Wednesday, July 31, 2013

House of Cards

This is a story of Fractional Reserve Banking, and how to turn $1,000 into $10,000.

In the United States, we have a banking system known as a fractional reserve banking system. This means that when a person decides to put his or her savings into a bank, the bank does not hold onto the entire amount of money the individual's deposit. The bank lends out some of the deposits to other individuals who would like to borrow the money at a certain rate of interest. In return, the bank gives the depositor a portion of the interest it receives. The bank serves as an intermediary, who brings borrowers and lenders together.

In the United States, the US Federal Reserve sets a reserve requirement for commercial banks. It tells the banks what percent of deposits, they must keep in their vaults. The remainder of the deposits the bank can lend out. Currently, the reserve requirement for banks are:

0% for a bank with less than $12.4 million in deposits
3% for banks with $12.4 million to $79.5 million
10% for banks with over $79.5 million.

For example, if one person deposits $1,000 into a bank with a 10% reserve requirement, that bank has to keep $100 in reserves. It can then lend out $900 to borrowers.

Those borrowers then purchases items with the money they borrowed, and a storeowner now has earned $900. When the storeowner then deposits the $900 into a bank, that bank now has $900 more in deposits.

Again, the bank has to keep $90 of the $900 in reserves, but can lend out $810 to borrowers.

The borrower spends the $810, which gets deposited into the bank of the person who earns the money, and the bank holds 10% ($81) of that deposit in reserves. The bank can then lend out the remaining $729.

And so on, until the bank can no longer lend out more money. At the end of the process, the total amount of money that has been deposited into the bank by all the storeowners (and the original depositor) adds up to $10,000.

But, wait a minute. Didn't we start out with only a deposit of $1,000? And isn't it just the same money being lent out and then re-deposited into the bank?

Why, yes! Through the bank lending part of the initial $1,000 and then re-lending that money to others when it comes back through the banking system (once it has been spent), we manage to increase deposits from $1,000 to $10,000.


This is known as the money multiplier. Through fractional reserve banking, a small original deposit can turn into ten times the amount of deposits. The money is multiplied (leveraged).

Money is literally created out of thin air through the lending process and the banks' balance sheets.

At the end, we have:
  • $1,000 Original Deposit 
  • $9,000 Lent Out 
  • $9,000 Re-Deposited 
  • $1,000 in Reserves 

In other words, there are $10,000 worth of claims on $1,000. The bank, through the magic of their balance sheet, argues that the $9,000 lent-out offsets the $9,000 deposited, but the fact remains that there are $10,000 worth of legitimate claims on only $1,000.

So, what would happen if all these store-owners try to collect their deposits? The money is not there.

Now, typically, a bank keeps more in reserves than the minimum required by the Federal Reserve (this lowers the money multiplier.) Banks do this precisely because they know that depositors will demand (and spend) bits of their money at a time, and the banks want enough liquidity (cash on hand) to be able to meet these demands.

The less risk a bank wants to take on, the more they will keep in their reserves and the less they will lend out, since the banks want to avoid what is known as a bank run, where depositors try to take out money that the bank does not actually have. But, while banks have incentive to keep money in reserves for liquidity purposes, they also have incentive to lend out as much as they can because they make interest from those loans.

Banks have to find a balance between liquidity and lending.

Lending can be wonderful thing. It may provide start-up businesses with the funds they may need to get off the ground. And, when banks are held accountable for the money they lend out to borrowers, the banks have incentive to make sure the funds are going to people who have good financial histories and prospects. As mentioned before, banks may also keep more in reserves than required by the Fed, in order to have enough funds available for withdrawal. The bank is relatively cautious when it is ultimately responsible to the depositors for their funds.

However, BIG problems arise when the bank is not held responsible for the money it lends out.

The banking system is highly intertwined: money borrowed from one bank may be deposited into another, which then gets lent out, and that lent out money may be deposited in still another bank. So, when depositors ask for their funds, and a bank is insolvent (can not pay the money), other banks may also be at risk.

The system only works to the extent that people have trust in it, but it can crumble like a house of cards when stressed. Since the Federal Government wants to protect the banking system from potential stress, they provide FDIC insurance. The Federal Reserve also acts as a lender of last resorts; It will provide loans to a bank to cover liquidity issues. On top of this, the Federal Government (US Taxpayer) also has a tendency to bailout insolvent banks in order to preserve the system and stop it from collapsing. In this situation, the Federal Government absolves the banks from responsibility to their depositors, which only encourages the banks to engage in more risk lending.

And build a bigger house of cards.

*All images where created by JGR of

Friday, July 26, 2013

Why Free Trade Is Good For You: An Illustration

We have all heard of the term Free Trade, but what does it really mean?

Free Trade means two individuals, who happen to live in different counties, are able to exchange goods with one another without interference from their respective governments. Interference can come in the form of tariffs, quota restrictions, or other regulations.

A tariff, for example, is a tax on imported (foreign) goods. The US government allows foreign producers to sell products to American Consumers, but at a higher price than the current world market price. In other words, American Consumers have to pay more if they want to buy from foreigners. The idea is that this policy will help American Producers be more competitive with foreign producers, and thus will boost domestic production and the economy.

AND... these policies do benefit American Producers. BUT... they come at a high cost to American Consumers.

Let's walk through a graphical example:

Market with Free Trade: shows the US Domestic Supply (SUSA), along with the US Domestic Demand (DUSA) for a product. The Pink Line represents the World Supply (SWorld).

At the world price, US producers supply QUSA and US Consumers buy QUSConsumer. The difference is imported from other countries:

The Green Triangle denotes American Consumer Surplus: how much American Consumers benefit from the trade.  The Brown Triangle represents American Producer Surplus: the amount American Producers benefit from the exchange.

Now let's look at a Market with Regulations. The graph below shows the same market once the United States Government implements a tariff on the good. The tariff increases the price American Consumers have to pay. They pay PTariff instead of PWorld.

While American production (QUSA) increases, American Consumers now buys less since the good is more expensive.

American Consumer Surplus is now a much smaller Green Triangle, while American Producer Surplus is a slightly bigger Brown Triangle. The Yellow Square is the Tax Revenue the US Government receives from the Tariff.  Unfortunately, the Blue Triangles are Deadweight Loss; nobody gets this.

To recap:

Because of the tariff, American Consumers lose the GREEN (above), while the American Producers only gain the BROWN (below).

 The US Government gets the YELLOW Rectangle:

And nobody gets the BLUE:

There is Deadweight Loss because some American Consumers are no longer able to afford the product because of the price increase, but they would have been able to if there were no trade restrictions. There is also Deadweight Loss due to the fact that US producers are wasting resources making a product that could have been made more cheaply by foreign producers. 

On top of this, with Free Trade, American Consumers would have spent the entire GREEN Rectangle below on the good:

However, with the tariff, they are unable to purchase this GREEN portion of the rectangle:

They reduce their consumption since they now have to pay more for a smaller quantity; this GREEN area:

Summing up, with the implementation of a tariff:
Americans go from having gains from trade that look like this:

To having gains from trade that look like this:

Restricting Free Trade (tariffs) hurts American Consumers more than it benefits American Producers. 

Now, let's look at an extreme case: when the US Government completely bans the sale of a foreign good in the United States.  

Market without Trade shows the Domestic Market when a foreign good is ban. The price consumers pay is higher than under Free Trade, and less of the good is consumed by Americans:

American Consumer Surplus is this small Green Triangle, and American Producer Surplus is this Brown Triangle:

If we compare this to the Market with Free Trade, American Consumers have lost the entire GREEN area below:

And, American Producers have only gained the BROWN area:

And again, no one gets the BLUE triangle, which are lost gains from trade (i.e., wasted resources and reduced consumption due to higher costs and prices).

Again, American Consumers lose more than American Producers gain from such polices. Trade Restrictions hurt more than help.

So, go for Free Trade.

We could say to the rest of the world: We believe in freedom and intend to practice it. No one can force you to be free. That is your business. But we can offer you full co-operation on equal terms to all. Our market is open to you. Sell here what you can and wish to. Use the proceeds to buy what you wish. In this way co-operation among individuals can be world wide yet free.  -Milton Friedman, Capitalism and Freedom

Thursday, July 25, 2013

The Government Spending Binge

This blogpost relates the US Federal Debt to the Average American Citizen's Income; it is an update of a post I originally published for in August of 2011: 

For most of this year, the talk in Washington has been focused on the debt, the debt ceiling, spending, and tax revenue. Politicians, economists, reporters, and citizens keeps referencing these large unfathomable numbers, like $16.98 trillion in debt. But what does that really mean?

How can the average American citizen relate?

Instead of looking at $16.98 trillion, a number which is almost as hard to comprehend as the concept of infinity, we can look to see how the debt would relate to the average American family's income of $50,000 a year.

Our current fiscal situation is comparable to the scenario below:
Income for 2013:      $50,000                 
Spending in 2013:    $65,000                 
Deficit for 2013:       $15,000                 

Without taking into account debt you have already accrued, it is clear that the above situation is unsustainable. You will have to change your habits significantly, if you are going pay off the $15,000. Unfortunately, $15,000 is not all you owe. Over the past years, you have not been fiscally responsible and you have racked up a total debt of $312,132, much more than you make in a year.

$312,132 is quite a looming debt for someone who makes $50,000 a year. If you continue down this path, and keep spending at the same level, at a higher level, or any level above the amount you make, you will soon be in a situation where you cannot possibly pay back your debts. You will default and go bankrupt.

However, there are two ways that this problem could possibly be solved. 1) You somehow find a way to greatly increase your income, or 2) you significantly cut spending.

While it would be incredibly convenient to be able to increase your income to meet your spending desires, in the real word this option is not very realistic. [In the United States, even though income tax rates have ranged from 94% to 25% for top income earners, historically, government revenues still stay around 18% of GDP.]

The only solution to your debt problem, which is currently leading you toward a colossal crisis, is to cut spending considerably. The only question that remains is: How aggressively will you do it? 

You cannot get out of your massive hole and solve your problem by increasing your spending, just at a slower rate, like Washington suggests.

A Washington type "solution" will not get you out of your fiscal mess. Instead, you have to completely change and restructure your entire life and priorities. Cutting your budget by 10% isn't enough; you will still be spending more than you are bringing in. Cutting your budget by 35% is still not enough; your yearly spending will still exceed your income.

As if your situation wasn't bad enough, you also have a whole bunch of unfunded liabilities you are expected to pay in the future. What exactly does that mean? It means you have a habit of handing out large IOUs to people and have been doing this for years. Unfortunately, the first large wave of these IOUs is coming due, and you do not have the money to pay for a considerable number of them. The current amount of unfunded liabilities you have is $2,297,243 and this number is growing every day. Your future spending is projected to increase exponentially as a result. 

You are in a very difficult situation. You unrealistically made promises; promises you have no way of keeping because you never had enough funds to fulfill them. So what do you do?
  • Hand out checks as they are due at first and exhaust all your funds very quickly, continue to wrack-up massive debt as you are doing it, dig yourself in a deeper hole, default, and watch the world come crashing down with you?
  • Or admit your mistake and make the necessary tough reforms and changes that will be required for you to be able to restore some of your dignity and fiscal sanity? Isn't it more honorable to explain to people that the money is just not there? No matter how much you wish it, it does not exist. We need to reform.

As of July 25, 2013:

Wednesday, July 24, 2013

The Depths of Debt

The sense of urgency concerning US debt problems has apparently faded into the background of American politics.  Have we simply gotten distracted? Or have we lost interest and given up the fight? We seem to be easily distracted by political scandals, such as the controversies surrounding politician Anthony Weiner, instead of remaining focused on the more detrimental activities our government officials have been engaged in.  We already knew Anthony Weiner liked to share his privates on the internet... now back to discussing the real issues: 

The graph above shows US Federal Deficit/Surplus Spending since 1940. While the US has engaged in deficit spending throughout history, recent years have displayed unprecedented levels of deficit-financed spending. In 2008, the annual deficit was $415.7 billion. A year later, it was $1.276 trillion.  Over the course of a year, the amount of deficit spending more than tripled. As we can see, our debt problems are becoming more and more compounded. The graph below tracks the magnitude of the US Federal Debt since 1940.

It's not news that the level of deficit spending, and hence our ever growing debt problems are a result of increased and unbounded US Spending. According to the Office of Budget and Management Total Outplays (in 2005 dollars) were: 
  • $982.2 billion in 1970
  • $1,368.2 billion in 1980
  • $1,831.3 billion in 1990
  • $2,039.9 billion in 2000
  • $3,022.2 billion in 2012
In other words, US Federal Spending has more than tripled over the last forty years. 

While US National Defense spending has become a smaller portion of the budget since 1970, Defense outlays have still increased considerably during that time.  Most significantly, however, is the large percentage of the budget that has be spent on Welfare Programs, such as Medicare, Medicaid, and Social Security. We can see this from the charts below, which show Spending as a Percentage of the Budget by Major Category for each decade. 

Naturally, it is difficult and politically unpopular to cut spending, but it is also unrealistic to continue spending and borrowing money at the rate we are. Greece is not a far off imaginary world. So, when will we get our priorities straight and find a way to get "fiscal house" in order? 

Introduction to the World

I started this blog a few years ago (2008) as a way of jotting down and describing funny interactions I had with people. I would listen to statements and quibbles individuals would make about the ways of the world, and invariantly discovered that I do not think or work within the same framework as they do.  My thoughts and methods being considerably emerged in the Economic Way of Thinking.

I wanted an outlet, and a method of conveying every day economic ideas to people. However, I felt uncomfortable being bold about the applications of economic concepts, as well as in my ability to introduce people to the basic principles; I was unsure of my knowledge and persuasiveness. So, I abandon the endeavor, always with the intention of revitalizing it one day. I would put my psychoanalysis on the shelf and focus on my own path. Until today...

Today, I started reading a book that provided me with insightful advice. The author said (paraphrasing): if you want to be successful in achieving your goals in life, start now. Don't wait for the moment you think you are ready.

Reading that made me realize that it has been almost three years since I shelved this endeavor. Since then, I've gone back to school and now have my Masters in Economics, and only have a little way to go before receiving my PhD. On top of that, I am also teaching undergraduate students in the subject. I cannot use an utter lack of knowledge as an excuse anymore. So now, I am taking that author's advice and just starting.

This blog with be a combination of new observations and learnings from economics, with some retelling of old stories that make me laugh and also bring me back to the reason I started writing to the abyss of the world-wide web. My goal is to bring economics into more people's minds, and persuade them to take up the Economic Way of Thinking. I am continuing my life-long education, and my hope is to bring others along for the journey.