The Federal Funds Rate
So far, we've talked about how the feds can control the money supply by performing open market transactions where they're buying and selling Treasury securities. But you might be thinking, "I don't hear a lot of open market transactions and Treasury bond buying." I hear them setting the federal funds rate, the discount rate, or the target rate. "What are these words, and how do they relate to open market transactions?"
We'll focus on the target rate. This is the rate that the Fed wants banks to lend reserves to each other on a very short-term basis. The reserves of the bank are the assets of the Federal Reserve. Let's assume that one bank's reserve is lower than the other. One has a reserve of 10%, and another has a reserve of 20%. Bank B has too much reserve, but he doesn't like that much reserve because you don't get interest on the reserve.So Bank B opts for a 15% reserve, whereas Bank A wishes to increase to a 15% reserve.So bank A wants to borrow that amount of money, which is either physical cash or reserve deposits with the Fed. Bank B has roughly that much money to lend. So bank B wants to lend money to bank A, probably overnight because people may want their money back suddenly.
So what interest rate does bank B charge to bank A?
Assume that Bank B will charge a 10% fee. Let's also say the feds decide the money supply isn't big enough. That the Fed wants to expand the money supply So what happens in this situation?
So what the Fed does is print notes and use those notes to buy Treasury bills. The cash will go to the people who sold the treasuries, and that person is going to put that cash in their bank. Some put it in bank A, and some in bank B. What's the net effect? The Fed's balance sheet increased a little bit; it took on some treasuries from the open market, and more cash got deposited in the banking system. All of a sudden, bank A needs less money because it received some reserve deposits from people. Maybe that bank now has a 12% reserve ratio, and bank B has gone from 20% to 22%. The demand for money at Bank A has decreased, and Bank B now has even more money to lend.
Now, for overnight lending, the demand has gone down and the supply has gone up. The price has got to go down for a little borrowing overnight. What's the price of borrowing? That is, after all, the interest rate. Maybe the transaction will occur at an 8% interest rate, and maybe the Fed has a target rate of 5%. So they'd just keep going through the motions.
More on the fed funds rate
The Federal Reserve always refers to the target rate as X. They don't talk about money. Bank B will have more reserves than Bank A before the Fed does anything. As a result, bank B may lend to other banks that require reserves or open checking accounts.Let's say bank A wants to borrow, bank B is willing to lend some, and the current rate is 6%.
Now the Federal Reserve wants to expand the money supply, which they don't tell us directly. They will say, "We're going to lower the federal funds rate to 5%." This means that their target rate is now 5%. They're going to perform open market transactions in such a way that now when the bank B offers money to the bank A, it's going to reduce its rate from 6% to 5%.
So the Federal Reserve could print some notes and buy treasuries with them. Regardless of where they purchase it, the seller will have no idea that he's selling to the Federal Reserve. The seller will look like he's selling to the market, just as if he were buying stock. You don't know from whom you're buying stock from.Now that the IOU has been exchanged for dollar bills, which he's going to deposit in the banking system, he might put some in bank A and some in bank B.
Now the bank's reserve ratio has gotten a little bit better. Its assets and liabilities have increased. The bank doesn't need money as badly to improve its reserve ratio, and bank B has an even better reserve ratio. The bank A demand for reserve ratio is a little bit lower, and the bank B supply is a little bit higher. Bank A will be willing to pay a little less for the reserves from bank B, and bank B is willing to charge less. So just by increasing the supply and decreasing the demand for reserves, if the Fed does this appropriately, it will go down to 5%. So they're increasing banks' lending capacity, which significantly increases M1.
How do target interest rates differ from money supply?
Why don't they simply manage the money supply by establishing a target money supply rather than a target interest rate? Why don't they just say we have a target of $900 billion, up from $800 billion? prints that 100 million base money, and M0 will get to 900 billion. You'll have the multiplier effect; lending will take place and increase the M1. Similarly, they could have the target M1. They could say we want the target to be $2 trillion. Why don't they just grow the money supply?
Maybe they could say, "Our goal for M2 is to always be 50% of GDP." So as the economy grows, we just have to make sure that if it falls below 50% of GDP, we have to print a little bit of money, and then we'll have a multiplier effect, and we'll keep measuring it. If it goes a little bit above, we'll do some open market operations and sell our treasuries and take reserves out of the banking system. That's a completely legitimate way of thinking about it, and there are two reasons why this might make sense.
The first is based on the belief that the short-term interest rates at which banks lend to one another are simply easier to measure than the money supply. I could sample the market at any moment of time.The other reason is a little bit more abstract. Let's say it's planting season. There are a couple of farm projects where farmers need money to buy seeds. The farmer will proceed if he can get loans at 20% or lower interest rates. So if someone is willing to lend at 21%, he will say no. Another farmer with an 18% interest rate project Another farmer with 12%. A factory guy with a good idea who is willing to build a factory if he can get funding at a 19% interest rate is competing with another factory guy with 3% funding who believes that the only way to move the project forward is if he can get funding at 3% or better. Another guy, who himself is not very confident, will only proceed with the project if he essentially gets money for free.
Let's say the money supply is fixed at that moment in time. Essentially, money is being lent to people who are willing to pay the highest interest rate. So for our convenience, let's assume everyone wants an equal amount of money to go with their project. The project to get the money will have an interest rate of 20%, 19%, and 18%. Let's say the interest rate is 17.9% for those three projects. Those three outstanding projects will not be completed. It's unfortunate that the 12% yield project, which is a fantastic idea, was not funded at the time.
Let's say the money supply stays constant in the medium term over the course of the year because that's what the Fed is targeting. So as we get away from the planting season, farmers' projects disappear, but if you're keeping the money supply constant, those two shady projects will be lent at a much lower rate. So you have a situation where the money supply is not elastic with demand, and the negative side effect for society is that when people needed money, we passed on good projects that really should have been done, and then later, when timing is bad and we keep the money supply constant, bad projects will get funded because there's so much money to go around and none of the people need to use it.
So this is the problem where, over a medium period of time, if you hold the money supply constant, you'll be passing up good projects when there's a lot of demand and then you'll be investing in bad projects when there's not much demand for projects.
Now, if you're managing the money supply according to an interest rate, the interest rate of the federal funds rate is the rate that banks lend to each other. When you inject reserves into the banking system, it lowers the rate at which reserves are lent to each other and also increases the lending capacity of the banks. So it expands the money supply, and expanding the money supply expands overall lending capacity, which lowers the rate at which banks lend to projects.With more money chasing the same number of projects, the cost of lending is going to go down. Let's say the Fed manages the target rate in such a way that bank lending to real projects drops to 8%. We're not fixing the money supply; we're just adjusting the money supply in such a way that the interest rate is fixed. So now, during the planting season, all projects above 8% are going to get funded. After planting season is over, we're still keeping the interest rate the same. Perhaps we will reduce the money supply in order to keep interest rates low, but only good projects will be funded.
It allows the money supply to expand and contract naturally in real time according to market demand for cash, and by setting the interest rate, you're setting the threshold over which you're willing to let projects that meet that threshold get funded.
What happened to the gold?
Whenever we started with our example, all the banks had gold as a reserve, and at some point they said, "Why are we each holding gold?" "Why don't we just all concentrate our gold in one reserve bank, and then that reserve bank can issue bank notes that could be tradeable for gold?" People gradually came to believe that they could use the bank notes themselves as reserves. Gold has nothing to do with the economy in our previous example, which is just giving a little confidence behind bank notes.
When we did our example, the whole point of having a flexible money supply was to be able to grow and contract money with the needs of the economy while still having outstanding notes because it's a fractional reserve system. We have more notes than the actual amount of gold. This was true even when the gold standard was in place. You had more dollars than you actually had gold. We have to keep a little bit of gold just in case people want to call your bluff. in case X percentage of people wanted their gold back. But gold itself served no other purpose. It wasn't good for the economy and wasn't helping transactions happen. To some degree, it's more of a pain than any kind of real value because you have to keep up this notion that the dollar bills could be translated into gold; it kind of forced the reserved ratio requirement on the central bank itself. The reserve ratio requirement is dependent on how much gold is found around the world. In order to increase the money supply with GDP because people are inventing computers, railroads, and cars, we're becoming more efficient, but in order to keep the money supply up with that extra economic activity if we stay on the gold standard and if we want to keep the ratios between the money and the gold, we'd have to grow our gold with the economy. That's a bit arbitrary. Maybe we can find a bunch of gold, maybe not.
The dollar bills aren't just liabilities and obligations of the central bank; they're actually obligations of the government. Would you rather have something backed by gold or backed by the government?
Most of you would say because you don't have trust in the government, but gold really isn't wealth. It can be used to represent wealth only because it's pretty and rare. It is unable to work or be eaten. Well, the government has the right and the authority to tax. It can extract rents from the country's economy, which is real wealth. That's labor, ideas, land, resources, and more. We had currencies backed by gold, but you still had inflation. In some ways, a currency backed by the whole nation's ability to generate wealth is a lot more valuable.
But gold was a stepping stone. To get things going and for people to believe in the bank notes, they had to be sold on gold first. If you trust the government's ability to manage the money supply effectively, and they're not going to print so much money that we have hyperinflation or so little money that we end up with a deflationary spiral, it really doesn't matter that we went off of the gold standard.
Overall discussion
We've been constructing an approximate banking system where we'll take deposits and realize that most of the deposits just sit there, so let's lend out some amount, and we have to keep some fraction aside as reserves. That way, we can use that money to lend more, and in the process, we create a multiplier effect and create money. When we first discussed reserves, we assumed they were gold reserves. Then we eventually showed that in a fractional reserve system, when you have the multiplier effect, you become kind of an advanced economy. To some degree, gold might sit in the central bank vaults and just provide confidence in the system, but really it does nothing there. In our previous topic, we learned that we can go off the gold standard. This is where we are today.
Let's revisit gold first. There's money and there's wealth. Wealth would be things like land, food, shelter, transportation, and entertainment to some degree, or it could be things that could produce these things like factories and computers. If you stay in this mindset, money is not wealth. Money is just a medium of exchange for wealth. The value of money really is the oil, or lubrication, of the economy. You'd have to barter if you didn't have any money. Within the context of the money medium of exchange, there are different types of money. There's paper money, hard currency, etc. Gold would fall under hard currency.
Is gold fundamentally and intrinsically worth more than paper money?
The fact that gold is scarce is either a benefit or a disadvantage. It's not like you can just print this stuff and there's going to be a set supply of it. If someone put a negative spin on it, scarcity would mean less flexibility. If you put a positive spin on it, it can't be manipulated. Both of these are probably true to some degree. It's just a scarce unit of exchange. I'm not saying gold will one day lose its ability to control some of these things or be exchanged for some of these things; money is fundamentally different from these things that actually provide utility. Gold does have some applications and provides entertainment in the form of jewelry or in industrial applications, but primarily it's a unit of exchange. As a unit of exchange, it facilitates wealth transactions and aids the economy in allocating resources efficiently.
Paper money is no longer scarce. It's controllable. You can take a negative or positive spin on this too. The positive is that it's flexible, and the negative is that it's manipulated. There are times in history when many governments just kind of pushed for populist agendas or to somehow try to defer problems; they did manipulate currencies, which led to hyperinflation and eventually made paper money worthless, but for the most part, paper money does retain value.
So, what is relative to the fact that gold will lose value, and what will be the catalyst for it?The bet on any type of investment is to realize what humans will do.
There are other ways we could have gone to an evolutionary banking system. Instead of a fractional reserve, we could have a full reserve system. I can tell you that 90% of your money will not be available to you tomorrow. It's going to be locked in for six months. The money that you want to have tomorrow, just put it aside; you're not going to get any interest on that aside money, and you might even have to pay me a little bit of money to keep it safe and to be able to access it from an ATM. This is less flexible, but also less subject to manipulation. Even within full reserve, we could have gone gold or not gold. Even in the most restrictive system based on some type of hard currency that cannot be printed or controlled by humans to some extent, some can be printed and manipulated slightly, as in the fractional reserve.
The discount rate
The federal funds rate is a target rate at which the Federal Reserve wants banks to lend to each other. What happens if bank A has more reserves than bank B? People are scared and try to pull their reserves out, and we all know that banks don't keep enough reserves to fulfill all of their obligations. The bank B has a liquidity issue if more people than it has in reserve are trying to withdraw the money. In a normal situation like that, bank B will borrow some reserves from bank A and pay interest.
What if bank A is scared to give reserves to bank B? The main flaw of the fractional reserve system is that no one's interest runs on the bank because it cannot pay one of its depositors. If there's just one weak link in the banking system, people lose confidence and start taking their money out. So to prevent this, the Federal Reserve has something called the discount window. It is, in essence, a lender's last resort to the banks. Let's say the federal funds rate is 6%, but that's broken and bank B is really desperate. It can go to the federal reserve and borrow directly from the federal reserve. In this case, the federal reserve will print notes and lend them to the bank in exchange for the bank providing some collateral to the federal reserve, which is known as a repurchase transaction. It's essentially just collateralizing a loan. The interest that the bank pays to the federal reserve is a discount rate when it can't borrow from another bank overnight. In general, the discount rate tends to be higher than the federal funds rate.
Repurchase agreements (repo transactions)
Let's say you're in desperate need of money, and I have money to lend to other people. I'm very careful with my money, so I want to make sure that you're good with it. I will lend you the money, but leave some collateral with me. If you pay back the money with low interest, you'll get your collateral back. This is how the pawn process actually works. A bank will give you a loan, and they'll collateralize it with the house. If you can't pay the loan, they keep the house. This is a pretty straight-forward collateralized loan.
What if, as a lender, I don't even like the notion of collateral? I actually want to make it very clear that I have ownership of the collateral when it happens. So we could do the exact same transaction. I'll buy the collateral from you for the amount you want, but we'll also have a side agreement that, at some future date, I'll agree to sell your collateral, and you'll agree to buy that collateral from me for something more than the amount that I have lent you. This is completely identical to what we did above, but here I've legitimized ownership of the watch. We have a repurchase agreement. From your point of view, it's called reverse repo.
This is how the Fed transacts. This is how FedLend operates, especially with the discount window.
Fractional reserve banking
You gave your gold to the bank for safe keeping.So now I have the gold as an asset. My liability is that you can demand the gold from the bank whenever you want. We can tell from the fractional reserve that there is a slight deficiency because the first thing the bank will do is keep a 10% reserve and invest the rest in good projects. The bank told you that you could withdraw 100 gold pieces at any time, but the reality is that you could withdraw 10 gold pieces at any time. This isn't completely true.
The current banking system works more like this: you give me 10 gold pieces, and I issue checking deposits to people, and my limit on how many checking deposits I can issue is based on the reserve requirements. Assume I have a minimum of 10% in internal reserves. So I make a loan to person B, and I give B the checking account that is equivalent to your account. This is essentially a promise to B that "this is the amount of time you want; come and get X amount of gold pieces from me whenever you want." But in reality, people actually don't get the gold pieces. In our modern system, we're not even dealing with gold. People are getting money that's not necessarily in the reserves. If I make another loan to person A, I'm going to create a checking account deposit for them. The whole reason this works is because people use these checking account deposits as a form of money. When I write you a check, I'm transferring one of the checking account deposits without any gold or any reserve currency actually changing hands. So that's how it works.
In a primitive example, I owe 100 gold pieces, where I lent out 90 and kept 10 as a reserve. I've told people or a person that you can come to me at any time and get your 100 gold pieces, but in reality, I've lent out all but 10 of them. In modern times, I've told people that I've got 100 gold pieces that they can get from me, but the reality is that I only have 10 gold pieces, and my other assets are just loans to people.
So what's wrong with the primitive one?
There was a discrepancy between what I told the depositor and reality in the past, but now I tell him, "You can demand money whenever you want as long as you don't demand more than 10%." In the primitive method, there's nothing stopping you from using the fractional reserve method. All you have to tell the depositor is that you can withdraw 10 gold pieces at any time and that you can withdraw more gold pieces when the loan is repaid. But why doesn't this happen? Well, the reality is that if you told the depositor this, they'd ask for interest on the loan that you're investing in because you're lending their money. But when a bank is allowed to tell half the truth using the primitive method, they don't have to pay interest.
The next thought might be that you're being a little bit dishonest when you tell the depositor that it's on demand, and because you're being dishonest, you're allowed to not give them as much interest as you would have to give them if you told them that their money was locked up, but what's wrong with that as long as you're a good investor and put these funds to good use? This might be true most of the time, assuming everything, but imagine the situation where we have multiple banks. Bank 1 and Bank 2 are very honest and good investors, but Bank 3 takes on extra risk. What is their motivation for taking on additional risk? Assume that bank 3 is willing to lend to people whom banks 1 and 2 were unwilling to lend to. As a result, the bank's three loans will be riskier. Why would they do that? Because if you give it to riskier people, you're able to take more interest from them, and this bank is the most profitable bank. Even worse, because he's getting extra interest, the bank could share more of that extra interest with their depositors. So you can earn higher yields on checking accounts. So they might attract the most depositors.
What happens as soon as things go bad? eral Reservead? As the world becomes more difficult, extra risk begins to rear its ugly head, and the bank becomes illiquid. You could argue that depositors deserved it, and badly. they're greedy. They put their money into risky banks that did shady things in order to get higher interest rates on their deposits. What haphappens? Well,is happens? You've made it this far. People will begin withdrawing from good banks as well, depleting all of the bank's reserves and leaving the bank with no reserves and unable to meet people's demands. People want Aaron to leave. as in "bank run." Because of one bad apple in the system, everyone starts spending their money, and there is no liquidity due to the fractional reserve system. It isn't banked. This good bank may still be worth the liabilities; the bank is solvent but lacks the funds to pay the on-demand creditors, so the bank is in trouble. uidity problem. That is why FederaleReserve, a resort-style reserve, exists. a bankrupt resort. Banks go to the Federal Reserve and request loans.
But how does the Federal Reserve know the difference between the good and bad banks? In this fractional reserve banking system, you have an unstable equilibrium where one bad apple can lead to a run on the entire system. Then the second problem is the difference between good and bad banks.
Deposit insurance
We have a slew of banks that have all lent out 90% of their reserves. The problem with a bank run is that if just one bank suddenly isn't able to give its depositors their money because it's ill-liquid, and we'll determine whether it's truly insolvent or simply doesn't have the money to give to depositors, then all depositors of all other banks panic and rush over to the banks and demand their money back. By definition of fractional reserve, these banks only have 10% of their deposits as reserves. So if more than 10% ask for their money, they are all going to be illiquid, and credit is going to freeze.
The first fix is the lender of last resort, which is our central or federal bank, and they'll never run out of reserves because reserves can be borrowed from them and all reserves are IOUs from the federal reserve. They're going to print some federal reserve notes, and then they're going to create an offset liability, and they have no reserve limits. They will give those notes to a bank in a desperate situation if the bank is unable to borrow from other banks. There is no limit to what the Fed could do in this regard. Obviously, there might be some implicit limit. If they keep doing this arbitrarily, people might not accept these Federal Reserve Notes as actually carrying value.
What if that bank is essentially insolvent? If that bank's loans are actually going bad, there's no reason for the central bank to lend to the bank. The second fix is to have insurance. So if a bank just has a liquidity problem—it's a good bank that ran out of reserves and no other bank is willing to lend to it—then it can go to the discount window at the Federal Reserve and borrow some reserve notes. Now that the situation is such that even that's not good enough and the bank is essentially out of business, it has been paying the FDIC (Federal Deposit Insurance Corporation) a little bit of deposit. It could tell depositors that even if the bank goes bust, the Federal Reserve is going to pay them directly. These are FDIC bank accounts. The federal reserve will make you whole regardless of what happens to the bank. This is a big fix.
What's the side effect on the banking system? Let's say we have four banks, and they're all FDIC-insured. This will solve the bank run problem. Now I don't care if that bank blows up; I can deposit my money in the bank that gives me the highest interest. Who's going to be the bank that's taking on the most risk? So once again, when you give relatively cheap insurance to all the banks, all the banks can attract money much easier by paying the insurance; they'd have to pay much less than without insurance. When you deposit money at the bank, you're lending money to the bank. The interest rate on your deposit is the same as the bank's borrowing costs. Now, if the bank didn't have FDIC insurance, it wouldn't have to pay 0.1% a year, but it would have to give me more interest. Now it can pay 0.1% a year to the FDICCC, but it's going to lower what it has to pay to depositors. It's a really good deal for the bank because they can now do risky things.
If I'm an insurance person and I know that each driver has a 10% chance of being in an accident, if there's an accident, it'll cost me $10000. So I can go to driver 1 and say, "Look, there's a 10% chance you're going to have an accident." "It would cost you $100,000 if you did, so I'm going to charge you $1100." I might do this with a million drivers. I'm going to bring in 1 million * 1,100, which is 1.1 billion in revenue from people paying premiums; how much do I have to payout? According to statistics, roughly 10% of drivers, or 100,000 drivers, will be involved in an accident. Each driver is going to cost me $10000.So I'm going to pay out $1 billion for the accidents. So I'll net $100 million every year. This works out well if the statistics are fine and people are willing to pay their premiums, because if you have enough drivers, the statistics really hold.
Now that you have financial insurance, you have a different situation. According to the FDIC, one out of every 1000 banks fails in any given year. But the reality is that when times go bad, bank failures tend to be related because they're all interlinked. One may be lending to a business that is dependent on another bank's investment. So the failures all relate to each other. So, if one bank fails, it is much more likely that other banks will fail all at once. You can't really follow the insurance model because the statistics don't apply.
Big picture
You can withdraw your deposit from the bank at any time, as long as no more than 10% of the people withdraw at the same time. This might not be the whole reason to say that the system is bad, but the more severe problem is that this kind of half-truth leads to the notion of a bank run. Everyone has the right to get all of their money back, but the reality is that everyone can't get their money back, which leads to panic. So to fix this problem of bank runs and panics, there have been kind of two fixes. You have the lender of last resort and, probably more importantly, the notion of FDIC insurance. This leads to the encouragement of risk-taking to essentially get more profits because all of the banks' borrowing costs are the same, so when they take on more risks, that bank will pay slightly higher interest to the depositor.
When you talk about any financial intervention, what's its purpose? You have savers who like to put their money in a big vault someplace, or maybe they would like to invest, but they don't know how, or their money doesn't have scale or can't be invested properly, and the financial intermediary says, "Give me all of your money, and I'll hire some really smart people to invest your money properly in good investments." They're taking savers' money and investing it, which should generate some positive yield. They'll give some fraction of that return back to the savers. Is fractional reserve banking a requirement for having financial intermediaries like this?
The simple answer is no. You don't need fractional reserve banking to do this. Many financial intermediaries in no way participate in the fractional reserve system. The obvious ones are venture capitalists, private equity firms, and hedge funds. Even if you want to run a commercial bank, I could take deposits. A commercial bank could tell people, "If you want money on demand, I'm not going to pay you any interest on it." "For the service of you having access to it on your ATM and for it to be secure and all of that, I'm going to charge you a little bit of money for on-demand money, and if you want interest on your money, you have to give me your money for a certain period of time." So, if you deposit $100 in the bank and only need $10 per day to run your household or business, you'll open a demand account for that $10, which will earn no interest, but for the rest of the $90, the longer you're willing to lock it up, the more interest you'll earn. The commercial bank that's not participating in fractional reserve banking can say, "Look, this guy has $10 to access whenever, and I'm not paying any interest on that." "I'm going to put that aside in my vault, and he can access that from his ATM, but the rest I can lend out."
What's the big deal about fractional reserve baking if it's enabling
The yield curve is a graph showing how much interest you pay for different durations. If you're lending money to the government, for 1 day you're willing to lend for 1% interest, for 1 year 2%, and for 10 years 5%. This might be for treasuries. Now for the investment-grade company to which I'm lending it. I want some premium over the Treasury bills because they're not as safe as the government. Then you might have really risky guys; the yield curve will have a high upward slope.
Fractional reserve banking allows for taking advantage of the yield curve without really adding any true value to society. Banks will accept demand deposits, which are essentially loans from their depositors. They are essentially overnight loans; if you do not go and get your money back within an hour, they will simply renew that loan. It's basically the shortest loan possible. So they're able to borrow money at a low part of the yield curve, and they can do it very safely and pay little interest because, even though people thought they might be doing risky activities, because of the FDIC insurance, people are lending to them like they're the government because they're going to get it back and the government can pay them back. So it really lowers their borrowing costs. It allows these banks to lend money over longer durations. They can then invest it in high-interest projects and attract a lot more attention. The only reason they can do this is because they have this explicit guarantee from the FDIC. It allows people to lend the money, and the bank will invest at the highest interest-giving end point of the yield curve.
A single person could get that interest if they invested in that end point of the yield curve, but they don't get insurance from the FDIC. So essentially, fractional reserve banking and the insurance that's come about to make fractional reserve lending viable do nothing but allow banks to arbitrage the yield curve. to borrow money at the short end and lend it out at the long end, making up the spread. This doesn't add any true value to society.
Lots of people in the banking system are champions of capitalism, but their whole industry is predicated on a government safety net. The notion of final intermederies without a fractional reserve system means they're in no way dependent on the federal government. They don't need the whole elaborate system of FDIC insurance, the discount window, or all these other interventions that the federal government makes. They could operate in general. But the fractional reserve system couldn't exist without government intervention. Is the fractional reserve system, which is dependent on the government, even capitalism? Where's the competition? Where's the innovation here?
If you're big enough, you get your FDIC insurance and keep arbitraging the yield curve and making money, but there's no innovation here. The person who takes the most risks and has federally subsidized insurance will be the most successful. Everything is dependent on the government. And in the end, the money that people are making comes from the subsidy of the federal government and taxpayers. Essentially, taxpayers are subsidizing the world so that people can simply arbitrage the yield curve with cheap insurance and extract subsidies from the rest of the population.
LIBOR
It's just an average of the interest rates that banks are lending to each other, and it's calculated by the British Bank Association. It's there to kind of provide a benchmark for other types of securities and financial transactions. It literally stands for London Interbank Offered Rate. When you go and deposit money in the bank, the bank won't leave all that money around. The way it makes money is by lending a good bit of money to other people as loans. It'll keep just enough cash on hand, and it thinks that when people actually come and ask for their money from their checking account, they'll have enough on hand. You could imagine that every now and then a bank might get low on cash or get close to the reserve requirement.
So in those situations, say Bank A gets that situation. It'll say, "Let me go borrow some money from another bank." So this is interbank borrowing. So bank B will lend it to bank A to get interest, and the rate that bank B lent to bank A was 1%, and it would be renewed every day. This rate is an interbank rate. The British Bankers' Association surveys a bunch of banks in London, asks for the interest lent to other banks overnight, and quotes that as an overnight LIBOR. It's done in ten currencies.