The Paul family's partial truth about the Federal Reserve [Opinion: The Arena]

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Federal Reserve Headquarters

The father and son Paul duo, Ron and Rand, have been pointing to the Federal Reserve's low interest rates, primarily under the Bush administration, as the primary factor in creating the housing bubble. If we do some root cause analysis on this, we find that the Fed's low interest rates were a contributing factor, but they were not the only contributing factor, and they were also not even the primary factor.

The argument goes that when the money supply is increased too much, and money becomes too cheap, speculative bubbles form. And that much is correct. But there are two mechanisms at work in how much the money supply increases. One of those mechanisms is the Federal Reserve's interest rate policies. But the other is how much leverage the fractional reserve banking system uses.

Remember how banks work.

Lets say the economy consists of 100 people, each has $100, and all of them have deposited their $100 into checking accounts at a bank. The bank then has $10,000 of cash in its vault. This $10,000 is one measure of how much money exists in the economy. It is the amount of cash that exists. We call it the "M1" money supply.

In the simplest of banking environments, banks make their money by lending out some of these deposits. What the bank might do is decide to keep one third of their customers' deposits in their vault, but lend two thirds of those deposits to other customers. This is the idea of fractional reserve banking. The bank keeps a fraction of its deposits available as a "reserve" and lends the rest out.

Two things happen when the bank does this. First, the amount of money in the economy increases from $10,000 to $16,666. We call this larger number, $16,666, the "M3" money supply. The second thing that happens, is that the bank ends up taking on a degree of risk that people might want to withdraw more of their money than the bank has kept in reserve in its vault.

It is easy to see that the more of its deposits a bank lends out, the more money it can make, but the more risk it will have that it won't have enough on hand to cover withdrawals. What we've learned over thousands of years of banking is that it is perfectly fine for banks to engage in fractional reserve lending, so long as they don't go too far.  In the example above, the bank has a 2:1 ratio of lending to reserves.  If the bank decided to lend $9,000 and only keep $1,000 in its vault, it would have a ratio of 9:1. It would stand to make a lot more profit this way, but it would also have a much higher risk of not being able to pay depositors.

Because bank failures have catastrophic effects for all people, whether or not they have benefited from the bank's lending in any way, we regulate how much banks have to keep in reserves. This limits their profits, but it also limits the risks we are all exposed to.

So with all that in mind, lets go back to Ron and Rand Paul, the Federal Reserve, cheap money, etc.

 

Lets say the short bar on the left is M1. This is the amount of money the US Treasury has created and that is circulating through the economy.  And lets say the tall bar on the right is M3. That is the amount of money in the economy when we take into account the effect of fractional reserve banking.

There are times when that bar on the right may not big enough to support enough economic activity to keep enough people employed. So the Federal Reserve, which is a giant bank with some special features, but basically a bank none-the-less, makes some more money available to the banks. This is the little red bar on the left. The banks add this to their vault, and it allows them to increase their lending. They add the three red bars on the right and, like magic, there is more money in the economy, more economic activity can happen, and more people can be employed.

But the opposite can happen too. Sometimes there is too much money in the economy. There is more economic activity than there are people available to work. This creates inflation, which reduces the value of money.

If there is a lot of inflation, the Federal Reserve may take away the red bar on the left, which makes the banks take away the three red bars on the right, which slows the economy, lowers employment, stems inflation, etc.

The Federal Reserve's job, in fact, is to try to strike a balance between "full employment" and "low inflation". It does this by increasing and decreasing the size of the red bar on the left.

But there is another way the M3 money supply can increase, and that is if banks increase their lending ratio. This can vastly increase the amount of money in the economy, but it increases the risk to all of us.
If banks increase their lending ratio, it increases their profits, increases their risk, increases our risk and, depending how much of a banks reserves are being borrowed from the Federal Reserve vs. from its depositors, it can even decrease the influence the Federal Reserve has on M3.

This is basically what happened in the last decade. While we never stopped regulating the maximum lending ratio banks could use, a change in the law in 2000 (written into the 2000 federal budget bill by then Senator Phil Gramm, a Republican from Texas, passed by the Republican controlled House and Senate, and signed by Democratic President, Bill Clinton) created a loophole.

The loophole gave banks a way to massively increase their lending ratio. Indeed, some of the large investment banks increased their lending ratios from 4:1 or 5:1 to 50:1!

This massively increased their profits, but it also massively increased their risk, and the risk to all of us.

Along the way, it also massively increased the M3 money supply. The increasing M3 money supply created the asset bubble in housing. The asset bubble in housing, together with the ballooning costs of the Bush wars in Iraq and Afghanistan, siphoned money out of the normal economy, which kept wage growth precariously low, even while employment and economic growth did okay. The mixed signals caused the Federal Reserve to retain its cheap money policies.

While the magnitude of these graphs are just designed to illustrate the premise of what happened, and no effort has been made to match them to actual economic numbers, what they make plain to see is that a huge amount of the increase in the money supply came not from the Federal Reserves cheap money policies, which contributed to be sure, but by the increase in leverage by the banks, due to the loophole that had been created in 2000.

When Ron and Rand Paul attack the Federal Reserve for creating the housing bubble, they don't tell you the whole story. While the Federal Reserve and its cheap money policies may have been a contributing factor, the far bigger factor was the loophole that allowed banks to profit enormously by exposing us all to the risk that eventually came to fruition in 2008.

Photo Courtesy of: Dan Smith

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Louisville.com's The Arena section features opinions from active participants in the city's politics. Their viewpoints are not those of Louisville.com (a website is an inanimate object and, as such, has no opinions).

 

 

 

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