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Biumiis m a wm m e i s m m m Lecture by Dr. Edison H. eraser, Chief of the Division of Research and Statistics, Federal Deposit Insurance Corpo* ration, before the Colorado school of Banking, University of Colorado, Boulder, Colorado, August 18, 1953 yesterday VS discussed the functioning of a free enterprise economy and the say by vhich the price mechanism channels resources, human and physical, into their most productive uses. Implicit in ay raaarks vas the assumption that business enterprises would be so coordinated by prices there would be full employment of all resources. It was also haplied that there would be stability in the value of our monetary unit. But the historical fact is that during the past two centuries our economy lias only intermittently operated at full capacity. Periods of full employ ment and prosperity have been followed by periods of unemployment and stagnation* These periods in t o m have been followed by prosperity in the continuous chain that Is called “The Business Cycle*1. Likewise the value of our monetary unlt»«*0ur economic ballot, to use yesterday*s ftnai gone up during periods of depression and down with prosperity• Host of you recall the early 1930's when millions of people were without work in the midst of vast productive powers and unused resources. We had what appeared to be an anomalous situation of people going hungry because too much food was produced and going cold because too much coal was mined and too many clothes manufactured. Some economists f^fti} cx$ it an "over producticn— «under consumption depression”, and we tried « 2 • to cure it by paying formers to plow under every third roe of cotton and by butchering the sows that were about to farrow a litter of pigs* Our aoaetary unit roee in value» as it had in all previous depressions» and only a few dollars were required to buy a day's labor, a bale of cotton, or a brood sow. In view of the importance of prices in a free enterprise economy, the question arises as to shy they behave as they do during the various phases of the business cycle. We know from experience that in both depression and inflation prices do not seem to function well as a regulator of our economic activity. Why not? Could it be that there is something wrong with our monetary system rather than with the price system Itself? That is to say, is the erratic behavior in the value of money the cause rather than the result of business instability? Certainly it is worthwhile to examine this hypothesis. In making an examination of this hypothesis we may start with the fundamental economic principle, the law of supply and demand, and ask the question: Is this principle applicable only to the various types of goods and services which are bought and sold in the economy, or is it applicable also to the circulating medium which is used in making payment® and fulfilling contracts? the answer to the latter question is ye®. When money is in great supply relative to the need for it, as measured in an appropriate manner, it tends to fall in value and each unit becomes worth less and less in buying goods and services; if money becomes scarce relative -3to the need, it tends to rise in value and fewer units will be required to tu3f a suit of clothes, a bushel of wheat, or an automobile, Chat i® to m -f a decline in the value of money due to an excessive increase in its quantity is the sane as a general rise in inflation. prices, this is What we call Similarly, a rise in the value of money due to a decrease in its quantity is simply another way of describing a general fall or defla tion of prices. neither inflation nor deflation occurs instantaneously. Xn @osse prices go up or down and this produces pressure on other prices. Moreover, many prices are fixed by contract or custom, or for other reasons are rigid and do not move readily* in the price structure, Ibis creates distortions generally speaking, in inflation these distortion» are such as to sake business unusually profitable and thereby to stimulate businessmen to feverish activity. Likewise, the distortion® of the price structure during deflation tend to make business unprofitable, whereupon businessmen find it necessary or at least expedient to reduce their working forces, thus producing unemployment. It should be emphasised that changes in the price level due to a change in the quantity of money is quite different than changes in relative prices due to changes in the supply of and demand for particular economic goods. These remarks on the role of the price system as a governor or regulator of a private enterprise economy, and cm the character and impact of inflation and deflation, lead us back to the problem ©f business insta bility, If the money supply does not remain stable in quantity with a ~ k ~ reasonable increase in line with the growth of the economy# p e r i o d of inflation and boom on the one hand# and of deflation and depression on the other# appear to be inevitable. Consequently# many economists have concluded that maintenance of monetary stability with a reasonable rate of growth ia the hey to economic stability* At this point you »ay be wondering what became of my announced, topic# "Banking in a Free Enterprise Economy". most The answer is simple: the important single function of the nation's banking system is provision of the circulating medium with which the economy operates. This 1» not its only important function# but were it not for this# banking would scarcely warrant the great attentimi which it receives* The plain fact is that more than seven-tenths of the nation's circulating medium has been created by the banking system. This may be shown by taking the beat measure of circulating medium now available# the Federal Reserve series "Deposits adjusted and currency"# and examin ing its construction. As of December 31# 1952# deposits adjusted plus currency totaled $195 billion* Of tills amount# about $8? billion va© currency outside of the banks and about $3 billion represented deposits in the postal savings system. Since this the banking system# it may be deducted* $30 billion was not created by This leaves a total of $165 billion, which is the "deposits adjusted" portion of our circulating medium. A word about "deposits adjusted” before going on. This simply means that from total deposits in ail operating banks# there has been - 5 * deducted interbank deposits, 11« S. government deposits, and cash item® in process of collection« This m s don© so as to arrive at a deposit total which most nearly represents the sum held in the banking system and available for use as circulating medium by the public« But surely, you sight say, this $165 billion of deposits simply represents money deposited with banks and m s not created by them. limited extent this is true* To a Even though we have already taken out cash items in process of collection and an amount roughly equivalent to balances with other banks, there is still other cash In the banking system, such as currency end coin, and aesiber bank reserves with Federal Beserve banks# Xa all, these other cash items amount to about $23 billion deduct this sum from oar ’’deposits adjusted" of is IjLa billion« $165 and when m billion, the result This is the basis of ®y statement that over seven-tenths of the nation’s circulating medium has been created by the banking system« In other words, there is $lte billion of deposits in the banking system which is not represented by cash in the bank® but, instead, is represented by other assets held by than. assets that the It was through the acquisition of these $lk2 billion of circulating medium was created. This is all very well, you might say, but is it not true that m individual bank never makes loans without first having more than sufficient funds* And if this is so, by what magic can you make it appear that the banks collectively do something which non® of them does individ ually. . 6 . Aa a matter of fact, there 1« no magic to it at all. To illustrate the process, let os assume that instead of 15,000 hanks, cur hanking system consists of three banks, let us further assume that each of these banks is "loaned up”, that is, their cash and reserve positions are such that they would hesitate to make any new loans until the old loans run off. seme of Finally, let us assume that a new depositor m L k s into Bank A with $1,0 00 in currency which he uses to open an account. Kow let us follow a aeries of events which are typical of thoae that are likely to occur. Bank A nay feal, with an additional $1,000 in cash, that it is now possible to accommodate a farmer who has applied for a $6oo loan with which to purchase seed. In doing so it gives him a $600 deposit, and within a few days the fanner's check is deposited by the seed merchant in Bank B. Bo far as Bank A is concerned, its deposit liabilities have increased by $1,0 00 and its assets by $hoO in cash and the faxmer’s $600 note. ramk B, receiving the $600 check from the seed merchant, goes through essentially the same procedure as Bank A. It feels that a loan of $1*00 to be used by one of its customers to purchase a television set is warranted, the $1*00 is placed to the credit of the b o r r o w , and promptly checked out to the appliance dealer who, in turn, deposits the check in his bank, Bank C. Bote that the net result to Bank B is that it has increased its deposit liabilities by $600, and its assets by $200 cash end the note of $1*00. * 7 * Bank C receives the #*00, and Is la position to amke additional loans up to sera® fraction of titts araount. But la order to hold the exsm Le to a reasonable length, let us say it delays asking use of this new money. What has been the result of this sequence of events, first, sot® that in each case the hank did not sake a loan until it had received souse additional cash and, further, each loan was for a smaller amount than the cash received. Bach hank might therefore deny emphatically that it "created” any money« How let us look at the banka together, our hypothetical 'hank ing system*. There is a deposit of $1,000 in Bank A, a deposit of #600 in Bank B and of #*00 in Bank C. Thus, we have #2,000 on deposit in the three banks which is available for spending by the original depositor, the seed merchant and the appliance dealer but, note carefully, that only #1,000 of this represented new cash coming into our banking system, remainder, #1,000 was, in the true sense of the word, "created”, fh© it did not exist prior to the original deposit and could not have come into existence unless the banks had acquired the assets they did. The relationship between banking and circulating medium also helps to explain why a bank failure was usually so much more disasterous to a community than the failure of a business concern of comparable else. The loss to the caamimity of the income of the failed bank’s employees was important, but of even more Importance was the fact that a portion of the ccamsanlty's circulating medium was literally wiped out. Usually <m 0 » only a portion of tha deposits in tha bank m s «mutually returned to the caaeunity by the liquidator and the balance, represented by worthless @&mts in the bank’s portfolio, urns forever lost to the depositors, •Today, with Federal deposit insurance, this particular prbblsa has to a great extent been solved. However, we can by no aeaas beecsae coegplaceat about bank failures since it is the function of operating basks which remains of priaary interest, »¿ith seven-tenths of the nation *s circulating aediuB consisting of bank-created funds it is clear that banking indeed plays a crucial part in the operation of a free-enterprise econoay. low crucial, nay be illustrated by a brief review of our banking history, forking vaa still in its infancy in this country when It became apparent to the various State governments that banks bad an inherent tendency to acquire as large a voluae of earning assets as possible «ad, continently, to expand their liabilities t© the public« Since, in this early period, these liabilities were generally circulating banknotes, rather than deposits, the relationship between bank lending and the creation cf circulating asdic® m s acre apparent than is the case today, Thus the inevitable inflations, which were generally followed by spectacular crashes whenever the banks were subject to- even relatively mild ©hocks, led the States to enact into law certain M a l t s to the expansion of bank liabilities, These limits were frequently in the form of requiring that circulating banknotes not exceed a given Multiple of bank capital* It is interesting to observe that in the early l800*s legislators often «* «* considered beak capital the equivalent of cash, that is, gold or silver, in the beak. Consequently, we can see in these early lavs the forerunners of our modern requirements, that banks maintain minimum reserve balances behind deposits* While helpful, such regulations were not a complete solution* As the country developed, new banks were rapidly formed. One of the first great and prolonged depressions in our history, which began with the panic of 1837, is largely attributable to the collapse of the banking system, following a spectacular period of expansion in the early 1830 *3 . Apparently the most important direct cause of this collapse was the decision of the Federal government in 1836, first, that only gold end silver would be accepted for government land sales, rather than banknotes and, second, that the very substantial government surplus, which at that time was deposited in a selected group of State banks, be distributed among the various States. The result was tremendous pressure ©a bank reserves with a consequent cessation of the growth of circulating medium and, finally, complete collapse. Other depression® during this period, most notably the ill-famed Panic of 1857, can also be directly attributed to the inability of the banking system to withstand sudden pressure m it® reserve®. It was about this time that renewed efforts were made by the various States to secure stability and safety of the circulating medium through the regulation of banking* Some of the attempts took the form of insurance of bank obligation®, and other plans sought to assure the 10 safety of circulating banknotes through the postlag of collateral* tween 1829 and 1858, Be* six States adopted plans for the protection of bank creditors by one or both of these net hods, and a limited measure of success was obtained. Finally, the Federal Government took action and a rather drastic solution was adopted by the Congress 1 and between 1863 1865 the notes of State chartered banks were taxed out of existence and the note* issuing function was made a monopoly of the newly formed national banks« The notes of the latter group of banks were, of course, guaranteed by the U, S. Treasury and were restricted in amount to $0 percent of the face value of those tl. 3 . bonds bearing the circulation privilege. It was rather Ironic that this solution was achieved Just at the time when deposits, rather than circulating notes, were coming to comprise the major part of bank obligations. Following the Civil war, deposits, which had been about equal to circulating notes just prior to i860, grew rapidly, and as early as 1885 they constituted about four* fifths of the nation's circulating medium. Thus, the problem of excessive expansion and contraction in bank liabilities which had been "solved” by 1865 was once again before the country after only two decades* It is hardly necessary for m to detail the instances of erratlcis® in business and banking since that time— everyone here certainly has m m am or more of the various charts that purport to show the course of general business over the last century or century and a half« On these charts, times of full employment are given such designations as war ** 11 » prosperity, Coolidge prosperity, merger prosperity, or gold resusptton prosperity, On the other hand, deflation years are called by each terms as primary post war depression, secondary post ear depression, debt repudiation depression, «id the rich man's panic. What are we to conclude from this brief survey of the record of banking instability? Certainly not that all our troubles would have b@«i avoided if w® had possessed a different banking system, or even no banks at all, for it must be emphasised that despite the periods Of expansion and contraction, banking on the whole played a most important role in the economic development of the country. If we had not had an independent banking system comprised of many individual units and oriented to the needs and wants of their respective communities, the rate of economic development of this nation would have been such slower. And, of course, continuation end preservation of such a system today is of great importance* Secondly t the fact that banks create circulating medium through their leading and investing operation« is not t© be condemned. On the contrary, it is a normal characteristic of a free enterprise economy. &hat is important is that we understand the banking and monetary policies which will result in banking stability and which will thus produce business stability. That is to say, we must preserve the Independence of our basks so that they can continue to serve the commerce and industry of their communities, but at the same time we must make mire that the banking system as a itele neither creates so ouch money a» to casse inflation nor so little m to cause depression. Putting it still another way, stability without sacrificing banking independence, m saust assire tanking low this is being accomplished will be discussed at the next two sessions of this class.
@FedFRASER