We like to think that when we deposit a dollar at the bank, it goes into a big vault and we can pull out that same dollar at any time. But that¿s not how the U.S. banking system works. Banks take that money and invest it to make money themselves, so cash gets spread around. This, naturally, leads to a big risk: What happens if those investments go sour? Well, you¿d be out of luck. You can¿t get your dollar back.

The Federal Reserve doesn¿t like that scenario, so it prohibits banks from putting all the cash it has on deposit on the line. In fact, the Fed forces banks to keep a portion of their assets at the Federal Reserve itself, to make sure that some of your assets won¿t get squandered if the bank¿s bets go south. These are called ¿reserves,¿ (hence, Federal Reserve. Got it? Good), and usually amount to 10% of the total cash kept in checking accounts.

These reserves are never exactly 10%, and banks like to keep a little extra in reserve ¿ not, as you might think, to make you more comfortable that they¿re in good financial shape, but rather so they can take that excess and lend it to other banks and make money off it. (They¿re banks, they can¿t help themselves.) The rate at which they make these loans is called the Federal Funds rate, which is set by the Federal Reserve¿s Federal Open Market Committee.

When you hear people chattering about how the Fed cut or hiked interest rates, this is what they¿re talking about: the interest rate banks can charge for lending money from their reserves. This begs the question: If these are essentially loans between banks, why is the Fed Funds rate so important for the rest of the economy?

Well, simply put, because loans make the financial world go round. Bank A lends Bank B $10,000 at a Fed Funds rate of 5%. Bank B then lends out $10,000 to a small business at 7%. The small business then takes that money and expands the business and hires new workers. Now someone is employed, Bank B has made interest off the loan, and Bank A is the richer for making it all happen. It¿s perhaps overly simplistic, but you get the idea. When you want the economy to thrive, you make lending cheaper.

Of course, sometimes you don¿t want the economy to thrive. In fact, you might want it to cool down, mostly to avoid money flooding the system and causing inflation. In that case, the Fed raises interest rates, making it difficult to lend or borrow.

Home / Markets / Economy

Thursday, October 02, 2008

Analysis

Biggest Crisis Since Great Depression... or Not

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Dunstan Prial

FOXBusiness

Fallout from the logjam in global credit markets has inevitably led to comparisons with the Great Depression of the 1930s.

In fact, the phrase “the worst credit crisis since the Great Depression” has become almost as ubiquitous as “mortgage meltdown,” and “Wall Street bailout” in media accounts of the storm currently pounding the U.S. financial system.

No less an authority than former Federal Reserve Chairman Alan Greenspan, while careful not cite the Great Depression specifically, wrote earlier this year that the turbulence that has upended Wall Street and now threatens Main Street will likely be remembered as “the most wrenching” since the end of World War II.

Obviously, it’s impossible to predict how bad things will get. But what’s the likelihood of soup lines, hobo camps and the resurrection of that oft-quoted Depression Era plea, “Brother, can you spare a dime?”

It depends on who you ask.

Jay Ritter, a finance professor at the University of Florida, says another depression is unlikely, and that any comparison between the two eras might begin and end with unemployment figures.

At the height of the Depression, he noted, nearly one in four Americans -- 24.75% -- was out of a job. Meanwhile, the most recent U.S. figures showed the unemployment rate at 6.1% in August.

But no one is suggesting we’re in the middle of a depression, rather that we may be headed toward one.

Thus, it may be more accurate to compare current unemployment figures to the onset of the Depression. According to the U.S. Census Bureau, the unemployment rate in 1929 was 3.2%, well below today’s figure.

Drawing conclusions is therefore difficult.

In any case, Ritter noted other differences between the two periods which he feels also point away from another depression.

For instance, in 2008 the U.S. auto industry is in disarray, a dismal scenario that has prompted factory closures and thousands of layoffs. The housing slowdown has caused thousands of construction layoffs, as well.

But other areas of the U.S. economy are booming, said Ritter, who cited energy and agriculture as sectors that are thriving despite the shutting down of credit markets.

“In the 1930s, almost everything collapsed,” he said.

An important question regarding the future health of the U.S. economy is how many more defaults are hiding in all those mortgage-backed securities gathering dust on the books of large financial institutions.

If the value of those loans continues to collapse, the domino effect, already devastating to Wall Street, could be catastrophic on a global scale.

That possibility scares Charles Geisst, author of the book Wall Street: A History.

“This is a very unusual period, maybe the most unusual we’ve ever seen. I don’t think anything compares to this,” said a pessimistic Geisst.

Because the global economy is so intertwined, a severe slump in any single large economy inevitably spreads to other economies.

“Nothing is isolated and anything that hits the financial system will immediately network through,” said Geisst.

Here in the U.S., the "virus" that has toppled Wall Street icons like Lehman Brothers and Bear Stearns, and battered mortgage giants Fannie Mae and Freddie Mac, now threatens millions of Americans’ savings via money market funds, pension funds, and 401(k) retirement plans, according to Geisst.

“We’re getting close to infecting our safety net,” he said. “It’s starting to see stress.”

Geisst said he fears the federal government, which has already proposed more than $1 trillion in bailout packages, will simply run out of money to prop up ailing lenders.

And printing more money will only lead to inflation, he said.

“Unfortunately, finance never looks at the past and creates a contingency plan,” Geisst lamented. “Look at the (proposed $700 billion) rescue plan. It had to be cobbled together because there is no contingency plan.”

Geisst said lack of regulation in the U.S. financial markets led us down the path we now seem headed. “We just let these institutions loose and this is what you get,” he said.

Ritter said some comfort might be taken from the fact that Fed Chairman Ben Bernanke’s is one of the world’s foremost authorities on the causes of the (first) Depression.

“If there was one economist in the world right now who should be head of the Federal Reserve, it’s the person we’ve got. It’s the right person in the right spot during the current crisis,” he said.