By Seth Myers
Even if you understand the bankruptcy of Lehman and the AIG "bail-out", with the stock market down over 20%, people want to know what to do with their money now. Before you decide what to do with your money you should understand the two possible outcomes so you can make an informed decision. To understand the possible outcomes we have to look at how financial institutions (banks) work and how they affect the rest of the stock market. Banks have simple business models; they borrow money from one person and lend it to another while taking the spread on the interest rates. When you deposit money in your savings account the bank pays you 3%, and then the bank lends that money out on a mortgage collecting 6%, so the bank profits 3%. Now, the bank can't lend out all your money because if you want to withdraw some of it they need to have it available. Banks generally have to keep 10% of your deposits available and since they have a lot of people depositing money they can meet almost any withdraws required. This simple business model leads to a potential problem.
If the bank gets more then 10% of their deposits withdrawn at the same time they won't have enough cash and will have to borrow money themselves to repay their depositors. This is called a "run on the bank" and if enough people withdraw their money at once the bank will run out of cash and fail. This is what happened during the Great Depression. Banks failed and there was a loss of the money multiplier effect.
The money multiplier effect is a powerful force in the economy and it takes a little intuition to grasp. Remember banks hold 10% of your deposits and lend out the other 90%. Now, consider what happens eventually to that other 90%... it ends up back in a bank. When it ends up deposited back in a bank the bank keeps 10% and lends out 90% again! If this keeps happening (like it should) the original amount of money deposited gets multiplied 10 times. This is why the important thing in the economy is the speed of money or how fast it makes it back to a bank after it's taken out so banks can multiple the money 10 times again.
However, this works in reverse too. If everyone starts pulling their money out of the bank and putting it under their mattress, like during the Great Depression, they are not just putting their money under the mattress, but 10 times their money. The economy can only grow/shrink as fast as money supply grows/shrinks in the long-run. This makes sense in a weird way, GDP represents all the money that changes hands and the money that can change hands is the money that exists. The more money that exists, the more money that can change hands, and the higher GDP is. But, pull money out of banks and you decrease the amount of money that exists by 10 times that amount. You can see why people putting money under their mattress helped cause the Great Depression.
Since people aren't putting money under their mattresses (yet) we have to look at what's happening now. Banks are stuck holding a bunch of "stuff" they can't sell. When a bank can't sell something they can't get more cash to lend out and the multiplier effect dries-up. This is called a liquidity crunch. For every dollar the bank gets stuck holding, 10 times that amount gets withheld from the economy. Since all this "stuff" related to real estate can't be sold, the banks and everyone else, have to sell stocks and other assets to raise cash when they need it. The selling of stocks creates more cash that eventually finds its way back to a bank and gets multiplied 10 times. Eventually enough money is created and someone can afford to buy all this "stuff". Once banks sell all the "stuff" they are holding right now the multiplier effect will start again on the cash they raise from selling the "stuff". This is how the economy and stock market will turn around.
Unless everyone starts pulling their money out of the banks before they can sell all this "stuff". Then the banks will go out of business and there will be no multiplier effect. You have to decide what's going to happen and what you should do with your money. Is everyone going to withdraw their money from banks, put it under the mattress, force banks out of business and put us in another Great Depression? Or, is everyone going to keep doing the same thing they've been doing, eventually bringing the multiplier effect back and putting us on a path of economic (and stock market) growth. If you decide we're heading for another Great Depression then you should be the first to the door of the banks to withdraw your money; however, if you decide everyone will keep doing the same thing then you should keep investing in the stock market.
Because of the safety valves in the system created after the Great Depression and our collective reliance on banks I believe we will avoid a depression and eventually (maybe even soon) the multiplier effect will take hold again spurring economic growth. We now have deposit insurance from the FDIC and SIPC ($100,000 on bank accounts and $500,000 on brokerage accounts, respectively) so you really can't lose your money even if a bank fails. Also, we are so reliant on the banking system I don't know how we'd pull our money out. How would you pay your bills without checks or online bill-pay? Most people don't even carry around cash anymore; everything is paid for with debit or credit. This reliance on the banking system preventing mass withdraws and the insurance assuring protection of people's money creates a banking system that will quickly start multiplying money again leading to economic growth.
Seth Myers, Investment Advisor Rep and Founder of IMYERS a Fiduciary Investment Adivsory Firm Specializing in the optimization of investment portfolios through Diversified Asset Class Allocations (DACA's) and 401k compliance with ERISA guidelines. Visit us at http://www.investingmyers.com
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