Introduction to economic activity

Economic activity began with the caveman, who was economically self-sufficient. He did his own hunting found his own shelter, and provided for his own needs. As primitive populations grew and developed, the principle of division of labour evolved. One person was more able to perform an activity than another and therefore each person concentrated on what he did best. While one hunted, another fished. The hunter then traded his surplus to the fisherman, and thus each benefited.

In today's complex economic world, neither individuals nor nations are self-sufficient. Nations have utilized different economic resources; people have developed different skills. This is the foundation of world trade and economic activity. As a result of this trade and activity, international finance and banking have evolved.

For example, the United States is a consumer of coffee, yet it does not have the climate to grow any of its own. Consequently, the United States must import coffee from countries (such as Brazil) that grow coffee. On the other hand, the United States has large industrial plants capable of producing a variety of goods, which can be sold to countries that need them.

If nations traded item for item, such as one automobile for 10,000 bags of coffee, foreign trade would be cumbersome and restrictive.

But instead of barter, which is the trade of goods without an exchange of money, all countries receive money in payment for what they sell. The United States pays for Brazilian coffee with dollars, which Brazil can then use the wool from Australia, which in turn can buy textiles from Great Britain, which can then buy tobacco from the United States.

Foreign trade, the exchange of goods between nations, takes place for many reasons such as: no nation has all the commodities that it needs, a country often does not have enough of a particular item to meet its needs, and one country can sell some items at a lower cost than other countries.

 

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FOR BANKING OPERATIONS

Seventeenth-century English goldsmiths provided the model for contemporary banking. Gold stored with these artisans for safekeeping was expected to be returned to the owners on demand. The goldsmiths soon discovered that the amount of gold actually removed by owners was only a fraction of the total stored. Thus, they could temporarily lend out some of this gold to others, obtaining a promissory note for principal and interest In time, paper certificates redeemable in gold coin were circulated instead of gold. Consequently, the total value of these banknotes in circulation exceeded the value of the gold that was exchangeable for the notes.

Two characteristics of this fractional reserve banking remain the basis for present-day operations. First, the banking system's monetary liabilities exceed its reserves. This feature was responsible in part for Western industrialization, and it still remains important for economic expansion. The excessive creation of money, however, may lead to inflation. Second, liabilities of the banks (deposits and borrowed money) are more liquid — that is, more readily convertible to cash-than are the assets (loans and investments) included on the banks' balance sheets. This characteristic enables consumers, businesses, and governments to finance activities that otherwise would be deferred or cancelled; however, it underlies banking's recurrent liquidity crises. When too many depositors request payment, the banking system is unable to respond because it lacks sufficient liquidity. The lack of liquidity means that banks must either abandon their promises to pay depositors or pay depositors until the bank runs out of money and fails. The advent of deposit insurance in the United States in 1935 did much to alleviate the fear of deposit losses due to bank failure and has been primarily responsible for the virtual absence of runs on US banks.

 

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COMMERCIAL BANKING IN THE USA

Commercial banks are the most significant of the financial intermediaries, accounting for some 60 percent of the nation's deposits and loans. The first bank to be chartered by the new federal government was the Bank of the United States, established in Philadelphia in 1791. By 1805 it had eight branches and served as the government's banker as well as the recipient of private and business deposits. The bank was authorized to issue as legal tender banknotes exchangeable for gold.

In the next three decades the number of banks grew rapidly in response to the flourishing economy and to the system of "free banking", that is, the granting of a bank charter to any group that fulfilled stated statutory conditions. Government fiscal operations were handled initially by private bankers and later (after 1846) by the Independent Treasury System, a network of government collecting and disbursing offices. The National Bank Act (1864) established the office of the comptroller of the currency to charter national banks that could issue national banknotes (this authority was not revoked until 1932). A uniform currency was achieved only after a tax on nonnational banknotes (1865) made their issuance unprofitable for the state-chartered banks. State banks survived by expanding their deposit-transfer function, continuing to this day a unique dual banking system, whereby a bank may obtain either a national or a state charter.

The stability hoped for by the framers of the National Bank Act was not achieved; banking crises occurred in 1873, 1883, 1893, and 1907, with bank runs and systemic bank failures. The Federal Reserve Act (1913) created a centralized reserve system that would act as a lender of last resort to forestall bank crises and would permit a more elastic currency to meet the needs of the economy. Reserve authorities, however, could not prevent massive bank failures during the 1920s and early 1930s.

The Banking Acts of 1933 and 1935 introduced major reforms into the system and its regulatory mechanism. Deposit banking was separated from investment banking; the monetary controls of the Federal Reserve were expanded, and its powers were centralized in its Board of Governors; and the Federal Deposit Insurance Corporation was created.

 

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BANKS AND BANK ACCOUNTS

Banks and bank accounts are regulated by both state and federal statutory law. Bank accounts may be established by national and state chartered banks, and savings associations. All are regulated by the law under which they were established.

Until the early 1980's interest rates on bank accounts were regulated and controlled by the national government. A ceiling existed on interest rates for savings accounts. Interest payments on demand deposit accounts were generally prohibited. Banks were also prohibited from offering money market accounts. The Depository Institutions Deregulation Act of 1980 (D1DRA) eliminated the interest rate controls on savings accounts. The restrictions on checking and money market accounts were lifted nationwide.

The operation of checking accounts is governed by state law supplemented by some federal law. Article 4 of the Uniform Commercial Code, which has been adopted at least in part in every state, "defines rights between parties with respect to bank deposits and collections." Part 1 of the Article contains general provisions and definitions. Part 2 governs the actions of the first bank to accept the check (depository bank) and other banks that handle the check but are not responsible for its final payment (collecting banks). Part 3 governs the actions of the bank that is responsible for the payment of the check (payer bank). Part 4 governs the relationship between a payer bank and its customers. Part 5 governs documentary drafts. These are checks or other types of drafts that will only be honored if certain papers are first presented to the payer of the draft.

The banking crisis of the 1930's led to the development of federal insurance for deposits which is currently administered by the Federal Deposit Insurance Corporation. Funding for the program comes from the premiums paid by member institutions. The bank accounts of individuals at institutions which are insured are protected for up to an aggregated total of $100,000.

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