Everything You Know About Money Is Probably Wrong — Pt.3
A nickel ain’t worth a dime anymore — Yogi Berra
A historical view of American banking
This is part three of my series on the brief history of money. You can find part one here and part two here. In this short journey we have (hopefully) dispelled a few of the more common myths around money and have roughly established how we got to where we are now. There are volumes of research devoted to this topic, but what I have presented are the broad strokes.
At the end of part two I made the claim that our global system of floating fiat currency has imploded. I went even further and said most people have not noticed yet and I stand by it. I will cover that in the next installment, but to understand my reasoning, let us go back to where we left off around 1970. Prior to the US abandoning the gold peg under Bretton-Woods, gold was redeemable at a statutorily fixed rate of $35 per ounce of gold. For a number of different reasons, this proved unworkable, as the US did not hold enough gold to redeem all demands for it.
Though the Johnson, Nixon, and Ford presidential administrations all tried to mitigate the problem, by 1976 the Jamaica Accords had arrived and almost all international currencies — including the dollar — ‘floated’ on the open market. In essence, currency went from representing gold or silver and instead became a promise to pay like value. One of the many results of this ‘float’ was a massive inflationary spike in the United States. In 1970, $35 would buy you one ounce of gold. By 1980, the same ounce of gold would cost you $700.
Currency…instead became a promise to pay like value
Right around this time, then President Carter made his (in)famous speech about a ‘Crisis of Confidence’ in America. For those living in Europe during the financial crisis of 2008, the speech features a lot of familiar themes, primarily the need for austerity measures to ‘right the ship.’ And, in fairness to Mr. Carter, what he proposed was essentially correct. Unfortunately, the (arguably) first big-R republican came on the scene in the form of Ronald Reagan. President Reagan’s economic plan was to break out the credit card.
To understand this, you first have to understand the basics of central bank monetary policy. Without doing a complete deep dive, the simple version is the central bank needs to roughly balance the number of dollars going out vs. the number of dollars coming in with a catch: the number of dollars going out should be slightly higher than the dollars coming in. The stated goal of the Federal Reserve is to keep this rate around 3% per year. The way they try to achieve this is by altering the interest rate they charge to banks either up or down.
Reagan’s economic plan was to break out the credit card
This is what that looks like in practice. These images are from a paper I published on student loan bankruptcies a few years back and it illustrates well what I am talking about here:
As you can see, starting right around 1980, there is a literal explosion of growth in both the Dow Jones Industrial Average and the rate of bankruptcies. If you look closer, you can see they almost track each other perfectly. What changed during this time? Massive deficit spending under the Reagan administration. Where Carter called for savings and austerity, Reagan threw a party and charged it to the national credit card.
Fractional reserve banking and deficit spending
Lower interest rates mean lower borrowing costs, which translates into more lending. This is a key point, because modern money is created every time a bank lends money. The way this occurs is attributable to the idea of fractional reserve banking, where a bank only has to hold a certain percentage of the funds it loans out. As an example, imagine your father loaned you $100 at 5% interest. Then, you turned around and loaned that same $100 to your friend for 7% interest. Not a bad deal for everyone involved, assuming your friend pays you back that is.
Let us change this a little bit and add the ‘fractional reserve’ part in. Same scenario, your father loans you $100 at 5% interest. Except this time you can loan that $100 to nine friends, as long as you keep the original $100. To do this you give each one of your nine borrower friends a card that has a $100 limit on it and they all have to pay you back at 7% interest. This is a pretty sweet deal, because if they all pay you back, you collect 2% interest on the first loan and 7% on the other 8, even though you only have $100 in your pocket. Not to mention they all owe you $100! In this Father, Friends, and You economy, you just created $800 of new money out of thin air.
This runs on the idea that, as long as you lend money to people that pay you back, you will profit handsomely. But, if one of them defaults and doesn’t pay you back, you can still pay back the original debt to your father. In other words, you have to keep a fraction (9/10) of the money you lend out in reserve in case a borrower defaults. In fact, this is roughly the reserve requirement the Federal Reserve forces upon banks in the United States. As a side note, the Bank of England has no reserve requirement at all! They rely on ‘prudence’…
As long as you lend money to people that pay you back, you will profit handsomely
If we expand this idea out, what the Federal Reserve wants to do is ensure the ‘new money’ being created through lending is about 3% more than the year before. This where you here terms in the media about ‘target inflation’, or inflation ‘running too high’ or ‘running too low.’ Returning to the Father, Friends, and You economy, the way dad would control how much you lend out and to whom is by raising or lowering the amount of interest he charges you in the first place. If he charges 20% interest, you have to charge your friends way more to borrow and they will be far less likely to want to do so.
Same in reverse, if he only charges you 2%, then borrowing and lending become cheap and more money will (probably) go out. Aside from the niggling problem of a tiny minority of people getting to make money from nothing except a minor default risk, the idea is roughly sound on paper. So, where did it all go wrong? Right here in the good ol’ US of A.
American banking and the urban/rural divide
Those who watch mainstream news like Fox or CNN might lean into the idea that the divisions in the US are getting worse each passing day and it makes sense why it seems this way. The deeper truth is these divisions have been in the US since day one. To understand why, we must look briefly at what the US really is, from a historical perspective. When the original colonies were established, they were intended to act as ‘new’ nation states. The inhabitants of New York considered themselves to be citizens of the country of New York. Same was true for Virginians, Georgians, and all the rest — much like how we look at the nations of Europe today.
What drove the concept of the United States was a loose economic and political union of individual nations, similar to what the European Union is doing now. Some of those early ‘countries’ in the US, especially in the slave-holding rural south, were particularly keen to maintain strong independence from the Union. When you hear arguments based on ‘states rights’, this is where the idea comes from. The core of that idea envisions a relatively ‘weak’ central authority and strong state authority. A poor, but roughly suitable comparison might be the United Kingdom in relation to the European Union. In essence, with ‘Brexit’ the UK did to the EU what the Confederate States tried to do to the US during the Civil War.
…the concept of the United States was a loose economic and political union…
On the other side is the concept of federalism, which envisions a ‘strong’ central authority and limited state authority. While the EU is not technically a federation like the US, it shares many characteristics. Likewise, some of the same divisions and disagreements you see in the US federal system are starting to crop up in EU politics. Much as in the US, the political divisions in the EU tend to follow similar US Liberal/Conservative ideologies. In turn, these ideologies are deeply rooted in historical concentrations of economic activity: urban oriented industrialism (liberals) and rural agrarianism (conservatives). For many reasons, and only generally speaking, urban industrialists tend to dominate the political economy of a given nation, usually to the detriment of the rural agrarians. Not always true, but definitely more often than not.
Slaves, cotton, and tobacco
That calculus changed in the rural US south in the early 18th century. Owing in large part to slave labor and the cash intensive crops of cotton and tobacco, the rural southern US became an absolute economic powerhouse. To make a tech analogy, the industrialized cities of the late 17th century were like Google, Apple and Microsoft and the rural agriculturists were like a huge swath of tech startups. Slaves, cotton, and tobacco were to the southern US like the Facebook, WhatsApp and Instagram startups became in the tech economy. How does this all relate to banking? Strong central banks in the form of the First and Second Banks of the United States were tried, but ultimately failed, largely due to resistance and obstruction by the agrarian south.
A strong central bank grants an enormous amount of financial power to the actors that control the central bank. For example, one of the defining characteristics of the UK during its time in the EU was its refusal to adopt the Euro, instead keeping the Pound Sterling. This was done to ensure the UK central bank retained its power to set monetary policy internally. Given the historical financial exploitation of rural agrarians, the US south was highly suspicious of a strong federal bank and wanted to retain control over internal monetary policy, much as the UK does today.
A strong central bank grants an enormous amount of financial power
This resistance to central banking led to long periods of volatility and instability, the era of ‘wildcat’ banking, and more currencies floating around the US than you could shake a stick at. For a modern reference point, early US banking looked an awful lot like DeFi and cryptocurrency markets today. It was all over the place and you never knew day to day if the ‘money’ you held one day would be valuable or worthless the next. A couple of major depressions and an even greater number of financial shocks later, the US compromise solution was the Federal Reserve (the Fed). While the Fed has generally served to stabilize US banking, it is also still constrained by many of the same issues and divisions rooted in the agrarian/industrial divide from centuries ago.
US banking and finance today are governed by a mix of state and federal authorities with widely varying degrees of regulatory power. Add to that some significant changes to the way banks were allowed to structure themselves in the 1970s and you get modern US banking and finance. In terms of relative stability, you might recall from part one of this series, the US financial system is everything and anything but stable. To reveal my tech-dork roots, our financial system today reminds me of Windows 95…once you think you have it figured out and working, it just crashes anyway. In the next part of this series, we will begin to tackle modern money and finance.
