73°F4:25 AM The Paul family's partial truth about the Federal Reserve [Opinion: The Arena]
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. |
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| 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. |
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| 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. 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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Article only half right
I appreciated this article, although i am dispointed in the assertian that the banks greed is what led up the financial bubble. I hear this quite a bit, and i cant believe people dont see this for what it really is. Here is my argument...
If a bank was allowed to fail, they would never take on such risk. If a bank is playing with house money (backed by the taxpayer) than they change eir business strategy.
You can blame this on greed but the fact is, if the ceo of say bank of america all of a sudden had morals and refused to take on risk on the taxpayers behalf, his competition would take on the risk and knock bank of america out of business.
Under the current policy (government policy that FORCES the taxpayer to take on all this risk) there will ALWAYS be banks that push the envelope beyond what is risky for a normal 100% privately backed bank.
The problem is with government and us the voters. Dont give the politcians the power to bail out private industry and private industry wont be incentivised to invest so heavily in lobbying. How can we blame everything on the rent seekers when we vote in politicians that say "work as hard as you want but i still choose the winners and losers, if you dont pay to play, your competition will"
I believe your facts are
I believe your facts are straight and your presentation of generally dull facts is mighty useful and entertaining but your analysis seems to be based on "they do it to us" paradigm. Think of this phrase "it increases the risk to all of us". Not that it was factually wrong -- but it is *only* factually right because Federal reserve (and FDIC) exist.
In a lost "normal" world without FED or FDIC, where commodity-based money do not bleed value every month:
1. I do not have to keep my money in the bank or "invest". In fact I won't if I am not a professional investor (why would I want to get Warren Buffets of the world on the other end of my trades -- and that's exactly who most of us is getting as a trading partner because stupid market participants part with their money even quicker now than decades ago). Thus, I incur 0 risk unless I willingly agree to it.
2. If I do feel like putting my money to a Bank, I estimate the risk. If they do not provide enough or clear enough information for me to do it up to my comfort's level they will have to leave without my deposit. And because there is no Fed for them to borrow from elsewhere, they will provide this information of required quality or die hard. Not only about their ratios but also a making-sense information about their exact exposures. And I will be willing to spend time and money to understand and audit this information (because there is no FDIC so I know others won't pay for my stupidity).
3. Economy does not care that much about the availability of credit. You see, in the lost "normal" times it was feasible to finance business with savings. It is only now, with fiat money bleeding value every day savers are losers. At normal times, savers used to do better than borrowers on average. A conspiracy theorist could argue this was the bankers' "true motivation" for creating the Fed -- to make businesses more dependent on borrowing.
And, finally:
"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."
In ideal world, maybe. But in the real world -- no way. Not even in theory. You see, it's only in fool's heads the Fed is independent of the spending-junkie government. From Congress -- maybe. But everybody keeps mum about the plain fact that it's the POTUS who hires (and consequently asks to resign if not by law than in practice) most of the Fed directors and their Chairman. Specifically, if today Bernanke suddenly decides that "there is a lot of inflation" and tomorrow the financing cost for Obama's wars and health care adventures becomes somewhat around 10-12% per annum (where it duly should be), the day after tomorrow Bernanke will resign, with all his supposed independence.. And his successor, whoever he or she is going to be, will absolutely coincidentally and independently calculate that the inflation is not too high after all and get the rates back where they belong.
The thing is that the de-facto job of the Fed is not "to strike a balance between "full employment" and "low inflation"". It is a cover-up (de-facto, not de-jure, whether they want to recognize it or not). The real job is to provide a cheap financing for eager-to-push-your-benefit-through-your-throat Federal Government monster. The history seems to confirm this theory: Central Banks appearances coincide with (I do not assert the direct causation here) the biggest and least popular government expenditures.
As for the asserted (not in this article) original goal of the Fed, it proved to be a complete failure. Any of us would be eager to exchange either Great Depression or Great Recession for a little, almost nice, 14-months 35%-at-worst recession of 1907 for the prevention of repetition of which the Federal Reserve was supposedly created. Thus, remind me again why should we not get rid of this expensive "safety device" that proved to increase, rather than mitigate, our suffering?
All of us
Bank failures hurt all of us even in a world with no central bank because when banks fail, the businesses that had their cash reserves in those banks fail, and the people who work for those businesses lose their jobs... Whether they themselves had any money in a bank or not.
Excellent analysis
Most insightful and provocative analysis. Without a doubt the Fed's recent policies have contributed greatly to our current economic problems. You might also have mentioned the Qualitative Easing (QE2) expansion of the M1 via the issuance of fiat currency.
What is recent?
Recent meaning since the crisis? Or leading up to it?
Neither QE1 nor QE2 are particularly relevant to this particular subject because they happened long after the housing bubble inflated and then burst.
But they are among my favorite subjects, so perhaps I'll discuss QE soon!