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35. PARADOX OF THRIFT
The “paradox of thrift,” more often referred to today as the “paradox of saving,” was originally described by the famed economist John Maynard Keynes. It’s a simple paradox: if more people save more money in a bad economy, that leads to a fall in aggregate demand, which makes the recession worse. This concept would have been easy to ignore—except that it became a big part of the story of the Great Recession.
What You Should Know
The paradox of thrift is something of a prisoner’s dilemma—increased saving, which may be good for an individual, is bad for the economy as a whole. Clearly part of what caused the last bust was overspending and an overextension of credit, while personal savings rates dropped below zero (see #3 Saving and Investment). The natural reaction of people to the fear of losing assets or income, and a widespread new aversion to risk, was to stop spending and start saving. Savings rates jumped almost immediately to 5 percent before falling off to a more moderate 3 percent.
The paradox of thrift served to blunt the effects of economic stimulation and reflation (see #34 Reflation) because, as the Fed injected money into the economy, people just saved it for a “rainier” day. It didn’t stimulate demand; thus it didn’t stimulate production, and few were better off. The lesson: people spend and invest when they perceive opportunity worth the risk, not just when they have money available to spend. The lesson for policymakers is to fix what’s causing the risk and let asset prices adjust; then the system is back in balance, and people won’t hoard money out of fear.
A corollary thought: if policymakers want people to save, they should increase—not reduce—interest rates. That would motivate people to save; in today’s environment the only thing that gets people to save is fear—that is not a path to economic health and well-being.
Why You Should Care
If you as an individual have cut your borrowing and spending, that’s a good thing. When economists and policymakers complain about the paradox of thrift, that shouldn’t influence you at all; it is not your responsibility to revive the economy!
36. RESERVE REQUIREMENTS
Reserve requirements oblige banks to keep a minimum fraction of their active demand deposits (largely, checking-account and other short-term account balances) set aside in reserve to meet customer withdrawals, written checks, and other routine transactions. The reserve requirement represents the “fraction” of the fractional reserve banking system (see #33) kept “at home” to meet customer demand.
What You Should Know
The Federal Reserve, specifically the Fed Board of Governors, mandates the reserve requirement. Today, it is 10 percent for transaction accounts exceeding $70.5 million at a given institution, and 3 percent for amounts between $12.4 million and $70.5 million. For the first $12.4 million, and for many other kinds of longer-term deposits like CDs or for corporate time deposits, the requirement is zero.
Such requirements make it easy for the banking system to generate considerable leverage, $10 or more for every $1 of deposits or Fed funds acquired. These requirements, however, are moderately high on an international scale; in the Eurozone the requirement is only 1 percent, and in the United Kingdom, Australia, and Canada, there is no set reserve requirement. This isn’t to say that banks in other countries are less regulated; they are just regulated differently.
Why You Should Care
The low reserve requirements give banks a lot of power to lend and effectively create money, but it’s easy to see how this leverage works the other way in times of crisis. Banks don’t have much of a cushion to work with, and thus must rely on the Fed for bailouts.
37. LOAN LOSS RESERVE
Any smart business or individual should set aside an emergency reserve of some sort in case something unexpected happens. The previous entry covered reserve requirements—minimum capital set-asides required by the Federal Reserve to cover unexpected withdrawals. But are these reserves, ranging from 0 to 10 percent of assets, adequate? Reserve requirements are there to protect against unexpected withdrawals, but what about the bigger elephant in the room—the potential default on bank loans? Where is the capital cushion to cover these losses? Isn’t this what really got us into the 2008–2009 credit crisis and the Great Recession that followed?
The short answer: indeed, banks were not sufficiently protected against bad loans. Banks do set aside so-called loan loss reserves to cushion against “normal” levels of loan defaults, but quite obviously most banks didn’t set aside enough to cover what actually happened.
What You Should Know
Banks set aside loan loss reserves on the balance sheet as a “contra,” or negative, asset. They book an expense every quarter known as a loan loss provision to put more funds in the reserve, then charge off the amount of a loan gone bad. The reserve helps avoid surprises. If a bank is accustomed to 1 percent of its loans going bad, and that amount indeed does go bad, the reserve covers it, and the charge-offs create no surprises in the financial statements. The bank remains healthy and continues to operate with the same amount of capital.
But if banks make riskier loans, or if their existing loans become more risky because of a declining economy, loan loss provisions should be increased by bank managers. They were, but probably not enough in these circumstances, as bank managers were reluctant to take even bigger hits to their bottom line by booking larger loan loss reserve provisions. As a result, bank capital positions declined, a factor leading to the bailouts that ultimately occurred.
Why You Should Care
Stronger, better-managed banks book adequate loan loss reserves to protect themselves, their depositors, and their shareholders. Growing loan loss reserves may reflect more conservative management—or may reflect a management worried about its loan portfolio. If you’re thinking about doing business with a bank, and especially investing in a bank, be careful about banks with loan loss reserves less than industry averages (as a percent of a loan portfolio) or with growing reserves—unless they give a credible explanation. Finally, the idea of such a “rainy day fund” applies not only to banks, but to other businesses and your own personal finances, too.
38. TIER 1 CAPITAL
The U.S. banking system, like others around the world, depends on its ability to lend as much money as possible, several times the original owners’ equity in the institution. If you have $1 to start a bank and can get $9 in customer deposits and/or loans from other banks or the Federal Reserve, you can lend out $10 to potential borrowers. You can make a lot of money on the $1 invested.
But what if one of your borrowers defaults on a $1 loan? You still owe your depositors $9, so your equity is wiped out. Perhaps you booked 1 percent as a loan loss reserve (see #37 Loan Loss Reserve), so you were prepared for a 10-cent loan to be written off. But $1? You’re in bad shape. $1.50? You’re out of business. This sort of scenario was common during the 2008–2009 banking crisis.
So if you’re a bank regulator, what would you look for as a sign of bank safety? The 10-cent loan loss reserve? That’s nice to have, and the larger the reserve the better. But is there a safety cushion beyond that? That’s where Tier 1 capital comes into the picture.
What You Should Know
Tier 1 capital is essentially the net equity in a bank (assets minus liabilities) plus the loan loss reserves. While loan loss reserves are set up to handle expected losses, Tier 1 capital is a better metric of how safe a bank is against unexpected losses.