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The Role of Banks in a Growing Economy
March 27, 2023
There’s a scene in Adam McKay’s The Big Short where Wall Street trader Ben Rickert purchases a couple hundred million dollars in financial products that bet against the growing 2007 housing market. Rickert conducts his trade in an unusual setting: a rural pub in the Irish countryside. At one point, a farmer next to him overhears Rickert as he transfers the millions of dollars in funds over the phone. The farmer yells, “a hundred million dollars!? What are you? A drug dealer or a banker because if you’re a banker you a f— right off.” His comment reflects a view shared by many others. People tend to view banks as nothing more than conglomerations of pompous middle-aged men who profit off our debts. But this notion is (partially) not true, and banks fill an important role in the economy which is often overlooked in many people’s mind.
Banks operate as the primary means for which a growth in utility is converted to a growth in wealth. What does this mean? First, it is important to understand some key principles that govern economics. Economists believe that an economy is always growing. Fluctuations in various markets which may cause recessions or downturns represent only minor interruptions to a general growth in the wealth that participants in an economy have. These small variations in market growth are described by the market volatility, a description of how likely a financial products and markets (stocks, options, or derivatives) are to fluctuate.
The primary reason for why an economy grows in the long run is because of an improvement in the factors of production. In other words, people will always improve the time and cost for which it takes to produce commodities or services. The skills required to produce these commodities and services is called the human utility. When human utility goes up, economists expect the cost of goods and services to decrease because people can make the same amount of goods with less work. When this happens, an economy grows.
Importantly, however, a growth in utility is not immediately reflected in a growth in wealth. Consider the hypothetical example of an aspiring business owner, Adrian, who has just graduated from business school. He has recently acquired the skills necessary to create a thriving car manufacturing firm that can produce cars at double the pace of any previous manufacturer! Yet, until Adrian puts his skills to use and creates his car factory, Adrian adds nothing to the economy. People in this imaginary country still purchase cars at their normal prices and no wealth has been added. Why hasn’t our brilliant car maker started his factory yet? Because the factory requires an initial investment to get started and Adrian is completely broke (The typical outcome of any business school graduate right out of college).
This is when the banks come in. The bank, whose wealth is comprised of the mutual savings of hundreds of other people in the population, offer Adrian a loan. Adrian takes the loan, effectively borrowing from hundreds of others who have trusted the bank with their savings. He is confident that his business will be successful enough to pay back the loan, and even to include some added interest on top of his initial debt. When he starts his business, he immediately begins making money, and he has no problems repaying his loan.
Most importantly, Adrian’s factory now makes cars which are two times cheaper than previous models. Because of Adrian, many more people can now afford vehicles. Those who could afford a single car before can now buy an extra car for their son or daughter. The population is undoubtably wealthier because of Adrian’s contribution. Through the loan the bank offered him, Adrian has converted his potential skills into tangible wealth. By tacking on an interest rate to his loan, the bank has capitalized slightly on Adrian’s insight into car manufacturing. Nonetheless, the population is generally better off because of Adrian’s factory and the loan that facilitated it.
Generalizing the example above, the primary function of banks is to aid in converting potential skills and human utility into tangible wealth. They do this through providing loans to people who can make an economy stronger. This may be through providing loans for a new business or providing mortgages for people (mortgages are a separate kind of investment, but function similarly because they invest in real estate companies that, presumable, show similar contributions in wealth). The money that banks use is not a bank’s own assets, but rather the combined wealth of hundreds of individuals who have trusted the bank to save their money and perhaps invest this money in products which will increase their wealth in the long run. Bank’s are merely the means of transferring our combined wealth into potential skills that will increase all our wellbeing.
Ironically, Rickert’s example above was a bet against the housing market, which would have profited if there was a significant decrease in the value of assets tied to the price of housing mortgages. Rickert and his team in the movie (fictionalized characters who each have real life counterparts) essentially bet that the loans being handed out by banks to individuals and investors for houses were not based on confidence that the value of real estate investment had fundamentally grown but rather under a presumption that market prices would grow; a phenomenon commonly deemed as a bubble in economies. Investments in bubbles are common because bubbles are hard to spot while they are happening. A growth in the value of products can be caused by an increase in demand for products produced by increased general wealth (a reflection of a growing economy) or by speculation of price increases which creates a positive feedback loop that encourages inflation of prices (an economic bubble). Banks can encourage bubbles by profiting off of certain types of investments that grow when prices grow.