Money, Credit, and Crises

What is money? Despite our daily use of it, it is not often that we ponder what makes something money, especially in the modern era where we take the prevalence of paper or digital money for granted. This chapter provides a short insight into these concepts, aiding the reader who is unfamiliar with the subject to build the essential knowledge pack required for the remainder of the book. The first chapter serves as an introduction to the world of money and banking, providing a quick overview of their history until the early twentieth century, including the creation of the world’s first central banks in Europe and the needs these institutions sought to address.

Throughout the history of economics there have been quite a few booms, bursts, crashes, panics, and crises. To examine each and every one of them would require a book of its own and already quite a few exist on the subject. Like most other aspects of life, the banking sector and its supervisors try to learn from their mistakes. For the majority of people, these mistakes, unfortunately, tend to have a strong impact on the overall economy and are usually dubbed as “crises”. The chapter begins with the panic of 1907 in the US, which underlined the need for an institution which would be in charge of guaranteeing that one bank’s money was as good as another’s, even when things go south. This need made the US charter a new “bank of banks”, the Federal Reserve, which would be the only issuer of the specie other banks would use. Next, the mother of all crises, the Great Depression is then examined, along with the policy actions (and inactions) which allowed it to last for more than five years. An important outcome of the Great Depression was the abandoning of the gold standard by most countries in the world and the setting of deposit insurance in the US. These two important and highly influential policy decisions are also examined. The chapter ends with an overview of the Bretton Woods system, along with a short overview of the reasons which led to its collapse and the secondary banking crisis in the UK, the first in which real estate was actively involved.

Following their exit from the gold standard, the US faced a beast the like of which it had not encountered in the past. In order to understand how banks impact the economy, we first need to elaborate on the connection between the commodity banks are producing, money, and the rest of the economy. After a brief overview of the concept of inflation, and the price level in general, an elaboration of the forces which impact the price level is made, both from the demand as well as from the supply side. Hyperinflation examples are overviewed, notably that of the Weimar Republic. The chapter ends with an elaboration on why the inflation rate should be stable, and prolonged deflationary or hyperinflationary periods are unwanted.

At the time countries were tied to the gold standard, money supply in the economy was, as already discussed, effectively controlled by the amount of gold in the economy. This chapter examines how modern banks function and how these institutions are essential for the money creation process. Bank balance sheet illustrations are presented in order to provide the reader with a clear view of the changes in the bank’s books after a new loan is created. Drawing from the above allows us to depart from the classical notion of a money multiplier and create an enhanced version, based on capital ratios. The chapter moves on to examine how changes in bank deposits, unrelated to changes in lending can signal potential incentives for excess lending or potential liquidity shortages in the future. The role of the central bank is also underlined in this chapter as, in the realistic case of multiple commercial banks, funds are limited to the provision of central bank liquidity, and to some extent, to changes in government debt.

It is easy to see that through the combination of the factors outlined previously, the banks’ willingness to lend and the peoples’ willingness to borrow will match and create new loans. Lending has the effect of increasing peoples’ purchasing ability and hence overall demand in the economy. This increase in money has important implications for the economy, the final outcome of which is an increase in the inflation rate, if the funds are used for the purchase of the goods or services included in the price index. If the funds are, however, used for the purchase of real estate then these effects are measured through an increase in the index of house prices as well as through the increase in the purchasing power of the people involved in the building industry. Price increases would urge those involved in the real estate sector to invest more, leading to more supply. If the increase in money availability continues, the loop goes on. However, the opposite loop can also manifest: when demand decreases then the feedback loop follows the reverse course, with constant decreases. Finally, the chapter deals with the important issue of over-indebtedness.

 Up until the 1970s, investment banking included just a handful of active players. Since then, investment banking has increased in both size and impact, taking up a much larger portion of total banking activities. This chapter overviews the services provided by investment banks, starting from the basic middleman service of connecting investors to fund seekers, and moving on to other more complex activities such as securities lending. To provide beginners with an understanding of how investment banking works, the chapter offers a simplified presentation of how financial instruments, such as derivatives and repurchase agreements, are constructed and used.

As you may have guessed or if you were living in almost any part of the world over the past twenty years, as experienced in everyday life, banks do not always do well. There have been many cases that banks have performed bad, and were either forced to shut down, merge with another institution, or even rescued using government money. Thus, in this chapter, we will delve more into the reasons banks fail as well as into the effects this can have on the economy. In particular, the chapter distinguishes “usual” recessions from banking crises, with liquidity being heavily affected as a result of banks being hurt financially, through write-offs (i.e. losses) and loan loss provisions as the number of non-performing loans increases. Through examples illustrated with the help of bank balance sheet graphics, these effects are overviewed and elaborated upon. The usual responses of central banks in downturns are also examined.

The Financial Instability Hypothesis (FIH) was developed by Hyman Minsky in the 1970s and 1980s, with the aim of answer the question of whether “it”, i.e. a Great Depression-like event, could happen again. Linking Minsky’s theory to the previous chapters, the reader can understand why banks may have an inclination to provide enormous amounts of lending to riskier investments in some times and why they can withhold their funds from prudent projects in other. The theory elaborates on the phases of lending and can explain why banks can become overly exuberant at times when the economy is booming, and overly pessimistic when faced with economic downturns. Understanding this can shed light to every banking crisis thus far, with short examples of recent crises.

No other banking activity has attracted as much attention in recent times as securitization. However, despite the huge publicity the topic has received, there has been no effort thus far to make the securitization process understandable, without relying on over-simplification and other rhetoric, usually unrelated to economics. To this end, this chapter firstly puts forth a simple, straightforward explanation of what securitization is and then traces its history to the 1970s and the rise of investment banks, while it also examines the reasons behind its initiation and prevalence over time. The impact of securitization on bank balance sheets is also elaborated through schematic representations of bank balance sheets before and after mortgage securitization. The chapter also includes items such as alternative, sub-prime, auto loan and credit card securitizations, and overviews the structure of securitized bonds from the investor’s perspective.

The innovative nature of securitization and the comparatively higher returns of structured products made more and more investors willing to participate in such deals. As a result, a variety of firms are now performing bank-like activities without being themselves part of the banking sector, comprising of what has come to be known as “shadow banking”, a term that has only recently entered the financial lexicon. Before reaching a proper definition, this chapter builds on the previous two chapters and further elaborates on the institutions which comprise the shadow banking system. The chapter ends with a discussion on why shadow banking matters for the economy.

As the previous chapter has illustrated, central banks and other policymakers have the difficult task of policing banks when times are good, and the even more difficult task of deciding how to react when panic sets in the economy. More recently, policymakers have been switching to policies other than the manipulation of interest rates, aiming at increasing liquidity provision, to assist ailing banks. Such policy actions have been dubbed as “unconventional”. The lessons learned in the previous chapters can assist in the evaluation of the two most important and controversial policy actions in today’s world: Quantitative Easing (QE) and negative interest rates. An evaluation of the impact from modern policy responses such as quantitative easing and the imposition of negative interest rates in the US, Europe, and Japan suggests that the effect was not as significant as expected by policymakers, for reasons that have more to do with the interaction between monetary and fiscal policy.

Previous chapters have provided a detailed overview of how the banking system functions. This chapter will not bore you with a recap of what has already been said. On the other hand, it will focus on how future developments can potentially affect the banking sector, including cashless societies, digital currencies and banks, cryptocurrencies, as well as potential policy options such as countercyclical bank capital buffers. While the possibility of a banking crisis will never be ruled out, and one can with certainty predict that there will be another banking crisis at some point, there is still room to blunt its effects and duration.