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33. FRACTIONAL RESERVE BANKING
Want to turn $100 into $500? Who wouldn’t? And the architects and designers of the worldwide banking system have found just a way to do that—through so-called fractional reserve banking. Fractional reserve banking is a fundamental principle in modern-day banking whereby banks keep a fraction of their deposits in reserve and lend out the rest. Fractional reserve banking allows banks to stay in existence to make a profit on funds lent out. More importantly, in the aggregate, fractional reserve banking effectively creates more money for the economy.
What You Should Know
Unless governed by the terms of a certificate of deposit, the money people have deposited in a bank can be withdrawn at any time. So how can a bank lend out money to others and earn a profit if it might have to return money to its depositors at a moment’s notice? Fractional reserve banking works on the theory that in all but the biggest crises, only a small fraction of depositors will want their money back.
This idea then turns banks loose to lend out the rest—directly to customers or to each other. When banks lend money to each other, the borrowing bank can keep a fraction of that loan and lend to still others—customers or banks—and the cycle repeats. By keeping only a fraction of the money in reserve, banks can lend the same money many times over, effectively increasing the supply of money through leverage. In aggregate, the supply of money is thus a multiple of the “base” money created by deposits—or by injections from a central bank. In practice, the amount of money in circulation can be five, ten, or even twenty times the amount injected into the banking system by the Fed or individual depositors.
This practice sounds risky, and indeed it can be, for if depositors see a crisis and demand all their money at once, it pulls the rug out from under the layers of leveraged loans. The Fed imposes a reserve requirement (see #36 Reserve Requirements) to mandate that banks keep at least a certain percentage of their deposits or funds in reserve to protect against bank runs.
But in the 2008 banking crisis, depositors became worried about their deposits in banks and withdrew in greater numbers, forcing a rapid contraction in reserves and in money to loan. The fear and contraction of lendable reserves fed on itself in a cycle of deleveraging (see #9 Deleveraging). Further, bank reserves were hit hard by bad investments, loan write-offs, and contracting asset values. The result was very restricted, or “tight,” credit, and the banking system nearly ground to a standstill. The Fed and the U.S. Treasury had to step in to create money and bolster bank reserves through TARP, the Troubled Asset Relief Program. These problems were amplified by the leverage created through fractional reserve banking.
This is not to say that fractional reserve banking is a bad thing—it is really a good thing when managed properly. It puts more money in circulation, makes credit easier to obtain, and fosters economic growth. The problems occur when banks get careless in how they lend money; when that happens the multiplicative effect occurs in reverse.
Why You Should Care
Fractional reserve banking occurs largely in the background; under normal circumstances it won’t affect your household finances or what you can pull from an ATM machine. But especially in the aftermath of the 2008–2009 banking crisis, it helps to understand what makes banks succeed or fail. Healthy banks lend money to you on favorable terms and keep the economy going. What happened during that period is a helpful reminder of the risks of using leverage to expand purchasing power.
34. REFLATION
Reflation is a term used somewhat informally in economics to refer to combined government efforts to stimulate an economy, particularly one hard hit by recession, deflation (see #19 Deflation), or an enduring decline in asset prices. The term is relevant in the aftermath of the Great Recession, as many economists felt that governments and the Fed in particular were engaging in deliberate actions to “reflate” the economy at the risk of creating runaway inflation later.
What You Should Know
When a government or central bank reflates an economy, it uses a combination of strong monetary stimulus (see #56 Monetary Policy and #17 Money Supply) and fiscal stimulus (see #55 Fiscal Policy) to radically encourage demand, and ultimately boost asset prices. In the aftermath of the crash of the real estate bubble, microscopic interest rates, trillions of dollars in direct capital infusions, bailouts, and tax rebates were all put into play to essentially inflate the prices of assets other than real estate. Those price increases could ultimately make real estate relatively more attractive and affordable, especially if expanded economic activity also increased incomes. That, in theory, would stop the slide in real estate prices, halt the deleveraging, and bring back a stable banking system and economy. As we’ve seen, to a large degree these policies have worked.
The problem recognized by many economists is that once such policy is enacted, it is hard to “turn it off.” The resulting inflation becomes a matter of expectation, and that makes it difficult to eliminate. (Note the fear and uncertainty in the markets in mid-2013 as the Fed a
Why You Should Care
Excessive inflation is an enemy to everyone except those who are in debt and can pay those debts later in cheaper dollars. Reflation policies can lead to excessive inflation; furthermore, they encourage more borrowing, which may put us back into the same position that caused Great Recession in the first place. When you see the government pull out all the stops to save an economy or to preserve the prices of overpriced assets, it’s a sign of bad times now and greater economic risk in the future. Likewise, when you see the prices of certain assets like gold rise to new heights because of reflationary policies, look out, especially if the policy changes and you’re still invested in these assets.
Many economists and investment professionals follow and recommend what they call the reflation trade. If rampant inflation is expected in a moderately growing economy, investors might want to avoid mainstream economies like the U.S. economy, where dollar depreciation and economic malaise will cripple the value of their investments. Since China is the world’s premier growing economy at this point and must buy most of its resources overseas, it has been felt by many that Australian and Canadian currencies and companies might fare well in a reflation scenario. Their governments aren’t forced to print money at this point, and they sell resources needed by the resource-hungry China and Asian world. Investments can be made in pure currencies or resource exporters, or simply local businesses like utilities paying dividends in local currency. Most recently, however, this investing “idea” has diminished in popularity, as China’s growth for an assortment of reasons has slowed. It goes to show that overseas investing isn’t for everyone, but this discussion shows the complicated, far-reaching, and international consequences of reflation, and how to prepare for it.