Where Did All The Money Go?
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The
Federal Reserve System (commonly referred to
as "the Fed") was created in response to the
Financial Crisis of 1907 in an attempt to deal
with what was perceived at the time to be the central problem of the
National Banking System, namely, the inability
of this system to deal with seasonal changes in the demand for currency
without placing a strain on banks and their ability to make loans. This
problem was dealt with by creating the
Federal Reserve System as a
central bank—that
is, a bank in which other banks can open deposits and from which other banks
can borrow money—and by giving the Federal Reserve the power to print its
own currency. At the same time, all other banks were prohibited from
printing currency. (Bernanke)
The Federal Reserve thus became the
lender of last resort within the banking
system, willing and—given its ability to print currency—able
to lend cash to other banks to meet their needs. It was believed that in
addition to the ability to meet the seasonal needs of banks for cash, the
Fed would also be able to eliminate financial crises by lending cash to
sound banks during times of financial stress while allowing unsound banks to
go out of business in an orderly fashion.
The mechanism by which the Federal Reserve functions within the financial
system, and by which the Federal Reserve derives its power, is quite simple
in principle and can be summarized as follows:
1.
The Federal Reserve determines the amount of currency that is
available to the economy.
2.
The Federal Reserve also sets the
reserve requirement ratio, that is, the fraction of deposits that banks
must hold in the form of reserves, where reserves consist of either the
currency banks have in their vaults (vault cash) or in their deposit at the
Federal Reserve.
3.
The non-bank public is free to determine how much of the currency
made available by the Federal Reserve is held by banks and how much is held
outside of the banking system.
4.
Given the amount of currency made available by the Fed, and the
amount of that currency the non-bank public chooses to hold outside the
banking system, banks are free to expand their loans and deposits (in the
manner explained in Chapter 5) as long as they can do so without violating
the reserve requirement that is set by the Fed.
Within this system, banks are limited in their ability to expand the amount
they can borrow from their depositors as they expand the amount they lend by
1) the amount of currency the Fed makes available to the economic system, 2)
the amount of this currency the non-bank public is willing to leave in
banks, and 3) the reserve requirement ratio set by the Fed. As is explained
below, the cornerstone of this system is the Federal Reserve’s ability to
determine the amount of currency that is available to the economic system.
The amount of currency that is available to the system is referred to as
the
monetary base, where the
monetary base is the sum of
currency in circulation (that is, currency in
the hands of the non-bank public) plus the reserves held by banks, either in
the form of vault cash or as deposits at the Federal Reserve.
The monetary base is the foundation on which the monetary system, indeed,
the entire financial system rests since only currency is
legal tender, which means that currency is the
only form of payment that creditors must,
by law, accept in the payment of a debt.
There are two ways in which the Federal Reserve can control the
monetary base, hence, the amount of currency
available to the economic system.
The first is by making or retiring loans to banks. The Federal Reserve makes
and retires loans to banks through what is referred to as the
discount window where the rate of interest
charged for these loans is referred to as the
discount rate. All loans made by the Federal
Reserve through the discount window must be fully backed by collateral
supplied by the borrowing banks, and these loans are made at a discount to
the face value of the collateral offered by the borrowing bank. Hence, the
terms discount window and discount rate. (FRB)
When the Federal Reserve makes a loan to a bank it does so by simply
crediting the reserve deposit of that bank at the Federal Reserve by the
amount of the loan. As a result, the reserve component of the monetary base
is increased directly by the amount of the loan. By the same token, when the
Federal Reserve retires a loan previously made to a bank, the bank pays off
the loan by deducting the amount of the loan from its reserve deposit at the
Federal Reserve. As a result, the reserve component of the monetary base is
decreased directly by the amount of the loan that is repaid.
The way in which a $1,000 loan by the Fed to a commercial bank affects the
financial situation of both the Fed and the banking system and, thus,
changes the amount of currency available to the economic system is
illustrated in Figure 6.1. When the Fed credits the amount of this
loan to the Reserve Deposits of the borrowing bank, this transaction
increases the Federal Reserve’s asset Loans to Banks
and its liability Reserve Deposits by the amount of the loan, $1,000.
At the same time, it increases the Banking System’s asset
Reserve Deposits and its liability Loans from Fed by the same
amount.
The fact that the Reserve Deposits in the banking system have
increased by $1,000 as a result of this loan means that the monetary
base—the sum of currency in circulation and reserves—has increased by this
amount. Since banks can now withdraw an additional $1,000 worth of currency
from their reserve account at the Federal Reserve, and the fact that the
Federal Reserve has the legal right to print the currency to pay for this
withdrawal,
means that the amount of currency available to the economy has increased by
$1,000 as a result of this loan.
This process, of course, works in reverse when the loan is paid back by the
bank. The Federal Reserve’s asset Loans to Banks and its liability
Reserve Deposits will fall by the amount of the repayment as the bank
repays the loan by allowing the Fed to deduct the amount of the repayment
from the bank's reserve account. At the same time, the Banking System’s
asset Reserve Deposits and its liability Loans from Fed will
fall by the same amount. Thus, all of the pluses in Figure 6.1 become
minuses.
The fact that the reserves in the banking system must decrease by the amount
of the repayment means that the monetary base will fall by this amount as
well, and there will be $1,000 less currency available to the economic
system than there was before the repayment took place since banks will now
be able to withdraw $1,000 less currency from their reserve accounts than
they could before the loan was repaid.
The second way in which the Federal Reserve can control the monetary base is
by buying or selling something. While it doesn’t matter what the Federal
Reserve buys or sells, when it comes to controlling the monetary base the
Federal Reserve generally restricts itself to buying or selling
government securities. The decisions of the
Fed to buy or sell government securities are made by the Federal Reserve’s
Open Market Committee and are referred to as
the Federal Reserve’s
open market operations. (FRB)
When the Federal Reserve buys a government security, the institution that
sells the security receives a check written on the Federal Reserve in the
amount paid for the security. In the normal course of events, the check will
be deposited in a bank, and, in turn, the bank will redeposit the check in
its reserve account at the Federal Reserve. When the check is deposited in
the bank’s reserve account the reserve component of the monetary base will
increase by the amount of the check.
Figure 6.2
illustrates the situation where the Fed purchases a $1,000 government
security from a member of the non-bank public. This transaction increases
the Federal Reserve asset Government Securities by the
amount of the purchase, $1,000. When the member of the non-bank public
deposits the check it received for the security in its bank account, the
liability Bank Deposits of the Banking System increases
by the amount of the check. When the bank, in turn, deposits the $1,000
check in its reserve account the asset Reserve Deposits of
Banking System increases by the same amount as will the
Federal Reserve liability Reserve Deposits.
Figure 6.2: A $1,000 Purchas by the Fed.
The only change that has occurred in the financial situation of the
Non-Bank Public at this point is there is the exchange of one
kind of asset for another—Government Securities held by the
Non-Bank Public have gone down while Bank Deposits held by
the Non-Bank Public have gone up by the same amount, $1,000.
But the fact that the reserves in the banking system have increased by
$1,000 as a result of this purchase by the Fed means that the monetary base
has increased by this amount, and there is now $1,000 more currency
available to the economic system than there was before this purchase took
place.
By the same token, when the Federal Reserve sells a government security it
will receive a check written on a commercial bank for the amount of the
sale. The Federal Reserve will then deduct the amount of that check from the
reserve deposit of the bank on which the check is written, and the reserve
component of the monetary base will decrease by the amount of the check. The
bank, in turn, will deduct the amount of the check from the account on which
the check was written. As a result, all of the signs in Figure 6.2
will be reversed, and the amount of the monetary base, that is, the amount
of currency available to the economic system, will be decreased accordingly.
Thus, when the Fed wants to increase the amount of currency available to the
economy it can either increase the amount it lends to banks or it can
purchase government securities. When the Fed wants to decrease the amount of
currency available to the economy it can either reduce the amount it lends
to banks or it can sell government securities.
The ability of the Federal Reserve to control the amount of currency that is
available to the economic system provided a mechanism by which the seasonal
demand for currency problem that plagued the
National Banking System could be eliminated.
After the Federal Reserve came into being, banks were no longer forced to
contract their lending as currency flowed out of the banking system in
response to seasonal changes in the demand for currency. Instead, banks
could borrow from the Federal Reserve or the Fed could purchase government
securities from the public in order to replenish the reserves that were lost
as the currency flowed out of the banks during spring planting or the fall
harvest. When the planting or harvest was over and the currency flowed back
into the banks, the Fed could absorb the excess currency as the loans it had
made were repaid and as it sold the government securities it had purchased
to meet the currency drain from banks.
It is important to note, however, that when the Federal Reserve changes the
monetary base in this way it can lead to changes in the financial system
that go beyond the changes indicated in Figure 6.1 and Figure 6.2
above. The Federal Reserve is not simply a passive agent that responds to
the seasonal changes in the demand for currency. The Fed can change the
monetary base through its lending and open market operations whether
currency is flowing into or out of banks or not. As a result, the Federal
Reserve has the power to affect the ability of the banking system to make
loans. This gives the Federal Reserve the power to affect the credit
conditions in the economic system irrespective of the seasonal demands for
currency by the non-bank public.
Consider the situation depicted in Figure 6.2 where the Fed has
purchased a $1,000 government security from a member of the non-bank public
and thereby increased the amount of deposits and reserves in the banking
system by $1,000. Now assume that the reserve requirement ratio is, say, 10%
and the banking system is fully loaned up before this transaction takes
place—that is, that the actual reserves held by banks are equal to the
reserves they are required to hold as determined by the size of their
deposits and the reserve requirement ratio set by the Federal Reserve.
Since the reserve requirement ratio is 10%, and this transaction increased
deposits by $1,000, the reserves banks are required to hold will increase by
$100 (by 10% of the increase in deposits). At the same time, this
transaction also increases the reserves that banks actually have
by $1,000. As a result, there is $900 in
excess reserves in the banking system ($1,000
increase in actual reserves minus the $100 increase in required reserves)
after this transaction takes place that did not exist before this
transaction took place. These excess reserves represent cash banks hold in
excess of what they are required to hold given their deposits and the
reserve requirement ratio—excess cash that can be used to expand the loans
and deposits within the banking system.
As banks make loans to, and borrow the money back from the non-bank public
in manner explained in Chapter 5, the loans and deposits in banks can grow
until there are no longer excess reserves in the banking system. If there
are no leakages of currency out of the banking system as this process of
expansion takes place, the system will eventually reach the point depicted
in Figure 6.3 where Bank Loans of Banking System
and Loans from banks of the Non-Bank Public
increase by an additional $9,000 bringing the increase in Bank Deposits
to $10,000.
Figure 6.3: Secondary Effects of a $1,000 Purchases by the
Fed from Non-Bank Public.
At this point the process of expansion must come to an end as required
reserves will have increased by $1,000 (10% of the $10,000 increase in
Bank Deposits), and there will no longer be excess reserves in the
system. The Non-Bank Public will have increased the Bank
Deposits it owns by an additional $9,000 and will have gone $9,000
deeper in debt to the banks (Bank Loans). And all of this has
taken place as a result of 1) the Federal Reserve purchasing a $1,000
government Security, 2) the banking system’s willingness to lend its excess
reserves, and 3) the non-bank public's unwillingness to increase the
amount of currency held outside the banking system.
This process works in reverse, of course, if the Federal Reserve sells a
$1,000 government security. Reserves and deposits would fall by $1,000, and
banks would find themselves with a $900 deficiency in reserves. Banks would
then be forced to reduce their outstanding loans by $9,000 as the non-bank
public paid off their debts to the banks and bank deposits would fall by an
additional $9,000. All of the signs in Figure 6.3 would be reversed
and there would no longer be a deficiency of reserves in the system.
The same kinds of results would be obtained if the Federal Reserve had
increased its loans to banks by $1,000 in this situation instead of
purchasing a government security. The only difference would be that the loan
would not have directly increased deposits by $1,000, and the non-bank
public would not have sold a government security. The entire $1,000 increase
in reserves would be excess reserve, and banks would be able to increase
their loans to the non-bank public by $10,000 instead of only $9,000. The
end result would be as depicted in Figure 6.4.
Figure 6.4: Secondary Effects of a $1,ooo Loan by the Fed.
Again, if the Fed reduced its loans to banks by $1,000 instead of increased
its loans by this amount all of the signs in Figure 6.4 would be
reversed.
While the Federal Reserve was able to solve the seasonal demand for currency
problem that had plagued the
National Banking System, it was not able to
solve the financial crisis problem that it was hoped it would solve. The
inadequacy of the Federal Reserve in this regard became painfully obvious as
the economy worked its way through the
roaring twenties and into the
Great Depression of the 1930s.
As we saw in Chapter 4, the 1920s began
with a rather steep recession in
1920-1921 followed by a
speculative bubble in the real-estate market.
(White)
This real-estate bubble was superseded by a speculative bubble in the stock
market which began in 1926 and burst in October of
1929. As real-estate and stock prices fell the
recession that had began in the summer of 1929 got worse, and a banking
crisis began in the fall of 1930 that didn't reach its climax until 1933 as
more than
4,000 banks and savings institutions went out
of business in that year alone.
As this drama unfolded it became impossible for the Federal Reserve to
resolve the situation by simply providing cash to sound banks in order to
save them while allowing unsound banks to go under. Even though the Fed was
able to deal with the liquidity problems of banks in meeting the demands of
their depositors for currency during the crisis, it was unable to deal with
the solvency problems of banks that developed during the crisis. The problem
was not simply that sound banks needed cash to meet their depositors’
demands for currency. The problem was that as banks contract their loans the
forced sale of assets on the part of debtors throughout the system caused
asset prices to fall, which, in turn, caused the value of the collateral
underlying bank loans to fall below the value of the loans that had been
made. (Pecora)
This drove otherwise sound banks into insolvency, and banks became unsound
faster than they could be saved. The result was the downward spiral
described in Chapter 4 that led to the Great Depression of the 1930s. (Fisher
Keynes
Kindleberger
Mian
White)
The experience of the 1920s also revealed a number of serious deficiencies
in the way the Federal Reserve was organized. Because of the inherent
mistrust of government in the United States at the time the Federal Reserve
was founded, there was a determined effort to decentralize power within the
Federal Reserve System. Toward this end, the
Federal Reserve was created as a voluntary, quasi-private institution owned
by the member banks, that is, by the banks that choose to join the
Federal Reserve System. And instead of
creating a single bank, the country was broken up into twelve banking
districts, each of which was given its own Federal Reserve Bank. Each
Federal Reserve Bank was governed by a nine member board of directors, six
of whom were elected by the member banks in its district and the remaining
three were appointed by a seven member Federal Reserve Board that was
established to oversee the system as a whole. The
Secretary of the Treasury and
Comptroller of the Currency served on the
Federal Reserve Board ex officio and the remaining five members were
appointed by the President and confirmed by the Senate. This arrangement
insured that the individual Federal Reserve banks would be dominated by the
member banks rather than by the federal government.
Even though the government-appointed Federal Reserve Board was established
to oversee the system as a whole, the lines of authority and responsibility
between the board and the district banks were not clearly drawn. As a
result, there was no central authority within the system, and it was
impossible for the Federal Reserve to pursue a unified or coherent national
policy in the absence of a consensus since each of the twelve Federal
Reserve district banks were free to follow their own policies irrespective
of the policies of the other district banks or those of the Federal Reserve
Board. (Meltzer)
To make matters worse, there were few provisions in the original Federal
Reserve Act that allowed the Federal Reserve to regulate or control the
kinds of behavior on the part of financial institutions that inevitably lead
to financial crises. The focus of the act was on providing an elastic
currency within the context of a decentralized system rather than on
regulating or controlling the behavior of financial institutions as such.
All of these factors combined to make it impossible for the Federal Reserve
to curb the speculative behavior in the real-estate and stock markets that
led up to the Crash of 1929 that ultimately led the country through a
downward spiral of defaults and into the Great Depression of the 1930s. (Fisher
Keynes
Friedman
Kindleberger
Meltzer
Eichengreen
Bernanke
Mian)
The
Dynamics of Financial Instability
As was explained in Chapter 5, during periods of economic growth and
prosperity the temptation to allow cash reserves to fall and to increase
leverage is irresistible for many financial institutions. Poorly managed
financial institutions tend to underestimate the risks of economic
instability in this situation as they see the road to riches in increasing
their leverage and in financing projects that pay the highest expected rates
of return. Those projects inevitably turn out to be the most speculative
projects that are the most at risk from economic instability. There are
powerful incentives for financial institutions to finance these projects
since huge fortunes can be made by those who facilitate and are able to take
advantage of the speculative bubbles that are created by this kind of
speculative activity. (Piketty)
In addition, while most people are honest, many are not, and in an
unregulated or poorly regulated financial system opportunities for fraud
abound. It is no accident that the most notorious fraud of all time was
perpetrated by
Charles Ponzi—the man for whom the
Ponzi scheme was named—during the poorly
regulated era of the roaring twenties or that the greatest Ponzi scheme of
all time was perpetrated by
Bernie Madoff during the recent period of
deregulation. Nor is it a coincidence that the frauds of
Charles Keating,
Michael Milken,
Ivan Boesky,
Jeff Skilling,
Ken Lay,
Andy Fastow, and
Bernie Ebbers occurred during this latter
period. As these individuals and countless others have shown, fortunes can
be made in the financial sector by people who fraudulently game the system,
and this fraud is most dangerous when it involves banks.
Given the banking system’s ability to increase the amount it can borrow as
it increase the amount it lends and the fact that a substantial portion of
the banking system’s
liabilities, namely its checking accounts, are
payable on demand, the banking system is particularly vulnerable to a run
that can bring down the entire system like a house of cards. This danger is
particularly acute during prosperous times when highly leveraged, poorly
(fraudulently) managed banks can earn more money than moderately leveraged,
well managed banks. In this situation poorly managed banks can offer higher
rates of interest to their depositors. This gives them a short-term
competitive advantage in the market for bank deposits. This situation
presents a dilemma to the well managed banks. If they do not follow the lead
of the poorly managed banks by matching the increases in interest on their
deposits the well managed banks will lose deposits to poorly managed banks.
If they do match these increases they will lose money unless they also
abandon their reluctance to increase their leverage and finance the kinds of
riskier speculative projects being financed by the poorly managed banks. (Black
Fisher
Phillips
Keynes) As a result, the very existence of the
well managed banks is threatened in this situation if they fail to follow
the lead of the poorly managed banks.
In addition, there are powerful psychological and social pressures that come
to bear on those who try to run a well managed bank in this situation. When
others are making fortunes through what seem to be unsound practices that
threaten your bottom line, it is exceedingly difficult to risk being wrong
on your own by standing up and going against the tide. It is much easier to
follow the crowd and risk going down together. As was noted by
John Maynard Keynes some seventy-five years
ago:
A sound banker, alas, is not one who foresees
danger and avoids it, but one who, when he is ruined, is ruined in a
conventional way along with his fellows, so that no one can really blame
him. (Keynes)
All of this feeds the speculation that leads to bubbles where prices are bid
up to unsustainable levels and then fall precipitously as the markets crash.
The problem is that when a poorly or fraudulently managed bank
underestimates the risks of economic instability, funds a speculative
bubble, leverages itself to dangerous levels, and induces its competitors to
follow suit, the poorly managed bank threatens the stability of the entire
financial system. If the bank is a particularly large or important bank, or
if a relatively large number of its competitors are induced to follow suit,
when the bubble bursts it can cause depositors to lose confidence in the
system itself, and the ensuing panic can bring down the entire financial
system as depositors try to get their money out of the banking system.
In addition, no other sector of the economy is as intricately intertwined
with the rest of the economic system as is the financial sector in which
banks play a central role. When this sector founders in the wake of a
bursting speculative bubble it puts the entire economic system at risk. We
don’t have to imagine a situation in which an unregulated or poorly
regulated financial system can bring down the entire economy. This has
proved to be the case throughout the history of finance and around the world
whenever a financial system has become overwhelmed by a speculative bubble.
(Kindleberger
MacKay
Skidelsky
Graeber
Reinhart
1819
1837
1857
1873
1893
1907
Galbraith)
In 1932 the Senate Committee on Banking and Currency set out to investigate
the cause of the ongoing depression. This investigation became known as the
Pecora Commission after its chief counsel,
Ferdinand Pecora. Pecora exposed
massive levels of fraud, corruption, conflicts of interest, and incompetence
on Wall Street which led to a public outcry for government regulation of the
financial sector. (Moyers
Galbraith) In response, Congress took a
decidedly pragmatic view of financial regulation in reining in the
speculative and fraudulent urges of the financial sector.
The
Glass-Steagall Act of 1933 created the
Federal Deposit Insurance Corporation (FDIC).
It also prohibited commercial banks from undertaking investment bank and
insurance company activities. This prohibition was designed to eliminate the
kinds of conflicts of interests that had fostered
corruption in the markets for securities in
the 1920s.
The
Securities Exchange Act of 1934 created the
Securities and Exchange Commission (SEC) to
regulate investment banks and the stock exchanges in order to prevent fraud
and corruption in the securities markets. Publicly traded corporations were
required by this act to file disclosure statements with the SEC to make
public important information about their firms subject to both civil and
criminal penalties for false or misleading statements and for important
omissions.
Insider trading was also outlawed as were the
stock manipulation practices such as
front running, disseminating false
information, and artificially trading a security to mislead investors.
The experiences of 1929 through 1033 also led to the
Banking Act of 1935 which centralized control
of the
Federal Reserve System in the Federal Reserve
Board. (Bernanke)
The Federal Reserve Board was symbolically renamed the
Board of Governors of the
Federal Reserve System
in this act and was reconstituted as its ex officio members (the
Secretary of the Treasury and the Comptroller of the Currency) were replace
by members appointed by the president and confirmed by the Senate. At the
same time, the legal authority to implement Federal Reserve policy was taken
out of the hands of the individual Federal Reserve district banks and vested
in a newly created
Federal Reserve Open Market Committee (FOMC)
made up of the seven members of the Board of Governors and five of the
presidents of the individual Federal Reserve district banks. Four of the
five presidents serve on a rotating basis, and the president of the New York
Federal Reserve Bank, because of the importance of New York City banks in
the financial system, was given a permanent seat on the FOMC. In addition,
the Fed was given enhanced power to regulate and control speculative
activities within the financial system. It was given the power to set
margin requirements on loans collateralized by
shares of stock, for example.
To prevent poorly or fraudulently managed banks from having a competitive
advantage over well managed banks in competing for deposits, banks were
prohibited from paying interest on demand deposits (i.e., checking
accounts), and the maximum interest rates banks were allowed to pay on time
deposits (i.e., savings accounts) was set by the Fed. To make all of this
work, a comprehensive regulatory and supervisory system was put in place to
ensure that banks were following the rules and not gaming the system to get
around the rules.
The
Maloney Act of 1938 amended the Securities
Exchange Act to create
Self Regulating Organizations (SROs) to
provide direct oversight of securities firms under the supervision of the
SEC and provided for the regulation of the
Over-The-Counter (OTC) market for securities.
The SEC was also authorized to impose its own capital requirements on
securities firms, and in 1944 the SEC exempted from its capital rule any
firm whose SRO imposed more comprehensive capital requirements.
In 1940 Congress passed the
Investment Company and
Investment Advisers Acts which brought mutual
funds under the purview of federal regulation, and in 1956 the
Bank Holding Company Act was passed
restricting the actions of bank holding companies. The
International Banking and
Financial Institutions Regulatory and Interest Rate Control
Acts were passed in 1978 to bring foreign banks within the federal
regulatory framework and to establish the limits and reporting requirements
for bank insider transactions. (RiskGlossary)
This regulation was
designed to break the boom and bust cycle in the financial sector of the
economy—which inevitably led to a boom and bust cycle in the economic system
as a whole—by prohibiting the kinds of reckless and irresponsible
speculative and fraudulent practices that inevitably lead to insolvency on
the part of poorly and fraudulently managed banks and drove many responsibly
managed banks out of business in the midst of financial crises. These
measures actually worked for over fifty years to accomplish this end.
Unfortunately, things began to change in the 1970s and 1980s as attitudes
toward government regulation of the economic system changed.
Endnotes
While this mechanism is quite simple in
principle, it is somewhat more complicated in practice. The
Federal Reserve System is a voluntary
organization, and not all banks are members of the system. Prior to
1980, the Fed only set the reserve requirement for member banks, that
is, for banks that chose to become members of the
Federal Reserve System. Reserve
requirements for nonmember banks were set by the states in which the
nonmember banks were chartered. In addition, there are different reserve
requirements for different kinds of deposits, e.g., time deposits
(savings accounts) have lower reserve requirement ratios than demand
deposits (checking accounts). What's more, the amount of currency banks
held in bank vaults (i.e., vault cash) was not considered to be part of
reserves from 1917 until 1959.
To simplify the exposition in
what follows these considerations are ignored and it is assumed there is
only one reserve requirement ratio that applies to all deposits and that
vault cash is part of reserves. See
Feinman for a history of the way reserves
and reserve requirements were determined from the nineteenth century
through the early 1990s and also
Keister for a more technical discussion
of the way in which reserve requirements are met by banks. For an
explanation of the role played by gold in the financial system prior to
1973 see
Brief History of the Gold Standard in the United States
The sum
of currency in circulation and the reserves held by the banking system
is sometimes referred to as
High-Powered Money. Also, see the previous footnote on reserve
requirements.
In the
real world, these transfers among accounts are, of course, done
electronically and do not involve the actual writing and transfer of
physical checks, but it is helpful to think of the process in terms of
how the transfers would occurred if they were accomplished through the
use of checks as an aid to understanding the process by which the end
results are obtained.
It should be noted that in order to simplify
the exposition and bring out the basic principles involved, the ways in
which the economy and other financial institutions react to changes in
the amount of currency available to the economy (i.e., changes in the
monetary base) are ignored in this example, and in the examples that
follow. Only the hypothetical situation in which the banking system
maintains zero excess reserves and there are no leakages of currency out
of the banking system is considered. In the real world, of course, banks
will not necessarily keep their excess reserves at zero and there will
be leakages out of the banking system of the sort discussed in Figure
5.6 at the end of Chapter 5. See
Tobin for a discussion of the way in
which these leakages occur and excess reserves are actually determined
within the financial system.
The nature of the problem here was succinctly
put by Charles Prince, former CEO of Citigroup, in his infamous and much
maligned comment in the
Financial Times: "When the music stops, in
terms of liquidity, things will be complicated. But as long as the music
is playing, you’ve got to get up and dance. We’re still dancing.” (See
Reuters)
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Where Did All The Money Go?
How Lower Taxes, Less Government, and Deregulation Redistribute Income and
Create Economic Instability
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