares going to public goods, G/Y, and private consumption, C/Y. Deflationary monetary policy has the opposite effect – it chokes off private investment relative to public and private consumption. In Chapter 9 we explore the effects of equivalent monetary and fiscal policies in a simple, short-run, closed economy macro model 9.3.

The Relationship between the Financial and “Real” Economies

Increasingly the economic “news” reported in the mainstream media is news about stocks, bonds, and interest rates. During the stock market boom in the late 1990s the media acted like cheer leaders for the Dow Jones Average and NASDAQ index. It was not uncommon for the major US media to report with glee that stock prices rose dramatically after a Labor Department briefing announced an increase in the number of jobless. In the aftermath of the East Asian financial crisis the media reassured us that stock indices and currency values had largely recovered in Thailand, South Korea, and Indonesia – as if that were what mattered – neglecting to report that employment and production in those economies had not rebounded – as if that were unimportant. And ever since the financial crisis of 2008 and the Great Recession that followed in its wake the media is full of cheery news about the recovery in the stock market ignoring that jobs and wages in the real economy have failed to rebound. What should we care about, and what is the relationship between the financial sector and the “real” economy?

In Chapter 2 we asked, “What should we demand from our economy?” The answer was an equitable distribution of the burdens and benefits of economic activity, efficient use of our scarce productive resources, economic democracy, solidarity, variety, and environmental sustainability. Nowhere on that wish list did rising stock, bond, or currency prices appear. This does not mean the financial sector has nothing to do with the production and distribution of goods and services. But it does mean the only reason to care about the financial sector is because of its effects on the real economy. If the financial sector improves economic efficiency and thereby allows us to produce more goods and services, so much the better. But if dynamics in the financial sector cause unemployment and lost production, or increase economic inequality, or hasten environmental deterioration, that is what matters, not the fact that a stock index or currency rose or fell in value. In an era when the hegemony of global finance is unprecedented, it is important not to invert what matters and what is only of derivative interest.

How can money, lending, banks, hedge funds, options, buying on margin, derivatives, or credit default swaps increase economic efficiency? Simple: by providing funding for some productive activity in the real economy that otherwise would not have taken place. If monetized exchange allows people to discover a mutually beneficial deal they would have been unlikely to find through barter, money increases the efficiency of the real economy. If I can borrow from you to buy a tool that allows me to work more productively right away, whereas otherwise I would have had to save for a year to buy the tool, a credit market increases my efficiency this year – and the interest rate you and I agree on will distribute the increase in my productivity during the year between you, the lender, and me, the borrower. If banks permit more borrowers and lenders to find one another, thereby allowing more people to work more productively sooner than they otherwise would have, the banking system increases efficiency in the real economy. If options, buying on margin, credit default swaps, and derivatives mobilize savings that otherwise would have been idle, and extend credit to borrowers who become more productive sooner than had they been forced to wait longer for loans from more traditional sources in the credit system, these financial innovations increase efficiency in the real economy.

But while those who profit from the financial system are quick to point out these positive potentials, they are loath to point out ways the financial sector can negatively impact the real economy. Nor do they dwell on the fact that what the credit system allows them to do is profit from other people’s increases in productivity. In 2002 when the first edition of the ABCs of Political Economy was published popular interest in learning about the downside potentials of financialization was limited. The mood was “let the good times roll,” and those like me who insisted on weighing the dangers of financial liberalization were shunned as kill-joys and scolds. What a difference the greatest financial crisis in eighty years makes! What a difference it makes when the financial crisis strikes in New York City not Bangkok or Buenos Aires, and hits the US and Europe harder than the developing world. And what a difference it makes when people finally begin to notice and care about rising inequality, and ask if financialization may have something to do with it.

At its best what the credit systems does, in all its different guises, is allow lenders to appropriate increases in the productivity of others. Why do those whose productivity rises agree to pay creditors part of their productivity increase? Because the creditors have the wealth needed to purchase whatever is necessary to increase their productivity while they do not. Moreover, if they wait until they can save sufficient wealth to do without creditors, borrowers lose whatever efficiency gain they could have produced in the meantime. But even when the credit system works well, that is, even when it generates efficiency gains rather than losses in the real economy, absent strong intervention the credit system will increase the degree of inequality in the economy. As the simple corn model in Chapter 3 demonstrates, if the laws of supply and demand are allowed to determine interest rates there is every reason to expect more than half of the increase in the borrower’s efficiency will go to the lender, thereby increasing inequality.

But besides increasing inequality the credit system can also generate efficiency losses instead of gains in the real economy. In Chapter 9 we look at a model 9.1 that makes clear how rational depositors can cause bank runs. We then look at a model 9.2 of a real corn economy with banks that shows how banks may generate efficiency gains when all goes well, but will make the real economy less efficient if there is a run on the bank. When depositors have reason to fear they will lose their deposits if they fail to withdraw before others do, the model demonstrates how banks will produce efficiency losses, not gains, in the real economy. In a second application of model 9.2 we show how international finance can generate efficiency losses as well as gains in a “real” global corn economy for similar reasons. The general lesson from models 9.1 and 9.2 is when borrowers and lenders become accustomed to finding each other through bank mediation and banks fail, it is possible for fewer borrowers to find lenders than otherwise would have, and therefore for the real economy to become less efficient than it would have been without banks. Similarly, when more highly leveraged international finance makes it more likely that international investors will panic, and capital liberalization makes it easier for them to withdraw tens of billions of dollars of investments from emerging market economies and sell off massive quantities of their currencies overnight, tens of millions can lose their jobs and decades of economic progress can go down the drain as banks and businesses in emerging market economies go bankrupt. This is how liberalizing the international credit system can make real less developed economies less efficient than they were when international finance was more restricted, as it was during the Bretton Woods era. And as citizens in advanced economies have recently discovered, these are among the potential downsides of lashing their real economies more tightly to the back of a credit system when the credit system proves unstable.

Banks, futures, options, margins, derivatives, credit default swaps, and other “financial innovations” all either expand the list of things speculators can buy and sell, or permit them to increase their leverage – use less of their own wealth and more of someone else’s when they invest. In other words these, and whatever new financial instruments speculators dream up in the future, simply extend the credit system. If the extension provides funding for some productive activity that would otherwise not have been funded, it can be useful. But all extensions increase dangers in the credit system by (1) increasing the number of places something might go wrong, (2) increasing the probability that if something does go wrong investors will panic and the credit system will crash, or (3) compounding the damage if the credit system crashes. New financial products add new markets where bubbles can form and burst. Increased leverage makes financial structures more fragile and compounds the damage from any bubble that does burst.4

There are two rules of behavior in any credit system, and both rules become more critical to follow the more leveraged the system. Rule #1 is the rule all participants want all other participants to follow: DON’T PANIC! If everyone follows rule #1 the likelihood of the credit system crashing is lessened. Rule #2 is the rule each participant must be careful to follow herself: PANIC FIRST! If something goes wrong, the first to collect her loan from a debtor in trouble, the first to withdraw her deposits from a troubled bank, the first to sell her option or derivative in a market when a bubble bursts, the first to dump a currency when it is “under pressure,” will lose the least. Those who are slow to panic, on the other hand, will take the biggest baths. Once stated, the contradictory nature of the two logical rules for behavior in credit systems makes clear the inherent danger in this powerful economic institution, and the risk we take when we tie the real economy ever more tightly to a credit system financial businesses and politicians have conspired to make more unstable and fragile over the past three decades.

The Financial Crisis of 2008: A Perfect Storm

The financial crisis that struck Wall Street in the fall of 2008 was not simply the result of some mortgage loans that should never have been made because the borrowers were not sufficiently creditworthy. Less than 20% of mortgages were in arrears when the crisis hit, which means that 80% of mortgagees were current with their payments. Only because unsustainable macroeconomic imbalances were permitted to evolve, only because prudent regulation of the banking industry dating back to the Great Depression was systematically dismantled under pressure from the financial industry, only because people like Laurence Summers and Timothy Geithner actively intervened to prevent regulation of highly speculative Wall Street investment banks and hedge funds, was it possible for the worst financial crisis in eighty years to unravel when a housing bubble – which had to come to an end at some point – finally burst. There were seven steps that led to what I call the perfect economic storm, which also contained a surprise ending for banks and those who tried to rescue them.

Traditionally, people in the US applied to local banks for mortgage loans, and the bank approving the loan held the loan for 30 years. Under these conditions banks insisted on collateral – 20% down was the standard for decades – and banks checked carefully to be sure applicants had a secure job, income sufficient to make their mortgage payments, and a good credit rating – because if a mortgagee defaulted the bank who authorized the loan would suffer the adverse consequences. This worked well enough for all involved for over half a century, except the big Wall Street banks were not involved in a major way and therefore weren’t making much money off the huge US housing market.

Step 1: The banks reviewing mortgage applications no longer kept the loans themselves. Instead, by the late 1990s most mortgages were sold within a few days of being approved to someone else, and often resold, and resold again many times within a few months, thereby creating a perverse incentive for the banks evaluating loan applications to no longer do their work carefully. Since local lenders were no longer holding the mortgages they no longer had an incentive to turn down applicants who were, in fact, poor credit risks. But why did large brokerage houses and investors buy these mortgages if many of them were now of dubious quality?

Step 2: Large Wall Street banks bought up huge numbers of mortgage loans from every region of the country and did something very creative with them. They chopped these loans up into tiny little pieces, and packaged together thousands of pieces of different loans into securitized debt instruments which they usually sold off to institutional investors, but sometimes kept as assets on their own books as well. But why did institutional investors buy these fancy mortgage-based securities if at least some of them contained poor quality loans?

Step 3: There are rating agencies who rate the riskiness of different securities. But the agencies do not provide this service for free, nor do the buyers of the securities pay for the evaluation. Instead, the agencies rating the securities are paid by the Wall Street banks who package the securities together for sale, which created a second perverse incentive. The Wall Street banks had little trouble getting almost all of their mortgage based securities rated Triple A – the highest rating, supposedly meaning the lowest risk for a buyer – by agencies that did not get hired and paid unless Wall Street banks were happy with their ratings.

At this point we had transformed a simple, straightforward and largely local home mortgage industry that worked well for half a century into an incredibly lucrative international business, because the Wall Street banks also sold their fancy Triple A rated mortgage-based securities to institutional investors and large banks in Europe and elsewhere. However, the whole business was now riddled with two, serious perverse incentives, with the Wall Street banks at the center raking in handsome fees for their securitization work which they proudly described to anyone who expressed concern as minimizing systemic risk by spreading risk more broadly.

Step 4: Fearful that the housing bubble in the US could not go on forever, in 2006 institutional investors, particularly in Europe, started to get cold feet and became more reluctant to buy the mortgage-based securities that had become the life blood of a global financial bubble. This is where what we might call “good old Yankee ingenuity” came to the rescue. A medium sized insurance company few had ever heard of named American International Group offered to sell insurance policies against the event that a securitized debt instrument proved to be of little value. Worried that the mortgage-backed securities you bought might be worthless due to defaults? No problem. All you have to do is buy an insurance policy from AIG.

Step 5: Almost overnight AIG became the largest insurance company in the world selling insurance to buyers of mortgage-backed securities, but what come to be known as credit default swaps were not classified as insurance, and thereby fell outside the purview of US government agencies regulating the insurance industry. As a result AIG was not required to set aside any significant amount of the handsome premiums they collected for the credit default swaps they sold. Instead they expanded their business and paid lavish dividends to their stockholders. Moreover, what quickly became a multi-trillion dollar market in credit default swaps not only fell outside all regulation, there was not even an information clearing house where one could determine the size of the market or who owned credit default swaps against what.

Of course as long as home prices kept rising this giant house of cards economists call a Ponzi scheme was not in jeopardy. But as soon as home prices peaked, and people whose financial plan relied on the price of their house continuing to rise because they could not afford their loan under other circumstances started to default, the whole house of cards began to unravel.

However, a 20% default rate on what came to be known as sub-prime mortgages would never have led to anything like the financial crisis that occurred had not the conditions for a perfect storm been permitted to evolve in the first place. The damage done by the inevitable burst of the housing bubble was magnified many fold because the financial sector was permitted to turn the reasonably profitable but reasonably safe home mortgage industry into a mammoth, global Ponzi scheme generating record profits for its players while it lasted. In other words, when the housing bubble burst what would have been a medium wave hitting only American coasts was turned into a tsunami that swept around the globe by the multiple perverse incentives described above. And what allowed these perverse incentives to evolve was a truly monumental failure to regulate key aspects of the mortgage, banking, financial, and insurance industries.

Step 6: But we were not done yet. A major surprise was still in store, first for the Wall Street banks, and then for the Bush and Obama administrations who both tried to clean up the mess by using taxpayer dollars to buy up the toxic assets on the books of the banks. The real economy you and I live in is completely reliant on the functioning of the credit system. Few of us can buy a house without getting a loan. Many of us pay for most of what we buy using a credit card – whose balance we either do, or more often do not pay off at the end of the month. Even more importantly, the businesses that employ us need loans to buy the intermediate inputs we need to work with, and finance shipping the goods we produce. As a result, when the credit system breaks down – as it did in the fall of 2008 – the real economy quickly begins to suffer as well.

Of course that is another way to understand the problem underlying this whole mess. Whereas the credit system should serve the real economy consisting of production and consumption, what is now referred to as financialization is the reversal of this relationship. Over the past forty years the financial sector has increasingly subjected production, consumption, and investment in new machines and equipment to its own purposes, and we have now discovered how badly that can work out for most of us. In effect the tail is now wagging the dog, and the dog is increasingly uncomfortable!

In any case, the point is our real economy will not function for us when the credit system seizes up – which is what happened in the fall of 2008. The credit system froze up because the big players at the top of the credit system, the Wall Street banks, were no longer willing to lend to one another because they knew that the fancy mortgaged backed securities many of them had kept on their own books were anything but triple A safe. In other words, the banks knew only too well that what came to be called their toxic assets were of questionable value. And when the Wall Street banks could no longer get credit from one another, credit froze up for the rest of us farther down the credit chain.

Understanding why the big banks suddenly would not lend to one another in the fall of 2008 and winter of 2009 is not only a fascinating story in and of itself, but also the key to understanding why the government had such a difficult time putting Humpty Dumpty back together again despite hundreds of billions of dollars of transfusions of taxpayer dollars via the Troubled Asset Relief Program, or TARP, launched by Treasury Secretary Paulson in October 2008, and trillions of dollars of commitments US taxpayers took on as the program was tweaked and ramped up by President Obama’s new Treasury Secretary, Timothy Geithner in the years that followed.

Nobody wants to discover they were the last to lend to someone who goes bankrupt the next day. Ordinarily Wall Street banks are happy to lend to one another large amounts, generally for short periods of time. Suddenly after the Lehman Brothers bankruptcy they were not. The reason was simple. Wall Street banks feared that the bank they lent to might be on the front pages of the newspapers the next morning as the latest Wall Street Bank to go bankrupt. They had good reason to fear this because all of them had kept substantial amounts of mortgage backed securities on their books that were no longer really worth what they were supposed to be, and because it had become clear that any credit default swaps they had purchased from AIG were worthless because AIG was virtually bankrupt by September 2008, and the Fed was intervening to keep the crisis in the credit default market from bringing down major investment banks around the world.

In truth the CEOs of the Wall Street banks knew very little about the actual work done in their own securitization departments since it was a recent and technically complex financial innovation. So a CEO had to call in the much younger head of his own securitization department to ask him how he could know if another Wall Street bank asking for a loan was on shaky ground because their securities were toxic. And this was the shocking answer he got: “There is no way to know. Just like they have no way to tell what is really in the packages we have put together, and therefore whether our assets are toxic or not, we have no way to tell what is really in their packages, and therefore if their assets are toxic or not.” How toxic were these mortgage backed security assets the big banks had on their books? On average they were worth 20% less than they once were because 20% of mortgage payments were now in arrears or default. So even a full write down meant that on average the assets should have been worth 80% of what they once were – which is bad news, but not a complete disaster. But to the banks surprise they discovered that the market price for the securities was practically nothing.

While the PR departments of the Wall Street banks were busy assuring the world that they were managing risk in a smarter way by spreading it out more, what the math whizzes the big banks hired to work in their securitization departments were actually doing was a brilliant job of hiding risk. In the process of chopping and packaging the different mortgages some of the securities they created contained 95% good loans and only 5% bad loans. But some of the securities contained only 5% good loans and the remaining 95% were bad. And only the people who created the packages had any way of knowing which were which. As long as defaults were few, as long as all of the securities had a Triple A rating, and as long as people assumed that credit default swaps really did provide insurance, hiding the risk was not a problem and worked for everyone. But as soon as the housing bubble burst and 20% of the underlying mortgages were in arrears things changed dramatically. The fact that the risk had been hidden so well, and nobody except the person who had done the chopping and packaging in the first place could tell where it was, turned a problem into a total disaster. The market price for the mortgage based securities did not fall by 20%, but instead fell by much more until nobody was willing to buy any of them except at fire sale prices, because no buyer, as an outsider, could distinguish the securities that were 95% good from the ones that were 95% bad.

Suddenly Wall Street banks were no longer willing to lend to one another, which froze the entire credit system. Moreover, if their securities were valued according to their going market prices all the Wall Street banks would be revealed as hopelessly insolvent – which is why the banks fought vehemently against proposals for mark to market accounting procedures for evaluating the assets on their books, and their protectors at the Fed testified against this proposal at hearings on Capitol Hill.

In sum, the Wall Street banks found to their shock that they had hoisted themselves on their own petard. Only the grave diggers knew where they had buried the risk, and clearly they could not be trusted to tell outsiders where it was. In effect the Wall Street banks had witlessly turned assets that should have been worth 80% of their former value on average into assets with very little, if any market value at all. The more clever a securitization department had been at playing this game of liar’s poker, the more the bank found itself in checkmate with nobody willing to buy its assets or extend it any loans. So what did the government do to try to unlock and fix the credit system, and why did it prove so difficult?

Step 7: First the Bush administration – under the leadership of his Secretary of the Treasury, Henry “Hank” Paulson Jr., Chairman of the Federal Reserve Bank, Ben Bernanke, and Chair of the New York Branch of the Fed at that time, Timothy Geithner – and later the Obama administration, under the leadership of his Chief Economic Advisor, Laurence Summers, his Secretary of the Treasury, Timothy Geithner, and Ben Bernanke – tried to rescue the Wall Street banks from the mess they created for themselves by taking their toxic assets off their books. Since the market price for these assets was quite low the whole idea was to have a buyer pay the banks far more than their toxic assets were then worth. First the taxpayer bailout of the banks took the form of direct US Treasury purchases of toxic assets through a “reverse auction” that was so hampered by perverse information asymmetries and conflicts of interest that Secretary Paulson could not achieve lift-off for his plan before leaving office. The Obama administration tried to disguise the taxpayer subsidy in the form of what they called “private public partnerships” where the Treasury Department, FDIC and the Fed provided free insurance against downside risk to induce private party participation in purchases of assets from troubled banks.

In the end neither of these attempts to rid the banks of their toxic assets at public expense worked very well. What finally stabilized the situation was Bernanke simply flooded the big banks with cash to keep them afloat, first by reducing the discount rate and opening the discount window to large noncommercial banks for the first time, and later through quantitative easing. In these and other ways Bernanke made clear that the Fed would not permit any of the remaining Wall Street giants to fail, which made it safe for them to start lending to one another again, unlocking the credit system. Once the banks no longer had to sell assets buyers could not evaluate quickly to stay alive, the value of their assets had time to rise closer to the roughly 80% on average they were worth. More importantly, after a couple of years of borrowing massively from the Fed at zero interest to buy risk free treasury bonds paying over 3% and lend to emerging market economies for even more, bank profits were once again soaring. But while the crisis is now over for the banks, the financial system is just as prone to crisis as it was before 2008 because (1) the Dodd-Frank Wall Street Reform and Consumer Protection Act was more fig leaf than reform, and does very little to prevent behavior that is profitable for banks but dangerous for the rest of us, and (2) the financial system is now crowned by a smaller number of even larger big banks who can be even more bold and reckless because they can be more sure than ever that they will be regarded as “too big to be permitted to fail.” Not to speak of the fact that all of the “real” North Atlantic economies remain stagnant, with high unemployment, and living standards for most Portuguese, Irish, Greeks, and Spaniards continue to spiral downward toward conditions we normally associate with the third world.

1	More precisely, M1, referred to as the “basic” or “functioning” money supply, includes currency in circulation, “transactions account” balances, and travelers’ checks. Beside checking accounts, transaction accounts include NOW accounts, ATS accounts, credit union share drafts, and demand deposits at mutual savings banks. The distinguishing feature of all transaction accounts is they permit direct payment to a third party by check or debit card. M2 and M3 are larger definitions of the money supply which include funds that are less accessible such as savings accounts and money market mutual funds (M2), and repurchase agreements and overnight Eurodollars (M3). By 2012 people held so much money in money market mutual funds and savings accounts that M2 had become more than four times larger than M1.
2	Our model and language oversimplify. While most federal taxes are personal taxes and therefore affect household disposable income, business taxes potentially affect investment decisions. Moreover, government transfer payments count just as much toward budget deficits as government purchases of military equipment, yet only the latter is part of the aggregate demand for final goods and services. And when the Fed cuts interest rates they make it cheaper for households as well as businesses to borrow. Beside business investment, monetary policy affects consumer demand for big ticket items like appliances, cars, and houses that people buy on credit. Nonetheless, a simple model, which we don’t use to make actual predictions in any case, that assumes (1) all of G is demand for public goods, (2) taxes affect only household disposable income, and (3) monetary policy only affects business investment demand, is useful for “thinking” purposes and not terribly misleading.
3	At the height of the financial crisis some of the largest financial institutions the Fed was most anxious to “bail out” were not commercial banks, but Wall Street investment banks which were not members of the Federal Reserve Banking System. Rules on who could borrow at the discount window were relaxed at that time to allow these banks to borrow from the Fed to avoid panic among their creditors.
4	For example, derivatives can disguise how many are speculating in a market. Frank Partnoy, a derivative trader turned professor of law and finance at the University of San Diego, described this problem as follows when explaining East Asian currency crises: “It’s as if you’re in a theater, and say there are 100 people and you have the rush-to-the-exit problem. With derivatives, it’s as if without your knowing it, there are another 500 people in the theater, and you can’t see them at first. But when the rush to the exit starts, suddenly they drop from the ceiling. This makes the panic all the greater.” Quoted by Nicholas Kristof in his column in the New York Times on February 17, 1999.