Money and the Banking System | Basic Economics by Thomas Sowell | Ch. 17

A large part of national economics is money and the banking system, which we will be taking a look at today in the 17th chapter of Thomas Sowell's Basic Economics.

If you want to see my summaries and analyses of previous chapters, please click here. Otherwise, here we go!

Chapter Summary

The headlining quote for this chapter is from Milton Friedman, who says:

A system established largely to prevent bank panics produced the most severe banking panic in American history.

Money and banking are essential parts of modern life today. Money helps distribute real resources around society, while banks handle the vast majority of that distribution. Thus, it is important to understand their roles in society.

The Role of Money

Money is very simple: it's an agreed upon intermediary for exchanging anything between people. From sea shells to tobacco, lots of different things have been used for money in the past. It's important to see that money for an individual may be associated with wealth, since other individuals will exchange goods or services for that money. However, on a national scale, money isn't wealth at all. Said country still needs to produce real goods and services.

That doesn't mean, of course, that money isn't valuable. Bartering, which is trading one good for another directly, is a very clumsy system that actually worsens economic activity. Thus, understanding money which is used as a medium of exchange is important.

Inflation, which is simply an increase in prices, is one of the first things to understand. When people have more ability (aka money) to spend, they tend to spend more. If there isn't an increase in productivity, then prices of existing goods increase as well, because that means that there is an increase in demand without an increase in supply. It's a situation where people attempt to outbid each other for what they want. And thus, when there is more money circulating in an economy, prices rise.

This becomes a problem when governments control money, due to the temptation to always try to create more of it. Thus, when there is an inherent limitation in supply of the money material (e.g. gold), it deprives these governments of the ability to inflate an economy. Thus, having something like a gold standard isn't saying that money now has intrinsic value, but simply saying that paper money is limited by the supply of gold.

A country's own money supply isn't just paper fiat, however. It includes whatever instruments exist that can be redeemed for other goods and services. This includes things like IOUs and credit cards, which means that when credits are liquidated, the result is like a reduction of money supply. In addition, countries can use the currency of other nations (e.g. the US dollar is used around the world).

When money isn't limited, inflation reduces the buying power of those who save. For example, the money one had in the 1960's could buy 6x more than in 2013. This means that those who saved their money in the 60's lost more than 80% of its purchasing power. When the public becomes aware of this “silent confiscation” of wealth by their government, they typically flock to gold.

So why would governments inflate? The simple answer is to avoid raising taxes. Raising taxes is politically dangerous, as it looks like an obvious move by the government to take money. Instead, by creating more money, and immediately using it to purchase resources, the government hands off the decreased buying power to the public while still retaining its buying power. Thus, inflation is the hidden tax, as it has the same effect of reducing the people's buying power as explicitly raising taxes.

This is why the wealthy often have their investments in stocks, real estate, or other tangible assets. By doing so, they avoid letting inflation take their value. And so, even when the government proposes to increase taxes on the wealthy, the result is that the wealthy don't receive any increase, because the taxes are on money, which the wealthy don't hold onto.

Deflation is, of course, the opposite of inflation. However, it isn't necessarily a good thing either. This is because declining price levels means that the money you used yesterday could have been used to buy more today. In a market, when things are bought to be sold at a later point, it wrecks havoc on financiers. For example, it causes creditors and debtors to default, as the assets purchased can no longer pay back the interest required on loans. Furthermore, people often save their money during noticeable deflation, escalating the contraction of the money supply, and further snowballing deflation.

What if the government prints money during a deflationary period? After all, if prices are decreasing, and printing money increases supply (and thus prices), could that counteract the effect of deflation?

The problem, of course, is that the things that produce deflation in an economy are not because of a lack of money, but rather a decrease or reduction in economic output. Let's say the reason deflation is happening is because of a shortage in food from farms. This means that there isn't enough harvest to go around, and people become unemployed, since there is less pay to go to them. With less people buying food and more people saving, the price of food begins to collapse. While the government can certainly print money for the unemployed, this does nothing to ensure that there is enough food produced to sell to these people.

We've discussed in previous chapters, of course, of how government involvement in society, whether it's minimum wage hikes or price limits or minimums on goods and services, have always resulted in even poorer economies. So is there a solution here?

Sowell offers a small story of the 1890's, when there was a large hubbub around getting rid of the gold standard, as people were losing the value of their goods during a deflationary period. In the end, political tensions were alleviated with the discovery of new gold in various countries. The value of gold dropped, thus rapidly increasing the value of farm produce. In other words, it wasn't the government that solved the economic problem, but the work of private citizens producing the needed result.

The Banking System and The Role of Banks

Banks exist for many reasons. First they exist to insure the money of other private and public entities at a lower cost. If there were no banks, there would be much more robberies of restaurants or homes or other businesses, since they would have to guard their own money. When multiple entities pool their money together, they can much better purchase the security necessary for their collective wealth.

However, they also play an active role in the economy. For example, since businesses often go from profit to debt, they sometimes cannot cover their own obligations to pay their employees. In these cases, a business can get a loan from the bank, and pay their employees, so that the business can, hopefully and eventually, repay when they are profiting once more.

This is especially important for startups. While certainly private businesses can save up their own money to bail themselves out, banks provide access to an economy of scale that de-risks certain aspects of maintaining businesses (e.g. as mentioned above), especially for the smaller business owners. Even individuals gain access to the greater economy by being financed by the bank if they are using credit cards for purchases.

Of course, in giving access to the economy at large, banks can also help individuals and businesses understand and evaluate investment prospects, such as stocks, bonds, and mutual funds. Furthermore, with banks financing different investments, theoretically, individuals and businesses can also use banks for savings accounts and pension plans.

Why do we need these financial intermediaries? A better way to look at it may be to look at countries which don't have these services. More often than not, these people in these countries are poorer, even if their country has a plethora of natural resources. This is because a financial intermediary is able to facilitate the exchange of natural resources, so that these raw materials can be turned into better goods and services like homes and businesses. In other words, they can help to better produce wealth economically.

Now we need to talk about fractional reserve banking, an integral part of banking today. Basically, modern banking allows banks to only hold a small fraction of the reserves needed to cover deposits and thus add more to the total money supply. The vast majority of depositors are not going to want their money at the same time, and so the bank can take the money they do have and lend it to others. By earning interest on what they loan out, they can make more money with what they currently have.

The problem may be obvious: this only works when depositors do not require most of all of their money at the same time as everyone else. And of course, such a situation may happen when times are tough, or when depositors in general don't believe that the bank will be able to pay them back, and attempt to withdraw all their money in panic. Even if a bank has assets it can sell to cover its debts, it may not be able to sell those assets fast enough to do so.

Such situations have happened, including during the Great Depression in the 1930's in the United States, and masses of banks capitulated. The US then created the Federal Deposit Insurance Corporation (FDIC) so that bank customers don't have to fear bank collapses.

In 1914, a little before all this happened, the Federal Reserve System was also created as a central bank so that the government could control private banks, since it has the power to tell them what they can keep in reserve, as well as lend to those banks. This created a sort of ethos around the Federal Reserve, where its actions or its chairman's words were taken as indications of what the government was going to do economically, which would then affect the prices of the stock market.

Interestingly, some of the worst bank failures in the US occurred after the Federal Reserve was established, including the market crash of 1929 and the Great Depression of the 1930's.

Banking Laws and Policies

Sowell begins this section with a warning in reference to banking, that we shouldn't “repeat the mistake that Lenin made in grossly under-estimating the complexity of business in general”. Let's dive in.

The act of lending out money to private businesses so as to get a return on investment is actually not an easy task. This was a problem that many post-communist nations had. The problem is in the collateral a bank takes, whether that collateral is easily liquidated when a borrower defaults. In many ways, it's easier for a bank to simply buy government securities and bonds, which seem to give a more dependable rate of return.

When there is distrust in the banks, people tend to invest in assets that are less liquid. For example, in India, despite its people having generally higher savings that Americans, much of its individuals' holdings are in gold, the highest in the world. This means that a large part of the country's wealth is actually not used to invest or finance, thus leading to less economic output. The savings that are in Indian banks are generally lent to the government rather than in businesses. The same can be said of China.

When private banks are able to lend more money to the private enterprises instead of the government, the net result tends to be higher rates of interest and thus, higher rates of savings. This in turn creates better economic growth, as banks learn to be more efficient in allocating resources to more successful businesses. But in all of this, there is a lot of risk involved. Is it possible for the government to mitigate these risks?

In the United States, before the FDIC existed, states also had a sort of deposit insurance. These states forbid banks from having branch offices, which was supposed to protect local banks from competition from bigger banks elsewhere. However, this actually made banks more risky since the concentration made it impossible to de-risk vis a vis economy of scale.

Thus, when thousands of banks failed in the 1920's and 1930's, those banks that failed were overwhelmingly in the small communities where these anti-branch laws existed. The FDIC was created in reaction to this, but it was a government reaction to terrible government regulations.

We know that a better scenario can happen because it did, in Canada. At the same time that US banks were failing by the thousands, there wasn't a single bank failure in Canada because it had only a few banks with thousands of branches. These thousands of branches spread the risk out across economic conditions. And even during the Great Depression, the US banks with numerous branches had little failure rates.

FDIC, and other government intervention insurance like it, create problems just as they attempt to reduce risks. After all, there is a chance that people who are insured may engage in more risky behavior than before. The same goes for financial institutions. In addition, governments may miscalculate risks, and give taxpayers the responsibility for cleaning up the mess they created.

This is basically what happened during the Great Recession. In 1977, the United States created the Community Reinvestment Act, attempting to reinvest in low-income communities and make home buying more affordable for low-income people with poor credit history. This incentivized banks to lend to riskier and riskier people, and resulted in the global financial crash (as well as collapse of entire banking institutions and Wall Street firms) in 2007.

My Thoughts

For those who have been following me for a while, this chapter may be eerily similar to a series I did called Be Your Own Bank. At that point in time, I had not read Basic Economics, but it's great to see how similar my ideas were in that series. If you're curious and haven't looked at it, I encourage you to read that series I wrote when I first started blogging on Coil, as it really does lay a foundation for a lot of things that I like to talk about in terms of economics.

Most of what Sowell wrote has to do with traditional finance, but I think it has a lot to say about today's changing landscape, as Fintech and blockchain rise in adoption around the world. So let's get into some crypto talk.

A Cautious Look at Cryptocurrency

I think it's important to understand that, at least today, the vast majority of crypto resides in the realm of currency. This means that, like fiat currency, the majority of crypto has no intrinsic value. Let's look at Bitcoin.

The ethos behind Bitcoin these days is that it is a store of value, just like gold is in the real world. I've compared gold and Bitcoin before, just to reiterate: gold has some intrinsic value because of its allure, its utility, and it's longevity. These are intrinsic traits of gold that make it desirable.

Bitcoin, on the other hand, is the first and worst of all the cryptocurrencies today. It has no utility outside of secure transference (which all the other cryptos have). Its longevity has so far been pretty great, but a decade is a bit short to say something has real longevity (gold has been desirable for at least a couple thousand years).

I'm not saying that Bitcoin is terrible. While it does have its detriments given above, in a sense it is a store of value, but not because of anything intrinsic. Instead, it is a store of value simply because that's what people believe it is. And in this it is actually quite similar to gold.

After all, if some apocalyptic crisis takes the world over, and human beings are left to sticks and stones to fend for themselves, both gold and Bitcoin would prove to be quite useless. And so, we arrive at what I've said above. Since a large majority of cryptos today seek to emulate the success of Bitcoin, the vast majority of them are simply mediums of exchange. Or, in other words, currency.

If we understand this premise, then, we understand that a majority of crypto is basically digital fiat. The mass withdrawal of that fiat from DeFi, even if most depositors are paid (since almost all DeFi is based on a collateralized system), we may still have a disaster on our hands. Adapting what Sowell has said, the ability of loan agents to liquidate their assets in order to pay back depositors is still a requirement in DeFi networks. And, of course, during a crises, it may be that the collateral they hold is actually difficult to liquidate.

This happened on Black Thursday in 2020, where a massive crash nearly upended the crypto space. While it thankfully didn't end crypto, it did show us how fragile the system can be in dire times.

In all of this, I'm not trying to denounce crypto — my intention is the opposite, in fact. My readers will know that I talk often about crypto and the revolution it can theoretically have on our society.

But it's important to come to grips with the fact that, if any crypto is going to survive and become a real asset, it needs to go beyond the simple “store of value” and “currency” narrative, and into the realm of mass utility. In other words, crypto needs to have a use-case that isn't just transferring value, but one that is intrinsically desired and useful in a variety of situations. DeFi can't just be about “yield farming”, as if the increase in one's holdings of a number of tokens is in itself valuable. The token must have value intrinsically.