So You Want to Know About Economics

by Roopa Pai

Here’s an interesting bit of trivia: How come big banks are always located in the largest, fanciest offices, in the most expensive part of town? Because they have tons of money, that’s why! Well, yes, but do they really need those big, fancy buildings? Wouldn’t they rather use the money they earn somewhere else?

  Well, like everyone else, banks use behavioural economics as well.

  Like every other vendor in the market, banks are trying to get your money. But unlike most other vendors, they don’t have a real ‘product’ that you can touch and feel. So what are they actually trying to sell to you? What do they want you to buy? The product that banks are selling to you is an idea called ‘trust’. You will only ‘buy’ from them (i.e., give them your money) if you trust them. You wouldn’t lend money to someone you didn’t trust, would you?

  And banks have figured out that big, impressive buildings send a telepathic message out to people that the bank is old and solid and trustworthy! That’s why they do it!

  LEARN THE LINGO

  A Run on the Bank!

  If every single person who had a savings account in a bank decided to withdraw all her money on the same day, would the bank be able to give it to her? More importantly, what would happen to the bank if every lender demanded her money back at the same time?

  The short answers to the two questions are: (1) eventually, maybe, but not immediately, and (2) the bank would have a real problem.

  See, banks don’t take your money and simply lock it up somewhere safe. If that was what banks did, you could very well do it yourself at home. Your money would just sit there in a triple-locked trunk, and unless some good fairy managed to magically get in and add to it, there would be exactly the same amount of money in there each time you checked, whether you checked after one year or ten.

  What banks actually do is take your money and lend it to other people. As long as things are going as per usual—people the bank has lent money to are repaying their loans on time, and people who they have borrowed from are not all asking for their money back at the same time—the bank is fine. But sometimes, things go wrong. Borrowers lose their money because of a bad decision, or a natural calamity, or a political upheaval, like a war. They are unable to pay the bank back, ever. Their loans are said to have gone bad.

  If a large number of big loans go bad, the bank is in serious trouble. It does not have enough money to pay back its own loans to its lenders, who are people like us! If word gets around that the bank’s loans have gone bad, people will want to take their money out as quickly as possible, before the bank runs out of the money it still has. People rush to the bank. When other people hear of it, they rush to withdraw their money, too. Panic spreads as people lose trust in the bank. A bank run, or a run on the bank, is now underway!*

  In real life, however, bank runs rarely happen. For one thing, even if a bank is failing because of bad loans, the public never gets to know. Often, the failing bank quickly borrows money from other banks, or the central bank of the country, and keeps things running as before, while it decides what to do. Or it shifts all its customers to another bank which has enough money to keep things running without causing any problems to the customer.

  In India, particularly, bank runs have almost never happened because the government has strict rules about how much of their money banks can lend out to people. This means Indian banks always have a decent amount of money in reserve for situations where a lot of people may want to withdraw all their money. This is a good thing for customers, but not such a great thing for banks, because it limits the amount of money they can invest, and therefore the amount of money they can make for themselves. There are also rules about who Indian banks can lend to—they have to ensure that lendees can pay their loans back before they lend to them. Better safe than sorry, what? This is a good thing for banks, because it leads to fewer bad loans, but not such a great thing for customers, who have to prove their ‘credit-worthiness’, or their ability to pay a loan back, before they can get that loan.

  Also, most Indian banks are nationalised, or backed by the government. Even if a bank ‘collapses’ because of bad financial decisions, the government guarantees that it will pay every penny of every lender’s money back to him. That’s very reassuring, don’t you think? That’s the other big reason why there have been almost no runs on Indian banks.

  Bet you didn’t know that!

  Banks can create money out of nothing!

  It’s true! This is how it works.

  Say you deposit ₹100 in your bank account. We already know that banks don’t just salt your money away in their vaults; they will lend/loan it out to someone else because that’s how they make money.

  Now, in most countries, including India, banks are not allowed to lend out all the money that they receive as deposits. They are obliged to keep a fraction of it with them in ‘liquid’ form (i.e., as actual hard cash). This is the bank’s reserve money. That way, if a lender decides one day that he wants all of his money back, the bank will be able to give it to him immediately*. This practice is called Fractional Reserve Banking (FRB), and is the most common form of banking in the world. What fraction of its deposits a bank is supposed to keep with it is decided by the central bank of the country. (Rules like these are necessary. Otherwise, banks would be tempted to lend out all the money they borrow from us, so that they can maximise the money they make for themselves. And if some of the bigger loans then went bad, the bank—and us—would be in very big trouble indeed.)

  Say the banking rules of your country insist that the bank hold at least 10 per cent of a lender’s money in reserve at all times. So, if someone comes asking the bank for a loan, the bank can lend her no more than ₹90 of your ₹100. Now that person takes the ₹90 and deposits it in her bank. Her bank has to keep ₹9 of that in reserve before it lends her money out to another person. This is what the chain of transactions could look like.

  And so on.

  Do you see what has happened in the bargain, though? The bank has created money out of nothing! Here’s how. You, and Persons A, B, C, D, E, F and G think you have ₹100, ₹90, ₹81 and so on respectively, because your bank says you do. If you go to your bank and ask for your money back, the bank will actually also give it back to you. In total, therefore, adding everyone’s money up, there is apparently ₹569.52 in the system.

  But. The only actual amount of money available is your ₹100, which you lent to your bank right at the beginning! The other ₹469.52 is entirely fictional!

  Does that mean banks are cheating us? Not really. After all, they will give you the exact amount you put in anytime you ask for it, and with interest. So what’s happening here? By ‘creating money’ through this process of using fractional reserves, bankers have worked a sort of magic across centuries. What happens to the ‘fictional’ money that is lent out to Persons B, C, D, E, F and G? It doesn’t lie around in safe lockers, either. It is out there helping people buy machinery, build things, set up stores, build homes for themselves. All this activity generates employment for people and profits for businesses. By putting more money in the system, FRB leads to an expansion in business activity. The economy of the country grows, and that’s a good thing. The idea of FRB has its roots in the theories of a famous British economist called John Maynard Keynes. His breakout book, The General Theory of Employment, Interest and Money, was published in 1936.

  In it, Keynes said that while it was good to allow people to manufacture, buy, grow and sell what they like without government interference, the government had to step in sometimes to keep the economy growing, especially in times when businesses failed and people lost jobs. People without jobs, said Keynes, would not spend money to buy things that other people made. That would force the people who make things to close down their businesses, because of which more people would lose jobs. This would go on and on until there would be no more money circulating, and the economy would stagnate. To prevent this from happening, said Keynes, the government and / or the central bank should st
ep in when businesses failed, and put money into the system to create jobs and restore people’s confidence, thus getting them to start spending their money again.

  FRB is one banking practice that puts money into the system. However, many people (including many economists) don’t agree with Keynes’ Economics, and argue that there is something unethical in the way FRB works to ‘create money out of nothing’. But since there are so few easy alternatives to FRB, and since it has been part of the global banking system for a very long time, it will be difficult to change it anytime in the near future.

  *The ‘thing’ could be a good or a service; we will limit our discussion here to goods.

  *The best-known example of a cartel is OPEC, the Organisation of Petroleum Exporting Countries. Here’s the short back-story of OPEC. In the 1950s, the world oil market was controlled by a group of seven oil companies, most of them American, called the Seven Sisters. They owned oilfields in Middle Eastern countries like Iran, Iraq, Kuwait and Saudi Arabia, and would buy oil from them at whatever price they (the Seven Sisters) decided. If any country refused to sell at that price, they would stop trading with them, putting that country into deep financial trouble.

  In 1960, Iran, Iraq, Kuwait, Saudi Arabia and Venezuela came together to form OPEC. They decided that it would be OPEC, and not the Seven Sisters, who would decide the price of a barrel of oil. The Seven Sisters would be forced to pay it, because they needed the oil! By forming a cartel, the oil-producing countries had neatly turned the tables on the foreign oil companies!

  *In Delhi, for instance, where air pollution has reached seriously hazardous levels, trucks passing through the city have to pay a pretty heavy ‘green tax’ since November 2015. The Delhi government hopes that because of the high tax, many trucks will stop taking the short cut through the city and instead go around the city to get to their destination, thus reducing the air pollution in Delhi.

  *Read the other book in this series So You Want to Know About the Environment by Bijal Vachharajani.

  *In the case of governments, the ‘customers’ are the citizens who have the power to vote for or against them, and the ‘products’ are ideas such as equality, justice, development.

  *Most money-lenders in Italy were also Jewish. Now you know where Shakespeare got his inspiration for Shylock in The Merchant of Venice.

  *This is also the way that foreign exchange (forex) firms make their money. They sell you foreign currency at a higher exchange rate than they buy your foreign currency from you. If you are travelling to the US and need to exchange your INR (Indian National Rupee) for USD (US Dollars), you have to pay about INR 69 for 1 USD. If you want to reconvert your extra USD to INR after you are back, the forex guy will only pay you around INR 66 for 1 USD. The ₹3 difference per USD is his income.

  *You’ve probably studied Compound Interest in math by now. This is the same thing.

  *Read Ruskin Bond’s lovely short story ‘The Boy Who Broke The Bank’ on a bank run in a small Indian village to understand how human psychology and Economics go together.

  *Of course, if every lender decides to draw out all his money on the same day, the bank will not be able to oblige (see section ‘A Run On The Bank’). But because every bank has thousands of depositors, this situation (of everyone wanting their money at the same time) will almost never arise.

  EPILOGUE

  MONEY CAN BUY YOU ANYTHING—BUT SHOULD IT?

  It has been almost 250 years since Adam Smith put out the revolutionary theory that free markets and free trade—people trading with each other furiously and continuously—was the way to build wealth for everyone. He was so persuasive in his arguments and made so much sense at the time that everyone adopted his ideas, and have been doing little else than trading with each other since then. Since Economics believes that any trade that benefits both sides in some way is a ‘good trade’ that should be encouraged, the world today has a new God of All Things, and its name is ‘The Market’.

  Clearly, free trade has been good for the world. It has made people and countries super-productive and richer than they might have been otherwise. But is there such a thing as too much free trade? Are all trades that benefit both sides really ‘good’? Should money be able to buy anything?

  Consider these scenarios.

  Scenario 1. You don’t want to go and stand in a long line for movie tickets for the latest superhero movie, so you decide to buy tickets online. You know that the already expensive multiplex ticket will cost you a little more because of the ‘convenience charge’ that the website will tack on, but you are willing to pay it. The movie theatre is happy that it is selling tickets without having a long, noisy line forming in front of its ticket windows, the website is happy that it made money by facilitating the trade between you and the movie theatre, you are happy because of the time and effort you saved by not having to stand in line. Economists would call it a good trade.

  Scenario 2. In an effort to reduce the use of plastic, your city has recently banned stores from giving out free plastic bags to customers; henceforth, there will be a charge on all bags that the store hands out. You keep forgetting to bring your own bag but don’t care too much—the bag charge is small and you don’t mind paying for it. The city is happy that it is making some money off your forgetfulness, the store is happy that they can still keep you as their customer (which they may not have been able to if they couldn’t give out plastic bags at all), and you are happy with the convenience. Again, a good trade, according to economists.

  Scenario 3. You work really hard in your Grade 12 and get a good rank in the JEE exams for the IITs. With your rank, there is a very good chance that you will get into a good engineering stream in one of them. That year, though, the government decides that they are spending too much money to fund the IITs. They tell the IITs that they must raise at least 50 per cent of their own funds to run the institute. The IITs decide that they will reserve a section of the seats—say 40 per cent—to students who want the seat so badly that they are willing to pay 5 lakh a year in fees. There is still a cutoff—you should still have a good rank—but you don’t have to have a top rank. The rupees five-lakh seats quickly fill up. The institute is happy that they have raised a good sum of money for themselves, the students who got those seats are happy that they got in despite getting lower ranks. A good trade! Never mind that there are now fewer seats open to students like you who cannot or don’t want to pay the high fee.

  Scenario 4. You have been ill with high fever for three days. Your blood test results come back with a dengue diagnosis. Your platelets are not dangerously low yet but your parents are taking no chances. They rush you to the hospital. There are patients ahead of you in line whose platelet counts are way less than yours. But you want to get to the doctor quickly. You know that the hospital offers the option of cutting the line to anyone who can pay three times the specialist’s consultation fee. Your parents pay it. You get seen by the doctor and get hospitalised immediately. You find out later that you got the last available bed. The doctor is happy that he got a higher consultation fee—he has been working his feet off with the dengue epidemic and he feels he deserves it. The hospital is happy that they got in some extra income—they get to keep a part of the doctor’s higher fees—and that they filled up all their beds. You and your parents are relieved that you got the last bed and were treated by the best doctor available.

  Now, since everyone involved in each of the four trades in the four scenarios ended up happy, economists and The Market would call all four ‘good trades’. But are they all really good? Also, are they all equally good?

  Scenario 1 is probably fine. Someone who didn’t want to pay the convenience charge but wants to see the movie will just get to the ticket counter earlier and get her ticket. If the movie is sold out by the time she gets to the head of the queue, too bad. She will come back the next day.

  Scenario 2 is not as fine as the first. Sure, you don’t mind paying for your plastic bag, but the point of the gove
rnment’s effort is to reduce the use of plastic. If people like you can’t be bothered to remember to bring their own bags and instead keep paying for plastic and using it anyway, the landfills (and gutters and cows’ stomachs) are still going to be full of it. Anything that contributes to that surely cannot be a good trade.

  Scenario 3 is even worse. You are nodding vigorously, because you are feeling the pinch this time from the 40 per cent reservation of seats. (Keep in mind that this kind of ‘reservation’ is different from the other kind, where seats are reserved for students from economically-backward or socially-oppressed sections of society. The first kind favours the rich, the second favours the disadvantaged. You decide which is fairer.) Sure, this particular trade ended up with all parties involved being happy, but what about the parties that suffered because of it, even though they were not directly involved?

  Also, what then happens to the value of the good being traded, which in this case is the IIT seat? Earlier, just getting a seat in an IIT would win the student huge respect; now the student will have to specify that he got an IIT seat ‘on merit’ to win the same respect. And people will still wonder if he is telling the truth. You see? The seat itself has been ‘devalued’.

  Scenario 4, you will agree, certainly cannot be called a ‘good trade’. Sure, you ended up getting the best and quickest treatment because such a system existed in the hospital (for now, let’s assume it is a purely fictional system which doesn’t actually exist in real life), but just for a minute, put yourself in the shoes of someone else in the queue who had waited in line since morning, was worse off than you health-wise, and was next in line to see the doctor before you burst onto the scene. Not such a ‘good’ trade now, is it?

  American political philosopher Michael J. Sandel thought about such trades a lot. Then he put down all his thoughts in a fascinating book called What Money Cannot Buy.