A Layperson’s Understanding of the Economy

by Madeleine Kando

One of the subjects I dreaded the most in school, was economics. I still let my husband balance our checkbook because it takes him only ten minutes compared to my day-long struggle to accomplish even that rudimentary task of our household finances.

Now that the subject of economics is in the forefront of politics, I feel a need to educate myself so that I understand at least the basics, when I listen to the news. Besides, there is a lot of talk about the banking system being the cause of our current fiscal problems and I want to understand how the system works.

Keynesians versus Austrians
Two of today's major competing economic theories are the Austrian School, represented by Friedrich August von Hayek and the Keynesian School, named after John Maynard Keynes.

The Austrian school is in favor of letting the market regulate itself without government intervention, even when things go wrong. The Keynesians say that government should play a role in the economy by government spending during recessions, by building government projects, etc, and thus generate money that flows back in the economy and improve it.

Austrians say that increasing consumer saving during hard times is the way to get out of a recession. Keynesians say that consumer spending is the answer because it creates a demand for products and more work. Let the saving take place when people can afford it.

Supply-Side versus Demand-Side Economics
Supply Side Economics has guided Republican economic philosophy ever since Ronald Reagan: The idea is that if the government cuts marginal tax rates, economic activity and growth will increase, and thus generate more tax revenue for the government. There is no evidence for this. For example, the economy grew more during the Clinton years, when marginal tax rates were higher.

The Austrian Von Hayek approach is most often associated with supply side economics, and contrasted with Keynesian economics, which is called Demand side economics. Keynes stressed that unless there is a demand for goods, factories won’t produce or hire workers. The supply-siders argue that SUPPLY should be stimulated by giving capitalists more tax breaks. They are totally wrong.

Fractional versus Full Reserve Banking
Another source of current debate, especially in the Libertarian camp, is whether our current banking system is the right one: whether we wouldn’t be better off with what’s called a ‘Full Reserve’ banking system. The current system is a ‘Fractional Reserve’ banking system, meaning that banks can loan out deposit money on a fractional basis. If someone deposits $100 in their bank, the bank can lend 90% of that money out to someone else (at interest).

Opponents of fractional reserve banking say that it is fraudulent, they even compare it to a ponzi scheme. Since most of the money in an economy is created by the banks making loans, they are basically creating money out of thin air and charging interest on it. They say that that is dishonest.

A Full Reserve banking system would require banks to keep 100% reserve on the deposits. How they would make loans if this were the case, is a mystery to me. But, like I said, my brain cells are already working overtime.

Fractional banking is a bit like timesharing an apartment in a resort, except that the thing that is shared is your money. You 'loan' your money to the bank (hopefully at some interest) and the bank can lend 90% of that money out to someone else with interest. Everything is fine except when the banks double-book your apartment, thinking they can make more money that way. If your family and three other families are booked to share the apartment at the same time, the bank is in trouble.

Full reserve banking has the advantage of never risking double-booking, since there is no timesharing. Everyone in the resort owns their own apartment. On the other hand full reserve banking means that most of the apartments are sitting there empty most of the time. There is hardly any tourism, no one has enough cash to pay for an apartment up front. The hotel goes belly up, and so do all the other resorts.

The Gold Standard versus Fiat Money
Ron Paul is all in favor of reinstating the Gold standard. Instead of our current system, which is based on ‘fiat money’ (the paper dollar), currency would be based on real gold. In other words, each dollar bill could be redeemed for a piece of gold. The disadvantage is that it is expensive to produce compared to fiat money (paper versus gold). It also would remove the government’s ability to manipulate the economy by printing more money or reducing interest rates. It would make the system more rigid. Some say that the Gold Standard would create a more stable system.

The FED
Proponents of a Full Reserve banking system with a return to the gold standard, more specifically the Libertarians in America, say that the Federal Reserve is the cause of everything that is going wrong with our economic system. The popular book 'The Creature from Jeckyll Island' by Edward Griffin is a good example of how the Fed is portrayed as a monster that has caused the current recession, and is out to destroy this country. But the Fed was created to control the excesses of the banking system, an attempt to regulate and steer the economy and to prevent extreme fluctuations. It doesn't always work of course, but there is no conspiracy against the population, as this book says.

The Federal Reserve Chairman (currently it is Ben Bernanke) and Board of Governors are appointed by the President of the United States. The 12 Federal Reserve Banks represent each part of the country. Then come the Commercial Banks and at the bottom, the banking public. It is structured so that only 3 of the 12 board members can be elected by a sitting President.

Most people with any understanding of modern economics (from Paul Krugman to Robert Reich to Paul Samuelson to Robert Heilbronner) agree that Ron Paul's libertarian ideas, a return to the Gold Standard, abolishing the Fed, and other such proposals are utter nonsense. In the next post I will try to explain why I agree with them. leave comment here