Chapter 10 gives an overview of the financial system, including how key economic actors use and create money. It places special focus on the unique position of banks to create new money by making loans, though not without liability. They fail when they miscalculate how much cash they need to keep on hand or when they take on too much risk.
Read this chapter to get a clear sense of why banks believe they’ll be rescued from their own bad choices.
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Key takeaways
John Law was a Scottish financier credited with introducing paper money to the masses in the 1700s. After fleeing London to escape a death sentence for murder, Law made his way to France, where he convinced the government to let him open a bank in 1716.
He issued paper money to the public at a time when most people made purchases with gold. The notes were supported by the bank’s gold and silver, and could be exchanged just like physical coins. Law then started the Mississippi Co., which was granted exclusive control of trade between France and its colonies in North America. To finance the company, he sold shares for both cash and state bonds with low interest rates. He then created more companies, expanding his empire and attracting more investors throughout France and across Europe and minting “millionaires,” a term that entered the vernacular because of the Mississippi Co.’s successes. Even working-class folks tried their hand at investing, hoping to get rich.
The speculation was so great that share prices surged 1,900% in less than a year, under the assumption that Law’s trading companies would eventually pay off. Except they didn’t. And people lost a fortune when share prices plummeted.
Even though economists often cite Law’s so-called bubble as a cautionary tale, it hasn’t stopped speculators from repeating history. More recently, we’ve seen the bursting of the dot-com bubble of the late 1990s and the real estate bubble that led to the Great Recession.
Important definitions
- Bank lending rate: The average interest rate charged by commercial banks to firms and households. It is typically above the policy interest rate so that banks can make a profit.
- Leverage: The use of borrowed money or debt to amplify returns on an investment. Leverage turns a good deal into a great deal. This is how banks make a lot of their money.
- Liquidity risk: The risk that an asset cannot be exchanged for cash rapidly enough to prevent a financial loss. This becomes an issue when depositors all decide to withdraw their money instantly, but the money isn’t there.
David Brancaccio’s thoughts on Chapter 10
Medieval alchemists were not able to turn base metals into gold. Yet, as I learned in this chapter, banks have that magical power — the power to create money.
Here’s how the U.S. central bank pulls off the alchemy needed to fund emergencies: It doctors its own accounts. The Federal Reserve creates money by typing extra numbers into its accounting ledger. The chair of the Federal Reserve during the financial crisis of 2008, Ben Bernanke, was once asked if the Fed was using taxpayer money to fund its rescue of the financial system. Bernanke said it was not tax money: “We simply use the computer to mark up the size of the account that [commercial banks] have with the Fed.”
It’s like balancing your checkbook by writing in an extra zero to the right of your bank balance. When the Fed creates more money for banks to have in reserve in this way, those banks can lend more, releasing money into the economy. Commercial banks can do the same thing. Banks lend out way more money than they hold in deposits — alchemy again.
This kind of magic lasts so long as the commercial banks have enough cash on hand to meet their customers’ transactions on a day-to-day basis. But it quickly dissipates when there’s a bank run, when everyone tries to get their money out at once and the bank’s coffers can’t meet the demand. That’s what happened in the 1930s — perhaps most famously depicted in Frank Capra’s film “It’s a Wonderful Life.” It’s also what happened more recently with Silicon Valley Bank after its tech-startup clientele rushed to withdraw all their deposits at the same time, leading to the bank’s failure.
Recommended watch
When banks lend money — for example, when someone takes out a mortgage on a new home — they are taking on the risk of that borrower defaulting on the loan. When many borrowers default all at once, as happened during the financial crisis, the central bank often bails out the commercial banks to keep the financial system solvent. Commercial banks thus tend to engage in overly risky practices, because they know some of the downside of their risk-taking will be borne by taxpayers. To understand how banks got into trouble and created a real estate bubble in the process, watch this video on YouTube: “The Crisis of Credit Visualized.”