Banking on Geniuses 2 - Money, Not Just Another Product

The first article in this series drew on a laudatory New York Times article about Mr. Jamie Dimon, the C.E.O. of JP Morgan Chase, to explain Mr. Dimon's vision of a very large bank being free to offer as many different kinds of financial products as it found convenient.  This article explains why we at Scragged disagree with Mr. Dimon.  Much as we dislike government regulation, we believe that there must, for the safety of everyone, be limits on the kinds of financial products any one business is allowed to offer.

Our difficulty with Mr. Dimon's vision is that although money has many characteristics of an ordinary commodity in that you can buy and sell money and the risk of changes in the value of money both now and in the future, it is not a product just like any other.  People have recognized this for a long time, which is why banks have been subject to special regulation for centuries.

Money, the Universal Commodity

Before the invention of money, people had to barter.  If you wanted to buy some lettuce, you'd have to meet someone who had some lettuce, find out what they wanted in exchange, and swap.  If you had apples and the other person had oranges, it was sometimes hard to agree on how to compare them.

This was so obviously awkward that gold has been used as a medium of exchange from the beginning of human history.  For small-scale commerce, gold works well because it's light, valuable, and hard to destroy.  You could swap gold for anything and the person who sold it to you could swap it for anything else.  In that sense, gold was and to some extent still is a universal commodity.

Ron Paul notwithstanding, though, gold has problems.  For one thing, carrying around enough gold to support a modern economy is inconvenient.  19th-century economies resolved this trouble by printing paper money which could be exchanged for gold if you wanted, but as long as everybody had faith that this promise would be honored nobody did - they carried the paper and let the gold sit in the vault.

Up until the Roosevelt depression. American money was backed by gold.  Any citizen could go to a bank and buy gold for about $30/ounce.  Since the government couldn't increase the money supply any faster than it was able to acquire physical gold, inflation was not a worry.

This had advantages for savers, but was inconvenient for governments - without inflation, government would have to pay back a billion dollars for every billion they borrowed.  During the Depression, the Roosevelt administration took the United States off the gold standard.  That way, he could run up the national debt and could pay it back in cheaper dollars.

What's more, Roosevelt not only refused to convert dollars into gold, he made it illegal for American citizens to own gold.  They had to turn their gold in for dollars.  That way, all Americans paid the price for inflation as a hidden tax on wealth.  This was perfectly in keeping with Roosevelt's progressive politics but reducing the value of money was not helpful to getting the economy moving again - why invest if you're afraid inflation and/or taxation will eat away all your profits?

The Invention of Banking

Gold is inconvenient lying around the house - people want to steal it.  Throughout history, powerful merchants who could afford to build and defend strong buildings would allow others to store their gold for a nominal fee.  Like the "Self Storage" businesses of today, you'd drop off your gold and pay so much a month.

Gold is fungible, which means that one bar of gold looks very much like another bar.  You wouldn't necessarily get back the same gold you put in when you made a withdrawal.  You'd get the equivalent weight, but it might be someone else's gold.  As long as the gold has same purity, this makes no difference.

Gold is heavy, so the clerks wouldn't always schlep the gold all the way to the back of the warehouse; they'd handle deposits and withdrawals from a smaller amount of gold piled near the front.

The story goes that some genius noticed that they never, ever touched the gold at the back of the warehouse.  They didn't need to because most people left their money for long periods of time.

Since all that gold was just sitting there gathering dust, an aggressive manager started taking the unneeded gold from the back and lending it out.  This genius was making money lending out other people's money!  Just like that, modern banking was born.

Good Times, Bad Times

The ability to put someone else's unused capital to work was a major innovation which led to a great deal of economic growth.  Banking centers such as Venice and Florence prospered, but there was a very hazardous down side.

Consider Shakespeare's play The Merchant of Venice.  Antonio, a wealthy merchant, wants to lend 300 ducats to his friend, but he's cash-poor.  His ships are at sea and, until they get back and he sells the cargo, he doesn't have the money.  He borrows it from Shylock, a wealthy banker.

When Antonio's ships are lost at sea, he can't pay back the money and he's in trouble.

Suppose Shylock had lent money to other merchants and their ships are are at sea.  Someone who has a lot of gold on deposit comes in and wants to send a caravan to China.  Shylock's records show that this guy has 1,000 ducats on deposit.  He needs 500 ducats to launch his caravan, but Shylock, having lent all the money to shipowners such as Antonio who can't pay, doesn't have cash to give him.

Shylock isn't bankrupt in that he will have money when the ships come in, assuming that they do, but he doesn't have it now.

Will the frustrated depositor keep quiet?  Most likely not.  As word gets out, everyone with money in Shylock's bank demands it back, but he can't pay.  That's called a "run on the bank."

At the time of the Roosevelt depression, most banks had lent money on real estate mortgages.  When homeowners and renters lost their jobs, they couldn't pay.

The banks didn't get the "future money" they'd paid for.  Without income, they couldn't meet normal requests for cash.  Word spread, everybody demanded money, and the banks closed.

The book The Great Depression: A Diary is a collection of notes made by Benjamin Roth, a lawyer who practiced in Youngstown, Ohio, during the depression.  He noted that when the banking system froze up, the entire economy froze up with it:

Oct. 16, 1931

Business is being operated in crazy-quilt fashion.  No one will accept checks and nobody has cash.  The wholesalers, most of whom have their offices in other cities, refuse to deliver merchandise to the stores except C.O.D. cash. P 31   [emphasis added]

Oct 17, 1931

The financial situation would be ridiculous if it were not tragic.  Everybody demands cash – no checks are accepted.  The Truscon Steel Co. paid its employees with checks drawn on a large New York bank and the local banks refused to cash them.  The check may be good today and bad tomorrow.   Even certified checks are regarded suspiciously.  P 32

The Disastrous Chain Reaction

Notice that the problems Mr. Roth observed weren't caused by all the banks failing.  Most of the banks were still perfectly healthy and checks drawn on them would in fact be honored - in the end, only about 20% of the banks failed.

The trouble was that nobody knew which banks could honor their checks on any given day and neither did the banks.  A bank might be strong and sound this morning, and collapsed by a run this afternoon.  We saw a shadow of this effect when Bear Stearns and Lehman Brothers collapsed over a weekend - bankers left Friday afternoon without a care in the world and arrived Monday morning to find the doors padlocked.

Banks are so important to the economy that we need strict rules to keep them from taking on too much risk.  The more risk a bank takes, the more likely it is to get in trouble.  What's worse, banks are linked together, so trouble in one spreads through the banking system.  Let's see how this works.

Antonio's misfortune in having his ships sink means he defaults on his loan to Shylock.  Antonio's stiffing his counterparty for 300 ducats means that Shylock can't pay his counterparty and on it goes.

Gold lying around in the store room "just in case" doesn't earn any money, so bankers try to lend as much as they can.  The problem is that if a bank lends out all the money, it doesn't take much of a withdrawal to trigger a run.

If the bank lends out only a small fraction of its reserves, a run is less likely, but the bank can't make as much money.  That's why "reserve ratios" are so controversial.  Some experts believe that 6% is pretty safe, others argue for more, others for less.

A chain of defaults ends only when the loan arrives at some counterparty with enough money to cover all the debts.  That's why we regard government as the "lender of last resort."  When things get really bad, only the government can stop the crash by backing up banks who're in trouble.  This works only because we all know that the government, having abandoned the gold standard, can print as much money as it needs, overnight via computer if necessary.  Dealing with the resulting increase in the money supply is put off for another day.

Fiat Money Has No Intrinsic Value

The risk of defaults in our economy is greater than with money backed by gold because our money is based only on confidence.  Gold always has value no matter what the government does, but modern currencies have no value of their own - you can't eat a dollar.

Once our government ended the relationship between gold and the dollar, the government was free to print dollars as much as they liked.  Being able to do this means that the government can always cover the last counterparty in line; that's what TARP and the Obama Stimulus were all about.

The downside is that modern money has no value of its own, it's money only because the government says so.   It's called "fiat money" because a dollar has value only by government fiat.

The price of gold has gone from $30 to $1,800 from the time of the Roosevelt Depression until now.  The rising price of gold means that the price of a dollar is going down, which we call "inflation."  Instead of buying 1/30 of an ounce of gold, a dollar buys 1/1,800 of an ounce, and correspondingly less of everything else.

Today's dollar is worth 1/60 of what a dollar was worth when Roosevelt abandoned the gold standard.  This made it a lot easier for the government to pay off the money Roosevelt borrowed.

Throughout history, governments always start with gold-backed money.  When gold gets inconvenient, they abandon the gold standard for something they can manipulate.  Benefitting the government and its chosen insiders this way is so common that there's a word for it - it's called seignorage, the difference between a piece of money's face value and the actual cost to manufacture it.

Ya Gotta Believe or Banks Fail

The government can say what it likes, but in fact, fiat money has value only if people believe the government enough to swap useful commodities such as lettuce at Wal-Mart for inedible greenbacks.  That's why confidence is so important.

If everybody believes Shylock has enough money to pay, they won't ask.  If they have the slightest inkling that he might be trouble, however, they'll demand all their money "just in case" and he'll go down even if the ships arrive tomorrow.

We saw this in 2010 - as depositors fled weaker banks, J. P. Morgan took in an additional $180 billion which came in handy.  People trusted J.P. Morgan when they didn't trust other banks, and JPMC benefited enormously.

When a Republican president is at the end of his term, our media tend to talk down the economy in the run-up to the election to help the Democrat.  When the economy is healthy this doesn't much matter, but when it's really on the edge, this is risky - if enough people lose confidence, whatever bubbles have formed in the economy pop and we have a crash.  Even if it doesn't get as far as a full-blown crash, rich people sell their stocks and buy gold, which won't help.

If our trading partners think that we're going to print a lot more dollars and run down the value of the dollars they've gained trading with us, they'll be less likely to to lend us more money for more trade.  Confidence is a very fragile thing and doing anything to weaken confidence is dangerous.

"Ya Gotta Believe" was the motto of Tug McGraw, who pitched for the New York Mets.  Self-confidence is as important in athletics as in banking, but in both cases, the results on the scoreboad may not always match up to the confidence.

In the next article, we'll look at what happens to the system as a whole when people lose confidence.