Money, Banking and the Economy

Banks and the monies they administer play an invaluable role in a local, regional, national and even international economic system. Indeed, money is the driving force behind an economy. How it is managed and distributed within a given system is often the most pivotal issue facing developing as well as developed economies. In light of this fact, it is important to understand what money is and the role it plays. This paper will cast a more comprehensive light on the fundamental purposes of these two concepts and how money and banks positively and adversely impact an economy.

Keywords: Capital; Central Bank; Commodities; Fiat Money; Futures Trading; Greenbacks; Money Market

Overview

At the end of the American Revolution, the fledgling United States immediately found itself in deep debt. There was no common currency, as the states printed their own money after the failure of the first American national money, the "continental". Without such resources, it was feared that the United States would fail to develop a stable economy after the departure of the British.

The new Secretary of the Treasury, Alexander Hamilton, looked to create what so many other countries had installed within their own governments — a central bank. The bank would be responsible for issuing currency and fund the states' debt. However, Hamilton did not limit his vision to these parameters. He saw the key to economic development in the new country to be the establishment of new businesses. His brainchild, the First Bank of the United States, would not only be the earliest incarnation of what would eventually become the Federal Reserve — it would be a major commercial bank in a country largely bereft of them ("A history of," 2009).

As the example of the first federal financial institution in the US demonstrates, banks and the monies they administer play an invaluable role in a local, regional, national and even international economic system. This paper will cast a more comprehensive light on the fundamental purposes of these two concepts and how money and banks positively and adversely impact an economy.

Money

Abraham Lincoln once commented on the need for the government to create, issue and circulate money that will satisfy its own spending needs as well as maximize the buying power of the consumers. By bringing such principles to bear, he is reported to have said, "Money will cease to be master and become the servant of humanity."

Indeed, money is the driving force behind an economy. How it is managed and distributed within a system is often the most pivotal issue facing developing as well as developed economies. In light of this fact, it is important to understand what money is and the role it plays.

Further Insights

In general terms, money is manifest in two forms. The first is a commodity, which is a physical currency that can be exchanged for goods and services. Commodities may be coins and paper monies, as long as they are interchangeable with other products of equal value. However, commodities may also be food products, grains and precious metals. Commodities may be exchanged in the open marketplace, or within a commodities exchange (InvestorWords.com, 2009). The second is fiat money. Although fiat money may appear in the form of currency as well, it has no value other than that which is assigned to it by those who printed or produced it (Hummel, 2008).

Commodities and fiat money have long played important roles in economies around the globe. In light of this fact, it is important to expound on the principles, benefits and shortcomings of each of these forms of money.

Commodities

Put simply, commodities are physical items that are exchanged on the open market. Gold and silver are among the most well-known commodities, but equally important as commodities are such items as wheat, soy, crude oil, steel and other items. Throughout history, commodities have been exchanged for money in the marketplace. Chicago, for example, became a central market for the exchange of wheat between farmers and purchasers.

By the mid-19th century, commodities markets had become more complex; in addition to the open exchange, the practice of speculation became more widespread. This practice involves an investor predicting the price of the exchange of commodities based on futures contracts (an arrangement between buyers and sellers for the future delivery of commodities) and trading on the market based on his or her assessment of the profitability of such contracts ("A brief history," 2009).

Today, futures trading has become a vast and highly profitable form of commodities exchange. The world's largest market for futures exchanges is the New York Mercantile Exchange (also known as NYMEX), which has been in operation since 1874 and represents trading of a myriad of commodities, from precious metals to foodstuffs to uranium. As an example of the breadth of NYMEX's own operations, the exchange has a port through which hundreds of thousands of transactions take place each day in 400 commodities markets (NYMEX.com, 2009). Although none are as large as NYMEX, there are countless, similarly constructed exchanges in operation around the world.

Futures trading offers the potential for enormous profitability, which accounts for the tremendous volume of trading being conducted. However, there are risks involved with such activity. Commodities such as wheat, oil and other resources are subject to changes in conditions that may affect their price, often in dramatic fashion. A cold weather spell might cause an immediate drop in prices for Florida-grown oranges. Similarly, a terrorist attack on a pipeline might immediately send oil prices skyward. The futures trader banks on such fluctuations, looking to reap the benefits of a sizable differential in the agreed-upon price of a given futures contract. However, when the negative event takes place, the same trader stands to lose significantly. While he or she may take steps to mitigate a loss, there is no guarantee that he or she will lose not only the initial margin but the entire amount in the account (National Futures Association, 2009).

Commodities remain a robust monetary form in terms of exchange. However, it is not the only form of money that is employed in great volume around the globe.

Fiat Money

Of course, most nations in the world do not rely on physical commodities like gold or silver to exchange products and services to back their currencies. Such forms of money like the US dollar, the British Pound and the Japanese Yen, for example, are known as fiat money, which is a token that is intrinsically worthless but is assigned value by its government.

Fiat money is not backed by another commodity, which contributes to its lack of value. Rather, it acquires its worth based on the confidence the consumers have in it. Governments may assign its worth, but they are not expected to back such currency when that value experiences negative conditions. The lack of depth in confidence in fiat money stems from the fact that such currencies are usually introduced during times of debt and/or financial crisis.

United States history provides an excellent example of the use of fiat money and the effect its unpredictable backing can have on an economy. During the Civil War years, the enormous cost of the military effort led the government, which had previously pegged US currency to gold, to create currency redeemable by gold at a future, unspecified date. In 1862, it began printing "greenbacks" in this vein. This currency was made possible by a Congressional act, which passed overwhelmingly and with President Lincoln's backing, and the Treasury Department, which borrowed about $900 million against US credit in order to give some strength to the greenbacks. Fortunately, the greenbacks program was short-lived, as the paper was discontinued after only one year — the debt created by a slimmed-down appropriation of greenbacks was significant and long-term, requiring bonds and taxes to be issued to help pay down what was owed (Mitchell, 1903).

The US was able to pay down the debt over the course of the next two decades. The country was further able to avoid inflation and price instability of the dollar by once again attaching a gold value to its worth, a trend that lasted until World War I. During that conflict, the US and other countries reintroduced fiat money, as their needs necessitated the creation of more paper than there was gold to which it could be attached. Again, the US and many of her allies avoided instability when the guns fell silent, as the industrialized world established the "gold standard," intrinsically linking the US dollar and the British pound to every other national currency, backed by the price of gold. The start of the Great Depression brought an end to the gold standard, as nations en masse attempted to sell their pounds and dollars for gold, ending the gold standard and causing the reissue of fiat money around the world ("Fiat Money History," 2009). The Depression only exacerbated the situation, as fiat money was the only currency available in a collapsed economic environment.

Fiat money does have its strengths and value, particularly during times when gold and other commodities are not in great volume or at top value. As stated earlier, however, this strength and value comes from perception. As one study suggests, the amount of backing a particular currency enjoys stems from its stability and durability in the face of regulation. According to Quint and Shubik, "The use of government money is intimately related to reputation, taxation, legal enforcement, and to the control over production and public goods in a modern society … Trust in government money is implicitly assumed" (2009, p. 6).

Based on the relative strength of the fiat monies (mostly in industrialized countries), a different form of commerce emerged from the demise of the gold standard: currency exchange. Once again, the difference between two or more currencies in terms of value is based on reputation and consumer backing rather than a given commodity. The exchange of currency is dependent on the comprehensive information that exists about its strength and the speed by which that information is transferred. It is understandable, therefore, that fiat currency exchange has become increasingly the norm in international finance (as opposed to commodities exchange), given the fact that information is transferred between parties exponentially faster today than it was only a decade ago (Araujo & Camargo, 2006). Such speed and comprehensiveness work to the benefit of fiat money's stability, value and exchange.

Exchanges

The exchange of commodities and currency is a fundamental underpinning of a stable economy. In fact, some argue that although the markets on which monies and goods are exchanged are subject to daily and long-term volatility and government policy that addresses such volatility is often equally inconsistent, stable, sound currency is the most effective and reliable element in ensuring fiscal and economic health (LeBaron, Deemer & Ungewitter, 2009).

The global recession which began in 2008 provides evidence of this hypothesis. As stock markets underwent near-collapses during the course of a year, housing markets bottomed out and credit debt skyrocketed, people around the world began to take account of their finances in a manner reminiscent of tactics used during the Great Depression. The mantra heard in virtually every household seemed to be "security over risk". Central to that policy was ensuring that the individual's money was "stashed" in a place or places that were safe from the tumult of the recession.

Money Markets

One such "hiding place" was the money market. Money markets are exchanges involving short-term debt securities, commercial paper, Treasury Bills and other monetary investments. As such, they are not typically seen as either high-yield or high-risk. Money markets have long been a component of mutual funds, 401(k) plans and other investment portfolios, serving as a repository for the investor's "loose change." They generally yield a small sum, usually about two percent, but at the same time, they very rarely lose money for the investor. Because of this low-risk, low-yield approach, investors typically saw little need for heavy involvement in money markets.

This perception changed in 2008. When people began losing money on the stock markets, and as more people were losing their jobs, money markets became an important way to protect an individual's money. The US federal government seemingly acknowledged this trend when, in late 2008, a key money market lost principal. The government intervened almost immediately with a rescue plan that helped right the market. Even as economists and the media reported signs of economic recovery in the spring of 2009, advisors still advocated strongly for wary investors to put their cash in money markets rather than on the stock market (Max, 2009).

With uncertainty prevailing in a global economic system that may soon recover from a powerful recession, investors are still clinging to their most important asset — money. Interestingly, this investor attention to money markets (Americans alone hold an estimated $13 trillion in money markets) may play a role in helping sluggish stock markets gain more investors. Central banks like the Federal Reserve, in an effort to catalyze the purchase of stocks, have during the recession lowered interest rates. It is their hope that such policies will entice previous investors to return to the fold, forgoing the minimal yields of money markets for the more potentially profitable stock markets ("Searching for value," 2009).

Banks & Banking

Money, whether in the form of a commodity or fiat, relies on some sort of backing to give it value. In the 17th century, as European nations became more numerous and offered their own currencies, some of the earliest banks were the central institutions whereby the myriad of currencies that were being exchanged could be reconciled for their values. Because of their proven ability to identify the value of money, banks over time became seen as the chief savings institutions of a given country as well as the place in which a person could entrust his or her money (Scott, 1981).

Of course, banks have not always achieved success in the long run. The bank panics and great financial tumult that accompanied the Great Depression provide an example of the conditions in which banks suffered. Still, as industrialized countries developed their own financial systems, banks have evolved along with these systems. Today, banks are manifest in several ways. Retail banks, for example, provide a range of basic services to consumers, such as mortgages, auto loans and other lending services in addition to checking and savings deposit accounts. Investment banks offer companies the ability to raise income through bonds and stock issuances and also provide assistance in mergers and acquisitions. Central banks, such as the Federal Reserve and similar institutions, conduct monetary policy, regulate the activities of financial organizations and even provide financial services like loans.

Banks rely on deposits in order to generate their own money. An individual may deposit his or her paycheck into an account, expecting to receive a modest one percent in interest. The bank in turn uses that money and the deposits of other consumers (known as capital) to support its other activities (such as issuing loans and mortgages). If a mortgage loan includes a five percent rate, and the one percent in interest is paid out to the account holder each year, the remaining four percent stays in the bank. This system is thus dependent on the ability of loan recipients to repay their debts. When they fail to do so, the bank's ability to cover its endeavors becomes compromised (Chua, 2009).

Bank Failures

Banks have evolved alongside consumer and commercial enterprise. Unfortunately, this means that when economic downturns take place, banks become entwined in them as well. The recession that began in 2008 provides an excellent example of this connection. As stocks began to tumble and the economy entered a recession, the situation was worsened by the faltering of banks. Early in 2008, federal regulators expressed concern that hundreds of banks, from the smallest local banks to large, international institutions, would fail because of consumer failure to repay subprime and construction loans (Isidore, 2008). Such a collapse in the banking industry echoed the late 1980s, when more than 200 banks folded under the savings and loan scandal, a number unequalled since the Great Depression.

That fear would ultimately prove valid, as 252 banks fell victim to the economy by the end of 2008 and the first quarter of 2009. Much of the precipitous fall of American banks was attributed to losses on loans, credit and other assets. The Federal Deposit Insurance Corporation (FDIC), which backs American banking institutions, reported in early 2009 that banks paid $69.3 billion to cover potential losses, an amount that more than doubled from 2008 (Gordon, 2009).

Banks play an integral role in the distribution and management of money owned not just by individual consumers but by commercial enterprises, non-profit organizations and the government as well. Because of that central positioning, they are closely tied to both the successes and failures consumers experience in the management of their own money.

Conclusions

Because of the scarcity of money for so many and the amount of customer money that is managed by banks, the concepts of money and banking generate considerable cynicism among the general public. However, money and banking have been woven into the fabric of American society since the birth of the country at the end of the 18th century.

This paper has cast a light on the varying forms in which money, one of the most precious of non-natural resources, become manifest. Commodities, such as gold and silver, have an intrinsic value attached to them based on the scarcity or abundance of them at a given time. Fiat money, on the other hand, has no value beyond the initial endorsement by a government — its long-term strength depends on word of mouth among those who are dealing in money.

Throughout the history of money management, banks have played an important role in the distribution and generation of individual and commercial money. In essence, banking institutions are at the center of any given monetary system, intrinsically linked between the consumer and his or her money. This unique position means that banks are subject to the same ebb and flow that consumers and their money experience.

The link between the three has become even stronger in the 21st century, as modern technologies and systems continue to build global networks capable of rapid information transmission. Despite the system-wide errors that helped begin and perpetuate the Great Depression and other financial crises (such as the global recessions of the early 21st century), there has been little call for any shift in policy that breaks the fundamental relationship between money and the banks that manage it.

Terms & Concepts

Capital: Cash or goods used to generate revenue through investments.

Central Bank: Government agency that issues monetary policy, controls money supply and interest rates and provides guidelines for other institutions.

Commodities: Physical items, materials and natural resources that are exchanged on the open market.

Fiat Money: A token that is intrinsically worthless but is assigned value by the government.

Futures Trading: The practice of investing in contracts between two parties who will exchange monies at a future date.

Greenbacks: American Civil War-era fiat money used to fund the war effort.

Money Market: Exchange that involves short-term debt securities, commercial paper, Treasury Bills and other monetary investments.

Bibliography

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Gordon, M. (2009, February 26). US banks post first quarterly loss since 1990. The Huffington Post. Retrieved June 15, 2009 from website http://www.huffingtonpost.com/2009/02/26/banks-post-first-quarterl%5f n‗170306.html.

Hummel, W. F. (2008). Money basics. Money: What it is how it works. Retrieved June 9, 2009 from http://wfhummel.cnchost.com/moneybasics.html.

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Max, S. (2009). 5 things to know about … stashing your cash. Money, 38, 28. Retrieved June 10, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=36938044&site=ehost-live. FT.-Mitchell, W. C. (1903). A history of the greenbacks. University of Chicago Press.

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Suggested Reading

Barba, R. (2009). Bankers' banks: Not like Silverton, but challenged. American Banker, 174, 5-6. Retrieved June 15, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=40743527&site=ehost-live

Duffy, F. (2008). Monetary theory. Monetary Theory — Research Starters Business. 1-9. Retrieved June 15, 2009 from EBSCO Online Database Research Starters Business. http://search.ebscohost.com/login.aspx?direct=true&db=e6h&AN=28544353&site=ehost-live

Keegan, D. (2009). Options strategy. Futures, 38, 18. Retrieved June 15, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=41128791&site=ehost-live

Otellini, P. (2009). Billion-dollar bets on the future. Directors and Boards, 33, 25. Retrieved June 15, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=40103780&site=ehost-live

Plosser, C. I. (2009). Improving financial stability. Vital Speeches of the Day, 75, 281-285. Retrieved June 15, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=40105999&site=ehost-live

Takemori, S. & Savtchenko, L. (2008). Monetary regimes and inflationary expectations. Japanese Economy, 35, 3-21. Retrieved June 15, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=39342030&site=ehost-live