Money, Banking and Finance Jeﬀrey Rogers Hummel Warren C. Gibson

Money, Banking and Finance

Je!rey Rogers Hummel Warren C. Gibson

January, 2009

(preliminary version, not for general distribution)

Cover art: “Gold Standard” c!2004 by Damon A. H. Denys

Used with the artist’s permission and with the cooperation of

Quent Cordair Fine Art, Napa, CA

www.cordair.com

ii

This is an early version of a projected textbook based on class-

room notes prepared by Prof. Je!rey Rogers Hummel for the

Money and Banking classes that he has taught for nearly 20

years. We believe that the bewildering array of institutions and

practices that we find in today’s world can best be understood

when based on an appreciation of the underlying theory and his-

tory. Because contemporary textbooks generally lack this back-

ground, we have been inspired to prepare the present volume,

which, as of December 2008, is in a very preliminary form.

Prof. Hummel is Associate Professor of Economics at San Jose

State University. Warren Gibson is a professional engineer, a

student of Prof. Hummel’s, and a lecturer in economics at San

Jose State.

We tentatively plan to make this book freely available online.

Pending our final decision, please do not make unauthorized

copies of this book.

We thank the students in our classes for their patience in using

this preliminary version. We also acknowledge the encourage-

ment of our department chair, Prof. Lydia Ortega

Version 0.92, copyright c! Warren C. Gibson.

Contents

Some Basic Concepts of Economics xiii

I The Nature and Origin of Money xvii

1 What is Money? 1

1.1 Spontaneous Order . . . . . . . . . . . . . . . . . . . . . . . . 2

1.2 Indirect Exchange and the Emergence of Money . . . . . . . 4

1.3 Subsidiary Functions of Money . . . . . . . . . . . . . . . . . 14

1.3.1 Unit of Account . . . . . . . . . . . . . . . . . . . . . 14

1.3.2 Store of Value . . . . . . . . . . . . . . . . . . . . . . . 16

1.3.3 Standard of Deferred Payment . . . . . . . . . . . . . 17

1.4 Credit Cards, Debit Cards, and Smart Cards . . . . . . . . . 18

1.5 Where is Money? . . . . . . . . . . . . . . . . . . . . . . . . . 19

1.6 The cashless society . . . . . . . . . . . . . . . . . . . . . . . 20

1.7 Money in modern society . . . . . . . . . . . . . . . . . . . . 20

1.8 Important terms and concepts . . . . . . . . . . . . . . . . . . 20

1.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2 The Purchasing Power of Money 25

2.1 Estimating the Purchasing Power of Money . . . . . . . . . . 25

2.2 The Demand for Money . . . . . . . . . . . . . . . . . . . . . 31

2.2.1 Transactions Demand for Money . . . . . . . . . . . . 32

2.2.2 Velocity and the Equation of Exchange . . . . . . . . 33

2.2.3 Portfolio Demand for Money . . . . . . . . . . . . . . 35

iii

iv CONTENTS

2.3 The Supply of Money . . . . . . . . . . . . . . . . . . . . . . 37

2.4 Important Terms and Concepts . . . . . . . . . . . . . . . . . 42

2.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

2.6 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

3 Government Control of Money 47

3.1 Legal Tender Laws . . . . . . . . . . . . . . . . . . . . . . . . 48

3.2 Gresham’s Law . . . . . . . . . . . . . . . . . . . . . . . . . . 49

3.3 Monopoly Mints . . . . . . . . . . . . . . . . . . . . . . . . . 50

3.4 Fiat Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

3.5 Socialism and the Abolition of Money . . . . . . . . . . . . . 58

3.6 Important Terms . . . . . . . . . . . . . . . . . . . . . . . . . 58

3.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

II The Nature and Origin of Credit 59

4 The Significance of Saving 61

4.1 Saving in a Monetary Economy . . . . . . . . . . . . . . . . . 63

4.2 Capital Goods . . . . . . . . . . . . . . . . . . . . . . . . . . 64

4.3 Direct Finance . . . . . . . . . . . . . . . . . . . . . . . . . . 66

5 The balance sheet 75

5.1 The Flow of Funds . . . . . . . . . . . . . . . . . . . . . . . . 79

5.2 Indirect Finance . . . . . . . . . . . . . . . . . . . . . . . . . 84

6 Fractional reserve banking 89

6.1 Origins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

6.2 E!ects of fractional reserve banking . . . . . . . . . . . . . . 91

6.3 The Government Central Bank . . . . . . . . . . . . . . . . . 101

7 The Varieties of Money: a Critical Comparison 111

7.1 Fiat Money Versus Commodity Money . . . . . . . . . . . . . 112

7.2 Distribution E!ects . . . . . . . . . . . . . . . . . . . . . . . . 114

7.3 Net Welfare E!ects of Inflation . . . . . . . . . . . . . . . . . 116


CONTENTS v

7.4 Benefits of Inflation . . . . . . . . . . . . . . . . . . . . . . . 118

7.5 A Future Gold Standard . . . . . . . . . . . . . . . . . . . . . 121

7.6 Important terms . . . . . . . . . . . . . . . . . . . . . . . . . 123

7.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

III Today’s financial system 125

8 Financial instruments 129

8.1 Components of the monetary aggregates . . . . . . . . . . . . 130

8.1.1 The monetary base . . . . . . . . . . . . . . . . . . . . 131

8.1.2 M1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

8.1.3 M2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

8.2 Other marketable instruments . . . . . . . . . . . . . . . . . . 136

8.2.1 U. S. government debt . . . . . . . . . . . . . . . . . . 136

8.2.2 Municipal bonds . . . . . . . . . . . . . . . . . . . . . 138

8.2.3 Government agency securities . . . . . . . . . . . . . . 139

8.2.4 Corporate securities . . . . . . . . . . . . . . . . . . . 143

8.2.5 Money market mutual funds . . . . . . . . . . . . . . 144

8.3 Present value and yield to maturity . . . . . . . . . . . . . . . 148

8.4 Risk and maturity factors . . . . . . . . . . . . . . . . . . . . 152

9 Financial institutions 155

9.1 Brokers, dealers and underwriters . . . . . . . . . . . . . . . . 155

9.2 Depository Institutions and Pure Intermediaries . . . . . . . . 159

10 Market Determination of Interest Rates 163

10.1 The Loanable Funds Market . . . . . . . . . . . . . . . . . . . 163

10.2 Real and Nominal Interest Rates . . . . . . . . . . . . . . . . 169

10.3 Deflation versus inflation . . . . . . . . . . . . . . . . . . . . . 170

10.4 Default risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

10.5 Marketability . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

10.6 Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . 174

10.7 Special Features . . . . . . . . . . . . . . . . . . . . . . . . . 174


vi CONTENTS

10.8 Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

10.9 Interest Rate Controls . . . . . . . . . . . . . . . . . . . . . . 177

IV Commercial Banking: History and Practice 179

11 The U. S. Experience 183

11.1 Pre-Civil War: From Chartered Monopoly to “Free” Banking 183

11.1.1 America’s First Central Bank . . . . . . . . . . . . . . 183

11.1.2 First Bank of the United States . . . . . . . . . . . . . 185

11.1.3 The Second Bank of the United States . . . . . . . . . 187

11.1.4 The Jacksonian Revolution . . . . . . . . . . . . . . . 189

11.1.5 “Free Banking” in the United States . . . . . . . . . . 190

11.1.6 Free Banking in Scotland . . . . . . . . . . . . . . . . 194

11.2 The Civil War (1861-1865)

and National Banking . . . . . . . . . . . . . . . . . . . . . . 195

11.3 Creation of the Federal Reserve System . . . . . . . . . . . . 197

11.4 The Great Depression of the 1930’s . . . . . . . . . . . . . . . 199

11.4.1 The Great Depression: a 2008 Reprise? . . . . . . . . 206

12 Banking Practice 209

12.1 The Regulatory Structure. . . . . . . . . . . . . . . . . . . . . 209

12.1.1 Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 212

12.1.2 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 214

12.1.3 Capital account . . . . . . . . . . . . . . . . . . . . . . 214

12.2 Asset vs. Liability Management . . . . . . . . . . . . . . . . . 215

V Non-bank intermediaries and financial deregulation 217

13 Survey of Non-bank Intermediaries 219

13.1 Savings and Loan Associations and Savings Banks . . . . . . 220

13.2 Credit Unions . . . . . . . . . . . . . . . . . . . . . . . . . . . 221

13.3 Pension Funds . . . . . . . . . . . . . . . . . . . . . . . . . . 221

13.4 Life Insurance Companies . . . . . . . . . . . . . . . . . . . . 222


CONTENTS vii

13.5 Property and Casualty Insurance Companies . . . . . . . . . 223

13.6 Finance Companies . . . . . . . . . . . . . . . . . . . . . . . . 223

13.7 Investment companies . . . . . . . . . . . . . . . . . . . . . . 223

13.7.1 Open-end mutual funds. . . . . . . . . . . . . . . . . . 223

13.7.2 Closed-end mutual funds . . . . . . . . . . . . . . . . 225

13.7.3 Exchange-traded funds . . . . . . . . . . . . . . . . . . 226

13.7.4 Hedge funds . . . . . . . . . . . . . . . . . . . . . . . . 227

13.7.5 Real estate investment trusts . . . . . . . . . . . . . . 227

13.7.6 Private investment funds. . . . . . . . . . . . . . . . . 228

13.7.7 Money-market mutual funds . . . . . . . . . . . . . . 228

13.7.8 Social Security: Not an Investment Fund . . . . . . . . 230

13.7.9 Diversification of Investment Companies . . . . . . . . 231

14 The Changing Regulatory Environment 233

14.1 Government Agencies That Regulate Non-bank Depositories . 233

14.1.1 Savings and Loans . . . . . . . . . . . . . . . . . . . . 233

14.1.2 Savings Banks . . . . . . . . . . . . . . . . . . . . . . 233

14.1.3 Credit Unions . . . . . . . . . . . . . . . . . . . . . . . 233

14.2 Innovation Fosters Deregulation . . . . . . . . . . . . . . . . . 234

VI Modern central banking 243

15 The Money Multiplier:

How Banks Create Money 245

15.1 How Base Money Gets Multiplied . . . . . . . . . . . . . . . . 245

16 The Federal Reserve System 249

16.1 Origins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

16.2 Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

16.3 Instruments of control . . . . . . . . . . . . . . . . . . . . . . 253

16.3.1 Monetary Instruments . . . . . . . . . . . . . . . . . . 253

16.3.2 Non-monetary instruments . . . . . . . . . . . . . . . 254

16.3.3 Other powers . . . . . . . . . . . . . . . . . . . . . . . 255


viii CONTENTS

17 Targets of monetary policy 257

17.1 Pre-1929 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257

17.2 The Great Depression

and the Keynesian revolution . . . . . . . . . . . . . . . . . . 257

17.3 Stagflation and the

monetarist counter-revolution . . . . . . . . . . . . . . . . . . 257

17.4 Monetary policy options . . . . . . . . . . . . . . . . . . . . . 257

17.4.1 Discretionary versus rule-based policy . . . . . . . . . 258

17.4.2 Monetary Policy Versus Democracy . . . . . . . . . . 259

17.4.3 Free Banking . . . . . . . . . . . . . . . . . . . . . . . 260

VII Money and the world economy 263

18 International trade and the balance of payments 265

19 Exchange rates, fixed and floating 267

19.1 The traditional gold standard . . . . . . . . . . . . . . . . . . 267

19.2 Monetary nationalism . . . . . . . . . . . . . . . . . . . . . . 267

20 Other aspects of modern international finance 269

20.1 Increasing private competition . . . . . . . . . . . . . . . . . 269

20.2 The international debt crisis . . . . . . . . . . . . . . . . . . . 269


List of Figures

1.1 Greek decadrachm coin, ca. 500 BC . . . . . . . . . . . . . . 12

2.1 Annual rates of change of three price indices. . . . . . . . . . 28

2.2 Supply and demand for commodity money . . . . . . . . . . . 38

2.3 Increased money stock in the 1920’s approximately balanced

increased demand for money. . . . . . . . . . . . . . . . . . . 39

2.4 Secondary e!ect on the demand for money following an OPEC

supply shock. . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

4.1 Stock certificate. . . . . . . . . . . . . . . . . . . . . . . . . . 70

4.2 Railroad bond. . . . . . . . . . . . . . . . . . . . . . . . . . . 72

5.1 Amazon.com had negative net worth during its early growth

years. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

5.2 The flow of funds . . . . . . . . . . . . . . . . . . . . . . . . . 80

5.3 Supply and demand of loanable funds . . . . . . . . . . . . . 82

5.4 Transaction costs drive a wedge between interest paid and

interest received. . . . . . . . . . . . . . . . . . . . . . . . . . 85

6.1 Gold bullion stored in the warehouse of the SPDR Gold Shares

Trust. The bars each contain 400 ounces of gold, valued at

about a third of a million dollars. . . . . . . . . . . . . . . . . 94

6.2 Federal Reserve assets for year-end 2007 and 2008. . . . . . . 105

6.3 Federal Reserve liabilities for year-end 2007 and 2008. . . . . 107

6.4 Gold note issued by a private bank, 1874 . . . . . . . . . . . . 108

ix

x LIST OF FIGURES

6.5 U. S. Treasury banknotes, 1880 . . . . . . . . . . . . . . . . . 109

6.6 Silver certificate issue by the U. S. Treasury, ca. 1880 . . . . . 109

6.7 Federal Reserve note, 1914 . . . . . . . . . . . . . . . . . . . . 110

7.1 Decline in purchasing power of the dollar. . . . . . . . . . . . 120

9.1 Traders on the floor of the New York Stock Exchange . . . . 157

10.1 Supply and demand of loanable funds. . . . . . . . . . . . . . 165

10.2 Yield curves for Treasury securities . . . . . . . . . . . . . . . 176

11.1 Pyramiding of reserves . . . . . . . . . . . . . . . . . . . . . . 187

11.2 A “greenback” – Civil War currency. . . . . . . . . . . . . . . 196

11.3 Dow-Jones Industrial Average, 1914-1940 . . . . . . . . . . . 201

14.1 U.S. bank failures, 1935-2004 . . . . . . . . . . . . . . . . . . 238

15.1 M1 multiplier. . . . . . . . . . . . . . . . . . . . . . . . . . . . 248


List of Tables

1.1 Goods used as money around the world. . . . . . . . . . . . . 9

2.1 GDP deflator, 1959-2004 . . . . . . . . . . . . . . . . . . . . . 30

12.1 Balance sheet of the Dartmouth Bank. . . . . . . . . . . . . . 211

12.2 Largest banks as of May, 2008 . . . . . . . . . . . . . . . . . . 216

xi

xii LIST OF TABLES


Some basic principles of

economics

Here is a brief list of concepts, by no means exhaustive, from elementary

economics:

Human action is the fundamental fact of human existence – that we

initiate actions which we believe will leave us better o! than alternative

actions, or no action. While we are very much subject to constraints and

influences from the physical and social worlds, we are choosing and acting

beings. A corollary of this basic fact is that only individuals act, and while it

is often convenient to ascribe actions to governments, corporations, etc., the

fact remains that these actions are performed by individual members of those

groups, acting, of course, under the influence of contractual relationships

that bind them to those groups.

Time preference is a reflection of our mortality, and states that, other

things being equal, we prefer present satisfaction to the same satisfaction in

the future.

Diversity is the fact that human beings have distinct interests, abilities,

knowledge, etc. Furthermore, natural resources are unevenly located around

the world.

Wealth is whatever a particular person desires.

E!ciency refers a person’s ability to get the most of what he wants

from what he has.

Scarcity is the fundamental fact of existence that gives rise to the science

of economics. Much of the goods and services that we desire in this world

xiii

xiv Some Basic Principles

are scarce, meaning we cannot get some without giving up something else.

Opportunity cost is what we give up to acquire a scarce good or ser-

vice.

Subjective value is a corollary of human actions that the value of a

good or service does not inhere in that good or service but rather in the mind

of the person evaluating it. The same good or services are valued di!erently

people, and for by the same person at di!erent times. Values are revealed

by action and are ranked, so that only ordinal numbers can be applied to

them. Market prices, by contrast, are objective and measured by means of

money prices.

Coercion is the use or threat of violent action, usually directed against

another person in order to induce an action which that person would not

freely choose. Two forms of coercion may be distinguished: initiated and

retaliatory.

A government is a group of people that holds a monopoly of the use of

force in a particular territory, which monopoly is at least passively accepted

by the majority of the inhabitants of that territory.

Market failure, government failure. Market failure is the idea that

free markets produce outcomes that are undesirable by some standard, and

must be corrected by government action. Government failure is the idea

that such programs may fail to achieve the intended result or even make

things worse.

Normative and positive statements: a positive statement is a state-

ment about what is, or what would be in some situation. The statement

may be correct or not, but it is at least open to objective analysis. A nor-

mative statement is a statement about what should be in some situation,

and is presumed to be exempt from objective analysis.

Gains from trade stem from the recognition that people choose to act

because they expect to be better o!, and therefore when we observe people

trading without coercion, we must assume that both expect to gain from

the trade.

Law of demand, law of supply. Each additional unit of a good or

service that we acquire is used to satisfy the most urgent unfulfilled need


LIST OF TABLES xv

which that good can satisfy. From this follows the law of demand which

says that as the price of a good increases, the quantity demanded decreases,

other things being equal. Likewise, supplier supply more of a good as the

price increases.

Elasticity refers to the price sensitivity of buyers and sellers in a par-

ticular market. When many buyers leave a market in response to a price

increase, their demand is said to be elastic. If most continue to buy in spite

of price increases, their demand is inelastic. The same concepts apply to the

responsiveness of sellers to price changes.

Stock and flow. The stock of a good is the amount that is present

some place and some particular time, while the flow of that good is the rate

at which the stock is increasing or decreasing. One’s assets, for example,

are a stock, while one’s income is a flow. Because the flow of goods is not

nearly as continuous as the flow of fluids in physics, economic flows are often

expressed as amounts which have flowed during a particular time period.

Interest payments, for example, are usually understood to be amount that

flows in one year, as are GDP and many other flows.

Public interest, public choice. The public choice viewpoint of the

actions of government agents emphasizes the incentives that such people face

and how those incentives are likely to influence their actions. By contrast,

the public interest point of view is the popular but naive assumption that

government agents always adhere to “the public interest.’


xvi Some Basic Principles


Part I

The Nature and Origin of

Money

xvii

Chapter 1

What is Money?

Some years since, Mademoiselle Zelie, a singer of the Theatre

Lyrique at Paris, made a professional tour round the world, and

gave a concert in the Society Islands. In exchange for an aria

from Norma and a few other songs, she was to receive a third

part of the receipts. When counted, her share was found to con-

sist of three pigs, twenty-three turkeys, forty-four chickens, five

thousand cocoa-nuts, besides considerable quantities of bananas,

lemons, and oranges. At the Halle in Paris, as the prima donna

remarks in her lively letter, printed by M. Wolowski, this amount

of livestock and vegetables might have brought four thousand

francs, which would have been good remuneration for five songs.

In the Society Islands, however, pieces of money were very scarce;

and as Mademoiselle could not consume any considerable por-

tion of the receipts herself, it became necessary in the mean time

to feed the pigs and poultry with the fruit.W. Stanley Jevons, Money and the

Mechanism of Exchange, 1875, p. 1.

Money is a fascinating phenomenon. It permeates everyday life and is

one of the most beneficial innovations known to humankind. Modern society

would be quite impossible without it. In later chapters, we will examine the

theory and history of financial institutions, regulation, central banks, and

international monetary economics. But before we can begin that journey we

1

2 Spontaneous Order

must understand what money is and how it came about. It may seem strange

to ask what money is, since most of us use some every day and therefore

we know it well. Or do we? Clearly the bills and coins we carry are money.

But are checks money? Credit cards, debit cards? Stocks and bonds? Gold

jewelry? The answers are not obvious, and we will defer classification of the

kinds of money until Chapter 8 at the end of Part II. In the three chapters

of Part I we will explore how money evolved out of barter, identify the

defining characteristic of money and its subsidiary functions, study how its

purchasing power is determined by the interaction of supply and demand,

and see how and why governments have acquired a monopoly of the business

of supplying money.

1.1 Spontaneous Order

It may strike you as strange, but money has uncanny similarities to lan-

guage. Not only are both pillars of civilization, but they also are extraordi-

nary examples of what social scientists call spontaneous order. The Austrian

economist Friedrich Hayek coined the term to refer to a “coordination that

results from human action but not from human design Consider language.

Language is not only our chief means of communication but also our medium

of thought. It consists of sounds and symbols that represent concepts. They

are organized according to complex rules of grammar and spelling into verbal

and written expressions. We, the co-authors of this text, are currently em-

ploying this well-ordered system to transmit ideas from our heads to yours.

So how did language originate and evolve? Who designed the rules of gram-

mar and spelling? Surprisingly, no one in particular, and while the results

are not perfect—witness English spelling—language works well.

Any native English speaker who has ever tried to read the plays of Shake-

speare will recall how di"cult this was at first. Given that Shakespeare

wrote in English, why should this be? The obvious answer is because En-

glish has changed significantly. For instance, we don’t use thee and thou

anymore and instead have replaced them with you. Yet no one in particular

planned these and the myriad other changes in the language since Shake-


Chapter 1: What is Money? 3

speare wrote. Even today, new words and phrases or new uses for old ones

stream into our language from technology (input, hacker, on-line) or from

youth (chill out, “bad” meaning “good”). Words take on new meanings –

“silly” once meant “sacred,” while “network” has become a verb meaning

to have a conversation. These changes regularly fill the columns of such

language gurus as William Sa"re, who pronounce judgment on them. The

changes go on, however, whether Sa"re approves or disapproves. Indeed,

how do you suppose language originated? Undoubtedly the same sponta-

neous process, since words are just commonly accepted sounds.

Spontaneous order contrasts with planned order. The building in which

you attend your college class is an example of a planned order. An architect

drew up plans that structural engineers amplified, and unless the contrac-

tors who constructed the building adhered very closely to the specifications

given in the plans, the building would have been incomplete or deficient.

Someone did actually attempt a planned language. In 1887 one L.L. Za-

menhof invented a totally new language called Esperanto, but despite its

simplicity and consistency compared with other languages, hardly anyone

speaks it.

We all, of course, individually make our own planned choices about lan-

guage. We personally decide what linguistic innovations to use or avoid.

Governments and other institutions may try to influence those choices. The

French government, for instance, is engaged in an ongoing but generally fu-

tile attempt to prevent the penetration of English words and phrases into

the French language. Often di!erences over language can result in bloody

conflicts, as the history of Eastern Europe amply attests. But languages

still spontaneously evolved without the guidance and beyond the direction

of a single, conscious plan. They are too complex, and remain essentially

spontaneous, decentralized, and often voluntary creations.

Consider the metaphor that Adam Smith used in his 1776 masterpiece,

An Inquiry into the Wealth of Nations for the concept of spontaneous order?

An individual pursuing his own private interest, wrote Smith, “generally,

indeed, neither intends to promote the public interest, nor knows how much

he is promoting it . . . he is led by an invisible hand to promote an end which


4 Indirect Exchange and the Emergence of Money

was no part of his intention [emphasis added].” If you ponder the idea of an

invisible hand as spontaneous order, you can probably come up with several

more examples. For instance, what about the checkout lines in grocery stores

or the flow of tra"c in multi-laned freeways? Does any central planner keep

the lines fairly even in length or the lanes fairly equally busy? Money, as we

will see, is another, major example of spontaneous order.

1.2 Indirect Exchange and the Emergence of Money

We are all aware of the benefits of social cooperation, and in previous eco-

nomics courses, you no doubt learned that one of the most vital forms of co-

operation is trade or exchange. Voluntary trade almost always creates value

and thereby adds to society’s total wealth. One of your authors is a big fan

of the now-defunct New Wave musical group, The last time he purchased

an Oingo-Boingo compact disc, he paid $19.98. A popular misconception

is that such a trade ought to be based on an equality of value between the

CD and the money. But with respect to the subjective preferences of the

buyer and seller, there can never be an equality of value. The buyer would

only give up money for the CD if he valued the CD more than the money,

while the reverse must be true for the seller. In other words, both parties to

a voluntary exchange expect to be better o! after the exchange takes place.

Trade therefore always results from a reverse inequality of value. Of course,

either party could discover she had made an entrepreneurial error; have you

ever paid to see a movie that you subsequently decided you did not like?

But people do not normally repeat such exchanges.

The reverse inequality of value is the source of the gains from trade.

Both parties expect to be better o! after the transaction than before, and

they usually say their are better o!, unless they are cheated (in which case

the trade is shown to have been involuntary) or they made a mistake. In

a prior economics class, you may have learned about consumer surplus and

producer surplus, which simply portray or measure these mutual gains from

trade. Not only does trade, in and of itself, make society richer, but it

furthermore allows us to take advantage of the diversity among people and



their material resources. It likewise permits specialization and the division

of labor and therefore enhances production as

Like so much else, however, trade has opportunity costs. It often takes

time, energy, and sometimes other resources, over and above what is di-

rectly exchanged, to complete a trade. These transactions costs include the

opportunity costs of finding a trading partner, negotiating the deal, and

monitoring its terms. For instance, suppose we wished to acquire a rare

Oingo-Boingo vinyl record. We first would have to find someone who had

the record and was willing to sell it, a task that before the Internet involved

far more e!ort than it does today. Once we found a potential seller, we

would have to negotiate a price. One of the authors, The Oingo-Boingo

connoisseur, is such a big fan that he might be willing to pay more than

$100 for this rare record. The seller might be willing to let it go for as little

$1. But neither party wishes to reveal that information. Finally, the buyer

might bring the record home and discover that it is far more badly scratched

than the seller promised, which could entail further costs in returning it and

getting a refund.

Keep in mind that the price paid by the buyer, or the goods surrendered

by the seller are not part of the transaction costs. Transaction costs are

in addition to the items actually exchanged (although they may include

prices paid in other transactions, such as the cost of an Internet connection).

These costs might be so high, in fact, that they dwarf all expected benefits

and preclude any exchange. Obviously the higher the transaction costs,

other things equal, the fewer the trades that take place. Thus, anything

that reduces transaction costs unambiguously increases gains from trade

and makes society wealthier.

The most basic form of trade is barter, or more precisely, direct exchange.

The Oingo-Boingo fan, for example, may exchange one hundred apples for

the CD. Both parties in this transaction are trading for something they

expect to use directly either in consumption or production: apples to eat or

for making apple pie; an Oingo-Boingo CD to listen to. Yet direct exchange

usually means high transaction costs. Finding someone who both has an

Oingo-Boingo CD and wants apples may be di"cult. Or what amounts to



the same thing, the number of apples someone may want in exchange for the

CD may far exceed the subjective value to our Oingo-Boingo fan of listening

to it. If the authors of this text had to trade their economics lectures directly

for food, they would probably go hungry. The transaction costs associated

with direct exchange are so severe that economists have given them a special

name: the problem of the double coincidence of wants. In order for direct

exchange to take place, both parties must want what the other is o!ering.

But finding such a double coincidence of wants is usually very di"cult.

Introducing a third person into this picture could overcome this problem.

Je! wants the Oingo-Boingo CD and has extra apples he would like to sell.

Ajax owns the CD but hates apples, so there is no double coincidence of

wants. But Penelope it turns out has a large endowment of chocolate chip

cookies that she would like to dispose of in exchange for some apples, and

Ajax loves chocolate chip cookies.

Has Wants

Je! Apples CD

Penelope Cookies Apples

Ajax CD Cookies

There are now two potential ways of capturing some gains from trade. The

most elegant is to assume a benevolent bureaucrat-god, who can orchestrate

a multilateral exchange by ordering Je! to give Penelope the appropriate

number of apples, ordering Penelope to give Ajax the appropriate number

of cookies, and ordering Ajax to give Je! the CD. Everyone is better o!. But

even though benevolent bureaucrat-gods do not exist, in small economies,

with su"cient face-to-face interaction and mutual trust, such multilateral

trade has sometimes arisen voluntarily.

A far less elegant but more practical solution depends upon one of the

three parties having some knowledge about both of the others. If that person

is Je!, he could take his apples and trade with Penelope for chocolate chip

cookies, after which he exchanges the cookies with Ajax for the CD. The

three parties have reduced transaction costs and captured the gains from

trade. But in the process, they are no longer engaged in direct exchange.



Je! instead has conducted indirect exchange. He traded for the cookies

not in order to eat them but to sell them, making the cookies a medium

of exchange. A medium of exchange, something acquire not because you

want to use it directly in consumption or production but only to trade it

for something else you want. The process seems complicated, but it realizes

the benefits of multilateral exchange without recourse to a central planner.

Many goods could theoretically serve as a medium of exchange. We

could rework the example in the previous paragraph using apples as the

medium or using the CD. But which of the three goods would you expect

to be least likely to serve in that capacity? Probably the Oingo-Boingo

CD, because people prefer to use as media of exchange goods that are more

marketable. Marketability is a measure of the extent to which a good or

service is desired in trade in a particular economy; the larger the market,

the more marketable the good. Apples and cookies have a larger market

than Oingo-Boingo CDs. And the more marketable the good, the lower

the transactions costs associated with buying or selling it. Yet the fact that

people are already using a particular good as a medium of exchange enhances

its marketability. As a result, people will spontaneously gravitate toward

one or two media of exchange that are commonly or routinely accepted

throughout the economy. When a medium of exchange becomes commonly

accepted, it has become money.

Observe that there are two elements to this definition of money: “com-

monly accepted” and “medium of exchange.” That makes monetary ex-

change a subset of indirect exchange. All moneys are media of exchange,

but not all media of exchange qualify as money. A modern example of in-

direct exchange without money occurred when an American firm, Pepsico,

began exporting Pepsi-Cola to the Soviet Union before its collapse. Because

of exchange rate barriers, rubles could not be easily converted into money

that could be spent outside the Soviet Union. So Pepsico, after selling Pepsi

for rubles, used its rubles to buy Russian vodka, which it then sold in the

United States for dollars. Vodka served Pepsico as a medium of exchange,

but it was not commonly accepted and therefore not money. (Some writers a

bit confusingly refer to indirect exchange without money as indirect barter.)



One of the most significant advances in human history because it ex-

panded enormously the gains from trade. And just as many languages

evolved historically, a vast array of goods have served as money. In me-

dieval Iceland people used a type of wool called wadmal. The ancient Greeks

used oxen; the Bantu of Africa used cattle, and in fact, that is where the

Latin word “pecuniary” comes from. The North American Indians employed

wampum, strings of shells or beads, and tobacco was money in colonial Vir-

ginia. Further south along the frontier, deer skins became money, giving rise

to the slang usage of “buck” to mean a dollar. Cowrie shells were at one

time a pervasive money throughout India and Africa. Salt became money in

Abyssinia, and bronze emerged as money in China. The ancient Aztecs of

Central America had four widely accepted media of exchange: ornamental

copper ax blades, quills of gold dust, woven cotton cloaks called quachtli,

and cacao (chocolate) beans. (The Incas of South America, in contrast,

with their centrally planned economy, never developed money and relied on

barter.) Red parrot feathers continued to serve as money in the Santa Cruz

Islands until 1961, while on the island of Yap in the South Pacific large

limestone wheels called fei, sometimes measuring up to four meters across,

performed the monetary function. Table 1.1 lists these and some of the

many other exotic commodities that have served as money in various times

and places. We still see occasional instances of this process among people

isolated from an outside economy or when the o"cial monetary system be-

comes defective. In prisons and prisoner-of-war camps, cigarettes, chocolate

bars, or chewing gum have evolved into money in order to reduce transac-

tion costs and facilitate exchange. Packages of Kent cigarettes circulated

as money in the underground economy of Communist Romania during the

1980s. Even in primitive economies where direct exchange remains feasible

and frequent, moneys have sometimes arisen to provide greater price flexi-

bility. Among the Aztecs, cacao beans were frequently employed to even out

trades of larger items, such as a load of firewood exchanging for an iguana.

One party or the other would throw in a few beans to make the price more

agreeable.

All of these are examples of what is called commodity money. They are



Barley ancient Mesopotamia

Bronze China

Butter Norway

Cacao beans Mayas and Aztecs of Central America

Cattle Bantu of Africa

Cognac post-World War II Germany

Copper ancient Egypt, the Aztecs of Central America

Cowrie shells India and Africa

Deer skins southern colonies of British North America

Fei (limestone wheels) Yap Island

Fishhooks Gilbert Islands

Kent cigarettes Communist Romania

Leather France and Italy

Nails Scotland

Oxen ancient Greece

Pepper Sumatra

Red parrot feathers Santa Cruz Islands

Reindeer Russia

Rice Philippines

Rum Australia

Salt Abyssinia

Sandalwood Hawaii

Silk China

Sugar West Indies

Tea bricks Mongolia

Tobacco colonial Virginia

Tortoise shells Mariana Islands

Wadmal (wool) medieval Iceland

Wampum (strings of shells or beads) North American Indians

Whale teeth Fiji

Table 1.1: Goods used as money around the world.



forms of money that are also regular commodities, useful in consumption

goods or production goods. People employ them both in consumption or

production and as media of exchange. Commodity money is often impre-

cisely defined as money with intrinsic value. But economic activity is not

governed by any such intrinsic value of goods and services, if what is meant

by “intrinsic” is some objective standard independent of people’s prefer-

ences; economic activity is governed only by the subjective value of goods

and services to specific individuals. Oil, considered a nuisance when it seeped

out of the ground before 1859, commands a market price not because it has

intrinsic value but because it can somehow satisfy human desires. So a more

accurate definition of commodity money recognizes that its monetary value

is closely tied to its commodity value. If chocolate chip cookies are com-

modity money, you must give up roughly the same quantity of other goods

and services to purchase the cookies irrespective of whether you intend to

eat them or spend them.

Eventually two commodities out-competed all others to become interna-

tionally accepted. Those were the two precious metals, gold and silver. In

fact, the word for silver is also a word for money in four languages: French

(argent), Spanish (plata), Hebrew (keseph), and ancient Greek (argurion).

Silver money goes back as far as 2500 B.C. in Mesopotamia. Other met-

als such as bronze in China and copper in India continued as money long

thereafter, but gold and silver came to dominate because they had desir-

able physical properties that made them superior. People prefer money to

be durable, which makes gold and silver better money than chocolate chip

cookies or apples. Gold does not corrode or degrade over time, and while

silver does tarnish, it is relatively indestructible. People want money to be

divisible and fusible, to facilitate transactions at varied prices, which gave

gold and silver an advantage over cattle. Both can be melted and formed

into objects of a wide variety of shapes and sizes. In some places the earli-

est employment of metallic moneys was to provide change for less divisible

commodity moneys such as cattle. Money is convenient when it can be

standardized, which makes tobacco an inferior money. Gold and silver are

chemical elements and therefore all instances of pure gold or silver are ex-



actly the same (although both metals are often alloyed with copper to make

them harder). Money is convenient when it is portable, which is why the

stone wheels of Yap did not catch on internationally. And finally, money

should be easily recognizable, so it can be easily verified in trade. A relative

scarcity that gives money a convenient value-to-weight ratio greatly facili-

tates the last two properties. If the monetary commodity is too abundant

then the amounts required for normal transactions cease to be portable.

If on the other hand the monetary commodity is too scarce, like platinum

(coined in Russia between 1828 and 1845), a gram or two of platinum, which

might su"ce for a small purchase, would be to small for convenient handling

or even recognition. None of these characteristics is absolutely essential for

money, and we have observed historical commodity moneys that lacked one

or more of them. But all of these characteristics gave gold and silver an

advantage because they reduced transactions costs.

Initially, gold, silver, and other monetary metals circulated by weight.

Hence, several units of weight—the shekel, the talent, and the pound—also

became units of money. But there were significant transaction costs in the

form of both weighing and also assaying (determining the purity of) these

metals. This led to the invention of coins. Coinage developed independently

in several locations, but the location about which we know the most was

the Kingdom of Lydia, in Asia Minor, in the seventh century B.C. Lydia’s

commodity money was electrum, a naturally occurring alloy of gold and

silver (Figure 1.1). Prominent merchants with established reputations began

stamping lumps of electrum with identifying marks or images, and these

electrum coins then circulated as a more convenient form of money. Bronze

coins in the shapes of tools and shells arose in China at about the same

time. Silver coinage may have originated in India as much as a hundred

years earlier, although such an early independent, origin is contested, and

gold and silver coins appeared in Persia a few hundred years later. Together

gold and silver coins eventually became known as specie.

The earliest coins probably specified only the fineness and purity of the

metal, but eventually coins specified the weight. Because coins could then

circulate by “tale” (tally, or count) rather than by weight, they further re-



Figure 1.1: Greek decadrachm coin, ca. 500 BC

duced transaction costs. Knowing the number of coins and the weight of

each makes it easier to tally the total amount of gold or silver. Coins there-

fore commanded a slight premium over the equivalent weight of raw metal

in the form of bullion or dust. In long-run equilibrium, the premium tends

to equal the costs of minting the coins (called brassage), making coinage a

viable business on the market. Private manufacture, for instance, character-

ized the earliest Chinese coins as well as later coinage o! and on throughout

Chinese history. Private mints successfully competed in the United States

until they were suppressed during the Civil War. Wherever domestic mints

proved insu"cient, it was profitable to import coins from abroad. Foreign

coins circulated widely in the U.S. during its early years, while most of the

ancient Greek city-states, including Sparta, had no mints of their own and

relied upon coins minted elsewhere. A particularly intriguing example of

a second-generation coinage that was mostly private occurred in Mamluk

Egypt at the end of the thirteenth century. Miscellaneous coins of various

origins, both gold and silver, new as well as old, would be handled in sealed

purses. The exact value was indicated on the outside, bearing the mark-

ing of a well-known merchant, banker, money changer, or infrequently a

government o"cial. This parallels the modern practice of selling high-grade



collectible coins in sealed packages labelled with the coin’s grade (condition).

In short, money constantly evolves and changes. Observe that every

step in this evolution, from barter through indirect exchange and primitive

commodity moneys, up to gold and silver and the minting of coins, low-

ered transaction costs and expanded enormously the gains from voluntary

exchange. Driven by the mutual benefits for all who traded, the origin and

development of money stands as a dramatic demonstration of spontaneous

order, with little conscious coordination and no necessary government in-

volvement. Of course, this evolution did not stop with the emergence of

specie, but continued forward to present-day forms of money in ways that

upcoming chapters will investigate in great detail. We will see how and why

governments became intimately involved with money. Yet money’s funda-

mental function as a commonly accepted medium of exchange that reduces

transaction costs and facilitates specialization and trade has remained fixed

and fundamental.

Despite the triumph of monetary exchange in modern economies, direct

exchange still survives in a few unique markets. Workers, for instance, do

not always exchange their labor solely for money wages. Because of an ex-

emption in the U.S. tax code, many employers o!er their employees fringe

benefits such as health insurance. While health insurance has a monetary

value, it is not money per se, and this form of barter, where labor is ex-

changed directly for medical care, goes a long way toward explaining the

high transaction costs and enormous e"ciencies in the American medical

market. Indeed, one way of avoiding taxes altogether is with barter trans-

actions in the underground economy.1 People also often trade-in their used

automobiles for new ones, rather than for money, probably because this

helps to overcome some of the transaction costs associated with asymmetric

information in the used-car market.

One major non-monetary market in modern economies is not conven-

1Employers generally provide health insurance to their employees but not, for example,

car insurance because the income tax code makes these provisions tax-deductible for the

employer and tax-free to the employee, whereas most non-cash forms of remuneration are

considered taxable.


14 Subsidiary Functions of Money

tionally thought of as such, although nearly everyone participates in this

market at some time in his or her life. Monetary transactions do sometimes

take place in this market, but they are not the most popular and are usually

frowned upon, because it is a market where people tend strongly to prefer

transactions with a double coincidence of wants. You may have already

guessed that what we are thinking of the market for dating, sex, and mar-

riage. Here is one case where a double coincidence of wants is considered

a good thing. But as a result, this market is notoriously ine"cient, with

long search times, lots of mistaken trades, many frustrated or lonely mar-

ket participants, and otherwise very high transaction costs (though various

Internet entrepreneurs now o!er services that reduce those costs).

1.3 Subsidiary Functions of Money

Once money emerges as a commonly accepted medium of exchange, it usu-

ally serves three other purposes as well. We refer to these as money’s sub-

sidiary functions. Some authors o!er one or all of these three functions as

alternative definitions of money, but we prefer to define money according to

its primary exchange function. This is not so much a substantive di!erence

as a semantic di!erence in how to best organize our thoughts. Although

money often serves these other purposes, it does not necessarily have to.

Indeed, there have been notable occasions when the medium of exchange

failed to provide these functions, and other items or combinations of items

did so.

1.3.1 Unit of Account

The first and most important subsidiary function of money is providing a

unit of account. This function is sometimes referred to as a standard or

measure of value.2 You can appreciate it better if you keep in mind that

all prices are ratios. Suppose one Oingo-Boingo CD trades for 100 apples.

The price of the CD is obviously 100 apples. But then what is the price of

2“Value” is a poor word here since subjective value cannot be measured – this is really

a price measure.



one apple? 1/100th of an Oingo-Boingo CD The fact that prices are ratios

is clearest in the case of exchange rates, which are the prices of one money

in terms of another. Thus if you are an American traveling in the United

Kingdom, you may be want to know the dollar price of pounds or the pound

price of dollars.

In a barter economy, every good potentially exchanges for every other.

Where n distinct items are traded, there would be n(n-1)/2 distinct ratio

prices, counting CDs per apples and apples per CD as a single price. So if

there were 1,000 goods in an economy, there could be 499,500 prices. Such

a multitude of prices hinders economic calculation. Imagine manufacturing

CDs that are traded for apples, chocolate chip cookies, rubies, and other

assorted goods or services, and when your workers and vendors are paid in

the same assortment. Now try to calculate your profit or loss.

Once a good becomes a commonly accepted medium of exchange, it

establishes comparable prices for all other goods and services. Although

some texts describe this role as a common denominator for all prices, it

actually is the common numerator: dollars per CD; dollars per apple; dollars

per chocolate chip cookie; or dollars per ruby. That is why economists

sometimes refer to the commodity providing the unit of account with the

French word numeraire. In the economy with 1000 di!erent goods, one

of which is money, the number drops from 499,500 to only 999 prices. But

more importantly, it greatly facilitates economic calculation by allowing easy

comparison of various goods and services. Businesses can sum up their costs

and their revenues and see whether the business is earning profits or su!ering

losses.3

3Suppose I am running a business that requires two tons of coal, 500 kw-hrs of electricity

and 100 hours of labor per month. Output consists of 1,000 widgets. How do I know

whether this is a worthwhile undertaking? Money accounting will tell me:

Expenses Revenues

Two tons of coal @ $40 $80 1,000 widgets @ $1.50 $1,500

500 kw-hrs electricity @ $0.12 $60

100 hrs labor @ $12 $1,200

Total expenses $1,340 Total revenues $1,500


16 Subsidiary Functions of Money

Clearly my profit is $160 this month. Indeed, how could accountants do

their jobs without a customary unit of account?

It is not enough to observe what commodity is used as a medium of

exchange. We also need to know how much of it constitutes one unit of that

medium. Money, more precisely, is the numeraire or medium of account.

The unit is some specific weight of the money. For example, in the British

colonies of seventeenth and eighteenth-century North America, one medium

of exchange was silver. The amount of silver serving as the unit of account

could be either the Spanish silver dollar or the British pound sterling, and

in fact, di!erent colonies would define the “pound” as di!erent amounts of

silver. Thus, a Virginia pound di!ered from a Massachusetts pound. In this

case a single medium had several units of account.

Under some circumstances, however, the unit of account can become

totally separated from the medium of exchange. During the German hyper-

inflation of 1923 (an episode that Chapter 3 will cover), Germans continued

to use the Reichsmark as money. But its value was falling so rapidly and

unpredictably that merchants began to quote prices in U.S. dollars. Today

in Chile, the medium of exchange is the Chilean peso, but many prices are

expressed in terms of the Unidad de Fomento (UF), merely an accounting

unit based on a bundle of goods and services. During the 1950s in the

Soviet Union for certain transactions, a constant ruble was the unit of ac-

count against changing quantities of ruble currency serving as the medium

of exchange. Some anthropologists believe they have uncovered cases where

a unit of account even emerged prior to money. The Middle Kingdom of

Egypt, for instance, undoubtedly used weights of copper as the unit for do-

mestic trade, although it is not certain that copper was yet a commonly

accepted medium of exchange. Some pastoral societies carried out transac-

tions in terms of livestock units even through livestock were not exchanged.

1.3.2 Store of Value

The second subsidiary function of money is as a store of value. It follows

inevitably from being a medium of exchange, because money thereby sep-

arates the act of selling from buying. You can sell your labor for money



today and then use the money to buy food or clothing later. During the

time you hold the money, it is a temporary abode of generalized purchasing

power. Thus money provides a convenient way of saving and accumulating

wealth, though by no means the only way. People can use any relatively

durable good as a store of value, such as cans of tuna fish or valuable paint-

ings. Some anthropologists contend that several of the primitive commodity

moneys listed in Table 1.1 did not actually circulate as commonly accepted

media of exchange but instead were only held as stores of value. Yet holding

wealth in the form of your medium of exchange reduces transaction costs.

You can readily spend the money on other available goods and services at

any time, whereas you usually have to convert the tuna cans or paintings

into money first.

While using money as a store of value lowers transaction costs, it can

introduce other opportunity costs that are sometimes significant. To the

extent that you hold any commodity as a medium of exchange you cannot

use it up in consumption or production. Thus hanging on to commodity

entails an opportunity cost. As some writers put it, commodity money

is “barren.” But they are seeing only the opportunity cost and not the

subjective benefit that people gain – the confidence that commodity money

will retain its purchasing power. When the economy is poor and markets

are thin, with few people buying or selling, individuals may find it less

costly to hold what little wealth they have in goods other than money. This

was apparently the situation in early medieval Europe between the fall of

Rome and the eleventh century. Although coins existed and were used in

some exchanges, the expense of holding them was so prohibitive that barter

remained common. Money’s convenience as a store of value can also diminish

over extended periods or when prices are rising rapidly. Severe inflation may

therefore separate money from its store of value function as e!ectively as is

separates money from the unit of account.

1.3.3 Standard of Deferred Payment

The final subsidiary function of money is as a standard of deferred payment.

Money provides the unit for expressing debts or payments due in the future.


18 Credit Cards, Debit Cards, and Smart Cards

This means that money becomes not only the preferred way of paying back

loans (because it is the medium of exchange) but also the preferred way

of specifying the amount repaid (because it provides the unit of account).

Notice that loans do not necessarily have to be paid back in money. One of

the authors sometimes loans his pickup truck to his neighbor, who usually

returns it with a full tank of gasoline. Early economies, even after the evo-

lution of commodity money, often continued to rely on debts denominated

in other goods, such as loans of seed repaid out of the crop, or a loan of

breeding animals repaid with animals. And here again, if prices are rising

rapidly, money may cease to be the standard of deferred payment even be-

fore it ceases to serve as a store of value or provide the unit of account.

Although loans may continue to be repaid with money, the exact amount is

no longer set in advance in monetary units but determined at the time of

repayment based on some index number.

Often texts omit this third subsidiary function because it follows from

money’s other roles. Yet it bears mentioning because the price at which

money loaned today exchanges for money in the future gives rise to an

interest rate. If you borrow $100 and repay $110 a year from today, the

interest rate on that loan is 10 percent, in terms of money. Although the

interest rate for money is the one that people almost exclusively deal with,

it is not the only interest rate in the economy. Even if no one directly

loans apples today in exchange for apples in the future, there is still an

implicit interest rate on apples, and one on chocolate chip cookies, and

perhaps another one on pickup trucks. Those interest rates need not equal

each other or the interest rate on money. The significance of this seemingly

subtle observation will become clearer once in Part 2.

1.4 Credit Cards, Debit Cards, and Smart Cards

Credit cards are very popular in advanced societies. You can purchase al-

most anything with a credit card. But are credit cards money? No, your

credit card is a convenient way to get a loan from the bank or other institu-

tion that issued your card. When you make a credit card purchase, the bank



transfers money to the merchant and that amount is added to the balance

which you owe the bank. Later on you transfer money from your checking

account or another source to the bank to pay down or pay o! the loan. So

credit cards are a convenient means of gaining access to money, but they

are not in themselves money. Likewise debit cards are a convenient means

of transferring money from your checking account to a merchant.

Your university may issue a card that you can use to make purchases on

campus and perhaps at o!-campus stores as well. Such cards are sometimes

called “smart cards,” or they may go by a brand name such as an “Access

Card.” You establish an account at the campus o"ce and transfer an initial

balance into the account, as you would with a bank checking account. You

make purchases by swiping the card through a point-of-sale terminal which

deducts the amount of your purchase from your account, and may show the

remaining balance on an electronic display attached to the terminal. These

cards reduce transaction costs, but are a temptation for some students to

over-indulge, and are a privacy concern to some, since the administrators

may be able to track what you buy, where, and when.

1.5 Where is Money?

We conclude with this strange-sounding question which is a cue to repeat our

definition of money as a “generally accepted medium of exchange.” If money

is generally accepted, that means it is a mass psychological phenomenon and

therefore it ultimately resides in our heads. The value that people ascribe

to money or any other good or service is not an intrinsic attribute of that

good, as is its color, weight, size, etc. Value resides in the consciousness

of the valuer and is revealed when the good is exchanged in a voluntary

transaction. Behind every economic issue are diverse human beings who

choose and act in pursuit of their individual goals.


20 The cashless society

1.6 The cashless society

One of the authors regularly polls his students about how much cash they

usually carry and how much use they make of debit cards or credit cards.

One or two per class usually say they carry no cash at all, relying entirely on

their debit cards. They can do so because the transaction costs associated

with debit and credit cards have dropped so much that even small purchases

like a can of soda can be conducted economically using cards.

Notwithstanding these trends, cash shows no signs of disappearing, es-

pecially from markets that are illegal, particularly the drug trade. Even in

legal market,s there is every indication that cash will continue to play at

least a niche role in our financial system.

1.7 Money in modern society

Although we have a clear definition of money, identifying just what does

and does not serve as money at a particular time and place, particularly

in an advanced society such as ours, is not always easy. We will defer the

classification of money until Chapter 8.

1.8 Important terms and concepts

Spontaneous order Reverse inequality of value

Transaction costs Direct exchange (barter)

Double coincidence of wants Multilateral exchange

Indirect exchange Medium of exchange

Marketability Money

Commodity money Coinage (minting)

Specie Bullion

Brassage Unit of account

Store of value Standard of deferred payment



1.9 References

Friedrich A. von Hayek discusses spontaneous order in The Constitution of

Liberty, (University of Chicago Press, 1960, p. 159-161. Hayek acknowledges

that the concept goes back at least to the time of Adam Smith.

Discussions of money as a solution to the problems with barter are ubiq-

uitous throughout economic principles and money and banking texts and can

be traced all the way back to Aristotle. But a step-by-step economic expla-

nation of how money could spontaneously originate first appeared in chapter

8 of Carl Menger’s Grundsatze der Volkswirtschaftslehre (1871), translated

as Principles of Economics (New York: New York University Press, 1981).

Ludwig von Mises elaborates upon this explanation in his Theory of Money

and Credit (Irvington NY: Foundation for Economic Education, [1912]1971).

More recent writers who elucidate the Mengerian approach in their open-

ing chapters include J. Huston McCulloch, Money and Inflation: A Mone-

tarist Approach, 2nd ed. (New York: Academic Press, 1982), David Glas-

ner, Free Banking and Monetary Reform (Cambridge: Cambridge University

Press, 1989), and Lawrence H. White, The Theory of Monetary Institutions

(Malden, MA: Blackwell, 1999).

A more technical and therefore more sterile presentation that empha-

sizes information costs is Armen Alchian’s article, “Why Money?”, reprinted

in his collection, Economic Forces at Work (Indianapolis: Liberty Press,

1977). The standard list of money’s desirable properties and its functions

(using slightly di!erent terminology) was not originated by Alchian but owes

its popularity to William Stanley Jevons’ economic classic, Money and the

Mechanism of Exchange, 23rd ed. (London: Kegan Paul, 1910), first pub-

lished in 1875. A famous article on money in P.O.W. camps is R. A. Radford,

“The Economic Organization of a P.O.W. Camp,” Economica, 17 (Novem-

ber 1945): 189-201.

Unfortunately there is no recent historical or anthropological survey of

the origin of money that is really good. Jack Weatherford, The History

of Money: From Sandstone to Cyberspace (New York: Three Rivers Press,

1997), is too popular and simplistic to be of much use except for anec-


22 References

dotal tidbits. Glyn Davies’ A History of Money: From Ancient Times to

the Present Day, rev. ed. (Cardi!: University of Wales Press, 1996), while

factually more substantial, is pompous and rambling with such a decided

bias against economics that it starts out with a gross, fundamental con-

fusion between wealth and money. The best of the recent contributions

is the co!ee-table book based on the British Museum collection edited by

Jonathan Williams (with Joe Cribb and Elizabeth Errington), Money: A

History (New York: St. Martin’s Press, 1997).

Among the older historical and anthropological works, especially valu-

able are Arthur R. Burns, Money and Monetary Policy in Early Times (New

York: Alfred A. Knopf, 1927); A. Hungston Quiggen, A Survey of Primi-

tive Money: The Beginning of Currency (London: Methuen, 1949); Paul

Einzig, Primitive Money: In Its Ethnological, Historical, and Economic As-

pects, 2nd ed. (Oxford: Pergamon Press, 1966); and Jacques Melitz, Prim-

itive and Modern Money: An Interdisciplinary Approach (Reading, MA:

Addison-Wesley, 1974). Anthropologists continue to debate the authentic-

ity of many alleged primitive commodity moneys, arguing that they often

served only as stores of value or as means of payment only for specific limited

transactions, such as bride-price, blood-price, or tribute. This is related but

not identical to the debate over whether money originated in many loca-

tions independently or defused from a few civilized centers. We do know for

certain that North American Indians were manufacturing wampum before

European contact, but that it only became widely used as money afterwards,

when European tools made manufacture less time consuming. Up until then

the exchange of wampum had mainly finalized treaties and similar bargains.

One of the strongest anthropological challenges to the economic approach

to money is the collection edited by Caroline Humphrey and Stephen Hugh-

Jones, Barter, Exchange and Value: An Anthropological Approach (Cam-

bridge: Cambridge University Press, 1992), especially the contribution by

Luca Anderlini and Hamid Sabourian, “Some Notes on the Economics of

Barter, Money and Credit.” These debates, however, only serve to under-

score the evolutionary nature of money. Exactly when a good crosses the

lines from pure commodity to medium of exchange and then to common



acceptance will of course be hazy. An outstanding but neglected survey of

these questions with a statistical test of about sixty primitive societies that

essentially confirms Menger’s account is ch. 6 of Frederic L. Pryor, The

Origins of the Economy: A Comparative Study of Distribution in Primitive

and Peasant Economies (New York: Academic Press, 1977).


24 References


Chapter 2

The Purchasing Power of

Money

We acquire money for purchase of goods and services. It is natural to ask how

much we can purchase with a unit of money at a particular time. Clearly, the

answer depends on what we wish to purchase. Yet it is helpful to have some

estimate of the general purchasing power of money even though such an

estimate must cross over di!erences in what we want to buy. Having such

estimates allows us to separate price changes due to changes in money’s

overall purchasing power from price changes due to real factors. It also

helps us study factors that may degrade or enhance the purchasing power

of money, as well as factors that might seem to influence purchasing power

but do not.

2.1 Estimating the Purchasing Power of Money

Economists have devised standard “baskets” or collections of goods and ser-

vices to provide a measure of money’s purchasing power. These collections

are used to calculate “price indices” and are intended to apply to everyone

in an economy, or at least everyone in a certain class of people, disregarding

the fact that people have widely varying spending patterns. The well-known

Consumer Price Index, for example, is a collection of goods and services that

25

26 Estimating the Purchasing Power of Money

attempts to replicate the spending patterns of consumers. The items in the

CPI do not carry equal weight but are assigned quantities that are supposed

to represent the allocation of a typical consumer’s income. Some of the items

in the CPI are not particularly controversial. We all consume food, clothing,

shelter, transportation, and other basics, but we choose di!erent quantities

and di!erent varieties of these basics. Moving beyond the basics and toward

luxury goods, we observe wide variations in people’s preferences.

In principle, it is a simple matter to calculate the price of a basket

(or “index” as it is more properly called) at a particular time and place.

Consider this basket consisting of three cabbages, two pairs of socks, and

one haircut. We calculate the price index by multiplying each item’s price

by its quantity and summing the results.

Item Price p Quantity q p " q

Cabbages p1 =$0.85 q1 = 3 p1 " q1 =$2.55

Pairs of socks p2 =$2.55 q1 = 2 p2 " q2 =$5.00

Haircuts p3 =$9.00 q3 = 1 p3 " q3 =$9.00

sum: $16.55

Although the arithmetic is simple, there are great practical di"culties in

gathering prices and setting quantities. The Bureau of Labor Statistics, an

agency of the U. S. Department of Labor, sends people into stores to write

down prices of goods for sale for use in calculating the CPI. Field workers

may find that cabbages are very cheap at harvest time and expensive during

the winter. The managers in charge of this index might choose to apply

a seasonal adjustment to the price of cabbage, increasing the harvest-time

price and lowering the winter price in line with observations of past seasonal

variations. In the case of socks, the field worker might find socks o!ered at

a special discount which would skew the price series if no adjustment were

made. The price of haircuts may not fluctuate much, but someone would

have to decide whether to count the tips given to the barber, and if so, how.

The purpose of price indices is to observe how they vary over time so

as to estimate changes in the value of money. The adjustments mentioned

in the previous paragraph are intended to minimize price changes that have

nothing to do with the value of money. Here is another problem: as time


Chapter 2: The Purchasing Power of Money 27

goes by, the contents of the basket may become less representative of what

consumers actually buy. For example, people generally consume less of items

whose relative prices have risen, either by finding substitute products or just

by cutting back or eliminating their purchases of that item. To see why this

is a problem, imagine that we are in a period of rising prices and that the

price of cabbages has risen a lot due to an insect infestation in the cabbage

fields, so that the price of cabbages rises. People will shift to lettuce or

do without cabbages in order to stay within their budget. But if the CPI

continues to assume the same quantity of cabbages, the higher price p1 will

push up the CPI figure more than if that q1 had been reduced to reflect

consumer cutbacks. This problem is called substitution bias.

A similar problem occurs when new products enter the marketplace or

old ones disappear. Personal computers and cellular telephone service are

now important to most consumers but they did not exist 20 years ago. Items

are added to the CPI or deleted from it from time to time as a result.

Personal computers raise another issue that has bedeviled the managers

of the CPI: changing quality. The power of personal computers has increased

dramatically since they were first introduced. Some adjustment to reflect

this fact seem in order, especially for PC’s but for other goods as well.

The BLS solution to this problem is “hedonic adjustments” from the Greek

word for “pleasure”. Hedonic adjustments attempt to capture the increase

in services provided by products such as personal computers. This is a very

di"cult estimate to make: how much more valuable is a one-GHz processor

than a 250-MHz processor? Nowhere near four times as valuable for the

average user, writing a book or checking the internet. It is estimated that

during recent times when the CPI was running at an average annual increase

of 3%, this figure would have been about 6% without hedonic adjustments.1

This is a very significant di!erence because many payouts, notably social

security payments, are raised automatically in line with the CPI. People

drawing social security benefits tend not to own personal computers so one

could argue that hedonic adjustments negatively impact them.

In addition to the consumer price index (CPI), the BLS calculates a

1www.shadowstats.com



“producer price index” (PPI), which purports to represent the costs faced

by typical producers. A third index is the “GDP deflator” which attempts

to measure the prices of all the goods and services produced in the entire

national economy, its “gross domestic product.” As Figure 2.1 shows, these

indices typically move together, but not always. The fact that they generally

correlate well with each other gives us some confidence in their usefulness.

Figure 2.1: Annual rates of change of three price indices.

The price one basket of goods and services, however it may be consti-

tuted, is the price level P , in units of dollars per basket. When the price

level rises, the purchasing power of a unit of money declines. The purchasing

power of money, abbreviated PPM, is defined as the reciprocal of the price

level, 1/P , in units of baskets per dollar. The absolute price level at any

given time is not as interesting as changes in P that are observed over time.

A rise in the price level is called price inflation (or just inflation). A decline

is called price deflation (or just deflation). A slowing of price inflation is

called disinflation.

It is important to keep in mind the distinction between relative prices and

the price level. If all money prices in an economy were to rise by 5%, the price



level would also rise by 5% while relative prices would remain unchanged.

Conversely, it is possible for some relative prices to rise and others to fall in

such a way that the price level remains unchanged. The ocean provides a

metaphor for prices which may be helpful. Think of the average level of the

water as the price level and the waves as relative prices. (Do you see why it is

logically impossible for all relative prices to rise simultaneously?) Between

1973 and 1980, for example, the CPI rose by 85% while heating oil rose

170% and clothing rose 40%. Thus the relative price of clothing expressed

in terms of units of heating oil actually fell even though its nominal dollar

price, along with most other prices, increased.

Price indices enable us to adjust observed prices – nominal prices – so

as to eliminate the e!ects of price inflation which as we shall see, results

primarily from increases in the money stock, or monetary inflation. Such

adjusted or “real” values attempt to remove the distortion that price infla-

tion brings, a distortion that is like a shrinking measuring stick. Think of

price indices as estimates of the shrinkage of the measuring stick that allow

us to eliminate the shrinkage from our observations. If nominal wages dou-

ble during a time period when the price level also doubles, real wages – the

purchasing power of those wages – are unchanged. Economists often denote

nominal magnitudes by upper-case letters and real magnitudes by lower-case

letters. If nominal wages are W, then real wages are w = W/P . Nominal

output Y , real output y = Y/P . Real GDP is nominal GDP divided by P .

Table 2.1 shows the GDP deflator for each year from 1959 to 2007.2

This particular index is set up so that the value for a particular year, called

the “base year,” is 100. You can see that the year 2000 was chosen as the

base year in this case, but selecting a di!erent base year would not change

any calculations based on this index. Now suppose one of your authors,

in a fit of nostalgia, recalls that the movie admission price for adults was

50 cents in 1960 and had risen to $9.00 in 2007. How much of this price

increase is real and how much is due to the declining purchasing power of

2The high precision implied by the display of three digits beyond the decimal point is

highly misleading to say the least, given all the gross approximations that underlie these

figures.



the dollar? Multiply each price by 100 and divide by the index value for

that year, resulting in prices expressed in year 2000 dollars. In this case,

$0.50"100/21.0 = $2.38; $9.00"100/119.8 = $7.51. The movie price in real

terms has risen approximately threefold, from $2.38 to $7.51, a substantial

increase but much less than the nominal price, which rose nearly forty-fold.

1959 20.751 1984 67.655

1960 21.041 1985 69.713

1961 21.278 1986 71.250

1962 21.569 1987 73.196

1963 21.798 1988 75.694

1964 22.131 1989 78.556

1965 22.535 1990 81.590

1966 23.176 1991 84.444

1967 23.893 1992 86.385

1968 24.913 1993 88.381

1969 26.149 1994 90.259

1970 27.534 1995 92.106

1971 28.911 1996 93.852

1972 30.166 1997 95.414

1973 31.849 1998 96.472

1974 34.725 1999 97.868

1975 38.002 2000 100.000

1976 40.196 2001 102.399

1977 42.752 2002 104.187

1978 45.757 2003 106.305

1979 49.548 2004 109.099

1980 54.043 2005 113.034

1981 59.119 2006 116.676

1982 62.726 2007 119.816

1983 65.207

Table 2.1: GDP deflator, 1959-2004

Now that we have a way to estimate money’s purchasing power, our

next task is to analyze the factors that determine it. The market prices of

marketable goods and service are determined by supply and demand. So too

is the price of money, its purchasing power. We will examine the demand

for money, the supply of money, and their interaction.



2.2 The Demand for Money

In your first economics class you learned the law of demand as applied to

ordinary goods and services. As the price of a good rises, people demand less

of it. Such changes are represented by movements along a downward-sloping

demand curve. Shifts of the entire curve to the left or right are caused by

any number of outside influences and are usually called just changes or shifts

in demand. You also learned about upward-sloping supply curves and how

their intersection with a demand curve defines the equilibrium price and

quantity in a particular market. We will now apply supply and demand

analysis to money.

You may be puzzled by the concept of “demand for money.” Don’t we

all want as much money as we can get? No, because we are concerned

with demand for money to hold in our wallets, checking accounts, etc. We

may want as much wealth as we can get, but a choice to hold additional

money entails an opportunity cost. We must give up some other form of

wealth to get the money to hold, other things being equal. You may, for

example, decide not to buy a new bicycle right now, in order to maintain

your checking account. Acquisition of money to hold entails an opportunity

cost just as with normal goods and services. Also, the law of demand says

that as the price of something declines, people demand more of it, and this

is true for money. Recall that money’s purchasing power is its price, equal

to the reciprocal of the price level: PPM=1/P. When the purchasing power

of money declines (and the price level rises) we want to hold more money,

other things being equal. We desire money only because we can buy things

with it, and we need more to acquire the same goods and services when

money’s purchasing power declines.

Although we demand money only for what it can buy, we may be quite

certain or quite vague about what we want to buy and when: money to pay

next month’s rent, money for next year’s tuition, or just some money to

keep on hand for unexpected opportunities or emergencies. We may even

hold money in anticipation of purchases by our heirs after our death. The

desire to acquire money to be spent immediately (or in the near future) is


32 The Demand for Money

called transactions demand. Money desired for expenditure later is a form

of saving, and is called portfolio demand.

2.2.1 Transactions Demand for Money

Here we list briefly some circumstances that generally prompt people to alter

their demand to hold money for transaction purposes.

First, people demand more money to hold as the supply of goods and

services increases, other things being equal. As wealth increases and if

people want to hold a constant proportion of their wealth as money, then

the amount of money they want to hold must rise.

Another influence is the cost of acquiring cash. If acquiring cash requires

standing in line at a bank, people will keep larger amounts on hand to reduce

this drain on their time. Automated teller machines have made acquiring

cash much simpler and thus provided incentive for people to maintain lower

cash balances. However, low-income people who lack bank accounts and

must rely on costly commercial check-cashing businesses will be inclined to

keep larger amounts of cash relative to their monthly expenditures.

Clearing system e"ciencies reduce the demand to hold money. A clearing

system is an arrangement among three or more individuals or business firms

for o!setting payments. If I owe you $10 and you owe me $8, I will just pay

you $2 and we “clear” the rest. Historically, clearing houses were private

organizations that arose spontaneously on the market for the purpose of

o!setting obligations among banks. They were typically jointly owned by the

private banks in a particular town or region. In the U.S. today the Federal

Reserve System operates a check-clearing organization called FedWire as

a business sideline. More e"cient clearing systems mean that less money

is tied up between the time a transaction is initiated and the time it is

concluded. Demand for money is reduced.

A third and somewhat minor influence on the demand for money is

the degree of vertical integration among business firms. Many years ago,

General Motors purchased starter motors from the Dayton Electric Co. Like

any buyer, GM kept money on hand to pay for the purchases. Later GM

acquired Dayton Electric and renamed it Delco. This acquisition was an



instance of “vertical integration” because starter motors flow “upward” in

the supply chain from Delco to GM. After the acquisition, this same flow

of goods no longer required money as it became simply a transfer of parts

within the newly integrated firm. While GM continued to use money as a

unit of account in its internal bookkeeping, money usually is not exchanged

between the divisions of a single business firm. Still later, GM spun o!

its parts division into a new company called Delphi. At that point, GM’s

demand for money increased slightly since it then had to buy parts that

were formerly requisitioned internally.

2.2.2 Velocity and the Equation of Exchange

Before discussing the portfolio demand for money we need to introduce

to the concepts of the velocity of money and the equation of exchange.

“Velocity” may be an unfortunate metaphor because it likens the movement

of money in an economy to the flow of a fluid in a pipe or channel. In fact,

every dollar is always in someone’s possession at any moment in time. Even

money in the form of checks being transported between banks (this is called

“float”) remains the property of the writers of the checks until such time

as it clears. Therefore it would be more appropriate to think of money as

hopping instantly from one person to another rather than flowing smoothly

like water. However, we will use “velocity” since this is a standard term in

economics. The velocity of money (or more precisely, its income velocity) in

a particular economy is the number of times an average dollar changes hands

during a particular year. An economy with a money supply of ten million

dollars in which total purchases in one year amounted to fifty million dollars

would have an average velocity of five transactions per year, excluding gifts

and thefts. Of course, some dollars might remain in one person’s possession

throughout the entire year while others might change hands 20 times, but

the average velocity, denoted by V, would still be five transactions per year.

In any given year, the amount of money spent on goods and services

equals the amount received for those goods and services. Every dollar spent

is a dollar of someone’s income. This very basic accounting identity will lead

us to a valuable tool for understanding the role of money in macroeconomic



events. We will work toward this tool by expressing this accounting identity

algebraically as the “equation of exchange.”

To understand the expense side of the equation, consider the role of one

particular dollar during a year. If that dollar is part of five transactions

during the year, it accounts for $5 of spending. Total spending is therefore

the number of dollars (M) times the average number of transactions (V ).

We now have the product MV on one side of the equation.

On the other side of the equation, we represent the total amount of goods

and services purchased during the year by the symbol y. Recall that in

macroeconomics we attempt to aggregate all the various goods and services

produced by an economy into “baskets.” y is then the number of baskets

that are traded in a given year, also called “real output.” The price level is

the price of one basket, P . The total dollar value of the goods supplied is

the value per basket times the number of baskets, Py. Equating aggregate

income and expenses yields the equation of exchange

MV = Py

This equation is dimensionally consistent. M is in dollars, V is in transac-

tions per year, and since transactions are dimensionless, MV is measured in

dollars per year. P is in dollars per basket and y is in baskets per year, so

Py is also in dollars per year.

The equation of exchange is not a theory but an identity. Its exact

truth follows directly from the definitions of its constituents. As it stands,

it is not particularly useful, though one occasionally encounters economic

theories that seem to violate it. But as we have said, economists are often

more interested in changes in macroeconomic aggregates such as M,V,P

and y than in their absolute level. Thus the equation of exchange is often

converted to a form that expresses a relation between changes in each of

these variables, which we denote by prepending #. The “delta” form of the

equation of exchange is3

#M + #V # #P + #y

3If you are familiar with calculus, you can follow this derivation using di!erentials:

d(MV ) = d(Py)



This form of the equation would tell us, for example, that if real output

were to rise by 3% in a given year (#y/y = 3%), velocity remained constant

(#V = 0), and if the money supply were to increase by 5% (#M/M = 5%),

then we could determine the change in the price level, #P by substitution:

5% + 0% = #PP + 3%

or

#PP = 2%

Later we will see how economists have used assumptions about which of the

four variables is more changeable and which can be considered constant to

develop theories about how #M e!ects #P.

2.2.3 Portfolio Demand for Money

People can hold money as a form of saving. Alternative forms of savings

include stocks and bonds, real estate, or even supplies of canned goods.

Money is the most liquid form of savings – you can spend it immediately in

case an emergency or unexpected opportunity arises. Money saved in a bank

or other institution may earn interest, but the rate is usually low. Therefore

one of the opportunity costs of holding money is the higher interest you

could probably earn on less liquid forms of saving. Also, people are less

V dM + MdV = Pdy + ydP

Dividing the left side by MV and the right side by Py (which we can do because these

two are equal), and rearranging yields

dM/M + dV/V = dP/P + dy/y

If we change di!erentials to finite changes, "M will be the fractional or percentage change

in money supply per year, corresponding to dM/M, and so on. Thus

"MM

+"VV

!"PP

+"yy

and we use the “approximately equal” symbol because the equation only approaches ex-

actness as the changes approach zero. The equation is close enough for practical use when

fractional changes are on the order of 10% or less.



inclined to hold money as savings if they anticipate substantial future rises

in the price level.

There is a crucial distinction between money and ordinary goods and

services. Goods used for production and consumption are, by definition of

those concepts, used up. But when we use money, it does not cease to exist.4

Because money is not used up, it is impossible for everyone in an economy

to decrease his or her money holdings simultaneously. If we want to hold

less money, we do not throw it in the trash – we spend it. But since every

dollar spent is someone’s dollar of income, an overall drop in the demand

for money can only translate into increased velocity, as we all spend faster.

Therefore the demand to hold money varies inversely with velocity.

Another factor that influences the demand for money is real output, y.

When there are more goods and services available for purchase, we tend to

hold more money. And as we have seen, a decline in the purchasing power

of money (i.e., a rise in P) leads to more demand for money. We can express

the relationship of money demand MD to these three factors symbolically

as

P $% Md & y $% Md $ V $% Md &

which merely says that the demand for money goes down when the price

level rises, up when real output rises, or down when velocity rises. The

demand for money is one of the most studied and controversial topics in

macroeconomics, and our limited discussion is intended only to provide you

with a general grasp of the concept.5 It is fair to say that changes in money

demand are usually quite small and rarely account for more than a small

portion of the changes in price level.

“Hoarding” is sometimes cited as an exceptional kind of demand for

money. A dictionary definition of hoarding is “to collect or lay up for the

sake of accumulation.” Hoarders of money, like the comic book character

4We omit occasional accidental losses of currency. Also, central banks can increase or

decrease the supply of money, but we will reserve these changes for study in Chapter 16.5The appendix to this chapter explains three theories of the demand for money: Fisher’s

quantity theory, Keynes’ liquidity preference theory, and Friedman’s permanent income

theory.



Scrooge McDuck, seem to be doing so just for the pleasure of holding them

and not for any service they might render in the immediate or distant future.

To identify an acquisition as hoarding, we must guess the motives of the

acquirer, which is always di"cult. Perhaps the hoarder derives pleasure

just from contemplating the cash in his possession, his bank balance, or his

stash of canned food. In any event, there is no good reason to suppose that

a significant number of people behave this way, except perhaps in times of

emergency. Even then, people must consume, and time preference cannot

be obliterated.

2.3 The Supply of Money

The law of supply states that as the price of a good or service increases, the

quantity supplied to the market also increases. The law of supply assumes

a situation where there are multiple competitive suppliers. This is not the

case at present since the Federal Reserve System is the sole supplier of base

money. However, in an economy where gold is money, there are multiple

suppliers of gold6 so that an increase the purchasing power of money elicits

increased supplies. Jewelry can be melted down and converted into coinage

and gold mining operations may start up in areas where mining was formerly

uneconomical. The law of supply is illustrated by the conventional upward-

sloping supply curve of Figure 2.3. Instead of the conventional labels P and

Q, the stock of money is labelled M and its price is labeled PPM .

Recalling that the PPM is the inverse of the price level P, we can write

in shorthand: M s ' % PPM ( % P '.

Over the course of the 16th century, for example, the money stock in-

creased substantially as gold and silver flowed into Europe from America.

This inflow resulted in price increases estimated at 200 to 300%. But in

the 1920’s in the United States, the money supply rose by about 45% and

yet prices stayed approximately level. Why? Because the 1920’s were boom

years, and the demand for money rose approximately in step with the sup-

6There could be a monopoly mint operated by the government with competitive private

gold miners supply bullion to the mint.


38 The Supply of Money

PPM

= 1

/P

Money supply, MM1

Ms

Md

Figure 2.2: Supply and demand for commodity money

ply. We must emphasize that relationships like the law of demand and the

law of supply assume that other factors remain unchanged. The law of de-

mand for money was not invalidated by the experience of the 1920’s. Its

e!ects were masked because other things were not unchanged: supply was

rising. So both supply and demand curves rose (moving equilibrium from

point A to B in Fig. 2.3, leaving the purchasing power unchanged while the

quantity in circulation increased noticeably).

When we study central banks in Chapter 16 we will encounter a pol-

icy proposal that central banks should adjust the supply of money so as to

maintain a steady price level. This would imply an upward-sloping supply

curve for money, since the quantity supplied would rise with its purchasing

power (fall with the price level). However we prefer to show vertical sup-

ply curves for money to emphasize the monopoly power that central banks

currently have over the money supply (Chapter 16).

Our models show that PPM and P are determined solely by Md and

M s, with M s usually predominant. Any e!ect that does not influence the



A B

M

PPM

Figure 2.3: Increased money stock in the 1920’s approximately balanced

increased demand for money.

demand or supply of money cannot influence the purchasing power of money

or the price level. This is an important result because it refutes many mis-

conceptions about the causes of price inflation. Can oil price rises instigated

by OPEC cause price inflation? Not directly; not without a change in Md

or M s! Can “consumer greed” or “corporate greed” or “reckless government

spending” cause price inflation? Not without a change in Md or M s. People

who are deceived by such fallacies are likely confusing relative prices with

the price level. Returning to oil, Japan and Germany had very low rates

of price inflation during the oil price hikes of the 1970’s, notwithstanding

their total dependence on imported oil. However, OPEC price increases did

have a small one-time e!ect on the price level. How? Supply constraints

caused real output to fall temporarily, which in turn decreased the demand

for money, which in turn led to a small increase in the price level (oil shock

% y ( % Md (% P ' as in Figure 2.3.

Thusfar our supply and demand analysis has proceeded as it would for


40 The Supply of Money

Ms

Md

M

PPM

=1/P

Figure 2.4: Secondary e!ect on the demand for money following an OPEC

supply shock.

any other good or service, but now we come to the crucial di!erence. Most

goods and services are used up in consumption or production. Once they

have been put to use they cannot be reused, at least not in total. Money, on

the other hand, is never used up.7 We acquire money not for its own sake but

for the goods and services we can buy with it, now or in the future. Increases

of ordinary goods and services make people better o!. Most of us are better

o! when there are more apples, more economics lectures, more telephones.

In sharp contrast, increases in the money supply confer no overall benefit on

society? Why is this? The answer lies in the distinction between real and

nominal magnitudes. People want money for what they can buy with it.

They care about the real value of their money, the inflation-adjusted value.

Following our convention, we denote real money demand by a lower-case

symbol, md = MD/P . If P falls, PPM rises, and each dollar is worth more.

7Worn-out bills and coins are constantly being replaced. This does not constitute a

change in the money stock.



If you as an individual want to hold more money, you will try to increase

your nominal cash holdings. But as we have said, all money is in someone’s

possession at any point in time: MS = MD. If the nominal money supply

remains fixed, we cannot all increase our money holdings.

We have now been led to the important conclusion that any stock of

money is as good as any other supply; increases or decreases confer no so-

cial welfare. We must qualify this statement somewhat by noting that in

the case of commodity money, the supply must provide practical amounts.

Thus platinum would not be practical for small purchases since no one would

want to purchase a newspaper for a few milligrams of platinum. At the other

extreme, no one would want to buy an economics text with a half ton of

sand. In thinking about increases in the money stock in the context of a

gold standard, we must remember that increases gold as intended for con-

sumption or production increase total wealth but increases in gold intended

as money do not. This important distinction lies in the intentions of those

who possess the gold, not in the physical metal.

Another qualification is that while one money stock is as good as another

(within the aforementioned limits), a transition from one stock to another

could have serious economic repercussions if such a change were large or

sudden.

We must also be aware of how any new money enters the economy.

Economists like to imagine helicopters flying overhead and dropping money

to people in proportion to their current holdings. But this never happens.

Some people always get the new money first, and only slowly, as it is spent

over and over, does it make its way to other people. Early recipients gain at

the expense of the later recipients. Although the new money will cause the

overall price level do rise (other things being equal), this does not happen

immediately. Those who first receive the new money are faced with the

existing array of prices. Prices rise gradually as the new money is spent

and re-spent. Those who get the money last are losers, because by the time

the money reaches them, prices have already risen. We thus have a net

transfer of wealth from those who get the money last to those who get it

first. This is called the “distribution e!ect” or “ripple e!ect” of monetary


42 Important Terms and Concepts

inflation. In addition to wealth transfer, inflation causes at least temporary

changes in relative prices. This is because new money not only goes to

particular people first, but it is also used to buy particular things, whose

price will tend to rise faster than other goods. We are assuming here that

most people will not know that new money has been created or will not

understand its inflationary e!ect. If people successfully anticipate the rise

in prices, it will happen more quickly, but there will still be distribution

e!ects.

Consider a counterfeiter, whose activities constitute a fraudulent increase

in MS . How does he profit from his work? Clearly he gains purchasing

power without having to earn it. If the fake money is detected, the holder

of the money at the time of discovery will lose. If it continues to circulate

undetected, the loss will be borne by all those who hold money, since the

increased money supply will have reduced its purchasing power. On the

other hand, debtors – people who owe money – will gain because they will

be able to pay o! their loans with cheaper dollars. When government agents

create new money, they benefit in the same way as counterfeiters. But they

do not have to worry about being caught and imprisoned.

The helicopter scenario is only a thought experiment: new money always

causes distribution e!ects. Only when we understand these distribution

e!ects can we properly analyze government intervention in the monetary

system.

2.4 Important Terms and Concepts

Purchasing power of money (PPM) Price level (P)

Relative prices Price inflation

Price deflation Real vs. nominal

Demand for money Velocity

Equation of exchange Money stock

Seasonal adjustment



2.5 References

Irving Fisher, The Purchasing Power of Money (1911)

2.6 Questions


44 Questions

Appendix to Chapter 2:

Theories of the Portfolio Demand for Money

Here we go into more detail about the demand for money Md?. We sum-

marize three theories: Fisher’s quantity theory, Keynes’ liquidity preference

theory, and Friedman’s modern quantity theory, also known as the perma-

nent income hypothesis.

The Quantity Theory of Money

Irving Fisher, a prominent economist of the early twentieth century, is asso-

ciated with the quantity theory of money. This theory begins by rewriting

the equation of exchange as

M =1

V" Py

and postulating that velocity is a constant. Letting k=1/V be a constant

and assuming equilibrium so that the quantity demanded (Md) equals the

quantity supplied (M),

Md = k " Py

Since P "y is just nominal income, this suggests that nominal income is

the sole determinant of the demand for money and that interest rates play

no role. Fisher’s view was that people hold money solely for transactions

purposes and not as a form of saving. This view was influenced by the fact

that during his time money never paid interest, whereas currently M2 money

balances pay interest, and even some checking accounts (which are part of

M1) pay interest.

Keynes’ Liquidity Preference Theory

John Maynard Keynes, in his 1936 book The General Theory of Employ-

ment Interest and Money took a broader view. To Fisher’s transactions

motive, in which demand is assumed proportional to income, he added a

precautionary motive and a speculative motive. The precautionary motive

is seen in people’s desire to hold some money for unexpected emergencies



or opportunities. Precautionary money holdings are seen as proportional to

income, like transactions motives.

Keynes lumped all investments other than money into a single category

which he called “bonds.” Fisher, Keynes assumed that money cannot pay

interest (a correct assumption for his time) and asked what speculative mo-

tive might prompt people to hold money instead of bonds which do pay

interest. We will see in a later chapter that the market value of a bond falls

when interest rates rise. If people are expecting a rapid rise in interest rates,

the consequent loss in bond value will o!set or even exceed the interest paid

by the bonds. In this situation people would prefer holding money to hold-

ing bonds. In general, Keynes saw the liquidity component of the demand

for money as inversely proportional to interest rates. Combining the three

motives, Keynes saw the demand for real money holdings mD = MD/P as

influenced by both interest rates and real income y = Y/P :

i $% mD & y $% mD $

Assuming Md = M and substituting into the equation of exchange, we see

that velocity is not constant but in fact is positively related to interest rates:

V =PY

M=

y

M; i $% V $

Friedman’s Modern Quantity Theory of Money

In 1956 Milton Friedman put forth a theory in which he assumed that money

can pay interest at a rate rm. He expressed the demand for real money

balances (Md/P ) as a function of five variables:

• Yp, “permanent income” which is the present value of expected future

income (directly related to money demand)

• rb ) rm, the average interest payable on bonds relative to interest

payable on money balances (inversely related to money demand)

• re ) rm, the average relative return on equities (inversely related to

money demand)


46 Questions

• !e ) rm, expected inflation rate relative to interest on money balances

(inversely related to money demand), and

• h, a ratio of human capital to non-human wealth thought to be in-

versely related to money demand

Friedman’s theory makes money demand less sensitive to interest rates

since rb, re, and rm would tend to rise together and thus the spreads between

them would be relatively stable. The major determinant in Friedman’s

theory is Yp and thus his theory has come to be called the “permanent

income hypothesis.” Eliminating interest rate spreads and the h term which

is not considered significant,

Md

P= f(Yp)

which is very much like Fisher’s quantity theory equation given above. Also,

while velocity is not strictly constant in Friedman’s theory, it takes the form

V =Y

f(Yp)

and if the relationship between Y and Yp is stable, so is the velocity.

How Stable is the Demand for Money?

Going into the 1970’s there was evidence in favor of the idea of the stability

of monetary demand. After that, money market funds and other financial

innovations began to skew the data. People began to move money from

checking accounts into money market funds because those funds paid gener-

ous rates of interest with only a little less liquidity than checking accounts.

This development would of course distort studies that focused on cash and

checking-account money.


Chapter 3

Government Control of

Money

Money can be supplied by private institutions with government playing no

role except perhaps indirectly through provision of police and judicial ser-

vices protecting property rights and prosecuting cases of fraud, theft, etc.

Direct government involvement in money can range from mild forms of regu-

lation or intervention to total takeover of the business of money. Up to now

our discussions of money have been rather general so that it has not been

necessary to distinguish between market-supplied money and government-

supplied money. We now make that distinction.

Why has government almost universally taken control of monetary sys-

tems? Why did Abraham Lincoln once say, “No duty is more imperative

than the duty [the Government] owes the people, of furnishing them a sound

and uniform currency”? As with any study of government activity, there

is a “public interest” point of view and a “public choice” point of view.

The public interest point of view holds that free markets fall short of some

standard of stability, justice, e"ciency, or other desirable attribute. Further-

more, according to this view, government can do a better job of producing

money than private firms can. The public choice point of view considers the

personal and group motivations of politicians, regulators, central bankers,

et. al. These motivations include power, salary, and fame. While control of

47

48 Legal Tender Laws

monetary institutions may feed these appetites directly, the primary benefit

to governments is the revenue they are able to secure through debasing or

inflating the money supply. As Nobel Prize winner Friedrich Hayek put it,

“History is largely a history of inflation, and usually of inflations engineered

by governments for the gain of governments.”1

3.1 Legal Tender Laws

A rather mild type of intervention into monetary a!airs was the specification

of what form of money people would be allowed to use, and the units with

which it was to be measured. An early example was the British pound

sterling. The British government specified that one pound of sterling silver

would be a standard unit of money.2 The public interest justification for such

specifications is that universal standards would reduce transaction costs.

Markets would produce a confusing and costly array of coins of varying

sizes and fineness; government would bring order out of this chaos. The

argument is dubious, however, in light of the numerous instances in which

free markets have converged to standards. Think of standard light bulb sizes

and shapes, right-hand-threaded fasteners, and VHS video tapes. The public

choice motivations are suggested by the ways in which in which governments

enforce monetary standards. The first motivation is tax collection. Taxes

collected “in kind” (that is, direct appropriation of commodities such as

grain or cloth) are di"cult to collect. The di"culty is somewhat akin to the

“double coincidence of wants” problem that arises in barter. Tax collectors

must know what is needed by the various government agencies and then find

citizens who have those goods ready for seizure (a variation of the “double

coincidence of wants” problem that besets barter economies). Food for the

military, for example, was a common need. A vast army of tax collectors

would be required to seize food at harvest time. But if taxes are to be paid

in government-defined money, these problems disappear, and government’s

1Denationalization Of Money, p. 272Britain’s monetary unit is still called the Pound Sterling, but in 2008 it would buy

only about a sixth of an ounce of silver.


Chapter 3: Government Control of Money 49

transaction costs are reduced. Thus European nations found it advantageous

to collect taxes from their colonial subjects in their own money (pounds,

francs, etc.). This helped them tighten control over their colonial subjects.

These early forms of legal tender laws could not force everyone to use

government-defined money in their private a!airs, but they did increase its

use greatly since the requirement to have government paper money money

on hand when the tax collector came around made it more likely that people

would use that same money in private commerce. These laws might have had

few undesirable consequences had governments not used them to promote

alternative forms of money, which became the main reason for legal tender

laws.

3.2 Gresham’s Law

Suppose two forms of money exist in a particular economy, such as gold

and silver. Can this happen without government intervention? It can be

and has been, for the simple reason that gold is more convenient for large

transactions and silver for smaller ones. A gold/silver ratio price emerges

in the market like the ratio prices in a barter economy. Historically, the

ratio was for many years approximately 16 ounces of silver for one ounce of

gold, but there is nothing intrinsic in these metals to suggest that this is

the correct ratio.3 The ratio that arises in any particular circumstance will

be the ratio of the purchasing powers of each money unit. This is called

purchasing power parity and will be explored in more detail when we study

foreign exchange.

In situations where two forms of money circulated, governments often

decided to fix the exchange ratio by law. The public interest justification for

this action was to eliminate the transaction costs associated with varying

exchange ratios between gold and silver. But the main consequence of such

laws, probably unintended, was to eliminate one of the metals as a form of

money. The explanation for this consequence is attributed to Sir Thomas

Gresham (1519-1579), an English merchant and a financial agent of King

3The ratio is currently close to 90 to 1.


50 Monopoly Mints

Edward VI, Queen Mary, and Queen Elizabeth. Gresham’s Law deals with

a special case of price controls. It is often summarized as “bad money

drives out good,” but this is an oversimplification that can easily lead one

to conclude that something about free choice of money that would lead the

“bad” kinds predominating.

To see how Gresham’s law works, suppose the equilibrium price is 15.5

ounces of silver per ounce of gold. If the government decrees a higher price

such as 16, there will be a surplus of silver so that people will not want

to use silver for money. It will be converted to candlesticks, exported to

other countries, or hoarded by people who hope the government intervention

will end. Gresham’s Law might better be stated as “artificially over-valued

money will circulate; under-valued money will not.” If the price decreed is

below the equilibrium price, 15 to one for example, the reverse situation will

arise. Silver will circulate and gold will disappear from circulation.

Three instances of this sort of intervention in the United States were

the Mint Act of 1792, which set a 15 to 1 ratio and drove out gold, the

Coinage Act of 1835 which set a 16 to one ratio and drove out silver, and

the Coinage Act of 1873, which e!ectively demonetized silver, whereupon

the market ratio fell to 30 to 1.

3.3 Monopoly Mints

Coinage, as we have seen, is a viable private enterprise, but once coins begin

to circulate by tale rather than by weight and fineness, opportunities for

fraud open up. One form of fraud is a reduction in the gold or silver content

of coins. This can be accomplished by clipping bits of metal o! the edges of

the coins or by shaking them violently in a bag and collecting the resulting

gold dust at the bottom of the bag. To counter clipping, mints began to

produce coins with milled edges. The little ridges you see on the edges of

present-day quarters and dimes are a holdover from this anti-fraud practice.

Governments began to set up their own mints. Like most government

businesses, these mints were not as e"cient as private mints and so govern-

ments simply outlawed competing private mints. The justification for this



arrangement was to insure the quality of coinage and reduce fraud. A bet-

ter explanation would point to the profits that government mints enjoyed.

Like any monopolist, they were able to increase revenues by restricting out-

put. Whenever they were able to mint coins whose face value exceeded the

value of the metal plus production costs (brassage), they enjoyed enhanced

revenue, called seignorage. On the other hand, some mints engaged in free

coinage. The U. S. Mint did this for a number of years, o!ering coins with

one ounce of gold in exchange for one ounce of gold dust, with no charge for

production.

Governments soon realized that they could raise seignorage revenue still

higher by issuing fraudulent coins themselves. One way to do this was to

simply issue smaller coins and decree that their value was the same as the

larger predecessor coins. One hundred of the old gold coins might be melted

down to make 150 newer and smaller coins. They were thereby enjoying the

same kind of benefit that a successful counterfeiter enjoys. But of course

government agents did not have to worry about being caught and punished

for their activities.

The impacts of coin debasement were threefold. First, there was an

increase in the money supply M s which caused the price level to rise. Then

Gresham’s Law came into play as old and more valuable coins were hoarded,

and this often prompted governments to “call in” these coins and forbid

hoarding of them. Third, there were distribution e!ects. The new money

was spent by the government into a market where the price level had not yet

risen, and many people did not see their incomes rise until well after prices

had risen, the net result being a transfer of real wealth to the government.

This transfer is very much like a tax. John Maynard Keynes, the prominent

twentieth-century economist summed up the situation well when he said

that issuing money allows governments to impose pseudo-taxes “in a manner

which not one man in a million is able to diagnose.”

The Roman denarius was a silver coin that was debased over the years.

In the year 54 A.D. this coin contained 94% silver. By 218 A.D. it was

down to 43%, and by 268 A.D. it stood at 1%, simply a silver wash over

a copper coin. It is no surprise that between 200 and 300 A.D. prices rose


52 Fiat Money

by about 50 times. On the other hand, the Greek drachma, a 65-grain

silver coin, originated before Roman times and kept its silver content and

its purchasing power roughly constant even after the fall of Rome. The

French livre tournois fell from 98 grains of fine silver to 11 grains during the

years from about 1200 to 1600 A.D. In general, debased coins have declined

in purchasing power roughly in step with the erosion of their commodity

value.

3.4 Fiat Money

Debased coins are still commodity money and this rather limits the seignor-

age available from coinage debasement. Demand for coins is fairly elastic,

especially when substitutes are available in the form of foreign coins. Thus

price inflation in Rome ran about 3% to 4% per year, a moderate figure

by modern standards. But monopoly enterprises like to sell into markets

where demand elasticity is low, meaning few substitutes are available. The

development of paper money opened up far more lucrative seignorage op-

portunities.

While paper money was a boon to governments eager to benefit from

seignorage revenue, this form of money actually emerged out of the free

market. Bank notes were paper certificates that could be redeemed for specie

at the bank of issue. They are thought to have appeared in China soon after

the year 1000. We will discuss money substitutes further in Chapter 6 but

for now we will note that governments quickly found seignorage opportunity

in this new form of money. They began to issue irredeemable paper money,

called fiat money after the Latin word for “command.” It only took until

about 1023 for fiat money to appear in China. Fiat money is best defined as

money whose monetary value has no relationship to its value as a commodity,

which in most cases is negligibly small. Contemporary Federal Reserve notes

are essentially useless for any non-monetary purposes and they cannot be

exchanged for any commodity.

Although fiat money is commanded into existence, people have to be

persuaded to use it before it will circulate widely. This may not be so simple.



In recent times we have seen the public reject the Susan B. Anthony and

Sacagawea dollar coins even though they are fully legal tender. Evidently

people prefer dollar bills, even though they are dirty and ugly, to dollar coins

which are relative heavy and awkward. So how can governments persuade

people to use its fiat money?

The answer lies in linking fiat money to pre-existing commodity money.

At first, the new money may be temporarily redeemable. This was the case

with Federal Reserve notes when they were first issued in the U.S. Second,

as we have indicated, governments make taxes payable in fiat money. Third,

legal tender laws are enacted. If you examine a dollar bill, you will find the

inscription “This note is legal tender for all debts, public and private.” In

other words, any private debt can be extinguished by payment of federal

reserve notes.4 Once people become accustomed to the paper money, they

accept it simply because they know others will accept it, and they forget

about its prior link to gold or silver.

The entire world today operates with fiat money, but in almost every

case, that money arose from prior commodity money. Pure fiat standards

have prevailed only since 1971, at which time the last link between the U.S.

dollar and gold was severed, and that is not enough time for us to estimate

how well this system can continue to work. Milton Friedman, perhaps the

most influential economist of the late twentieth century said, “it remains

an open question whether the temptation to use fiat money as a source

of revenue will lead to a situation that will ultimately force a return to

a commodity standard – perhaps a gold standard of one kind or another.

The promising alternative is that over the coming decades the advanced

countries will succeed in development of monetary and fiscal institutions

that will provide an e!ective check on the propensity to inflate and that will

again give a large part of the world a relatively stable price level over a long

period of time.5

4Tecnically, checks drawn on commercial banks are not legal tender. However, a check

with su#cient funds behind it is so readily convertible into currency that it serves as de

facto legal tender.5Milton Friedman, “Money Mischief” p. 259.


54 Fiat Money

Coins can be fiat money, not just paper money. Iron tokens circulated

in ancient Byzantium, for example, and their value as iron was much less

than their face value. The current U.S. coins are made of metal whose

value is unrelated to their face value plus brassage. A quarter, for example,

costs about five cents to make, including labor and capital in addition to

metal. At one time in the 1970’s, the price of copper rose high enough that

it almost became profitable to melt down pennies. 1982, the Mint started

making pennies out of zinc, with a copper wash. In 2008, however, the price

of zinc had risen to the point where pennies again cost more than one cent to

make. Pennies seem to disappear from circulation almost as fast as they can

be minted – people throw them into jars or simply discard them. Annual

proposals to abolish the penny are invariably defeated by the zinc lobby.

The American colonies were among the first to issue paper money. Wars

are the most expensive of all government activities, but this particular war

was in large part a revolt against taxation. In fact, the Continental Congress

had no powers of taxation. How, then, to finance the war? Here is what

they did: 6% ($5.8 million) by taxation in the form of requisitions on the

individual colonies 19% was borrowed ($11 million from domestic lenders,

$7.8 million from abroad) 78% was newly issued money

Six million dollars was issued in 1775, $19 million in 1776, and after

that new issues began to appear every fortnight. Predictably, the value of

the currency, called Continentals, fell sharply against specie: by 1/3 as of

October 1775, to 30-to-one in 1779, and 167-to-one in 1781. The Continen-

tal currency became worthless and the phrase “not worth a Continental”

entered the American language.

The Continental episode was the first modern instance of hyperinflation,

which is the name for extreme rates of inflation, often defined as rates ex-

ceeding 50% per month. More technically, hyperinflation is a situation where

prices rise even faster than the money supply because of falling demand for

money. In fact, expectations play a key role in the degree to which inflation

of the money supply translates into price inflation. We can discern three

stages:

1. When people first see price increases, they often believe they are tem-



porary. “I’ll wait and buy after prices have fallen back to normal.”

Demand for money increases slightly, and price inflation lags behind

money inflation.

2. After a time, people no longer believe the situation is temporary. “I’d

better buy now before prices rise even more.” Money demand begins

to fall.

3. As inflation races ahead, people are eager to get rid of their money.

“I’ll buy anything just to get rid of this depreciating currency.” In

e!ect, people are trying to avoid the implicit inflation tax. Demand

for money falls rapidly and price inflation races ahead of monetary

inflation.

A similar inflationary episode took place during the French revolution.

Many of the leaders of the revolution were men of principle and wanted to

find ways to avoid the fiscal irresponsibility of the previous regime. They

devised new form of paper money called assignats. At first, the new currency

was backed by lands seized from the Church, but it gradually evolved into

a pure fiat currency. Notwithstanding interest paid on some issues and

draconian penalties in the form of fines, imprisonments and death that were

enacted to try to stop people from substituting other forms of money, the

assignats quickly lost value and ultimately expired worthless. As always,

the loss fell mainly on the poor and the ignorant.6

During the U.S. Civil War, both the Union and Confederate govern-

ments issued paper money to finance the war. The Confederacy issued

about $1 billion, and the Confederate currency su!ered nearly the same hy-

perinflationary fate as the Continentals of less than a hundred years earlier.

Relative to its initial gold value, the Confederate dollar fell to 32.7 cents

in 1862, 29.0 1863, and 1.7 cents in 1865, when the war ended. The Union

government only printed enough of its new paper “Greenbacks” to roughly

double the money supply. Thus prices in the North rose by “only” 90.5% in

four years while Confederate prices rose some 2,676%. One of the most mas-

sive hyperinflations in history occurred in Germany in the early 1920’s and

6Andrew Dickson White, “Fiat Money Inflation in France.”


56 Fiat Money

is traceable to the draconian reparations imposed by the victorious Allies

following World War I. Its magnitude can be seen in the price of butter

Year Event Price of one lb. of butter

1914 Before WWI 1.4 marks

1918 After wartime monetary expansion 3.0 marks

1922 Hyperinflation sets in 2,400 marks

1923 Near the end 6 trillion marks

Ironically, when hyperinflation had reached the third stage, the author-

ities, not understanding the fall in Md and its consequences, sincerely be-

lieved that the root of their problem was a shortage of money and advo-

cated even more massive issuances of paper money. Hyperinflation was

ended when a new mark was introduced by dropping eight zeros from the

old mark. More importantly, expansion of the money supply was brought

to an abrupt halt. This is called a currency reform. Hyperinflation also vis-

ited post-Soviet Russia in the 1990’s. Although this episode did not reach

the extremes seen in Germany, it did prompt the authorities to undertake a

currency reform in which each new ruble replaced 1,000 old rubles.

It is interesting that even during the worst of the German hyperinflation,

people continued to use the rapidly depreciating marks rather than reverting

to barter. This shows the huge social benefits of even a very bad money

relative to no money at all. Neither did the Germans used foreign money for

the most part. It was still convenient to use the same money that everyone

else was using. Another hallmark of the German hyperinflation: it was

the first to be engineered by a central bank rather than directly by the

government. (We will study central banking in Chapter 16. The political

consequences of the German hyperinflation were enormous. The middle class

was wiped out and the stage was set for Hitler’s rise to power. These are but

two examples of countless instances in which governments have degraded a

monetary system.

What are the benefits of paper money? Transactions costs fall because

paper is more convenient than coins for larger transactions. (For smaller

transactions coins are better because paper wears out faster. The lifespan

of a contemporary one-dollar bill is only about 18 months.) But these same



reduced costs can be had where gold and silver certificates replace coins

in daily transactions. Such money substitutes have been o!ered by private

banks. A weightier argument in favor of fiat money is based on the resource

cost of commodity money. As we have seen, commodity money is money

that is embodied in some physical form that has consumption or production

use that parallels its use as money. Every ounce of gold that is used as

money is an ounce that will not be worn on a lady’s wrist, not fill a decayed

tooth, not coat the connectors of a printed circuit board. Paper money frees

up these precious resources for use in satisfying important human wants.

And yet, this is not what has happened in the U.S. since it went on a pure

fiat money standard in 1971. Shortly after that time, the price of gold was

freed from its prior o"cial fixed price of $42 per ounce. The market price

began to rise, slowly at first, an then in a frenzy hit $850 per ounce in

1980. People were acquiring gold as a hedge against rising inflation, so if

anything there was less gold available for consumption. Furthermore, the

U.S. government continues to hold its stock of gold even though no longer

has any monetary function. If you check the balance sheet of the Federal

Reserve System online or in a financial publication such as Barron’s you will

find 263 million ounces listed as an asset, valued at the pre-1971 price of

$42.22 per ounce.7

Fiat money can be compared to paper bicycle locks. As long as thieves

respect these “locks” or believe they are unbreakable, they will function

without the expenses of hardened steel and keys. As long as people believe

in fiat money, it will serve its purpose without the resource costs of com-

modity money: the opportunity cost of commodities that sit in vaults and

therefore cannot be consumed. Defenders of fiat money point out that it

allows government to control the money supply. This control constitutes a

macroeconomic tool at the disposal of policy-makers for the purpose of coun-

tering the inherent instability that some economists, particular followers of

John Maynard Keynes, see in free markets. We will consider counter-cyclical

7The market price of gold was about $850 per ounce in 2008. “Troy ounces” are used

to measure weights of gold and silver, and these are di!erent from the ounces used in most

commerce, called “Averdupois ounces.” One troy ounce equals 31.1035 grams.


58 Socialism and the Abolition of Money

monetary policy further in Chapter 18.

3.5 Socialism and the Abolition of Money

3.6 Important Terms

Real cash balances Real money supply

Neutrality Legal tender

Gresham’s law Bimetallic standard

Seignorage Brassage

Debasement Fiat money

Token coin Hyperinflation

Resource cost

3.7 References


Part II

The Nature and Origin of

Credit

59

Chapter 4

The Significance of Saving

We are now ready to study credit and saving. Later we will combine these

concepts with the basics of money which we have just covered. This will

give us a foundation for understanding financial systems.

The word credit comes from the Latin credare, to trust. When we extend

credit to someone, we provide money, goods, or services in the present and

trust that they will return money, goods or services to us later. You may

therefore feel flattered when someone by extends credit to you, but from an

economic point of view, when you accept credit you assume an obligation

to pay later. That obligation is not an asset but in fact the opposite of an

asset: a liability, as we shall see in the course of this chapter.

A person who provides credit is saving. Exchange can provide enormous

gains in wealth, and saving adds to the benefits of exchange by providing

the capital that is so necessary economic growth and prosperity. Saving, as

we use the word in ordinary conversation, calls to mind bank accounts or

jars of pennies, but we need a more fundamental understanding. Just as we

developed the concept of money beginning with a primitive barter economy,

we will develop the concept of saving starting from a primitive example.

Robinson Crusoe, alone on his desert island, faces some stark choices.

He can stay alive by picking berries but he would prefer to add some fish to

his diet. He needs a net to catch fish, but in order to make one, he has to

take time and energy away from picking berries. He might accumulate some

61

62

berries before starting work on the net or he could give up some leisure by

taking fewer naps. However he proceeds, he will have to give up something

valuable in the present for the sake of increased future production. He will

be saving.

This simple example shows that leisure is a consumption good. When

we choose to take naps, play games, watch movies, or grow roses, we reap

direct pleasure from time and energy that we devote to these activities,

and this time and energy could have been devoted to producing goods and

services. Foregone production is thus an opportunity cost of leisure. The

benefits of leisure, like the benefits we get from any kind of consumption,

are entirely subjective. All we can say when we see someone taking leisure

time is that he prefers to devote this particular hour (his marginal hour)

to leisure rather than alternative productive uses of his time. Leisure also

illustrates the diversity of people’s choices. Some people use leisure time

to sleep, some play golf, some even read tracts on economics for pleasure.

These activities acquire the status of leisure only from the attitudes of the

people who engage in them. Some people hate golf, economics, or even sleep!

Crusoe also reminds us of the fundamental fact of scarcity that underlies

all economics. Whenever we acquire scarce goods we must forgo opportu-

nities to acquire other goods. The opportunity cost of saving is present

consumption and this tradeo! involves a time element. Time preference, a

basic fact of human life, explains the cost of saving. Time preference refers

to our preference for consumption in the present over the same consumption

in the future, other things being equal. We therefore choose to forgo present

consumption only when we expect to receive more in the future than we have

to give up in the present. How much more is a subjective matter, varying

from one person to another and varying over time for a particular person.

There is a name for this “how much more:” interest. How much more is

today’s ten dollars worth to us versus ten dollars next week? Or to put it

di!erently, how much compensation do we require to persuade us to wait? If

we require an additional dollar to persuade us to delay for a month receiving

$10 that is owed to us, that dollar is interest. Some people might want $2

for that delay while others might settle for fifty cents, and that same person


Chapter 4: The Significance of Saving 63

might settle for forty cents next week, when circumstances change. We say

someone with a relatively strong preference for present satisfaction, like the

one who requires an extra $2 persuasion to wait, has high time preference.

A person with very high time preference is pejoratively called a spendthrift

and a savings fanatic a miser.1 Notice that although interest is usually

accounted for and paid in terms of money, it need not be. I might accept

one additional apple as interest to induce me to wait a month for payment

of ten apples that are owed to me. Notice further that interest does not

give rise to time preference, just the reverse. Time preference is a basic

fact of human life. How is it that there is only one rate of interest, given

that we all have di!ering degrees of time preference?2 For the same reason

that there is only one market price for apples even though some of us like

apples better than others. As a person buys more apples, the marginal

subjective value of each apple declines, and with it, the price he is willing

to pay. When that price has declined to the market price, he stops buying

apples. Similarly, a person whose time preference exceeds the average time

preference as reflected in the market rate of interest will borrow more (or

loan out less) until the marginal value of the last loan is equal to the price

paid, at which point he will stop borrowing. Conversely, someone whose

time preference is below average will borrow less (or loan out more).

4.1 Saving in a Monetary Economy

As our Robinson Crusoe story has shown, money is not always involved in

acts of saving. Indeed, although most saving in advanced economies uses

money just as most exchange uses money, we can find a few modern examples

of non-monetary saving as when a manufacturing firm adds to its inventory

of finished goods. In Chapter 1 we learned how indirect exchange leads to

1Misers have very low time preference, but no one could have zero time preference

since such a person would have no preference for eating versus saving his food for future

consumption.2There are many di!erent interest rates corresponding to various maturities as we shall

see in Chapter 8. So to be more precise we should say that for a given maturity and risk

level, there is only one market rate of interest.


64 Capital Goods

the emergence of money which avoids the problem of the double coincidence

of wants. Savers face a more severe form of the problem of the double

coincidence of wants. Compared to someone who wants to exchange present

goods, a borrower in a barter economy – someone who wants to acquire

present goods in exchange for future goods – not only has to find someone

willing to provide those particular goods, but also someone who agrees to

the duration and terms of the loan. Again, money solves the problem. It

is safe to say that money amplifies the benefits of saving even more than it

amplifies the benefits of exchange of present goods. One can save money and

loan it to a borrower who wants to buy present goods. When the loan term

expires, the borrower can sell goods and settle the loan with money. When

Robinson Crusoe gathers vines to make a fishing net, we identify that act

as both saving and investing. But saving in money form opens a conceptual

separation of the acts of saving from the act of investment: the creation of

capital goods. Suppose I have been buying a daily $3 latte but decide to

accumulate that money in a jar instead. After a year I loan the money to

my neighbor so he can buy some tools for his machine shop. I have saved

and my neighbor has invested. If all goes well, his investment enhances his

income. At the end of another year he returns my money plus interest.

We will now examine the various forms of saving in a monetary economy

and how savings are used for investment and consumption.

4.2 Capital Goods

The phrase “capital goods” is synonymous with “production goods” which

we have already defined as goods used to produce other goods. When we

use the word “capital” by itself we will be referring to money used to pur-

chase capital goods. However, you should be aware that some authors use

“capital” by itself to refer to capital goods.3

3To add to the confusion, some writers, particularly those of a Marxist persuasion,

use the term “capital” to represent a class of people, as in “capital versus labor.” The

term “capitalism” as a label for a system in which the means of production are privately

owned is a poor choice since all societies beyond the most primitive employ capital. In

fact, the term was coined by Karl Marx, capitalism’s pre-eminent enemy! We prefer the



Returning to the concept of capital goods, notice what happens when

we sell anything for money – goods, services or labor. There are only three

things we can do with the money we receive. We can consume it by spending

it on goods and services like flowers, bicycles or haircuts. We can buy shares

of stock, bonds, or equipment for our business, thereby investing it. Or we

can put it in our checking account or our cash drawer, thereby adding to

our cash balances. Expressed as a simple flow-of-funds equation, we have

income = consumption + #cash balances + investment

with the understanding that the equation applies to a specific time period

such as a month, a quarter, or a year. Note the # indicates change in cash

balances because whereas income, consumption and investment are flows

(amounts specific to some time period), one’s cash balance is a stock.

The most direct form of investment is the purchase of a capital good –

a physical asset that is a tool of production. A wealthy investor buying a

factory, an oil well, or a TV station would be purchasing a capital good. A

proprietor who owns a restaurant might buy kitchen equipment. Even people

who work for wages sometimes make capital investments. Suppose you buy

an automobile for $15,000 and suppose 60% of the miles you drive are for

transportation to work and the rest for family purposes. You are buying

a car partly for production (driving to work) and partly for consumption

(family uses). You have made a $9,000 investment in a production good (60%

of $15,000) and a $6,000 consumption purchase. If you borrow the $15,000

you would categorize $9,000 as an investment and $6,000 as dis-saving, a

concept we will discuss later.4 Our example shows that cars cannot be

classified as production goods or consumption goods except by reference to

the plans of the particular individuals who drive them. In fact, no economic

aspects of any goods and services are intrinsic to those goods or services.

These aspects always depend upon the desires and plans of the person who

is putting them to use in service of some goal, or contemplates doing so.

term “market economy.”4However, the Internal Revenue Service will not allow you go claim a deduction for

this or any other expenses of a car you drive to work!


66 Direct Finance

A car is a durable good, meaning it is capable of providing services over

a significant span of time. As you drive a car, its finish dulls, mechanical

problems arise, and it goes out of style. This is called depreciation, and

represents gradual consumption of the automobile’s value. Suppose that

instead of purchasing the car you leased it for $300 per month. You would

attribute $180 of that payment (60% of $300) to the cost of driving to work

and the rest to consumption. However, the $180 would not be an investment

since that sum would simply be a payment for the current month’s use of

the car.

4.3 Direct Finance

If you want money for purchase of capital goods but don’t have it, you might

be able to borrow it. A credit transaction, as we have said, is an exchange

of a present good (or service or money) for a claim to some other good (or

service or money) in the future. If both are money, that money would be

serving as a standard of deferred payment, which was mentioned as one of

the subsidiary functions of money in Chapter1. The borrower is called a

debtor and his obligation is a liability. The lender is a creditor and his right

to future money or goods is an asset. Credit instruments are called many

things: loans, promissory notes, IOU’s (“I owe you”), bonds, bills, notes,

mortgages. Because of time preference, lenders require inducement in the

form of interest to persuade them to delay consumption. Debt instruments

are an alternative to real investments (land, materials, etc.) as a use for

savings.

In addition to financing production goods, savings can be used to finance

consumption by people who do not want to wait for their income to catch up

with their desires. Consumer loans, credit card loans and pawnshop loans

are all examples of debt-financed consumption.5 The vast majority of home

purchases are financed by mortgages, thus allowing people to start consum-

ing the services of a house before they have accumulated enough money to

5Although people starting small businesses occasionally resort to credit cards or pawn-

shops, both of which charge high rates of interest, as a source of capital.



pay for it in full. Borrowing for consumption or consumption of one’s savings

is the opposite of saving and is therefore called dis-saving. When we dis-

save, we forgo some future consumption for the sake of present consumption.

Many households go through a lifetime cycle of dis-saving during early adult-

hood, saving during highly productive middle years, and dis-saving again in

retirement. Young people forming a household often borrow to buy a house,

a car, etc. During their middle years they typically pay down these debts

and save for retirement. Upon retiring from the workforce, they typically

begin to consume their savings. Payouts from pensions and annuities are

dis-saving. However, since Social Security deductions from paychecks are

taxes and not a form of saving, it follows that Social Security benefit pay-

ments are not dis-saving but rather a forced transfer of wealth from younger

to older workers. Compulsory private retirement accounts, which have been

proposed as alternatives to the present Social Security system, would also

be a form of forced savings.

If over the course of some time period, typically a year, a household saves

more than it dis-saves, it would be called a savings unit. Otherwise it would

be called a dis-saving unit. Households are typically savings units since

households are the ultimate source of capital for production. Businesses are

more often dis-saving units. But a company that re-invested its earnings in

its own business or retained some of its earnings for investment in govern-

ment securities, for example, it would be a savings unit. (Remember that

earnings are calculated after depreciation has been subtracted from income.)

However, a business whose dividend payouts exceeded its earnings would be

dis-saving. Government are typically dis-saving units, but the lack of capital

accounting for most government entities makes this di"cult to estimate.6

Debt instruments as an institution are quite old. As an example, bills of

exchange arose early in the development of mercantile societies to facilitate

trade between regions. Tobacco grown in colonial Virginia was purchased

by tobacco merchants in England. The tobacco farmers wanted to be paid

as soon as they parted with the tobacco, but the merchants did not want to

6For example, the cost of a new road is fully expensed during the time of its construction

rather than being depreciated over time.


68 Direct Finance

make payment until they received the goods. In other words, neither party

wanted to own the tobacco while it was in transit. Some imaginative person

saw this unmet need as a profit opportunity and invented bills of exchange.

Merchants in England issued these bills in the form of written promises to

pay for the goods at some specified future date. Tobacco growers acquired

these bills and sold them to a financier, who in essence made a loan that

enabled the farmers to be paid immediately and the merchant to pay later.

Financiers engaged in this trade came to be called factors. The bills were

secured by the tobacco, meaning that if the merchant failed to pay at the

specified time, the factor would acquire title to the tobacco. The bills paid

interest in the form of a discount. This means that a farmer might be paid

only £98 for a bill which would be worth £100 when it reached England,

the di!erence being the interest earned by the factor. That interest would

cover the opportunity cost of fronting the money, the risk of default, and

profit. Of course, all parties gained from this arrangement. To the farmer,

the benefit of being paid immediately exceeded the £2 he had to give up.

To the factor, those £2 were worth more than the interest income his funds

might have earned elsewhere plus the risk of occasional default.

A factor holding a bill could remit it to England in exchange for specie.

However, transportation of gold and silver across the ocean was expensive

and risky. More often, holders of bills would sell them to importers who

needed money to purchase English goods for sale in America. As such

arrangements became more common, goods flowed back and forth across

the ocean as did bills of exchange, but there was very little transportation

of specie. Thus bills of exchange resulted in a more e"cient clearing system

which increased net social welfare, and as we have seen, reduced the demand

for money.7

Notice that the story of the emergence of bills of exchange is an example

of spontaneous order. Somebody saw a profit opportunity, tried the idea

7We might ask whether bills of exchange achieved the status of money since they were

widely used as a medium of exchange. They did not, because although they circulated

fairly widely among merchants, they were not used by the general public. They were not

a generally accepted medium of exchange.



and succeeded. Others imitated it and it became common practice. No

government agent planned or implemented the idea. Of course, governments

may have entered the picture later by imposing taxes or regulations on the

market for bills of exchange.

Individual extension of credit is just one way to save. Savers may also

form jointly owned organizations to acquire capital goods in the form of

partnerships or corporations. Business corporations are more common than

business partnerships because their owners (shareholders) bear limited lia-

bility. This means that they are not individually responsible for the debts

of the corporation.8 Partnerships lack this protection, but enjoy certain

tax advantages. Limited partnerships are a hybrid type of organization,

combining some features of a corporation and some features of an ordinary

partnership. They include a general partner (who may be an individual,

a corporation, or another partnership) who bears full liability and limited

partners who enjoy limited liability like corporate stockholders. In either

corporations or partnerships, shares represent joint ownership of the capital

goods. When they are successful, they pay dividends to their owners, who

also exercise nominal control over the a!airs of the organization in the form

of voting rights.

In past times, business corporations were chartered by royal governments

who typically granted monopoly privileges along with the charter. Thus in

return for assumption of some of the British government’s debt, the Crown

granted the British East India Company, a private corporation, a monopoly

on trade with India. In the United States at present, formation of a new

corporation is a routine matter. It is necessary to register a new corporation

with a state government, but this does not convey any particular privileges or

sanction beyond limited liability. In particular, the liability limitation that

the owners of corporations enjoy is not, as it might seem, any sort of special

privilege. It is simply a warning to anyone who is contemplating dealings

with the corporation that they cannot pursue the owners individually to

remedy any failure of the corporation to honor its obligations. Limited

8However, in today’s economy when banks grant loans to small corporations, they

typically insist that the principal stockholders personally guarantee those loans.


70 Direct Finance

Figure 4.1: Stock certificate.

liability is signaled by abbreviations such as “Corp.” or “Inc.” or “Ltd.”

appended to company names. People contemplating doing business with

corporations can decide whether or not limited liability poses an acceptable

risk. Limited liability does not shield either employees or stockholders from

prosecution for fraud or other criminal behavior.

In the past, ownership of shares of stock was documented by stock cer-

tificates which brokers mailed to purchasers of stock. Stock certificates such

as the one shown in Figure 4.1 were usually elaborately engraved. Very few

investors now receive stock certificates and instead rely on electronic records

of ownership. The certificate in Figure 4.1 was for a railroad which was pro-

jected to serve a coal mine near Brazil, Indiana. Purchasers of bonds also

received elaborate certificates such as the one shown in Figure 4.2. This

railroad bond, issued in 1891, is typical of bonds issued during that era.

Attached to the bond were coupons dated six months apart which could



be clipped and redeemed for interest payments. The bond promises to pay

principal and interest in “gold coin of the United States of the present stan-

dard of weight and fineness.” Gold contracts such as this were unilaterally

abrogated by President Roosevelt during the Great Depression.

When a corporation is formed, shares of stock are sold to investors. For

example, 50,000 shares may be sold for $2 each, providing the corporation

with $100,000 in capital. Some shares of corporate stock can be resold in

markets that have developed for that purpose. These are called secondary

markets. The best-known secondary markets in the United States are the

New York Stock Exchange, where some trading still takes place in a build-

ing in lower Manhattan although most is now done electronically, and the

NASDAQ exchange which is all electronic. In addition to shares of stock,

bonds and limited partnership units are also traded on these exchanges.

When people buy and sell shares of a particular company, that company is

not a party to the trade.9 This is called secondary trading, and while the

volume of secondary trading (the number of shares traded per day) dwarfs

the volume of new issues of stocks or bonds, new issues are economically the

most important aspect of capital markets. Capital markets generally, which

include markets for initial shares of stock and new bond issues, provide the

financial “fuel” that powers the great engines of innovation and productiv-

ity that drive free market societies. The market prices of these instruments

arise out of the judgments of the buyers and sellers as to (1) the productive

value of the collection of capital goods that the shares represent and (2) how

other traders are likely to appraise the shares.

The emergence of joint ownership as represented by partnership units

and shares of stock enables us to distinguish business firms from households.

Both can be thought of as property-managing units, but whereas the primary

function of households is to manage consumption for a single person, a family

or perhaps a commune, the function of a business firm, be it a corporation, a

9This is not to say that corporate managers are indi!erent to the market price of their

company’s stock. First, they themselves may hold large amounts of stock. Second, they

may lose some of their salary or even be fired if the company’s stock performs poorly.

Third, a high market price makes it easier for companies to issue new shares of stock –

secondary o!erings – to finance new activities or to buy other companies.


72 Direct Finance

Figure 4.2: Railroad bond.



partnership or a proprietorship, is to manage property for production. True,

there are still a few family businesses such as farms or restaurants where the

same group acts as both a household and a firm, but for the most part, the

functions have separated. Of course, we must recognize that all business

firms are ultimately owned by households.


74 Direct Finance


Chapter 5

The balance sheet

We now introduce a basic tool of finance which is the balance sheet. A firm’s

balance sheet is a snapshot of its financial position in time which lists all its

assets and all its obligations, and the sum of each category must be the same

– they must balance. Balance sheets are often depicted as a “T account”

where lines like the letter T are used to separate assets from liabilities. Here

is a very basic balance sheet for a company we will call ABC Manufacturing.

ABC Manufacturing

Assets Liabilities and net worth

Machines & bldgs $5 million Credit instruments (debt) $2.5 million

Shares of stock (equity) $2.5 million

Total $5 million Total $5 million

As you can see, the total assets are $5 million as are the total of liabilities

($2.5 million credit instruments) and net worth ($2.5 million shareholder

equity). Credit instruments (bonds or loans) usually have a fixed nominal

face value and pay a fixed nominal amount of interest. Thus, the holder of

a five-year $1,000 bond bearing 5% interest will receive five annual interest

payments of $50 (or more likely ten bi-annual $25 payments) plus a lump-

sum payment of $1,000 at the end of five years. Shareholders are called

“residual claimants” because they are entitled to the residual – whatever is

left over after all other liabilities have been subtracted from assets. This

75

76

follows from the basic rule of accounting which says that assets must always

be equal to the total of liabilities and shareholder equity. Net worth – the

equity of the stockholders – is calculated last and is the number that makes

the total on the right-hand column equal to the total on the left.

Now suppose a year has passed and ABC has prospered. Its earnings

(income) can be used only three ways, much like an individual’s earnings.

An individual can use cash income for consumption, saving, or addition to

cash balances. Since businesses are not organized for the purpose of con-

sumption, we would substitute distributions to shareholders or partners for

consumption and write the equation and instead of saving, add reinvestment

in the business (acquisition or replacement of capitals goods) plus repayment

of any debt

income = distributions + #cash balances + reinvestment + debt repayment

Again we must note that each term in the equation is totaled over a specified

time period such as a month, a quarter or a year. In this case, assume our

company’s machines and buildings have depreciated to a value of $4 million

because they have aged and su!ered wear and tear. It has also accrued

earnings (accounting profits), some of which have been retained in the form

of cash balances and some used to pay down debt. The balance sheet now

looks like this:

ABC Manufacturing


Machines & bldgs $4.0 million Credit instruments (debt) $2.0 million

Cash $3.5 million Shares of stock (equity) $5.5 million

Total $7.5 million Total $7.5 million

Shareholder equity (assets minus liabilities) has more than doubled, from

$2.5 million to $5.5 million. In addition, the company has accumulated $3

million in cash. This cash could be used to expand the business or it could

be paid out to shareholders in the form of dividends.1

1Because of distortions caused by tax laws, corporations sometimes buy some of their

own shares in the open market, and then retire those shares in lieu of declaring dividends.


Chapter 5: The balance sheet 77

Of course, things may go badly. Suppose instead that ABC’s revenues

have fallen short of its expenses so that after a year there has not only been

no buildup of cash but new debt has been taken on as well. We now have

this balance sheet:

ABC Manufacturing


Machines & bldgs $4 million Credit instruments (debt) $5 million

Shares of stock (equity) -$1 million

Total $4 million Total $4 million

The shareholders, whom we have characterized as residual claimants, not

only have lost all their equity but have seen it turn negative. Assuming the

assets have been valued accurately, if the firm were to close its doors at this

point, the creditors would only get back $4 million of the $5 million owed

to them. Stockholders would get nothing, but they would not be liable

for the $1 million shortfall because corporate stockholders enjoy limited

liability. Actually, negative stockholder equity is not uncommon and it

does not necessarily mean that the company must close its doors. Young

companies that are growing rapidly are sometimes in this situation ). They

are counting on high enough future returns to overcome the negative equity

and build up enough positive equity to reward their shareholders with future

dividends, share repurchases, or both. Amazon.com was an example of such

a company during its early years (Figure 5). Investors did not panic when

the company was technically insolvent because they were confident that it

would grow its way out of this situation, which it did.

Why does shareholder equity appear on the liability side of the com-

pany’s books? The word “equity” has a positive connotation which might

lead you to believe it belongs on the asset side of the books but that is not

correct. You could think of shareholder equity as an expectation that the

company will be liquidated some day, whereupon its assets would be sold

and the proceeds distributed to the shareholders. Shareholder equity is of

Each remaining share represents a slightly larger fraction of the company and thus its

market value is increased, other things remaining equal.


78

Figure 5.1: Amazon.com had negative net worth during its early growth

years.



course an asset to shareholders, and would appear on the asset side of their

personal balance sheets. Stated di!erently, shareholder equity is the amount

that makes assets balance liabilities.

Our examples show that stockholders take on more risk than bondholders

but can also reap greater rewards. Stockholders’ equity can increase without

any limit when a company prospers or can be wiped out when it performs

poorly. Bondholders’ returns are more certain but they do not benefit from

the company’s prosperity except in the sense that default becomes less likely.

If the company should face bankruptcy or liquidation, bondholders are paid

o! before shareholders get anything.

A great variety of hybrid financial instruments have arisen that are nei-

ther pure bonds nor pure equity. Convertible bonds are bonds with attached

warrants that entitle holders to purchase shares of stock at a specified price.

Preferred stock is a class of stock that pays a fixed dividend and is usually

redeemable by the company at some specified date and price. The claims

of preferred stockholders precede those of the common stockholders in case

of bankruptcy or liquidation but are inferior to the claims of bondholders.

And if you check the stock exchange listings, you will find a host of hybrid

issues identified by whimsical acronyms like TIGRS, MIPS, and QUIBS to

name a few.2

Despite their di!erences, debt and equity perform the same basic eco-

nomic function. Both are securities or financial instruments. Each is the

holder’s asset and the company’s liability. Both provide pooling of resources

to purchase capital goods and labor. Both are claims to capital goods,

though the details vary as we have seen. But their economic function – to

convert savings to capital – is identical.

5.1 The Flow of Funds

The diagram in Figure 5.2 depicts very broadly the flow of funds among

households, financial institutions, business firms and governments. At the

2TIGRS: Treasury Investment Growth Receipts, MIPS: Monthly Income Preferred Se-

curities, QUIBS: Quarterly Interest Bonds.


80 The Flow of Funds

Figure 5.2: The flow of funds

bottom of the diagram we see the most important flow, which is households’

use of disposable personal income for consumption. Consumption is, after

all, the ultimate purpose of all economic activity. Gross domestic product

(GDP) consists of this consumption plus investment, which is provided by

capital markets, as well as government expenditures.3 Some government

expenditures flow directly to individuals in the form of transfer payments

(Social Security, welfare programs, etc.). Most government funds are spent

for salaries, materials, weapons, etc. Government funding comes from indi-

viduals and corporations in the form of taxes. Corporations and households

both provide savings to the capital markets. Complex as it may appear,

this diagram leaves out many details. For example, net borrowing by gov-

ernments, businesses, and individuals is not shown. Also, we are considering

3Gross domestic product figures are meant to provide an indication of the economic

welfare of a nation. Some authors consider the inclusion of government expenditures in

GNP problematic, either because (1) they consider them intermediate goods or (2) because

such expenditures are coercively funded and therefore do not necessarily reflect the desires

of the people who were taxed to provide the funds.



a closed economy, meaning we neglect imports and exports. Finally, some

flows can be negative, such as corporate or personal savings.

Households supply most of the savings in a modern economy. Corpora-

tions engage in saving when they use some of their earnings to expand their

business or buy other companies. State and local governments are savers,

on average, because most are required by law to balance their budgets and

to maintain reserve assets to back their pension obligations. Until recently,

pension funds have been invested primarily U. S. government obligations

which meant they are loaning their savings to the federal government, which

is a borrower on a massive scale. In recent years, however, some pension

fund such as CalPERS, the California state employee pension fund, have

ventured into exotic investments like commodities and real estate. This

fund had performed quite well up until 2008, when it su!ered a decline of

about 40%.

The existence of financial instruments creates a market for monetary

saving called the loanable funds market. This market is a conceptual device

broadly conceived to include money used to purchase new issues of both

stocks and bonds, but excluding secondary purchases of these instruments.

Like other markets for goods and services, this market can be analyzed with

a supply-and-demand diagram. However, our diagram will di!er somewhat

from those you learned about in your basic economics course. Ordinary

supply/demand diagrams show quantities of some good or service on the

horizontal axis and the price per unit of that good or service on the vertical

axis. Since we are studying the market for loanable funds, the horizontal

axis of our graph represents money or more specifically, amounts that people

want to loan and which borrowers want to borrow for purchase of equity or

debt instruments in a given time period such as a year. Funds are supplied

by savers who want to acquire those instruments and are demanded by

those who issue them. The vertical axis must be a unit price, but what is

the price of loanable funds? As in any supply/demand analysis, it is the

price that demanders are willing to pay to get the goods, or the price that

suppliers want to get for supplying them. As we said above, the inducement

that gets people to loan money is called interest, so the vertical axis of our


82 The Flow of Funds

Figure 5.3: Supply and demand of loanable funds

supply/demand diagram will be an interest rate, expressed in percent per

annum.4 Note that interest rates almost always refer to a time period of one

year, as expressed by the Latin phrase per annum. Thus if you borrow $100

today and are obliged to repay $110 a year from now, you are paying interest

at the rate of ten percent per annum (per year). When “per annum” or some

phrase like “annual percentage” is not appended to a particular interest rate

and there is no other indication of a time period, it is safe to assume that

per annum is intended, as in “a five percent mortgage.”

Figure 5.3 shows a supply/demand diagram for loanable funds. On the

horizontal axis we have the quantity of funds demanded or supplied in a

given period of time such as a year, represented by the symbol L. On the

vertical axis is the composite interest rate expressed in per cent per an-

4The time period for the quantity on the horizontal axis need not match the one-year

time period for interest on the vertical axis.



num, represented by the symbol i. We are lumping funds for purchase of

stocks and bonds into a single loanable funds market and thus our interest

rate is some sort of composite return on stocks and bonds. We draw an

upward-sloping supply curve LS representing the amounts of money people

are willing to supply for purchase of stocks and bonds as a function of the

composite interest rate. Higher interest encourages savers to greater quanti-

ties of loanable funds. A downward-sloping demand curve LD is the amount

of money borrowers wish to acquire. Higher interest dampens demand for

loanable funds.

Like all supply and demand curves, these are only qualitative and hypo-

thetical in nature. Attempts to quantify these curves, whether they repre-

sent loanable funds or any other goods or service, run afoul of the simple fact

that there is no reliable way to determine how much suppliers would supply

or demanders would demand at various hypothetical prices. And if these

numbers could somehow be determined, they would soon become obsolete

due to changes in circumstances. However, it is reasonable to assume that

the law of demand and the law of supply prevail, so that we can confidently

draw downward-sloping demand curves and upward-sloping supply curves.

Demanders of loanable funds fall into three categories: (1) producers

who want money to buy capital goods, materials or labor for production,

(2) consumers who are dis-saving, i.e., borrowing money for present con-

sumption, and (3) governments which are running deficits, i.e., spending

more than they are receiving in taxes.

In each case, remember that we are talking about net flows. For produc-

ers, this means the net of new funds raised minus capital funds returned to

investors. For consumers, it is new borrowing minus repayments of existing

loans in a particular time period. For government, it is the net issuance of

new bonds minus payments for maturing bonds being redeemed by holders.

Again, all three of these are totals for a particular time period such as a

year.

Instead of presenting the market for loanable funds, where savers supply

the funds and companies demand them, we could have turned things around

and discussed a combined market for stocks and bonds where the roles were


84 Indirect Finance

reversed: savers would demand these instruments and companies would sup-

ply them. While this would have been valid, the market for loanable funds

lets us see directly the role of a composite interest rate since that is what

is shown on the vertical axis. In a market for stocks and bonds, the role of

interest rates would be somewhat obscured.

5.2 Indirect Finance

With direct finance, a saver loans directly to a borrower. You loan your

brother-in-law $100. Or you buy stock directly from a company through its

dividend reinvestment plan. Or perhaps you buy Treasury Bonds through

its Treasury Direct web site. In general, though, direct finance is ine"-

cient because lenders and borrowers have di"culty finding one another –

the “double coincidence of wants” problem again. There is a great variety

of risk levels, maturities (time until a bond or loan is repaid) and amounts of

money represented by debt instruments available for purchase in the market

for loanable funds. Not only is lack of information a hindrance to finding

exactly the right investment, but before the investment (ex ante) buyers also

face adverse selection – the tendency of less reliable borrowers to seek funds.

After the investment (ex post) they face moral hazard (the temptation to

take more risks with others’ money than they might with their own). These

costs drive a wedge between supply and demand and result in less saving

than the theoretical equilibrium point would predict under the assumption

of zero transaction costs (Figure 5.2). This means that suppliers of loan-

able funds receive a lower interest rate i1 while recipients pay a higher rate

i2. This is very much like the retail/wholesale split that is seen in many

markets.

Innovative people who devise new transaction methods are rewarded

with profits if market participants perceive the benefits they receive from

these new methods to be greater than the price charged by the innovator.

Within the confines of direct exchange, this is exemplified by the emergence

of specialists called brokers and dealers. Brokers and dealers match buyers

and sellers and can be found not just in finances but in all sorts of busi-



0 2 4 6 8 10 12 14 160

1

2

3

4

5

6

Q

P

Figure 5.4: Transaction costs drive a wedge between interest paid and in-

terest received.

nesses: scrap iron, restaurant supplies, musicians for hire. Many of them

now operate on the internet, with greatly reduced transaction costs. In

the financial world, brokers and dealers match buyers and sellers of stocks,

bonds, mortgages, and other financial instruments. Mortgage brokers, for

example, find home buyers who want mortgage loans and match them with

banks and other institutions that have funds to loan. Stock brokers, oper-

ating through various stock exchanges, match buyers and sellers of stocks.

Costs of stock transactions, which were once fixed by the government, have

fallen dramatically while service has improved. Customers using stockbro-

kers’ web sites now routinely see their trades completed in seconds, paying

perhaps $10 for a transaction that might have cost $100 (not adjusted for

price inflation) prior to the 1975 deregulation of brokerage commissions. In

addition, customers now get free access to vast quantities of research data

which was di"cult to get in 1975.


86 Indirect Finance

So-called “junk bonds” are a financial innovation that appeared relatively

recently. One of the determinants of the rate of interest on a particular bond

is the risk of default. Bonds with higher risk carry higher interest rates

as compensation for that risk. Michael Milken was an innovator who was

chiefly responsible for the emergence of “junk bonds” in the 1980’s. The

term “junk” is a sardonic reference to the low credit quality and consequent

high interest rate of these bonds; “high-yield bonds” is a more polite term.

Milken opened up a new avenue of finance which provided enormous benefits

to the economy, yet he was convicted and sent to jail on dubious charges of

securities fraud.

Even more recently, on-line services have appeared that match borrowers

and lenders. One of these is called prosper.com. At this site, prospective

borrowers register, and their credit reports are examined by the site. If

they are accepted as borrowing members, they can post requests for loans

in which they state the amount they want, why they need it, and when they

plan to pay it back. Prospective lenders can bid on all or part of a particular

loan request. Interest rates are very high, suggesting a high degree of risk,

and lenders are advised to invest only small amounts in many individual

loans.

But as of Jan. 1, 2009, the site had suspended all activity, because reg-

ulators had caught up with them. This notice appeared:

Prosper has started a process to register, with the appropriate

securities authorities, promissory notes that may be o!ered and

sold to lenders through our site in the future.

Until we complete the registration process, we will not accept

new lender registrations or allow new commitments from existing

lenders ... A successful registration can take several months, but

we assure you we will do our best to move forward as quickly as

possible. Until this process is complete, we’re required to be in

a quiet period and will be unable to respond to press, blogger

or other inquiries about Prosper or the registration filing until it

becomes e!ective.



There is no way of knowing whether prosper.com will be able to complete

its registration or whether the costs and restrictions they might su!er would

be enough to put them out of business.

More significant than these innovations was the development of indirect

finance. Many investors do not want the responsibility of choosing and

monitoring a borrower, even with the advice of a broker or dealer. They are

willing to pay someone to do the whole job for them. Organizations that

perform these services are called financial intermediaries. They borrow funds

from willing lenders, pool the proceeds, and lend to willing borrowers. The

interest rate that they charge to borrowers is higher than the interest they

pay to lenders, and this “spread” is the source of their income. Their services

make the flow of funds in the loan market much more liquid than it would

be otherwise. Pawn brokers were an early form of financial intermediary

and still occupy a niche in today’s financial scene. People bring almost

anything of value to pawn brokers – jewelry, guitars, golf clubs – as security

for personal loans. If they default on the loans, the pawnbrokers sell the

security.

Merchant banks were an early form of financial intermediary that arose

in medieval Italy. They faced numerous government restrictions as well as

a complete prohibition of interest by the Catholic Church. While usury is

mentioned in the Bible, this prohibition probably drew its strength more

from the fact that most loans were made to poor people who were likely to

default, so that only high rates of interest would induce borrowers to lend.

These high rates of interest ran afoul of the requirement that the faithful be

kind and generous to the poor. Business loans were quite another matter,

since borrowers were generally not poor at all, but the Church’s attitude

remained. The early merchant banks got around this restriction by o!ering

shares rather than by borrowing money. This hastened the development

of corporations, which usually raise most of their capital in the form of

equity. Banks in Muslim countries to this day find creative ways to skirt the

continuing prohibition of interest by Islamic law.

While religious strictures against usury have faded, at least in the West-

ern world, governments still use the concept to justify intervention into loan


88 Indirect Finance

markets in the form of interest rate ceilings. There are many laws that

forbid a willing lender and a willing borrower to complete a transaction in

various circumstances if the interest rate exceeds the legal ceiling. Like all

price ceilings, these limits gave rise to shortages, provided they are binding,

i.e., that they are set below the market-clearing rate.

We have said that all income goes to consumption, increased cash bal-

ances, and/or investment. Investment in turn can be divided into acquisition

of capital goods (real investment), direct finance, and indirect finance. Flow-

of-funds diagrams can be used to track these flows on a national level, as in

Figure 5.2.

Thus far we have maintained an analytical distinction between demand

and supply of money versus the supply and demand for saving or for loanable

funds. Banks, however, blur this distinction through what is called fractional

reserve banking, which we will take up next.


Chapter 6

Fractional reserve banking

6.1 Origins

Gold warehouses began to appear in England in the 17th century, although

deposit banking existed in China as early as 1000 AD. As a direct outgrowth

of the emergence of specie (gold and silver) as money, merchants began to

deposit their gold and silver with goldsmiths for safekeeping. This was a

natural extension of the goldsmiths’ business since they were familiar with

the various forms of specie, had good reputations, and were equipped with

storage vaults. When customers left their gold or silver, the goldsmith is-

sued a paper receipt which could be used later to redeem the goods. These

receipts, like any credit instrument, were an asset of one party (their holder)

and a liability of another (the goldsmith). These instruments had no speci-

fied maturity, but the assets in storage were redeemable on demand, meaning

the holder of a receipt could go to the goldsmith at any time during business

hours and demand to exchange it for gold or silver. The goldsmith charged a

fee for his services which the customers were willing to pay for the benefits of

increased convenience and security. A T-account for a goldsmith (ignoring

equity) might look like this:

89

90 Origins

William the Goldsmith


Gold £5,000 Receipts issued £5,000

Total £5,000 Total £5,000

These services were similar to warehouse services provided for owners of

commodities like grain, but with one di!erence. If grain is not used fairly

quickly it will rot. Not only are gold and silver highly durable, but as we

have seen, when they function as money they are not used up as grain is,

but merely pass from hand to hand.1 In addition, holders of receipts who

needed money to buy something would often just use a warehouse receipt

to pay for it. This saved the holder the trouble of going to the goldsmith,

redeeming some specie, and then presenting it to the seller who might then

return it to the very same goldsmith. Warehouse receipts thus began to

function as money substitutes. They circulated like money since they could

be transferred from person to person – they were negotiable. They became

popular because they reduced transaction costs. Not only were fewer trips

to the goldsmith necessary but there was also less wear and tear on coins. As

warehouse receipts became more common, goldsmiths began to notice that

specie seldom left their vaults. Being profit-seeking businessmen, they asked

themselves how they might put these seemingly idle resources to work. They

could, of course, simply embezzle it – take it and spend it for themselves.

However, such crimes would be discovered sooner or later and they would

be out of business, or worse. A more moderate course of action, one that

may or may not have violated the expressed or implied contract between

them and their customers, was to loan it out. Thus if the goldsmith from

the example above were to loan out half his gold, his balance sheet would

become

William the Goldsmith


Gold £2,500 Receipts issued £5,000

Loans £2,500

Total £5,000 Total £5,000

1Ignoring wear and tear on coins and their occasional loss in disasters and shipwrecks.


Chapter 6: Fractional reserve banking 91

Now William the Goldsmith was in the credit business – he has become a

financial intermediary or more briefly, a banker.

Our goldsmith’s assets and liabilities balance in terms of amounts, but

the T-account fails to show an important imbalance: their time structure.

The goldsmith’s liabilities are all payable in gold on demand, but his loans

could not usually be called in quickly or easily. In short, he was “borrowing

short and lending long,” and this became an important problem of bank

management. His reserves – the gold actually remaining in his warehouse

– were only a fraction (in this case, half) of his liabilities. Here we have

a rudimentary form of fractional reserve banking. Goldsmiths’ warehouse

receipts came to be called bank notes like the one shown in Figure 6.3.

6.2 E!ects of fractional reserve banking

The most apparent e!ect of fractional reserve banking was an increase in

the use of paper money which reduced transaction costs substantially. But

paper money could be used in a 100% reserve system as well, so that although

paper money and fractional reserve banking evolved more or less in parallel,

the two developments are conceptually distinct. Leaving aside the shift to

paper money, there were other and more important benefits and risks that

accompanied fractional reserve banking.

Now our goldsmith or banker has a new source of revenue: interest

earned on loans. With competition, some of this new income is passed on

to depositors. Customers no longer pay the goldsmith to store specie but

instead are paid by the goldsmith/banker for the opportunity to loan out

most of the funds they deposit. The payment consists of interest paid on the

deposit. Of course, this interest must be less than the loan interest received

by the banker, but the spread is held down by competition.

The economy as a whole enjoys a net gain from the introduction of

fractional reserve banking. Idle cash balances are put to work as investments.

We have said that increases in the money stock confer no net social benefit,

but to the extent that some of the gold and silver that was released from

the vaults went into consumption uses – jewelry and such – there was a real


92 E!ects of fractional reserve banking

net benefit. This gain is permanent, but the cost is a temporary dislocation

during the time that money substitutes are expanding relative to reserves,

as purchasing power shifts from holders of money to bankers.

As an aside, notice that in our modern economy many businesses have

adopted policies similar to fractional reserve banking. Airlines, for example,

typically “overbook” their flights. They sell more seats than are available

on a flight, knowing that a few passengers usually don’t show up. If they all

show up, the airline company o!ers compensation to anyone willing to give

up his seat. Companies that provide services over the internet – including

banks! – do not provide su"cient server capacity to accommodate all their

online customers simultaneously, knowing that it is most unlikely that they

all will try to log in at once. Roads, telephone systems, and cafeterias o!er

further examples which are at least partly analogous to fractional reserve

banking. To be sure, these examples are not perfect analogies because they

are examples of flows whereas bank deposits are stocks. They are not com-

pletely analogous because they represent services, which are flows, whereas

bank deposits are stocks.

We have listed the benefits of fractional reserve banking, now what about

its drawbacks? The primary hazard of fractional reserve banking is the

possibility of a run on the bank. A run is usually a sudden and dramatic

event and therefore quite di"cult to anticipate. If for some reason, some

critical number of depositors begin to doubt the ability of the bank to honor

its redemption obligations, other depositors will notice this and join in with

demands for redemption. The bank may actually have su"cient assets to

cover its liabilities to the depositors, but since some of those assets are in the

form of long-term loans which cannot easily or quickly be converted to cash,

it may be unable to satisfy a crowd of depositors clamoring for redemption.

This situation is called illiquidity. Bank runs have historically featured long

lines of anxious depositors waiting to get into the bank. The first people

in line get all their money and the last get none, and this of course is the

source of the urgency.2

2The classic Jimmy Stewart movie “It’s a Wonderful Life” includes a dramatic bank

run scene.



A second hazard is the risk of insolvency. A bank becomes insolvent

when circumstances cause its liabilities to exceed its assets. Assets can lose

value for a variety of reasons, but most notably when borrowers default on

their loans or seem likely to do so.3 (All large modern banks are stuck with

a certain number of what are called non-performing loans, but such loans

amount to less than 1% of outstanding loans in a well-run bank.) An illiquid

bank cannot meet depositors’ demands in the short run. An insolvent bank

cannot meet them in the short run or the long run.

As an aside, note that people who fear bank runs can still obtain some-

thing like 100% reserve banking. Most present-day commercial banks o!er

safe deposit boxes for rent where one can store gold or any other small valu-

ables. Of course, banks do not issue “warehouse receipts” for the “deposits”

that go into these boxes. Nor do they aggregate people’s gold coins, which

would be a further cost saving under true 100% reserve banking. Online

transfer services that denominate their payments in gold, such as e-gold,

have not been particularly successful. However, exchange-traded funds that

buy and store gold and silver bullion have been spectacularly successful.

The SPDR Gold Shares Trust now holds about 25 million ounces of gold

in its warehouse (Figure 6.2), valued at over $21 billion at year-end 2008.

Similarly, the iShares Silver Trust held about 220 million ounces of silver,

valued at some $2 billion. These exchange-traded funds are traded on the

New York Stock Exchange, and their share prices, which are set by supply

and demand, may be more or less than the market value of their per-share

bullion holdings.

On a macroeconomic level, a move from 100% reserves to fractional

reserves increases the money stock and therefore, other things being equal,

raises the price level. In our example above, when the goldsmith made his

3When a bank decides that a loan will never be paid back, it writes o! the loan,

removing it from its list of assets. It is not always clear when a particular loan should be

written o!, since often the circumstances of a particular borrower are unique. In contrast,

some bank assets are actively traded which makes it easy to assign a value to them. For

example, if a bank holds $1,000,000 in Treasury notes which are currently trading at 98.5

cents on the dollar, it can adjust the value of these bonds to $985,000 on its balance sheet.

This adjustment process is called marking to market.



Figure 6.1: Gold bullion stored in the warehouse of the SPDR Gold Shares

Trust. The bars each contain 400 ounces of gold, valued at about a third of

a million dollars.

first loan, the money stock went up by £2,500. You may see this more

clearly if you envision the bank loaning out its own notes instead of loaning

out gold – the result is identical. If banknotes are lent out, some will be

returned for redemption in gold, and if gold is lent out, some of it will be

deposited in exchange for banknotes. Either way, the market will approach

the same equilibrium in which some of the new money is in banknote form

and some is in specie form.

Consider now a hypothetical economy in which gold in circulation as

money amounts to £1,000,000.4 Suppose banks hold £100,000 of that sum

and have issued banknotes 100% backed by that gold. The aggregate balance

sheet for these banks (excluding capital which will be discussed later) is

Aggregate bank balances

in a gold economy

Gold £100,000 Notes £100,000

Total £100,000 Total £100,000

Now banks as a whole reduce their reserve ratio from 100% to 20% – they

issue new loans until they reach a point where the gold they hold equals to

4£ is the symbol for the British pound sterling. In our example we assume a pound

stands for a certain weight of gold, as it once did.



20% of their total liabilities, on average. The balance sheet becomes:

Aggregate bank balances

in a gold economy

Gold £100,000 Previously issued notes £100,000

Loans £400,000 Newly issued notes £400,000

Total £500,000 Total £500,000

The aggregate reserve ratio for these banks is equal to the gold in reserve

divided by total notes outstanding, or £100,000/£500,000 = 20%.

What has happened to the total money stock? It was £1,000,000 prior to

the expansion and was then increased by £400,000 – the amount of the newly

issued notes. We can get the same sum by observing how much money is in

circulation after the expansion: £900,000 in specie and £500,000 in notes for

the same total of £1,400,000. Note that reserves are not counted as part of

the money stock, since they are not available for use as a general medium of

exchange. Also note that 100% reserve banking does not increase the money

stock since under this rule, all deposits are converted to reserves. The lower

the reserve ratio, other things being equal, the greater the amount of new

money that is created when new deposits are made.

We have now uncovered an important insight: in a fractional reserve

system, private banks create money. Private banks create money when they

increase their deposits and loan out all but a fraction of those funds. Some-

one who deposits $100 in a bank counts that $100 as part of his money

stock. If $90 of that deposit is loaned out, the borrower counts that $90

as part of his money stock. $100 has been converted to $190 through the

bank’s fractional reserve practice.

Private banks cannot, however, create money on a whim as government

central banks can. They can only do so when they attract new deposits and

choose to loan out some of these deposits rather than adding them all to

reserves. Banks usually do not hold much in the way of “excess reserves”

which are reserves above and beyond the statutory minimum, because they

forgo interest income on these funds if they do. Furthermore, when deposits

shrink and and there are no excess reserves, banks must call in some loans



in order to maintain required reserves, and when they do so they shrink the

money stock.

What happens to the price level when fractional-reserve banking replaces

100% reserve banking? The increased money stock causes a rise in the price

level and a decline in the purchasing power of money. Under a gold standard,

the PPM is the price of gold. But since gold, or any commodity money,

is used for consumption as well as for money, the rise of fractional-reserve

banking frees up some gold for consumption that otherwise would have been

used as money. Users of gold – jewelers, dentists, electronics firms – face

declining costs, and competitive pressures transfer some of that benefit to

consumers. In other words, society as a whole benefits. Recall that we are

posing a situation where fractional reserve banking arises spontaneously on

the market without any government involvement. Profit-seeking bankers

have discovered a way to reduce the cost of the monetary system and enjoy

enhanced profits, at least for the short run. Everyone benefits. Of course,

if a transition to fractional-reserve banking were sudden, it could be very

disruptive. However, institutions that arise via spontaneous order, as we are

assuming here, usually do so gradually.

Now we might ask whether private banks enjoy gains from money cre-

ation comparable to the seignorage that governments and central banks en-

joy when they create money. The answer lies in the fact that private banks

operate in a competitive market. The di!erence between the interest they

charge on loans and the interest they pay on deposits, called their spread,

is the primary source of banks’ profits. If a single bank were to introduce

fractional-reserve banking in a formerly 100% reserve market, it would en-

joy a one-time boost in profits. But competing banks would follow suit, and

spreads would tend toward an equilibrium level of zero economic profits.5

Subsequent increases in loan volume would yield approximately this same

level of profits.

There is another way to look at the benefits of fractional reserve banking.

Recall that commodity money entails resource costs. The resource cost of

gold sitting idle in banks is an opportunity cost because that gold cannot

5That is, conventional accounting profits equal to the going rate of interest.



be used to adorn women, fill teeth, or coat the connectors of printed circuit

boards. Gold released from bank vaults can of course fulfill these functions.

The paper and ink used to create money substitutes constitute very small

resource costs and electronic transfer systems are even more e"cient.

Notice that the advent of fractional reserve banking is yet another ex-

ample of spontaneous order, not involving government action. However,

governments have interjected themselves heavily into the banking industry

as we shall see in subsequent chapters.

Banknotes have several features that make them attractive as money.

First, they are redeemable. Though they are mere paper and ink, they rep-

resent a promise to pay specie on demand, much as the receipt you get from

the dry cleaner represents your ownership of the suede jacket you left there

for cleaning. Second, they are negotiable, meaning they can be exchanged

from one person to another without any noticeable transaction costs. Fi-

nally, paper is more convenient than gold because it is lighter in weight and

can be folded. Banknotes are not, however, the last word in convenience.

If you carry large amounts of negotiable banknotes you may find their bulk

to be inconvenient, and worse, you may be robbed. Profit-motivated banks

began to o!er a solution to this problem in the form of checkable deposit

accounts. The holder of such an account can write checks, sometimes called

drafts, that entitle the person receiving the check to redeem it for money at

the bank on which the check was drawn. The check can be drawn in any

amount that is less than the check-writer’s current account balance.

The first checks were made out to the “bearer,” meaning whoever physi-

cally possessed the check. Bank notes are also spendable by their bearer, but

bearer checks have one important distinction vis-a-vis banknotes. Whereas

a banknote is a liability of the bank of issue and will always be redeemable

as long as the bank has su"cient specie in its vault, a check is a liability of

the account holder and is only redeemable as long as the bank is liquid and

the account holder has su"cient funds in his checking account. Thus there

is a greater risk of not getting your money when you accept payment in the

form of a check rather than banknotes. In the past, checks were generally

accepted only by payees who knew the payer’s reputation or had some con-



tinuing relationship with the payer such as an electric utility has with its

customers. Fifty years ago, stores did not accept checks in payment for pur-

chases. Now electronic check validation systems have been invented to make

this form of payment much more attractive. Also, banks have also instituted

steep penalties for “bouncing” checks, i.e., returning checks for which the

account holder has insu"cient funds. These penalties tend to discourage

people from writing bad checks (colloquially called “rubber” checks).

Nowadays we almost always make checks payable to a particular person

or business firm, not to the bearer. Such checks can only be redeemed by

the person or firm to whom they are made out and this makes it relatively

safe to send checks in the mail. Technically such checks can be negotiated

somewhat like bearer checks. If Smith writes a check payable to Jones, Jones

can write “pay to the order of Brown” on the back and sign his name and

then use the check to pay Brown. Brown then takes the check to the bank

for redemption. Or Brown could endorse the check over to Green, and so on.

But this seldom happens because the amount Jones wants to pay Brown is

not likely to be equal to the amount of the check that Smith wrote the check

for. We will discuss modern mechanisms for clearing checks in Chapter 12.

Could unregulated fractional-reserve banks create new money without

limit? Could they cause hyperinflation – a collapse in the value of money

and a runaway acceleration of price inflation? Absent government inter-

ference, the answer is almost certainly no, not as long as their notes and

deposits remain redeemable. There are two sources of redemption that tend

to “discipline” banks against excessive issues of new liabilities, whether in

the form of bank notes or deposits. The first is that in the long run banks

would not be able to issue more notes and deposits than the public wants to

hold. Consider Bank A, a note-issuing bank that maintains fractional gold

reserves. Anyone holding a note issued by Bank A can take it to that bank

and demand gold. Anyone holding a check drawn on Bank A can likewise

present it for redemption in gold, provided the account on which the check

is drawn has su"cient funds. People will increase their redemptions of Bank

A’s notes or hasten to cash checks drawn on Bank A if they have doubts

about its liquidity or worse, its solvency. As we have seen, such doubts can



spread like a virus from person to person, causing a run on the bank. Sec-

ond, people may deposit banknotes and checks from Bank A into another

banks, such as Bank B. Bank B will take these to Bank A and present them

for redemption, again raising the possibility of a bank run.6

Banks are in business to make a profit. If they su!er a run and they

have no insurance or other strategy for mitigating the run, they go out of

business and the bank owners lose their investment and the employees likely

lose their jobs. So fractional-reserve banks have an incentive to hold an

optimal level of reserves. If that level is too high, their profits will su!er. If

it is too low, they risk a run. The banks whose managers are most skilled at

reducing the risk of a run will be able to reduce reserves and thereby increase

profits.7 Those who are most successful over time acquire a reputation which

enhances their prospects of continued success.

So the willingness of customers to hold banknotes and deposits plus the

competition of other banks and the possibility of adverse clearings serve

to restrain banks against excessive increases of the money stock. We must

emphasize that these are purely market phenomena, as we have not yet

introduced government into the picture. This arrangement – competitive

issue of banknotes and deposits by private unregulated banks – is called free

banking, and its viability is upheld by historical episodes in Scotland, Swe-

den, Canada and elsewhere. Historically, nearly all such banks functioned

as fractional reserve banks. While the price level is necessarily higher un-

der fractional-reserve banking than under 100% reserve banking, fractional

reserve banking, once established, does not lead to sustained price inflation

6In the normal course of business Bank A will have some of Bank B’s notes and checks

that it wants to redeem, and vice versa. These redemption activities are called clear-

ing, and in order to increase the e#ciency of clearing operations, clearing houses arose

which specialized in o!setting the obligations among the various banks within a particular

geographic area.7Do not confuse reserves with reserve requirements. The latter are minimum amounts

of reserves that governments force banks to hold. While reserve requirements are imposed

on some kinds of accounts at U. S. banks, there are no government-imposed reserve re-

quirements in Canada or Switzerland. We will say more about reserve requirements in

our study of central banking in Chapter 12.



partly because reserve levels did not normally fluctuate much.8

The threat of bank runs constitutes a powerful and healthy discipline

constraining the actions of managers of unregulated banks. They constitute

a form of market discipline imposed on poorly managed banks which though

painful to some, may be the best option in a bad situation, just as liquidation

or bankruptcy may be the best option for a failing business firm. Of course,

depositors su!er when a run erupts, as do the bank’s shareholders if it is

forced to cease operations. But perhaps depositors have some obligation

to inquire as to the soundness of any bank with which they do business.

If they are not personally capable of evaluating a bank, they can rely on

information obtained from specialists who are.

Individual bank runs are one thing, but what about a contagion of bank

runs, known as a bank panic? A panic might arise if all banks had inflated

their liabilities in concert, to the point where overall confidence in the sys-

tem broke down. Or some natural disaster might spread fear and distrust

and lead to a run on all banks, including banks that are quite solvent. In

our subsequent study of international banking and finance, we will see how

discipline could be imposed by foreign banks demanding redemption. A

world-wide panic is di"cult to imagine but is theoretically possible.

The possibility of bank panics calls forth a public-interest justification

for government regulation of banks, and in fact banks in the U.S. and else-

where are now heavily regulated, and in some countries they are government-

owned. Later we will encounter two U.S. government agencies that regulate

banks, the Federal Deposit Insurance Corporation and the Comptroller of

the Currency. However, the most important government regulatory insti-

tution in all nations is its central bank, which in the U.S. is the Federal

Reserve System. Central banks will be our next topic. The Federal Reserve

System will be examined in detail in Chapter 16.

8Some advocates of “hard money” argue that fractional reserve banking is fraudulent,

since the same money seems to be in the possession of both the depositor and the loan

recipient (Section 7.5). But any doubts about fraud could easily be cured by full disclosure

on the part of the bank. They further argue that fractional reserve banking is inherently

unstable. This is unsupported by historical experience.



6.3 The Government Central Bank

Fractional reserve banking, created by private banks in a process of spon-

taneous order, posed a problem for governments, which had become accus-

tomed to seignorage as an easy source of revenue. With an increasing share

of the new money entering an economy now coming from private fractional

reserve banks outside of government control, government seignorage revenue

began to decline, at least in relative terms. Recalling that seignorage is ef-

fectively a tax on cash balances, we see that bank-created money is not part

of the seignorage “tax base” and so the government misses out on some of

the easy revenue it might otherwise have enjoyed. From a public choice

point of view, this situation constitutes a major incentive that gives rise to

the creation of central banks. As we have already mentioned, the possibility

of bank panics provides a public interest justification for these institutions.

The solution hit upon by governments was to monopolize banking just as

they had earlier monopolized the business of minting coins. The means to

accomplish this new monopoly was a central bank. But what exactly is a

central bank?

A private institution whose clients are ordinary commercial banks – a

banker’s bank, could be called a central bank. But for our discussion, we

will define a central bank as any bank that enjoys some monopoly privilege

conferred by a government. The Bank of England was one of the first central

banks. It commenced operations in 1694, having been chartered by the

Crown to finance English wars. The Bank loaned money to the government

in return for special privileges.

Central banks have enjoyed a variety of privileges over time. Sometimes

governments insist that taxes be paid in notes issued by its central bank.

But two other privileges emerged as the most important. The first was a

grant of a monopoly on note issues. Private banks we forbidden to engage

in this business, and the government was able to recapture the seignor-

age that had been lost when fractionally backed private notes were issued.

Gradually, a second privilege was granted. Central banks were allowed to

stop fulfilling their contractual obligation to redeem their banknotes on de-


102 The Government Central Bank

mand. Such banknotes thereby ceased being true bank notes and became

fiat money instead. Through this process, the central bank becomes a de

facto government agency, gaining for governments a second way to issue fiat

money in addition to direct issues of fiat money by the government Treasury,

such as that shown in Figure 6.2. All the nations of the world now have

fiat money systems and notes issued by central banks constitute almost the

entire money stock.

Let us examine simplified and rounded-o! versions of the balance sheets

of the central bank, the Fed, and private banks using 2005 figures. We will

add complications later.

Central bank ($ billions)

Assets Liabilities

Loans 850 Currency 775

Reserves 75

Total 850 Total 850

Currency belongs on the liability side of the central bank’s balance sheet, but

it is unlike any liability of a private firm. This is because fiat money cannot

be redeemed or exchanged for anything but more fiat money. The central

bank may accept your fiat money and give you di!erent denominations in

exchange, or it will trade worn-out bills for new ones, but that is all. Reserves

are assets of private banks and liabilities of the central bank. In a purely fiat

money system, reserves are simply bookkeeping entries rather than currency

or specie.

Now assume the private banking system is represented by this highly

simplified balance sheet, which omits vault cash, physical assets and equity

capital:

Private banking system

($ billion)

Assets Liabilities

Reserves 75 Deposits 750

Loans 675

Total 750 Total 750



In this situation the total money stock9 consists of $750 billion in deposits

plus $760 billion in currency in the hands of the public (the $5 billion in

vault cash does not count) for a total of $1,525 billion. The diagram below

shows that fiat money consists of currency plus reserves, and that deposits

are a multiple of reserves. Note a potential source of confusion here in that

reserves are a form of fiat money but they are not part of the money stock.

They are not part of the money stock because they cannot be spent; they

are not a medium of exchange.

This shows that when a central bank issues more fiat money under fractional

reserve banking, there is a multiple expansion of the money stock since some

of the new money makes its way into banks, where it is multiplied by the

process we have seen. Recall that under a gold standard, a fractional-reserve

policy reduces resource costs. Under a fiat money standard, fractional re-

serves do not entail any such saving because there are no resource costs.

Hence there is no wealth e!ect or welfare gain from money creation, but

there are nevertheless distribution e!ects.

Central banking can exist without fiat money. What happens if a central

bank promises to redeem some or all of its notes for specie? Early in its

history, the Federal Reserve System did in fact issue redeemable gold notes,

and the Treasury redeemed its notes for silver prior to 1933. Thus silver and

gold continued to play a diminishing role in the U.S. money system between

9Some authors, particularly financial journalists, use the term “money supply.” We

prefer “money stock” because we are referring to the total existence at any particular

time, and we reserve “supply” to denote flows.



the Fed’s 1916 inauguration and the 1971 severing of the last link between

U.S. money and gold. In this intermediate situation there were actually

three tiers or levels of money. At the top level, we have the Fed’s simplified

balance sheet looking like this

Central bank

($ billion)

Assets Liabilities

Gold 1.5 Fiat money 4.0

Loans 2.5

Total 4.0 Total 4.0

and the private banking system is represented by this simplified balance

sheet:

Private banking system

($ billion)

Assets Liabilities

F.R. notes & gold 3 Deposits 42

Loans 39

Total 42 Total 42

Notice the reserve ratio is reserves divided by loans = 3/39 = 7.7% (not

the ratio of reserves to total assets which would be 3/42). Finally, we have

the money stock represented by these figures (refer to the diagram on the

previous page for the source of these numbers):

Total money stock

(monetary gold: 4.5 )

Gold in circulation 3

Federal Reserve notes 4

Subtotal (potential reserves) 7

Subtract actual reserves -3

Currency 4

Add deposits 42

Total money stock 46



Dec 2008 Dec 2007

Gold certificate account 11,037 11,037

Special drawing rights certificate account 2,200 2,200

Coin 1,688 1,680

Securities, repurchase agreements, term

auction credit, and other loans 1,219,723 1,597,146

Securities held outright 495,629 740,627

U.S. Treasury 475,921 740,627

Bills 18,423 78,916

Notes and bonds, nominal 410,491 470,984

Notes and bonds, inflation-indexed 41,071 36,911

Inflation compensation 5,936 4,892

Federal agency 19,708 0

Repurchase agreements 80,000 56,750

Term auction credit 450,219 4,923

Other loans 193,874 186,630

Net portfolio holdings of Commercial Paper

Funding Facility LLC 334,102 0

Net portfolio holdings of Maiden Lane LLC’s 73,925 0

Items in process of collection 979 (192)

Bank premises 2,194 2,134

Other assets 620,057 66,711

Total assets 2,265,904 925,701

Source: Federal Reserve Table H.4.1

Figure 6.2: Federal Reserve assets for year-end 2007 and 2008.

Figures 6.2 and 6.3 present consolidated Federal Reserve balance sheets

for 2007 and 2008. We have chosen not to use the usual T format, so as

to highlight the drastic changes that took place during 2007 and 2008. The

most significant items are these

• “Treasury securities held outright” are securities (bills, notes, bonds)

that the Fed has acquired by open market operations (section 16.3.1).

These sums represent debt that has been monetized, i.e., paid for with

newly created money. The decline is due to open-market sales of some



of these securities.

• “Term auction credit” is an item that barely existed in 2007. Most of

this item is collateral that has been accepted for loans made to deposi-

tory institutions under the new Term Auction Facility, a “temporary”

program to assist depository institutions that are “in generally sound

financial condition” and “are expected to remain so over the terms of

TAF loans.”

• “Commercial paper LLC” is a limited liability corporation that was set

up in the fall of 2008 when the market for commercial paper dried up,

threatening corporations which rely on them for short-term financing

as well as money market funds and other institutionss that buy them

as safe, short-term assets.

• Three LLC’s have been set up under the name “Maiden Lane.” The

first advanced funds to JPMorgan to acquire Bear Stearns, an invest-

ment bank that was on the brink of failure. The second was used

to purchase mortgage-backed securities from American International

Group, an insurance company that had expanded into this and other

forms of derivative securities. The third purchase collateralized debt

obligations from AIG.

• “Other Federal Reserve assets” are primarily securities denominated

in foreign currencies.

The most important liabilities are these

• “Currency in circulation:” technically this item belongs on the liability

side but in fact, Federal Reserve Notes are not redeemable for anything

but more such notes. There is no actual or potential obligation to pay

anything as there is with ordinary liabilities.

• “Deposits other than reserve holdings” consists mostly of funds that

the Treasury has deposited at the Fed to support bailout operations.

The Treasury has recently borrowed much more than it needs to meet



Liabilities Dec 2008 Dec 2007

Federal Reserve notes 853,168 849,716

Reverse repurchase agreements 88,352 88,317

Deposits 1,248,034 1,241,984

-- Depository institutions 860,000 819,404

-- U.S. Treasury, general account 106,123 118,058

-- U.S. Treasury, supplementary

financing account 259,325 289,247

-- Foreign official 1,365 1,190

-- Other 21,221 14,085

Deferred availability cash items (2,471) (2,537)

Other liabilities and accrued dividends 31,728 33,673

Total liabilities 2,223,753 2,216,227

Capital accounts

Capital paid in 21,076 21,071

Surplus 21,076 16,846

Other capital accounts 0 4,600

Total capital 42,152 42,517

Source: Federal Reserve Table H.4.1

Figure 6.3: Federal Reserve liabilities for year-end 2007 and 2008.

current expenditures, taking advantage of its opportunity to do so at

historically low rates.

• “Reserve balances” are commercial bank reserves, both required and

excess. Excess reserves skyrocketed at the end of 2008. This was in

part due to a policy change whereby the Fed pays interest on reserves,

thereby making them more attractive to hold than they formerly were.

But it also likely reflects banks’ wariness about making loans in a

recessionary environment.

Another interesting Fed asset is its gold stock, valued at $11,041 million.

This is a holdover from the time prior to 1965 when some Federal Reserve

notes were redeemable in gold. This gold reserve is valued at $42.22 per



Figure 6.4: Gold note issued by a private bank, 1874

ounce which was the arbitrary price that the government fixed just prior to

severing the last link between the dollar and gold in 1971. The government

is holding about 261 million which at today’s market price of about $485 per

ounce, would be worth about $126.8 billion rather than a paltry $11 billion.



Figure 6.5: U. S. Treasury banknotes, 1880

Figure 6.6: Silver certificate issue by the U. S. Treasury, ca. 1880



Figure 6.7: Federal Reserve note, 1914


Chapter 7

The Varieties of Money:

a Critical Comparison

In Chapter 6 we saw how banks “pyramid” money on top of reserves of

fiat money or commodity money. Economists refer to both fiat money and

commodity money as high-powered money because they have the “power” to

be multiplied when they enter the banking system. These forms of money

have the power to be multiplied when they are deposited in a bank. Contrast

high-powered money with money substitutes which are issued by banks and

are redeemable on demand for high-powered money. High-powered money is

also called outside money because it lies outside the banking system, while

money substitutes are called inside money. Thus, suppose you possess ten

$20 gold coins: this is high-powered or outside money. You then deposit

them in a bank, which issues $200 in new banknotes covered by those coins.

The new banknotes are money substitutes or inside money.

High-powered or outside money can be either commodity money or fiat

money. Fiat money can be (a) created and spent directly by the govern-

ment, (b) issued by the Central Bank, or conceivably (c) issued by private

institutions.1 Fiat money comes in two forms: bills (notes) and coins. We

1Actually, outside money is not always identical to high-powered money. Federal Re-

serve notes were once redeemable for gold. They were high-powered because of their

redeemability but were also inside money since they were a Fed liability.

111

112 Fiat Money Versus Commodity Money

will use the term currency to refer to these two forms collectively, although

some writers reserve the term currency for paper money, in contrast to coins.

In the U.S., our paper money, as we have said, is issued by the Federal Re-

serve while coins are minted by the Treasury. Since it costs a little over

three cents to produce and distribute a new quarter, for example, the Trea-

sury gains about 22 cents in seignorage revenue for every quarter.2 This

seignorage revenue is remitted to the Treasury by the Bureau of the Mint,

and the Fed’s only involvement is in the distribution of coins to banks. In

the U.S. today, banks issue deposits but they are not allowed to issue either

banknotes or coins.3 The closest thing we have to private banknotes are

travelers’ checks. These are issued by American Express and other private

companies and are used by people who plan to travel to foreign countries

where their U.S. money is not accepted. Travelers’ checks are essentially

unregulated and unlike traditional banknotes, they are only spent once. As

we shall see, travelers’ checks are counted as part of the money stock, but a

very small part.

7.1 Fiat Money Versus Commodity Money

Only about 35 years have elapsed since the whole world embarked upon

a pure fiat money regime. This is not enough time to assess the long-term

viability of the fiat-money system. However, we can make a few observations

that shed some light on the system.

Fiat money theoretically saves the resource costs associated with com-

modity money. But as we saw in Section 6.3 the U.S. government has

2According to the Bureau of the Mint, coinage costs as of 2007 were 1.67 cents per

penny and 9.53 cents per nickel. Thus pennies and nickels may now cost more to make

than their face value – negative seignorage, while dimes and quarters still provide positive

seignorage. The mint faced a similar situation in the 1970’s when pennies were mostly

copper and the price of copper rose sharply. It responded by changing the composition of

pennies to zinc with a thin copper coating. In 2008, the House passed a bill providing for

steel cents and nickels. At this writing, it had not passed the Senate.3In Hong Kong and Scotland, private banks currently issue banknotes. However, they

represent government fiat money and therefore are economically speaking not any di!erent

from banknotes issued by a central bank.


Chapter 7: The Varieties of Money: a Critical Comparison 113

retained its stash of gold at Ft. Knox that was once required as legal back-

ing for Federal Reserve notes. This hoard, amounting to some 261 million

ounces, seems to serve no purpose. One can speculate that the American

public still views this gold as some sort of indirect assurance of the value

of its money. When asked in a Congressional hearing why the government

continued to hold gold given that it was no longer need to back the money

stock, Fed chairman Alan Greenspan answered, “in times of extreme eco-

nomic crisis gold has been the only means to settle accounts.” Greenspan

was evidently saying that the U.S. gold stock still served as some sort of

emergency reserve or implicit backing.4 Whatever the reason, the market

value of that gold at this writing is about $126 billion. That gold could pre-

sumably be sold and the proceeds distributed to taxpayers or used to pay

down the national debt. Another important distinction is that money pro-

vides the government with a tool to control the economy which it lacks under

a commodity money standard. Your appraisal of this situation will depend

on whether you believe government control of the economy is desirable or

even possible.

Sustained inflation is unlikely under a gold standard, since gold mining

is a very laborious and expensive process, requiring years of exploration,

permitting, mining operations, and environmental restoration. By contrast,

fiat money can be created in any quantity at virtually no cost so that there is

no limit to the amount of price inflation that is possible under a fiat money

standard. Of course, if someone should find an economical way to convert

base metals into gold – the age-old goal of alchemy – there could be high

inflation under a gold standard, and gold might lose its position as a favored

medium of exchange.

Why is sustained inflation undesirable? We have said that any reasonable

stock of money will serve as well as any other, but problems arise during

the transition to a di!erent (usually larger) money stock. If money were

4In 1966 Alan Greenspan published an essay, “Gold and Economic Freedom,” in which

he stated that “gold and economic freedom are inseparable” and “in the absence of the

gold standard, there is no way to protect savings from confiscation through inflation.” He

recently stated that he stands by this essay.


114 Distribution E!ects

completely neutral – that is, if it had no influence on real factors in the

economy – even the transition period would not matter. But money is not

neutral. In particular, there are always distribution e!ects associated with

increases in the money stock under either a fiat standard or a commodity

standard, and they can be quite disruptive. Let us examine them in some

detail.

7.2 Distribution E!ects

The first e!ect of an increase in the money stock is an increase in the price

level P and a concomitant drop in the purchasing power of money (PPM).

Most assets and liabilities are priced in nominal terms which means that

when the PPM drops, the real value of these assets and liabilities will drop

proportionately, other things being equal. Thus debtors gain and creditors

lose. Stung by such losses, creditors may be reluctant to engage in further

lending, and this makes it more di"cult to raise capital for expansion of

production. Or they may demand an inflation premium in their next loan.

Typically, lenders ask higher interest to compensate for anticipated future

inflation. If inflation becomes severe, loans may be tied to some price index

(indexation) or they could be denominated in terms of gold or some foreign

currency.

People on fixed incomes su!er losses under inflation. Fixed incomes

are incomes that cannot easily be changed in response to price inflation.

In contrast, many people’s wages are adjusted annually and those adjust-

ments can and usually do include a component that accounts for inflation,

or “the cost of living.” Social security payments are automatically adjusted

at the beginning of each year using a formula tied to the Consumer Price

Index. People who depend on investments for income su!er from inflation

in varying degrees. Those who hold bonds will experience declines in the

purchasing power of both their interest and principal payments. However,

stock prices and dividends may rise in response to inflation, providing some

relief to holders of these assets. Some asset categories actually do well under

inflation, such as precious metals or shares of mining stocks. Demand for



precious metals rises under inflation since many people see them as financial

havens.

Depreciation is an important item in accounting for any business firm.

Buildings and equipment wear out and have to be replaced or refurbished.

Accountants must estimate the yearly decline in the value of buildings and

equipment as they age. The loss in value (depreciation) appears on the ex-

pense side of a firm’s income statement. At best, estimating depreciation is

a tricky proposition. When prices are rising, the nominal replacement cost

of a particular machine may be much higher than was estimated when its de-

preciation schedule was established. The result is that some business firms’

reported income may be overstated because of the failure to adequately ac-

count for price inflation in the depreciation schedules. That exaggerated

income will be fully subject to corporate income tax, which amounts to a

stealth tax increase caused by inflation.

Inflation gives rise to an implicit tax on cash balances. Under a fiat

standard, some of the value of the cash in your pocket essentially leaks out

and is lost or transferred to other market participants or to the government

just as if it had levied a tax on that cash.

A further e!ect of inflation is price distortions or changes in relative

prices. When new money is created, it is not distributed uniformly to

all prior holders of money, as if it were dropped by helicopters, to use a

metaphor favored by economists. Some people get the new money first.

They can spend the money before prices have risen. The next people to

get it face only a small rise in prices, but the last people get it only after

prices have fully adjusted upward. This phenomenon is sometimes called

the “ripple e!ect” of new money; it is also known as the Cantillon e!ect

after the 18th Century economist of that name.

If people correctly anticipate inflation, they can dodge its e!ects in some

circumstances. Creditors, as mentioned, can build inflation hedges into the

terms of their loans. “Fixed” incomes can be adjusted for inflation. De-

preciation schedules can be adjusted appropriately. People can divert their

savings into precious metals. Of course, such strategies will have mixed

success, and substantial resources may be consumed in the process of devis-


116 Net Welfare E!ects of Inflation

ing and carrying out such strategies. Furthermore, some e!ects cannot be

avoided even if they are fully anticipated. The drop in purchasing power of

cash balances is unavoidable, and virtually everyone must hold some cash

balances. Distortions due to the ripple e!ect are very di"cult to avoid since

the ripple process is nearly invisible. As Lord Keynes put it,

Lenin is said to have declared that the best way to destroy the

Capitalist System was to debauch the currency. By a continu-

ing process of inflation, government can confiscate, secretly and

unobserved, an important part of the wealth of their citizens.

By this method they not only confiscate, but they confiscate ar-

bitrarily; and while the process impoverishes many, it actually

enriches some. As the inflation proceeds and the real value of

the currency fluctuates wildly from month to month, all per-

manent relations between debtors and creditors, which form the

ultimate foundation of capitalism, become so utterly disordered

as to be almost meaningless; and the process of wealth-getting

degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means

of overturning the existing basis of society than to debauch the

currency. The process engages all the hidden forces of economic

law on the side of destruction, and does it in a manner which

not one man in a million is able to diagnose.

7.3 Net Welfare E!ects of Inflation

As mentioned, people try to protect themselves from anticipated inflation,

and the measures they take consume time and resources. Financial firms

and large corporations hire experts to try to predict future price inflation.

Individuals buy expensive newsletters which purport to know what invest-

ments will do well under inflation. Precious metals are often cited as such

investments, leading to the ironic situation of a greater resource cost under

a fiat money standard, in the form of gold, silver, diamonds, etc. held by

fearful investors, than might occur under a fractional-reserve gold standard.



Even industrial materials such as copper, nickel and zinc may be held as

inflation hedges. And in fact during hyperinflation, people may acquire al-

most any asset with some durability just to get rid of their money: paper

towels, canned foods, pencils, etc.5

Inflation has serious e!ects on productive activity. When an expansion

of the money stock is unanticipated, it will generate a temporary decline

in interest rates. Business people can easily be fooled into thinking this

decline represents an overall drop in time preference (though they may not

use that exact term) and will respond by shifting assets away from consumer

goods toward producer goods, and most especially into projects that take

the most time to mature and are therefore most sensitive to interest rates.

Later, when the monetary expansion is recognized and interest rates reverse

course, it is seen that there has been no change in time preference at all and

the investments made on this assumption are revealed to be unsustainable.

A recession results.6

When inflation is anticipated, people sometimes add clauses to contracts

to attempt to compensate for it. Business owners’ attention is partly di-

verted away from managing their business and into inflation-watching. Be-

cause it is very di"cult to anticipate inflation over long periods of time, long-

term contracts are avoided or negotiated at higher costs. Projects which by

their physical nature require long startup times are more di"cult to finance.

An ironic example of such a project would be a new gold mine. A new gold

mine requires many years of exploration, permit seeking, assembling equip-

ment and workers, digging and processing ore, and finally environmental

restoration after the lode has been exhausted. With financing for long-term

ventures hard to come by, the supply of new gold may drop just as inflation

has pushed up demand for it.

Some people get rich by successfully anticipating inflation. A gambling

mentality begins to crowd out the focus on production that is more preva-

5The time and money that people spend in e!orts to avoid the e!ects of price inflation

are sometimes called shoeleather costs, a phrase which we believe tends to trivialize a quite

serious issue.6This is a brief sketch of Austrian business cycle theory.


118 Benefits of Inflation

lent under a stable monetary regime. People eagerly anticipate the latest

announcements of “money supply” figures, gold prices, or whatever indicator

has captured the public’s attention. This was the case in 1980, when much

chatter at cocktail parties was about gold, silver, and diamonds. Inflation

was halted soon after that and the prices of inflation hedges collapsed.

We should not lose sight of the benefits people accrue from holding

money for unexpected purchases or as a way of saving. People hold less

money when they anticipate inflation. They thereby lose some of the con-

venience of money holdings, whether cash or demand deposits, that they

would otherwise enjoy.

Relative price changes are important and sometimes subtle signals that

guide a market economy. In an inflationary environment, it can be hard to

tell whether the rise in a particular price simply reflects the overall price

level or whether there has been a relative price change. This is because

business people are most closely attuned to prices in their own specialty

than to overall prices. Relative price changes call for a di!erent responses

– basically, shifting of assets to di!erent lines of production. General price

inflation carries no such implication.

How significant are these e!ects? Under mild inflations such as we have

experienced in the U.S., these costs are low. One estimate puts the figure at

$15 billion per year, which is about $50 per person. Under hyperinflation,

savings are wiped out and monetary calculation becomes very di"cult. The

German hyperinflation of 1920-23 virtually destroyed the middle class in

that country and helped pave the way for the rise of Hitler and the Nazis.

7.4 Benefits of Inflation

Notwithstanding all the pernicious e!ects of inflation that we have outlined,

governments face strong temptations to generate inflations. One incentive

is seignorage, which was explained above. Another is slow-motion debt

repudiation. The government is the economy’s biggest debtor and therefore

has the most to gain from reduction of the real value of its debts. A third

e!ect is bracket creep. For income earned in 2008, for example, the tentative



federal individual income tax schedule for a married couple filing jointly was

as follows

Income up to $16,050 10%

From $16,050 to $65,100 15%

From $65,100 to $131,450 25%

From $131,450 to $200,300 28%

From $200,300 to $357,700 33%

Above $357,700 38%

These ranges of income are called tax brackets. As nominal incomes in-

crease, people drift into higher income brackets and thus pay higher rates,

even though the real value of their income may be unchanged. This is called

bracket creep. Actually, the tax codes have been modified so that most of

these brackets are indexed to inflation. The $16,050 bracket boundary for

2008 was $15,650 in 2007, for example. A major exception is the alternative

minimum tax. The AMT is a separate parallel income tax regime which

takes e!ect when one’s income reaches a certain level, and its e!ect is to

partially eliminate some deductions like charitable contributions. The AMT

is fiendishly complex and makes planning very di"cult for high-income in-

dividuals. With the progress of inflation and because the AMT brackets are

not indexed for inflation, more middle-income Americans have been snared

in the AMT net. There have been proposals to eliminate or reform the AMT

but nothing has been done as of this writing, although Congress has passed

a last-minute one-year patch in each of the last several years.

In the short run, a burst of inflation can reduce unemployment and lower

interest rates, and while these e!ects may seem positive, they do not endure

and in fact are almost always reversed in the long run. They are a lot

like the e!ect of a dose of cocaine – a temporary high followed by painful

consequences. We will have more to say on this topic in subsequent chapters.

It should be no surprise that the record shows more inflation under fiat

money than under commodity money. Although the U.S. has not su!ered

hyperinflation since the Revolution (excluding the Confederacy), its price

level history demonstrates fiat money’s inflationary bias. Figure 7.4 shows

the decline in purchasing power of the U. S. dollar since 1959 as measured by


120 Benefits of Inflation

Figure 7.1: Decline in purchasing power of the dollar.

both the Consumer Price Index and the Producer Price Index. As you can

see, a 1959 dollar has lost all but about 15 to 20 cents of its value since that

time. Note also that most of these years were years of advancing productiv-

ity. This means that had there not been any increase in the money stock,

we would have expected continuing gradual declines in the price level. That,

in fact, is exactly what happened during much of the nineteenth century in

the U.S.

Compare England under commodity money during the period from 1650

to 1914. While price levels can only be estimated roughly for these early

years, the best figures we have show an approximate rise in the price level

for those 264 years of approximately zero!

The costs of the inflations we have experienced following the transition to

fiat money must be weighed against the resource cost of commodity money.

Resource costs, though real, may be a small price to pay avoid the devasta-

tion of inflation.



Fiat money can be compared to paper bicycle locks. Paper locks will

work just as well as steel locks as long as everybody believes in them. Fiat

money can work well as long as people believe in it, and on the whole it

did work rather well during the Greenspan era. Both inflation and interest

rates were relatively low during his tenure as Fed chairman. But paper

bicycle locks don’t usually work in the long run and fiat money may not

either. Gold and silver sitting “idle” in vaults may be the sort of monetary

restraint necessary to protect us from our rapacious politicians.

7.5 A Future Gold Standard

If we consider the use of money substitutes under a gold standard, we find

that resource costs could be quite modest. Under a gold standard with

fractional reserves and no central bank, the level of reserves can sink as low

as public confidence will allow. Money substitutes could function very well

with only a residual amount of gold backing them. Suppose, for example,

that following a transition to a fractional-reserve gold standard, our present

M1 money stock, which as this was written amounted to about $1,600 billion,

were backed by gold in the amount of about 10% of M1, or $160 billion.

Suppose further that this additional demand for gold had driven the price

to $1,600 per ounce from its present $900 per ounce. Then 100 million

ounces ($160 billion divided by $1,600 per ounce) would have to sit idle in

bank vaults. Compare this to the 261 million ounces that actually sit idle in

Ft. Knox, for no apparent reason except distrust of the fiat money system.

Or if you prefer, take the M2 figure of $6,592 billion and back 5% of that

with gold.7 You would need about210 million ounces.8 Thus it is entirely

possible that an actual gold standard could entail roughly the same or even

lower resource costs than a fiat money standard.

If money substitutes were totally deregulated, what sort of system might

arise? What would “monetary freedom” look like? Here are three predic-

7M1 and M2 are two ways to measure the money stock. See chapter 8.8To be fair, we should also assess the impact on consumers of gold of a rise to $1,600

per ounce.


122 A Future Gold Standard

tions from prominent free-market monetary theorists:

• The late Murray N. Rothbard was an advocate of “hard money” who

predicted a return to a traditional commodity standard with 100%

reserves. He denounced fractional reserves as fraudulent and inflation-

ary. A small group of Austrian economists continues to advocate this

position.

• Lawrence White and George Selgin, leaders of the contemporary “free

banking” school of thought, predict a commodity standard with frac-

tional reserves. They see no fraud as long as there is full disclosure

to depositors and they believe the market would value the reduced

resource costs enough to overcome any reticence about fractional re-

serves. Banks could further boost confidence by means of insurance

or mutual assistance contracts.

• The late Friedrich Hayek, winner of a Nobel Prize, represents a variant

of the free banking school. He does not see gold as a viable basis for

money. Instead, he envisions privately issued fiat money with compe-

tition serving to prevent abuses.

• Others have suggested that a “basket” of commodities be specified as

currency backing.

Of course, the market would ultimately pick a winner from among these or

other as yet unforeseen possibilities. Resource costs would be driven down

to the point where the marginal benefit of one more unit of reserves would

approximately equal the marginal benefit realized in terms of increased con-

fidence or marketability.



7.6 Important terms

Credit Saving

Interest Capital

Durable and non-durable goods Finance, direct and indirect

Savings unit, dis-saving unit Bills of exchange

Factor Specie

Corporation Partnership

New York Stock Exchange NASDAQ Stock Exchange

Balance sheet Loanable funds

Junk bonds Usury

Fractional reserve banking Bank run

Bank panic Illiquidity

Insolvency Free banking

Resource costs

7.7 References


124 References


Part III

Today’s financial system

125

127

Having covered the fundamentals of the financial system, we are ready to

study the interaction of money, intermediation and credit through fractional

reserve banking.

If you look through the “Market Week” section of Barron’s weekly news-

paper, you will find listings for common stocks, preferred stocks, partner-

ships, mutual funds (open-end and closed-end), exchange-traded funds, for-

eign currencies, bonds (corporate and government; convertible and conven-

tional), options, money-market funds, bank deposits, annuities, guaranteed

investment contracts and commodity futures (agricultural, currencies, fuels,

metals, lumber, financial indices) and more – in short, a bewildering variety

of financial instruments. All this variety results from two basic incentives.

First, like markets generally, financial markets in o!er rewards to those who

innovate new financial products that investors are willing to buy. Second,

financial markets are heavily regulated.9 This provides an incentive for in-

novators to devise ingenious ways to circumvent regulations. In many areas,

governments and market innovators are constantly trying to leapfrog each

other in an endless round of regulations and sidestepping innovations.

We will examine the intricacies of the financial markets in terms of in-

struments, institutions that create them, and the markets in which they are

traded.

9While markets in the United States are some in respects the freest in the world, our

financial sector is one of the most heavily regulated – more so than Japan’s, for example.


128


Chapter 8

Financial instruments

All financial instruments, with the exception of outside money, are someone’s

asset and someone else’s liability. If I have a checking account at Citicorp,

the account balance is my asset and the bank’s liability. If I own a U.S.

Treasury bond, it is my asset and the Treasury’s liability. The one-dollar

silver certificates the authors used in 1960 were their asset and the Treasury’s

liability. But if you hold contemporary one-dollar bill, which is a Federal

Reserve note, it is your asset but nobody’s liability.1 Federal Reserve notes

are outside money as are Treasury coins.

Money is the most basic financial instrument. Although its definition –

a generally accepted medium of exchange – is conceptually simple, it is not

so easy to identify just what particular instruments fit that definition in a

give time and place. We will now look carefully at what actually constitutes

money in our present economy, and how its various forms are summarized

in standard monetary aggregates.

1Notwithstanding the fact that outstanding currency appears on the liability side of

Federal Reserve’s balance sheet. It appears there simply as a formality; the Fed is not

obligated to redeem its notes for anything except more notes.

129

130 Components of the monetary aggregates

8.1 Components of the monetary aggregates

Our definition of money is conceptually simple: a generally accepted medium

of exchange. But the task of identifying just what is and is not generally

accepted as a medium of exchange in our current society is not so simple.

This is because our economy has progressed far beyond the earliest forms of

money, where people used only cattle or cigarettes or gold coins for exchange.

You might think of currency as the most evident form of money, and indeed

there is presently a great deal of currency in circulation, but in fact most

transactions are carried out using other forms of money. As an exercise,

calculate how much currency you spent last month and how much you spent

using checks, your debit card, your credit card, or on-line transfers. Chances

are the your currency transactions are a minority of the total. Most of us

keep more money in our checking accounts than in currency. Some students

in one of the author’s classes report that they carry no cash at all, relying

on their debit cards for all purchases.

What else besides currency serves as money in our society? Checks are

used to complete a substantial number of transactions, but in fact a check is

not money, but rather an order to transfer money from the writer’s checking

account, where the money actually resides in the form of an electronic record,

to the payee – the person to whom the check is written. That person will

most likely deposit it in his checking account but could, instead, exchange

it for currency or perhaps, as we have seen, endorse it over to a third party.

Credit cards are not money but rather a means of obtaining a loan from the

bank issuing the card. Debit cards are not money either. Like checks, they

are used to e!ect a transfer from one person’s checking account to another’s.

A gold coin minted by the U.S. Mint in 1900 was once money, but it is not

now because such coins are no longer used as a medium of exchange.

Economists have devised several categories of money ranging from nar-

row to broad. The narrowest category is the most liquid; broader categories

are less liquid. No one category serves best for every kind of economic analy-

sis, and for some analyses, any category will do. The three major categories

which we shall describe the three most common classifications: the mone-


Chapter 8: Financial instruments 131

tary base, M1, and M2. Other variations on these categories are sometimes

used.2

8.1.1 The monetary base

The monetary base consists entirely of outside money – money that has

not been multiplied by entering the fractional-reserve banking system. It

consists of currency in circulation (paper notes issued by the Federal Reserve

System and coins issued by the Treasury) plus bank reserves. Bank reserves

are vault cash3 plus deposits held at the Fed by private member banks.4

Bank reserves are not really money because they do not circulate, which is

to say that they are not a medium of exchange. These assets are best thought

of as potential money. At year end 2008, the monetary base consisted of

$880 billion of currency (vault cash plus currency in circulation) plus $571

billion in bank reserves for a total of $1.3 trillion.5

There are versions of the monetary base that vary slightly in their

makeup. One of these is “money of zero maturity” or MZM. These vari-

ations are not important for our purposes.

2M3 was a category that was discontinued a few years ago, though some private indi-

viduals continue to track it. It added more assets to M2 including (1) large certificates of

deposits (face value exceeding $100,000), (2) repurchase agreements, or REPOs for short,

(3) Eurodollars, which are dollars held by U.S. residents in overseas branches of American

banks, and (4) money-market mutual fund shares held by corporations. M3 assets were

negotiable but not redeemable, and they are actively traded on secondary markets.3Vault cash is so named because at one time it consisted primarily of currency stored

in bank vaults. Nowadays banks store a great deal of currency in ATM machines, which

is where most of their customers get their cash. Vault cash is not counted in any of the

monetary aggregates since it is not in circulation.4Reserves are held at the Fed in electronic form; no paper is involved. Reserves can

also be held by foreign central banks, the Treasury, or the International Monetary Fund.

The latter categories are not important for our purposes.5Bank reserves were about $16 billion in 1950, rose as high as $37 billion in the 1980’s

and dwindled to about $9 billion in August, 2008. In September, bank reserves began

to skyrocket. This was partly in response to the Fed’s new policy of paying interest on

reserve balances but also, and perhaps mainly, due to the reluctance of the banks to lend

in uncertain times.



8.1.2 M1

The next category of money is called M1. It consists of (1) currency in cir-

culation (i.e., excluding vault cash), (2) travelers’ checks, and (3) so-called

transaction deposits. Travelers’ checks are sold to people who plan overseas

travel, and have one attractive feature which is the ability to replace them

if they are lost or stolen. Traveler’s checks that have been issued but not

yet used are counted in M1. But they have lost market share to credit cards

in recent years and therefore constitute only a very small part of M1, hav-

ing peaked at about $10 billion in the 1990’s and since dropped below $6

billion. Transaction deposits consist primarily of demand deposits (check-

ing accounts) but also include certain interest-bearing checking accounts

that, although technically not redeemable on demand, are actually directly

spendable. This minor category includes NOW accounts (“notice of with-

drawal”), an early form of interest-bearing checking account that appeared

in the 1970’s, ATS accounts (“automatic transfer service”) and Credit Union

share draft accounts, which are almost identical to bank checking accounts.

We lose very little if we streamline our definition of M1 to include just

1. Currency in circulation

2. Checking account balances

3. Travelers’ checks

Notice that M1 and the monetary base overlap since both include currency

in circulation. Reserve balances are part of the monetary base but not M1;

checking account balances are part of M1 but not the monetary base.

8.1.3 M2

The next category is M2 which includes everything in M1 and four more

items: (1) savings deposits, (2) small certificates of deposit, (3) retail money-

market mutual funds, and (4) money-market deposit accounts. Each of these

requires some explanation.

Savings deposits consist of bank passbook accounts and statement ac-

counts. In the past, people who opened savings accounts were given a little



book with blank pages called a passbook. They would take their passbook

to the bank and the teller would accept deposits or pay out withdrawal re-

quests and write the amount of the transaction and the new balance in the

passbook. Passbook accounts have all but vanished, but they remain in the

definition of M2. Statement savings accounts are like passbook accounts

except they substitute a written periodic statement to the saver instead of

a passbook.

Certificates of deposit are bank savings instruments with specified ma-

turities such as six months, one year, five years, etc. Originally, these were

represented by paper certificates, but now many savers buy them through

brokerages and hold them in their accounts without any paper document.

They are not intended to be redeemed before maturity but they usually can

be, with a penalty typically in the form of a partial loss of interest. Only

certificates of deposit in amounts of $100,000 or less are counted in M2.

$100,000 was until recently the the largest deposit that is covered by FDIC

insurance (more about which later).

Money-market mutual funds are funds run by mutual fund companies

like Vanguard or Fidelity. They accept customers’ money and use it to buy

debt instruments having maturities of 90 days or less. The term “retail”

means that they are marketed to individuals rather than to large institutions.

These funds are discussed more fully in Section 8.2.5

Money-market deposit accounts are similar to money-market mutual funds

except that they are o!ered by banks and they are insured by a federal

agency.

The common attribute of the four asset classes that M2 adds to M1 is

that they are not negotiable but are redeemable.6 Negotiability means they

can be exchanged from person to person; redeemability means the issuer

will provide outside money or a di!erent form of inside money in exchange

for the asset on demand. Thus a holder of an M2 asset can exchange it for

spendable money at any time. The fact that one can write checks on the

assets in a money market fund make them seem like spendable money but

6Even small CD’s bought through brokers are sometimes negotiable. Bid and ask prices

are available and a sale can be e!ected very quickly.



technically they are not.

The assets that M2 adds to M1 are less liquid than those in M1. Liq-

uidity, you will recall, is a term that denotes the degree to which an asset

can be exchanged at low transaction cost and at a predictable price.

As of November, 2008 the figures for these monetary aggregates were as

follows (amounts in billions):

Monetary base:

Currency $800

Reserves $571

Total $1,371

M1:

Currency: $800

Demand deposits: $410

Other checkable deposits: $300

Traveler’s checks: $6

Total $1,516

M2

Savings deposits $4,007

Small time deposits $1,350

Retail money market funds $1,054

M1 $1,516

Total $7,927

To repeat, the first two categories which together constitute bank reserves

are not really money since they are not generally accepted media of ex-

change. This could be a source of confusion since they are counted in dollars

and otherwise may give every appearance of being money. But if we are to

adhere to our definitions and categories, we should consider them potential

money, not actual money.

While the table above might seem to include every asset that could con-

ceivably be proposed as money, there are other fairly liquid assets that might

appear to be candidates for classification as money but are not. Treasury



bills trade in a very liquid market. They are available in huge quantities

and have short maturities which means that their market values fluctuate

only slightly and hence they are very liquid. But Treasury securities, while

they are highly liquid, are never considered a form of money, even in its

broadest sense.7 Likewise if you hold shares of stock that are listed on a

major exchange, you can sell them and get your money in three days, but

the price you will receive may vary a lot and you have to pay a brokerage

fees. Shares of stock are therefore even farther from money on a liquidity

scale. In summary, if you hold Treasury securities or shares of stock, they

are certainly part of your wealth and are a lot more liquid than your house

but they are still not part of your personal money stock.

Money stock figures are not easy to calculate in practice. The Fed issues

weekly estimates of the value of each of the monetary aggregates, but these

are only estimates for a variety of reasons. To calculate the monetary base,

the Fed also needs to know how much currency is in circulation (not in bank

vaults) and the levels of member bank reserve holdings at the Fed. The

latter figure is easy to come by, but currency moves in and out of bank

vaults all the time, which means that estimates must be used. To estimate

M1, the Fed needs to find the level of bank deposits, and here again money

is constantly flowing in and out of these accounts, so estimates must be

used. As we move into M2, the figures are even more di"cult to come by.

Because of all this uncertainty, the Fed issues weekly preliminary estimates

along with revised figures for previous periods.

In addition to revised figures, seasonally-adjusted figures are often is-

sued. There are certain times of year when people demand more currency –

Christmastime in particular. Sometimes it is desirable to eliminate these sea-

sonal fluctuations from the data in order to bring into better focus changes

that might be caused by other factors. This is done by computing a normal

seasonal variation and then subtracting that variation from the raw figures.

Money stock figures can be found in Barron’s, the Wall Street Jour-

nal, and numerous web sites. Note that financial publications use the term

7Yet money-market fund balances, which often invest in Treasury bills, are counted in

M2.


136 Other marketable instruments

“money supply.” We prefer the term “money stock” because “supply” im-

plies a flow instead of a stock. However, it is safe to assume that “money

stock” and “money supply” mean the same thing.

Which is the true money stock: the monetary base, M1, M2, the former

M3 or some other variety? There is no one definition that is best for all

situations. M3 is no longer available, and there was a time when a lot

of money was moving out of M1 into M2. This would have distorted any

calculations based on M1, but not M2 since M2 includes everything in M1.

So generally speaking M2 may be preferable but in many situations it doesn’t

much matter.

8.2 Other marketable instruments

There is an immense variety of loans outstanding and we cannot even list all

of the varieties. We will look at a few that are highly visible because they

have large secondary markets. They all fall into one of two broad aggregates,

money markets, with maturities of one year or less, and capital markets, with

maturities over one year. The term “money markets” is most unfortunate

because these are not markets where people “buy and sell money” as the

name might imply. To add to the confusion, money market mutual funds are

part of the “money market” but not the only part. When institutions evolve

spontaneously, they do not always produce tidy categories or terminology.

We must take extra care not to let these problems of terminology mislead

us.

8.2.1 U. S. government debt

The U.S. government is the world’s largest debtor. It issues perhaps the

best known and most widely held debt securities. These include

1. Treasury bills are issued in 90-day, 180-days and one-year maturities.

They do not issue separate interest payments but instead are issued

at a discount, and their yield to maturity takes the place of direct

interest payments. Thus if you pay 99.8 for a Treasury bill that ma-



tures in 90 days (one quarter of a year) you annualized interest rate is

approximately

4 "100 ) 99.8

100" 100% = 0.8% per annum

Treasury bills are quoted in terms of their yield (e.g., 3.26 for a note

whose discount amounts to an annualized yield to maturity of 3.26%).

2. Treasury notes, duration one to 10 years. These pay interest twice a

year.

3. Treasury bonds, duration 10 to 30 years. These also pay interest twice

per year.

4. Savings bonds. These are available in small denominations and are

not negotiable. Interest accrues over time and is paid when the bond

is cashed in. If you cash a savings bond within one year after you buy

it you will forfeit some of the interest. After you have kept it 30 years

it will stop paying interest.

Although none of these instruments is negotiable, meaning they cannot be

redeemed from the Treasury before maturity, they are quite liquid because

there is an active secondary market for bills, notes and bonds.

Individuals can easily buy Treasury securities directly from the Treasury

at a special web site, http://www.treasurydirect.gov. The Treasury will

debit the purchase price from your bank account and deposit interest pay-

ments into your account (except for Treasury Bills which are issued on a

discount basis). You can also buy them through a broker in which case

your interest payments will be added to your cash balance at the broker-

age and you will pay the broker a commission on the transaction. Treasury

securities are subject to federal income tax but are exempt from state and

local income tax. Treasury bonds and savings bonds are also available in

inflation-adjusted forms. The Treasury adjusts the principal value of the

bonds periodically in line with the Consumer Price Index. Because of this

feature, the interest these securities pay is lower than that available from

non-indexed securities.



U.S. government securities are considered extremely safe because of the

government’s taxing power and (to a lesser extent) its seignorage privilege.

But it would be an exaggeration to call them perfectly safe, as evidenced

by the fact that large institutions can buy insurance to protect a portfolio

of Treasury securities against default. The cost of this sort of insurance is

very low, but increased about sixfold during the latter half of 2008.

8.2.2 Municipal bonds

State and local governments issue debt securities collectively known as “mu-

nicipal bonds” or just “munis.” Issuers include not just municipalities as

the name would imply but also state governments, counties, school districts,

water districts, etc. These securities are exempt from federal income tax

and usually from state income tax for residents of the states in which they

are issued. There is a fairly wide variation in the quality of these issues

and there are occasional municipal bankruptcies, such as Orange County,

California in the 1990’s or the City of Vallejo, California in 2008. As in

corporate bankruptcy, holders of bonds issued by these agencies may get

some of their investment back or none.

Because of the tax exemption they o!er, muni bonds are more valuable

than a taxable bond of the same quality, coupon, and maturity. This is

especially true for high-income individuals who pay a high marginal income

tax rate. As compensation for this di!erence, muni bonds almost always

pay less interest than corporate (taxable) bonds of the same quality and

maturity. For example, a recent issue of Barron’s reports a yield on the

Dow Jones Bond Index of 6.14% versus 5.80% on the Bond Buyer Municipal

Bond Index.8

There are mutual funds that specialize in municipal bonds. They are

popular because of the expertise of their managers and the diversity of their

holdings. Most funds buy only the bonds of a single state and market them

8This spread does not fully reflect the Muni tax advantage for most buyers. For

example, someone in the 25% tax bracket would take home 75% of 6.14% on an average

corporate bond, or 4.61%. The fact that the average muni yielded 5.80% suggests that

other factors are at work, perhaps wariness about munis’ credit quality.



to residents of that state who then enjoy full exemption from state as well

as federal income tax on the dividends paid by these funds. There are even

muni money market funds – funds that buy only muni bonds due in 90 days

or less, so as to maintain a one dollar share price.

Muni bonds vary widely in quality. State and local governments can get

in local di"culty, as when the City of Vallejo, California declared bankruptcy

in 2008. Rating agencies rate muni bonds, and local governments often find

that it pays to provide purchasers of their bonds with insurance which they

can obtain from private firms, thereby raising the quality of their issues and

lowering the interest that they pay.

In theory, high-quality muni bonds should yield less than Treasury secu-

rities because interest on the latter is subject to federal income tax while the

muni bond interest is tax exempt to borrowers who live in the state where

the bond is issued. Yet such was the magnitude of the “flight to quality”

at year end 2008 that short Treasuries were paying essentially zero for the

shortest maturities out to about 3% on 20-year bonds, while munis were

yielding 4% or more.

Outstanding municipal bond securities amounted to nearly $2 trillion at

year-end 2008, with about 50,000 separate issuing agencies ranging in size

from tiny school districts to the State of California.

Nearly all state and local capital projects are financed by bond issues.

It is probably safe to say that the average voter does not think about the

interest cost of the bond issues that he votes on. Total interest payments on

a 30-year bond paying 3% per annum will add up to more than the entire

principal, meaning that projects are essentially paid for more than twice

over.

8.2.3 Government agency securities

The U.S. government is not just the economy’s biggest debtor but also one of

its largest intermediaries. There are three classes of intermediary functions

that the government engages in.

First, the Treasury sometimes subsidizes loans directly. Although out-

right loans are sometimes granted, loan guarantees are more common. For



example, the Air Transportation Stabilization Board o!ers loan guarantees

to airlines that have su!ered financial losses as a result of the terrorist at-

tacks of 9/11. No government funds were loaned; the airlines borrowed

from private banks which were assured that the government would make

good on the loans if the airlines defaulted. Loan guarantees are attractive

to politicians because they appear to o!er something for nothing. Favored

constituencies – the owners, employees, and customers of the airlines in this

case – get what they want with no immediate cost to the taxpayer. Any

possible defaults would likely occur after these politicians had left o"ce.

The liability assumed by the Treasury is called a contingent liability since

the Treasury will have to expend funds only if the beneficiary of the loan

guarantee fails to perform.

Second, there are a large number of special subsidiary agencies that bor-

row money and re-loan it for purposes that are allegedly underserved by

private markets. These are government agencies that often borrow from

the Treasury, through an intermediary bureau called the Federal Financing

Bank. Third, there are organizations called government-sponsored enter-

prises which issue stock and bonds to the public. The government does not

directly guarantee the obligations of the GSE’s but it is considered likely

that Congress would bail them out if they got into di"culty. Markets have

priced their securities to yield interest only a little higher than what ordi-

nary Treasury securities yield, and this indicates that market participants

believe that GSE securities are very nearly as secure as Treasuries.

Here are some of the major agencies and government-sponsored enter-

prises. A bit of spontaneous order has entered this picture in the form

whimsical names like Fannie Mae which evolved from nicknames used by

traders to terms used by organizations themselves.

• Mortgage credit institutions have been set up in response to the notion

that the social benefits of home ownership will not be fully realized

unless governments provide some sort of subsidy, direct or indirect, to

people who borrow money to buy homes.

– The Federal National Mortgage Association (FNMA or “Fannie



Mae”) is a former government agency which was converted to a

GSE. It borrows at low rates and uses the proceeds to acquire

mortgages. It has grown enormously and now boasts assets of $x

trillion. In addition to issuing straight bonds and stock, Fannie ???

Mae engages in elaborate hedging and derivative operations.

– The Federal Home Loan Mortgage Corporation (“Freddie Mac”)

is also a GSE that acquires mortgage loans and it has also grown

enormously, with assets approaching $x.x trillion. There have

been proposals in Congress to reduce the size of Fannie Mae and

Freddie Mac because of the enormous taxpayer bailout that might

be necessary should one of these institutions fail. The plethora

of arcane financial derivatives that they use has also generated

concerns.

– Government National Mortgage Association (GNMA or “Ginnie

Mae”) is another mortgage organization. Unlike Fannie Mae and

Freddie Mac, its securities enjoy the explicit full faith and credit

of the U. S. government, but it is not owned by stockholders as

Fannie and Freddie are.

– The Federal Housing Administration provides mortgage insur-

ance to borrowers whose credit is not good enough for conven-

tional loans.

• Institutions related to savings & loan associations and to provide in-

direct assistance to home buyers:

– Federal Home Loan Banks Financing Corporation

– Federal Housing Administration

• Several government institutions provide agricultural credit, presum-

ably because private markets under-produce loans to farmers relative

to some supposed ideal level. A more likely explanation lies in the

political power of the representatives of the agricultural states.

– Farm Credit Banks



– Farm Credit Financial Assistance Corporation.

– Federal Agricultural Mortgage Corporation (“Farmer Mae”) Oth-

ers

• Others

– Student Loan Marketing Association, a GSE that buys student

loans from the private banks that issue them.

– The Export-Import Bank provides loans and loan guarantees to

firms which export goods and services.

– The Tennessee Valley Authority issues securities to finance its

flood control, navigation, and power generation activities in the

areas around the Tennessee River.

Some of these agencies in this partial list were created during the Great

Depression. The conditions of the time may or may not have justified their

creation. Regardless of the fact that conditions have changed greatly since

that time, it seems these agencies can only grow larger over time.

The two largest government-sponsored enterprises, Fannie Mae and Fred-

die Mac, started out life as government agencies but then were privatized,

while retaining their special mission to support the housing market. The

dual loyalties of these institutions, to their stockholders on the one hand and

to their special mission on the other hand, may have been the key to their

failure. In particular, foreign holders of their debt and equity securities as-

sumed that they enjoyed the backing of the federal government even though

there was no such explicit guarantee. Fannie and Freddie spent heavily on

lobbyists and campaign contributions so as to help deflect any questions

about the lavish salaries paid to their executives or the high leverage ratios

that they employed.

In 2008 Fannie and Freddie su!ered massive losses as the housing market

began to unravel, taking down mortgage-backed securities with it. In July

Fannie and Freddie saw their stock prices fall by almost half. In response, the

Treasury announced an increase in the GSE’s line of credit at the Treasury

and other measures. These measures proved inadequate, and on September



7 of that year, the regulator of Fannie and Freddie announced his intention

to place them under a “conservatorship.” The Treasury pledged up to $100

billion for each organization in return for $1 billion in senior preferred stock

yielding 10% per annum. A cap on the size of their portfolio of mortgage-

backed securities was also imposed. The extent of future taxpayer losses, if

any, is unknown at this time. Fannie Mae stockholders, however, saw their

shears plunge to less than $1 per share from %80 in January, 2007. Preferred

stockholders fared somewhat better.

The Government National Mortgage Association was never privatized

and did not su!er from the problems that brought Fannie Mae and Freddie

Mac to grief.

8.2.4 Corporate securities

Corporate stocks (part of the capital market) are the largest single class

of financial instruments, amounting to about $10 trillion at year-end 2005.

Daily trading on the New York Stock Exchange averages well over one billion

shares, and NASDAQ turnover is even higher. While the stocks of publicly

traded companies are well known, there are thousands of corporations whose

stock is “closely held,” meaning it is not available to the public but only to

limited groups of individuals, often managers or employees of those compa-

nies. Growing companies that want additional capital can issue stock in an

initial public o!ering (IPO). This is called “going public.” The Securities

Exchange Commission which regulates stock trading in the United States

has strict rules that must be followed by companies that go public.

Corporate bonds (also part of the capital market) are another important

source of capital for corporations, with an active secondary market. In fact,

the dollar volume of daily bond trading dwarfs that of stocks. There are

two basic kinds of bonds: debentures, which are general-obligation bonds,

and mortgage bonds backed by assets such as buildings and land. A fairly

small number corporate bonds are traded on the New York Stock Exchange

and elsewhere. For historical reasons, bond prices are quoted in cents per

dollar of face value, with fractions of a cent expressed in thirty-seconds. If

you look at bond prices in the Wall Street Journal you will see numbers



like 98:30 which means the bond trades for 98 and 30/32 cents per dollar of

face value, which as a decimal is 0.98375. Thus a bond with a $10,000 face

value is quoted at 98:30 and thus is trading for $9,837.50. Stock prices were

switched from fractions to decimals a few years ago but the bond markets

have yet to follow suit, perhaps because there is much less public awareness

of bond trading as compared to stock trading.

Commercial paper (part of the money market) is a relatively new type of

financial instrument. Large corporations with good credit such as General

Electric can bypass banks and borrow money directly thus reducing their

transaction costs. Commercial paper is not backed by collateral, and paper

whose maturity is less than 270 days, they are not subject to government

regulation. Yet defaults or other problems were very rare in this market

prior to the crisis of 2008, when the Fed stepped in to buy up distressed

commercial paper.

Bankers’ acceptances (part of the money market) are bank-guaranteed

bills of exchange. A banker’s acceptance is simply a piece of paper that

announces the bank’s willingness to guarantee a debt instrument of a busi-

ness firm. Banker’s acceptances are actively traded and are widely held by

money market funds. They are a contingent liability of the bank that issues

them.

Mortgage-backed securities are a relatively new development. Mortgages

are not very marketable since they represent such a wide variety of properties

and borrowers. This provides a strong incentive to securitize these assets.

Nowadays if you take out a mortgage, chances are it will be securitized, which

means it will be purchased from the institution that created the mortgage

and bundled with other mortgages into a fund that is financed by issuing

shares, i.e., securitized. Government guarantees are an additional advantage

of mortgage-backed securities.

8.2.5 Money market mutual funds

Money-market mutual funds are a central feature in today’s financial land-

scape, amounting to some $3.4 trillion in mid-2008 before declining. An

addition, they provide an interesting chapter in the history of money and



banking.

Money market mutual funds (MMMF) appeared in the U.S. financial

world around 1970, a time when interest rates were rising but Regulation Q

prevented banks from o!ering competitive rates on savings accounts. At the

same time, the Treasury raised its minimum for purchase of Treasury Bills

from $1,000 to $10,000, putting them out of reach of small savers. Clever

entrepreneurs stepped into this breach and invented money market funds

which had several new and attractive features. They o!ered rates of return

comparable other short-term rates, a high degree of safety, low minimum

balances, and most importantly, a constant one-dollar share price. Most

funds later added check-writing privileges, usually with a minimum amount

like $100 or $250, intended to limit the expense associated with clearing

many small checks. E"cient and a!ordable computer systems enabled the

operators of successful funds to meet expenses and clear a profit by charging

shareholders a fraction of one percent of their fund balances. These charges

were not levied directly, but were subtracted from the fund’s income prior

to distributions to shareholders. Technically, shareholders were owners of

equity stakes in a mutual fund, but for all practical purposes, and mainly

because of the constant one-dollar share price, the check-writing privilege,

and in recent years, online transfer privileges, they began to view these

balances as part of their personal money stock. Indeed, small money-market

fund balances were added to the definition of the M2.

How is it that MMMF share prices are kept at exactly $1.00; no more,

no less? The answer lies in the short maturity of the instruments that

MMMF’s hold. The value of such a security, which could be commercial

paper, Treasury Bills, or municipal securities such as revenue anticipation

notes, depends on two things (assuming unchanging risk): their maturity

and the prevailing short-term interest rate. Short term securities are issued

in discount form, meaning that purchasers buy the security at a discount

from par. Thus if you buy a $10,000 3-month Treasury bill for a quoted

price of 99.6, you pay $9,960 and the $10,000 you receive three months later

consists of your $9,960 principal plus $40 representing interest. The rate of

interest is thus $40 divided by $9,960, multiplied by four to make an annual



rate of 4 " ($40/$9, 960) " 100% = 1.61 percent per annum.

The value of an instrument with a short maturity is dominated by the

time remaining to maturity. Its value almost inexorably rises daily as ma-

turity approaches, barring a sharp overnight jump in interest rates. Specif-

ically, suppose a $10,000 discount instrument has 30 days to maturity in

an environment where the short term interest rate is i = 3.0 percent per

annum. Its market value is

PV =FV

(1 + i)n/365=

$10, 000

(1 + 0.03)30/365= $9, 975.73

This security’s value will march in nearly a straight line toward $10,000. But

suppose the short-term rate of interest jumps from 3% to 3.5% overnight.

The next day’s value will be

PV =$10, 000

(1 + 0.035)29/365= $9, 972.70

This would be a problem because of the way MMMF’s keep their share price

at $1.00 They do so by computing the value of their holdings at the close of

business each day and crediting the increase to the shareholders in the form

of additional shares. Thus if a fund has ten million shareholders and the

market value of its holdings has increased from $10,000,000 to $10,001,000

overnight, it will credit 1,000 new shares to its shareholders. Although new

shares are issued nightly, they are not typically not reported until a monthly

statement issued or the account is closed. An overnight drop as illustrated

above would be a problem because technically the funds cannot take shares

away from shareholders. But because such an event is exceedingly unlikely

and because management would very likely step in to cover such a temporary

loss, it is essentially a non-issue.

The failure of a MMMF to maintain a one-dollar share price is called

“breaking the buck.” During the entire history of MMMF’s, there had been

only one instance of breaking the buck until 2008 when a second instance

occurred. Most MMMF’s are managed by large firms that o!er a range

of mutual funds, ETF’s, and other financial products. Breaking the buck

would be a severe blow to the reputation of such firms, perhaps because



many MMMF shareholders are at best dimly aware that they are equity

investors in a fund whose fortunes can rise and fall. Therefore, firms will

absorb losses in their MMMF for some period of time in order to avoid

breaking the buck.

The Reserve Primary Fund held short-term securities issued by Lehman

Bros. Holdings, whose September 2008 bankruptcy caused the market for

those securities to dry up, whereupon the Reserve Fund marked their value

to zero on their books. One of this firm’s MMMF’s dropped to 97 cents on

the dollar, and the firm imposed a seven-day waiting period for redemptions.

Another stood at 91 cents on the dollar – hardly a catastrophic loss at a time

when the stock market averages were dropping by larger larger percentages

in one day.

Perhaps the biggest threat to MMMF’s is sustained ultra-low interest

rates, such as those that prevailed at the end of 2008. For example, in early

January the yield on Schwab’s $34 billion Treasury Money Market fund

had sunk to an astonishing 0.02% after operating expensese of 0.6% were

deducted.9 The yield was sure to drop because with an average duration of

55 days, the fund’s portfolio didn’t yet reflect the recent drop in Treasury

rates to essentially zero. This left Schwab with a choice of waiving fees,

which would cut into its earnings, or phasing out the fund.

All money market funds share the structure outlined above but within

those confines there are several varieties. Most invest in a mix of corpo-

rate and government securities, typically commercial paper and short-term

notes. Others invest solely in U.S. Treasury securities, and their sharehold-

ers are exempt from state income taxes on the dividends they receive. Sill

others invest in short-term municipal securities and their shareholders enjoy

exemption from both state and federal income tax10

In Chapter 6 we discussed the phenomenon of bank runs. We might

ask whether MMMF’s are run-proof. They certainly are not subject to the

first-come-first-serve aspect of a classic bank run, wherein those first in line

may get all their bank deposits converted to cash, leaving others to get little

9Wall Street Journal, Jan. 15, 200910Provided the reside in the state where the securities are issued.


148 Present value and yield to maturity

or none. In the case of a MMMF failure, all shareholders would receive the

same percentage of their funds, e.g., 92 cents per dollar invested.

Still, a run on a particular MMMF or all funds as a whole could pro-

duce a great deal of distress as funds rushed to dump securities in order to

meet redemptions. In fact, in September 2008, the the failure of the Re-

serve Primary funds to maintain their $1.00 share price, the Lehman Bros.

bankruptcy, along with general market unrest led many investors, including

one of your authors, to move their MMMF fund assets either to insured

bank accounts or to MMMF that invest solely in Treasury securities. In

response, the Treasury announced it would guarantee most money market

funds against losses up to $50 billion for a period of one year. It is likely

that this guarantee will be extended after the year is up.

8.3 Present value and yield to maturity

We have said that the market value of a debt instrument varies inversely with

market interest rates. Why is this? Suppose you buy a $10,000 bond that is

due in five years and pays interest at a rate of 5% per annum, the prevailing

rate when you buy it. Let us say it pays $500 in interest at the end of each

year. You hold on to the bond for two years, happily collecting your $500

interest payments, but then decide to sell it rather than wait three more

years for it to mature. You then discover that the market rate of interest

for such bonds has risen to 6%. No one will buy your 5% bond when they

can get a 6% bond with the same credit quality on the market, maturing in

three years, unless you o!er the bond at a discount price – something less

than $10,000. That lower price is called the discounted present value of the

bond, and it gives your bond a yield to maturity that makes it competitive

with comparable new bonds.

How do we calculate present value and yield to maturity? Suppose you

invest $100 at 5% for a year. At the end of the year you get $105 and you

reinvest that at 5% for another year, after which you get (1 + .05)" $105 =

$110.25. One more year like that, and you have (1+.05)"$110.25 = $115.76.

If we call the initial $100 the present value (PV ) and the final value after n



years the future value (FV ), the relationship is

PV =FV

(1 + i)nor FV = PV (1 + i)n

where the interest i must of course be a decimal value. Thus for a $100

three-year loan or bond at 5%,

FV = $100 " 1.053 = $115.76

We have assumed that the interest for each year is not paid until the

end of the year. Suppose instead of 5% paid annually, you get paid 2.5%

twice a year? This is called semi-annual compounding and we use the same

formula but set i = 0025 and n = 6 for six 6-month periods instead of n = 3

for three years:

FV = $100 " 1.0256 = $115.97

Compounding weekly (52 weeks per year) the return would be

FV = $100 " (1 + .05/52)3!52 = $116.18

These di!erences are trivial in today’s low interest rate environment, but in

1980 when interest rates were approaching 15%, banks o!ered more frequent

compounding to be competitive.11

The yield to maturity of a bond or other debt instrument is important

when its market value has risen or fallen. Yield to maturity reflects both

the stream of future interest payments and the rise or fall in the value of

the bond as it reaches maturity. In the example above, suppose our $10,000

5% bond has three years to run but market rates of interest for bonds of

this duration and quality are now 6%. What market value for this bond will

make its yield to maturity equal 6%? We calculate the present value of the

three remaining interest payments plus the present value of the principal,

using not the 5% bond coupon but the 6% prevailing rate:

PV =$500

1.06+

$500

1.062+

$500

1.063+

$10, 000

1.063= $9, 632.70

11The limiting case is called continuous compounding for which the formula is FV =

PV " ein where e is the base of natural logarithms. $100 # e0.05!3 = $116.183


150 Present value and yield to maturity

So the bond should sell for something close to $9,632. If you repeat this

calculation using a 4% going rate of interest you should come up with a

present value that is greater than $10,000.

Mortgage loans are structured somewhat di!erently than bonds. While

they typically have a fixed maturity date, conventional mortgages have a

fixed monthly payment which is part interest and part principal. The pay-

ments are computed so that after the last monthly payment has been made

(the 360th on a 30-year loan), the principal has been reduced exactly to

zero. Applying the present-value formula to a stream of 360 fixed monthly

payments P, we would have a loan value of

LV =P

(1 + i/12)+

P

(1 + i/12)2+

P

(1 + i/12)3+ · · · +

P

(1 + i/12)360

where we have used i/12 in the denominators because we need a monthly

interest rate. If we know FV , PV , and n and wish to solve for the interest

rate i we have a di"cult problem which can only be solved numerically.

Many calculators have this function built in, as do spreadsheet programs.

We have seen how a bond’s market value is related to the spread between

its coupon interest rate and the prevailing market rate for bonds of the same

maturity and quality. If the market rate rises above the bond’s coupon rate,

its value falls, and vice versa. The rise or fall brings the bond’s yield to

maturity closer to the prevailing interest rate. Bonds with longer maturity

are more sensitive to interest rate fluctuations than those of shorter maturity.

The table below shows what happens to the market price of various 5% bonds

of equal quality but varying maturities as interest rates rise to 6% and then

10%.

Market price of a hypothetical 5% bond

Market rate

Maturity 5% 6% 10%

1 yr $10,000 $9,906 $9,545

5 yr $10,000 $9,579 $8,105

10 yr $10,000 $9,264 $6,928

30 yr $10,000 $8,624 $5,287



As you can see, the 30-year bond declines very steeply as the market interest

rate rises and the one-year bond is not very sensitive at all. In fact, a rise of

the market interest rate from 5% to 10% has knocked almost half the value

o! a 30-year bond. Why is this? The total return from a 30-year bond is

made up mostly of interest payments so its present value is very sensitive to

interest fluctuations. Such extreme price fluctuations can be a problem for

people who are risk-averse but they are an opportunity for people who want

to speculate on changes in interest rates. In contrast, a one-year bond’s

return consists primarily of principal so it is not much a!ected by interest

fluctuations.

Consider again the present value of a steam of interest payments, leaving

aside the present value of the principal. Assuming a constant annual interest

payment P , what happens to the present value of the stream of payments

as the maturity of the bond increases? It goes up, obviously. What if

the payments extend to infinity? Such bonds actually exist, though they

are now rare. They are called perpetual bonds or consols.12 If the bond

matures in N years with annual interest i, we can write the present value of

the payment stream as

PVN =N!

n=1

P

(1 + i)n

Now let N become infinitely large. Doesn’t the sum of an infinite number

of terms have to be infinite? No, this is one of many infinite series that

converges to a finite value which is easily shown to be

PV" ="!

n=1

P

(1 + i)n=

P

i

This table shows present values of a stream of 5% annual interest payments

for varying numbers of years:

12Consols were first issued in 1751 in England by Henry Pelham’s Whig government.

They got their name from the fact that they were used to em consolidate a number of

previous bond issues.


152 Risk and maturity factors

N PVN

10 $1,840.02

20 $2,867.48

50 $3,940.47

100 $4,154,39

* $4,166.67

8.4 Risk and maturity factors

The price of a bond depends on two other factors which we have not yet

considered. First is its quality, reflecting estimates as to how likely the bond

issuer is to pay the principal back when it comes due, or conversely to default

on it. A company that defaults on its bonds is in very serious trouble, much

more so than if it ceases paying dividends to stockholders or if its stock price

drops a lot. Bankruptcy is often the next step for such companies.

At year-end 2008, for example, the Bank of America bond due Dec. 1,

2017, with a coupon interest rate of 5.75%, was trading at 57 for a current

yield of 15.8%, a reflection of the di"culties in which this bank found itself

at that time. The Wells Fargo 6.45 of Feb. 1, 2011, in contrast, was priced

above par at 104.597, yield 4.085%, reflecting not only Wells Fargo’s sounder

condition but also the short maturity of that bond.

Bond investors typically do not have the time or expertise to evaluate a

company’s financial soundness and so they rely on experts. Two prominent

bond-rating firms in the U.S. are Moody’s and Standard & Poors. They

each have ratings systems that identify the credit quality of bond issuers

as shown below. The lower grades, labeled “not investment quality,” are

commonly called “junk bonds.” Some institutions are not allowed to invest

in junk bonds or avoid them as a matter of policy. On the other hand,

some funds specialize in junk bonds. They try to pick junk bonds that they

consider undervalued and they diversity into a wide range of issues so that

they can sustain default by a small number without excessive adverse e!ects

on their overall portfolio. Of course, the reward they seek for themselves

and their investors is high income and manageable risk.



Moody’s Standard & Poor’s

Highest quality Aaa AAA

High quality Aa AA Investment

Upper medium A-1, A A Grade

Medium Baa-1, Baa BBB

Speculative Ba BB Not

Highly speculative B, Caa B, CC, CCC investment

Default Ca, C D grade

In 2008 these organizations came under fire for some questionable ratings

and for allegedly improper relationships with some of the institutions they

were evaluating.


154 Risk and maturity factors


Chapter 9

Financial institutions

Savers are very di!erent in terms of time preference, risk preference or aver-

sion, income, wealth, age, etc. In response to the wide variety of savers’

needs, financial entrepreneurs have developed a vast array of financial ser-

vices, institutions, and markets. As in markets generally, innovators have

devised products that no one anticipated, such as money markets or junk

bonds, but which found favor with investors once they became known. We

will take a broad look at the categories of institutions that server savers and

investors.

9.1 Brokers, dealers and underwriters

A financial broker is a person or firm who matches buyers and sellers of

financial instruments (mainly stocks and bonds) but does not take title to

either the funds or the securities being traded. Brokers operate in many

other markets: real estate, scrap iron, truck transportation – even marriage

brokers! None of them take title to the goods or services that they broker.

A financial dealer is a person or firm which acquires an inventory of

stocks or bonds or other financial assets for resale to or on behalf of its

customers. There are also dealers in used cars, oriental rugs, and antique

furniture. Dealers purchase their inventory and o!er it for sale to their

customers.

155

156 Brokers, dealers and underwriters

While the conceptual distinction between these two kinds of financial

institutions is clear, many financial firms o!er both brokerage and dealership

functions as we shall see.

Stockbrokers are a well-known class of brokers. Individual stockbrokers

work for stock brokerage firms such as Merrill Lynch or Charles Schwab.

Stock brokerage firms conduct their business mainly through stock exchanges.

All major brokerage firms are members of the New York Stock Exchange

and other exchanges. Fifty years ago, most stock trades were conducted on

the floor of the New York Stock Exchange with lesser exchanges operating

in Boston, Philadelphia, Cincinnati, San Francisco and elsewhere. These

were bustling trading floors where most trades were conducted face-to-face.

The New York Stock Exchange still conducts some trading on its floor in

its iconic lower Manhattan headquarters building, but much of the volume

has moved to its electronic operations. Specialists were stationed at posts

around the floor and were responsible for completing trades and maintaining

an inventory of shares to help maintain orderly markets (Figure 9.1). Trades

in many minor stocks were handled by brokers contacting other brokers by

telephone in what was called the “over-the-counter” market. The former

American Stock Exchange was acquired by the NYSE and renamed “NYSE

Alternext.” NASDAQ is an all-electronic trading operation that evolved out

of the old over-the-counter market.1 At one time, it was a mark of distinction

for a corporation to have its shares listed on the NYSE, while over-the-

counter issues were largely small and speculative and therefore somewhat

suspect. But now some major corporations such as Microsoft and Intel

retain their NASDAQ listings.

1The NASDAQ exchange was once known as an “over-the-counter” operation. It was an

association of firms which handled the stock of companies too small to be listed on the New

York or other exchanges. Transactions were conducted by telephone until the 1970’s, when

a computerized system called the National Association of Securities Dealers Automated

Quotation System (NASDAQ) was implemented. This evolved into the present-day highly

sophisticated exchange which essentially lives in cyber-space, and to the average investor,

appears to function just like the older exchanges. As this is written, the New York Stock

Exchange is moving more into electronic trading, and its floor operations may some day

be discontinued.


Chapter 9: Financial institutions 157

Figure 9.1: Traders on the floor of the New York Stock Exchange

Specialist members of the exchanges act as dealers for the stockbrokers,

and each of them handles the shares of only a few firms. Specialists are

dealers because they hold inventories of the stocks in which they specialize,

and their income is derived from the spread between the price at which they

o!er to buy shares and the price at which they o!er to sell them. These

prices are known as the bid and ask prices. For example, the specialist in

IBM stock may ask $83.17 and bid $83.02 at a particular moment. However,

stockbrokerage firms often hold stocks for their own account which they may

trade with their customers, thereby assuming some market risk. When the

do so, they are acting as dealers rather than brokers

Deregulation has allowed banks to establish stock brokerage operations

in recent years, and some mutual fund companies such as Fidelity and Van-

guard have established brokerage operations. But at this time the market

is still dominated by large firms such as Merrill Lynch and Charles Schwab.

Practically all brokerage firms let their customers trade through their in-

ternet web sites, and some are on-line only. Not only do they o!er nearly

instant execution of trades, but they also o!er access to vast quantities of


158 Brokers, dealers and underwriters

investment information, and at much lower prices than in past years.

Primary financial markets are markets where newly issued instruments

are sold to investors. Secondary markets are markets where investors trade

existing instruments among themselves. Brokers and dealers are part of the

secondary market. Firms that participate in primary markets are called

underwriters.2 A single firm may have a brokerage division as well as an

underwriting division.

Underwriting is the process by which investment bankers raise invest-

ment capital from investors on behalf of firms issuing securities, either eq-

uity or debt (shares of stock or bonds). Underwriters also handle muni

bond issues. (The term “underwriter” originally referred to the provision

of insurance. Supposedly each risk-taker would write his name under the

total amount of risk that he was willing to accept.) Modern underwriters

advise firms on issuance of new securities and find buyers for their securities.

For large issues, underwriters usually form syndicates (groups of underwrit-

ers), in which each member firm assumes the responsibility and the risk of

marketing its specific allotment of shares. So while they are best classified

as brokers – matching buyers and sellers – underwriters as risk-takers have

some of the attributes of dealers. Major underwriting firms include Goldman

Sachs, Smith Barney (now being sold o! by Citigroup), Morgan Stanley, and

the recently bankrupted Lehman Brothers. These firms are commonly called

investment banks and their business is often called “investment banking” in-

stead of underwriting. This is unfortunate terminology since these firms are

not banks in the sense in which we use the term. They do not engage in in-

direct finance and they do not issue financial instruments of their own, these

being the essential economic attributes of banks. Underwriters are called

investment banks partly because at one time banks had departments that

provided underwriting services, and in many countries they still do. During

the Great Depression, the U.S. government forced banks to divest them-

selves of their underwriting operations. During the crisis of 2008 Lehman

2This term stems from the early days of insurance underwriting in England, where the

terms of a policy were written up and then insurers wishing to participate would write

their names under the description.



Brothers was allowed to fail and other investment banks were allowed to

convert to deposit banks.

Just as banks have been allowed to start brokerage operations, stock-

brokers can now o!er most of the services of banks. For example, Charles

Schwab owns a bank that issues insured deposits and o!ers mortgages and

other loans. Schwab also issues credit cards, runs money market funds, and

provides cash withdrawals from ATM’s. Wells Fargo is an example of a

bank which has expanded into brokerage and insurance. These two firms

have almost completely overlapped each other’s markets. Notwithstanding

all this expansion, we must bear in mind the conceptual di!erence between

dealers and brokers.

9.2 Depository Institutions

and Pure Intermediaries

Intermediary institutions are classified as “pure” intermediaries and depos-

itory institutions.3 Pure intermediaries include insurance companies (life,

property, and casualty), private pension funds, and state and local govern-

ment pension funds. Insurance companies collect premiums on the policies

they write and invest the proceeds in portfolios of stocks, bonds, real es-

tate, etc. They draw on these funds when their customers present claims for

insured losses. Pension funds invest in the same sort of assets for the ben-

efit of retired employees to whom they have guaranteed certain retirement

benefits.

Depository institutions consist of banks, savings and loan institutions,

savings banks, and credit unions. At present, all of these institutions per-

form basically the same functions and their names and legal constitutions

are largely accidents of history. Savings and loan associations were origi-

nally set up to provide mortgages to individuals who wanted to buy homes.

Many of these were mutual associations, meaning they were owned by their

3Although these functions are often combined in a single firm, it is important to keep

them conceptually separated, so we will assume firms perform purely one function or the

other.


160 Depository Institutions and Pure Intermediaries

customers. Savings banks were generally mutual organizations of depositors

and borrowers in a local region. The savings and loan crisis of the 1980’s

eliminated many S&L’s.

Credit unions provide many of the retail services that commercial banks

o!er, but only people who belong to some a"nity group – such as employ-

ees of a particular company – may become customers (“members”). There

are two points of view regarding credit unions. A “public interest” point

of view is represented by statements on the National Credit Union Associa-

tion’s web site. “Where people are worth more than money” is an economi-

cally meaningless statement, as is “a person’s desire to repay (character) is

considered more important than the ability (income) to repay.” A “public

choice” point of view would stress the exemption from income taxes enjoyed

by credit unions.

Mutual funds are aggregations of savers’ funds that are used to buy

stocks and bonds. The benefits of aggregation include diversification and

expert management. People who buy stocks as investments should not put

all their money in the stock of a single company but should spread the risk

over several stocks. This is hard for small savers to do, but they can buy

a small number of shares in a well-diversified mutual fund. Customers also

benefit from the expertise of the fund managers and the research information

which they have available. Fidelity and Vanguard are two such firms, each

o!ering dozens of mutual funds.

The net asset value of a single mutual fund share is equal to the total

value of the fund’s holdings divided by the number of shares outstanding.

Mutual funds are classified as open-end and closed-end. Open-end funds

stand ready to sell new shares and redeem existing ones on demand. For

this reason, the price of the shares is exactly the same as the net asset

value. Open-end funds can be purchased through brokers and banks or

directly from the fund companies that issue them. Closed-end funds issue a

certain number of shares initially but do not issue further shares. Someone

who wants to acquire shares of a closed-end fund must buy them from an

existing owner of shares. Many closed-end funds are listed on the stock

exchanges. Because closed-end funds do not generally issue new shares,



gaps usually open between their net asset value per share and their market

value per share. That is, the shares either trade and a premium or a discount

to their net asset value. Premiums and discounts reflect market judgments

of the future values of the fund’s holdings, and these spreads can get as high

as 25%; 10% one way or the other is not unusual.

Exchange-traded funds are very much like closed-end mutual funds, ex-

cept that ETFs typically buy a fixed basket of assets, such as those included

in the Standard & Poors 500 Index. Initially ETFs were focused on common

stocks but a vast array of new ETFs have arisen to track specific industries,

commodities, foreign securities, etc. Like closed-end mutual funds, ETFs do

not issue new shares in small amounts, but they do issue “creation units,”

large blocks of shares, to insititutional investors who wish to acquire them.

Recently, regulators authorized actively managed ETFs, all but eliminat-

ing the distinction between ETFs and closed-end mutual funds. ETF’s now

outnumber closed-end funds.

Real estate investment trusts (REIT) were formed for the purpose of

providing some of the tax advantages of real estate investing to small savers,

whereas before only wealthy investors could enjoy these benefits. Unlike

corporations, REITs can only hold real property (apartments, commercial

buildings, and retail buildings) or mortgages. They pay no corporate income

tax provided they distribute most of their income to shareholders.

We have already discussed money-market mutual funds which buy short-

term debt instruments, keep their share price at $1, and o!er conveniences

like check-writing and on-line transfers.

Yet another class of financial firms are those that provide consumer fi-

nancing such as car loans or personal loans. Household Finance Corporation

is one of the largest such companies. Firms have also been set up to provide

working capital to small start-up companies. Allied Capital is such a firm,

making loans to hundreds of small businesses and paying high dividends to

its shareholders.

Depository institutions are distinct from other financial institutions in

three important ways. Of course, depositories accept deposits, but what

are deposits and how do they di!er from other financial instruments? They


162 Depository Institutions and Pure Intermediaries

are short-term debt instruments which are available on demand at a fixed

nominal value – they are redeemable on demand. What about money market

funds? They look a lot like deposits because they are, at least de facto,

redeemable on demand. But technically, money market shares are equity,

not debt. Here is a case where the distinction between debt and equity has

become quite blurred.

Secondly, deposits are important because they are a form of money sub-

stitutes (inside money). As we have seen, the money supply is increased

or decreased when depository institutions gain or lose money. What about

money market funds? Retail MMMF assets are counted in the M2 money

supply, so their expansion or contraction also e!ects M2. Here again, we

have a blurring between the deposits of banks and the shares of money-

market funds which technically are equity shares.

Finally, bank deposits are insured by the Federal Deposit Insurance Cor-

poration, an agency of the federal government. Government regulators also

require a minimum level of reserves to back bank deposits. Money market

funds are usually not insured nor are they subject to reserve requirements.

Credit unions have their own government deposit insurance agency, though

recently a few Credit Unions, interestingly, have chosen to switch their busi-

ness to a private deposit insurance company. Investments held by stockbro-

kers are insured by the Securities Investors Protection Corporation. This

insurance only provides protection against fraud or misappropriation, not

against loss of investment value. Private pension funds are backed by the

Pension Benefit Guaranty Corporation, another government agency. In 2004

and 2005 there were some prominent corporate bankruptcies that allowed

private corporations to unload their pension obligations onto the PBGC.


Chapter 10

Market Determination of

Interest Rates

Now that we know something of the components of the financial system

– instruments and institutions – we can take a more detailed look at the

interest markets they create and the variety of interest rates that are found

on those markets. Recall that we have described interest in its most general

sense as an incentive that must be o!ered to induce someone to forgo present

consumption in exchange for future consumption. Time preference is the

basic fact of human existence that gives rise to interest.

We want to focus on interest rates that are determined by competitive

buying and selling of securities in markets. Although our analysis will refer

to bonds and interest, it is meant to encompass equities and dividends as

well. Savers enter these markets with funds ready to purchase securities and

borrowers enter with securities to o!er. Supply and demand analysis works

in these markets in just as in markets for ordinary commodities with slight

di!erences.

10.1 The Loanable Funds Market

Consider an abstract market for securities of unspecified type. These could

be commercial or government bonds or bills, commercial paper, or even

163

164 The Loanable Funds Market

shares of stock. We amalgamate all these into a single abstract category

in order to to a first-level analysis of the supply and demand forces that

determine interest rates.

We might be tempted to draw demand and supply diagrams relating the

quantity of those securities to their price. But we will defer that approach

for a moment and instead reverse the point of view and look at the demand

and supply of the savings coming into the market in search of securities to

purchase. We call these savings “loanable funds” – funds ready to be used

to purchase securities. While we should have no problem identifying the

dollar amount of funds o!ered (in a particular time period) as the quantity

variable, what would be the price of those funds? The answer lies in the

definition of interest. Just as 50 cents in cash may induce me to part with

my apple, 5% annual interest may induce me to part with $1,000 of my

savings for a year. Interest is the price of loanable funds.

(Note that financial publications often refer to interest as “the price of

money.” The money they are talking about is money to be invested – what

we call loanable funds – and so for their purposes that phrase is satisfactory.

But it would be entirely unsatisfactory for us because our definition of money

is so much broader. We will insist on identifying interest as the price of

loanable funds and avoid the phrase “price of money.”)

Supply and demand curves for loanable funds are shown in Figure 10.1.

The downward-sloping demand curve indicates that people will want to bor-

row more as interest rates decline, other things being equal. The upward-

sloping supply curve indicates that people will be more willing to loan more

as the interest rate rises, other things being equal. The intersection marks

an equilibrium quantity of funds supplied and the interest rate at which they

are supplied.

Bear in mind that the quantity axis on this graph represents flows, i.e.

quantities per unit time. Interest is expressed in percent per annum. Quan-

tities of loanable funds are the dollars flowing through this market in any

convenient time period: typically months, quarters or years.

We must sound several notes of caution. First, like all supply and de-

mand curves, ours are purely notional. We know which way they slope and


Chapter 10: Market Determination of Interest Rates 165

Loanable funds

Inte

rest

rate S

D

Figure 10.1: Supply and demand of loanable funds.

we know from observation (or can imagine knowing) where they intersect,

but we have no grounds to attempt precise descriptions of the curves them-

selves. Second, there are many other influences on the supply and demand

for loanable funds that are exogenous to this picture – they are assumed

to remain unchanged so that we can isolate the interaction between price

(interest rate) and quantity. While that is a legitimate and useful tactic,

we must not lose sight of all the other hidden variables that influence in-

terest rates. Among these might be price inflation, changes in tax laws,

or increased wealth. Also, we have seen that credit quality and maturity

are major determinants of interest rates, but rather than treating these as

exogenous to a single supply/demand graph we would segment the mar-

ket for loanable funds into many markets, each representing a particular

combination of maturity and quality.

The loanable funds approach may seem counter-intuitive. We could

turn the market for apples upside down and look at the supply of apple-

purchasing funds in terms of the price that those funds command, which

would be the number of apples per dollar. Then the supply of loanable

funds would become the demand for bonds and vice versa. This is a le-

gitimate approach which some authors follow, but we adopt the loanable



funds point of view because we are trying to explain how interest rates are

determined by market forces and a loanable funds diagram shows interest

rates explicitly on the vertical axis. With loanable funds diagram in front of

us we can imagine how changes in exogenous variables shift the curves and

move the equilibrium point. An increase in the demand for loanable funds,

when more people want to borrow, would shift the demand curve to the

right, resulting in more loans at a higher interest rate. More savers o!ering

their funds will shift the supply curve to the right, resulting in more loans

at a lower interest rate.

Of course, this analysis leaves unanswered the question of what causes

shifts in the demand for money. We will have more to say about that in

later chapters. We will also examine the supply of money under a fiat money

regime such as we have now as well as a free banking regime.

If we bear in mind that interest arises from time preference we see in-

terest not just in the loanable funds market but in almost any economic

activity that spans a significant amount of time. Think of capital goods:

goods capable of producing consumption goods in the future. The prices of

those capital goods that require the most time to bear results will be most

sensitive to interest rates. Stated di!erently, if people in the aggregate are

highly oriented to the present, they will strongly prefer consumption and

will require high interest to persuade them to save. The prices of durable

consumer goods which mete out their services over a long span of time are

also interest-sensitive. Another example would be the relationship between

the sale price and the rental price of a house.

The tendency of the loanable funds market to move toward equilibrium,

but never reaching it because of ever-changing circumstances, is no di!erent

from the function of other free markets. Lenders seek the highest returns for

their funds consistent with their time horizon and risk tolerance. Borrowers

seek low rates. When a temporary shortage of loanable funds arises, a rise

in interest rates induces lenders to lend who were not quite willing to lend at

the old rates. Conversely, borrowers who were only marginally interested in

borrowing leave the market. These responses tend to eliminate the shortage.

The concept of profit can be a source of confusion. This is especially true



in a sole proprietorship. If you go into business buying apples at wholesale

and selling them at retail, you may be happy when you have sold enough

to pay the cost of the apples plus expenses. But you are not yet earning

profit, not until you have paid yourself the going wage for apple-sellers. Any

income left after paying yourself that wage is profit.

Accountants, business people, and the income tax authorities all regard

profits as the residual after all expenses have been paid, whether for la-

bor, materials, or depreciation of capital assets. Economists view profits

somewhat di!erently. Economists define profits (or losses) as the residual

after all opportunity costs have been subtracted from income. Economists

include the interest that could have been earned on the capital invested in

the business. This is called pure profit or economic profit as distinguished

from accounting profit. Pure profit is always less than accounting profit.

If firms are earning positive pure profits (economic profits) in a particu-

lar market, competitors are drawn in and prices drop, driving those profits

toward zero, assuming there are no disruptions such as new technology. Of

course, the opposite is true if firms are su!ering negative pure profits (losses),

in which case firms will shift production to other goods, prices will rise, and

pure profits will rise to zero, which is the same as saying that accounting

profits will tend toward the going rate of interest. If you ponder this fact you

may be struck with the harshness of competitive markets. Even the most

successful firms must constantly battle the market’s relentless gravitational

downward pull on their profits. Of course, this imaginary state where all

profits have vanished, where all markets are at equilibrium, and all plans

are perfectly coordinated – this so-called evenly rotating economy – never

comes about. We live in a world of constant change o!ering new profit op-

portunities to those alert entrepreneurs who can devise the best adaptations

to changing conditions. But only temporary profit opportunities!

Profits are essential to the functioning of markets as are losses. Losses

are less evident because those who su!er sustained losses must leave the

market relinquish control to entrepreneurs who are more skillful or luckier.

Interest, by contrast does not go to zero. Interest, unlike profits, is not

dissipated by competition: it is permanent. Why? Because time flows one



way, so time preference is one way, and interest derives from time preference.

Saving requires that we forgo present consumption for the sake of in-

creased consumption. When we save money and loan it out, who gets the

present consumption that we forgo? In the case of a consumer loan, the bor-

rower gets the present consumption. You loan your brother-in-law money to

buy a Chevy which he pays you back after five years, plus interest. You take

the money and buy a Cadillac and park it next to his five-year-old Chevy.

It is convenient to subtract consumer loans from total lending in order to

study the connection between saving and investment.

In the case of business investment, it is not so obvious who gets the

present consumption that you as a lender forgo. So let us trace it through.

You buy a life insurance policy for $5,000. The life insurance company,

if we neglect expenses, buys a $5,000 corporate bond. The bond issuing

company buys $5,000 worth of capital goods – machine tools, for example.

The machine tool manufacturer pays its workers $2,500 and its suppliers

$2,500. The suppliers pay for materials and labor. And so on with their

suppliers. Ultimately, most of the money goes to workers who use their

wages for present consumption. Some goes to owners as profits and they

consume those profits. Of course, workers and stockholders could invest

part of their income in which case we would further trace their savings and

ultimately find workers and owners consuming, bearing in mind that the

end purpose of all production is consumption.

A key aspect of this little analysis is the fact that workers are paid at the

conclusion of each work period, typically two weeks or half a month. But

the owners must wait until the goods are sold before receiving any income.

If workers were willing to wait for their pay until the goods had been sold,

there would be no need for a capitalist to provide savings because the workers

would have done so and they would earn the interest. Of course, workers who

are so inclined can often buy stock in the company they work for. However,

financial advisors discourage too much of this since if the company fails, a

worker who has substantial savings invested in company stock will not only

lose his job but those savings as well. Many Enron employees bought stock,

having been encouraged to do so by management just months ahead of the



company’s collapse, and su!ered this way.

10.2 Real and Nominal Interest Rates

Having distinguished profit from interest, we now need to distinguish be-

tween real and nominal interest rates. Earlier we distinguished real and

nominal magnitudes of wages, prices, income and cash balances. Real mag-

nitudes are adjusted for inflation, and are called that because in many situa-

tions we are interested in relative price changes so we strip away the change

in price level – price inflation – to reveal the relative changes that are due

to other factors: real factors. Nominal magnitudes are not adjusted.

With respect to interest rates, suppose you loan out $100 and get back

$110 a year later. If prices have doubled, you have su!ered a substantial real

loss – a loss in purchasing power. In order to accurately assess what happens

to interest under price inflation, we need a formula for real interest rates,

meaning the rate of return adjusted for the declining purchasing power of

money.

If the rate of price inflation is p = #P/P per year, the purchasing power

of PV dollars is reduced to PV/(1 + p) after one year. If the market rate

of interest is i then PV dollars become PV (1 + i) dollars in nominal terms

after one year. The real rate of interest r is the rate that when applied to

our initial amount PV yields its reduced purchasing power increased by the

nominal rate of interest:

PV (1 + r) =PV

1 + p(1 + i)

Solving for r,

1 + r =1 + i

1 + p

r =1 + i

1 + p) 1 =

i ) p

1 + p

For example, if the inflation rate is 12% and the nominal rate is 10%, the

real rate is

r =0.12 ) 0.10

1 + 0.1= 0.0182


170 Deflation versus inflation

or 1.82%. With an inflation rate that is much less than 100% (p << 1), it

is reasonable to drop the 1 + p in the denominator leaving the approximate

formula

r # i ) p

which gives 2% instead of 1.82% for the example – close enough. When in-

terest rates are high, the precision of the exact formula is misleading because

price inflation is typically changing rapidly in such circumstances, making

calculations all the more problematic.

Calculation of real interest rates for past periods is inexact because price

indices are inherently imprecise. They are, after all, based on arbitrarily cho-

sen baskets of goods and services. Projection of real interest rates into the

future is even less exact because we must rely on estimates of future price

inflation rates, which even expert prognosticators have di"culty with. Nev-

ertheless, this is a problem facing anyone who contemplates lending money

in an inflationary environment – some estimate must be used. Fortunately,

the money markets distill the collective estimates of all the market partici-

pants and this collective wisdom is about as good as it gets. In particular,

futures contracts on interest rates provide this information.

10.3 Deflation versus inflation

Price deflation refers to a declining overall price level and is the opposite

of price inflation. You might think that deflation would call forth all the

e!ects of inflation, but in reverse. In some respects this is true but in some

important respects it is not. It is true that under deflation:

• Creditors gain at the expense of debtors, to the extent that deflation

has not been accounted for in their agreed-upon interest rate – the

reverse of the situation under inflation.

• People who hold cash or bonds see the real value of their holdings

increase, also the reverse.

• People devote resources to seeking protection against the adverse ef-

fects of deflation as they do under inflation



One major di!erence is that deflation is rarely both severe and sustained.

If sustained, it is usually mild. If severe, it is usually sudden and sharp. In

the first case people don’t need to worry much about it and in the second

case there is not much they can do about it since it hits almost without

warning. But if you see deflation coming and want to protect yourself, the

obvious strategy is to hold more money since the purchasing power of money

is rising.

Let us return to the concept of the real rate of interest. To compensate

for inflation, lenders demand higher interest rates. To compensate for de-

flation, borrowers demand lower interest rates. But nominal interest rates

cannot go lower than zero. Why not? Suppose someone wants to borrow

$100 from you and proposes to return $99 after one year – interest at neg-

ative one percent per annum. No matter what happens to the purchasing

power of money and no matter how much you trust the borrower, what could

possibly induce you to accept such a deal, as opposed to simply keeping the

$100 in your pocket during the whole year?1 Thus if nominal interest rates

should fall very close to zero, people would lose all reason to make financial

investments. The incentive to save would evaporate and money would cease

to function as a standard of deferred payment. Moreover, this situation can

be temporarily self-reinforcing. Assume that price deflation is the result of

a declining money supply. In response, people increase their portfolio de-

mand for money. In other words, the velocity of circulation declines. This

increases price deflation further. This is just the opposite of the inflation-

ary situation where expectations cause velocity to rise which in turn makes

prices increases run ahead of money supply increases, at least for a time.

Although the dire consequences of deflation as we have sketched them

are theoretically possible, in reality they almost never happen. To begin

with a gold standard regime, it is di"cult, though not impossible, to en-

vision a situation where the stock of monetary gold would fall steeply and

1For a brief intraday period in late 2008, the interest rate on certain Treasury bills

dipped ever so slightly into negative territory. Some investors were obviously willing to

forgo all interest on such bills, but why would they pay the borrower to hold their money?

The very slight negative rate could be considered a fee paid for safekeeping of funds for

which there was no better alternative, e.g., funds above the bank insurance limit.


172 Deflation versus inflation

suddenly. Suppose, for example, someone discovered a cure for cancer that

required significant amounts of gold. There are two possibilities. First, the

process might require a significant one-time transfer of gold to new machines

that e!ected the cure. Or it might involve ongoing injections of gold into

cancerous tumors. In either case, a deflationary shock would occur as gold

was converted from monetary uses to clinical uses suddenly and in signif-

icant quantities. But equilibrium would return as new mines opened up

or as people figured out how to recycle some of the gold used in the new

treatment. Also note that under a gold standard, some of the gold required

by the new cancer cure would be drawn out of non-monetary stocks of gold

(such as meltdown of jewelry) and some would be diverted from supplies

that would otherwise flow to consumption. In either case, the existence of

a consumption market would soften the e!ects of the new demand on the

market for monetary gold.

Deflationary shocks under a government fiat money regime are even more

di"cult to imagine, since governments do not ordinarily have anything to

gain from contractions of the money supply. Recall that when they increase

the money stock, governments gain seignorage revenue and devalue their

outstanding debt. Both of these e!ects would reverse themselves under a

situation where the government was deliberately reducing the money stock.

In order to reduce the stock of money, the Treasury or the central bank

would essentially have to burn some of its incoming tax revenue. Also,

outstanding debt would have to be paid o! with more valuable money, which

would further strain the Treasury.

We must not confuse declines in the overall price level – price deflation

– with declines in particular relative prices. Prices of personal computers

have plummeted in recent years in both real and nominal terms, especially

when adjusted for the power of those computers.2 Very few people complain

about this situation. And while many early computer manufacturers have

been driven out of the business as a result of fierce competition (even IBM

2Computer engineers like to say that if automobile manufacturing had progressed at the

rate at which computers have progressed, a Rolls Royce would cost $1 and get 1,000,000

miles per gallon!



sold its personal computer operation in 2004), most of those that remain,

such as Dell, continue to earn respectable profits in spite of rapid price

declines.

10.4 Default risk

The first factor that a!ects the risk of a loan or bond is its nominal risk –

the risk that the borrower might not pay the interest due on the bond and

perhaps even fail to pay all or any of the principal at maturity. This situation

is called default and it is a serious matter, since a bond is a legal obligation

as contrasted with a share of stock which carries no promise about either

dividends or the share price. A borrower who defaults on a loan is often

forced into bankruptcy. If the borrower is a corporation, its stockholders are

not liable for bond defaults, though their shares of stock will likely become

worthless, since in bankruptcy the claims of bondholders have priority over

those of stockholders. Investors buying bonds from companies perceived to

be more likely to default will require more interest which can be thought

of as default insurance. When adverse events occur after a bond has been

issued, the market price of that bond will drop as a result of the increased

risk brought about by those events.

As we have indicated, U.S. government bonds are considered nearly risk-

less because they are backed by the power of taxation and by the govern-

ment’s unlimited power to print money. While there are no legal limits,

there are limits to how much taxation people are willing to bear. Likewise,

the financial markets, including overseas investors who have recently been

absorbing a great deal of U.S. government debt, keep a close watch on the

volume of debt that is monetized (purchased by the Fed using newly created

money).

10.5 Marketability

Some bonds are more marketable than others, meaning it is easier to find

buyers for them. Bonds issued by IBM, for example, are actively traded


174 Tax Treatment

and their prices are easy to obtain from brokers, though not quite as easily

as stock prices. In contrast, consider a bond issued by a small and obscure

company. Such a bond would not be as marketable, perhaps not marketable

at all, and therefore even if that company’s prospects were just as sound

as IBM’s, its bonds would pay higher interest as compensation for lack of

marketability.

10.6 Tax Treatment

Most bond interest is subject to federal and state income tax. However, as

we have indicted, muni bonds (issued by states and various local government

agencies in addition to municipalities) government obligations are exempt

from state and local income taxes. Favorable tax treatment is a bonus that

results in a lower rate of interest compared to a taxable bond of the same

quality and maturity.

The value of the tax exemption on muni bond income depends on the tax

bracket of the purchaser. Those individuals who are taxed at the highest

rate will get the most benefit from this exemption. One way to compare

taxable bond income to muni bond income is to compute the after-tax yield

of each class using one’s personal tax bracket. It makes no sense to buy

muni bonds in a tax-deferred account such as an IRA since no tax is paid

on any income in such accounts until funds are withdrawn in retirement, at

which point all of those funds are taxed as ordinary income.

10.7 Special Features

Some bonds carry special features, sometimes called sweeteners, that are

attractive to investors and induce them to accept lower rates of interest.

Convertible bonds are bonds that the holder may, at his option, exchange

for shares of stock in the company issuing the bond. The conversion price

and term are fixed at the time of issuance, and the prospect of being able to

acquire shares that have risen above the conversion price makes these bonds

attractive. Some investors see the high yield as compensation for the risk of



conversion. Most mortgages can be (and usually are) paid o! in advance of

their maturity without any penalty to the borrower. This is a kind of put

option, meaning the mortgage holder has the right to “put” it back to the

lender (or more likely, the firm to which the mortgage was sold) at any time.

Some bonds are accompanied by warrants which entitle their holders to buy

shares of the company’s stock at a certain price. Warrants are a kind of call

option. They grant their holder the right to call away shares of stock from

the writer of the option (which is the company in the case of warrants).

Sometimes bonds (and more commonly, preferred stocks) are callable.

This means that after some specified date, the issuer has the right to re-

purchase the bonds at some specified price, i.e., call them in. For example,

preferred stocks are usually issued at $25 per share, and may be callable by

the company at 25, starting five years after their issuance. Such provisions

are a benefit to the company and thus require somewhat more interest to

make them attractive to buyers.

10.8 Maturity

As we have indicated, a bond’s maturity date is the date when its principal

is to be returned to the lender (or maturity may refer to the time remaining

until this date). As a rule, people require higher interest rates to induce

them to lend for a longer period of time, assuming other factors are equal.

Active markets for bonds of various maturities give rise to a yield curve,

which is a plot of interest rate versus maturity. A particular yield curve is

specific to bonds of a certain, tax treatment, etc. and should be thought of

as a snapshot at any particular time. Yield curves are most commonly show

interest rates on Treasury securities. The yield curve shown in Figure 10.8

for Treasury securities as of January of several recent years is based on rates

quoted for bills, notes, and bonds. Note that these are not time history

plots. Rather, each curve is a snapshot taken in di!erent years and showing

the yields available on securities due in three months, one year, etc.

The yield curve for 2007 slopes down slightly. This situation is called an

inverted yield curve, where short-term rates exceed long-term rates, These


176 Maturity

3 mo 6 mo 2 yr 5 yr 10 yr 30 yr0%

1%

2%

3%

4%

5%

6%

Maturity

Inte

rest

rate

20092008200720062005

Figure 10.2: Yield curves for Treasury securities

are rare and are thought by some to be a harbinger of an economic downturn.

In any event, economists have long been fascinated with yield curves and

have struggled to devise theories explaining them. Here are four.

The pure expectations theory holds that di!erent maturities are perfect

substitutes so that the yield curve reflects expectations of future short-term

rates. A drawback of this theory is that over a long period of time expec-

tations of falling rates should be about as common as expectations of rising

rates, and yet the yield curve nearly always slopes upward.

The segmented market theory holds that di!erent maturities are not

substitutes at all. Each lender and each borrower, says this theory, has his

own preferred maturity and there is little entrepreneurial arbitrage between

the markets for di!erent maturities. But as an empirical fact, interest rates

of di!erent maturities tend to move together, as in the figure above.

The preferred habitat theory strikes a balance in assuming that bonds of



di!erent maturities are only imperfectly substitutable. The theory says that

on the whole, people slightly prefer shorter maturities and require higher

interest rates to induce them to go longer. That is, the short end of the

maturity spectrum is their “preferred habitat.”

The liquidity premium theory says that lenders will accept lower interest

rates for shorter maturity. This explains the normal upward-sloping yield

curve but not inverted curves.

10.9 Interest Rate Controls

As we saw in Chapter 5, usury laws have been common throughout history.

Usury laws set a maximum legal interest rate, and when this rate is below

the rate that clears the market, shortages arise. The riskiest borrowers are

shut out of the market and so they turn to the black market – suppliers of

credit commonly known as “loan sharks.” Their cost of borrowing is thereby

raised substantially.

In addition to black markets, banks and other lenders have devised nu-

merous ways to avoid usury laws. For example, lenders may require com-

pensating balances. This means that if the bank loans you $1 million at a

government-imposed ceiling rate of 5you to keep at least $200,000 in a non-

interest-bearing checking account, it is essentially charging a rate higher

than 5because you are only getting $800,000 net and your $50,000 annual

interest payment represents a rate of $50,000/$800,000 = 6.25

Governments sometimes impose ceilings on the amount of interest banks

pay. In the U.S., a rule known as Regulation Q made it illegal to pay

interest on checking accounts from the time of its adoption in 1933 until

its repeal in 1986. This amounted to a choke point in the flow of savings

through intermediaries. The intent of the regulation was to increase the

interest spread for banks thereby granting them quasi-monopoly profits. Its

main e!ect was financial disintermediation, i.e., a reduction in savings via

intermediaries below the level that would have prevailed with no controls

and the likelihood that competition would have forced banks to pay some

interest on checking accounts. Some of these savings moved to direct finance


178 Interest Rate Controls

and some were lost altogether. Thus if intermediation increases the e"ciency

of the flow of funds, disintermediation does just the opposite.


Part IV

Commercial Banking:

History and Practice

179

181

Commercial banking is perhaps the most highly regulated industry in

the U.S. today, even following the deregulation of the 1980’s and 1990’s. At

various times, and to some extent presently, the government has controlled

entry into the business, establishment of branch o"ces, the businesses which

banks may or may not engage in, the kinds of assets they may hold, and

the kinds of liabilities they may incur, and the maximum interest rates they

may pay. In return, government has bestowed upon the banking industry the

status of a cartel, relieving banks to some extent from the harsh discipline

of competition.


182


Chapter 11

The U. S. Experience

The present state of the banking industry – a confusing combination of

restrictions, special privileges and free-market operations – is not something

anyone would have designed. The best way to make sense of the current

situation is to trace its history. We will focus on the evolution of banking in

the U.S., beginning with the Revolutionary era. This will help us appreciate

the various forms of banking and will enhance our understanding of business

cycles, and provide some insight into the emergence of central banking.

11.1 Pre-Civil War: From Chartered Monopoly

to “Free” Banking

11.1.1 America’s First Central Bank

Prior to the Revolution the American economy was fairly primitive. Planta-

tions were largely self-su"cient and what exchange there was often took the

form of barter. Many people used primitive commodity forms of money, such

as wampum and tobacco, and those silver and gold coins that did circulate

were mainly of Spanish origin rather than British. Transatlantic trade was

the most highly developed aspect of the economy. This trade was facilitated

largely by bills of exchange rather than flows of money. Bills of exchange,

as we saw in Chapter 4, were an innovative alternative to the problematic

183

184 Pre-Civil War: From Chartered Monopoly to “Free” Banking

shipment of specie across the ocean.

In Chapter 3 we mentioned the creation and demise of the Continental

currency during the Revolutionary War. Following the financial chaos sur-

rounding the Revolutionary hyperinflation, the Continental Congress took

steps to restore stability and to better finance the revolution. In 1781 they

chartered America’s first bank, the Bank of North America. They intended

this bank to function as a central bank1 and patterned it after the Bank of

England. But it was also America’s first commercial bank.

We might ask why this bank required a Congressional charter. To an-

swer that, we must realize that these were the waning years of the age of

mercantilism. Mercantilism was a very influential political philosophy in all

the major European countries from about the sixteenth to the eighteenth

century, and received its most serious challenge in the form of the laissez

faire ideal which Adam Smith set forth in his 1776 book “The Wealth of Na-

tions.” This book was just beginning to command attention when the Bank

of North America was started in 1782 so it is safe to say that mercantilist

sentiments, though perhaps not as strong as in Europe, were still influen-

tial in America at the time. Mercantilism was an open alliance between

merchants and the state in which governments granted charters that con-

ferred monopoly privileges. That is to say, the notions of incorporation and

monopoly went hand-in-hand.2 Thus, banks like almost any other major

business at the time, had to approach the government for a charter.3

The Bank of North America was spearheaded by Robert Morris, a signer

of the Declaration of Independence and a wealthy merchant.4 Despite its

1We will study central banks in Part VI.2The modern sense of “monopoly” refers to a firm that eliminates its rivals through

competition. The traditional usage, which applies to the era of Mercantilism, refers to

coercive elimination of rivals through government action. Examples of the latter type

of monopoly would be the East India Company of the 17th and 18th centuries or the

electric utility companies of present times. The other kind of monopoly which we might

call “e#ciency monopolies” are very rare and when they do arise, there is no historical

record of them charging the monopoly price that is theoretically possible.3See Section 5.2 above.4Morris at one time functioned as a one-man de facto bank, issuing notes backed by

his own personal credit. He was imprisoned for three years for bankruptcy following


Chapter 11: The U. S. Experience 185

monopoly privileges, however, it did not work out as intended. It drew

criticism for issuing too many notes relative to its species holdings. At one

point it hired people to urge noteholders not to present them for redemption

– a tactic that only worsened confidence. After just a year of operation

Morris gave up his Congressional Charter and continued to operate under a

charter from the state of Pennsylvania. The bank became known as the First

Pennsylvania Bank, and was merged into today’s Wachovia Bank, a large

nationwide commercial bank that was recently acquired by Wells Fargo.

After the transformation of the Bank of North America, all banks were

for a time state-chartered. In 1784 the Bank of New York and the Bank

of Massachusetts began operation under state charters and by 1800 fully 29

state-chartered banks were operating. The process of state bank chartering

was fraught with politics and favoritism. For example, the Bank of New York

was created by leading elements of the dominant Federalist Party. Aaron

Burr, a Republican opposition leader and future Vice President, wanted

to open a competing institution. He had to disguise it as a corporation

intended to provide New York City with wholesome water, in 1794 opening

the Manhattan Company as a bank subsidiary. This bank was one of the

ancestors of today’s JPMorgan Chase.

11.1.2 First Bank of the United States

In 1789 the U. S. Constitution took e!ect, replacing the prior Articles of

Confederation. President Washington’s Secretary of the Treasury, Alexan-

der Hamilton, was eager to to establish another central bank in part to help

pay o! the lingering Revolutionary War debt but also to bring the nation’s

nascent financial system under central government control. The result was

the Bank of the United States, later known as the First Bank of the United

States. Congress granted the new Bank a twenty-year charter. The charter

granted a number of special privileges. While monopoly note issue was not

one of them, it held Federal government deposits, it was the only bank al-

lowed to establish inter-state branches, and its notes could be used to pay

unsuccessful land speculation and died in poverty and obscurity.



taxes (i.e., they held public legal tender status), In addition, the government

provided part of the Bank’s equity capital. It was, in its time, America’s

largest corporation. As of 1809, its simplified balance sheet was as follows:

First Bank of the United States, as of 1809

(Amounts in millions)

Assets Liabilities

Land & buildings 0.5 Equitya 10.0

Specie reserves 5.0 Retained earnings 0.5

U. S. securities 2.2 Notes 4.5

Due from state banks 0.8 Deposits 8.5

Loans 15.0

Total $23.5 Total $23.5

aOne fifth provided by the Federal government

This balance sheet provides some insight into banking practice at the time.

For example, the reserve ratio, equal to the amount of gold and silver re-

serves divided by the sum of notes and deposits outstanding, was 5/13 =

38% and the ratio of capital to equity was 10/23.5 = 42%. Although this

reserve ratio is high by present-day standards, other banks used these notes

as a basis for further expansion, the result being a 72% rise in the price level

between 1791 and 1796. Thus the ratio of private banks’ aggregate liabilities

to the reserves held by the second bank would be a much smaller number.

The term pyramiding is used for such situations, where a bank’s liabilities

are a multiple of its reserves, and those reserves are in turn a multiple of

another bank’s reserves (Figure 11.1).

Banking was a divisive political issue at this time. The Federalists, led

by Washington and Hamilton, were the pro-bank party, and they stood

for a powerful central government, tari!s, internal taxes, a large standing

army and a large national debt. The Republicans,5 led by Thomas Je!er-

son and James Madison, wanted frugal government, free trade, no internal

5Sometimes called the Democratic Republican Party and unrelated to the modern

Republican Party



Figure 11.1: Pyramiding of reserves

taxes, militia rather than a standing army, and a reduction or elimination

of government debt. The Republicans won the dramatic election of 1800, in

which no candidate received a majority of the Electoral College so that the

outcome had to be determined by the House of Representatives, with each

state’s delegation getting one vote. Je!erson became President, and he set

about dismantling the Federalist state. As part of this program, the charter

of the Bank of the United States was allowed to expire in 1811, by which

time Madison was President. This left the U.S. with no central bank, only

state banks.

11.1.3 The Second Bank of the United States

As so often happens, another war crisis meant another banking crisis. The

War of 1812 was financed largely by borrowing and in response to the new

demand for loans, about 200 new state banks were chartered.6 Soon specie

reserves were inadequate to cover liabilities and once again, the banks were

allowed to take their cue from the Bank of England and suspend specie

6Including the City Bank of New York, a predecessor of today’s Citibank.



payments. Thus the War of 1812 was financed mainly through privately

issued fiat money as the U. S. continued to borrow and pay out unredeemable

private bank notes. After the war it was generally agreed that banks must

return to making specie payments but it was di"cult to see how this might

be done in light of the great expansion of credit during the war, in addition to

a great deal of credit extended to purchasers of public lands, many of whom

could no longer make their installment payments. With specie payments

suspended, the notes of many banks began to trade at a discount. This

was especially problematic for the Treasury which received payments from

public land purchasers largely in depreciated currency, but had to make its

purchases mainly in the East where the money had depreciated much less.

In response to this situation, the Second Bank of the United States was

formed in 1816, much like the First Bank only bigger. Its balance sheet as

of 1832 was as follows:

Second Bank of the United States, as of 1832

(Amounts in millions)

Assets Liabilities

Land & buildings 3 Equity 35

Specie reserves 7 Notes 21

State bank notes 3 Deposits 23

Loans 66

Total $79 Total $79

Here we see a lower reserve ratio than in the First Bank, 7/44 = 16%.

The primary justification for the Second Bank was to help state banks

resume specie payments. During its first three years of operations it did

so, but only by expanding its own notes which state banks then used as

reserves, with actual gold obtainable only from the Second Bank – another

instance of pyramiding. Only the Second Bank’s notes were receivable in

payment of taxes.7

7Tari!s were the only federal taxes levied at the time, and very few people paid these

taxes.



It was not long before America’s first modern bank panic hit, the Panic

of 1819, which was also a period of economic contraction.8 Specie payment

was suspended, but because the government’s control of the economy was

quite limited, the panic ended fairly soon and specie payment was soon

resumed. But the episode left a bad taste and opposition to the Second

Bank mounted. So important was the issue that it led to a new political

alignment. The Whigs replaced the Federalists as defenders of banking

and government intervention; prominent Whigs included Henry Clay, John

Quincy Adams and Daniel Webster. In opposition, Martin van Buren of

New York forged a new Democratic party to carry on the tradition of laissez

faire. Van Buren recruited war hero Andrew Jackson to run for President,

and Jackson won a sweeping victory over incumbent John Quincy Adams

in the pivotal Presidential election of 1828.

11.1.4 The Jacksonian Revolution

Jackson’s victory was a cultural shift as well as a political shift, as Jackson

was a rugged frontiersman, in sharp contrast the Eastern elite (typified by

Adams) who had dominated American politics up to that time. It is no ex-

aggeration to call the victory of Andrew Jackson and his party a revolution.

One shift was the rise of the concept of general incorporation, ending the

monopoly privileges of incorporation which as we have seen were a holdover

from the Mercantilist era. Jackson and his party favored free trade and low

tari!s, yet despite the fact that tari!s and land sales were the only sources

of federal government revenue, the national debt was paid down to zero in

January 1835, for the first and only time in American history.

Jackson and his followers also advocated “hard money,” i.e. specie or

note issue fully backed by specie – no fractional reserves. They wanted to

abolish central banking which they viewed as the root of inflationary mis-

chief. These positions led to the famous “Bank War” which pitted Jackson

against Second Bank President Nicholas Biddle. Biddle was an astute politi-

cian, and put several Congressman as well as Supreme Court Chief Justice

8Economic “booms” generally coincide with monetary expansion and “busts” with

monetary contraction. We will study macroeconomic cycles further in Chapter 17.



John Marshall on the bank’s payroll. But Jackson was even more skillful at

the game of patronage. When Congress re-authorized the Second Bank in

1832, four years in advance of the expiration of its charter, Jackson vetoed

the bill. In his veto message he denounced the bank as a “hydra-headed

monster.” In response, Biddle called Jackson’s veto statement “a manifesto

of anarchy.” The veto stood but the Bank’s charter still had four years to

run. Jackson was re-elected in 1832 and in 1833 he withdrew federal funds

from the Second Bank (firing two Secretaries of the Treasury in the pro-

cess) and deposited them in various state banks which critics called his “pet

banks.” After the expiration of the Bank’s charter in 1836, it struggled on

for a while as a private bank, finally failing in 1841.

11.1.5 “Free Banking” in the United States

As of 1836, the Federal government had no role at all in bank chartering or

regulation. However, state governments remained very active in bank a!airs.

Such was the general distrust of banks that nine states, taking hard money

doctrines to an extreme position, outlawed banking altogether. Some states

set up monopoly state-run banks which were essentially miniature central

banks while others continued to allow multiple chartered banks. Six states

tried note insurance and New York, in 1829, tried a form of deposit insur-

ance called a “Safety Fund” which was not successful. The most common

arrangement, exemplified by Michigan in 1837 and New York in 1838, came

to be called “free banking.” This entailed general incorporation of banks,

paralleling other industries, meaning that no longer would a charter entail

monopoly privileges. Anyone could get a bank charter if they met certain

requirements. Private banks issued notes and accepted deposits with their

reputations and ultimately their survival serving as the restraints on over-

issue of either notes or deposits.

But the “free banking” of this time was not altogether free. No interstate

branch banking was allowed, and branching within many of the states was

likewise prohibited. Unincorporated banks were not allowed to issue notes.

State governments mandated capital/asset ratios and conducted examina-

tions of banks’ books. They imposed reserve requirements and prohibited



issuance of small-denomination notes so as to lessen competition with U.S.

token coins. Their charters spelled out the activities that banks were allowed

to pursue. And finally and perhaps most importantly many states required

banks to accept state government bonds as reserve assets. This meant that

state governments could issue bonds at will and force banks to treat them

almost as if they were “as good as gold.” Of course in many cases they were

not, and this was a de-stabilizing influence.

Despite all these restrictions, this was the freest banking era the U. S.

has ever had, and it was a time of considerable competition. That competi-

tion largely served to regulate the circulation of privately issued banknotes.

How did this system, which seems so strange from our modern perspective,

actually work?

Private banks issued notes that were redeemable for gold or silver on

demand. Although banks issued notes in excess of the reserves they held

– fractional reserve banking – there was no problem as long as there were

not too many simultaneous demands for redemption. So although private

banks could create money out of nothing by issuing new bank notes, their

redemption obligation severely restricted their ability to do so. Not only

might depositors, seeing a large increase in notes, become concerned and

call for redemption in large numbers (a “bank run”), but perhaps more im-

portantly, other banks which had acquired large stocks of the notes of an

over-issuing bank might present them for redemption. A surge in redemp-

tion demands by other banks is called “adverse clearing.” Because a free

bank’s reputation is its most valuable asset, bankers were generally rather

careful about keeping enough reserves to maintain confidence. Of course

this theory describes purely free banking and does not contemplate govern-

ment interventions such as the requirement that state bonds be accepted as

reserves.

During this time banks were constantly receiving notes issued by com-

peting banks. Transporting these notes to the banks of issue, redeeming

them for coins, and bringing the coins back home would be a very ine"cient

operation. Private clearinghouses arose to settle obligations between banks,

thereby reducing transaction costs substantially. These organizations acted



like bankers’ banks, places where bankers could take notes of other banks

and exchange them for their own notes or, occasionally, for coins.

A notable example of a clearinghouse operation was the Su!olk Bank

clearing system which operated from 1819 to 1859. Boston was the hub

of commercial and cultural life in Massachusetts and consequently a large

volume of banknotes from banks outside Boston – “country banks” – were

spent in the city. These notes circulated at a discount not only because the

soundness of those banks was uncertain but also because the transporta-

tion costs associated with redeeming them for specie were substantial. This

was especially problematic for merchants who did not want to alienate their

country customers by refusing or discounting their notes. Seeing a profit op-

portunity, the directors of the Su!olk Bank o!ered a service whereby they

would accept the notes of country banks at par, provided those banks would

maintain funds on deposit without interest. The Su!olk Bank earned income

from this arrangement primarily by loaning out the deposited funds at inter-

est. The system worked so well that many years later the U.S. Comptroller

of the Currency, John J. Knox, commented in a moment of candor that the

Su!olk Bank did its job “as safely and much more economically than the

same services can be performed by the government.”9

Clearinghouses evolved to provide more services than just note exchange.

Some of them cleared checks and guaranteed note values. They provided

incentives for banks to honor their redemption obligations while at the same

time reducing the transaction costs and resource costs of banking – the

amount of specie that had to be maintained as “idle resources” in support

of redemption obligations. In general, clearinghouses, whether organized for

profit or as non-profit associations of member banks, increased the overall

e"ciency and stability of the banking system.

In some cities there were no clearinghouses, and note brokers took on

the job of exchanging the notes of various private banks, much like the es-

tablishments in today’s airports that exchange foreign currencies. Brokers

were much less e"cient and less convenient than clearinghouses, and some

have criticized free banking on this ground. But we must remember that

9John Jay Knox, “A History of Banking in the United States,” New York, 1903.



prohibition of nationwide banking retarded the growth of banking in remote

locations, and clearinghouses can only arise where there is a su"cient num-

ber of banks located reasonably close by. Note brokers were thus the next

best solution given the prohibition of branch banking.

The free banking system in the United States came to be called “wild-

cat banking” by its critics, suggesting that private note-issuing banks were

reckless and irresponsible and that only centralized government control could

prevent a catastrophic market failure. But upon examination, many of the

problems of the free banking system turn out to be examples of government

failure, not market failure. Suspension of specie payments was, after all,

authorized by state governments. Even the most scrupulous banker, seeing

suspension as fraudulent and immoral, knew that if he continued to o!er re-

demption when his competitors did not, his bank would likely be drained and

he would be out of business. He thus faced great pressure to join in the un-

scrupulous activity. State governments, as we have indicated, forced banks

to hold state government bonds as part of their reserves. This of course

provided bankers with a strong incentive to purchase state government debt

since they could pyramid notes and deposits on top of these bonds as if they

were gold. Again, should any banker balk at the propriety of this arrange-

ment he would likewise place himself at a distinct competitive disadvantage.

Of course some banks did fail, as would be expected even under pure free

banking, and the impact of bank failures was lessened greatly when Federal

deposit insurance was instituted in the 1930’s. But under government con-

trol, depositors often su!ered substantial losses in purchasing power. Which

was greater? An estimate of all the losses to noteholders due to bank failures

during the entire free banking epoch amounted to about $1,851,000, not a

trivial sum. Yet this is less than the loss in purchasing power su!ered due

to the 2% inflation in just one year, 1860, under government control.

Bank panics erupted in 1837 and 1857. What of these? The 1837 panic

was triggered by a credit contraction instituted by the Bank of England

in response to inflation and gold outflow in Britain. This put pressure on

American exporters and banks. The Bank of the United States had engaged

in heavy cotton speculation and the falling price of cotton prompted it to



suspend specie payments. The 1857 panic was triggered by overexpansion

and once again resulted in a government-sanctioned suspension of specie

payments. Both of these panics ended quickly and were far less severe than

the Great Depression of the 1930’s.

11.1.6 Free Banking in Scotland

The most highly developed system of free banking held sway in Scotland for

fully 128 years, from 1716 to 1844. In 1716 the Bank of Scotland lost its

monopoly on note issue and a number of private free banks arose to take its

place. Scotland is much smaller than the United States and has no equivalent

of American State governments, and these facts probably made it easier for

free banking to arise in that country. In any event, in contrast to the U.S.,

the private note-issuing banks of Scotland could open branches anywhere in

the country and were not obliged to accept government bonds as reserves. A

nationwide clearinghouse operated and all the banks accepted each other’s

notes at par. Many of the ills that critics might expect to beset free banking

were absent from Scotland. There was only one significant bank failure

during that era – the Ayr Bank – which resulted in only modest losses to its

customers. No single bank grew to dominate the market, which was highly

competitive as attested to by the modest spread of one to two percentage

points between loan and deposit interest rates.10 The populace was served

by more branch o"ces per capita than either England or the United States.

Bank notes were typically protected by “option clauses” allowing the bank

to delay redemption payments, with interest added during the time of delay.

Such clauses served the interests of both banks and noteholders as they

helped prevent bank runs, but they were outlawed in 1765. The partners

who owned a bank typically bore unlimited responsibility for its liabilities.

This of course was a major incentive for bank managers to act prudently

and served as a partial private alternative to deposit insurance.

Free banking came to an end with the enactment of Peel’s Act in 1844

10Lawrence White, “The Theory of Monetary Institutions,” Blackwell, 1999, p. 83. The

loan-deposit interest rate spread is the source of bank profits, and its low value suggests

intense competition.



which extended the central banking powers of the Bank of England to Scot-

land as well. Ironically, Peel’s act was a result of hard money sentiments.

And under the new system there were two serious bank failures, in 1857 and

1878.

Perhaps the U.S. banking system would have evolved in the direction of

Scottish free banking. We will never know, because U.S. free banking was

ended abruptly by the biggest crisis in the entire history of the Republic:

the Civil War.

11.2 The Civil War (1861-1865)

and National Banking

During peacetime the U.S. government had minuscule budgets, amounting

to a few million dollars annually – about 1.5% of GDP versus more than

20% currently. Except during wartime or panics, budget surpluses were the

norm. Prior to the Civil War, the total national debt stood at $66 million,

most of it run up during the Mexican-American war of 1848. The cost of the

Civil War to the Union government alone was about $1.7 million per day.

Notwithstanding heavy new taxes (including the first U.S. income tax) and

massive borrowing, part of the war burden was financed by issuance of new

paper money called Greenbacks. In the fall of 1861 Secretary of the Treasury

Salmon P. Chase (whose name survives in today’s JPMorgan Chase bank)

attempted to float a massive $150 million bond issue but because Chase,

a former Jacksonian, tried to get private banks to purchase the new issue

with specie, and because confidence in the private banks was beginning to

erode, specie payments were suspended both for private banks and for the

Treasury itself with respect to its notes.

As part of the Legal Tender Act of 1862, Congress authorized $150 mil-

lion in Greenbacks (Figure 11.2). These were declared to be legal tender

for all debts, public and private, and were not backed by specie, though the

Treasury was still obligated to make interest payments in specie. Congress

declared that this would be the first and only issuance of this kind but this

promise was soon forgotten, with repeated issues bringing the total to about


196The Civil War (1861-1865)

and National Banking

Figure 11.2: A “greenback” – Civil War currency.

$415 million in 1864, a stupendous sum relative to the size of the economy.

The National Banking Acts of 1863, 1864, and 1865 e!ectively monetized

this war debt, transforming it into a government-managed paper currency.

It established a system of nationally chartered banks, unique in that no other

business firms were federally chartered. While this system used general in-

corporation and was nominally open to free entry, in fact each proposed new

bank had to gain the approval of the Comptroller of the Currency,11 whose

o"ce administered regulations and restrictions on their activities. National

banks could not issue their own notes, but instead were required to dis-

tribute U.S. Bank Notes supplied to them by the Comptroller. These notes

had to be backed by government bonds and were guaranteed at face value.

This system created a market for national debt which, by the end of the

War, had reached the staggering sum of $2.8 billion. With limitations on

federal power still taken seriously, Congress did not see fit to outlaw notes

issued by state-chartered banks, but it accomplished this end by impos-

11Pronounced “controller.”



ing a prohibitive 10% tax on such notes. This set an ominous precedent

for taxing something into oblivion that could not be explicitly prohibited.

The National Banking Acts established a currency monopoly, but instead

of a central bank, it created a system of many tightly regulated national

banks. Still no branching was allowed with the exception of some estab-

lished branches that were “grandfathered” in. And while state-chartered

banks could no longer issue notes, they could still accept deposits. Thus

a dual banking system was established in which national banks could issue

notes and accept deposits while state banks could only accept deposits.

The new national banking system did not eliminate financial instability

and the banks did not fully return to specie payment until 1875 – ten years

after the end of the war – at which time Greenbacks were made fully con-

vertible into gold. Panics continued under the new system. The years 1873,

1893 and 1907 all saw bank panics, the last a severe episode in which banks

were once again permitted to suspend specie payment.

Among other regulations, national banks were required to maintain min-

imum levels of reserves to back their deposits. Reserve requirements became

a fixture of banking regulation in the twentieth century. The presumed ben-

efit of reserve requirements was to improve the soundness of banks, but a

cost had to be paid in terms of reduced liquidity. And in fact, an entirely

new source of illiquidity arose. Notes were now fully insured but conversion

of deposits into notes involved a contraction of the money stock which had

not been the case with private note issue. That is because U.S. notes served

as reserves, and have we have seen, private deposits were pyramided on top

of those notes so conversion of deposits to notes involved a reversal of the

pyramiding which does not happen when deposits are converted to private

notes, both of which pyramid on top of specie.

11.3 Creation of the Federal Reserve System

The establishment of the nation’s third central bank, the Federal Reserve

System, was part of a broad political movement called progressivism. Con-

ventional wisdom views this movement as a populist uprising in opposition


198 Creation of the Federal Reserve System

to monopoly big business. And while academics and intellectuals lent sup-

port, much of the Progressive movement was actually led by big business,

particularly the Wall Street firm of J. P. Morgan, in an attempt to establish

monopoly cartels and escape the harsh discipline of free-market competition.

Control of the banking system was a key element of their plans. Support for

a central bank was drummed up at a series of well-publicized conferences.

A draft bill for the new Federal Reserve System was worked out at a secret

meeting of top business and banking leaders in 1910 at a private island o!

the coast of Georgia. It took longer than expected to line up support for the

bill, partly due to Democratic victories in the 1910 congressional elections,

but the Federal Reserve Act was passed by Congress in December 1913.

The primary justification for the new central bank was the need for

an elastic currency, one that could respond to seasonal fluctuations in the

demand for cash holdings, particularly at harvest time. The new Federal

Reserve System was also to act as a “lender of last resort,” providing a safety

net that would preclude disastrous bank runs and bank panics.

There was substantial lingering distrust of central banking in the minds

of the public at the time. To allay suspicions, the System was organized as a

network of semi-autonomous regional banks. Each regional bank issued its

own notes, all superficial variants of a single national currency.12 National

banks were required to join the System and state banks were given the option

to join. Joining meant purchasing shares of “stock” which paid a six percent

annual dividend. But to say that these arrangements made the Fed, as it is

commonly called, a private institution is a mistake. The member banks did

not own the Fed in any real sense because they could not sell their shares

and they exercised no real control of its policies or operations.

As the Fed ramped up its operations, national banknotes were phased

out. The new Federal Reserve Notes could be used as bank reserves along

with gold, silver and Greenbacks. Thus Federal Reserve Notes provided

a new basis for money creation since private banks could pyramid their

assets on top of them. In addition, the Fed took over the functions of the

12Until recently, Federal Reserve notes were marked with a letter indicating the branch

that theoretically issued them, e.g., A for New York or L for San Francisco.



many private clearinghouses that had arisen since the Civil War. The Fed

provided a national clearinghouse function which had not evolved privately

mainly because of the prohibition of interstate branch banking.

The Fed came upon the scene just in time to facilitate U.S. participation

in World War I. International gold payments were suspended and the money

stock was expanded substantially. Predictably, a severe wartime price in-

flation resulted – the worst since the Revolution. This was followed by an

equally severe business depression in 1921-22. There were no bank panics

during this time, and the depression ended quickly. Credit for the recov-

ery is perhaps due to the inability or unwillingness of either the Fed or the

Harding Administration to step in with macroeconomic remedies.

As the 1920’s drew to a close, the country was about to experience its

worst depression ever. The Great Depression of the 1930’s would make prior

business cycles seem trivial by comparison.

11.4 The Great Depression of the 1930’s

The term “panic” is rather scary and was replaced by the milder “depres-

sion.” Later this term was replaced by “recession,” an even softer term.

All three terms refer to the same basic phenomenon which we shall call

a depression. Depressions are economy-wide phenomena characterized by

high unemployment, falling output, clusters of business failures, and price

deflation.

Individual sectors of the economy have their ups and downs like the

peaks and troughs in the ocean. Agriculture had entered its own depression

prior to 1929, but there is no reason why this downturn should have spread

to the entire economy. The peaks and troughs in the ocean do not account

for a drop in the average water level.

Profits and losses pervade the market economy. Individual businesses

routinely fail due to bad management, erroneous predictions, or just bad

luck. But why would almost all businesses be struck by a wave of simulta-

neous losses? It is no explanation to say that managers were simultaneously

a$icted by some mysterious lapse in judgement. Some false signal must have


200 The Great Depression of the 1930’s

permeated the economy and led businesses into systematic errors. That sig-

nal could only come through money because money permeates the economy

like nothing else. We must look to money to find answers to the mystery of

the Great Depression.

Recall the distinction between relative prices and the price level. Changes

in the money stock only a!ect the price level in the long run but in the short

run they a!ect relative prices as well. One relative price permeates the entire

economy: the interest rate, which is the price of loanable funds.

Let us begin with the levels of the U.S. money stock prior to the Great

Depression. Following the inflation of World War I, the M2 money stock

stood at about $32 billion. It shrank by about 10% during the Depres-

sion of 1921-22. Over the next decade it grew at an annual rate of about

4.6%, standing at $46 billion in 1929. Yet prices remained roughly constant.

This was because output increased substantially during the Roaring Twen-

ties due to new technology and a rising population, resulting in increased

demand for money that roughly matched the increased supply (Figure 2.3.)

As Figure 2.3 shows, the price level remained roughly constant because of

increasing demand to hold money. This increase was due to the healthy

gains in real output that occurred during that decade, due in large part to

technological advances such as automobiles and radios.

Figure 11.3 shows the tremendous rise of the Dow Jones Industrial Aver-

age from about 1929 to 1929, followed by the reversal that took the average

all the way down to 1914 levels during the depths of the Depression, followed

by a substantial recovery to 1937 and then another reversal. Not until the

1950’s did the DJI exceed its 1929 highs.

The stock market boom worried many observers including Fed policy-

makers, who throttled back on the money supply during 1928-29. The stock

market crashed in October 1929, but in the following months the crash began

to look like a one-time event with no great significance for the economy as

a whole, much like the crash of 1987 which was steeper than that of 1929

but had few long-term consequences. The economy might have recovered

starting in 1930, but in October of that year the first of three massive

waves of bank failures struck. During each of these waves, panic spread



contagiously and by the end of the Great Depression fully 9,000 banks had

failed – a truly astonishing number.

Figure 11.3: Dow-Jones Industrial Average, 1914-1940

To understand these events we must underscore the distinction between

illiquidity and insolvency. A bank is insolvent if its liabilities exceed its

assets. A bank is illiquid if it has insu"cient cash or other highly liquid

assets to meet short-term demands for withdrawals. Insolvency means that

a bank’s total assets, irrespective of liquidity, are insu"cient to cover its

liabilities. Insolvency is generally a more serious matter than illiquidity and

can be more di"cult to pinpoint since it often depends on assigning a value

to loans whose prospects for collection are uncertain.

Many of the banks which failed – closed their doors and failed to pay o!

some or all of their deposits – were merely illiquid, in some cases lacking only

a few pennies on the dollar. The most dramatic example was the December

1930 failure of the private Bank of United States in New York City. Not

only was this the largest bank to fail up to that time, with $200 million of

deposits, but its name suggested to many that it was some sort of o"cial

bank. The bank was able to pay o! 83.5% of its liabilities despite having to



liquid some assets at “fire sale” prices. It could easily have been saved by a

merger or other means but a plan to do so fell through at the last minute.13

The waves of bank failures that swept the U.S. during the Great Depres-

sion amounted to the worst bank panic in U.S. history and indeed in world

history. The problems climaxed with a “bank holiday” declared by Presi-

dential fiat on March 6, 1933 and confirmed retroactively by Congress a few

days later. During this time banks were not only forbidden from honoring

withdrawal requests, but had to stop all operations and literally close their

doors. Although the holiday lasted just six days, more than 5,000 banks did

not reopen their doors right away and over 2,000 of these never reopened.14

The main consequence of all these bank failures, aside from countless

personal tragedies, was a one third collapse in the M2 money supply, from

about $45 billion to $33 billion in 1933. This breathtaking fall, and the

government’s response to it, was the key element in the Great Depression.

Several questions suggest themselves. Why was the commercial banking

system, after 20 years of operation under the Federal Reserve, so vulnerable?

What was the trigger that started the chain of failures? And what was the

response of the Fed, the banks’ lender of last resort? Basically – nothing!

Said President Hoover, “I concluded [the Reserve Board] was indeed a weak

reed for a nation to lean on in time of trouble.”

A comparison with Canada is instructive, since Canadian culture and

institutions are quite similar to those of the U.S. Canadian banks enjoyed

much more freedom than their U.S. counterparts. There were only a handful

of banks in that country, most of them nationwide in scope, since there were

no restrictions on branch banking. There no reserve requirements and there

was no central bank. While Canada also su!ered from the depression, it

experienced a relatively mild 13% contraction of its money supply, and most

notably there were no bank failures. (Recall there were some 9,000 failures

in the U.S.) The Canadian story provides strong evidence of the ill e!ects

of the U.S. prohibition of branch banking, a policy nearly unique among

13Milton Friedman & Anna Jacobson Schwartz, “A Monetary History of the United

States, 1857-1960,” Princeton, 1963, p. 309.14Friedman and Schwartz, op. cit., p. 330.



industrialized nations. The U.S. prohibition on note issue exacerbated the

situation as did the centralization of reserves at the Fed, since any Fed

mismanagement would be amplified throughout the banking system.

Why did the Federal Reserve fail to act? One explanation is a lack

of reliable statistics on the money stock, particularly M2, which became

available only in 1963. In addition, the Fed watched interest rates rather

than the money stock. And when Keynes’ “General Theory of Employment

Interest and Money” was published in 1936, it diverted attention away from

changes in the money stock and toward increases in demand for liquidity.

Massive unemployment, as we have said, was a key feature of the Great

Depression. How can money explain unemployment? The answer lies in

its impact on wage rates. Conceptually, the rate of unemployment can be

divided into a natural rate, which is always positive, and a cyclical or dise-

quilibrium rate which can be positive or negative. The natural rate includes

frictional or search unemployment that results when unemployed people

take time to find a good job rather than accepting the first o!er that comes

along. It also includes people who are collecting welfare payments and are

thus less motivated, or not motivated at all, to find a job. Institutional un-

employment results from interventions such as minimum wage laws or union

privileges. The rest of unemployment is cyclical unemployment, associated

with the business cycle and of primary interest to macroeconomists.

Unemployment got as high as 25% of the labor force during the Great

Depression. In addition many people held emergency government “make-

work” jobs whose productivity was dubious at best could therefore be called

under-employed. Unemployment amounts to a surplus in the labor market.

When the money supply falls, prices must also fall or else unsold surpluses

accumulate. In labor markets, surpluses mean unemployment. During the

depression, government policy toward prices in general and wage rates in

particular was to prop them up, or as economists describe it, make them

“rigid downward.” This was the basic cause of unemployment during the

depression. Wage rigidity was accomplished largely by means of legislation

that granted special privileges to labor unions.

The Smoot-Hawley tari! was enacted in 1930 just as the depression



was getting underway. This act raised tari! rates to their highest level in

American history. Predictably, international trade fell by 60% from 1930 to

1932, wiping out a great deal of the mutual gains from trade. While U.S.

exports amounted to only about 5% of its domestic GNP, that figure was

about 14% in the U.K., Germany and France. The Smoot-Hawley tari! had

more drastic e!ects on these countries than on the U.S., e!ectively spreading

the depression world-wide and helping to sew the seeds of fascism and war

in Europe.

In response to earlier depressions, government policy had been to do es-

sentially nothing but cut its own expenditures. This tradition was reversed

during the Great Depression and the reversal began not with Franklin Roo-

sevelt who took o"ce in March, 1933 but with his Republican predecessor,

Herbert Hoover. It is ironic that Hoover is often condemned as a do-nothing

president. Campaigning for President in 1932, Hoover said,

We might have done nothing. That would have been utter ruin.

Instead we met the situation with proposals to private business

and to Congress of the most gigantic program of economic de-

fense and counterattack ever evolved in the history of the Re-

public.

Hoover’s administration spent more on such programs than in the previous

30 years, including the Hoover Dam in Nevada, which was renamed the

Boulder Dam when his reputation sagged, and later became the Hoover

Dam again.

It is instructive to compare the Great Depression to an episode men-

tioned earlier, the Panic of 1837. During the period 1839 to 1843 the money

stuck fell by 34%, about as much as it fell between 1929 and 1933. Here are

statistics showing the changes in various aggregates:



1839-43 1929-33

Money stock -34% (M2) -36%

(M1) -34%

Prices -42% -31%

Number of banks -23% -42%

Real gross investment -23% -91%

Real consumption +21% -19%

Real GNP +16% -30%

Notice that prices fell sharply during the 1839-43 episode, more so than in

the Great Depression. In other words, there was no government interference

to make prices rigid downward. Not only was there full employment dur-

ing this depression but output actually increased by 16%, notwithstanding

declines in the money stock and in investment. This is indicative of the

fact that contractions are not uniform but hit the loan market first, and

then later lead to business failures. Note that a full-employment depression

of 1839 to 1843 was something that could not be explained by Keynesian

theory.

In summary, the Great Depression was a prolonged maladjustment to

deflation that resulted from monetary contraction. So how did it end? World

War II began, and the military draft absorbed fully 22% of the pre-war labor

force. The good news was that many men were no longer unemployed. The

bad news was that they were forcefully employed in the business of getting

shot at. The true end to the Great Depression came only with the partial

freeing of the economy after the war’s end.

Let us examine some of the financial consequences of the Great Depres-

sion. First, the U.S. went o! the gold standard when Roosevelt, using patri-

otic exhortations, forced all citizens to surrender their personal holdings of

gold. Thereafter, possession of gold, with some industrial and numismatic

exceptions, was made a crime punishable by ten years in jail and a $10,000

fine. New contracts denominated in gold were forbidden and those already

in e!ect were abrogated. The price of gold for international settlements

was arbitrarily raised from $20 to $35 per ounce. The prohibition of gold

ownership remained in e!ect until 1974.



In 1933 the Federal Deposit Insurance Corporation (FDIC) was estab-

lished to guarantee bank deposits up to $2,500. The insurance did indeed

eliminate bank panics but gave rise to solvency problems in their place, as

we shall see when we examine the S&L crisis of the 1980’s and the financial

crisis of 2008.

Second, the government reduced competition in the banking industry by

regulating interest rates, thus transforming that industry into a cartel. The

justification was that cut-throat competition was to blame for bank panics.

Banks were prohibited from paying interest on demand deposits (checking

accounts) and on inter-bank deposits. Interest paid on time deposits and

savings deposits was fixed by Regulation Q, which as we shall see became

very problematic in the 1970’s.

Securities markets and particularly the stock markets were subject to

new regulations. The Securities Exchange Commission (SEC) was set up

in 1934 under the guise of protecting small investors from fraudulent or

misleading practices by brokers, corporate managements, and investment

bankers. (There has been no evidence that the SEC has actually made se-

curities less risky, as witness the $50 billion Ponzi scheme run by Bernard

Mado! that collapsed in 2008.) In 1933 the Glass-Steagall Act split invest-

ment banking and commercial banking asunder. Commercial banks were

prohibited from engaging in stock market transactions.

11.4.1 The Great Depression: a 2008 Reprise?

The U.S. economy was o"cially deemed to have entered a recession in De-

cember 2007 and remained in that situation at year-end 2008, with many

forecasters predicting a continuation through and perhaps beyond 2009. In

the popular press, comparisons with the Great Depression abound. Will

history repeat itself?

Of course we cannot answer this without knowing how much worse the

current downturn might get or how long it will last. Even after it ends, it

will take years to develop a proper assessment. Nevertheless, we venture to

outline some di!erences between then and now:



• We live in a vastly more sophisticated time. Information is available in

much greater quantities and is nearly instantaneous. No Fed o"cial,

for example, could be excused for saying he didn’t know what was

happening to the money stock.

• Financial markets around the world are tightly interconnected. Capi-

tal flows across borders in amounts and speeds that would have been

unimaginable in the 1930’s. Policymakers must be aware of interna-

tional reactions to their programs, whereas in the 1930’s they generally

ignored international repercussions and got away with it.

• Federal deposit insurance has not eliminated bank failures, but has

rendered them harmless to most bank depositors. However, this does

not mean that the risks of bank failures have been eliminated; rather,

they have been socialized.

• Thus far the 2008 recession has been nowhere near as severe as the

Great Depression. Unemployment, in particular, is still in single digits,

in contrast to the peak figure of 25% during the 1930’s.

• Fed chairman Ben Bernanke, a student of the Great Depression, has

declared his firm intention to avoid the monetary deflation that the

Fed of the 1930’s allowed to happen. Indeed, the monetary base sky-

rocketed during 2008 and the wider M1 and M2 are following along.

• The federal government has intervened massively in the banking sec-

tor, the insurance sector, and to a lesser extent, other industries such

as the automobile business. At this writing, they have lurched from

one program to another, making it very di"cult to give any sort of

assessment.




Chapter 12

Banking Practice

12.1 The Regulatory Structure.

The Great Depression created the basic regulatory structure that we have

today. There was substantial deregulation during the 1980’s and 1990’s but

the basic concepts of government control remain undisturbed. Presently,

there are four categories of banks. There are four categories of banks, num-

bering as follows (2005 figures):

Charter Fed member FDIC-insured number

National yes yes 2001

State yes yes 935

State no yes 4,338

State no no 500

The establishment of a new bank requires permission of either a state

chartering authority or the Comptroller of the Currency. There has been

some relaxation of requirements recently, in part because the state and fed-

eral chartering agencies are in competition with one another. And in fact, at

least one clever entrepreneur has created a business in helping people start

banks – www.startabank.com.

There were until recently strict limits on the activities in which banks

could engage. They were forbidden to sell stocks and bonds or insurance, for

209

210 The Regulatory Structure.

example, products that many large banks now o!er through a"liates or sub-

sidiaries. Bank mergers are subject to review by their regulatory agencies,

and sometimes by the Anti-Trust Division of the Justice Department.

We have already commented on branch banking restrictions and how

they weakened the U.S. banking system relative to countries like Canada.

Originally no interstate branching was allowed and many states restricted

or prohibited branch banking entirely. In 1900, out of 12,427 banks in the

country, only 87 had any branches at all. One one occasion a bank in

Texas built a tunnel under a street so it could set up operations on the

other side without technically establishing a branch. In Ohio, banks at one

time could establish branches only within a single county, and as a result

the smaller of the state’s 88 counties were stuck with small and ine"cient

banks. These restrictions have been almost entirely eliminated and so we

now have several large nationwide banks including Citicorp, Wells Fargo,

Bank of America and Wachovia. Small branches have been established in

retail stores, airports, and other previously unthinkable locations. Stand-

alone automated teller machines are also common.

The disestablishment of many regulations came about largely as a result

of successful e!orts to sidestep them. Bank holding companies, established

to control the stock of individual banks, were the most common tactic.

Texas with its outright prohibition had many of them, First Interstate Ban-

corp being the largest. Single-bank holding companies also arose as a way

of avoiding prohibitions on non-bank activities such as insurance and stock

brokerage. Citicorp, which merged with Travelers’ Insurance to form Citi-

group, was the largest of these.

So-called “non-bank banks” were organizations that took advantage of

the definition of a bank as a business o!ering both commercial loans and

deposits. By omitting one or the other of these activities, “non-bank banks”

were able to avoid regulations on interstate banking. At one time, American

Express, First Nationwide, Merrill Lynch, Sears Roebuck and J.C. Penney

all took advantage of this loophole, which was closed by Congress in 1987.


Chapter 12: Banking Practice 211

The Dartmouth Bank

Assets ($ thousands) Liabilities ($ thousands)

Cash in vault 1,071 Demand deposits 18,633

Balances at FRB 5,286 NOW accounts 30,619

Checks in process of collection 7,644 Deposits of U. S. Treasury 690

Balances at correspondent banks 530 Deposits of states and political

subdivisions

602

Federal funds sold 7,000 Passbook and statement savings

deposits

4,834

Certificates of deposit 5,497 Money market deposit accounts 40,007

Treasury notes and bonds 6,584 Small denomination time de-

posits

32,727

Government agency issues 3,551 Securities sold under agreement

to repurchase

11,509

Municipal bonds 4,632 Large denomination time de-

posits

6,230

Mortgage-backed securities 3,091 Mortgage indebtedness and

other liabilities

2,242

Corporate notes, bonds and

stocks

5,710 Total liabilities 148,093

Loans 101,640 Equity capital

Bank premises and other assets 4,720 Common stock 200

Total assets 156,956 Surplus 1,003

Undivided profits and capital re-

serves

7,660

Total equity capital 8,863

Total liabilities and equity capi-

tal

156,956

Table 12.1: Balance sheet of the Dartmouth Bank.

12.2 A Commercial Bank’s Balance Sheet.

Table 12.1 shows the balance sheet of a typical small bank, the Dartmouth

National Bank, which serves Hanover, NH, a town of approximately 8,000

residents. It was chartered in 1865 by the Comptroller of the Currency. In

1985, the Indian Head Corporation, a bank holding company in Nashua,

NH, purchased the Dartmouth National Bank, exchanging shares of its own

stock for shares of stock in Dartmouth National. Indian Head is one of four

large bank holding companies in the state.



12.1.1 Assets

Following standard accounting practice, assets are listed on the left-hand

column and liabilities on the right. Since assets exceed liabilities, as they

must for any solvent bank, there is positive equity capital and the sum of

liabilities and equity capital equals total assets. “Vault cash” consists of

cash in the bank’s vaults, teller drawers, and automated teller machines.

Vault cash plus “balances at the FRB” (Federal Reserve Banks) constitute

the bank’s legal reserves. “Checks in the process of collection” are checks

on their way to the Fed where they will be added to the bank’s deposits.1

“Balances at correspondent banks” arise when banks open demand deposit

accounts at other banks. The Dartmouth Bank has no branches in Boston,

for example, so it might maintains deposits at the Bank of Boston to facili-

tate check clearing.2 The Bank of Boston would record Dartmouth’s deposit

account as a liability.

Cash items are reserves in an economic sense since they pay no interest.

Until recently, reserve balances at the Fed paid no interest either, but that

changed in 2008. Notice that required reserve balances at the Fed di!er

from the ordinary reserves that households or businesses might maintain –

“rainy day” funds that we might tap in an emergency. Bank reserves cannot

be tapped for any reason other than a decreased deposit base.

While bank regulators mandate minimum levels of reserves for certain

types of deposits, but banks are free to maintain higher levels. “Excess re-

serves” are thus the di!erence between actual and required reserves. Some-

times banks hold excess reserves out of prudence – anticipation of larger

withdrawals than the minimum level of reserves would reasonably support.

But in recent years, banks have tended to loan their excess reserves to other

1Starting in 2004 it was no longer necessary to physically transport paper checks to the

Federal Reserve. Electronic images could be transmitted instead, resulting in much a much

speedier clearing operation and correspondingly lower assets in this category. However

some consumer groups objected to this change because it meant that recipients of checks

were no longer required to physically forward checks for clearing but could directly debit

the writer’s account via electronic means.2This is a form of pyramiding and raises the question as to whether such inter-bank

deposits should be counted in the money stock.



banks whose reserves were temporarily inadequate. This market for inter-

bank loans is called the “Federal funds” market, a somewhat misleading

name since neither the Federal government nor the Federal Reserve System

is directly involved. At the time this snapshot of Dartmouth’s finances was

taken, it had loaned out (“sold”) $7 million of fed funds to other banks.

This sum appears as an interest-earning asset on the bank’s balance sheet.

Another bank with net Fed Funds borrowings would record a liability in the

appropriate amount.

The fed funds rate is a very sensitive interest rate indicator, and it was

until very recently the target that the Federal Reserve used in conducting

its open market operations, as we will see in Chapter 16.

Bank assets generally fall under one of two broad categories: instruments

with secondary markets, called investments, and those that are directly ne-

gotiated and carry unique features. Secondary reserves are liquid assets

like CD’s purchased, treasury bills, commercial paper and banker’s accep-

tances. Other investments include treasury securities, government agency

issues (mainly bonds), municipal bonds (issued by states, counties, cities,

sewer districts, etc.), mortgage-backed securities, and some corporate debt,

but not corporate stocks. The “corporate stocks” mentioned on the Dart-

mouth balance sheet are actually shares in the Federal Reserve, which the

bank was required to buy when it became a member of the Fed, and shares

of “stock” in the Student Loan Marketing Association, a quasi-government

agency. Banks are not allowed to hold ordinary common stocks as assets.

Dartmouth’s loan portfolio appears as a single line item, but bank loans

generally fall into one of several categories. Business loans (commercial and

industrial) are the most important category. Other categories include loans

to financial institutions, agricultural loans, real estate loans (mortgages)

and margin loans (loans advanced through brokers to their customers for

stock purchases). A Federal Reserve regulation limits margin loans 50% of

the value of the stocks purchased. All of these loans bear di!erent interest

rates. A bank’s lowest advertised rate is called its “prime rate.” However,

this term is less meaningful than it once was as competition has driven some

banks to advertise “sub-prime” rates.



Finally, the item labeled “bank premises and other assets” captures the

current depreciated value of Dartmouth’s land, buildings, furniture, etc.

12.1.2 Liabilities

Now we consider liabilities, the sources of funds for the bank. Demand

deposits are the bank’s checking account liabilities. NOW accounts were

an early form of interest-bearing checking accounts that are now obsolete.

Government deposits are another form of demand deposits, though they can

pay interest. All of these items are counted in the M1 money stock.

Savings deposits (passbook and statement varieties) are time deposits

with fixed interest and variable maturities. Small time deposits (under

$100,000) have a fixed maturity. Money market deposit accounts pay vari-

able interest and have varying maturities. All of these count as part of the

M2 money stock.

The remaining types of liabilities can be called managed liabilities in that

management can control them directly rather than relying on customers to

open accounts.

12.1.3 Capital account

Lastly, we have the capital account. This represents the money the original

investors put into the bank plus accumulated profits and must be equal to

total assets minus total liabilities. Just as a bank’s reserve ratio measures

its liquidity, a bank’s capital-asset ratio (equal to 8.863 divided by 156,956

or 5.6% for Dartmouth) is a measure of its solvency. If its capital should

all be exhausted the bank would be insolvent. Regulators require banks to

maintain certain minimum levels of capital relative to assets.

In the financial crisis of 2008, many bank assets became hard to evaluate.

An asset subject to the “mark-to-market” rule must appear a bank’s balance

sheet at its current market value. In 2008, trading all but ceased in certain

asset classes such as mortgage-backed securities, making it all but impossible

to mark them to market. For this and other reasons, many banks began to

experience capital shortfalls. In response, the Treasury purchased shares in



a large number of banks, hoping this would keep them solvent and active

in the loan market until the crisis somehow ended and the Treasury could

redeem its investments.

12.2 Asset vs. Liability Management

The art of managing a deposit bank like the Dartmouth Bank consists ba-

sically in balancing risk versus reward. Managers must maintain enough

liquidity to meet Fed requirements, to honor withdrawal requests without

embarrassment. While FDIC relieves them of worries about bank runs,

they are nonetheless strongly beholden to the stockholders who want gen-

erous dividends and an ever-rising stock price. Should the bank fail, the

FDIC will make all insured depositors whole, and following the practice in

recent failures, probably uninsured depositors as well. But stockholders are

wiped out in a bank failure, and likely the holders of the bank’s bonds as

well. Bank managers trade liquidity versus earnings. They do not want to

leave any more resources idle than is necessary to provide su"cient liquidity

because profits will su!er if they do.

At one time, management focused almost entirely on asset management.

They tried to find borrowers who would pay high interest but be unlikely

to default. Similarly, they trade o! income versus risk in the securities they

buy. And they must always watch their liquidity because although they can

borrow fed funds to cover shortcomings, these borrowings can be costly if

overdone.

This was a time when banks were once largely sheltered from competition

by government regulations, making it unnecessary for them to worry about

competing for funds. Wags devised the “3-6-3” rule for bank management:

pay interest at 3%, collect interest at 6%, and be on the golf course by 3PM.

But this happy state was rudely interrupted by deregulation, which made it

possible – indeed necessary – for banks to vary the interest rates they o!ered

in order to attract deposits. Thus if liquidity began to slip banks had the

option of attracting more liabilities in addition to selling assets, which, prior

to deregulation, was their only strategy.


216 Asset vs. Liability Management

Nowadays banks engage in both asset and liability management. They

pay close attention to the yield curve and to economic forecasts. And in

light of the events of 2008, we might add a third category of management:

political management. With most medium and large-size banks having taken

Treasury money – in some cases neither needed nor wanted – it has become

increasingly necessary to watch the political winds. At year-end 2008, they

were getting many questions from politicians and journalists as to why they

had not speedily loaned out the new government capital.

Table 12.2 lists the ten largest U.S. banks by assets as of May, 2008. This

information is already outdated as Wells Fargo has acquired Wachovia.

($ million)

Citigroup (New York) $2,199,848

Bank of America Corp. (Charlotte, NC) 1,743,478

JPMorgan Chase (Columbus, OH) 1,642,862

Wachovia Corp. (Charlotte, NC) 808,575

Taunus Corp. (New York) 750,323

Wells Fargo (San Fransisco) 595,221

HSBC North America Inc. (Prospect Heights, IL) 493,010

U.S. Bancorp (Minneapolis) 241,781

Bank of the New York Mellon Corp. (New York) 205,151

Suntrust, Inc. (Atlanta) 178,986

Table 12.2: Largest banks as of May, 2008


Part V

Non-bank intermediaries and

financial deregulation

217

Chapter 13

Survey of Non-bank

Intermediaries

A financial intermediary, as you will recall, is an institution that helps those

who seek debt or equity capital and those who seek to invest their savings

to find each other – “middlemen” if you will. Recall also that banks (and

bank-like institutions) are distinguished from other intermediaries by the

fact that they accept deposits payable on demand. Depository institutions

include

• Commercial banks such as Citicorp or Wells Fargo (which currently

number about 8,300 in the U.S.)

• Savings & loan institutions and savings banks such as Downey Savings

(1,400). Collectively, S&Ls and savings banks are called “thrifts.”

• Credit unions (9,500)

Non-depository institutions include

• Life insurance companies such as New York Life

• Property and casualty insurance companies such as Allstate

• Private pension funds, run by a declining number large corporations

and most governments as an employee benefit

219

220 Savings and Loan Associations and Savings Banks

• State and local government pension funds

• Consumer finance companies such as Household Finance

• Investment companies such as Fidelity or Vanguard o!ering open-end

mutual funds, closed-end mutual funds and exchange-traded funds.

• Real estate investment trusts such as BRE Properties. Shares of these

trusts typically trade on stock exchanges.

13.1 Savings and Loan Associations

and Savings Banks

As we have indicated, there was considerable distrust of banking in the early

years of the United States. Partly as a result of this, the first savings and

loan institution, the Philadelphia Savings Fund Society, was formed in 1816,

and by the 1830’s there were many such institutions. Their key feature was

that they were owned by their depositors and typically made loans for home

purchases. When these institutions came under federal regulation, they were

allowed to pay higher interest on deposits than banks. The rationale for this

di!erential is that home ownership is a good thing but does not draw enough

funding in a free market, thus justifying government intervention. A public

choice interpretation of this situation would point to the large number of

votes that might be influenced by mortgage subsidies.

An example of the evolution of this type of institution is provided by

the now defunct Washington Mutual Bank, or “WaMu” as it styled itself.1

The Washington National Building Loan and Investment Association was

organized in 1889 to provide funds for rebuilding in the wake of a disastrous

fire that swept Seattle in that year. Its name was changed to Washington

Savings & Loan in 1908. In 1983 it made an initial public o!ering as a

corporation and did business business as Washington Mutual Bank even

though there was nothing “mutual” about it, i.e., the depositors do not own

1This institution got into distress largely as a result of dubious mortgages, and was

acquired by JPMorgan Chase in 2008 in a deal arranged by the FDIC.


Chapter 13: Survey of Non-bank Intermediaries 221

the bank. It was a commercial bank with its deposits insured by the FDIC

and its shares traded on the New York Stock Exchange.

A crisis struck the savings and loan industry in the 1980’s which took

many years and a great deal of tax money to solve. We tell this story below.

Partly as a result of that crisis, the number of savings and loan associations

has declined from around 6,300 in 1960 to about 1,000 currently.

13.2 Credit Unions

Credit unions are very much like banks. The main di!erence is that they are

non-profit organizations and their customers are called members. Members

are supposed to share some common bond such as working for the same

employer. And credit unions have a vague mandate to promote thrift among

their members.

Originally, credit unions began with savings accounts and consumer

loans. In recent years, in an e!ort to keep pace with bank competition,

they have expanded into home loans, checking accounts, credit cards, insur-

ance, and money orders.

Banks consider credit unions an irritation because of their exemption

from income taxes. Banks scored a victory in 1998 when the Supreme Court

reined in the definition of eligibility for credit union membership. This was

partially undone by legislation passed by Congress in 1998.

The number of credit unions has declined from about 24,000 in 1969 to

about 8,100 today, largely as a result of mergers and consolidations. Total

assets of credit unions are a small fraction of bank’s aggregate assets.

13.3 Pension Funds

Employees of most businesses and nearly all governments exist retirement

programs as part of their compensation. These programs are o!ered pri-

marily because the income tax code makes them more advantageous than

compensating employees entirely in cash and letting them engage whatever

retirement savings plans they might choose.


222 Life Insurance Companies

A pension is a kind of retirement program that provides retired employ-

ees with fixed periodic (typically monthly) payments – an annuity. Funds

are contributed by the employer, and employees can typically add contri-

butions that are taken out of their paychecks. The business or government

agency invests the money in a fund that is almost always managed by a

professional manager. The corporation or agency is responsible for seeing

that the fund is adequate to meet future obligations. Pension funds usually

include focus on bonds and stocks but may also purchase real estate and

other more unusual investments. Most government agencies and some of

the larger corporations o!er pensions. But smaller businesses, and increas-

ingly even large businesses, o!er retirement programs such as 401k’s, which

allow employees to make their own investments. The benefits they receive

in retirement depends on the performance of the investments they choose.

In 1974 Congress established the Pension Benefit Guaranty Corporation

for the purpose of insuring private pensions. Companies that participate pay

insurance premiums and submit to certain regulatory rules, and in return

the PBGC guarantees the fund against failure or shortfalls. Recently, a

number of companies such as United Airlines have dumped their pension

obligations onto PBGC, generally as a part of bankruptcy proceedings. This

has brought into question the adequacy of PBGC assets relative to potential

liabilities. At year-end 2008, the PBGC sought an increase in premiums to

cover an $11.2 billion shortfall, largely the result of bankrupt companies

dumping their pensions.

13.4 Life Insurance Companies

Life insurance companies provide insurance against the financial consequences

of early death. They collect premiums which are invested mainly in bonds

and mortgages, but to some extent in stocks as well. The aggregate value of

these assets is now about $3.5 trillion. Many life insurance companies make

all their profits from the income on their investment portfolios, and often

su!er losses on their underwriting business (premiums minus payouts).

American International Group is a large insurance company that su!ered



a liquidity crisis in 2008 resulting in an $85 billion line of credit provided

by the Federal Reserve system in exchange for warrants to purchase about

80% of the company.

13.5 Property and Casualty Insurance Companies

These companies insurance against loss from fire, theft and accidents. They

bear more risk than life insurance companies because disasters such as Hur-

ricane Katrina can expose them to large and unpredictable losses. Conse-

quently, they hold more liquid assets than life insurance companies, espe-

cially U.S. treasury securities and corporate and municipal bonds.

13.6 Finance Companies

Finance companies loan money to people for purchase of durable goods such

as automobiles or furniture. General Motors Acceptance Corporation, for

example, is a subsidiary of General Motors Corporation that makes loans to

purchasers of GM cars. These businesses raise funds by issuing commercial

paper or bonds. Those that are organized as corporations have share capital

as well.

13.7 Investment companies

Investment companies pool investors’ funds and invest mainly in domestic

corporate stocks and bonds but also in government securities, foreign se-

curities, foreign currencies and commodities. Their principal o!erings are

open-end mutual funds, closed-end mutual funds, exchange-traded funds,

hedge funds and real estate investment trusts. Many companies o!er sev-

eral of these kinds of products.

13.7.1 Open-end mutual funds.

By far the most common type of investment fund is the so-called open-end

mutual fund, pioneered in 1924. Shares of such funds are purchased directly


224 Investment companies

from the fund company or through brokers or dealers. The management

company will issue new shares to anyone at any time and will redeem shares

upon demand – that is, they are always open to new investors.2 The sale or

redemption price is equal to the fund’s net asset value which is the market

value of all the fund’s assets divided by the number of shares outstanding.

This figure is calculated at the end of every business day, and all orders to

buy or sell shares are executed after that calculation is complete. Thus a

buy order placed over a weekend will be executed late Monday afternoon.

Funds keep a certain amount of cash on hand to meet redemption requests

but beyond that they generally put excess cash to work in new investments.

Their asset choices are constrained by regulations such as a requirement

(for most funds) that no more than 5% of their assets be invested in a single

stock.

Funds vary widely in their investment objectives. Some buy a broad

range of stocks, some focus on shares of technology companies, retailers, en-

ergy companies, etc. Some buy mainly stocks of Asian, European, or Latin

American companies. Others buy bonds of various maturities and qualities.

Some funds advertise themselves as “socially responsible” and will not pur-

chase shares of companies like tobacco manufacturers. But at least one fund

deliberately targets “sin” stocks like tobacco and alcohol. More exotic funds

may buy precious metals or commodities or may engage in short selling.3

All funds issue a government-mandated prospectus which discloses the fund’s

objectives and its past performance. Since these documents are filled with

mandated legal jargon, they are of little use to investors, who generally seek

advice about mutual funds from financial publications or internet sources.

Mutual funds generate fee income for their owners. In the past, it was

common for funds to levy sales charges, called a loads, of up to 9%, for

2Sometimes, however, fund managers perceive that their funds have gotten so big that

they have become di#cult to manage. They therefore close their funds to new investors,

though they typically allow existing shareholders to continue purchasing new shares. For

example, the Dodge and Cox Stock Fund was one of the largest and most successful

mutual funds, and was closed to new investors for several years. It reopened just in time

to experience a precipitous decline.3Defined as the sale of borrowed securities in anticipation of a price decline.



buying their shares. Front-end loads are fees charged at the time shares are

purchased and back-end loads are charged when shares are sold. Competi-

tion has driven loads out of the market for the most part, so that with the

exception of a few specialized funds, most are no-load funds, i.e., funds that

do not levy any direct sales charges.4 They are left with management fees

as their income source, and these vary widely from fund to fund.

Individual investors typically lack the time or motivation to research

stocks, which is one of the reasons they are led to mutual funds which have

full-time professional managers. Ironically, however, most broadly based

stock mutual funds do not perform as well as the averages. As a result,

index mutual funds have gained in popularity. Many of these are based on

the Standard & Poor’s index of 500 stocks (the S&P 500) meaning that

they hold all 500 of those stocks in their portfolio, weighted the same as

they are weighted in the S&P 500: by market capitalization. Not only do

these funds out-perform most actively managed funds, but they also have

very low expenses since they have no need for research departments or active

managers.

13.7.2 Closed-end mutual funds

Closed-end mutual funds di!er from open-end mutual funds in one key re-

spect: they issue issue a fixed number of shares in an initial public o!ering

and put the proceeds to work in whatever investments they have chosen to

specialize in. Once launched, these funds do not issue new shares nor do

they redeem existing shares. Instead, investors wishing to acquire shares in

a closed-end fund must buy them from existing shareholders. Closed-end

funds vary widely as do open-end funds, but there are far fewer of them com-

pared to open-end funds. Many closed-end funds are listed on the NYSE

and other exchanges and are bought and sold through stockbrokers, just like

individual shares. The market price of closed-end fund shares is determined

4Many funds like to discourage trading in and out of their shares, and to do so, they

may charge a back-end fee for redemption of shares held less than some specified period

like one year. Unlike loads, however, these funds generally accrue to the benefit of the

remaining shareholders rather than being paid to management.



by supply and demand and is not necessarily equal to the fund’s net asset

value. Deviations of 10% above and below NAV are common and 20% or

25% deviations are not unknown. The deviations may be in part a reflection

of investors looking beyond the NAV and discounting the future prospects

of the fund’s holdings.

An advantage of closed-end funds is that the managers do not have to

worry about redemption requests. They do not need a cash bu!er to meet

redemptions nor do they have to worry about possible short-term unpopu-

larity of their investments. A minor advantage to investors is the ability to

buy and sell them throughout the day, not just once a day as with open-end

funds. They can also be sold short, unlike open-end funds. However, the

total value closed-end funds has always been a small fraction of the total of

open-end mutual funds. The spread between market price and NAV may be

one deterrent to these funds.

13.7.3 Exchange-traded funds

A third class of investment funds is closely related to closed-end mutual

funds but has been growing rapidly, largely at the expense of open-end mu-

tual funds. These are called exchange-traded funds (ETF’s) and like closed-

end funds, they are traded on the stock exchanges. They can be considered a

blend of closed-end funds and open-end index funds. Like closed-end funds,

they trade on the stock exchanges and have a market prices that typically

vary from net asset value. Unlike mutual funds (open or closed) they do

not change their portfolios once they commence operations, with very few

exceptions. For example, on of the most popular ETF’s is the so-called

“spider” fund (exchange symbol SPDR) which is just like an S&P 500 index

mutual fund except that it is closed-end. The SPDR managers must make

occasional trades due to companies entering or leaving the S&P 500, but

this happens infrequently. ETF’s are available in almost the same range of

specialties as are mutual funds: stocks of all kinds, bonds, commodities, etc.

Recently, actively-managed ETF’s have been authorized, further nar-

rowing the distinction between these funds and closed-end mutual funds.



13.7.4 Hedge funds

Yet another class of investment funds are hedge funds. “Hedging” is the

practice of taking a position in opposition to some other position that one

holds so as to reduce risk. For example, if I am an American and someone

is obligated to pay me Euros a year from now, I may purchase a contract

for delivery of Euros at that time in order to pin down the price and avoid

the risk that the Euro may decline relative to the dollar. However, many so-

called hedge funds now engage in little or no actual hedging, instead focusing

on other exotic and often risky trading strategies. Hedge fund managers are

free to engage in risky behavior that mutual fund managers are not allowed

to engage in, such as concentrating funds in just a few securities, leveraging

(use of borrowed money), and short-selling. Furthermore, hedge funds are

lightly regulated. Only individuals with high net worth are allowed to buy

them because government regulators believe that less wealthy people must

not be allowed to take big risks with their capital. Hedge fund operators

charge not only an annual fee but take a large percentage (typically 20%) of

any gains they achieve. While some hedge funds have been highly successful,

others have not, and it is questionable whether hedge funds on average are

worth the high fees they charge.

Barron’s, a leading weekly investment publication, prints a monthly sum-

mary of the performance of several hundred hedge funds (in addition to fairly

extensive mutual fund coverage). There is also a listing of “funds of funds,”

which are funds that invest in shares of various hedge funds. It is not clear

that the additional fees that these funds charge are warranted by the returns

they produce. Their objective is to reduce risks via diversification, but di-

versification also tends to drive returns toward average values, thus perhaps

defeating the purpose of hedge fund investing.

13.7.5 Real estate investment trusts

Real estate investment trusts were authorized by Congress in response to

a perceived inequity in the tax laws which allowed wealthy individuals to

derive special tax benefits from ownership of real estate (houses, apartments,



commercial buildings, and land). REITs, as they are called, were created so

that small investors could enjoy the same advantages. REITs operate under

special restrictions and in return enjoy favorable tax treatment. They are

restricted to two categories of investments: real property and mortgages on

real property. Many funds hold only real estate or only mortgages although

some hold both. They operate like closed-end mutual funds and are traded

on the stock exchanges, They must stay nearly fully invested and must

distribute at least 90% of their earnings in the form of dividends. As long

as they conform to these restrictions, they are not subject to any corporate

income tax, just as mutual funds pay no corporate income tax. REIT’s

usually provide above-average rates of return but they vary widely in quality

and some can be quite volatile.

13.7.6 Private investment funds.

People with large amounts to invest (typically $5 million or more) sometimes

hire managers to select investments tailored to their personal circumstances

(age, risk tolerance, etc.). These arrangements typically involve a generous

amount of “hand-holding” which of course is reflected in high fees.

13.7.7 Money-market mutual funds

Money-market mutual funds are open-end mutual funds that invest in safe,

short-term debt securities. They were discussed in Section 8.2.5 because they

are included in the M2 money stock. Interestingly enough, any economist

can explain how they work and why investors like them, yet as far as we

know, no economist predicted them prior to their emergence around 1970.

This was a time when Regulation Q imposed a cap on the amount of inter-

est that banks could pay on savings deposits. During this inflationary time,

market interest rates rose far above those caps. Investors began to “disinter-

mediate,” i.e., shift funds out of banks in search of yields that might at least

keep up with price inflation. The only good alternative to savings accounts

at the time was Treasury Bills which could be purchased in multiples of

$1,000. But because the Treasury was swamped with small orders, it raised



the T-Bill minimum to $10,000, thus shutting out most small investors. At

this time smart entrepreneurs conceived of a mutual fund that invested only

in very short-term debt instruments. Recall that bond prices vary inversely

with yields, and bonds with shorter maturities experience lower variations.

Because of their ultra-short maturity, it would be extremely unlikely that

the market value of MMMF assets could drop enough to generate negative

yield to maturity which made it possible to maintain the share price at

exactly $1.00, while the MMMF yield would vary with market conditions.

MMMF dividends are always paid in the form of new shares credited to each

shareholder’s account.

The $1.00 share price, while not guaranteed, has almost never been vi-

olated. Only one or two instances of “breaking the buck,” as this is called,

have been recorded, and it is likely that management malfeasance was to

blame in these isolated instances. For all practical purposes, MMMF bal-

ances can be treated like bank accounts and in fact, most funds allow share-

holders to write checks on their accounts (subject usually to a minimum

amount of $100 or $250 per check and a limited number of checks per

month). Most also o!er on-line transfers to and from commercial banks

free of charge. Retail MMMF balances are so liquid that they are counted

as part of the M2 money stock. Money-market mutual funds are subject to

regulations with regard to maturities (90 days or less) and credit quality.

Typical MMMF assets include commercial paper, bankers acceptances and

government securities.

There are now several hundred money-market mutual funds, totaling

over $2 trillion in assets. About $1.7 trillion of this is in funds whose pay-

ments are fully taxable. The rest is in funds that specialize in very short-

term muni bonds (see Section 8.2.2) which makes their dividends exempt

from federal income taxes. Most muni MMMF’s specialize in issues of a

single state which makes their yield exempt from state income taxes in that

particular state.



13.7.8 Social Security: Not an Investment Fund

We mention Social Security here because on superficial examination it might

seem to be an investment fund. It receives payments from workers and their

employers, holds a portfolio of securities, and pays out benefits to retirees.

But a closer look shows this is not an investment fund in any meaningful

sense. First, the “contributions” it receives are compulsory: they are taxes.

Second, no one is entitled to any particular benefits. Congress can change

the benefits at any time. Furthermore, average returns are far less than

might reasonably be expected from private investments, typically on the or-

der of 1.5% per annum.5dgar K. Browning, “The Anatomy of Social Security

and Medicare,” Independent Review, Summer 2008 Payouts taxable to those

with medium or high income. Most importantly, the assets of the Social Se-

curity Trust Fund are problematic. Nearly everyone agrees that government

securities are absolutely safe in that the dollar amounts of principal and in-

terest will be paid (but of course with no guarantee of the purchasing power

of these payments). Thus it might seem that the Social Security System is

being prudent in limiting its investments to Treasury securities, as by law

it must. But if we recognize that the Social Security System is an integral

part of the same Federal government that issues Treasury securities, we see

a problem: it appears that the left hand is lending money to the right hand,

which then spends it, while the left hand continues to claim it is holding

an asset. Because of massive tax increases enacted at the behest of the

Greenspan social security reform commission, the Social Security System

currently takes in more than it pays out. It has therefore been a net buyer

of Treasury bonds and has helped fund general expenditures. As the “baby

boomers” begin to retire, it will shift gradually to a position as a net seller

of bonds. This will strain the federal budget, requiring higher taxes, more

borrowing, or lower expenditures than would otherwise be the case.

In his first term, President George W. Bush proposed partial privatiza-

tion of Social Security. Young workers would be allowed to divert some of

their social security “contributions” into private accounts that would func-

5E



tion much like IRA or 401K accounts. The proposal got nowhere and is

unlikely to receive serious consideration in light of the stock market melt-

down of 2008, which took down many people’s 401-k or other retirement

investment accounts..

13.7.9 Diversification of Investment Companies

While banking functions remained separated from other investment activi-

ties by regulatory walls, those walls have become nearly invisible to investors.

A visit to the web site of Wells Fargo Bank, for example, reveals not only

the usual panoply of bank products (checking and savings accounts, CD’s,

mortgages) but also brokerage services, annuities, and a full line of insur-

ance products. While the insurance products are represented by links to

other web sites, Wells Fargo is attempting, probably with some success, to

position itself as a one-stop financial services center.

Charles Schwab was one of the first discount brokers. A visit to their

web site shows not only the traditional brokerage products (stocks, bonds,

mutual funds) but also full banking services through the Charles Schwab

Bank and a link to a commodity trading firm. A visit to the Vanguard

site shows a little less diversification: they o!er traditional fund products

including open- and closed-end mutual funds and exchange-traded funds in

addition to annuities and brokerage services, but not insurance.

All of these firms make strong appeals to retirement investors as this is

a major source of income which could be enhanced should any privatized

options to Social Security ever be enacted.




Chapter 14

The Changing Regulatory

Environment

14.1 Government Agencies That Regulate Non-

bank Depositories

14.1.1 Savings and Loans

Savings and loan associations can be chartered by the federal government or

state governments. All federally chartered S&Ls have their deposits insured

by the FDIC as do most state-chartered S&Ls. Both are supervised by the

O"ce of Thrift Supervision, part of the U.S. Treasury Department.

14.1.2 Savings Banks

Savings banks are institutions that generally fall midway between banks and

S&Ls. They are required to hold only relatively high quality assets. Most

savings bank deposits are insured by the FDIC.

14.1.3 Credit Unions

Credit unions, as explained in Section 13.2, are non-profit associations and

are therefore exempt from corporate income tax. Most credit unions are

233

234 Innovation Fosters Deregulation

insured by the National Credit Union Administration, a federal agency. A

few have chosen private insurance in lieu of NCUA insurance, however.

14.2 Innovation Fosters Deregulation

At one time commercial banks and thrifts had a tidy market-sharing ar-

rangement in that government regulation protected them from competition.

We might well describe this arrangement as an oligopoly (control of a mar-

ket by a few participants) or a cartel (collusion among a group of suppliers

to control a market). In particular,

• Commercial banks enjoyed a monopoly on demand deposits, and thus

checking services.

• Thrifts were allowed to pay higher interest on their time deposits and

savings deposits under Regulation Q (although prior to 1966, interest

paid by thrifts was not constrained).

• Thrifts were highly regulated as to their asset mix. They were confined

mainly to mortgage loans.

• Banks had higher capital requirements, and thrifts enjoyed some tax

advantages.

This arrangement persisted for a number of years, but the rising interest

rates of the 1970’s knocked them out of this happy equilibrium. All deposi-

tories were hit by disintermediation – withdrawal of deposits by savers eager

to find higher rates to compensate for price inflation. These were times of

serious price inflation, first hitting double digits (11%) in 1974, easing o! in

1976, but rising again in 1979-81 to a peak of around 15%. Clearly, anyone

earning 3% in a bank account when purchasing power was declining at a

10% or 15% rate was su!ering substantial losses.

Banks, but especially S&Ls, were losing business to foreign banks, the

new money market mutual funds, junk bonds, gold and silver, diamonds,


Chapter 14: The Changing Regulatory Environment 235

collectibles, real estate, canned goods, and just about anything that peo-

ple thought might hold its value against the ravages of inflation. Finding

regulatory loopholes became a matter of survival for depository institutions.

One of the authors disintermediated some of his savings during that

time. Though a resident of California, he opened an account at the Coolidge

Bank in Boston. This bank and others in Massachusetts and New Hamp-

shire had won permission from the courts to issue what were for all intents

and purposes interest-bearing checking accounts, called NOW (Notice of

Withdrawal) accounts. The author had an account on which he could write

checks, with the remaining balance earning 5% or more per annum. This in-

novation let the proverbial cat out of the bag. Commercial banks and S&Ls

in New England were incensed. Congress and the regulators listened, and

soon they too were allowed to issue NOW accounts, followed soon thereafter

by the same permission in New York State. These developments precipitated

massive regulatory overhaul.

In 1980, Congress enacted the Depository Institutions Deregulation and

Monetary Control Act (DIDMCA), consisting of three parts

• All federally regulated depository institutions, nationwide, were per-

mitted to issue interest-bearing checking accounts: NOW accounts,

ATS accounts (Automatic Transfer Service), and for credit unions,

“share draft” accounts. Regulation Q was phased out over six years.

• The monetary control part was in part a response to the Fed’s declin-

ing control over the M1 money supply, as depositors fled from M1 to

M2 assets. Furthermore, banks were withdrawing from the Federal

Reserve – 300 of them in the prior six years. In response, the Act

provided these powers:

– The Fed gained control of reserve requirements for all deposito-

ries, not just nonmember banks but also S&Ls, savings banks,

and credit unions

– The Fed was authorized to enter the check-clearing business and

to charge a fee for this service.



– Deposit insurance was raised to$100,000 per account from the

$40,000 level that had been established in 1974. Thus deposit

insurance had increased 40-fold since 1933, a period during which

prices in general had increased only about eight times.

But DIDMCA did not solve all the problems of depositories. Money

market mutual funds had entered the picture and were sapping the deposits

away from traditional institutions. As we have seen, these funds had come

seemingly out of nowhere to provide safe, convenient market-rate returns

to small and large savers. (NOW and ATS interest rates were subject to a

5.25% ceiling until 1986.)

In addition to disintermediation woes, S&L’s were su!ering from interest-

rate risk. Like banks, S&Ls borrow short and lend long. This is a special

problem when interest rates are rising because they must o!er higher rates to

new depositors while stuck with low-interest long-term rates. The problem

was particularly acute for S&Ls because they were making mostly mortgage

loans of up to 30 years’ duration.1 Variable-rate mortgages, which can

largely overcome this problem, were prohibited until 1979.

This led to the first S&L crisis. By 1982 fully three quarters of S&Ls

were insolvent and the industry as a whole had a negative net worth of

about $150 billion, assuming assets marked to market. Regulators, instead

of closing them down, decided to exercise forbearance, giving them time to

The Garn-St. Germain Act was passed in 1982. This act allowed sav-

ings and loans and savings banks to make loans other than mortgages, such

as commercial loans and consumer loans and even “junk” bond finance.

DIDMCA had phased out Regulation Q and raised deposit insurance from

$40,000 to $100,000 per customer. This was an explosive mix. To begin

with, most S&L managers lacked expertise in these areas. The agency that

provided insurance to S&L’s, the Federal Savings and Loan Insurance Cor-

poration (FSLIC) had insu"cient personnel and insu"cient expertise to

oversee these new activities. To make matters worse, a severe recession hit

the country in 1981-82, one that had been engineering by the Federal Re-

1Prior to 1934, most mortgages were written for only three to five years.



serve in order to choke o! the inflation that reached historic levels. As a

result, many S&L assets turned sour, especially in Texas. Losses mounted

to the point where over half of the S&L’s, by some estimates, were insolvent

by the end of 1982.

Hesitating to close insolvent S&L’s, FSLIC regulators chose further reg-

ulatory forbearance. They loosened capital requirements and stretched ac-

counting principles. The situation was allowed to worsen so that by 1989 it

had reached crisis proportions. A half-hearted measure called the Compet-

itive Equality in Banking Act was passed in 1987. The real bailout came in

1989 with the passage of the Financial Institutions Reform, Recovery, and

Enforcement Act of 1989 (FIRREA). The Federal Home Loan Bank Board

and the FSLIC were abolished and a new O"ce of Thrift Supervision was

established as a bureau of the Treasury Department. The FDIC became

the sole provider of deposit insurance, but with one fund for banks (the

Bank Insurance Fund) and one for thrifts (the Savings Association Insur-

ance Fund). The Resolution Trust Corporation (RTC) was set up to clean

up the wreckage of insolvent S&L’s. It seized assets of about 750 S&L’s and

sold about 95% of these assets, receiving an average of 85 cents on the dollar.

The cost of his bailout was approximately $150 billion, some of which came

from the assets of the Federal Home Loan Banks but mostly from the sale

of new government debt. Finally, FIRREA tightened capital requirements.

By 1991, FIRREA was making progress but the FDIC was running out

of funds. In response, Congress enacted yet another piece of legislation,

the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in

1991. The FDIC was given greater authority to borrow and was told to

raise insurance premiums with a goal of achieving an insurance fund equal

to 1.25% of insured deposits. p. 279.

What can we learn from the S&L crisis? Was it a market failure? Lax

regulation? Too much regulation?

Moral hazard was a direct and inevitable consequence of deposit insur-

ance. Without it, bank managers would have been much more circumspect

in their operations. Of course, they might have sought private deposit in-

surance, but the providers of this insurance would have incentives to watch



Figure 14.1: U.S. bank failures, 1935-2004

Source: FDIC

their insured banks carefully and to withdraw insurance from banks that

went too far. (Just the threat of withdrawal would be su"cient in many

cases.) In contrast, the FDIC and FSLIC insured all banks and S&L’s with

little or no attention to the risks they were taking.

Private insurers face moral hazard problems. They deal with them by

various means: deductibles, co-insurance, risk-based premiums, and regu-

lations that purchasers of insurance must agree to. Government insurance,

being politically motivated, lacked many of these sound principles. First, de-

positors were relieved of all responsibility for seeing to the soundness of the

people who invested their money – all they had to do was locate the FDIC

sticker on the door. Further, management was partially protected form bad

consequences of heavy risks. The FDIC charged a uniform premium of 1/12

of one percent per year on insured deposits. Thus, while deposit insurance



solves the liquidity problem – insuring that depositors can get their funds –

it creates a solvency problem.

After the passage Garn-St. Germain, thrifts seemed to recover and the

forbearance strategy seemed to be working. Interest rates eased, and asset

values seemed to rise. But many of these assets were dubious, high-risk

assets.

This led to the second thrift crisis. One commentator labeled the worst

institutions “zombie S&L’s,” technically insolvent institutions that were still

in business, with little to lose, facing incentives to increase risks dramatically.

They o!ered high interest on insured deposits thus putting pressure on their

solvent competitors. On the other side of the balance sheet, they increased

this pressure by making loans at low rates. To add a new metaphor, the

zombie S&L’s were like black holes sucking solvent S&L’s toward oblitera-

tion. Some were paying high interest rates with new deposits – a quasi-Ponzi

scheme. Factors exacerbating the situation included brokered deposits, gen-

erous accounting principles, the too-big-to-fail idea, and, as so often happens

in regulatory regimes, regulators who too close to the institutions they were

supposed to be regulating – not necessarily corrupt, but perhaps emotionally

invested in saving them.

When governments set regulatory standards for banks or any other in-

dustry, an inevitable consequence is that the customers and stockholders

cease worrying about the regulated aspects of those businesses. Thus min-

imum standards tend to become maximum standards because the lack of

consumer oversight removes incentives to do any better than the minimum.

“The government will take care of it,” becomes the general attitude. When,

as in the case of the FSLIC, a regulator is unable or unwilling to do its

job, you have the kind of disastrous situation that gave birth to the zombie

S&L’s and precipitated the general collapse. It is certainly possible that

better management of the FSLIC might have lessened the damage. But it

is also possible that market oversight would have prevented the crisis from

getting started at all.

These three aspects of the situation, deposit insurance, Regulation Q,

and the FSLIC failure, all suggest that the S&L crisis was a massive gov-



ernment failure and in no way a market failure. To be sure, some lessons

have been learned, like risk-based premiums, and the rate of bank failures

is back down to “normal” levels, yet there can be no assurance that some

other crisis may arise out of government regulation.

It is instructive to ask how deposit insurance fared in other countries.

No other countries adopted deposit insurance until the 1960s or 1970s., yet

beforehand, they did not have the same problem with bank runs as the U.S.

had experienced in the Great Depression. Most notably, Canada and most

other countries had no restrictions on branch banking, and thus enjoyed a

less fragmented banking system. Also, foreign banks generally faced fewer

restrictions on their activities nor were deposit banks kept separate from

investment banks.

Economists disagree about many things but they are nearly unanimous

in calling for some kind of deposit insurance reform. One reform has been in-

stituted – risk-based deposit insurance premiums. Insured banks are ranked

from 1 through 5, 4 and 5 being problem banks. Their insurance premiums

are charged accordingly, thus giving bank managers an incentive to “clean

up their act” and stay out of the lower categories.

Yet another piece of legislation would be required before the S&L crisis

could be laid to rest. The Financial Institutions Reform, Recovery and

Enforcement act of 1989 (FIRREA) did the following:

• Instituted the largest bailout in history up until that time – ultimately

totaling $160 billion of which $132 billion was borne by taxpayers. As-

sets of insolvent thrifts were turned over to a new government agency,

the Resolution Trust Corporation, which ultimately disposed of them.

• Modified the regulatory structure once again. The FSLIC was abol-

ished and its functions were taken over by the FDIC, which established

a separate insurance fund for S&Ls called the Savings Association In-

surance Fund (SAIC). Also, the Federal Home Loan Bank Board was

abolished and its regulatory functions were turned over to the new

O"ce of Thrift Supervision, part of the Treasury Department and

analogous to the Comptroller of the Currency, which is also under



Treasury. Other FHLBB functions were turned over to the Federal

Housing Agency.

• Thrifts were re-regulated. They were required to divest junk bonds

and to increase their real estate holdings from 60% to 70% of assets.

Higher capital requirements were instituted for banks, and bank hold-

ing companies were permitted to purchase solvent as well as insolvent

thrifts.

• Harsh penalties were meted out to some of the more notorious players,

including prison terms of up to twenty years.




Part VI

Modern central banking

243

Chapter 15

The Money Multiplier:

How Banks Create Money

15.1 How Base Money Gets Multiplied

We now examine the “money multiplier” that operates in a fractional re-

serve banking system such as we now have. Recall that the M1 money

supply consists of currency in circulation, demand deposits and travelers’

checks. Omitting travelers’ checks which are a minor component of M1, we

can write M1= C + D. The split between C and D is determined b individ-

uals’ aggregate desire to hold currency versus their desire to hold demand

deposits. We can express this as a fraction c = C/D. People tend to hold

less currency when they increase their use of credit cards and debit cards.

Automatic teller machines also reduce the demand for currency since it is

easier to get cash from these machines than to get it by standing in line

inside a bank branch.

Our task is to derive a money multiplier km that shows how base money

is multiplied when it enters the economy as M1 money, i.e. we want to find

km such that M1 = kmB. The variables we use are

245

246 How Base Money Gets Multiplied

B base money

C currency

R bank reserves

D deposits

M1 M1 money stock

rr required minimum reserve ratio r = D/R

r banks’ average actual reserve ratio, r + rr

Now base money B consists of currency C and reserves R; B = C + R.

As we have seen, reserves are accounts kept at the Federal Reserve for the

benefit of commercial banks. Banks are required to maintain reserves in the

amount of at least 10% of their demand deposits.1 We will call this 10%

figure (which as we will see is set by the Fed) rr.

Consider three cases:

1. A single commercial bank with no currency in circulation. Then C = 0,

M = D, B = R and km = M/B = D/R = 1/r Thus

km =1

rM = B "

1

r#M = "B "

1

r

where # means “change in” and r is an average reserve ratio. Thus

for example, r = 1/4 results in km = 4, a fourfold mulitplication of

base money into M1 money.

2. With multiple depositories but still no currency, the result is the same

3. Currrency is introduced.

We now develop the latter assumption. Assume that banks hold no ex-

cess reserves, i.e. their actual reserves are equal to the minimum required

reserves. Call the currency/deposit ratio k = C/D. Then

km =C + D

B1Actually no reserves are required for the first $6.6 million in demand deposits, 3% for

amounts from $6.6 to $45.4 million, and 10% above that. Since most banks of any size

hold demand deposits far in excess of $45.4 million, the average reserve requirement is

very nearly 10%.


Chapter 15: The Money Multiplier:How Banks Create Money 247

=C

B+

D

B

=C + D

C + R

=C/D + D/D

C/D + R/D

=k + 1

k + r

so that

M1 = Bk + 1

k + r#M1 = #B

k + 1

k + r

Thus we see that the money stock is a function of three variables:

• B – controlled by the monetary authorities (or by market factors in

the case of a gold standard)

• r – controlled by banks (but subject to r + rr)

• k – controlled by the public

Thus base money becomes M1 money through a multiplication process.

How significant is this multiplier? Suppose the public wants to hold $5 in

demand deposits for every $1 in currency. Then c = C/D = 1/5 = 0.2.

With r = 0.1 the multiplier is

c + 1

c + r= 0.2 + 10.2 + 0.1 = 4

Thus every new dollar of base money results in $4 of M1 money (1/6 of

that, or $0.67 in new currency and the rest, $3.33, in new demand deposits).

Again, we are assuming that banks hold no excess reserves. Excess reserves

are costly for banks because they earn no interest, so banks maintain them

only when they see a good reason to do so, such as expected heavy with-

drawals or expected forthcoming loan opportunities. Excess reserves allow

them to accommodate either of these contingencies without calling in loans,

o!ering higher interest to draw more deposits, or borrowing federal funds.

If they find themselves holding a temporary excess they can loan those

funds to another bank which is in need of reserves to meet its requirement.


248 How Base Money Gets Multiplied

Figure 15.1: M1 multiplier.

This bank-to-bank loan market is called the federal funds market. Fig-

ure 15.1 shows an estimate of the M1 multiplier which has been declining

steadily in recent years.

Clearly the Federal Reserve does not have complete control of the M1

money stock since the money multiplier which converts base money into M1

contains terms that are outside the Fed’s control. The currency/deposit ratio

is entirely determined by the preferences of the public. Currency is becoming

less important in ordinary daily transactions as people find credit cards and

debit cards increasingly convenient. But demand from drug dealers and

others eager to hide their transactions, along with overseas demand for U.S.

currency, have led to increasing demands for currency in recent years.


Chapter 16

The Federal Reserve System

16.1 Origins

In the United States, the Federal Reserve System, commonly called “the

Fed,” is the central bank. The Fed commenced operations in 1913, fol-

lowing legislation passed in 1912. The public interest justification for the

creation of the Fed was the need for an “elastic” currency, one whose sup-

ply could expand during times of greatest need, such as harvest time or

Christmastime, and contract at other times. While legally authorized by

Congress, the decision to start a central bank was probably reached at a

secret conference organized by J. P. Morgan, arguably the most powerful

Wall Street financier of his time, held in 1910 at his private island o! the

coast of South Carolina. A public choice viewpoint of the creation of the

Fed would point to the private interests of the House of Morgan and his

allies in business and politics.

16.2 Organization

The legal structure of the Federal Reserve is not economically important and

we explain it here partly because some people on the fringes of economics

use it as a basis for silly conspiracy theories. Legally, the Fed is owned by

private member banks like Citicorp or Bank of America. These banks are

249

250 Organization

required to buy shares of Federal Reserve stock and that stock pays them

a fixed 6% yearly dividend. But this stock bears little resemblance to the

shares of private corporations. Member banks may not sell their shares of

Fed stock and the dividend cannot be changed. While the Fed earns profits

on its operations, it cannot distribute those profits to its “owners” except

through the 6% “ dividend.” The member banks’ ownership of “ stock” does

not give them the right to vote out the management as the stockholders of

an ordinary corporation could. From an economic point of view, the Fed

should be thought of as a government agency, albeit an agency with some

very special obligations and privileges as we shall see.

Let us now focus on the functioning of the Fed. Fiat money issued by

the Fed or any other central bank, rather than being spent directly by the

government, is loaned out. The Fed does not actually lend money directly

to the Treasury. Instead, through its open-market operations, the Fed buys

Treasury securities from New York bond dealers. These are typically Trea-

sury Bills that were first purchased by a commercial bank or other private

party. When it does so, it reduces the supply of these bonds in the private

market, thereby making it easier for the Treasury to issue new bonds into

the market.

As of 2006, the Fed held about $800 billion worth of Treasury securities,

and this constitutes about one sixth of the total federal debt (not counting

debt in the hands of Federal agencies like the Social Security Administra-

tion). This $800 billion worth of debt is said to have been monetized, because

in essence it has been taken o! the market and replaced with newly created

money.

We must emphasize that the Fed really does create new money “out of

thin air.” When buys bonds in the New York bond market, the Fed pays

with money that never existed before. This activity is some ways similar

to counterfeiting which is of course illegal. We shall return to the e!ects of

new money on the economy subsequently.

What does the Fed do with the Treasury securities that it acquires? It

holds them and collects interest on them from the Treasury and it presents

them for redemption when they come due. The interest on $800 billion worth


Chapter 16: The Federal Reserve System 251

of securities amounts to a lot of money. For example, if the average interest

rate on the Fed’s holdings were 3%, its annual interest income on its $800

billion holdings would be about $24 billion. However, the Fed is required by

law to return these interest earnings to the Treasury. This money flowing

into the Treasury can be viewed as an indirect form of seignorage, although

this is not as significant to the Treasury as the Fed’s “soaking up” of supplies

of Treasury debt so as to clear the way for more new debt.

There is an important condition attached to the legal requirement that

the Fed return its interest earnings to the Treasury. The Fed is allowed to

deduct its operating expenses from the amount remitted to the Treasury.

In other words, the Fed sets its own budget. All other Federal agencies

must compete for Congressional appropriations during each year’s budget

cycle. The public-interest defense of this arrangement is that it helps the Fed

maintain its independence from political pressures since Congress cannot use

the threat of budget cuts to wield undue political influence. However, the

flip side of independence is accountability. To the extent that the Fed is

unaccountable to the people’s elected representatives, it is undemocratic.

Also, the freedom to set its own budget gives the Fed incentive to spend

lavishly on salaries and facilities. One of the Fed’s main spending priorities

is hiring economists either for its sta! or as consultants. By so doing, the

Fed can di!use opposition to its policies or its existence.

The law also grants the Fed a monopoly on note issue. When the authors

were young, one-dollar bills were silver certificates, issued by the Treasury

and redeemable on demand for the silver coins that circulated then. These

certificates were discontinued when all silver was removed from U.S. coins in

1965,1 and since then all paper money has been issued by the Fed. When the

Fed was created, its twelve branches were more independent than they are

today. A remnant of that independence could be found on notes issued up

until about 2002, which bore a letter indicating the Federal Reserve district

that issued that particular note, such as A for New York and L for San

1After 1965, the U. S. Mint issued half dollars containing 40% silver for a few years,

but these did not circulate. In recent years, the Mint has issued gold, silver and platinum

“coins” which, though they are legal tender, do not circulate as money.


252 Organization

Francisco. The earliest Federal Reserve notes showed the district of origin

quite prominently as you can see in Figure 6.3.

Under our present system, issuance of Federal Reserve notes does not

in itself represent creation of new money. The money that the Fed creates

in open-market operations is in electronic form. Some of this money is

converted to notes as requested by private banks in response to customer

demands. These banks can request shipments of fresh bills from the Fed at

any time, and the Fed deducts the amounts from the private bank’s account

at the Fed. The bills are actually printed by the Bureau of Engraving and

Printing, a separate government agency. Private banks also return worn

bills to the Fed for replacement with fresh bills. One-dollar bills typically

wear out in less than two years, but higher-denomination bills last somewhat

longer.2

We have seen that the Fed can create new money at will through its

open-market operations. But we must remember that private banks also

create money via the fractional reserve system. Moreover, they now use

the central bank’s notes as reserves because these notes usually enjoy the

government’s legal tender sanction, which you will recall requires that all

taxes be paid in that money, and in a stronger form, requires in addition

that all holders of all debts, public and private, accept central bank money

in payment of these debts.3 We can envision two tiers of money creation.

First, the central bank issues new money and then private banks pyramid

2One-dollar bills have been a headache for the monetary authorities for a number of

years. New Susan B. Anthony one-dollar coins, smaller than the silver dollars of earlier

years, were issued in 1979, but the public did not accept them because they were easily

confused with quarters. Then in 1997 the Mint tried issuing brass-colored coins bearing

the likeness of Sacagawea, but these have also failed to catch on and are generally appear

only as change returned by government-owned vending machines in post o#ces, train

stations, etc. Canada solved its one-dollar problem by simply discontinuing its one-dollar

bill. However, it had a two-dollar bill in circulation which was not plagued by superstitious

rejection as U.S. two-dollar bills were. These stories show that even when governments

monopolize the issuance of money, they cannot force the public to accept particular forms

of it.3Thus we see printed on all our paper currency, “This note is legal tender for all debts,

public and private.”



their monetary expansion on top.

16.3 Instruments of control

The Federal Reserve System has a great deal of influence on the U. S. econ-

omy and indirectly, on the entire global economy. The speeches of the Fed

Chairman are carefully dissected by financial commentators searching for

clues about future policy shifts. Markets eagerly await the results of regular

meetings at which the Fed may decide to change course in its conduct of

monetary policy.

16.3.1 Monetary Instruments

Open market operations

The Fed has three powers that influence the money supply. We have already

discussed open-market operations in which the Fed buys Treasury securities

using newly created money, or sells them and e!ectively destroys the money

it receives. For the last several years the Fed has announced target Fed

Funds rates, and these targets are widely publicized. But the public is less

aware of the fact that the Fed achieves its targets by manipulating the money

stock through open market operations.

Discount Rate

The Fed’s other two monetary control powers are not much used. One is

the discount rate, which is the rate at which the Fed stands ready to loan

reserves to member banks. Unlike the Federal Funds rate, the Fed actually

sets the exact discount rate that it wants. But the Fed prefers that member

banks obtain needed reserves by borrowing them from other commercial

banks, that is, in the Federal Funds market. As a result the discount rate

does not play a direct role in the conduct of monetary policy. It is generally

set at a rate somewhat higher than the Federal Funds rate. For example, as

this is written, the Fed Funds target rate is 5.25%, the average rate for recent

transactions is 5.24% and the discount rate is 6.25%. The discount rate does


254 Instruments of control

serve as a sort of “circuit-breaker,” in case for some reason a sudden demand

for Fed Funds were to drive the Fed Funds rate substantially higher than the

target rate, it banks would want to borrow from the Fed’s Discount Window

rather than in the Fed Funds market.

Reserve requirements

The third discretionary power that the Fed wields is the reserve requirements

for demand deposits. This has been set at 10% for many years and while

reductions in this requirement could increase the money supply, and vice

versa, this tool is considered rather blunt in comparison to open market

operations.

16.3.2 Non-monetary instruments

The Fed has acquired miscellaneous other powers as a result of historical

circumstances. These are relatively insignificant at present.

Margin requirements

In addition to its monetary control authority, the Fed is empowered to set

margin requirements for stockbrokers. During the speculative boom of the

1920’s, some people bought stocks using borrowed money. This practice is

called “buying on margin.” They put up as little as 10% of the purchase

price, borrowing the rest from the broker, and brokers typically borrowed

from banks. Stockholders in this position are very vulnerable to price de-

clines, because a drop of just 10% in the price of their stock would wipe out

their equity and they would get a call from their broker (a “margin call”)

demanding that they put up more money or have their position sold out. It

was thought that margin buying contributed to the severity of the 1929 stock

market crash, so the Fed was given the authority to set minimum margin

requirements, currently 50%. Between 1934 and 1974 the Fed changed this

figure 22 times, but it has remained at 50% since 1974. Note that the 50%

requirement was in e!ect at the time of the 1987 crash, which in percentage

terms was more severe than that of 1929.



Regulation Q

As we indicated in our discussion of banking, the federal government at

one time limited the amounts of interest that banks could pay on savings

accounts, under Regulation Q. This regulation was administered by the Fed-

eral Reserve but has been abolished.

16.3.3 Other powers

At one time, President Carter blamed consumers’ overuse of credit cards for

the high rate of price inflation at that time. For a brief time in 1980 the Fed

was given some control over consumer credit. At one time the Fed also had

some control of down payments by home buyers.


256 Instruments of control


Chapter 17

Targets of monetary policy

17.1 Pre-1929

Prior to 1929, the quantity theory of money held sway, and it was thought

that the price level would rise in concert with the money supply. How-

ever, there was disagreement about other aspects of banking. The Cur-

rency School of thought of mid-nineteenth century England was dedicated

to hard money and opposed to fractional-reserve banking. The Banking

School thought that limited fractional-reserve banking was acceptable. This

school also advocated the “real bills” doctrine which held that short-term

loans for productive business purposes should be the basis of currency.

17.2 The Great Depression

and the Keynesian revolution

17.3 Stagflation and the

monetarist counter-revolution

17.4 Monetary policy options

Two ways of conducting monetary policy are currently recognized. Actual

policy can be a blend of these two. We will add a third option, free bank-

257

258 Monetary policy options

ing, which is not widely known or discussed but which has theoretical and

historical underpinnings that we believe merit examination.

17.4.1 Discretionary versus rule-based policy

The concept of monetary policy as a tool for managing the economy gained

currency during the Keynesian revolution. Keynesians advocated an activist

monetary policy, meaning that the monetary authorities should stand ready

to react to macroeconomic events as needed and should not be bound by

any strict rules. Economic slowdowns would be met with injections of new

money while booms would be countered by monetary restraint.

Milton Friedman took an opposing point of view, at one time advocating

strict rules for monetary policy. The money supply should be increased at

some fixed annual rate. Whether the chosen rate was 2%, 3%, 4% or some

other number mattered less than a commitment to keep that rate constant.

Under this regime, a computer would be adequate for the conduct of mon-

etary policy, said Friedman. As his main justification for this position, he

cited the “long and variable lag” between the implementation of a monetary

policy change and the time when the change e!ects the economy. By the

time a change takes hold, conditions might have changed so much as to make

the policy counter-productive, according to Friedman.

Friedman’s extreme rule ran afoul of the shifting characteristics of the

monetary aggregates during the 1970’s. Deregulation opened up new sub-

stitutes for traditional M1 money holdings (cash and checking accounts). In

particular, money-market mutual funds, which are counted in M2, o!ered

almost as much liquidity and higher interest than checking accounts. This

posed a problem for the Friedman rule since someone must decide whether

the specified percentage increase is to be applied to M1, M2, the monetary

base, or some other measure. As a result of this problem, Friedman has

backed away from his proposal for a strict rule.

The Taylor rule is an alternative targeting rule for interest rates. It

requires first that targets be selected for price inflation and real output

growth. It also requires an estimate of a desurabke long-term equilibrium

real fed-funds rate. These three numbers are then combined with observed


Chapter 17: Targets of monetary policy 259

values of price inflation and real output growth. Four terms are added to

get the desired fed-funds target rate:

1. The long-term target real fed funds rate (2% is usually selected)

2. The rate of price inflation, #P/P

3. Half of the “inflation gap” which is the di!erence between the actual

rate of price inflation and the target rate.

4. Half of the “output gap” which is the di!erence between potential and

actual output.

This rule implies that both price inflation and output growth are important

and should play a role in the target formula. during the period from 1960

to 2003, the Taylor Rule tracks fairly well with the Fed Funds rate. Some

have suggested that Chairman Alan Greenspan has been following this rule

although there has been no public commitment to do so. And if the Taylor

rule were ever to be enshrined as o"cial policy, there would be substantial

political pressure to modify or abolish it in recessions or inflationary periods.

There would also be pressure from economists who think their proposed

improvements on the Taylor rule should be written into policy.

17.4.2 Monetary Policy Versus Democracy

We have seen that the Federal Reserve System is independent of Congress

and the President in one important respect: it sets its own budget. However,

the Chairman and the other members of the Fed Board of Governors are

appointed by the President, which suggests that they are at least mildly

beholden to him. Also, the Fed Chairman is required to testify periodically

before Congress. So the Fed is to some degree independent of political

pressures and in some ways not. What is the right degree of independence?

Independence shields the Fed from short-term politics and thus, at least

in theory, enables it to “do the right thing.” On the other hand, in our

democracy all departments of the government are supposed to be account-

able to the people’s elected representatives. What is the right balance be-



tween independence and accountability? There will probably never be a

definitive answer to this question.

This question brings up the more general conflict between democracy

and the Keynesian idea that fiscal and monetary policy rules can be de-

rived from correct economic theorizing and that the government’s job is

therefore simply to implement correct policy. This of course clashes directly

with both the theory and practice of democracy. To repeat, the theory

is that elected representatives should have ultimate control. And in prac-

tice, congress people are constantly urged to “do something” about real and

imaginary problems of all sorts, but particularly economic problems. They

have substantial incentives to intervene in such things as monetary policy,

or at least to give the appearance of having held the monetary authorities

accountable.

17.4.3 Free Banking

Free banking, as we have seen, is in its pure form a situation devoid of gov-

ernment involvement in monetary a!airs. Private banks accept deposits as

they do now, but in addition they would issue their own name-brand ban-

knotes (or perhaps an electronic equivalent of paper banknotes). They would

hold whatever reserves seemed best able to attract customers and preserve

their reputations as sound institutions – while specie seems a likely candi-

date, there are other possibilities. Competitive pressures would constrain

them against excessive issuance of banknotes or expansion of loans relative

to reserves. Basically, they could not over-issue relative to the public’s de-

mands to hold their notes or deposits. Clearinghouses could be independent

profit-making companies or non-profit associations of banks.

In the United States, the term “free banking” has been associated with

the experience of the nineteenth century, a time when the rate of bank failure

and fraud was not insignificant. The name “wildcat banking” has become as-

sociated with this time for that reason. However, the reality was that banks

were by no means entirely free during that time. One form of government

control was the common prohibition of branch banking, which prevented

stronger city banks from expanding into rural areas, thereby leaving those


Chapter 17: Targets of monetary policy 261

areas for small, under-capitalized or mismanaged banks. A further inter-

vention was the requirement on the part of many state governments that

state-chartered banks hold state government bonds as part of their reserves.

A more instructive historical episode was that of Scotland during the

time period 1715-1844. This episode came closer to pure free banking and

the results were on the whole quite good. Competing private banknotes

circulated freely throughout Scotland, and there was only one significant

bank failure in all that time, the Ayr Bank. One of the precautions taken

against bank runs was the “option clause” which was attached to banknote

issues. This gave the bank an option to delay redemption of its notes in case

a run should begin to develop. The delay was of limited duration and the

notes were to bear interest during that time. However, option clauses were

outlawed in 18xx and the entire free banking period in Scotland came to an

end in 1844 with the passage of Peel’s Act, which among other things gave

the Bank of England, which had long since established itself as England’s

central bank, dominion over Scottish banking as well.




Part VII

Money and the world

economy

263

Chapter 18

International trade and the

balance of payments

265

266


Chapter 19

Exchange rates, fixed and

floating

19.1 The traditional gold standard

19.2 Monetary nationalism

267

268 Monetary nationalism


Chapter 20

Other aspects of modern

international finance

20.1 Increasing private competition

20.2 The international debt crisis

269

Index

Alchian, Armen, 28

Amazon.com, 79

Anderlini, Luca, 29

Aristotle, 28

Balance sheet, 77

Bank panics, 98

Bank runs, 92

Bankers’ acceptances, 134

Banking

fractional reserve, 89

benefits of, 91

drawbacks of, 92

Banks

central, 99

fractional reserve, 95, 97

merchant, 87

Barron’s Business and Financial Weekly,

63, 121, 174

Barter, 22

Bills of exchange, 73

Bonds

corporate, 133

junk, 86

market value of, 138

marketability, 162

maturity, 164

municipal, 129

special features, 163

tax treatment, 162

Brassage, 19, 56

Breaking the buck, 136

Burns, Arthur, 29

Capital, 70

Central bank, 103

Certificates of deposit, 124

Checks, 96

Civil War, U.S., 19, 61

Coinage Act of 1873, 56

Coins

Chinese, 19

copper, 57

debasement of, 57

Denarius, 57

earliest, 19

Livre Tournois, 57

Sacagawea, 103

silver, 57

Susan B. Anthony, 103

Commercial paper, 134

Continental Congress, 59

Corporations, 74

Counterfeiting, 47

270

INDEX 271

Credit, 67

Credit cards, 9

Credit unions, 146

credit unions, 177

Crusoe, Robinson, 67

Currency, 122

Davies, Glyn, 28

Debit cards, 9

Deflation, 160

Deposits, savings, 124

Depreciation, 113

Einzig, Paul, 29

Equation of exchange, 38

Exchange

direct, 12, 22

indirect, 12

Exchange-traded funds, 173

Export-Import Bank, 132

Federal Deposit Insurance Corpora-

tion, 148

Federal Home Loan Banks Financing

Corporation, 132

Federal Home Loan Mortgage Corpo-

ration, 131

Federal Housing Administration, 132

Federal National Mortgage Associa-

tion, 131

Federal Reserve System, 100

creation of money by, 101

function of, 101

gold holdings of, 107

note issue monopoly, 102

Fidelity, 170

Finance

direct, 72

indirect, 85, 86

Finance companies, 148, 170

Financial instruments, 121

Financial intermediaries, 169

Fisher, Irving, 49

Free banking, 98

French revolution, 60

Friedman, Milton, 50, 59

Glasner, David, 28

Gold, 93, 107, 117

gold, 111

Goldsmiths, 89

Goods

durable, 71

Government National Mortgage As-

sociation, 131

Greenspan, Alan, 111

Gresham’s law, 55, 57

Hayek, Friedrich, 10, 28, 118

Hedge funds, 174

Hoarding, 42

Hugh-Jones, Stephen, 29

Humphrey, Caroline, 29

Hyperinflation

Confederate, 61

German, 61

Inflation


272 INDEX

as a tax, 113

distortions caused by, 113

distribution e!ects, 112

net welfare e!ects of, 114

inflation

incentives for, 115

sustained, 111

Insolvency, 93

Insurance companies

Life, 170

Property and casualty, 170

Interest, 68, 156

real rate of, 159

Interest rates

controls, 165

Jevons, William Stanley, 9, 28

Keynes, John Maynard, 49

Legal tender laws, 54

Liquidity, 125

Loanable funds, 83, 151

Loans

Risk

default, 161

McCulloch, J. Huston, 28

Melitz, Jack, 29

Menger, Carl, 28

Mint Act of 1792, 56

Mises, Ludwig von, 28

Monetary aggregates, 122

Monetary base, 123

Money

benefits of holding, 115

commodity, 111

creation of by private banks, 94

demand for, 36

emergence of, 12

fiat, 57, 63, 104, 111, 117, 118

hard, 118

high-powered, 108

liquidity preference theory of, 49

modern quantity theory of, 50

outside, 108

paper, 58

portfolio demand for, 41

purchasing power, 31

purchasing power of, 43

quantity theory of, 49

stability of demand for, 51

standard of deferred payment, 25

store of value, 24

subsidiary functions of, 21

supply of, 43

transactions demand, 37

unit of account, 22

Money market mutual funds, 134, 148

Money stock

calculation of values, 127

M1, 123

M2, 124

M3, 125

Money-market deposit accounts, 125

Money-market mutual funds, 125, 175

Mortgage-backed securities, 134

Mutual funds, 147, 170


INDEX 273

closed end, 172

open-end, 171

Non-bank intermediaries, 169

Order

planned, 11

spontaneous, 10

Pension Benefit Guaranty Corpora-

tion, 148

Pension funds, 170

Pepsico, 15

Permanent income hypothesis, 50

Pound sterling, 54

Present value, 137

Price index, 31

Profit

accounting, 154

economic, 154

Quiggen, A. Hungston, 29

Radford, R. A., 28

Real estate investment trusts, 148,

174

Resolution Funding Corporation, 132

Rothbard, Murray N., 118

S&P 500 index, 173

Sabourina, Hamid, 29

Saving, 67, 72, 155

Savings and loan associations, 170

Savings and loans, 177

Savings banks, 170, 177

Securities

government agency, 130

Seignorage, 56

Selgin, George, 118

Shakespeare, William, 10

Smith, Adam, 11

Specie, 19

Spyders, 173

Stock, corporate, 133

Stockbrokers, 144

Student Loan Marketing Association,

132

Tale, 19

Tennesee Valley Authority, 132

Transaction costs, 24

Treasury securities, 128

Underwriting, 145

Unidad de fomento, 23

Usury, 87

Vanguard, 170

Velocity of money, 38

Washington Mutual, 170

Weatherford, Jack, 28

White, Lawrence, 28, 118

Williams, Jonathon, 28

Yield curve, 164

expectations theory, 164

inverted, 164

liquidity premium theory, 165

preferred habitat theory, 164

segmented market theory, 164

Yield to maturity, 137, 139


Documents

Money, Banking and Finance Jeﬀrey Rogers Hummel Warren C. Gibson