As discussed in Why Money Is Valuable money is a form of public infrastructure which is upheld through the public power of taxation. The need to obtain money to pay our taxes creates a universal demand for the currency within the national economy and allows it to function as a medium of exchange. Its usefulness as a medium of exchange then serves as the most significant basis of its value. There are a number of other forms of public support to the value of the dollar as well, which maintain this essential public infrastructure.
Under the current system banks are not required to hold in reserves the full amount they owe to depositors. Instead, they are allowed to back most of their liabilities, which are of fixed value (deposits) with assets of unfixed value (loans), making them prone to collapse. This leaves the entire system fundamentally unstable and vulnerable to collapse. As a result, public institutions have assumed responsibility for supporting the system and the banks through which it functions. As one bank failure threatens contagion and systemic collapse threatens the value and stability of the dollar, these various forms of support to the banking system are effectively forms of maintenance of the public infrastructure that is our national currency.
The first line of defense against systemic collapse is the Fed’s support of the interbank lending market, or “Fed Funds Rate.” By targeting an interest rate for reserves, the Fed makes it easier for banks to obtain the reserves necessary to settle their obligations to depositors.
A second line of defense is the lender of last resort facility at the Federal Reserve. In the event that a bank is unable to borrow, from other banks, the reserves necessary to meet its obligations, the Federal Reserve acts as the lender of last resort – provided the bank is able to provide collateral that the Fed deems to be of sound value. This can allow a bank to meet its obligations when it otherwise wouldn’t be able to, which allows the bank to avoid fire sales of assets and bankruptcy.
A third line of defense is federal backing of deposit insurance. Deposit insurance is a federal guarantee that bank deposits will be redeemed in full, up to the FDIC limit (now $250,000). This federal guarantee reassures the public that there is no need to panic and withdraw their deposits before others do. The guarantee itself prevents bank runs from occurring, which dramatically reduces systemic instability.
A fourth line of defense is bailouts. Bailouts can provide banks the necessary “capital buffer” to sustain losses and survive a crisis, which prevents the crisis from compounding in the wake of a bank failure.
A fifth line of defense is “fiscal stimulus.” Fiscal stimulus is a temporary increase in federal spending that is not offset by raising taxes. This stimulus boosts economic activity, which helps borrowers earn the money necessary to make their loan payments. This reduces the number of non-performing loans on bank balance sheets, which supports the value of bank assets. This further protects the banks from failure and protects the system from collapse.