March 20, 2023

Bucks Blog: How Lenders Make Money (and Create It Too)

In this excerpt from his new book, “Man vs. Markets,” Paddy Hirsch, senior producer for personal finance at American Public Media’s business radio program production house, Marketplace, explains the basics of lending from the bank’s side of things.

Mr. Hirsch, perhaps best known for his series of whiteboard drawings and videos, leads the Marketplace team that produces two special newspaper sections and two hourlong radio shows each year in partnership with The New York Times.

Today most banks work this way: borrowing money from depositors at one rate of interest, and lending the money out again at another, higher rate of interest. And pocketing the difference.

You might think that makes bankers pretty selfish. They pay measly rates of interest to their depositors and charge higher rates to people who want to borrow from them. In the end they’re firmly focused on making a profit for themselves and their shareholders. The loans they make are a way to make that money.

Fortunately, the banks’ lust for profits works to everyone’s advantage.

The loans the banks make to companies and people usually do a great deal of good. The money helps us to buy everything from groceries to cars and houses, and it helps companies expand and hire. If people are able to borrow (and don’t overstretch), the money they borrow can help grow businesses and create jobs, and that’s good for everyone.

There’s another benefit to banks’ desire to lend money out in order to make profits: Lending creates money. Out of thin air!

This is how the magic works. One day, Mr. Smith comes to his bank and deposits $1 million. The bank keeps 10 percent, or $100,000, in reserve, in case Mr. Smith wants some of his money quickly.

The next day, Mrs. Jones comes to the same bank and asks for a $900,000 loan, to buy a private jet. The bank lends her the money. Suddenly the amount of money in the system has almost doubled. There’s the million dollars that Mr. Smith has in his bank account. And there’s the $900,000 loan the bank made to Mrs. Jones. Both are assets — Mr. Smith can point to his million-dollar balance on his statement, and Mrs. Jones has a briefcase full of cash — so both are real. The bank has turned a million dollars into $1.9 million, just like that.

Dan Archer

Mrs. Jones drives out of the airport and gives the briefcase full of cash to Mr. Sharif, of Sharif Aviation. Mr. Sharif gives Mrs. Jones the keys to a gently used Bell 407 helicopter and puts the cash in his bank. The bank puts 10 percent ($90,000) aside as a reserve and lends $810,000 to a clothing manufacturer who needs to buy some new equipment. The clothing maker gives the equipment salesman the $810,000. He takes it to his bank, which holds 10 percent in reserve, and . . .

You get the picture. That $1 million has now more than tripled, in terms of its purchasing power. And yet there’s no new money in the system — it’s still just a million dollars. It’s the banks’ ability to lend that money out, over and over, that creates a ripple effect through the economy and improves everyone’s ability to spend and to grow. Lending and borrowing can be a good thing, in other words. So long as you don’t overdo it.

Which means that banks aren’t all bad. Yes, some banks — or the bankers who run them — do make mistakes. Some bankers cheat, some bankers lie, and some bankers take foolish risks that threaten the entire global economy. But most banks and bankers work to our mutual benefit, and the network of the country’s banks has become an essential part of our economy, driving money through the system like a heart pumping blood around the body.

Excerpted from “Man vs. Markets: Economics Explained (Plain and Simple),” published by Harper Business. Copyright © Paddy Hirsch, 2012. Reprinted with permission.

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In France, the Pain of Rating Downgrade Is Especially Acute

An S. P. downgrade provides no truly new information about the euro region’s debt struggle, now entering its third year. But the move at least symbolically places the crisis squarely on the doorstep of the Continent’s second-biggest economy after Germany — which retains the AAA credit rating of which France can no longer boast.

Keeping that top credit rating had long been a badge of honor for France — and a political point of pride for President Nicolas Sarkozy, who now enters a difficult re-election campaign with a stigma that his opponents will no doubt seek to exploit.

Mr. Sarkozy had often boasted of France’s gilt-edged standing, and the looming prospect of its loss had recently become a prime topic of political discussion, a hot issue on talk shows and fodder for comedians and political cartoonists.

But whether the S. P. downgrade will have a market effect on France’s cost of borrowing money is something only the coming months and weeks will tell.

Indeed, because the demotion has been widely anticipated, French officials have said the impact will be manageable. French debt, and that of most other euro zone governments, was already trading as if a downgrade had happened. Yields on French 10-year government bonds have been than a percentage point above Germany’s, the European benchmark.

“It isn’t the end of the world” for France, said Jacob Funk Kirkegaard, an economist at the Peterson Institute for International Economics in Washington. “There will be a lot of terrible headlines,” he said in an interview before the official announcement of an S. P. downgrade, “but it’s not going to cause French bonds to decline a lot on a persistent basis.”

But France’s credit rating does have broader implications for the euro zone. France is one of the major financial backers of the European rescue fund, the European Financial Stability Facility, which is meant to prevent the credit contagion that began in Greece from spreading to large countries like Italy and Spain.

The price of its rescue fund, whose borrowing costs depend in part on the credit ratings of its contributing nations, will now probably rise because of the downgrades to France and others. Higher costs could make the fund less effective in stemming the euro crisis.

Many French leaders have noted that S. P.’s downgrade of the United States’ AAA credit rating in August had not stopped investors from flocking to Treasury securities. To a large extent, though, the United States has a special safe-haven status, as the world’s largest economy and as a financial power outside the euro zone, that France does not.

At the time S. P. issued the American downgrade last summer, it had warned that France — of all the major economies that still held the highest credit grade — was the most vulnerable because its finances were being eroded by the European crisis. That warning came as the stocks of two of the country’s biggest banks — Société Générale and BNP Paribas — were being hammered by investors amid rising concern that they had been weakened by the crisis. The shares of both banks have continued to decline since then. Many French and European officials have accused the ratings agencies of fanning the flames. As Europe’s crisis wore on, each time a troubled country — whether Spain, Ireland, Portugal or Greece — announced a new program to improve its finances, they said, S. P. or Moody’s or Fitch crushed confidence by issuing fresh downgrades or warnings shortly thereafter.

Indeed, French officials were livid in November after S. P. erroneously sent out an e-mail saying that it had already lowered the rating on France’s sovereign debt. The company quickly apologized, but the French finance minister, François Baroin, opened an investigation.

Until December, Mr. Sarkozy had warned that a downgrade would bite, especially as he outlined two back-to-back austerity programs meant to reduce France’s budget deficit of nearly 6 percent of gross domestic product — as well as pare debt of 87 percent of G.D.P., the highest of any AAA-rated European country.

But with his main political rival, the Socialist candidate François Hollande, turning up the heat in the campaign, Mr. Sarkozy has reversed course, telling voters since then that a downgrade would be manageable.

That may be: French banks and others in Europe that hold piles of French government bonds are raising tens of billions of euros to meet new regulatory requirements to guard against a worsening of the crisis.

And while the credit rating of Europe’s current rescue fund may also be cut, European officials have already teed up a replacement, the European Stability Mechanism, whose operation does not depend as much on credit ratings. That is because governments would pump taxpayer money directly into the fund.

Nonetheless, France will have to work to renew its financial luster, especially if it is subsequently downgraded by other ratings agencies. French officials say their priority now is to demonstrate that the euro area is solid, while also showing that France is working to improve its own finances.

Mr. Sarkozy’s austerity programs, including higher taxes on items like some food and beverages that kicked in across France recently, are aimed at whittling the country’s budget deficit to 3 percent of G.D.P. by 2015.

They were also intended to prevent France’s international borrowing costs from rising to unhealthy levels. While French officials expect their measures to soothe investors, one senior finance official conceded in a recent interview that “there is some element of unpredictability” after a sovereign debt rating cut.

“Our job,” said the official, who spoke on condition of anonymity, “is to explain things and to do what is necessary to make sure that, independent of our rating, France remains rock-solid.”

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You’re the Boss: Do You Know Enough About Accounting?

Bart Justice had money in his accounts and didn't realize he was spending more than he was making.Eric Schultz for The New York TimesBart Justice almost lost his document-destruction business.

Today’s Question

What small-business owners think.

In a small-business guide to accounting that we’ve just published, Darren Dahl writes about Bart Justice, who started a document-destruction business, Secure Destruction Service, in 2004. The business, based in Huntsville, Ala., grew from $70,000 in annual revenue its first year to $500,000 four years later. To finance his growth, Mr. Justice kept borrowing money from the bank, not realizing that the more he grew, the more he needed to borrow because his revenue was not covering his expenses. The loans meant he had money in his accounts — but it was borrowed money. “I knew how to print a financial statement from QuickBooks, but I couldn’t tell you what it meant,” he said. It took the intervention of business owners in a peer group Mr. Justice joined to convince him that if he didn’t master his finances he was going to lose his business.

Have you had a similar experience? What’s the most important lesson you’ve learned about accounting?

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European Bank Raises Rate for 1st Time Since 2008

Jean-Claude Trichet, the E.C.B. president, argued that the bank needed to attack inflation even though many economists believe that raising borrowing costs could damage weaker economies like Portugal, which only a day earlier became the third country in the euro area to request an international bailout.

With what sometimes sounded like contrarian pride, Mr. Trichet said that the rate increase was perfectly in tune with economic growth.

“There is no contradiction, but full complementarity in doing what is our prime mandate, which is to deliver price stability,” he said at a news conference after a meeting of the governing council of the E.C.B. “We do what we have to do even when it is difficult, even when it is not necessarily pleasing everyone.”

Asked by an Irish reporter what he would say to families in Ireland who will now have to make higher payments on their adjustable-rate mortgages, Mr. Trichet said low inflation “benefits all, including, of course, those who have the most difficulty at the present.”

The increase in the benchmark policy rate to 1.25 percent from 1 percent puts the E.C.B. at odds with the Federal Reserve, which continues to stimulate the U.S. economy, as well as the Bank of England, which on Thursday left its benchmark interest rate at 0.5 percent, despite an increase in inflation.

The E.C.B.’s decision, which Mr. Trichet said was unanimous on the 23-member governing council, drew muted praise from places like Germany, where the rate increase could help prevent the economy from overheating. But the reaction from other quarters was sometimes scathing.

The rate increase could have dire consequences for Greece, Ireland and Portugal when they are already having severe problems borrowing money at reasonable rates, some economists said. Portugal’s caretaker government gave in to market pressures on Wednesday and joined Greece and Ireland in seeking an emergency bailout.

“Tighter monetary policy will only add to the burden of reeling peripheral countries and increase the risk of a much worse debt crisis,” Marie Diron, a former E.C.B. economist who now advises the consulting firm Ernst Young, said in a note Thursday. “We hope that this rate hike is not the start of a series of rate increases that would seriously endanger the fragile recovery.”

Michael T. Darda, chief economist at MKM Partners, a research firm in Stamford, Connecticut, said the E.C.B. was repeating the same mistake that the Fed made in the 1970s and 1980s, when it responded to higher oil prices by raising rates, and, instead, created recessions.

“Those recessions were not oil-induced but Fed-induced,” said Mr. Darda, citing an academic paper by Ben S. Bernanke, now the Fed chairman, that criticized Fed policy at the time.

Though interest rates are still low by historical standards, they are high in relation to Europe’s stuttering growth rate, Mr. Darda said.

“The ultimate effect is that they are going to restrain inflation in Germany and France but will cause deflation in the periphery, which will cause austerity programs to fail,” Mr. Darda said by telephone. “This could very well spread into Spain and Italy.”

Mr. Trichet said that a rate increase would hold down long-term borrowing costs, by giving lenders confidence that inflation would not erode their profits.

The Bank of England faces similar inflation concerns, but left its main policy rate alone after recent economic data painted a mixed picture of the strength of Britain’s recovery. It also kept its bond-purchase plan at £200 billion, or $325 billion.

Not all economists were so critical of the E.C.B. move.

“Fear that this step by the E.C.B. will lead to a worsening of the crisis in the peripheral countries is overdone,” Michael Heise, chief economist at the German insurer Allianz, said in a note to clients. Even if the E.C.B. raises the rate to 2 percent by the end of the year, real interest rates would still be lower than inflation, he said.

In light of strong German growth, the “rate decision was without doubt logical,” Karl-Heinz Boos, executive director of the Association of German Public Sector Banks, said in a statement, though he added that the E.C.B. should be cautious about raising rates further.

And Mr. Trichet suggested that another rate increase soon was not a foregone conclusion. “We did not decide today that it was the first of a series of interest rate increases,” he said. Analysts interpreted his remarks to mean that the E.C.B. might wait several months before raising rates again.

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