When the Economy Slows Down, Many Point the Finger at Banks

Banks

With our entering a period of at least global economic slowdown, we need to be aware of the potential for political dissent, and a lot of this anger is directed at the banking sector.

We don’t have to go back very far in time to see how economic slowdowns can rile up a lot of people. During the Great Recession, these dissenters were well in view, even occupying various spaces to protest the disparity between the common people and the elite.

Much of the finger-pointing was directed at financial institutions, and all the bailouts that we saw back then really festered this discontent. They say a little knowledge can be a bad thing, in comparison with ignorance or actual knowledge, and the general view of the banking system and the way our money supply and our economy works is certainly something that is in need of improvement.

It doesn’t help that some economists make statements such as banks create money out of thin air, and although that’s far from the truth, it does serve as testimony to how this issue isn’t a simple one at all, and one that can involve some real misunderstandings, even at the level of an economist.

The pubic is even more in the dark here though, and for instance, most believe that the bailouts at the height of this recent crisis were transfers from taxpayers to the financial institutions. Fed Chairman at the time Ben Bernanke even made a rare public statement trying to better explain what was going on at the time, but this ended up going over the heads of just about everyone, which wasn’t unexpected.

What Bernanke tried to explain is that these bailouts consisted of adjustments in the accounts that these financial institutions have with the Federal Reserve, and the Federal Reserve is the bank of banks essentially. It’s not that there wasn’t money given away here, but this was more like their account balances with the Fed were adjusted upward, in order for them to stay in business.

This was not, as some believed, akin to a check being written the same way as we would do when the government purchases something, the Mexican wall for instance. The Federal Reserve does have quite a bit of power to manage the financial sector and the economy, and they do this not with cold hard cash but by essentially manipulating things like their balance sheets and interest rates, as well as account adjustments with banks, and this was really just a matter of moving numbers around.

Money Does Not Arise out of Thin Air, Although It’s Still Pretty Nebulous

As we learn such things, we might end up being a little shocked by this money seemingly being created from nowhere, but the nowhere part of this really is based upon the faulty idea that money is represented by currency, but currency only accounts for about 3% of money these days.

The fact that 97% of money isn’t currency but something else is another fact that does confuse a lot of people, and many think that banks have created all this money out of thin air, as they might think that the Fed did with these bailouts if they knew that it wasn’t currency or tax dollars that was used here.

Ultimately, it is various measurements of money supply that matter, and nothing else really. It is at this level that the Fed acts, keeping a close eye on things and making adjustments if needed. The real upshot of these bailouts is that they increased money supply, and did so rather unilaterally, as if the Fed just waved a magic wand and created it, or if they just printed new money if all we had for money was just currency.

This does bring up some concerns of course, as this is inflationary, for the same reasons as just printing more money is. This was a time of recession though, and these actions were deemed necessary not only to prop up the recipients of this money, the financial institutions that were helped, it also provided an anecdote to all the credit losses that these institutions suffered, at a level that was indeed a big concern.

The Fed did have this weapon at its disposal, and it was fortunate that they did use it. Critics of these things don’t generally have much of an idea of the function of it though, and especially aren’t that aware of what would have happened if they didn’t, because they don’t understand how important credit is to our economy and how much damage widespread credit defaults can cause.

Maintaining the Health of Credit Markets is Simply Critical

We did get a taste of this during that recession, but what happened was nothing like what could have if not for the Fed acting as they did. Their efforts to help also extended to their no longer charging interest to banks at all for several years, something that many people would find distasteful as well.

The main goal of the Federal Reserve is actually managing the credit market, and credit is truly the lifeblood of our economy. It’s hard to overstate how important this is, but saying it’s the entire blood supply wouldn’t be an exaggeration at all because it is so close to that. Promoting more credit in a time of economic slowdowns and especially during a recession is simply vital.

Those who shake their fists at banks may see things like rate cuts as deserving of an extra shake or two, even though the anger here arises from a real lack of understanding. People are riled up against banks generally at the best of times from issues they have with our fractional banking system, and don’t realize how vital this is to our modern way of life.

It’s not that we couldn’t get by without it, but with so much invested in it now, it’s even hard to imagine the level of economic depression that getting off of credit would cause. What we’d lose here isn’t the banks no longer being able to create money out of nothing, not that they do this anyway, it would mean that we would not be able to borrow money anymore.

If banks had to hold your money on deposit with them in their vaults, and not lend it out, then they would have not be able to lend money. People want to borrow though, and the vast amount of credit out there is clear testimony to that. Without the ability to borrow, growth would grind to a halt and dramatically reverse, something no one would ever want.

When a bank lends money, they do not create it, and the only thing created is an obligation for the borrower to repay the loan and the bank being on the hook if they do not. The money does multiply in the marketplace, and this does create further opportunities for banks to lend out a portion of the money that does get spent on whatever the loan is for, but each time there is an obligation created and we call this credit, not nothing.

The vast majority of our money supply comprises of this credit outstanding, and therefore having the obligations that this creates being fulfilled, with the money being paid back in an orderly fashion, is what our house of cards depends on. When this does not happen, our money supply tanks, in a menacing way. The cards fell a bit during the Great Recession with all the credit defaults we experienced, but it could have been much worse if the market was left to try to fix this on its own.

Banks do not have any magicians on staff to conjure up money, and if they did, the value of our money would sink as fast as it has when governments irresponsibly expand the money supply beyond our capacity, as you can bet that if they did have a magic wand they would be using it liberally.

Every time a bank lends money, they do take on real risk, and if anything, this risk is even more prominent given the fractional banking system, at least in the aggregate. Banks satisfy people’s needs to borrow, and the fact that this system allows them to better fulfill these borrowing needs than would otherwise be possible is a good thing to be sure, and it allows our economy to grow.

It’s actually the singular reason why our economies grow actually, and don’t just shrivel up. A lot of people harbor a considerable amount of anger against what they consider to be the fat cats of banking, who are demonized and held to be holding money that somehow is rightfully ours.

Should economic growth continue to decline enough, the volume of these voices will no doubt rise again. Should we be considering joining them, having at least a simple understanding of what goes on with our banking system, including our central bank, would serve to disarm this discontent.

Many people want us to curtail the banking system, but have no idea of how devastating such an idea would be.