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26. GOLD STANDARD
Are your dollars as good as gold? That’s the central question to understanding what a gold standard is and how it works.
What You Should Know
In the gold standard monetary system, paper currency is pegged and convertible into preset, fixed quantities of gold. The supply of money is specifically tied to gold reserves held by central banks (see #16 Money and #17 Money Supply). The gold standard prevailed during the late 1800s and the first half of the twentieth century, but gradually subsided starting in the Great Depression, and was done away with altogether in 1971, after many years where $35 in paper could be exchanged for an ounce of actual gold. This means that central banks, including the Federal Reserve, effectively have no constraints in terms of expanding and contracting the money supply to affect monetary policy (see #56 Monetary Policy).
The gold standard was designed to protect a nation from abuses of monetary policy, and specifically the risk of hyperinflation from an overexpansion in the money supply. Today, we trust governments and central banks not to get carried away with monetary policy. Since no country actively uses the gold standard, those living in fear of hyperinflation buy the metal outright, and have pushed the price of gold up to a recent high of more than $1,900 an ounce, although it has subsided to the $1,200–$1,400 range recently—still high by historical standards.
Many economists following a traditional, pure capitalist, laissez-faire, government-can-do-more-harm-than-good doctrine favor a return to the gold standard (see #59 Austrian School). Doing so would be difficult and painful now, as the rate of currency growth has far outpaced the rate of gold production from mining. A return to the standard would entail a drastic reduction in the value of the dollar and most other currencies, as there wouldn’t be enough gold to go around to back all of the dollars and other paper currencies in circulation.
Why You Should Care
The gold standard debate is theoretical for most of us, but serves as a reminder that money is simply a commodity, and if there is too much of it, its value goes down. Many investment advisers recommend holding at least some gold in your portfolio, as the actual metal or as commodity futures or gold mining stocks, to anchor at least a portion of your wealth to a gold standard. That’s up to you—and there are plenty of downsides—but understanding the gold standard can help you think through such an investment.
CHAPTER 4
Banks and Central Banking
We have discussed the economy and money; the next logical thing to talk about is banks and the banking system. As grain elevators distribute grain and lumberyards distribute lumber, banks distribute money. They store your spare money and allocate it as capital to others (hopefully) who need it for a good economic reason.
Banks are part of a banking system and, for better or for worse, are interco
27. COMMERCIAL BANK
For the most part, when you think of “bank,” you’re thinking of a commercial bank. A commercial bank serves the public—ordinary consumers and “main street” businesses—with an assortment of accounts, savings, checking, and loan services.
What You Should Know
A commercial bank gets funds from customer deposits, including checking and savings accounts, certificates of deposits (CDs), and other time deposits. It may also get funds by selling securities, especially government bonds back to the government, or by short-term borrowings from government or private investors. In turn, it earns income by lending those funds to businesses needing operating capital, and to consumers for a variety of purposes.
While they lend funds for businesses to use, commercial banks are distinguished from investment banks (see #28 Investment Bank) because they do not buy or sell securities for their own part or on behalf of individuals or corporate clients. In fact, huge bank losses on investments prior to the Great Depression led to the failure of many banks (some 20 percent of all banks failed), which then led to legislation, specifically the Glass-Steagall Act of 1933, prohibiting commercial banks from engaging in investment banking activities. That law was repealed in 1999, allowing megabanks like Citigroup and JPMorgan Chase to combine commercial, investment, and many other financial operations into a single holding company.
Arguably, that led to some of the problems seen in the recent global crisis, as the investment banking arms of several big banks put their entire company in jeopardy. The phrase “too big to fail” became part of the common citizen’s vocabulary. Recently, the so-called “Volcker Rule” has reintroduced a ban, with certain exceptions, on commercial banks and their affiliates to engage in “proprietary trading”—that is, trading the markets for their own benefit using what amounts to your funds—but a full-scale reenactment of Glass-Steagall separation of commercial and investment banking activities hasn’t happened. Although much is beyond the scope of our discussion, suffice it to say that commercial and investment banks are subject to different banking laws and capitalization rules.
It should also be noted that at one time there were significant differences between banks and so-called savings and loan, or “thrift,” institutions. Many thrifts were nonprofit, and had regulatory restrictions on the source of their funds and the amount of interest they had to pay on funds acquired. A combination of regulation and poorly thought-out deregulation led to the S&L crisis in the late 1980s. Today, thrifts continue to exist, but are much more like commercial banks than in the early years. Most do not offer the complete array of services that commercial banks do, which now offer investments, business lending and advice, and general financial advice.
Why You Should Care
The banks you generally deal with are commercial banks, unless you’re involved in securities trading, mergers and acquisitions, or in taking companies “public” by selling stock or other securities. Commercial banks are set up to handle your normal banking needs, and are regulated to provide the sort of banking products and safety (insured deposits, for example) that the general public expects.
28. INVESTMENT BANK
Never seen a local branch of Lehman Brothers? Or a Bear Stearns or Goldman Sachs ATM machine? There’s a reason for that. The reason—although not as distinct as it once was—is that these big banking names are investment banks, not commercial banks (see #27 Commercial Bank). These banks are primarily in the securities business, not the general banking business.
What You Should Know
Investment banks are in business primarily to raise capital on behalf of clients, to advise them on mergers and other corporate restructuring, and to make markets for securities. Clients include corporations, governments, pension funds, and large investment companies like mutual funds. In fact, they not only buy and sell securities on behalf of clients, but they also try to make money by dealing in the markets on their own behalf, in an activity known as proprietary trading. While this is once again illegal for commercial banks because of the recently enacted “Volcker Rule” (see #27 Commercial Bank and #39 Dodd-Frank), it is still a big part of what investment banks do.