Monetary Exchange
Money is so much a part of our day-to-day existence that we are likely to take it for granted, failing to appreciate all that it accomplishes. But it is important to realize that money is very much a social contrivance. Like the wheel, it had to be invented. The most obvious way to trade commodities is not by using money, but by a system in which people exchange one good directly for another. And the best way to appreciate what monetary exchange accomplishes is to imagine a world without it.
Under a system of direct barter, if Farmer Jones grows corn and has a craving for peanuts, he has to find a peanut farmer, say, Farmer Smith, with a taste for corn. If he finds such a person (this was called the double coincidence of wants by the classical economists), they make the trade. If this sounds easy, try to imagine how busy Farmer Jones would be if he had to repeat the sequence for every commodity he consumed in a week. For the most part, the desired double coincidences of wants are more likely to turn out to be double wants of coincidence, where Jones gets no peanuts and Smith gets no corn. Worse yet, with so much time spent looking for trading partners, Jones would have far less time to grow corn. Thus:
Money greases the wheels of exchange, and thus makes the whole economy more productive.
Under a monetary system, Farmer Jones gives up his corn for money. He does so not because he wants the money per se, but because of what that money can buy. Money makes his shopping tasks much easier, for it allows him simply to locate ‘a peanut farmer who wants money. And what peanut farmer does not? For these reasons, monetary exchange replaced barter at a very early stage of human civilization, and only extreme circumstances, like massive wars and runaway inflation’s, have been able to bring barter (temporarily) back.
Bankers have a reputation, probably deserved, for conservatism in politics, dress, and business affairs. From what has been said so far, the economic rationale for this conservatism should be clear. Checking deposits are pure fiat money. Years ago, these deposits were “backed” by nothing more than the bank’s promise to convert them into currency on demand. If people lost trust in a bank, the bank was doomed.
Thus, it has always been imperative for bankers to acquire a reputation for prudence. This they did in two principal ways. First, they had to maintain a sufficiently generous level of reserves to minimize their vulnerability to runs. Second, they had to be somewhat cautious in making loans and investments, since any large losses on their loans would undermine the confidence of depositors.
It is important to realize that banking under a system of fractional reserves is an inherently risky business that is rendered relatively safe only by cautious and prudent management. America’s continuing history of bank failures bears sober testimony to the fact that many bankers have been neither cautious nor prudent. Why? Because this is not a recipe for high profits. Bank profits are maximized by keeping reserves as low as possible, by making at least some risky investments, and by giving loans to borrowers of questionable credit standing (because these borrowers will pay the highest interest rates).
The art of bank management is to strike the appropriate balance between the lure of profits and the need for safety. When a banker errs by being too stodgy, his bank will earn inadequate profits. When he errs by taking unwarranted risks, his bank may not survive at all. Many banks have perished in the latter way in recent years, especially in the savings and loan industry.
