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BANKING IN A FREE ENTERPRISE ECONOMY
Lecture by Dr. Edison H. Cramer, 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 17, 195^•
Yesterday we discussed the functioning of a free enterprise
economy and the way by which the price mechanism channels resources,
human and physical, into their most productive uses.
Implicit in my
remarks was the assumption that business enterprises would be so coordinated
by prices there would be full employment of all resources.
It was also
implied 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
has 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 turn have been followed by prosperity in
the continuous chain that is called "The Business Cycle".
Likewise the
value of our monetary unit--our economic ballot, to use yesterday's
analogy— has gone up during periods of depression and down with prosperity.
Most of you recall the early 19301s 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 called it an
"over production--under consumption depression", and we tried to cure it
by paying farmers to plow under every third row of cotton and by butchering
_ p
the sows that were about to farrow a litter of pigs.
Our monetary unit
rose 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 why they behave as they do during the various
phases of the business cycle.
We know from experience that in both de
pression 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 worth
while to examine this hypothesis.
In making an examination of this hypothesis we may start with
the same fundamental economic principle we discussed yesterday, 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 payments and fulfilling contracts?
latter question is yes.
The answer to the
If too much money is created 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 not enough money is created relative to the need, it tends to rise in
value and fewer units will be required to buy a suit of clothes, a bushel
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of wheat, or an automobile.
That is to say, a decline in the value of
money due to an excessive increase in its quantity is the same as a
general rise in prices.
This is what we call inflation.
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 deflation of prices.
Neither inflation nor deflation occurs instantaneously.
In each
case some 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.
structure.
This creates distortions in the price
Generally speaking, in inflation these distortions are such
as to make business unusually profitable and thereby to stimulate business
men to feverish activity.
Likewise, the distortions 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 emphasized 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 on the character and impact
of inflation and deflation, lead us back to the problem of business insta
bility.
If the money supply does not remain stable in quantity with a
reasonable increase in line with the growth of the economy, periods of in
flation and boom on the one hand, and of deflation and depression on the
-
other, appear to be inevitable.
k
-
Consequently, many economists have con
cluded that maintenance of monetary stability with a reasonable rate of
growth is the key to economic stability.
At this point you may be wondering what became of my announced
topic, "Banking in a Free Enterprise Economy".
The answer is simple:
the most important single function of the nation's banking system is
provision of the circulating medium with which the economy operates.
This is not its only important function, but were it not for this, banking
would scarcely warrant the great attention 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 best measure of circulating medium now available,
the Federal Reserve series "Deposits adjusted and currency", and examin(p73iing its construction. As of December 31; 1953; deposits adjusted plus
currency totaled $201 billion.
Of this amount, about $28 billion was
currency outside of the banks and about
in the postal savings system.
$2
billion represented deposits
Since this $30 billion was not created by
the banking system, it may be deducted.
This leaves a total of $171
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 all operating banks, there has been
deducted interbank deposits, U. S. government deposits, and cash items
in process of collection.
This was done so as to arrive at a deposit
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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 might say, this $171 billion of deposits
simply represents money deposited with banks and was not created by them.
To a limited extent this is true.
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,
(p737
P/i"'’*-'
such as currency and coin, and member bank reserves with Federal Reserve
banks.
In all, these other cash items amount to about $23 billion and
when we deduct this sum from our "deposits adjusted" of
result is $l48 billion.
$171
billion, the
This is the basis of my statement that over
seven-tenths of the nation's circulating medium has been created by the
banking system.
In other words, there is $1^8 billion of deposits in
the banking system which is not represented by cash in the banks but,
instead, is represented by other assets held by them.
It was through the
acquisition of these assets that the $1^8 billion of circulating medium
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was created.
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This is all very well, you might say, but is it not true that
an 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 none of them does
individually.
As a matter of fact, there is no magic to it at all.
illustrate the process, let us assume that instead of
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banking system consists of three banks.
Let us further assume that all
of these banks are ''loaned up", that is, their cash and reserve positions
are such that they would hesitate to make any new loans until some of
the old loans run off.
Finally, let us assume that a new depositor walks
into Bank A with $1,000 in currency which he uses to open an account.
Now let us follow a series of events which are typical of those that are
likely to occur.
Bank A may feel, with an additional $1,000 in cash, that it is
now possible to accommodate a farmer who has applied for an
with which to purchase seed and fertilizer.
$800
$800
loan
In doing so it gives him an
deposit, and within a few days the farmer's check is deposited by
the seed merchant in Bank B.
So far as Bank A is concerned, its deposit
liabilities have increased by $1,000 and its assets by
the faimer’s
$800
$200
in cash and
note.
Bank B, receiving the $800 check from the seed merchant, goes
through essentially the same procedure as Bank A.
of
$600
It feels that a loan
to be used by one of its customers to purchase a television set
is warranted.
The $600 is placed to the credit of the borrower, and
promptly checked out to the appliance dealer who, in turn, deposits the
check in his bank, Bank C.
Note that the net result to Bank B is that
it has increased its deposit liabilities by $ 800, and its assets by
$200
cash and the note of $ 600.
Bank C receives the $600, and is in position to make additional
loans up to some fraction of this amount.
But in order to hold the example
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to a reasonable length, let us say it delays making use of this new
money.
What has been the result of this sequence of events.
First,
note that in each case the bank did not make a loan until it had received
some additional cash and, further, each loan was for a smaller amount
than the cash received.
Each bank might therefore deny emphatically that
it "created" any money.
Now let us look at the banks together, our hypothetical "bank
ing system".
There is a deposit of $1,000 in Bank A, a deposit of $800
in Bank B and of $600 in Bank C.
Thus, we have $2,400 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,^00 was, in the true sense of the word, "created* .
The
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.
That is to
say, its creation was possible because: first, new money--in other words
new reserves— came into the banicing system; and second, the banks used
the new reserves to acquire additional assets.
The source of bank reserves and how they are also created
will be discussed later.
Before doing so, let us consider the conse
quences of this primary function of banking--the creation of circulating
medium.
With seven-tenths of the nation's money supply consisting of
bank-created funds, it is clear that banking indeed plays a crucial part
-8 in the operation of a free enterprise economy.
How crucial, may he
illustrated by a brief review of our banking history.
Banking was still in its infancy in this country when it be
came apparent to the various State governments that banks had an inherent
tendency to acquire as large a volume of earning assets as possible and,
consequently, to expand their liabilities to the public.
Since, in this
early period, these liabilities were generally circulating banknotes,
rather than deposits, the relationship between bank lending and the
creation of circulating medium was more apparent at that time 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 shocks, led the States to enact into law certain limits
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 bank capital the equivalent of cash, that is, gold or silver,
in the bank.
Consequently, we can see in these early laws the fore
runners 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, foblowing a spectacular period of expansion in the early
1830 's «
Apparently the most important direct cause of this collapse was the
decision of the Federal government in
1836,
first, that only gold and
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 on bank
ieserves with a consequent cessation of the growth of circulating medium
and, finally, complete collapse.
Other depressions during this period,
most notably the panic of lo5 (, can also be directly attributed to the
inability of the banking system to withstand sudden pressure on its
reserves.
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 obligations, and other plans sought to assure the
safety of circulating banknotes through the posting of collateral.
tween 1829 and
1858,
Be
six States adopted plans for the protection of bank
creditors by one or both of these methods, and a limited measure of
success was obtained.
Finally, the Federal Government took action and a
rather drastic solution was adopted by the Congress: between
1863
and
l86p 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
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10
by the U. S. Treasury and were restricted in amount to 90 percent of
the face value of those U. S. 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
i 860, 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 Hsolved" by
1865
was once again before the country after only two decades.
It is hardly necessary for me to detail the instances of
erraticism in business and banking since that time--everyone here
certainly has seen one 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 designa
tions as war prosperity, Coolidge prosperity, merger prosperity, or gold
resumption prosperity.
On the other hand, deflation years are called by
such terms as primary post war depression, secondary post war depression,
debt repudiation depression, and 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
been avoided if we had possessed a different banking system, or even no
banks at all, for it must be emphasized that despite the periods of undue
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11
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 eco
nomic development of this nation would have been much slower.
And, of
course, continuation and preservation of such a system today is of great
importance.
Secondly:
the fact that banks create circulating medium through
their lending and investing operations is not to be condemned.
On the
contrary, it is a normal characteristic of a free enterprise economy.
What 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 banks
so that they can continue to serve the commerce and industry of their
communities, but at the same time we must make sure that the banking system
as a whole neither creates so much money as to cause inflation nor so little
as to cause depression.
Putting it still another way, we must assure bank
ing stability without sacrificing banking independence.
How this is being
accomplished will be discussed at the next two sessions of this class.
@FedFRASER