Apr 11, 2009

Saving by Laurence J. Kotlikoff

Entire Article From Encyclopedia of Economics:

Saving means different things to different people. To some, it means putting money in the bank. To others, it means buying stocks or contributing to a pension plan. But to economists, saving means only one thing—consuming less out of a given amount of resources in the present in order to consume more in the future. Saving, therefore, is the decision to defer consumption and to store this deferred consumption in some form of asset.

Saving is often confused with investing, but they are not the same. Although most people think of purchases of stocks and bonds as investments, economists use the term “investment” to mean additions to the real stock of capital: plants, factories, equipment, and so on.

Between 1990 and 2005, the annual rate of U.S. net national saving (net national income less private consumption expenditures less government consumption expenditures, all divided by net national income) averaged only 5.3 percent. In contrast, the nation’s saving rate was 7.6 percent in the 1980s, 10.3 percent in the 1970s, and 13.0 percent in the 1960s.

The 2004 rate of U.S. saving of just 2.2 percent is remarkably low, not only by U.S. standards, but also by international standards. Differences in how the statisticians in different countries define income and consumption make comparisons across nations difficult. But, corrected as well as possible for such data problems, America’s saving rate is significantly lower than that of other industrialized countries. This explains, in large part, why the United States has run a very large current account deficit (see International Trade) in recent years. The U.S. current account deficit measures the amount that foreigners invest in the United States net of what Americans invest abroad. Because Americans are not saving very much, they do not have much to invest in the United States, let alone abroad. Foreigners are making up the difference by investing heavily in the United States.

Why do countries save at different rates? Economists do not know all the answers. Some of the factors that undoubtedly affect the amount people save are culture, differences in saving motives, economic growth, demographics, how many people in the economy are in the labor force, the insurability of risks, and economic policy. Each of these factors can influence saving at a point in time and produce changes in saving over time.

Motives for Saving


The famous life-cycle model of Nobel laureate Franco Modigliani asserts that people save—accumulate assets—to finance their retirement, and they dissave—spend their assets—during retirement. The more young savers there are relative to old dissavers, the greater will be a nation’s saving rate. Most economists believed for decades that this life-cycle model provided the main explanation of U.S. saving. But in the early 1980s, Lawrence H. Summers of Harvard and I showed that saving for retirement explains less than half of total U.S. wealth. Most U.S. wealth accumulation is saving that is ultimately bequeathed or given to younger generations. The motive for bequests and gifts from older to younger Americans is unclear. A very large component of the bequests may be unplanned, simply reflecting the fact that many people do not spend all their savings before they die. In this case, people save to consume, not bequeath, but end up bequeathing nonetheless.

In recent years, a much larger fraction of the retirement savings of the American elderly has been annuitized. That is, the savings take the form of company pensions or Social Security that pay regular checks until death, with no payments after the person dies. Having your retirement finances come in the form of an annuity eliminates the risk of living longer than your money lasts. One possible result of the increased annuitization of retirement assets may be that people, especially those who have already retired, have less incentive to save more in case they “live too long.”

The precautionary motive—that is, the motive to save in order to be prepared for various future risks—is one of the key reasons people save. Besides the risk of living longer than expected, people save against more mundane risks, such as losing their job or incurring large uninsured medical expenses. Computer simulation studies show that the amount of precautionary saving can be very sensitive to the availability of insurance against these and other kinds of risks. For example, the decision not to insure low-risk but high-cost health expenditures such as nursing-home care can lead to a 10 percent increase in national saving.

Another issue related to motives and preferences for saving is the role of the rich in generating aggregate saving. Do rich Americans account for most of U.S. saving? Not really. Relative to their incomes, some of the rich save a lot, and some dissave. So, too, for the poor. There is considerable mobility of wealth in the United States, at least over long periods of time (see human capital). The fact that the ranks of the rich are continually changing suggests that some of those who are initially rich dissave and dissipate their wealth, while others who are not initially rich save considerable sums and become rich. Former heavyweight champion Michael Tyson, for example, grossed an estimated $400 million during the heyday of his boxing career but ended up declaring bankruptcy. Sam Walton, who started Wal-Mart, started life in poverty and ended as one of the richest people in the world.
Economic Growth and Demographic Change

A country’s saving rate and its economic growth are closely connected. This follows from the life-cycle model. If there are more young people around than old people because the population is growing, there will be more workers saving for their retirement than there will be retirees who are dissaving, that is, spending down their assets. This will leave overall net saving positive. The higher the population growth, other things equal, the higher will be the saving rate. The same is true of technical change. Suppose there are the same number of young people around as old people, but the young earn more than did the old because of technological change. Then the young will save more than the old dissave, which, again, will imply a positive saving rate.

In an economy not experiencing growth in technology or population, one would expect, at least in the long run, saving to be zero, with the exception of the saving needed to replace depreciating capital. If there is no engine for growth, in the long run the saving the young do for retirement, to leave bequests, or for any other reason would exactly offset the dissaving of retirees, leaving the economy’s total saving at zero. The economy would have positive assets (claims to capital) but would experience no increase or decrease in the level of these assets over time.

That an economy’s overall long-run saving rate is zero does not mean that no one saves or dissaves. Rather, it means that the positive savings of those accumulating assets exactly balance the negative savings of those decumulating assets. For growing economies, long-run saving is likely to be positive to ensure that the stock of capital assets keeps pace with the number and productivity of workers.

Recent years have seen a large increase in the number of workers and in productivity per worker. The increase in the number of workers is due to baby boomers entering the workforce. The increase in productivity is due to the fact that baby boomers are in their peak years of productivity, and also due to a growing capital stock and to technological improvement, especially in information and communications technology. The fact that these factors did not suffice to raise U.S. saving rates means that other forces, to be discussed below, reduced national saving.
Labor-Supply Decisions

National saving is the difference between national income and national consumption. Labor income represents about three-quarters of national income. So changes in labor income, if not accompanied by equivalent changes in consumption, can greatly affect an economy’s saving rate. Take, for example, the recent remarkable increase in U.S. female labor force participation. In 1975 half of the women age twenty-five to forty-four participated in the labor force; by 1988 more than two-thirds were in the labor force. This increase in the female labor supply is a major reason, if not the main reason, for the rise in U.S. per capita income since 1975.

If the additional net-of-tax income these women earned had all been saved, the U.S. saving rate after 1980 would have exceeded 20 percent. Because much of the increase in labor supply was by women age eighteen to thirty-five, particularly married women, one would expect them to have saved some portion of that income for their old age. Assuming this did occur, we need to look elsewhere to understand the puzzle of why U.S. saving fell.

Adding to the puzzle is the ongoing increase in the expected length of retirement. More and more Americans, particularly men, are retiring in their late fifties and early sixties. At the same time, life expectancies continue to rise. Today’s thirty-year-old male can expect to live to age seventy-six, 5.3 years longer than the typical thirty-year-old could expect in 1960. If he retires at age fifty-five, today’s thirty-year-old will spend almost half of his remaining life in retirement. Economic models of saving suggest that aggregate saving should depend strongly and positively on the length of retirement. Thus, with the retirement age decreasing and life expectancy increasing, economists would expect people to save a lot more—not a lot less.

Economic Policy

Government policy also can have powerful effects on a nation’s saving. To begin with, governments are themselves large consumers of goods and services. In the United States, federal, state, and local governments account for more than one-fifth of all national consumption. More government consumption spending does not, however, necessarily imply less national saving. If the private sector responds to a one-dollar increase in government consumption by reducing its own consumption by one dollar, aggregate saving remains unchanged.

The private sector’s consumption response depends critically on who pays for the government’s consumption and how the government extracts these payments. If the government assigns most of the tax burden to future generations by borrowing in the present and repaying principal plus interest on the borrowing in the future, current generations will have little reason, other than concern for their offspring, to reduce their consumption expenditures.

If current generations are forced to pay for the government’s spending, the size of the private-sector consumption response will vary according to which generation foots the bill. The older the people who are taxed, the larger will be the reduction in consumption. The reason is that older people, being closer to the ends of their lives, consume a higher share of their remaining lifetime resources than do younger ones. Thus, taxing retirees, say, instead of forty-year-old workers, will reduce private-sector consumption and increase national saving.

Finally, different taxes have different incentive effects. For example, the government might raise its funds with taxes on capital rather than taxes on labor income. By lowering the after-tax return to saving, taxes on capital income discourage saving for future consumption and thus reduce saving.
Explaining the Decline in U.S. Saving

What explains the recent decline in U.S. saving? One cause that can quickly be dismissed is increased government consumption. In the 1960s, when the national saving rate was 13.0, the ratio of government consumption to national income was 18.6 percent. Since the 1990s, the government’s consumption rate has been 17.5 percent but the saving rate has averaged only 5.5 percent.

Could disincentives to save be responsible for the decline in U.S. saving? Not likely. Marginal personal tax rates on taxable capital income have fallen dramatically over the past two decades. In addition, the effective marginal tax on capital income earned on saving done within a retirement account, such as an Individual Retirement Account, is zero.

The main explanation for the decline in national saving appears to be the major and ongoing government policy of taking an ever larger share of resources from young and future Americans and giving them to older Americans. Because the elderly are close to the ends of their lives and have much higher propensities to consume than younger people and the unborn, redistributing from young and future U.S. generations to older generations raises national consumption and lowers national saving.

The distribution of resources across generations arises through a host of fiscal policies, including deficit finance, the pay-as-you-go finance of Social Security and Medicare benefits, shifts in the tax structure away from consumption and capital income taxation toward wage taxation, and even capital depreciation and expensing provisions. In recent decades, increased distribution to the current elderly has come primarily in two forms. The first is giving the elderly additional medical benefits under the Medicare and Medicaid programs. The elderly receive these benefits in kind, which means the only way they can get the benefits is to use them; one cannot “save” a Medicare payment. The second is cutting the taxes the elderly pay.

The Implications of Low Saving for Baby Boomers

Americans used to save at a fairly high rate. As a consequence, the collective stock of U.S. wealth holdings is still quite large—roughly thirty-five trillion dollars. This is enough to finance all Americans’ consumer expenditures for about five years. But about 60 percent of this wealth is owned by people who are fifty or older, who appear to be spending a good deal of it on themselves. If the elderly do end up spending rather than bequeathing the bulk of existing U.S. wealth, will younger Americans, particularly baby boomers, accumulate enough savings to maintain the standard of living they currently enjoy in their old age?

Based on current evidence, the answer appears to be no. Compared with their parents, baby boomers can expect to retire earlier, live longer, rely less on inheritances, receive less help from their children, experience slower real wage growth, face higher taxes, and replace a smaller fraction of their preretirement earnings with Social Security retirement benefits. Unless baby boomers change their saving habits substantially and relatively quickly, they may experience much higher rates of poverty in their old age than those currently observed among U.S. elderly.

Investment by Kevin A. Hassett

Entire Article From The Encyclopedia Of Economics:

Investment is one of the most important variables in economics. On its back, humans have ridden from caves to skyscrapers. Its surges and collapses are still a primary cause of recessions. Indeed, as can be seen in Figure 1, investment has dropped sharply during almost every postwar U.S. recession. As the graph suggests, one cannot begin to project where the economy is going in the near term or the long term without having a firm grasp of the future path of investment. Because it is so important, economists have studied investment intensely and understand it relatively well.

What Is Investment?

By investment, economists mean the production of goods that will be used to produce other goods. This definition differs from the popular usage, wherein decisions to purchase stocks (see stock market) or bonds are thought of as investment.

Investment is usually the result of forgoing consumption. In a purely agrarian society, early humans had to choose how much grain to eat after the harvest and how much to save for future planting. The latter was investment. In a more modern society, we allocate our productive capacity to producing pure consumer goods such as hamburgers and hot dogs, and investment goods such as semiconductor foundries. If we create one dollar worth of hamburgers today, then our gross national product is higher by one dollar. If we create one dollar worth of semiconductor foundry today, gross national product is higher by one dollar, but it will also be higher next year because the foundry will still produce computer chips long after the hamburger has disappeared. This is how investment leads to economic growth. Without it, human progress would halt.



Investment need not always take the form of a privately owned physical product. The most common example of nonphysical investment is investment in human capital. When a student chooses study over leisure, that student has invested in his own future just as surely as the factory owner who has purchased machines. Investment theory just as easily applies to this decision.

Pharmaceutical products that establish heightened well-being can also be thought of as investments that reap higher future productivity. Moreover, government also invests. A bridge or a road is just as much an investment in tomorrow’s activity as a machine is. The literature discussed below focuses on the study of physical capital purchases, but the analysis is more widely applicable.

Where Do the Resources for Investment Come From?

In an economy that is closed to the outside world, investment can come only from the forgone consumption—the saving—of private individuals, private firms, or government. In an open economy, however, investment can surge at the same time that a nation’s saving is low because a country can borrow the resources necessary to invest from neighboring countries. This method of financing investment has been very important in the United States. The industrial base of the United States in the nineteenth century—railroads, factories, and so on—was built on foreign finance, especially from Britain. More recently, the United States has repeatedly posted significant investment growth and very low savings(2004). However, when investment is funded from outside, some of the future returns to capital are passed outside as well. Over time, then, a country that relies exclusively on foreign financing of investment may find that it has very little capital income with which to finance future consumption. Accordingly, the source of investment finance is an important concern.

If it is financed by domestic saving, then future returns stay at home. If it is financed by foreign saving, then future returns go abroad, and the country is less wealthy than otherwise.

What Makes Investment Go Up and Down?


The theory of investment dates back to the giants of economics. irving fisher, arthur cecil pigou, and alfred marshall all made contributions; as did john maynard keynes, whose Marshallian user cost theory is a central feature in his General Theory. In addition, investment was one of the first variables studied with modern empirical techniques. Already in 1909, Albert Aftalion noted that investment tended to move with the business cycle.

Many authors, including Nobel laureate trygve haavelmo, contributed to the advance of the investment literature after the war. Dale Jorgenson published a highly influential synthesis of this and earlier work in 1963. His neoclassical theory of investment has withstood the test of time because it allows policy analysts to predict how changes in government policy affect investment. In addition, the theory is intuitively appealing and is an essential tool for any economist.

Here is a brief sketch. Suppose you run a firm and are deciding whether to purchase a machine. What should affect your decision? The first observation is that you should purchase the machine if doing so will increase your profits. For that to happen, the revenue you earn from the machine should at least be equal to the costs. On the revenue side, the calculation is easy. If, for example, the machine will produce one thousand donuts and you can sell them at ten cents apiece, then you know, after subtracting the noncapital costs such as flour, exactly how much extra revenue the machine will produce. But what costs are associated with the machine?

Suppose the machine lasts forever, so you do not have to worry about wear and tear. If you buy the machine, then it produces donuts and the machine’s manufacturer has your money. If you decide not to buy the machine, then you can put the money in the bank and earn interest. If the machine truly does not wear (i.e., depreciate) while you use it, you could, in principle, purchase the machine this year and sell it next year at the same price, and get your money back. In that case, you gain the extra revenue from selling donuts but lose the interest you could have had if you had just placed the money in the bank. You should buy the machine if the interest is less than the extra money you will make from the machine.

Jorgenson expanded this basic insight to account for the facts that the machine might wear out, the price of the machine might change, and the government imposes taxes. His “user cost” equation is a sophisticated model of investment, and economists have found that it describes investment behavior well. Specifically, a number of predictions of Jorgenson’s model have been confirmed empirically. Firms buy fewer machines when their profits are taxed more and when the interest rate is high. Firms buy more machines when tax policy gives them generous tax breaks for doing so.

Investment fluctuates a lot because the fundamentals that drive investment—output prices, interest rates, and taxes—also fluctuate. But economists do not fully understand fluctuations in investment. Indeed, the sharp swings in investment that occur might require an extension to the Jorgenson theory.

Despite this, Jorgenson’s theory has been a key determinant of economic policy. During the recession of 2001, for example, the U.S. government introduced a measure that significantly increased the tax benefits to firms that purchased new machines. This tax “subsidy” to the purchases of machines was meant to stimulate investment at precisely the time that it would otherwise have plummeted. This countercyclical investment policy follows significant precedent. In 1954, accelerated depreciation was introduced, allowing investors to deduct a larger fraction of the purchase price of a machine than had previously been allowed. In 1962, President John F. Kennedy introduced an investment tax credit to stimulate investment. This credit was enacted and repealed numerous times between then and 1986, when it was finally repealed for good. In each case, the Jorgenson model provided a guide to policymakers of the likely impact of the tax change. Empirical studies have confirmed that the predicted effects occurred.
The Theoretical Frontier

In Jorgenson’s user cost model, firms will purchase a machine if the extra revenue the machine generates is a smidgen more than its cost. This prediction of the model has been the subject of significant debate among economists for two main reasons. First, some economists who study recessions have found that financial constraints have affected investment. That is, they argue that sometimes firms want to purchase machines, and would make more money if they did so, but are unable to because banks will not lend them money. The extensive literature on this topic has concluded that such liquidity constraints do not significantly affect most large firms, although occasional liquidity crises cannot be ruled out. Such liquidity constraints are more likely to affect small firms.

The second extension of the basic user cost theory owes to a seminal contribution by Robert McDonald and Daniel Siegel (1986). They noted that firms do not typically purchase machines when the extra revenue is just a smidgen more than the cost, but, instead, require a bigger surplus before taking the plunge. In addition, consumers and businesses appear to be very reluctant to adopt novel technologies. McDonald and Siegel developed a model of investment that explained why. Their analysis has two key features that differ from Jorgenson’s: first, the future is highly uncertain; second, a firm has to “nail down” a new machine that it purchases and cannot expect ever to be able to sell it. That is, the purchase of a machine is “irreversible.”

These two features change the analysis. Consider, for example, a firm that traditionally powers its furnaces with coal deciding whether to buy a new, more energy-efficient natural gas–powered furnace that costs one hundred dollars today but has an uncertain return tomorrow. If the price of natural gas does not change, then the firm stands to make a four-hundred-dollar profit by operating the new furnace. If the price of natural gas increases, however, then the new furnace will remain idle and the firm will gain nothing from owning it. If the probability of either outcome is 0.5, then, using a zero interest rate for simplicity, the expected net present value of purchasing the machine is (Scenario 1):

(0.5 × $400) + (0.5 × 0) − $100 = $100

Because the project has a positive expected cash flow, it might seem optimal to buy the furnace today. But it is not. Consider what happens if the firm waits until the news is revealed before deciding, as shown in Scenario 2. By waiting, the firm will actually increase its expected profit by fifty dollars. The reason the firm is better off waiting is that if the bad news happens—that is, if natural gas prices increase—the firm can avoid the loss of one hundred dollars by not purchasing the furnace at all. By waiting, the firm is acquiring better information than it would have if it bought today. Note that the two examples would have the same expected return if the firm were allowed to resell the furnace at the original purchase price if there is bad news. But this is unrealistic for two reasons: (1) many pieces of equipment are customized so that once installed they would have little or no value to anyone else; and (2) if gas prices rise, the gas-powered furnace would have little value to anyone else.

The general conclusion is that there is a gain to waiting if there is uncertainty and if the installation of the machine entails sunk costs, that is, costs that cannot be recovered once spent. Although quantifying this gain exactly is a highly mathematical exercise, the reasoning is straightforward. That would explain why firms typically want to invest only in projects that have a high expected profit.

(see table for example here)

The fact of irreversibility might explain the large fluctuations in investment that we observe. When a recession begins, firms face uncertainty. At these times, it may be optimal for each firm to wait until some of the uncertainty is resolved. When many firms do that, wild swings in investment occur. Recent work by Ricardo Caballero, Eduardo Engel, and John Haltiwanger (1995) confirms that these factors may also be important in explaining the steep drop in investment during recessions.

That economists have a fairly strong understanding of firms’ investment behavior makes sense. A firm that maximizes its profits must address investment using the framework discussed in this article. If it fails to maximize profits, it is less profitable than firms that do, and will eventually disappear from the competitive marketplace. Darwinian forces weed out bad companies.

As mentioned above, investment ultimately comes from forgone consumption, either here or abroad. Consumer behavior is harder to study than firms’ behavior. Market forces that drive irrational people out of the marketplace are much weaker than market forces that drive bad companies from the market. Accordingly, the study of saving behavior, that lynchpin for investment, is not nearly as advanced as that of investment. Because the saving response of consumers must be known if one is to fully understand the impact of any investment policy, and because saving behavior is so poorly understood, much work remains to be done.

Apr 9, 2009

New Regulations Proposed By The Treasury Department

(First read the post with the extract on Financial Regulation)

Every time there is a financial crisis new regulations and rules are implemented. The problem is that our hindsight is 20/20. Once a crisis has occurred the regulators realize that if certain rules had been set before hand this problem would never have happened (or at least have been unlikely).

First, what is a ‘Systemically Important Firm’?


Suppose the town has two big banks and a big insurance company and 4 small banks and a small insurance company. The big banks hold most of the money from the mine, farms and ranches. The big insurance company has insured all the big ranches and farms.
Most of the money in the town is in the big banks. If the small banks fall there will be a lot of capital loss. A lot of people will be unhappy. If the big banks and the big insurance company fall then most of the money of the town will cease to exist.

From the point of view of the town the loss of the small banks and insurance company will cause scandals and possibly a small recession. If the big banks fall then most of the capital in the entire town is lost. A serious recession/depression will result.

Look at it this way; The banks pass loans between each other, they have stocks in each other, they even are connected to the insurance company. i.e. all the big institutions are interconnected.

Each one of the big financial institutions of the town represent ‘systematic risk’ i.e. if one falls they can hurt the entire town financial system.

From the point of view of the town each one of the big banks and the big insurance company are ‘too big to fail’.

The following is from the Treasury Department's Press Release:


A Single Independent Regulator with responsibility over Systemically Important Firms and Critical Payment and Settlement Systems:

While we strengthen prudential oversight for all firms, we must also create higher standards for all systemically important financial firms – regardless of whether they own a depository institution – to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy. We will work with Congress to enact legislation that defines the characteristics of covered firms; sets objectives and principles for their oversight; and assigns responsibility for regulating these firms.

1) Defining a Systemically Important Firm:In identifying systemically important firms, we believe that the characteristics should include:

• The financial system's interdependence with the firm;
• The firm's size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding;
• The firm's importance as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.


This first point explains how they plan to determine if a firm is big enough to cause damage to the whole system if it collapses. i.e. they tend to find all the companies that are ‘too big to fail’ and regulate them from the beginning. If they do this properly then we will be able to avoid the global economic collapse the big financial institutions can cause with their failure. (i.e. they pose a risk to the local and global financial system)

2) Focusing On What Companies Do, Not the Form They Take:

These institutions would not be limited to banks or bank holding companies, but could include any financial institution that was deemed to be systemically important in accordance with legislative requirements. These provisions will focus on what companies do and their potential for systemic risk – and no longer on the form they take – to determine who will regulate them.


Past regulation has focused on controlling, say ‘Banks’. Yet a firm can be involved in transactions that affect banks and are like banks but they call themselves by some other name. Thus they don’t have to follow the already established laws for capital reserve requirements i.e. if the law says you should put 10% of the money you get aside for safety and NOT loan it out, by changing their definition some companies can avoid this law and loan it all out (and do other funny stuff such as over leveraging assets – giving out much more money than they have).

By looking for all ‘systemically important firms’ they are essentially looking for all the ‘too big to fail’ financial institutions. By identifying them they become easier to regulate.


II. Higher Standards on Capital and Risk Management for Systemically Important Firms:

1. Setting More Robust Capital Requirements:Capital requirements for these firms must be more conservative than for other institutions and be sufficiently robust to be effective in a wider range of deeply adverse economic scenarios than is typically required.

2. Imposing Stricter Liquidity, Counterparty and Credit Risk Management Requirements:Supervisors will also need to impose liquidity, counterparty, and credit risk management requirements that are more stringent than for other financial firms. For instance, supervisors should apply more demanding liquidity constraints; and require that these firms are able to aggregate counter-party risk exposures on an enterprise-wide basis within a matter of hours.


3. Creating Prompt-Corrective Action Regime: The regulator of these entities will also need a prompt-corrective action regime that would allow the regulator to force protective actions as regulatory capital levels decline, similar to the powers of the FDIC with respect to its covered agencies.

IN the banking basics post money put aside is the ‘capital reserve’. After identifying the biggest, most important financial institutions, they will be forced to have larger capital reserves. Thus they will be more liquid (i.e. they will have more money held in reserve).

If you go through the new proposed regulations of the financial system you will notice that they are pretty comprehensive. If properly implemented they should be able to prevent such a financial crisis in the future.

To read more about the financial regulation proposed by the US treasury department click here. According to the website more outlines on the new regulations is forthcoming.

Financial Regulation by Bert Ely

From the Encyclopedia of Economics:

Financial regulation in the United States, and elsewhere in the developed world, breaks down into two basic categories: safety-and-soundness regulation and compliance. While this entry focuses on U.S. financial services regulation, it broadly reflects what occurs elsewhere.

Financial institutions serve various purposes. Depository institutions (banks, savings and loans [S&Ls], and credit unions) transform liquid liabilities (checking accounts, savings accounts, and certificates of deposit that can be cashed in prior to maturity) into relatively illiquid assets, such as home mortgages, car loans, loans to finance business inventories and accounts receivable, and credit card balances. Depository institutions also operate the payments system where bank balances are shifted between parties through checks, wire transfers, and credit and debit card transactions. Insurance companies fall into two broad categories—life and health insurers, whose policies provide financial protection against death, disability, and medical bills; and property and casualty insurers, whose policies protect policyholders against losses arising from fire, natural disasters, accidents, fraud, and other calamities. Stockbrokers and related investment banking firms are central players in the capital markets where businesses raise capital and where individuals and institutional investors buy and sell shares of stock in business enterprises.

The basic goal of safety-and-soundness regulation is to protect “fixed-amount creditors” from losses arising from the insolvency of financial institutions owing those amounts, while ensuring stability within the financial system. Fixed-amount creditors are bank depositors, beneficiaries and claimants of insurance companies, and account holders at brokerage firms who are owed fixed amounts of money. Investors in a stock or bond mutual fund are not fixed-amount creditors because the value of their investments is determined solely by the market value of the fund’s investments. Financial institutions with fixed-amount creditors include banks, S&Ls, credit unions, insurance companies, stockbrokers, and money-market mutual funds (MMMF). Compliance regulation broadly seeks to protect individuals from “unfair” dealing by financial institutions and in the financial markets and to impede such crimes as “money laundering,” although this crime is hard to define.

Financial regulation in the United States is carried out by an alphabet soup of federal and state agencies. The federal bank regulators include the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the National Credit Union Administration. The Securities and Exchange Commission (SEC) regulates stockbrokers, MMMFs, stock and bond mutual funds, stock trading—including the stock exchanges—and financial disclosures by publicly traded corporations. State regulators oversee state-chartered banks, savings institutions, and credit unions as well as all insurance companies. State securities regulators are a junior partner to the SEC in that field.

Safety-and-Soundness Regulation

Safety-and-soundness, or solvency, regulation seeks to prevent financial institutions with fixed-amount creditors from becoming insolvent. Because government regulation cannot prevent all insolvencies, however, governments have created mechanisms to protect at least small fixed-amount creditors from any loss when a depository institution, insurance company, or brokerage firm has become insolvent—that is, has “failed.” These mechanisms, such as deposit insurance, insurance guaranty funds, and investor protection funds, can properly be viewed as a product warranty for solvency regulation. That is, they protect fixed-amount creditors against losses when the “product,” regulation, which is supposed to protect fixed-amount creditors, fails to prevent a financial institution’s insolvency.

For the more than three centuries that banks and insurance companies have been chartered by governments, notably with the founding of the Bank of England in 1694, governments have imposed regulations to ensure that these institutions remain both solvent (the value of their assets exceeds their liabilities) and liquid (they can meet payment requests, such as checks and insurance claims, when presented). The principal solvency regulation today centers on capital regulation; that is, the financial institution must maintain a positive capital position (its assets exceed its liabilities) equal to at least a certain portion of its assets. Other solvency regulations force asset diversity by limiting loan and investment concentrations among various classes of borrowers or the amount of credit extended to any one borrower.

In 1988, banking regulators in the industrialized world began to implement a bank capital regulation, now called Basel I, which related the amount of capital a bank had to hold to the riskiness of its assets. Although Basel I was crude in many regards, many banks are financially stronger today because the amount of capital they hold bears a better relationship to the riskiness of their assets. Banking regulators are now attempting to implement a more sophisticated capital standard, called Basel II. When or if Basel II will be fully implemented is an open question.

Solvency regulations are enforced by examiners who assess the value of an institution’s assets and determine the scope of its liabilities, a particularly important function in property and casualty insurance companies. A financial institution can become insolvent (its liabilities exceed the value of its assets) if it suffers a large sudden loss or a sustained period of smaller losses. Likewise, a seemingly solvent bank or insurance company can turn out to be insolvent if examiners find hidden losses—assets have been overvalued or liabilities have not been recognized. Quite often, fraud is the underlying cause of those losses.

Even honest managements can experience sudden losses if a large natural disaster causes a spike in insurance claims or if the value of loan collateral plunges. While there was some fraud in the twelve hundred S&Ls that failed during the U.S. S&L crisis of the 1980s, much of the insolvency loss in those failures arose from the collapse of real estate values, particularly in Texas. To help prevent another S&L crisis, in 1991 the U.S. Congress enacted a set of regulatory reforms, called Prompt Corrective Action, to ensure that regulators would not again drag their feet in closing insolvent banks and S&Ls. While these reforms seem to be working, they have not been tested by a full-fledged banking crisis.

Often, insolvent banks are illiquid—that is, they do not have enough cash on hand to pay customer checks and deposit withdrawals. This almost certainly is true when there is a run on the bank. Illiquidity also can strike a solvent bank, although that is relatively rare. To prevent banking panics in the event that banks cannot honor withdrawal requests, Congress has authorized the Federal Reserve to act as a lender of last resort; that is, the Fed stands ready to lend to an illiquid bank when no one else will, provided the bank can fully collateralize its loan with high-quality assets.

MMMFs represent a special case with regard to solvency regulation and liquidity concerns. By design, MMMFs have no capital, that is, the value of their assets must always equal the face value of the shares they have issued to their shareholders; these shares usually are valued at one dollar per share. Also, MMMFs are not authorized to borrow from the Federal Reserve. SEC examiners therefore must determine that an MMMF’s assets can readily be sold or redeemed for their stated value. Since MMMFs have no fixed-amount creditor protection comparable to deposit insurance, they can invest only in low-risk assets so that no MMMF will “break the buck,” which could unleash a “run” on all MMMFs—that is, MMMF shareholders would attempt to cash in their MMMF shares at the same time. Given that MMMFs had $2.1 trillion of shares outstanding at the end of 2006, that is a legitimate fear. Although the Federal Reserve does not admit to this, it is widely believed that the Fed would provide emergency liquidity to the MMMFs should there be a run on them, in order to maintain the stability of the U.S. financial system, even though this action might be costly to taxpayers.
Deposit Insurance and Other Fixed-Amount Creditor Protection Schemes

Various fixed-amount creditor protection schemes have emerged in the United States, usually in response to crises arising from regulatory failures. State-provided deposit insurance dates to 1829 with the formation of the New York Safety Fund. Fourteen state deposit insurance funds eventually operated, but all had failed by the onset of the Great Depression. In 1933, following the failure of nine thousand mostly small banks in 1930–1933, Congress chartered the FDIC. Shortly thereafter, it created the Federal Savings and Loan Insurance Corporation (FSLIC) to insure S&Ls. In the aftermath of the S&L debacle, which so far has cost taxpayers about $124 billion, Congress abolished the FSLIC and gave the FDIC responsibility for all bank and S&L deposit insurance.

While deposit insurance for credit unions (called “share insurance”) started at the state level, in 1970, Congress created the National Credit Union Share Insurance Fund (NCUSIF) to give credit union members the same level of protection that bank and S&L depositors have. Today, with the exception of 175 state-chartered credit unions served by a private insurer, the federal government insures all bank, S&L, and credit union depositors.

Since 1980, the basic deposit insurance limit has been $100,000 per depositor per bank, S&L, or credit union (up from an initial $5,000 in 1934). However, because bank accounts can legally be titled in various ways, a family can hold many times that amount in insured deposits in a bank. While business deposits are insured, too, deposits in the foreign offices of U.S. banks are not. On December 31, 2006, the estimated amount of insured deposits approximated $4.6 trillion. Uninsured deposits in domestic and foreign offices of banks, S&Ls, and credit unions totaled another $3.8 trillion.

Congress intended, when it passed major deposit insurance reforms in 1991, that uninsured depositors not be protected should their bank fail. Instead, Congress wanted uninsured depositors (presumably more sophisticated than small depositors) to monitor their bank’s condition and to withdraw funds from the bank if it got into trouble. In effect, bank runs are supposed to wake up regulators who fail to close a failing bank before it becomes insolvent. However, Congress’s desire to share insolvency losses with uninsured depositors clashed with a real-world reality: depositor flight from a large bank could undermine confidence in large sound banks, leading to a banking collapse, a freeze-up of the payments system, and serious economic damage. Therefore, as a practical matter, the $100,000 insurance limit applies only to small banks, and not to so-called too-big-to-fail banks.

U.S. banking regulators have been loath to publicly identify America’s too-big-to-fail banks, preferring to maintain the fiction that no bank is too big to fail. In its 1991 reform legislation, however, Congress included a “systemic risk” exception, which gives the regulators (with the approval of the president and the secretary of the treasury) the authority to protect all depositors (domestic and foreign) and all other creditors of a large failing bank if the regulators have determined that trying to impose losses on uninsured depositors and other creditors “would have serious adverse effects on economic conditions or financial stability.” In other words, uninsured deposits are, in fact, insured if they are in a large bank.

Governments in other industrialized countries have stated their belief that some banks are too big to fail. Therefore, despite deposit insurance schemes similar to those of the United States, only large depositors in small banks have to worry about suffering a loss should their bank fail. Even then, many countries are reluctant to enforce their deposit insurance limits. Japan is an excellent example, as its government postponed implementing explicit deposit insurance limits while cleaning up its massive banking problems, without any loss to depositors.

The home countries of globally active banks—those with branches or banking subsidiaries in other countries—will find it difficult not to protect depositors and other creditors in other countries in which a troubled bank operates because of concerns of regulatory retribution if it tries to protect only home-country depositors. New Zealand, where most banking assets are controlled by very large banks headquartered elsewhere (principally Australia), is a beneficiary of this phenomenon.

Because U.S. insurance companies are chartered and regulated solely by the states, the states have assumed protection of insureds through two sets of “guaranty funds,” one for life and health insurance companies and one for property and casualty companies. The types of protections and the dollar limits of those protections vary among the states. State governments’ intent is to protect small insureds and those with relatively small insurance claims—a few hundred thousand dollars at most—from any loss.

Although similar to deposit insurance, guaranty funds differ in one important respect. While the FDIC and NCUSIF collect premiums in advance of the payment of losses, the guaranty funds (with the exception of New York’s) collect funds from surviving insurance companies only as they make payments to insureds and claimants. Like deposit insurance, though, the guaranty funds are actuarially unsound because they do not charge risk-sensitive premiums: riskier institutions pay no more, per dollar of protection, than safer institutions.

The Securities Investor Protection Corporation (SIPC) protects customers of failed stock and bond brokerages from brokerage fraud (stolen cash and missing securities), but not from loss in the market value of securities they own. The maximum SIPC protection per customer is $500,000, including a maximum of $100,000 for cash claims.

Another federal financial insurance venture is the Pension Benefit Guaranty Corporation (PBGC). Unlike the insurance and guaranty funds described above, the PBGC is not a “product warranty” for failed regulation. Instead, it protects beneficiaries of defined-benefit pension plans that have been taken over by the PBGC because the pension plan sponsor (usually a financially troubled corporation) has gone bankrupt or out of business. Steel companies and airlines are among the firms that have dumped their unfunded pension liabilities on the PBGC. As happened with the FSLIC, federal taxpayers may eventually be forced to bail out the PBGC.

Common to all government insurance and guaranty programs is “moral hazard,” the risk that the insured or guaranteed institution will make economically unwise bets because severe losses from these bets will fall on taxpayers, while owners and managers will profit from winning bets. As insurers learned long ago, properly priced insurance premiums are key to minimizing moral hazard. This moral hazard was the main cause of the s&l crisis in the 1980s. Unfortunately, government insurers cannot charge truly risk-sensitive premiums without experiencing severe political opposition from those who would pay high premiums because of their riskiness. Hence, moral hazard will continue to plague government insurance and guaranty programs. (read more)

About Adam Smith - The guy who came up with the term 'invisible hand'

This Whole Post Is From The Library Of Economics:

With The Wealth of Nations Adam Smith installed himself as the leading expositor of economic thought. Currents of Adam Smith run through the works published by David Ricardo and Karl Marx in the nineteenth century, and by John Maynard Keynes and Milton Friedman in the twentieth.

Adam Smith was born in a small village in Kirkcaldy, Scotland, where his widowed mother raised him. At age fourteen, as was the usual practice, he entered the University of Glasgow on scholarship. He later attended Balliol College at Oxford, graduating with an extensive knowledge of European literature and an enduring contempt for English schools.

He returned home, and after delivering a series of well-received lectures was made first chair of logic (1751), then chair of moral philosophy (1752), at Glasgow University.

He left academia in 1764 to tutor the young duke of Buccleuch. For more than two years they traveled throughout France and into Switzerland, an experience that brought Smith into contact with his contemporaries Voltaire, Jean-Jacques Rousseau, François Quesnay, and Anne-Robert-Jacques Turgot. With the life pension he had earned in the service of the duke, Smith retired to his birthplace of Kirkcaldy to write The Wealth of Nations. It was published in 1776, the same year the American Declaration of Independence was signed and in which his close friend David Hume died. In 1778 he was appointed commissioner of customs. In this job he helped enforce laws against smuggling. In The Wealth of Nations, he had defended smuggling as a legitimate activity in the face of “unnatural” legislation. Adam Smith never married. He died in Edinburgh on July 19, 1790.

Today Smith’s reputation rests on his explanation of how rational self-interest in a free-market economy leads to economic well-being. It may surprise those who would discount Smith as an advocate of ruthless individualism that his first major work concentrates on ethics and charity. In fact, while chair at the University of Glasgow, Smith’s lecture subjects, in order of preference, were natural theology, ethics, jurisprudence, and economics, according to John Millar, Smith’s pupil at the time. In The Theory of Moral Sentiments, Smith wrote: “How selfish soever man may be supposed, there are evidently some principles in his nature which interest him in the fortune of others and render their happiness necessary to him though he derives nothing from it except the pleasure of seeing it.”1

At the same time, Smith had a benign view of self-interest, denying that self-love “was a principle which could never be virtuous in any degree.”2 Smith argued that life would be tough if our “affections, which, by the very nature of our being, ought frequently to influence our conduct, could upon no occasion appear virtuous, or deserve esteem and commendation from anybody.”3

Smith did not view sympathy and self-interest as antithetical; they were complementary. “Man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only,” he explained in The Wealth of Nations.4

Charity, while a virtuous act, cannot alone provide the essentials for living. Self-interest is the mechanism that can remedy this shortcoming. Said Smith: “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest” (ibid.).

Someone earning money by his own labor benefits himself. Unknowingly, he also benefits society, because to earn income on his labor in a competitive market, he must produce something others value. In Adam Smith’s lasting imagery, “By directing that industry in such a manner as its produce may be of greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”5

The Wealth of Nations, published as a five-book series, sought to reveal the nature and cause of a nation’s prosperity. Smith saw the main cause of prosperity as increasing division of labor. Using the famous example of pins, Smith asserted that ten workers could produce 48,000 pins per day if each of eighteen specialized tasks was assigned to particular workers. Average productivity: 4,800 pins per worker per day. But absent the division of labor, a worker would be lucky to produce even one pin per day.

Just how individuals can best apply their own labor or any other resource is a central subject in the first book of the series. Smith claimed that an individual would invest a resource—for example, land or labor—so as to earn the highest possible return on it. Consequently, all uses of the resource must yield an equal rate of return (adjusted for the relative riskiness of each enterprise). Otherwise reallocation would result. George Stigler called this idea the central proposition of economic theory. Not surprisingly, and consistent with another Stigler claim that the originator of an idea in economics almost never gets the credit, Smith’s idea was not original. The French economist turgot had made the same point in 1766.

Smith used this insight on equality of returns to explain why wage rates differed. Wage rates would be higher, he argued, for trades that were more difficult to learn, because people would not be willing to learn them if they were not compensated by a higher wage. His thought gave rise to the modern notion of human capital. Similarly, wage rates would also be higher for those who engaged in dirty or unsafe occupations (see Job Safety), such as coal mining and butchering; and for those, like the hangman, who performed odious jobs. In short, differences in work were compensated by differences in pay. Modern economists call Smith’s insight the theory of compensating wage differentials.

Smith used numerate economics not just to explain production of pins or differences in pay between butchers and hangmen, but to address some of the most pressing political issues of the day. In the fourth book of The Wealth of Nations—published, remember, in 1776—Smith told Great Britain that its American colonies were not worth the cost of keeping. His reasoning about the excessively high cost of British imperialism is worth repeating, both to show Smith at his numerate best and to show that simple, clear economics can lead to radical conclusions:

A great empire has been established for the sole purpose of raising up a nation of customers who should be obliged to buy from the shops of our different producers all the goods with which these could supply them. For the sake of that little enhancement of price which this monopoly might afford our producers, the home-consumers have been burdened with the whole expense of maintaining and defending that empire. For this purpose, and for this purpose only, in the two last wars, more than a hundred and seventy millions [in pounds] has been contracted over and above all that had been expended for the same purpose in former wars. The interest of this debt alone is not only greater than the whole extraordinary profit, which, it ever could be pretended, was made by the monopoly of the colony trade, but than the whole value of that trade, or than the whole value of the goods, which at an average have been annually exported to the colonies.6

Smith vehemently opposed mercantilism—the practice of artificially maintaining a trade surplus on the erroneous belief that doing so increased wealth. The primary advantage of trade, he argued, was that it opened up new markets for surplus goods and also provided some commodities from abroad at a lower cost than at home. With that, Smith launched a succession of free-trade economists and paved the way for David Ricardo’s and John Stuart Mill’s theories of comparative advantage a generation later.

Adam Smith has sometimes been caricatured as someone who saw no role for government in economic life. In fact, he believed that government had an important role to play. Like most modern believers in free markets, Smith believed that the government should enforce contracts and grant patents and copyrights to encourage inventions and new ideas. He also thought that the government should provide public works, such as roads and bridges, that, he assumed, would not be worthwhile for individuals to provide. Interestingly, though, he wanted the users of such public works to pay in proportion to their use.

One definite difference between Smith and most modern believers in free markets is that Smith favored retaliatory tariffs. Retaliation to bring down high tariff rates in other countries, he thought, would work. “The recovery of a great foreign market,” he wrote “will generally more than compensate the transitory inconvenience of paying dearer during a short time for some sorts of goods.”

Some of Smith’s ideas are testimony to his breadth of imagination. Today, vouchers and school choice programs are touted as the latest reform in public education. But Adam Smith addressed the issue more than two hundred years ago:

Were the students upon such charitable foundations left free to choose what college they liked best, such liberty might contribute to excite some emulation among different colleges. A regulation, on the contrary, which prohibited even the independent members of every particular college from leaving it, and going to any other, without leave first asked and obtained of that which they meant to abandon, would tend very much to extinguish that emulation.7

Smith’s own student days at Oxford (1740–1746), whose professors, he complained, had “given up altogether even the pretense of teaching,” left him with lasting disdain for the universities of Cambridge and Oxford.

Smith’s writings are both an inquiry into the science of economics and a policy guide for realizing the wealth of nations. Smith believed that economic development was best fostered in an environment of free competition that operated in accordance with universal “natural laws.” Because Smith’s was the most systematic and comprehensive study of economics up until that time, his economic thinking became the basis for classical economics. And because more of his ideas have lasted than those of any other economist, some regard Adam Smith as the alpha and the omega of economic science.

A Possible Source Of Revenue For Newspapers/Newsrooms

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Problem: Newsrooms/newspapers help investigate important issues. Currently the information is given away for free online. (the serious problems - I believe - that we have with the media will be addressed later)

Google has a program called "Adsense". Basically if you have a website you can subscribe to the Google Adsense and put a little box on your website that contains ads from Google. The ads are paid for by advertisers who pay per click i.e. each time someone clicks on a link they pay for that visitor. So Google makes money by putting these ads on its website and having other online publishers (private websites) put up their ads as well. The incentive for these other publishers putting up Google Ads on their websites is that they get a share of the profits on each click.

For example: This blog has Google ads on it. If someone clicks on a link that pays Google a dollar then I would get, say 20-30 cents. Since this is based on how many visitors visit my site and click on the links - the more visitors I get the more potential money I can make.

Here’s a possible idea that may help a little:


Now let’s look at another aspect of the newspaper situation. Google gets it’s news from newspapers and publishes it online. They put up their ads next to the news and make money. The newspapers/newsrooms don’t make money. Suppose the newsrooms all go bankrupt and Google no longer has a source of content (news stories) to publish on its websites and thus loses a source of revenue in the long run.

OR

Google could use the Adsense model and pay a percent of profits from the ads to the newsrooms for their stories. That way the newsrooms only get money when Google makes money so Google isn’t stuck with a contract that may not make sense in the long run. Google will lose a little profit on the ads in the short run as they pay out the commission but will gain revenue in the long run as the newsrooms will have a source of revenue to continue writing news stories.

The alternative is to lose the newsrooms and not have any news stories to publish and Google News would have to be scraped.

Of course, this will probably not solve the problem and there may be more problems than I know about in getting such a revenue model into place. However, it is a possible source of revenue for newspapers that is worth looking into.

? Also, since Google is not going to publish news from every newsroom this could also create more competition as reporters seek to get the best story to be published on Google News and get more webpages of revenue. (I’m not sure how the current model works)

Apr 8, 2009

Basics Of How Banks and Loans Work

In the old days, when the frontier of America was being settled, people would make, grow or barter for everything they needed. For example; a farmer would grow his crop, make his own well/fences and offer what he had to someone else in exchange for something he wanted from the other person. That is how trade began with the Native Americans. Traders would take fur pelts and in exchange would give them horses or guns etc. This process of exchange is called barter.

Before we had money we bartered for what we wanted. The problem with barter is that we have to have what the other wants in order to get what we want.

Later gold became a standard of exchange. So now if we wanted a horse and had a cow we didn't have to find someone who had a horse and wanted a cow to make an exchange - we could just sell the horse, get some gold and go buy a cow. That is how money makes it easier to trade.

As the amount of gold in an economy grew a new fad developed. People would put their gold in a safe place with an institution (like a jeweler) and the jeweler would give the person a note saying how much gold the person had kept with them. Since it was risky to carry alot of gold around (as it was heavy) people just started using their notes from the big jewelers as proof of how much gold they had and simply transferring over the note to someone in exchange for what they wanted. This is how paper money was born.

After a while a jewelers noticed that people didn't withdraw most of the gold that they kept with them for safety. The people would just pass around their notes. On average a person would take only 30 percent of the gold that was kept with them (just an example).

So what the jewelers did was assume that people would only take out 30% of what they put in which means that for every 100 dollars worth of gold deposited only 30 dollars of it would ever be taken out. So these jewelers started keeping 30 dollars of every gold deposit aside (called a "reserve" or "capital reserve") and would loan out the remaining 70 dollars to people at an interest rate.

The person who took out the loan would - over time - pay back the gold he borrowed plus the interest rate for the gold he borrowed. The person borrowing doesn't mind as he gets his money to do what he wants and pays a little extra for the ability to get the money he needs. The jeweler is taking on risk by giving out the loan and the interest is the profit made for taking on the risk. This is how loans came to be.

The process of loaning only works as long as people trust the jeweler to keep their gold safe. If people begin to think that the jeweler may have squandered their money away then of course they will want their money back. If one person wants all their money back that is not a problem. The jeweler has enough gold from many people to easily pay back one or two or even three people in full. However, if everyone wants thier gold back then that is a problem as the jeweler kept only 30 percent of it and loaned out 70 percent. In other words, the jeweler doesn't have the gold it has been loaned out - thus they can't pay back everybody. If everyone can't get their money back they panic and start demanding their money. This is how a bank run starts.

If people don't get their money back then they lose trust in the jeweler and will not keep their gold with the jeweler and the jeweler will go out of business.

All of the above assumes ONE jeweler. But suppose there are two jewelers?

Then if one jeweler lends out 70 dollars of gold and the person borrowing the gold puts it for safe keeping in another jewelers safe house THEN the other jeweler will do the same thing as the first one. 30% of the seventy dollars is kept and the rest is loaned out. Thus the money circulates in the economy and 'creates' more money as people work to pay back loans. This is a factor of economic growth.

Here is how a modern bank works (image from here):



By paying interest people want to put money in. This gives the bankers money to lend out and they get interest from taking on the risk. They charge more interest on loans than they give to depositors and thus they make a profit. For the person putting in the money in the bank they have safety for their money and for the person taking out the loan they have money for business. So everyone wins.

Since banks runs in the 30's destroyed the economy as many banks collapsed (with people losing their trust in the banks) the government stepped in and insured the bank up to a certain amount thus assuring the average person that they would get their money back if the bank went bankrupt. This was done to prevent bank runs in the future as more often then not a good solid bank can be destroyed just by the rumor that it is in trouble IF that rumor started a bank run.

Thus, in America, the FDIC guarantees all deposits up to 100,000 dollars. This is to keep the banks safe and running. The banks give out loans and the economy grows. The basic process of loans and 'money creation' which expands an economy is illustrated by the following image (taken from here)



Extracts about banks from "How Banks Work":

The funny thing about how a bank works is that it functions because of our trust. We give a bank our money to keep it safe for us, and then the bank turns around and gives it to someone else in order to make money for itself. Banks can legally extend considerably more credit than they have cash. Still, most of us have total trust in the bank's ability to protect our money and give it to us when we ask for it.

What is a bank?

According to Britannica.com, a bank is:

an institution that deals in money and its substitutes and provides other financial services. Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid and charged, respectively.

Banks are critical to our economy. The primary function of banks is to put their account holders' money to use by lending it out to others who can then use it to buy homes, businesses, send kids to college...

When you deposit your money in the bank, your money goes into a big pool of money along with everyone else's, and your account is credited with the amount of your deposit. When you write checks or make withdrawals, that amount is deducted from your account balance. Interest you earn on your balance is also added to your account.

Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the Federal Reserve. The reserve requirement is currently 3 percent to 10 percent of a bank's total deposits. This amount can be held either in cash on hand or in the bank's reserve account with the Fed. To see how this affects the economy, think about it like this. When a bank gets a deposit of $100, assuming a reserve requirement of 10 percent, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.



Why does banking work?

Banking is all about trust. We trust that the bank will have our money for us when we go to get it. We trust that it will honor the checks we write to pay our bills. The thing that's hard to grasp is the fact that while people are putting money into the bank every day, the bank is lending that same money and more to other people every day. Banks consistently extend more credit than they have cash. That's a little scary; but if you go to the bank and demand your money, you'll get it. However, if everyone goes to the bank at the same time and demands their money (a run on the bank), there might be problem.

Even though the Federal Reserve Act requires that banks keep a certain percentage of their money in reserve, if everyone came to withdraw their money at the same time, there wouldn't be enough. In the event of a bank failure, your money is protected as long as the bank is insured by the Federal Deposit Insurance Corporation (FDIC). The key to the success of banking, however, still lies in the confidence that consumers have in the bank's ability to grow and protect their money. Because banks rely so heavily on consumer trust, and trust depends on the perception of integrity, the banking industry is highly regulated by the government.

Types of Banks

­There are several types of banking institutions, and initially they were quite distinct. Commercial banks were originally set up to provide services for businesses. Now, most commercial banks offer accounts to everyone.

Savings banks, savings and loans, cooperative banks and credit unions are actually classified as thrift institutions. Each originally concentrated on meeting specific needs of people who were not covered by commercial banks. Savings banks were originally founded in order to provide a place for lower-income workers to save their money. Savings and loan associations and cooperative banks were established during the 1800s to make it possible for factory workers and other lower-income workers to buy homes. Credit unions were usually started by people who shared a common bond, like working at the same company (usually a factory) or living in the same community. The credit union's main function was to provide emergency loans for people who couldn't get loans from traditional lenders. These loans might be for things like medical costs or home repairs.

Now, even though there is still a differentiation between banks and thrifts, they offer many of the same services. Commercial banks can offer car loans, thrift institutions can make commercial loans, and credit unions offer mortgages!


More later.

Apr 3, 2009

Politics As Usual In The Legislative Branch Of Government

The Senate and Congress are part of the legislative branch of government. If they pass a law (after all that haggling and grandstanding) it can be vetoed by the Executive branch (i.e. the President) or totally thrown out by the Judicial branch (i.e. the courts). These branches of government are kept separate for a reason. To keep a system of checks and balances in place to keep demands of one majority getting out of hand. (learn more about the 3 branches of government)

The legislative branch always consists of a majority. Sometimes it's Republicans and sometimes it's Democrats. The minority always accuses the majority of trampling over their rights. The fascinating thing is that the Republicans and Democrats use the exact same arguments when in minority or majority in the Senate or Congress. Watch the following video as an illustration...

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Notice: Clip of republican saying reconciliation is wrong and then flashback to four years ago when it was right. Same for Nanci Pelosi (Democrat). IN other words, what's going on in the Senate and Congress is "Politics As Usual In The Legislative Branch Of Government".



Extracts from "Political Behavior In A Democracy"


Extract 1: In democratic politics, rules typically give a majority coalition power over the entire society. These rules replace the rule of willing consent and voluntary exchange that exists in the marketplace.

Extract 2: One Congress or legislature cannot bind the next, and so a political solution, other than the grant or sale of private rights, lasts only as long as the political muscle of those who push it. Any political program, land allocation, or treaty can be reversed as political pressures change.

The 3 Branches of Government

There are three branches of the American Governmental System. They can be represented by the following diagram (from ourcourts.org.)



The following is an interview of Justice Sandra O Conner the website she is promoting is Our Courts.Org

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Political Behavior In A Democracy

Political Behavior by Richard L. Stroup

The fact of scarcity, which exists everywhere, guarantees that people will compete for resources. Markets are one way to organize and channel this competition. Politics is another. People use both markets and politics to get resources allocated to the ends they favor. Even in a democracy, however, political activity is startlingly different from voluntary exchange in markets.

People can accomplish many things in politics that they could not accomplish in the private sector. Some of these are vital to the broader community’s welfare, such as control of health-threatening air pollution from myriad sources affecting millions of individuals or the provision of national defense. Other public-sector actions, such as subsidies to farmers and restrictions on the number of taxicabs in a city, provide narrow benefits that fall far short of their costs.

In democratic politics, rules typically give a majority coalition power over the entire society. These rules replace the rule of willing consent and voluntary exchange that exists in the marketplace. In politics, people’s goals are similar to the goals they have as consumers, producers, and resource suppliers in the private sector, but people participate instead as voters, politicians, bureaucrats, and lobbyists. In the political system, as in the marketplace, people are sometimes (but not always) selfish. In all cases, they are narrow: how much they know and how much they care about other people’s goals is necessarily limited.

An advocate of the homeless working in the political arena typically lobbies for a shift of funding (reflecting a move of real resources) from other missions to help poor people who lack housing. The views of such a person, while admirable, are narrow. He or she prefers that the government (and other givers) allocate more resources to meet his or her goals, even though it means fewer resources for the goals of others. Similarly, a dedicated professional, such as the director of the National Park Service, however unselfish, pushes strongly for shifting government funds away from other uses and toward expanding and improving the national park system. His or her priority is to get more resources allocated to parks, even if goals espoused by others, such as helping the poor, necessarily suffer. Passionate demands for funding and for legislative favors (inevitably at the expense of other people’s goals) come from every direction.

Political rules determine how these competing demands, which far exceed the government’s ability to provide them, will be arbitrated. The rules of the political game are critical. Is the government purely democratic or a representative democracy? Who can vote? Over what domain of issues can the government make decisions? How much of the society’s output is available for diversion to political allocation? The rules provide answers to these questions, influencing not only who gets what from society’s product, but also how big the product itself will be and how much of it is diverted from the production of goods and services and devoted instead to influencing the political game.

Why do individuals and groups often seek their aims in the political sector rather than in markets? The motives range from public spirited to narrowly selfish:

• Political solutions can compel people, on threat of prison or worse, to financially support politically chosen goals. This solves the financial “free rider” problem caused by the fact that with solely voluntary provision, even citizens who do not pay for national defense or for, say, a sculpture in the town square can potentially benefit from the expenditures of those who do.

• Imperfections in the legal protection of one’s rights, such as one’s right to be safe from harmful air pollutants, or even one’s civil rights, can be addressed politically.

• Even in a democracy, political action can allow one group to benefit at the expense mainly of the rest of society. Except for gifts and unintended spillovers, this does not happen in a free market with protected property rights, where those who pay are the ones who benefit, and transfers such as gifts are strictly voluntary. (Political victories, however, are often costly to those who win them; lobbying is not free.)

Some aspects of the political process, however, work against those who pursue their goals via the political route:

One Congress or legislature cannot bind the next, and so a political solution, other than the grant or sale of private rights, lasts only as long as the political muscle of those who push it. Any political program, land allocation, or treaty can be reversed as political pressures change. In other words, a political solution cannot be purchased: it can only be rented. A political act is inherently less secure than a private purchase or trust arrangement, if property rights are secure.

• Truly innovative activity is often difficult to sell to the majority of the political group, such as the Congress or a specific committee, which must agree to the proposed action. In the free market, on the other hand, innovations typically are funded when only a few entrepreneurs and capitalists believe in them because only their capital, not that of all taxpayers, is at risk.

For ordinary citizens who are not politically active, political activity has very different consequences from market activity. Although such citizens may benefit from political action that others take, they are bound by all and must pay for some political outcomes, whether in their own interest or not. Ordinary citizens are outside the political process except when they vote and when they have concentrated, or special, interests and are politically well organized. Dairy farmers, for example, typically know little or nothing about how much they pay to operate the national park system or whether the parks are well managed. However, they are keenly informed about the federal milk program, which restricts milk production and keeps milk prices high. Thus, they do not have an incentive to act politically to control the costs of the national park system, but they do have an incentive to act to expand the milk program. Their counterparts, such as conservation advocates eager to expand the national park system, know little about the costs they are bearing to support the milk program and concentrate instead on expanding the park system and its budget.

Although political activity has benefits as well as costs, political behavior causes some predictable problems for citizens in general:

• One-to-a-citizen ballot votes, the currency of the formal democratic marketplace, do not allow voters to show the intensity of their preferences, as dollar votes do when citizens focus their budgets—some spending more on housing, others on entertainment, education, or their favorite charity.

• The voter purchases a large bundle of policies and cannot pick and choose. In a representative government, the voters select a single candidate (the “bundle”) to represent them on many different issues. Voters cannot vote for the position of one candidate on issue A, the position of another on issue B, and so on, as they do routinely when shopping for thousands of items in the marketplace. In a representative democracy, fine-tuning one’s expression at the ballot box is impossible.

• An individual voter has virtually no chance of casting the decisive vote in an election. Even among the more than four thousand elections held each decade to fill the U.S. House of Representatives, a race decided by less than one hundred votes is newsworthy at the national level, and a recount is normally conducted. Moreover, the cost of an uninformed or mistaken vote that did make a difference would be spread among other citizens. This differs from the cost of a mistaken personal purchase, the full burden of which the buyer pays. People thus have little incentive to spend valuable time and effort learning about election issues beyond their narrow personal interest, monitoring politicians’ overall performance, or even voting. Instead, voters are “rationally ignorant” on most issues. Thus, it makes sense for a politician to pay attention primarily to special interests on most issues, and to use the financial support of special interests to campaign on “image” issues at election time.

• Because politicians do not sell their interests to their successors (the way the owners of companies, farms, and houses do), they have an incentive to provide current benefits while delaying costs into the future whenever possible. They have less incentive to invest today for the benefit of the future. Future voters cannot affect elections now, but will simply inherit what current voters leave to them—both debts and assets. In contrast, private assets can either be sold to benefit the owner directly or given by bequest. Only charitable instincts among voter-taxpayers (and perhaps the lobbying of special interest groups such as weapons system suppliers or owners of real estate that may go up in value if a project is built) will push for a costly project with benefits mainly in the future. Charitable instincts toward the future are present in the private sector, too (especially in private charities), and are reinforced by the fact that future productivity and profits are reflected in today’s asset prices, including the stock price of a corporation.

One special interest that has gained at the expense of consumers and taxpayers is wool and mohair producers. During World War II, military planners discovered that U.S. wool producers could supply only half the wool the military wanted. Partly for this reason, and partly to give added income to wool growers, Congress passed the National Wool Act in 1954. Mohair, produced by Angora goats, had no military use but was included as an offshoot of the wool industry. Although wool was removed from the military’s list of strategic materials in 1960, the program survived and continued to grow.

Under the Wool Act, growers were given subsidy checks to supplement what they received in the market for their wool. In 1990, the wool subsidy rate was 127 percent, so a farmer who got $1,000 for selling wool in the market also got a $1,270 check from the government. The subsidy rate for mohair was a much larger 387 percent. The subsidies were paid for by tariffs on imported wool. Thus, consumers were paying more for imported wool, which also drove up the market price paid for domestic wool, a close substitute. The economy operated less efficiently because less wool was imported, even though the imported wool would have cost less to produce and to buy. The subsidy program, together with the higher price caused by the wool tariff, meant that domestic land, labor, and capital resources were applied to the production of wool and mohair instead of to more valuable goods.

Nevertheless, political support for the program was strong, and Congress continued it. Thousands of very small checks were sent to small growers in every state. Almost half of the 1990 payments were less than $100. Many of those receiving them were willing to write letters and to vote for those who support the program. Nearly half of the money, though, went to the 1 percent of the growers who were the largest producers. The largest checks, nearly three hundred of them, averaged $98,000 and accounted for 27 percent of the program’s 1990 cost. Recipients of these large checks could be counted on to contribute to organizing costs and to give campaign donations to members of congressional committees critical to the subsidy program. By contrast, because American taxpayers paid only a few dollars per family (Wool Act subsidies were $104 million in 1990), most taxpayers were unaware of the program and of how their elected representatives voted on it. Even though taxpayers were numerous and the Wool Act cost them a lot as a group, each taxpayer lost so little that none had an incentive to become organized or knowledgeable on the topic. Thus, the Wool Act, which harmed the interests of the great majority of voters, survived until 1996, the last year of a three-year phaseout of the program mandated by Congress in 1994. But organized interests are resilient. A subsidy program that effectively set minimum prices for both wool and mohair was part of the 2002 Farm Act and seems likely to persist for years to come.

Although such special interest groups are sometimes in line with more general interests of the citizens, there is little to confine their actions when they are not. For example, the general public wants national defense, and weapons contractors have an interest in providing the means to obtain defense. But the contractors and the government’s military itself will push for far more elaborate, extensive, and costly means of defense than would a knowledgeable citizen with broader interests.

Political activity is often seen as a way to solve problems not handled well by the private sector—sometimes including everything from pollution problems and national defense to the redistribution of income to the poor. Clearly, private-sector results in each of these areas are unsatisfactory to many, and there are massive, growing political programs aimed at each of these goals. But the problems just described reduce the ability of the political system to reach the sought-after goals—or to reach any goal in a least-cost manner.

Pollution control programs, from the Clean Air and Clean Water acts to the Superfund program, have received great political support. The cost to the economy of environmental programs is generally agreed to be more than $100 billion per year. Yet political manipulation of each program is widely recognized to have led to large imperfections in handling these problems. A classic case has been the political uses of the 1977 amendments to the Clean Air Act. Bruce Ackerman and William Hassler showed that by requiring the use of expensive scrubbers on coal-fired power plants, the amendments effectively protected eastern coal interests while harming both the health and the pocketbooks of millions of Americans. Robert Crandall of the Brookings Institution showed that eastern and midwestern manufacturing interests used the same amendments to stifle competition from new Sunbelt factories. Jonathan Adler has since documented a number of similar cases in which environmental policy initiatives have produced private benefits at public cost.

Bureaucratic performance in achieving the voters’ goals is also a serious concern. Leaders of government agencies make strong, consistent attempts to gain larger budgets and more regulatory authority to further their programs. They often can achieve their ends with a “can’t do” stance in place of the “can do” attitude needed for market success.

A perennial case in point is the “Washington Monument strategy” of the National Park Service. At budget time, the service frequently threatens to curtail visiting hours at its most popular attractions, such as the Washington Monument, if its budget request is not met, and it threatens to blame Congress and the budget process when tourists complain. Other agencies use this and similar tactics to seek more support for their narrow programs. In doing so, too often they impose enormous costs on society. It is hard to imagine a private firm—even a large, bureaucratic one—responding to hard budget times by curtailing its most popular product or service. The private firm would lose too much business to the competition.

Summary


Political behavior in a democracy has both prospects and problems that differ from those of private, voluntary activity. Political action can force all citizens to comply with decisions made by their elected representatives. Because these political decisions are supposed to be for the benefit of all, the support of all is commanded. But because no single citizen’s ballot is decisive, voters are not very effective at monitoring the intent and the efficiency of political action. Voter turnout is often low, and even very intelligent voters are notoriously uninformed on policy issues. Americans of voting age cannot, on average, even name their congressional representative. Such results are not as strange as they may sound when the impact of political rules on individual incentives is examined.