Basics of Banking: Lending Money at Interest
Banks earn a profit by lending money at interest; when borrowers pay back what they owe, they also pay the bank a percent above the amount lent. Borrowers include both individuals who want to purchase homes and consumer goods, and businesses which are financing their operations or investing in their own expansion.
To acquire money to lend, banks do at least two things: attract depositors by guaranteeing to pay them interest on their savings accounts; and borrow money from other, larger banks. In most countries, banks can also borrow from a central government-run bank (called the Federal Reserve in the United States). Also, in some countries (including the United States), banks make investments in stocks, bonds, and other financial instruments to earn higher rates of return.
What is Money Worth?
Like any commodity—corn, soybeans, cars, shoes—the value of any currency is based on supply and demand: high demand and low supply raises the value of money, while low demand and high supply lowers the value. The trick to remember, however, is that if there is a high supply and low demand of a currency—too much money in the money supply—the value of money drops, so prices actually go up. The consumer needs more currency to buy things if the market feels that there is too much of it. This is called inflation.
Until the early 1970s, most national currencies were “backed” by gold (and silver); in other words, its “worth” was denominated in metal. Since that time, countries have generally based the value of their currency on whatever the domestic and international financial markets determine it to be (through the concept of supply and demand explained above). Almost always, international finance is denominated in U.S. dollars (although the Euro, the British pound, the Chinese yuan, and the Japanese yen are also important international currencies).
As seen in the example of hyperinflation during the Weimar Republic in Chapter 8, too much money in the money supply may mean that wages chase prices, which in turn chase wages; causing an inflationary spiral with people losing their savings to buy basic food items. However, the example of hyperinflation reveals one positive aspect to inflation: it is easier to pay off debts since the new currency is worth less than what was borrowed.
Normal inflation, therefore, can be a good thing, since it can encourage borrowing to buy things: what you borrow today may not be worth as much by the time you pay off your loan. However, defining what is “normal” inflation, and achieving that level, is the challenge faced by banking systems. Usually central banks in each country play a key role in determining the money supply; in the United States, that is the Federal Reserve System—the “Fed.”
Financial Concepts in the U.S.: Inflation and the Federal Reserve System
The Federal Reserve System was established in the United States in 1913 during the period of activist government known as the Progressive Era. Other countries already had government-run central banks, and the U.S. had experimented with this idea in the 1820s and 1830s, but had abandoned it, relying exclusively on the private banking system.
A few years before the Fed existed, in 1907, a financial crisis broke out, called the “Bankers’ Panic.” Banks stopped lending to businesses and to each other, fearing that they would not be paid back, threatening the stability of the U.S. economy. However, private banking tycoon J.P. Morgan stepped in, lent money to banks that were on the verge of collapse, and investors’ confidence in the financial system was restored.
After the panic, many people began thinking that maybe having the entire U.S. banking system dependent on a single private citizen was a bad idea, and that the U.S. should adopt the “central bank” concept from other countries. Thus, the Fed was organized. There are checks and balances involved: members of the Federal Reserve board and its chair are appointed by the U.S. President for set terms of office; and their appointments need to be approved by the Senate.
Interest Rates, Banks, and Lending
The Fed lends money to banks at interest, which then lend to each other and to the rest of the economy at a higher rate of interest. The interest rate banks use to lend to each other is called the prime rate. It is usually three percentage points above the Fed’s interest rate to the banks. For example, if the Fed’s rate is 1%, then the prime rate is 4%. Banks make profits by lending money at interest—but they have to also pay back the Fed.
The banks that borrow from other banks establish a higher interest rate than the prime rate for loans to businesses and personal borrowers. Borrowers are typically required to pay back at least the monthly interest rate plus a bit of “principle” (the original amount borrowed).
The bank’s rate may fluctuate for individual borrowers based on how much confidence a bank has that they will be paid back. This decision is based on a “credit rating” which is established by private companies like Standard and Poor’s and Moody’s. The credit rating is measured by determining previous borrowing history and how well a borrower reliably pays back their loans (including on credit cards). Banks also consider other factors, for both individuals and businesses, such as savings and other investments, before lending money.
If a bank or other lending institution has less confidence in a borrower, they will charge a higher interest rate. This means the borrower would have to make higher required monthly payments—the reasoning is that if they borrower eventually stops making payments, at least more of the debt will be paid off to the bank up front.
Controlling the Money Supply: The Fed’s Interest Rate and Monetary Policy
As mentioned, the Federal Reserve plays an important role in determining interest rates. It uses this power to establish a healthy rate of inflation or to help stimulate the economy.
Consider the following problems and their solutions:
Problem—High inflation. Solution—Fed raises interest rates.
If the Fed’s rate goes up, the prime rate goes up and banks, businesses, and consumers borrow less and buy less because borrowing gets too expensive. This means less money in the money supply, which controls inflation. However, high interest rates may also slow down the economy because businesses will invest less and consumers will not buy as much.
Problem—Slow economic growth or a recession. Solution—Fed lowers interest rates.
If the interest rate goes down, banks, businesses, and consumers borrow more and buy more. This stimulates the economy. However, lower interest rates may lead to inflation—more money in the money supply—or to investors taking too many risks (the fundamental problem behind the 2008 Financial Crisis).
The Fed’s Monetary Policy, 1979-Today
In the late 1970s and early 1980s, when there was a recession with over 10% inflation and high unemployment, the Fed raised interest rates and the prime rate went up to control inflation. At the time, banks actually competed with prizes and other incentives to attract depositors, including establishing high rates of interest on savings accounts. People spent less and saved more, which also affected the money supply. The policy also deepened the recession, in the short run.
After the crisis began to fade, the Fed gradually lowered interest rates, just in time for the huge technology boom of the 1990s. New companies borrowed more at low interest rates. However, when the tech boom slowed down around 1999, the Fed lowered interest rates even more to stimulate the economy. This policy led to increased borrowing to buy real estate, which indirectly led to the 2008 Financial Crisis.
Since 2008, the prime rate has been very low, sometimes barely above 0%, in order to stimulate economic growth. In the U.S., the recovery was gradual but sustained—jobs were added to the economy for every month from mid-2009 until the beginning of the 2020 Coronavirus Pandemic.
The Fed and Quantitative Easing: Another Tool in the Toolbox
At the beginning of the 2008 Financial Crisis, the Fed also began a policy of “quantitative easing.” This means that the Fed buys bank debt—what banks borrow from the Fed or other banks—so that banks can lend money instead of using it to pay off their own debts. This also stimulates the economy by encouraging more lending.
The Fed Compared to Other Central Banks: No “Sovereign Funds”
Unlike other central banks—for instance, those of China and Japan—the Fed does not make investments. In the case of China and Japan and other countries, central banks maintain “sovereign funds” by buying investments in their own countries, or in others. In this way, these sovereign funds purchase U.S. government debt by buying U.S. bonds (see below).
Taxes, Government Borrowing and the World Economy
Taxes and Government Revenue
Taxes pay for government services (military, police, prisons, education, infrastructure, Social Security, etc.), but there are several different kinds of taxes. For instance in the United States, the U.S. federal government raises revenue by taxing—taking a percentage—of individual income and corporate earnings. The federal government also raises revenue through some sales taxes, especially on gasoline, alcohol and tobacco. Customs and tariffs (taxes on foreign imports) are still around but are a lot less important than they were in the nineteenth century as a source of revenue.
State governments in the U.S. are more likely to raise revenue through sales taxes and fees for certain government services (license plates, hunting licenses, etc.) Sales taxes are a percentage of the purchase price of consumer goods, but not all goods are taxed (for instance, Minnesota is unique in that the state does not levy a sales tax on clothing). Most, but not all, states also have taxes on personal income and corporate earnings.
Municipal governments in the U.S. usually collect property taxes (and, in some cities, sales taxes) to raise revenue. Property taxes are based on the value of real estate held by an individual or corporation.
School taxes in the U.S. are also almost always property taxes, which explains why rich suburban school districts can provide better public schools than poor urban and rural districts.
The Tax Debate: “Tax and Spend” vs. “Trickle Down”
“Tax and Spend”: Classic Keynesian economics. Advocates of this perspective argue that government projects and services help build the country’s future (infrastructure, education, affordable housing, etc.) while providing jobs, especially during hard economic times. (Most Democrats agree with this idea to a degree).
“Trickle Down”: Cut taxes as much as possible. Those who promote this theory believe that individuals and businesses should have more money to spend any way they wish. Consumers will stimulate the market through personal spending, while businesses will reinvest and help grow the economy. This will create more government revenue as new workers and growing businesses are paying taxes. (Most Republicans agree with this theory to a degree).
Government Borrowing: Selling Bonds
Governments at every level and all over the world borrow money by selling bonds to finance spending on projects and services. Bondholders are paid interest on bonds, but, like stocks, may also resell them to other investors. Government bonds are paid with revenue (through taxes) gradually over years, spreading the debt to the next generations. This makes some sense: Why should current taxpayers pay completely for a new bridge, school, or public park which will be used by everyone for decades to come? Spreading the debt is seen as fairer.
United States federal Treasury Bonds are sold around the world to individuals, banks, and global sovereign funds (the government banks of China, Japan, and many others). The U.S. government has consistently made payments on its bonds for over two centuries and so U.S. bonds are considered globally as the best and safest investment–they are purchased even if they are being sold at almost no interest (which has been the case for most of the last 12 years).
Congress determines the maximum debt the U.S. government can maintain through bonds, called the “Debt Ceiling.” The debate about whether or not to raise the debt ceiling is similar to the tax debate: some, especially among Democrats, advocate issuing bonds to invest in America’s future, especially while interest rates are low. Others, particularly among Republicans, feel that the government should not burden future generations with more government debt. Like determining the best rate of inflation, the proper prime rate for an economy, and the level of taxation, economists and politicians also debate about how much government debt is too much.
Confidence in Government Debt
An important consideration for investors interested in buying government bonds is the confidence in a government’s ability to pay its debt. Just like individuals and businesses, as long as a government continues to pay its debt completely and on time, then banks will lend more money to the government, adjusting the interest rate based on their level of confidence. Even countries have credit scores from rating agencies to help lenders and investors make decisions.
However, unlike individuals, governments never completely pay off debt, but that is less important than their ability to borrow based on how well they keep up on payments. For instance, Germany did not finish paying all reparations from World War One until 2010, yet this fact had little effect on its economy, which has consistently been among the world’s top three for decades.
If a nation’s economy collapses or some other disaster happens, or the debt gets too big (and again, there is a lot of debate over what “too big” is), then investors will have less confidence and a government will be unable to sell bonds and borrow money. This has happened not only to countries but also U.S. territories, most recently Detroit and Puerto Rico. The debt payments are restructured by the lenders, or reneged upon entirely, with future borrowing greatly affected because of the lack of confidence by investors and lenders. Sometimes a government built infrastructure that did not end up stimulating economic growth; other times, they did not foresee huge changes—like a population leaving a city for the suburbs. And sometimes, especially in certain developing nations, corrupt politicians and administrators robbed the funds, saddling a government with debt but leaving nothing of value.