Financial Intermediaries

Financial middlemen have grown up to accommodate about every imaginable type of saver and borrower. Savings and loan associations are much like the savings departments of commercial banks; they draw mainly the savings of lower- and middle-income individuals, make mainly realestate loans, and have grown enormously since World War II. Life-insurance companies are huge financial intermediaries. Total premiums paid on life-insurance policies and annuities in 1967 were nearly $20 billion, of which almost half represented savings—that is, accumulation of reserves by the insurance companies against future policyholder claims. Insurance companies use these funds in many ways—for government bonds, realestate and business loans, and direct real-estate and business investments. “Consumer finance,” or “sales finance,” companies get most of their funds secondhand from the banks and insurance companies, and then lend these funds directly to consumers at higher rates.

Federal, state, and local governments, though they’re out of place in this section on private institutions, have become important financial middlemen between savers and investors. Whenever governments borrow from private savers to finance their expenditures, they’re behaving much as private financial middlemen do, though the resulting forms of real investment are different— roads, schools, and space missiles, instead of factories and houses.

Direct Conversion of Savings

Often no financial intermediary is involved in the investment of savings. Every year, businesses re-invest billions of dollars of their own earnings in buildings, equipment, and other investment goods. Individuals buy new houses, which are considered a form of investment in the national income accounts. Individual savers also invest directly in new stocks and bonds, leading on toward real investment.

Financial Investment and Real Investment

In everyday conversation, the term “investment” is used in several different ways. Often it means financial investment—that is, the process of taking funds and “investing” them in stocks, bonds, or the like. Sometimes it also means “in- vesting” in real assets, like houses, as when you buy a new or used house. Each usage is justified by the dictionary, but it is important to remember that in economics, harking back to Chapter 4, the term investment is defined specifically to mean real investment in currently produced capital goods—factories, machinery, housing, and the like. Thus, if you buy a government bond, this is often considered investment in the newspapers and everyday conversation, but it is not investment as the economist defines the term. In economics, if I use my savings to build a new house, that’s real investment. But if I buy General Motors stock, that’s only a financial transfer, which passes my savings on to the man who sells me the stock, or to General Motors if it’s new stock issue. The question then is: What does that man, or General Motors, do with the funds? Only if the funds go on into real investment in newly produced capital goods or housing is there investment in the economic sense of the term.

THE SUPPLY OF CURRENCY

(GOVERNMENT-ISSUED MONEY)

Most financial intermediaries take savers’ funds and channel them on toward investment without increasing or decreasing the stock of spendable money. But the commercial banks, unlike others, may actually increase or decrease the stock of money as they make and collect on loans and investments. In fact, the supply of money in our society depends largely on the lending activities of the commercial banks. Most of the rest of Part A of this chapter, therefore, is devoted to an analysis of the way commercial banks operate, and the way they may increase the nation’s money stock through their lending activities.

But first, a brief section on the forces governing the supply of currency—government-issued coins and paper money. Currency makes up only about one-fifth of our money supply, and it is used primarily to finance small transactions. As a practical matter, whenever you have a bank deposit account, you can readily get currency, merely by writing a check on your account. Indeed, this is the way currency is placed in the hands of the public. Although it is formally issued by the government (mainly the Federal Reserve Banks, to be explained ~3resently), new currency is made available to the general public through providing it to the banks, which in turn pay it out to depositors on demand. In essence, the Federal Reserve always stands ready to print up enough currency to permit the public to get currency in exchange for any deposits it has.

* As of January 1, 1967. Includes $5 bil-
lion of currency held in bank vaults which was
excluded from Table 11-1.

Table 11-2 shows the kinds of currency now held by the public. Note that “Federal Reserve notes,” which constitute most of the paper money you see, make up 90 per cent of all currency. “Other paper money” is mainly silver certificates, which are gradually being replaced by Federal Reserve notes, so that soon our currency system will be made up entirely of F.R. notes and coins.