GOOD AND BAD PAPER

by Maarten de Kadt,                                       
That dollar bill you have in your pocket, just a fancy piece of paper, plays an important role in the financial crisis that surrounds us today. We call it “money” because the government declares that it is. While cash is the basis of all other kinds of money, it is only a small part of the money supply. Cash in circulation and checking accounts comprise 18% of the money supply that includes savings accounts, certificates of deposit, and money market mutual funds.

Most of the money you have not otherwise spent or invested you’ve probably put into a checking account. This gives banks the power to create more money by lending it to someone else while you are not using it. The thing is banks as a group can lend it multiple times at the same time. They know a portion of the money you’ve entrusted to them will not be used. I don’t mean you as an individual. Rather the “you” is a collective you representing all of us who have entrusted our money to the banks.

We mostly use money to buy things. Money used to buy and sell is called a “medium of exchange.” The bank, however, uses your money to permit someone to buy or construct something and pay that expense back later. In that use money is called a “means of deferred payment.”

In times when the economy is growing banks can lend out money, even many times more than the initial amounts of money entrusted to them and not worry about the responsibility they have of paying checking account holders back their money any time a check is written. There is always enough money coming in to cover the money going out. It is not unlike a huge, legal, Ponzi scheme. If unlimited loans were made on checking accounts there would be a problem if the economy stopped growing as fast as it was up until 2008 or so.

To keep banks solvent, bank regulations restrict banks to lending out less than about 10 times the total value of their checking account holdings. The investment sides of large banking/financial institutions do not have the same restriction, however. They can and have invested many times more than their financial worth. During the early years of the 21st century, banks had a great deal of ‘spare’ money on hand. They needed to invest their assets in order to improve their profits. Housing was one area in which they could invest (for a time anyway). But that did not account for all the funds available to them for investment during the time the economy was growing. Since their perception was that investment in production of some commodity or another was not going to earn as much, they invested in financial securities, unwisely as the 2008 crisis has shown. Building new things, needed to stimulate the economy and create jobs, did not happen.

Investment in the large number of financial instruments that occurred in the first years of the 21st century would not have been legal under a law established in 1933: the Glass-Steagle Act. That law required the banking function to be separated from the investment functions of financial institutions. The protective effect of that law was effectively repealed under the Clinton administration in 1999 when the Gramm-Leach-Bliley Act became law. And the credit run-up and crash is now history.

Money is needed to facilitate exchange, to enable people to build things and pay for them over time, and to enable safe storage of accumulated wealth. Banks are needed to facilitate each of these kinds of transaction. But regulation is also needed to prevent the extreme buildup of credit and extreme risk taking that occurred leading up to and continuing through the current financial crisis. Healthy economic activity creates new infrastructure and jobs. Reckless banking in paper that can become worthless such as credit default swaps or variable rate mortgages, won’t achieve that. So in their current configuration, by using their excess money to buy financial instruments, bank giants have become a benefactor of the 0.1% and the enemy of the rest of us by creating profit for the few and foreclosure for the many.

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