Understanding The S&L Mess


Also, given the value of the materials they worked with, the goldsmiths necessarily were expert at safeguarding valuables. People who had surplus gold and silver of their own began leaving it with goldsmiths for safekeeping, and the smiths would in turn give them receipts. It was at this point that one of the great inventions of the modern era appeared, its inventors forever nameless: paper money. People began accepting the goldsmiths’ receipts in the marketplace instead of the valuables those receipts represented. In other words, the receipts, soon called bank notes, became money.

It did not take the goldsmiths very long to notice this or to take the next logical step. If the receipts were used as money, why not issue receipts, instead of the gold itself, when making a loan? This they proceeded to do, and here a very strange thing happened. By issuing receipts when making a loan, the goldsmiths created money out of thin air. The precious metal in the goldsmiths’ vaults remained, of course, money. But the receipts they issued in its stead were also money. The goldsmiths had become bankers.

There was one big problem. The receipts remained money only so long as everyone in the marketplace believed in them or, more precisely, in the banker. As long as people believed that the goldsmith would exchange his paper for gold at any time, all was well. But if that belief, for whatever reason, began to crumble, disaster for the banker, for his depositors, and for his borrowers lay straight ahead.

The reason is simple. When the banker issued receipts instead of gold in making a loan, there came to be more receipts than there was gold on hand to redeem them. If everyone tried to turn their receipts into gold at once, the bank failed. There is nothing dishonest about this. If the loans were properly collateralized, everyone would, eventually, get their money. But by that time, of course, the bank would be long out of business.

A loss of faith by the marketplace, therefore, is every banker’s nightmare. For this reason bankers, far more than other businessmen, have had to guard their reputations zealously. As Walter Bagehot explained more than a century ago in his masterly study of British banking, Lombard Street, “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.”

The most important way bankers have guarded their reputations is to keep adequate reserves, money in the vault ready to meet any demand for withdrawal. As long as everyone asking for his money receives it promptly and courteously, no one is likely to doubt the bank’s solvency.

Once bankers can create money, the temptation to create too much is very strong. That’s why banks need constant watching.

But despite the overwhelming need to maintain an impeccable reputation, bankers are human. They are sometimes too agreeable to their friends, sometimes too optimistic, or too greedy, or dishonest. Once someone possesses the magic power to create money, the temptation to create too much is very strong. That’s why banks need constant watching. Banks are too important to be left to bankers.

And never forget that banks are in the money business. That’s why Willie Sutton robbed them. That’s why politicians want the bankers on their side and are thus predisposed to favor the bankers over the banking system.

In Britain the Bank of England, founded in the late seventeenth century, evolved in the eighteenth century into a “central bank,” a watchdog institution insulated from politics, with the power to regulate all British banks and thus protect what is, properly cared for, a great national asset: the power to create money. By setting reserve requirements and capital minimums, a central bank has the power to control how much money the banks create and thus influence the business cycle. The United States has spent two hundred years trying to develop a similarly effective watchdog. The S&L disaster is the expensive proof that we have not yet succeeded.

There were no banks in colonial America, first because Britain forbade their establishment and second because the Colonies, which operated largely with a barter economy, had hardly any gold or silver in circulation on which to base a bank. With independence, a few banks were chartered by states, first in Pennsylvania in 1782 and then in New York and Massachusetts in 1784.

Today these would be called commercial banks. They accepted “demand deposits” from merchants and businessmen (that is, they agreed to return the money to the depositor at any time he wanted it). And they issued bank notes in order to make demand or short-term loans to the same merchants, allowing them to finance inventories and accounts receivable. This form of bank evolved into today’s socalled full-service banks, many of them giant institutions such as the Bank of America, Chemical, and Chase Manhattan.