Where Did All The Money Go?
This
book is available in Kindle and paperback format at Amazon.com for a
nominal contribution to this website.
Prior to the Civil War, all you needed to start a bank was a charter from a
state and access to a printing press. Banks would accept deposits, make
loans, and print banknotes that were, in essence, a promise by the bank to
pay the bearer on demand an amount of gold or silver at a fixed price. Banks
accepted deposits in the form of gold, silver, and banknotes issued by
private banks and made loans, generally in the form of banknotes that they
printed themselves. The banknotes printed by private banks circulated in the
community alongside coins minted by the United States Mint and the mints of
other countries. Given the lack of specie (i.e., gold or silver coins),
banknotes printed and issued by private banks served as the primary
medium of exchange in the economy and were the
dominant form of money.
There was a great deal of financial instability caused by this kind of
monetary system, and, as was noted in Chapter 4, there were at least three
major financial crises prior to the Civil War, in
1819,
1837, and
1857. At the same time, there were two
attempts by the federal government to regulate the financial system during
this period. The first was the creation of the
First Bank of the United States which existed
from 1791 to 1811, and the second was the creation of the
Second Bank of the United States which existed
from 1816 to 1836.
The First and Second Banks of the United States were the only banks
chartered by the federal government prior to the Civil War, and because of
the fact that federal deposits were kept in these banks they dominated the
financial system. They performed many of the functions of a
central bank in that they policed the other
banks in the system by collecting their banknotes and presenting them for
redemption in gold or silver. This limited the ability of the other banks to
print money, and in so doing the First and Second Bank of the United States
helped to stabilize the money supply and credit conditions in the country.
These banks, however, were private institutions chartered to serve the
interests of their shareholders, not to serve the public good, and it was
felt by many that the political and economic power they wielded by virtue of
their relationship to the government was abused. The fate of the Second Bank
of the United States was sealed when its president,
Nicholas Biddle, opposed Andrew Jackson in the
1832 election. A bill to renew its charter was vetoed by Jackson in that
year, and the last nail was driven into its coffin in 1833 when Jackson
decreed that no more government money would be deposited in the Second Bank
of the United States. (Trumbore
NCpedia
Phillips)
The demise of the Second Bank of the United States left the country with no
financial institution that could perform the functions of a central bank.
The First and Second Banks of the United States were far from satisfactory
in this regard,
but without them there was chaos. Since each bank was responsible for the
banknotes it issued, one had to evaluate the worth of a given banknote on
the basis of the soundness of the issuing bank—that is, its ability to honor
its promise to redeem its banknotes in gold or silver. With hundreds of
banks issuing these notes this was no easy task. There were
over a thousand kinds of banknotes in
circulation by 1860. Banknotes issued by failed banks circulated alongside
the notes of sound banks and, of course, counterfeiting has always been a
problem—even before the Civil War. As a result, banknotes did not
necessarily trade at par, and the result was a very unstable and inefficient
currency system that hindered the growth of trade and economic development.
This situation changed dramatically with the passage of the
National Banking Acts of 1863 and 1864. These
acts created the
National Banking System with the intent of
providing a stable and uniform national currency and, not coincidently, to
help finance the Civil War. These two goals were accomplished by requiring
that the banknotes printed by federally charted national banks be backed by
Treasury securities equal in value to ninety percent of the value of the
banknotes printed by national banks. These securities provided a secure
backing for
National Bank Notes since they could be sold
to redeem the notes if the issuing bank failed. In addition, in 1865 a 10%
tax was levied on non-national-bank banknotes and on all transactions using
non-national-bank banknotes. The existence of this tax essentially forced
all banks that wished to print their own banknotes to join the
National Banking System.
The fact that banks were forced to purchase Treasury securities in order to
print banknotes not only helped to finance the Civil War, it also limited
the amount of
National Bank Notes that could be circulated
in the economic system by the amount of Treasury securities that were
available to banks to back the notes they issued. The result was a stable
and uniform national currency made up of 1)
National Bank Notes tied to the total value of
Treasury debt outstanding, 2)
United Sates Notes which were the
greenbacks printed by the federal government
to pay the troops during the Civil War, 3) gold and silver coins that were
minted by the U.S. or other treasuries, and 4)
Gold Certificates issued by the Treasury which
were, in effect, warehouse receipts for gold held at the Treasury.
While the National Banking Acts of 1863 and 1864, bolstered by the 1865 tax
on non-national-bank banknotes, did provide a stable and uniform national
currency, these dramatic changes in our financial system did not solve the
problem of financial crises. The reason is that these reforms failed to deal
directly with the unique solvency and liquidity problems faced by banks that
cause the financial system to be inherently unstable.
The solvency problem faced by any businesses, including a bank, is best
understood in terms of
the fundamental equation of double entry bookkeeping:
Assets = Liabilities + Net Worth
where
Assets denotes the value of everything
the business owns;
Liabilities denotes the value of
everything the business owes to others, and
Net Worth (also referred to as
owner’s equity, equity capital, or just capital or equity) is defined
as the difference between the value of the Assets owned by the
business and the value of the Liabilities owed by the business:
Net Worth ≡ Assets - Liabilities.
The significance of this equation, for our purposes, is that it illustrates
the solvency problem of banks, namely, the need to maintain a positive
Net Worth. If the value of a bank’s Liabilities is greater than
the value of its Assets, its Net Worth will be negative and
the bank will be insolvent. The fact that it is insolvent means that
if the bank is forced into bankruptcy the value of its assets are
insufficient to cover the value of its liabilities, and some of its debtors
will not get paid back all they have lent to the bank. Insolvency puts a
bank in a very precarious position because, in an unregulated banking system
without deposit insurance, no one wants to hold deposits in a bank that is
insolvent. As a result, nineteenth century banks were susceptible to what is
known as a
bank run where all of its depositors lose
confidence in the bank’s ability to meet its financial obligations and try
to close their accounts at the same time.
The Liquidity Problem of Banks
Most businesses can meet their liquidity needs (i.e., their needs for cash)
by structuring the term to maturity of their liabilities (i.e., debts that
they owe) to match the term to maturity of their assets (i.e., things that
they own). They can, for example, finance real estate which yields a return
over a relatively long period of time with 15 or 20 year loans, equipment
with a shorter lifespan with 5 to 10 year loans, and inventories with loans
that correspond to the period of time it takes for their inventories to turn
over. A business that has its liabilities structured in this way can
generally muddle through, even if it is insolvent, with the hope of
rebuilding its net worth so long as it can service its debt (i.e., make the
requisite interest and principle payments) and so long as it can retain the
confidence of its short-term creditors.
The situation is fundamentally different for a bank. As was noted in Chapter
4, banks are financial intermediaries. They are in the business of borrowing
from the ultimate lenders, the bank’s depositors,
and lending to the ultimate borrowers, those who borrow from banks. At the
same time, most of the assets of a bank are made up of relatively long-term
commercial, business, and real-estate loans that it makes to its customers.
These assets have term to maturities far beyond the term to maturities of
the bank's deposits, many of which, namely, checking accounts, are payable
on demand.
Thus, by their very nature, banks are not able to structure the term to
maturity of their liabilities to match the term to maturity of their assets.
As was indicated above, an ordinary business can generally muddle through
when it is in financial difficulty so long as it can service its debt and
retain the confidence of its short-term creditors. This is so because, in
general, a relatively small portion of an ordinary business's liabilities
are short term and the number of short-term creditors with which it must
contend is relatively small. As a result, an ordinary business generally has
the option of sitting down with its local banker and suppliers, opening its
books, and undertaking a rational discussion of its financial viability to
arrive at a rational decision as to whether or not its short-term credit
should be continued. The situation is much different for a bank.
Even a small bank has thousands, if not tens of thousands of short-term
creditors that hold its deposits. Unlike the debts of most businesses, a
large portion of a bank's debts (its checking accounts) are payable on
demand. What’s more, in an unregulated financial system that lacks deposit
insurance there is no incentive at all for the depositors of a bank to even
listen if a bank tries to explain its financial situation. The depositors
know that if the bank were to fail those who close their accounts first
while the bank still has currency on hand to cover withdrawals will not lose
their money while those who wait will not be able to get their money out of
the bank until its assets have been liquidated. What’s more, when a bank is
insolvent those who wait will not get all of their money back. As a result,
in the absence of deposit insurance, even a rumor that a bank is insolvent
can lead to a run that can force it out of business if it can’t come up with
the cash (currency) needed to meet the demands of its depositors. And, as we
will see, even if a bank is solvent before a run begins, if asset prices
fall as the bank is forced to sell its assets in the face of a run it can be
driven into insolvency.
Compared to banks, most businesses borrow relatively little compared to
their net worth—that is, compared to the amount of money the owners have
invested in the business—since creditors
generally refuse to lend to a business if the owners do not have a
substantial amount of their own money invested in it. In addition, the rates
of interest businesses have to pay, especially small businesses, are
generally fairly high, and business owners often find it more profitable to
reinvest their profits in their business by paying off their debts as soon
as possible than to continue to borrow. As a result, the
leverage ratios of most businesses—that is, their total debt divided by
their net worth—tend to be relatively low.
[27]
The situation is much
different for a bank. Banks are in the business of
borrowing from one group of people and lending to another group of people.
That's what banks do. They make a profit from the difference between the
costs of the funds they borrow in the form of deposits and the revenues they
receive from the loans they make to businesses and private individuals. So
long as the costs of the funds they borrow are less than the revenues they
receive from their loans banks can increase their profits by both
borrowing and lending more money. As a result, unlike ordinary business
owners, bank owners seldom find it more profitable to reinvest their profits
in their bank by paying off their debts than to continue to borrow, and the
leverage ratios of banks tend to be relatively
high.
It is this fundamental difference between ordinary businesses and banks—that
ordinary businesses generally have an incentive to pay down their debts and
banks generally do not have an incentive to pay down their debts—that makes
the financial system inherently unstable. To fully understand why this is so
we have to take a closer look at how the banking system works.
What happens to the money when a bank makes a $1,000 loan? The person who
borrows the money has but three choices as to what to do with it: 1) spend
it, 2) just hold on to it, or 3) redeposit it in a bank. If the choice is to
spend it, then the person or business that receives the money in payment for
whatever is purchased is faced with these same three choices. If the choice
is eventually made to redeposit the money that was lent in the bank that
made the loan, the bank that made the loan is able to borrow the $1,000 back
from the person who deposits it. As a result its deposits will increase by
$1,000, and the lending bank gets the cash back. But even if the
$1,000 is redeposited in another bank, whatever bank it is redeposited in
will be able to borrow the $1,000 that was lent back from the person who
deposits it and will be able to increase its cash by the $1,000 that was
lent. Thus, even though the lending bank loses the cash when it makes a
loan, some other bank in the system will eventually get the cash back
if the money that is lent is redeposited in a bank.
The fundamental point that must be understood here is that when a bank makes
a loan unless none of the cash that is lent by the bank is redeposited in
the banking system, the banking system as a whole does not lose all of the
cash that is lent. To the extent it is redeposited in the bank that made
the loan that bank gets some of the cash back, and to the extent it is
redeposited in some other bank that bank gets some of the cash. In either
case the amount of cash in the banking system as a whole does not
fall by the amount of the loan. What does change is the amount of money
that the banking system is able to borrow from its depositors. Only if
the non-bank public decides to hold all of the newly lent cash outside the
banking system—and thereby, increases the total amount of currency held by
the non-bank public outside the banking system by the amount of the
loan—will the banking system not be able to borrow back some of the money
that is lent.
To see how this works, consider what would happen if you were to start a
bank in a small town with $1,000 in cash and if every time you made a loan
all of the proceeds of that loan were subsequently redeposited in your bank.
Each time you lent your $1,000 and it was redeposited in your bank you would
be able to lend it again. As a result, your deposits would grow to $10,000
after you had lent your $1,000 and it had been redeposited in your bank ten
times while your cash and equity capital would remain unchanged at $1,000.
If we ignore the other assets and liabilities of your bank, your financial
position after making those ten $1,000 loans would look like Figure 5.1
where your bank’s Assets are listed on the left side of the table in
this figure, and its Liabilities & Net Worth are listed on the right
side of this table.
Figure
5.1: Your Financial Situation after Lending $10,000.
The fact that your Deposits have grown to $10,000 after you have made
ten $1,000 loans while your Cash Reserves and Net Worth remain
at $1,000 in this situation means the
leverage of your bank (your total debt divided
by your Net Worth) increases from zero, when you had no debt in the
form of deposits, to 10 when your deposits (your total debt) grew to
$10,000.
This is a very profitable position for you to be in so long as it costs you
less to manage your deposits than you make from your loans. If, for example,
you can lend at 5% and it cost you 3% to manage your deposits, before your
deposits grew you could make only $50 a year by lending out your $1,000
worth of capital. After you lend your $1,000 ten times and your deposits
grew to $10,000 you would then be making $200 a year on your $1,000
investment in your bank—you would be taking in $500 on the $10,000 you had
lent at 5% and it would cost you $300 (3% of $10,000 worth of deposits) to
manage your $10,000 worth of deposits. Thus, instead of making only a 5%
return on your $1,000 worth of equity capital you would be making a 20%
return on that capital.
Leverage is a
beautiful thing for a bank when it
comes to making money. If you were able to grow your deposits in this way to
$30,000 by making $30,000 worth of loans that were redeposited in your bank,
your financial situation would look like Figure 5.2.
Figure
5.2: Your Financial Situation After Lending $30,000.
Your leverage ratio would be 30 to 1, and you would be able to make
$600 ($30,000x.05 - $30,000x.03 = $600). This would yield you 60% annual
return on your $1,000 investment! Even if it cost you as much as 4% to
manage your deposits you would still make $300 in this situation and earn a
30% return on your investment.
While leverage can be a money-making machine for banks, it also poses two
serious risks. The first comes from the fact that the use of leverage
increases the liquidity problem of banks. In the above example, you are only
able to achieve a 30 to 1 leverage ratio because people are willing to lend
you money by redepositing it in your bank. You have borrowed $30,000 from
your depositors but only have $1,000 worth of cash on hand (Cash Reserves)
as a reserve to meet the needs of your depositors for currency. If
your depositors choose to take $1,000 worth of currency out of their
deposits your financial situation would look like Figure 5.3.
Figure 5.3: Your Financial Situation after $1,000 Withdrawal.
Unless you can find an alternative way to raise cash in this situation—say,
by borrowing from other banks or selling some of the asset you own for
cash—you are going to be in trouble if your depositors try to withdrawal
more cash since you have no cash to give them.
The second risk comes from the fact that the use of leverage increases your
risk of becoming insolvent. If your bank is leveraged at 30 to 1, that means
your net worth is equal to less than 3.4% of your assets. It also
means that if the values of your assets falls by 3.4%—say, because some of
your debtors go bankrupt or abscond with the money—your financial situation
would look like Figure 5.4.
Figure 5.4: Your Financial Situation after 3.4% Loss.
Your Loans would now be worth only $28,980 (.966x$30,000) which means
that when we add this to your $1,000 worth of Cash Reserves the value
of your Assets would be $29,980 while your liabilities, Deposits,
would still be $30,000. You would be insolvent because your liabilities
exceed your assets by $20, and you would not be able to pay off all of your
depositors if you were forced into bankruptcy even though you still have
$1,000 in cash to service your deposits.
Finally, it should be noted that the ability of banks to increase the amount
they can borrow by increasing the amount they lend is not unlimited. It
depends crucially on the willingness of the non-bank public to keep their
cash in banks. An expansion of bank loans is generally accompanied by an
increase in economic activity that increases the need for the non-bank
public to hold currency outside of banks to finance their day to day
transactions. As a result, it is unlikely that all of the money lent will be
redeposited in a bank.
If, for example, you started your small town bank with $1,000 cash and only
96% of your loans were redeposited in your bank you would not be able to
leverage you capital 30 to 1 since 4% of the cash you lent would remain
outside your bank as the currency held by the non-bank public increased.
Thus, by the time you made $25,000 worth of loans your deposits would have
increased by only $24,000, and 4% of the $25,000 you lent ($1,000) would not
be redeposited. Your financial situation would then look like Figure 5.5.
Figure 5.5: Your Financial Situation with a 96% Redeposit
Rate.
At this point you would have no more cash to lend. Thus, the maximum
leverage you could obtain would be 24 to 1 in this situation, but even this
is not obtainable. If you did leverage yourself this far you would have no
Cash Reserves to meet the demands of your depositors in the event one
of them wished to make a withdrawal. To play it safe you would have to keep
some cash on hand to meet this contingency.
If you chose to keep cash reserves equal to, say, 5% of your deposits to
protect yourself from unexpected withdrawals you could then only lend
$11,364 before your deposits rose to $10,909 and your cash fell by $455 (4%
of your $11,364 worth of loans) to $545 (5% of your $10,909 worth of
deposits). At that point your financial situation would look like Figure
5.6.
Figure 5.6: Your Financial Situation with a 96% Redeposit
Rate and 5% Reserves.
You would have to stop lending in order to maintain your Cash Reserves
at 5% of your Deposits and would, by choice, be limiting your
leverage to a ratio of 10.9 to 1.
Thus, banking was a continual balancing act during the nineteenth century
between expanding leverage in order to increase profits while maintaining
cash and equity reserves to deal with the liquidity and solvency problems
that this expansion inevitably entails. This balancing act was made even
more difficult by virtue of the fact that when times were prosperous and
money was being made hand over fist, the temptation to allow cash reserves
to fall and leverage to increase was, for many banks, irresistible. This was
particularly so when people had confidence in the banking system and kept
their money in banks.
Since, deposits expand automatically as banks expand their loans in this
situation, banks automatically receive the cash they need to further expand
their loans and, hence, their leverage. If banks did not make a determined
effort to increase their cash and equity as their deposits were expanding
during prosperous times their cash reserves as a percentage of their
deposits would automatically fall and their leverage would automatically
increase as well. It is not until the crisis came and the non-bank public
lost confidence in the system and began to withdraw their cash from banks
that banks would be forced to face the inevitable liquidity and solvency
problems they had created for themselves.
There were two major failings of the National Banking System. The first had
to do with the inelastic nature of the supply of currency within the
National Banking System. The second had to do with its failure to adequately
regulate the behavior of banks.
Inelastic Supply of Currency
Even though the National Banking System was
able to provide a sound and stable currency, it did so by tying the issuance
of
National Bank Notes to the amount of Treasury
securities outstanding and making it impossible for non-national banks to
issue banknotes. As was noted above, the result was a stable and uniform
national currency made up of 1)
National Bank Notes tied to the total value of
Treasury debt outstanding, 2)
United Sates Notes which were the
greenbacks printed by the federal government
to pay the troops during the Civil War, 3) gold and silver coins that were
minted by the U.S. or other treasuries, and 4)
Gold Certificates issued by the Treasury which
were, in effect, warehouse receipts for gold held at the Treasury. All of
these sources of currency were more or less fixed, and, as a result,
there was no way by which the banking system as a whole could increase the
amount of currency available to the non-bank public without reducing the
amount of currency held inside the banking system. This led to a serious
problem.
During the normal course of economic activity there were seasonal changes in
the demand for currency on the part of the non-bank public. When the demand
for currency increased, say during the spring when crops were planted and
especially in the fall when additional cash was needed to pay seasonal
workers during the harvest and to purchase the crops from farmers, currency
would flow out of the banks. This would place a strain on the cash available
to banks to meet the needs of their depositors. It would also cause a
tightening of the market for bank loans as banks were forced to contract
their lending as depositors withdrew cash from their accounts.
As currency flowed out of the banks to meet seasonal demands and banks were
forced to cut back on their lending, interest rates would rise. The pressure
on the banks for cash would thus be transmitted to those who relied on the
banks for credit. Potential borrowers who were unable to get new loans and
debtors who were unable to renew their existing loans at acceptable rates of
interest would be forced to cut back their economic activity. At the same
time, debtors who could not renew their existing loans would be forced to
sell the collateral underlying these loans or to sell other assets they
owned in order to meet their obligations to the banks. These forced sales of
assets, in turn, caused a fall in asset prices throughout the system which
strained the system even further as debtors found it more difficult to meet
their obligations to the banks in the face of falling asset prices. If this
strain became particularly severe it would cause some debtors to default
which would threaten the solvency of their banks and, in some instances,
lead to bank failures.
Bank failures inevitably shook the confidence of the public and created the
possibility of a financial crisis through a run on the system. Once a run
began, there was no mechanism within the National Banking System
by which a run on the system could be contained since there was no way to
replenish the cash that a panicked public took out of the banks. When a bank
ran out of cash it would be forced to shut its doors whether it was solvent
or not, and if the panic was sufficiently widespread the system would simply
implode as the entire system was forced to suspend payments of cash to
depositors. The end result was a massive disruption in economic output and
employment with extreme hardship throughout the economy.
A Failure to Adequately Regulate the Behavior of Banks
The second major failing of the National Banking System was that there was
no mechanism within the National Banking System
to deal with the tenuous nature of the financial stability of banks.
Specifically, there was no system of regulation within the National Banking
System that regulated the behavior of banks that kept banks from engaging in
the kinds of behaviors that lead to speculative bubbles and financial
crises.
The instability caused by the rigidity of the supply of currency within the
National Banking System became clear as the
country worked its way through the financial crises of
1873,
1893, and
1907. The experiences of these crises
eventually led to the creation of the
Federal Reserve System in 1913 in order to
deal with this problem. Unfortunately, as we will see, the need to
adequately regulate the behavior of banks did not become clear, and the
ability to adequately regulate the behavior of banks was not built into the
Federal Reserve System.
This book is available in Kindle and paperback
format at Amazon.com for a nominal contribution to this website.
Where Did All The Money Go?
How Lower Taxes, Less Government, and Deregulation Redistribute Income and
Create Economic Instability
Amazon.com
Endnotes
The Second
Bank of the United States has even
been credited with having caused the
1819 crisis.
In
the case of nineteenth century National Banks, those who held the
banknotes printed by the bank were also the ultimate lenders. For ease
of exposition and in order to highlight those aspects of
nineteenth-century banking that are relevant to our modern financial
system, the role of banknotes printed by National Banks in the National
Banking system will be ignored in what follows except when explaining
the limitations of the National Banking System.
Again, for ease of exposition and in order to
highlight those aspects of nineteenth-century banking that are relevant
to our modern banking system the role of gold in the National Banking
system will be ignored in what follows. See a
Brief History of the Gold Standard in the United States
published by the
Congressional Research Service for a history of the way in which the
Gold Standard affected the monetary system prior to its disintegration
in the 1930s and its formal abandonment in 1973.
The leverage ratio is sometimes defined as the
ratio of total assets (rather than total debt) divided by net equity.
Since the fundament equation of double entry bookkeeping (NE = A - L)
implies that the assets over equity ratio (A/NE = L/NE + 1) is always
one greater than the liabilities over equity ratio, the two ratios
measure the same thing, and the choice between them is, for the most
part, arbitrary.
I have, again, simplified this example of a
nineteenth century bank by ignoring the way in which banknotes printed
by the bank fit into the operation of the bank and the role played by
gold in a banking system encumbered by the rules of the gold standard
that existed at the time. These are important to a faithful
understanding of how the nineteenth century banking system functioned,
but they are ignored here to simplify the exposition in order to
highlight those aspects of the nineteenth century system that pertain
directly to our modern system. (See:
Brief History of the Gold Standard in the United States.)
It
should be noted that the liquidity and solvency problems of banks are
distinct problems. The liquidity problem has to do with having enough
cash on hand to meet your day to day obligations. The solvency problem
has to do with having assets of sufficient value to cover your debts.