How could debt problems in Greece – a country of 11 million – trigger a financial crisis not only across Europe but for the world as a whole?
Although the current crisis is more pronounced than earlier ones in its international ramifications, we’ve learned that all financial crises follow familiar patterns.
The role of credit in economies is key. And credit, which stems from the Latin word credere, meaning “to believe in or trust,” depends on people’s trust in the financial system.
Shake that trust and the economy itself trembles. This has been true for at least 500 years. Unfortunately, modern financial institutions and government policies now amplify instability rather than reduce it.
Economic activity depends on households’ ability to buy goods and services and on businesses’ ability to build facilities, hire workers and buy raw materials. In an ideal world, this might all be accomplished with cash on hand. But in practical terms, households and businesses must resort to borrowing at times.
This does not mean an economy using credit necessarily is unsustainable. It rather recognizes that both well-managed businesses and prudent people benefit from being net savers at some times and net borrowers at others.
An economy that channels money from savers to borrowers and back again uses resources more efficiently, producing more goods and services than one that doesn’t.
In the modern world, credit depends on a central bank’s control of money, but also on how timidly or boldly banks make loans.
Regulations requiring banks to keep a certain fraction of their deposits in reserve put an upper limit on this, however. If this reserve requirement is 10 percent and the Federal Reserve creates $1,000 in new bank reserves, $900 could be lent out. But this $900 then is deposited somewhere else in the banking system, permitting an additional $810 of lending. That sum, when redeposited, successively supports new loans of $729, $656, $590 and so on, each 10 percent smaller than the one before. This process increases the total “money supply” available many-fold.
In practice, this “monetary multiplier” is limited by the public’s willingness to hold cash and by banks’ decisions to not lend out as much as possible. So, in the past 50 years, the money supply usually is seven to 12 times the “monetary base” that the Fed actually controls.
When people lose confidence in the banking system, however, and decide to pull out their funds, the total money supply and available credit shrink by a similar multiple. This drying up of credit slows spending by households and businesses and thus slows the overall economy.
A smaller economy lowers business profits and household income, further shrinking spending by each. A vicious downward spiral can develop – as it did in 1873, 1907 and 1929-1933. In the last case, real output shrank by a fourth and unemployment neared 25 percent.
The whole credit system thus depends on people trusting and believing that their money is safe in the banking system.
Moreover, remember that banks and institutions like mutual funds are financial intermediaries. That is, they accept deposits from savers and make loans to borrowers.
Most of the loans are for fixed terms of months or years but many deposits can be withdrawn on demand. Thus, if many depositors or investors want their money immediately, it can be impossible for a bank to come up with the needed cash, even if the pre-crisis value of its assets comfortably exceed its liabilities. The same is true for bond and money market mutual funds.
When banks or mutual funds cannot supply cash to customers who want out, public fear soars and the cycle accentuates. If nothing is done to break it, the economy enters a prolonged slump from which it will recover only over a long period of time as confidence slowly rebuilds.
It is important to recognize that such crises have occurred well in the past. This was long before the existence of the Federal Reserve and during times when paper money was – at least in theory – redeemable for gold or silver. Such a crisis could happen in the late Middle Ages and Renaissance even when the only source of credit expansion was a “bill of exchange” used by merchants.
There already were international contagion effects centuries ago. But since international financial relationships were smaller relative to overall economies, these effects generally were less severe, although some were extreme in the 1920s and 1930s.
In addition, high levels of financial leverage and the increasing use of derivative securities contribute to the current fragility of the global financial system. But these factors merit a column of their own.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.