Social Education 58(1), 1994, pp. 27-28
1994 National Council for the Social Studies
What Is the Role of Banks in the Economy?
Most people (including many history teachers) think of banks as places where depositors store money for safe-keeping, and they think of money as the coins and currency they carry in their pockets. Contrary to popular opinion, however, the most important function of banks is not to act as a warehouse for funds; it is to make loans to borrowers and, in the process of doing so, to create new money. The teaching activity at the end of this article will describe the complicated process by which this occurs. This newly created money becomes a part of the money stock people use every day to facilitate exchanges of products and of productive resources in markets. In their routine lending activities, banks are thus able to alter the quantity of money available in the economy and to influence the quantity and prices of products sold.
When banks throughout the country make too few loans to borrowers and, as a result, create too little money, unemployment can increase. Business firms finance much of their production with borrowed money. When loan money is unavailable, or available only at high interest rates, firms may have to reduce production and lay off workers. The workers who lose their jobs spend less on goods and services, and falling sales signal retailers to order fewer products from suppliers. Suppliers, in turn, adjust to a reduction in orders by laying off more workers.
Bank failures were numerous throughout the nineteenth century in the United States and, whenever a bank failed, money that the loan-making process had created disappeared. A rumor about a bank's stability could cause nervous depositors to withdraw their funds in cash. This often caused even sound banks to fail. Sometimes (most notably in the panics of 1873 and 1893) a contagion of bank failure swept through the country, forcing business firms into bankruptcy as loan money dried up, resulting in long-lasting depressions.
A single bank had two ways of defending against large cash withdrawals. One was to stop making loans and to demand early repayment of outstanding loans. The other was to keep some funds on deposit as extra reserves in larger banks. Small, country banks kept reserves in city banks, and city banks kept reserves at major banks in New York City, the &Mac222;nancial capital of the United States.
This pyramiding of reserves meant that, when one bank got into trouble, it reduced its loan position and removed reserves from another bank. The second bank, in order to compensate for its loss of cash, had to reduce its loans and withdraw some of the cash held as reserves in a third bank. As the chain of events spread from one bank to another, money disappeared as some banks failed and others called in loans.
The U.S. Congress established the Federal Reserve System in 1913 as a lender of last resort to provide banks with a new source of reserves. Banks could now borrow reserves by depositing loans as collateral with a Federal Reserve District Bank. The Federal Reserve bank paid out the reserves in the form of Federal Reserve notes based upon the value of the deposited loans. Now individual banks that experienced large cash withdrawals did not have to withdraw cash from other banks, thus spreading panic. The power of the Federal Reserve to create new reserves also meant that no longer did a fixed amount of reserves support the United States banking system and the United States money supply. Banks were freer than before to make loans and to create new money to support and expand the United States economy.
Banks, Money, and the Great Depression
If the Federal Reserve Act solved the problems of the United States banking system in 1913, why did thousands of banks fail in the early years of the Great Depression and why did almost one-third of the money of the country disappear? Milton Friedman and Anna Schwartz, in their classic book, A Monetary History of the United States, 1867-1960, show that the Federal Reserve System failed in its role as a lender of last resort. At a time when widespread panic made it necessary to restore the faith of the American people in the banking system, the Federal Reserve banks for the most part lent reserves with great reluctance, and then only to banks that were not in trouble. As more banks failed, depositors withdrew cash as fast as they could, thus assuring the failure of many otherwise sound banks.
Bank failures ceased only after newly elected President Franklin Roosevelt closed all banks, ordered audits of their books, and then allowed sound banks to reopen. Also, in 1934 Congress passed the Federal Deposit Insurance Act. This act insured deposit accounts up to $2,500. When depositors knew that they would get their money back if a bank failed, panic withdrawals ceased. Congress then reorganized the Federal Reserve System with more power located in a central governing board in Washington and less power for the regional Federal Reserve banks than before. Even so, throughout the rest of the 1930s, banks that had survived the terrible years of 1929 to 1933 remained reluctant to lend, and the money supply did not grow enough to encourage renewed economic activity. Many economic historians feel that the economy would have recovered long before the end of the decade if United States banks had not lost faith in the Federal Reserve System.
A Simulation of Money Creation
How might teachers of U.S. history approach the study of banks and money? The following brief simulation illustrates to students how bank notes came to be money in the early years of United States history. It also explains why bank runs occurred so frequently in the United States until the mid-1930s. A good place to teach this lesson is in conjunction with study of the Panic of 1837, a time of numerous bank failures.
1. Before class, prepare about thirty slips of green paper, roughly the size of dollar bills. On each slip, write "Can be exchanged for one quarter."
2. Explain to the class that many banks were founded in the decades after the Revolutionary War. These banks were privately owned, but they were chartered by state governments. (The First and Second Banks of the United States were private banks, but the national government chartered them.) The state banks created new money on the basis of the gold and silver they held on deposit. This new money was in the form of paper bank notes, which they used to make loans. (Today, banks, savings and loan institutions, and credit unions create new money when they make loans by adding dollar &Mac222;gures to the checking accounts of borrowers.)
3. Ask students to de&Mac222;ne money. After taking some answers, de&Mac222;ne money as "anything that is freely accepted in exchange for goods and services." Tell students that when people in an economy specialize in the goods and services they produce, money becomes necessary so that they can exchange their specialty for the specialties of others. That is, money is a medium of exchange. People accept something as money if they have faith they can exchange it later for goods and services that they want.
4. Ask students to take out all the quarters they have. Tell them that you are going to start a bank to keep their quarters safe. Select one student as a teller. Have the teller record on the chalkboard the name of each student and the number of quarters each deposits.
5. Take the quarters of several students, giving them in exchange the green money you made before class. Put the quarters in a safe place-your pocket or desk. After several students make deposits, have the teller count up and record the total number of quarters deposited.
6. Tell the students that the bank notes (slips of green paper) now held by several students will probably work as well (at least in this classroom) as a medium of exchange as the quarters did. After all, anyone who holds such a bank note can take it to the bank at any time and get a quarter for it. The note is backed by the quarter on deposit at the bank. Therefore, people in the area, if they trust the banker, will probably begin to accept bank notes in exchange for goods and services. When this happens, the bank notes become money.
7. Ask students how much money is now in circulation. The answer is that the same amount of money is in circulation as there are quarters in the bank. The quarters in the bank are not money as long as they are in the bank instead of circulating in the community.
8. Now make loans to several students who have no quarters, so that they can buy lunch, buy school supplies, get tickets to the football game, and so on. Make the loans by using additional bank notes. Have the teller record each loan on the chalkboard by using additional bank notes. Have the teller record each loan on the chalkboard in the form of the number of notes loaned.
9. Explain that the people students buy from will accept the bank notes because each note is backed by a quarter at the bank. Point out that anyone who acquires bank notes created by lending has the same right to trade them for quarters as the original depositors do. Ask students what the total money supply is now (all the bank notes), and show that the notes are no longer backed 100 percent by the quarters on deposit at the bank.
10. Ask students, "Is the bank in trouble?" They are likely to say that it is, but the bank probably isn't in trouble as long as the ratio of paper money to quarters is not too large. The reason is that people don't generally all come to the bank at the same time to withdraw their quarters (or, in the nineteenth century, their gold or silver). Paper money is easier to carry around than a big load of quarters or gold and silver coins. On any given day, about as many people will probably come to the bank to deposit coins as to withdraw them. Usually, banks in the nineteenth century were able to borrow from nearby banks to cover days when withdrawals substantially exceeded deposits.
11. Explain to the students that this willingness to leave cash on deposit at banks for long periods of time is the basis for fractional reserve banking-a banking system in which a relatively large amount of money can be created on the basis of a smaller amount of something of value (like the quarters, or gold and silver in the nineteenth century, or deposits at the Federal Reserve banks today).
12. Ask one of the students who has deposits at your bank:
A.Suppose that one day I am seen at the travel agency buying a one-way ticket to Rio de Janeiro. What will you probably do? (That student and other depositors probably reply that they will hurry to your bank to withdraw their quarters, starting a bank run. Since the value of the bank notes is greater than the value of the quarters in the bank, there is a strong possibility that the bank will fail and not all bank notes will be redeemed.)
B.After I hop a plane to Rio, are your bank notes still money? (The bank notes in circulation are no longer money because no one will now accept them in exchange for goods and services.)
13. Explain to the class that people began to use checking accounts before the Civil War and banks began to make loans by adding dollar figures to the checking accounts of borrowers. The amounts in checking accounts then and now are money as long as others will accept them in exchange for goods and services.
Friedman, Milton, and Anna Jacobson Schwartz. A Monetary History of the United States, 1867-1960. Princeton, N.J.: Princeton University Press, 1963.Jean Caldwell is Professor of Economics and Director of the Center for Economic Education at the University of Central Oklahoma in Edmond, Oklahoma. Robert L. Highsmith is Vice-President of Programs and Research for the National Council on Economic Education in New York City.