Thursday, March 22, 2012

Bank Failures and the Great Depression

We have a banking system called "fractional reserve banking." The amount of cash held by a given bank is its reserves. However, banks carry *less* money than the *total* amount of money they theoretically hold on behalf of their clients.

Suppose a bank has ten clients, each with a thousand dollars in their account. Suppose the bank only holds onto two thousand dollars cash at any given time, instead of the full ten thousand. Where is the rest of the money? Tied up in investments the bank has made. This is how banks make money (apart from fees), they use your money to invest. Investment drives the economy, it's why restaurants and stores are built, it's why factories are built, etc., because somebody somewhere invested the money.

Anyway, they only have two thousand bucks for these ten clients. This normally works fine, because it is quite rare for every client of a bank to withdraw all of their money. If each client only withdraws a hundred here or there, AND at the same time they are depositing their paychecks regularly, then everything is peachy. The bank always has enough cash to supply their customers with the withdrawals they want to make. The bank still would technically owe each person the full amount of their money *if* they asked for it, but how often does that happen? People tend to let their money sit in the bank, accruing interest (or it's just safer than keeping your cash under your mattress.

However, if all of this bank's ten clients wanted to withdraw all ten thousand of their bucks, the bank would be unable to pay them (unless it could borrow the cash from someplace else). It only has two thousand, cash. If they can borrow the eight thousand, then fine, everybody gets their money (though the bank has lost its customers and owes money, but that's another story).

But what if they can't borrow the eight thousand? Then they can either limit the amount each person can withdraw (which may be illegal, depends on the terms of the contract the customer has with the bank, etc.), OR they can just give the customers their money on a first-come, first-serve basis.

Let's say all ten customers are in line, they all want to withdraw their money. The first guy in line gets his thousand bucks. The second guy then gets his thousand bucks. The last eight people are simply out of luck, the bank that owes them each a thousand bucks has just gone out of business, it has no more cash (again, this is assuming the bank can't borrow the cash from somewhere else).

Now let's say that you just heard that the situation I just described has happened. "Boy," you think,"I hope I don't get screwed out of my money. I better get over to my bank and get all of my cash out of there ASAP before my bank goes out of business!" So you get over to the bank but a hundred other people had the same idea and your bank is already out of business (again, assuming they couldn't just borrow the money). All over the country, people panic and make a "run on banks," trying to be first in line to get their cash out.

The fractional reserve banking system wasn't meant to handle this, the banks have to be able to borrow the cash or else they go out of business and their customers watch their hard-earned cash disappear. Forever.

In recessions before the Great Depression, when a run on banks would happen, banks did whatever they needed to show customers that their money was safe. If they could *encourage* customers to *not* withdraw all of their money, then they were okay and they (the banks) wouldn't need to borrow. Banks would put stacks of cash in their front windows to show how sound they were. A combination of these tactics and the necessary borrowing will usually stop a run on banks before it explodes.

To talk about how this affects the Great Depression though, we need to talk about the Federal Reserve (aka "The Fed"), the quasi-governmental bank that acts as the lender of last resort. In the scenario I described above, I kept saying that there would be no problem if the banks could just borrow the cash they needed. The first thing they'll try is borrowing from another bank, usually not the Fed.

However, during the run-up to the Great Depression, and *during* the Great Depression, the Fed made a series of major, MAJOR blunders. In fact, it was the Federal Reserve, not some stock market crash, which created the Great Depression. An economist named Milton Friedman won the Nobel Prize in Economics for demonstrating this empirically, and the current head of the Federal Reserve readily admits that the Fed was the fault of the Great Depression.

One of their big mistakes was to *not* lend money to the banks that needed it. Their (idiotic) view was "let these banks go out of business, it will get rid of incompetent bank managers." Unfortunately what happened is what something with ten minutes basic background in fractional reserve banking could have predicted: a major run on banks exploded all over the country. Banks failed all over the place, cash just disappeared from the economy, and major deflation followed. It was part of what they call "The Great Contraction," when the US money supply shrunk by a full third, and it was entirely due to the moves the Fed had made both before and during the Great Depression. The "stock market crash" was merely a symptom of the problem the Fed had created with loose monetary policy, and had the Fed not continued making bad moves, it would have been a normal recession, rather than a Great Depression.

Monday, March 24, 2008


We'll get to demand later. For now, we're starting with supply. Yes, supply and demand are cliches, but they actually mean something and they mean something very important. I think it's important to tackle each one separately, instead of in one quick lesson like most economics texts. The reasons will become clear by the end of the next lesson.

We've talked about how economics is the study of resources and allocation and blah blah blah. Actually I just talked and you fell asleep. Actually I just typed. But who supplies these resources? Somebody has to. And why do they do it?

Well, the people who supply things are the suppliers, and they supply because they want your money. At least in a modern economy that's how this works. It's always possible there could be something else they wanted in exchange. In primitive barter economies they might just want one of your goats or your hot daughter. But for the most part, they want money, and they want as much as they can get out of you. So for the rest of this lesson we'll assume they are supplying for money.

Firstly, how are suppliers decided? Do they select themselves and choose what they will supply? That's pretty rare. Just imagine if you tried this. Let's say you like sculpting turkeys out of cheese. Like a centerpiece thing for parties. And let's say you blow big time at making cheese turkeys. And you charge five thousand dollars for each cheese turkey, so that you can become rich superfast.

How successful would you be? In the real world, not very. The only way I can see this scheme working is if you were a celebrity, but then people wouldn't buying your cheese turkeys exactly, they'd be buying a piece of your fame and a piece of prestige. The turkey would be perfunctory. And if you used Havarti it would be a Havarti perfunctory turkey.

Okay, so the turkeys aren't selling at $5,000 each and your landlord has disconnected the utilities for lack of payment. You're shivering in your bathroom eating canned yams, with loads of cheese turkeys surrounding you. Wow, I'm starting to feel sorry for you. Cheer up! You can always lower the price. People are usually willing to buy more at a lower price. I feel inclined to say that again for some reason, perhaps it's important.


There. I'll probably come back to that in some future lesson, hmm....

Anyway, you lower the price to $2,000. No takers. $1,000, and you put ads in the Sunday paper. You put on a turkey costume and strut around main street with a big sign inviting people to taste your cheese turkey. If the cops don't escort you away, you might be really lucky and land a sale to a passing billionaire. You keep slashing the price, dramatically. You have to scare up some money to get your lights turned back on. You finally get down to $20 per cheese turkey, the cost of the cheese and materials. You make one sale. And the bottom falls out of the cheese turkey market, all potential buyers are satisfied. You have a firesale at one dollar each from your window to passing school children, and then cry in despair. Man, I'm making myself miserable here.

But cheer up! Your floor-mopping skills are second-to-none! All of this time while nobody wanted to buy your cheese turkeys your cleaning skills were going to waste. You open up a maid service and the local mansion-dwellers can't hire you fast enough! You're working full-time and pay your rent, your bills, your bookie, and that person with "the photos."

And yet, as awesomely shiny as your floors are, they aren't as good as your cheese turkeys. The way you used a slice of Provolone for a neck waddle. Genius! Why couldn't you just do what you were best at and get paid for that?

Cuz nobody wanted it badly enough. They wanted it for one dollar each (except that one guy who paid fifty). Less than you were willing to supply them for. It wasn't your choice, but it was the choice of the market that you be a cleaner.

Now how can a market choose? It's not a person, right? No, actually, it's LOTS of people. When somebody says "let the market choose" or "market forces" what they are really talking about is the combined decision-making of everybody in the economy. Not enough people were willing to pay a price for which you'd be a cheese turkey-supplier, but there were enough people willing to pay you to clean. You don't like cleaning really, but they are paying you enough that you are willing to supply the cleaning.

So suppliers don't just choose what to supply, and us unwitting dupes just line up and take it at the price they charge, right? Of course not, it's completely obvious that the supplier doesn't alone choose what to supply. They have to respond to the market. As obvious as this is, a lot of people, from the non-smart to the very-smart, hold opinions or make arguments that assume suppliers work the first way, that they call all of the shots and we just take what they dish out.

"But Jacob," you say, "corporations have too much power. They are too big, one person can't make them change their ways." In the last respect you'd probably be right, one person can't, but this ignores a lot of factors in the economy. We'll get to those in the next lesson. As for "power" in an economy, it's not just measured in money. That's another thing we will get to someday.

I'd like to finish this lesson by giving examples of suppliers, because at this point you may be under the impression that they are all businesses. Not exactly.

1)A gas station owner. What does he supply? A gas station, and if need be lawyers.
2)Gas station manager. What does he supply? (yes, still a he) Management of said gas station. While not self-employed, he is still supplying something.
3)Gas station clerk. What does she supply? Grounds for divorce for the gas station manager's wife! Zing! Seriously though, she supplies service and general clerkly duties. I'd like to point out that I just made up the word "clerkly" and the auto-spell checker didn't try to correct me.

So you, in some way, are probably a supplier, unless you're some unemployed deadbeat. Or an heiress. Until next time......

Tuesday, November 6, 2007

Money (Part II) and Wealth (Part I, I guess)

In my last Pulitzer-winning entry to this blog, I wrote about money, and how it replaced the barter system. To see this previous entry, you'd have to scroll down.

Well I kind of lied. It didn't replace the barter system, it just made it easier to work with. Keep in mind that money isn't wealth, as it has no inherent value. Nothing has inherent value. But if money isn't wealth, then what the heck is? What's a wealthy person if not somebody rolling in dough? And I'm not talking about a guy who fell into the dough vat at Entemenn's and is trying to free himself. He's a goner and dough vats are death sentences.

Anyway, wealth is made up of actual things, and money is just used as an exchange medium to smooth the process along. Let's use a barter example. Farmer Brown wants to use a bag of grain from his farm to buy shoes for his horse from the blacksmith. What's really being traded is the "market value" of Farmer Brown's production, in this case a bag of grain. Now what if instead of the barter system we had money? Well, Farmer Brown would buy horse shoes with money instead. But what's really changed? He got that money by selling his grain. On a fundamental level, he's still using the market value of his production to buy things, only it's money, because having one standard thing that everybody accepts--and can be exchanged with and valued against other commodities--makes things work in case the local blacksmith is allergic to grain.

Or maybe it's you, using the money you earned from your job at McDonald's to buy socks. The labor you gave McDonald's resulted in a certain amount of production, which was worth a certain amount, which was your wage. Instead of buying socks with hamburgers and fast service though, you bought it with money. McDonald's gave you money for your production so you could trade the value of your production in at the store to get socks. Your purchasing power is proportional to the value of your production, ya see? That's what determines wages--productivity.

In these hypothetical exchanges, the actual wealth involved was grain and horse shoes in the first example, and fast food and service and socks in the second example. Money wasn't the wealth, it was just an exchange medium. This distinction is important to keep in mind because it leads to fallacies about economics. When you want to gauge a person's wealth, or a group of peoples' wealth, or a nation's wealth, you don't want to count their money--you want to see what things they actually own. It doesn't make sense to complain about the price of things going up if peoples' income is going up in proportion with rising prices--people still have the same purchasing power.

By the same token, if prices in general are falling (due to businesses becoming more efficient and not because of deflation--more on this later), it is the same effect as everybody having a higher income. In other words, when a Wal-Mart moves into your neighborhood, your income goes up. :-) This economic principle bothers the Wal-Mart haters of the world, but it makes for a great example.

Look around you, at the things in your house. Look at the computer you're reading this off of. All of that stuff is your wealth, not what's in your bank account. Remember this and economics will make more sense, especially when it comes to doohickeys like inflation, deflation, stagflation, claymation, and PlayStation.

Sunday, October 14, 2007


Money. Dough. Bread. Mazoolah. Cha-ching. Greenbacks. The Green. Benjamins. Sweet Georgie Pea-Pod. Shim sham shadoobie. All of these are the names we give to money. Some were coined by me just now. Regardless of what we call it, money performs the same function. Why the heck do we have money, and what exactly is it? This is important, and I swear I'm not just coming up with filler material for my blog.

Without understanding money you can't really understand the economy, and since you work eight hours a day for the stuff, wouldn't you like to know what it is?

First, let's imagine an economy without money. It's not hard, because we used to have economies without money. They used the barter system. Bartering was when you exchanged stuff for other stuff. You might buy a meal at an inn with a big sack of grain, or use a dozen eggs to buy a new fork.

Imagine the complications this would lead to, since each barter exchange is negotiated on a one-to-one basis. For a shopkeeper to fix a certain amount of eggs as being worth a fork, or any other item, would be impractical if there happened to be an abundance of eggs. Suddenly his forks are all sold out and he's left holding huge bushels of eggs. He's eating omelets for a week, but after that some of his eggs will have gone bad. Maybe he could find enough buyers for all of his eggs in time, but it's a gamble, and he'll have to accept whatever the egg-buyers will take in trade.

You can't be sure what your goods will get you in trade, or that your goods will last long enough to be traded to somebody who has something you want. And what about big stuff? How many eggs does it take to buy a car? How many horse shoes does it take to buy a railroad? Land sakes, how many thimbles does it take to buy a space shuttle?!

And what about governments and businesses? How do they pay people? With beaver pelts? The ancient Roman government paid its soldiers in salt, or salarium as they called it, from which we get the word salary. So they were on the right track, they were sticking to one thing, and soldiers could plan their household budgets according to the amount of salt they expected. Salt had many uses. It could preserve meat, be sprinkled on food to heighten the tongue's sense of taste, and I guess that's it. All I can think of anyway. Doubtless Roman soldiers used the salt they didn't use around the house to barter with local shopkeepers, colosseum hot dog sellers, and any number of pomade outlets. I believe English soldiers were paid with beef, so this type of thing wasn't uncommon before blessed money was invented.

"Just a darn minute," you say. "I know they had money back then, they had gold coins and silver coins and stuff!"

That's true, they did. But not everybody did. Early money was based on precious metals (precious meaning "rare," not "aw, isn't that gold vein precious?"), and you carried around little pieces of the stuff with you that had been stamped with some emperor's mug on it. These were like the twenty or hundred dollar bills of their day, and most peasants carried around their salt, beef, chicken beaks, eggs, thimbles, and whatever else stood in for their dollars, quarters, nickels, and Sacajawea dollars.

Whether it was an actual good that had a use, or a precious metal (can't do much with them), both were mediums of exchange, like how CDs are a medium of music.

Eventually people discovered "credit," and that by "writings notes" of this "credit," you could travel from the place where the guy wrote the note, carrying this piece of "paper" which contained the "credit," to the place where the "credit" could be "redeemed" by somebody with gold. They were the early banks, and they gave the velvet rope industry a reason to exist. Although they didn't call themselves banks really, and instead of making people wait in line they just punched them in the head and instead of having inconvenient hours they just stabbed you in the chest. How I miss that system.

I'm kidding, of course, but this whole credit doo-hickey took the world by storm, and next thing you know people with lots of money are printing their own paper money, which was really just a less personalized and non-autographed version of the note of credit. Leaving aside the complications of different states with different money and different countries with their own money (I know, how crazy is that?), let's just say that eventually we Americans got to where we are today, with our dollar bill.

So up until the 1970s, instead of carrying around a huge store of goods with you when you went to the store (in case they don't want any eggs in exchange for their matches), you could hand them dollars, for which they could go and exchange with a federal bank for a dollar's worth of gold. In effect, each dollar was a note of credit saying "IOU a dollar's worth of gold."

Then they took us off the gold standard, so currency wasn't worth a certain amount of gold any more. Gold standards are sort of impractical these days. So now, instead of dollars being a little note of credit saying "IOU one dollar worth of gold" they are.....well, what the heck are they worth now? What makes money valuable if it's not worth gold?

Let me change your thinking here: what made gold valuable in the first place? Certainly not its uses, since they were limited. Jewelry alone can't account for the high value placed on gold. The value of gold is the same as the value of paper money--it is valuable because people are willing to accept it for trade. Why are they willing to accept it? Because they expect others to accept it also.


Nothing has "inherent value." Gold itself isn't valuable without somebody placing value on it, and its value as money (i.e. an exchange medium) derives from the expectation that others will put value on it as well. Money is the same way. It's just printed paper. It's value comes from our expectation that we can buy things with it. The real value of money is what can be bought with it, not the money itself. Once you start thinking of money as a paper representation of actual goods and services, you understand money better and you understand the economy better.

Gold was durable, scarce, and others valued it as an exchange medium, which made it good as money for its time. But it's impractical today because it is heavy, not easily divisible, and I frankly don't like the idea of my country's money supply being partly tied up in peoples' necklaces. Control of the money supply is important to prevent monetary problems, and having paper money makes that easy. Paper money is pretty tough (for paper), is hard to duplicate (making it scarce), and others see a lot of value in it. Paper money is what's called "fiat money," meaning it has value by government fiat, or command. The government says "this is money" and if we don't expect the government to fall then we can rely on it.

Fiat money is worthless if nobody accepts it, such as when Iraq was invaded in 2003. There were pictures in the media of Iraqis cheerfully burning their Iraqi money with Saddam's picture on it, because his government was no more. That is the main weakness of fiat money, but I still like the system (easy for me to say, in this country). Some countries actually tie their currency into the US dollar, the way we used to tie ours into gold.

The big weakness of gold, apart from the ones I already mentioned, is that when they invent replicators like on Star Trek, elements like gold will be easy to replicate, making gold abundant and worth a lot less. Hey, it'll happen!

Sunday, October 7, 2007

Introduction and the First Lesson: Incentives Matter

Hi everybody. This is the first post on my new blog about economics. People have told me I should have a radio show, or lobby Congress or the President, or run for office myself. So I did the next, most effective thing which will doubtlessly reach millions of people overnight--I started a blog.

Throughout this blog you will see me use humor on occasion, or what I call humor, but it doesn't mean that what I say is not to be taken seriously. Which is to say that what I say should be taken seriously, even if I use humor. Which is a roundabout way of mentioning the seriousness of not saying what I'm thinking when I use humor. Or something.

Before I get into today's lesson, I'd like to explain what economics is and why it is so darn important. A quick definition taken from some other economist who probably won the Nobel Prize or something:

Economics is the study of the allocation of scarce resources which have alternative uses.

"What? I thought economics was about money. Or business. Or something."

Nope, economics does not necessarily concern itself with money, or markets, or businesses, or government, or stocks, or banks, or any of the other things you may immediately think of when you hear the term "economics."

Now a resource is a thing which can be used as an input into a process to get a certain output. Like putting gasoline into a car. The resource is gas, the output is an engine that runs. Some important points to note here, which explain how gasoline is an economics thing, is that 1) gasoline has other uses and 2) gasoline is scarce.

Think about it. If a certain resource were infinite, what need would there be to economize? We'd all have enough. Demand would be satisfied everywhere. But resources are scarce. Breathable air is scarce, oil is scarce, healthcare is scarce, education is scarce, food is scarce, DVD players are scarce. Just because something is in abundance doesn't mean it's not scarce. Scarce means "less than infinite," or "finite" in other words. Part of the problem of economics is getting a limited resource to the largest number of people, or satisfying as much demand for that resource as possible.

And gasoline can be used for other things. It can be used to fuel other peoples' cars instead of your own, or it can be used in lawn mowers, or for entertainers to set their farts on fire. Gasoline isn't the only resource with alternative uses. Wood, steel, plastic, time, space, and even human beings themselves have alternative uses. Another part of the problem of economics is putting resources to their most valued use first, rather than putting them to a use that isn't as valued.

So, now you see how economics is not just about money, or markets, or things of a financial nature. It is about any scarce resource that has alternative uses, and how it can be allocated.

Why is this important? Don't we elect politicians so we don't have to worry about this kind of thing? Shouldn't we leave this to the experts? Yes and no. Some things belong in the hands of politicians because politicians are best able to handle those particular things, but a great many things are best left to people to decide. I don't say this because of some political ideology or philosophical notion of rights, but simply because it's more economical. You'll understand more as this blog goes on.

Back to why economics is important: Because people starve to death. Governments have committed genocide and gone to war. People go without the health care they need to survive or the education they need to get a job or the basic necessities they need to get by. Because single mothers don't make enough to raise a family. All from bad economic policies put into place, or economic problems ignored or exacerbated by the government.

Economics is not, and should not, be the concern only of rich people living comfortable lives, because when bad economics is put into action the people on the margin are the ones who suffer first, and who suffer the worst. An inadequate education system is much harder on a single mother than on a Senator's son who will wind up in an Ivy League university. Rampant inflation is far worse for blue collar workers living paycheck to paycheck than it is on the CEO of Viacom. (which is not to say that all business owners are rich, most of them are not and many of them make less money than those they employ)


I hope you're not too bored, and you're still with me, because now that I have my intro out of the way I can start the first lesson. And since you were nice enough to read this far (you didn't skip ahead, did you?) I'll make it as brief as possible. Here's the lesson: incentives matter. Corollary: so do constraints.

I should probably add a little meat to those bones, huh? What is an incentive? It's a thing that leads people to do...things. For instance, the incentive to avoid starvation will make you eat food. The incentive to avoid being killed will make you not run with the bulls in Pamplona. The incentive to have a higher material standard of living will make you go for a job that pays more money, even if you're already quite comfortable where you are. That one incentive is the incentive from which most other incentives flow--that is, the incentives that matter in economics--because it is the incentive to make ourselves better off (meaning having a higher material standard of living) which drives the economy. It's how enough food is brought into cities to feed a million people a day, it's how gas is brought to the gas station, it's how drugs are invented. Somebody followed their incentive to engage in a trade that made themselves better off. And as a side effect, it made somebody else better off too.

You worked for your boss. He got your production (whether you produce cars, insurance, or just mopped floors, it's the same principle), and you got his money. Your incentives were coordinated so that you each were better off. You valued the wage more than the time and effort it took to earn it, and he valued your output more than the money he paid you for it. Without incentives, nobody would go to work, eat, sleep, poop, or bring food to grocery stores.

If all of this seems stupidly simple, and a waste of time to even cover, then consider that many very intelligent, educated, and powerful people have put into place economic policies which totally ignore the importance of incentives. The Soviet Union, for instance, was a country that existed many moons ago. From 1917 to 1991, if memory serves me right. The economy was wholly owned and controlled by the government under a system called "communism," and there was no such thing as privately owned property. Everybody worked to support everybody else, not for themselves. Really. By removing the profit motive (a very important incentive in economics) nobody really felt like doing work. The only incentives that existed under this system were the incentive to avoid starvation, jail time, or execution. Over time the Soviet authorities realized they needed to provide incentives to get people to do things, so they started giving better apartments and things like refrigerators and tvs to their top performers.

Basically, millions of people in the Soviet Union wound up starving to death, and those that lived through the whole thing lived in horrible poverty. It was a country that could put a man into space but couldn't feed its people. This isn't to harp on the Soviet Union (I am a Russophile, after all), merely their economic system.

That was just one really horrendous and obvious example of how incentives matter. There are other policies or economic systems which also ignore incentives, but few if any are as bad as communism was (and still is, in countries like Cuba and North Korea), so it's great to use as a clear example. Starvation drives the point home better than do higher costs for sugar, doncha know.

"Didn't he say something about constraints?"

Yes I did, and this will be quick. Well, I'll try to make it quick. Constraints are the opposite of incentives. Incentives lead us toward something (earning more money, eating, going to work, buying things) and constraints drive us away from things. An example is how the higher tax on gasoline (currently 46 cents per gallon I think) adds to the price of gasoline, making us buy less gas and drive less than we would if the tax on gasoline were just a normal sales tax. Basically, incentives lead us to things that would make us gain, while constraints drive us away from things that would make us lose.

This isn't to say that constraints are worse than incentives, they are just different. I, personally, prefer a system of laws where there are constraints in place that keep guys with pantyhose on their heads from breaking into my apartment and stealing my HD DVD player ($233 at Amazon with free shipping, you can't beat that). A penalty for something is a constraint, and jail time or having your balls tased by a rookie cop counts as a penalty. It would make that panty-headed guy lose. He'd lose his time and his freedom, both of which are of value to him because he could use those resources to gain. Either with a job, finding coins on the street, or just walking through a park and enjoying the day.

Boy, I haven't talked about scarce resources with alternative uses and how they can be allocated much, have I? Never fear, I just wanted to set the groundwork by talking about the most fundamental thing in economics, the importance of incentives and constraints, since they are what guide human behavior and without human behavior, an economic model is just a plan.

Until next time..........