Free banking

The term "free banking" is generally used to describe a structure of the credit market based on the principle of laissez-faire and characterized by the absence of entry and exit barriers, freedom of monetary issue and the possibility of unrestricted lending and borrowing.

The best-known examples of free banking are those observed in Scotland (from the end of the monopoly of the Scottish Bank to the Peel Act) and in the United States (between 1837 and 1863).

One of the principal supporters of a free banking regime was Mises, whose theories were adopted (and further developed) by the Austrian School. He declared his approval for free banking while recognizing its limitations. In his view, acceptance of a liberalized banking activity did not imply abolition of every form of control over monetary issue: his awareness that banks could issue money without any limit led him to turn his attention to an integral gold monetary system (see Mises, 1949).

Flow of funds

The flow of funds (or financial account) is a system of accounting that records all finan- cial transactions of an economy. Bookkeeping both the financial stocks and flows, it tracks the sources and uses of funds for each institutional sector and for the economy as a whole. The flow of funds is one of the key instruments in national accounting together with the national income and product account, the national balance sheet, and the input- output matrix. It is one of the primary components of the System of National Accounts (SNA) of the United Nations. First published in 1953, the flow of funds was incorpo- rated within the SNA in 1968.

Financial supervision

Financial supervision is a basic tenet of a resilient financial system. Supervising the various components that make up the financial system - to wit, financial institutions, markets, and infrastructures - is indeed a critical precondition for the implementation of a consistent framework for financial regulation aimed at enhancing the resilience of the financial system as a whole. Against this backdrop, financial supervision and financial regulation are intimately related. Beyond identifying and assessing emerging risk to financial stability stemming from the macroeconomic and financial environment (through macro stress tests, for instance), supervisory authorities must continuously monitor that the regulatory framework in place provides an even playing field for finan- cial institutions and that, accordingly, it does not prompt the latter to shift their activities to other less or non-regulated segments of the financial system (the so-called "boundary problem in financial regulation"; see Goodhart, 2008, pp. 48-50).

Financial innovation

Financial innovation is defined as "the act of creating and then popularizing new financial instruments, technologies, institutions, markets, processes and business models - including the new application of existing ideas in a different market context" (World Economic Forum, 2012, p. 16).

Merton and Bodie (1995) and Tufano (2003) provide categorizations of financial innovations according to the functions they have been serving, throughout history, in terms of reducing financial markets imperfections such as transaction costs (including asymmetric information), missing markets, and the existence of taxes and regulation. As a result, financial innovations have facilitated trade and provided ways of managing risk. By contrast, the conceptualization of financial innovation presented by heterodox eco- nomics is grounded in the separation between financial and industrial capital (see Niggle, 1986). This separation can be traced back at least to Karl Marx and is germane to the duality of the role of finance, which may be "extraordinarily powerful in mobilising and allocating finance for the purpose of real investment. But, by the same token, it can both trigger and amplify monumental crises" (Fine, 2007, p. 4).

First and Second Banks of the United States

The United States is unique among Western industrializing nations in that it had no central banking institution during its initial period of sustained economic growth (1840- 1910). It experimented with a form of central banking in its first 50 years of nationhood, but ultimately turned away from central banking in favour of a divorce between the central State and the banks and direct monetary stabilization by the Treasury.

Between 1790 and 1840, the US federal government chartered two banks, both called at the time the Bank of the United States, but subsequently differentiated, for the con- venience of history, as the First and Second Banks of the United States. Both institu- tions were commercial banks chartered to address problems in public finance; both were the largest banks in the country and the only ones allowed to operate a national branch network; and both encountered political opposition to their charter renewal and closed after operating for 20 years. The First and Second Banks carved out a distinct niche in the US monetary system, supplying larger-denomination notes and drafts that circulated throughout the national economy and were regarded as equivalent to specie (gold and silver coins), the ultimate reserve and settlement asset at the time.

Financial instability hypothesis

The "financial instability hypothesis" is the term given by the American economist Hyman P. Minsky to his theory explaining why capitalist market economies are prone to instability. The theory integrates macroeconomic analysis with an original microeco- nomic view of how capitalist firms operate. Financial fragility refers to the build-up of debt that precedes the breakdown in economic activity, in a market capitalist economy with a sophisticated debt-based financial system. The crisis then bequeaths a legacy of unsustainable debt to succeeding periods until a boom revives expenditure and sales revenue sufficiently to make the debt burden manageable, whereupon the cyclical build- up of debt resumes.

Financial literacy

While no universally-accepted definition of financial literacy exists, one that is broad and often cited comes from the United States President's Advisory Council on Financial Literacy (2008, p. 4): "the ability to use knowledge and skills to manage financial resources effectively for a lifetime of financial wellbeing." Economists (and other researchers), however, are particularly concerned about two issues regarding financial lit- eracy: (i) how best to improve financial literacy; and (ii) how much of an impact (if any) higher financial literacy rates will have on actual financial behaviour.

One of the most comprehensive studies of Americans' financial knowledge, skills and behaviour comes from the FINRA Investor Education Foundation (2009). They sur- veyed over 28,000 people across the United States in October 2009. The survey included a basic financial literacy test that resulted in a failing average grade (less than 60 per cent). Also, they found that only 35 per cent of households had enough savings to cover three months of expenses (rainy-day funds). 73 per cent of households had at least one credit card, but only 41 per cent of them reported that in the last 12 months they always paid their debts in full. Despite these findings, over two-thirds of people surveyed ranked themselves as highly knowledgeable about personal finance overall.

Financial deregulation

In a broad sense, the concept of financial deregulation refers to the gradual elimination of the financial regulation that was born out of the Great Depression and the early post- war period, particularly as applied to interest rates, exchange rates and international flows of capital. The concept also refers to the application of many other controls over financial markets, for example regulations on commissions that can be earned in stock markets or on the conditions of stock and bond issuance. Also covered by this concept are the removal of controls on the specialization and size of financial intermediaries, as well as on the geographic space of markets, including the lifting of controls over the expansion of cross-border financial transactions.

Financial deregulation is a process that has occurred in almost all countries, but usually as a reaction to what is happening in other markets, because policy makers have considered that financial regulations impose competitive disadvantages. During the 1980s, the deregulation of interest rates, both on the assets and liabilities sides, was promoted largely as a response to the unregulated operation of several large institu- tions in the London-based Euromarket. During the same years, many of the existing capital controls began to be lifted in the largest North Atlantic financial markets, and by the 1990s the widespread mobility of capital began to be characterized as financial globalization.

Financial bubble

Financial bubbles have a long tradition in academic literature. Early references to "bubbles" can be found in Keynes's (1936 [2007], pp. 158-9) General Theory, but the wide- spread use of this expression in the financial sphere has been popularized by the pioneer- ing contributions of Minsky (1975 [2008]) and Kindleberger (1978). Later, increasingly since the 1980s, a growing number of studies have attempted to analyse the dynamics leading to the emergence of financial bubbles, especially in the framework of general equilibrium analysis (see, in this regard, Tirole, 1985).

Conceptually, a financial bubble exists "if the reason that the price [of a financial asset] is high today is only because investors believe that the selling price will be high tomorrow - when 'fundamental' factors do not seem to justify such a price" (Stiglitz, 1990, p. 13, emphasis in the original). To put it in a nutshell, a financial bubble implies that the price of a financial asset deviates in a significant and persistent way from its so- called fundamental value (which, according to conventional financial theory, represents the discounted sum of future forecasted dividends over an infinite time horizon) because investors buy an asset today with the expectation of selling it in the future at a higher price, thus realizing a capital gain.

Finance and economic growth

It is by now widely acknowledged that finance matters for economic growth and that the financial system may have an important impact on the speed and the stability of economic growth. Following "real analysis" (Schumpeter, 1954, p. 277) and hence the "classical dichotomy" between the "real" and the "monetary" spheres of the economy, classical, neoclassical and new classical mainstream economics consider that the growth of economic activity is determined by "real" forces only. However, there have always been dissenting views in the history of economic thought relying on "monetary analysis" (ibid., p. 278), in which monetary and financial factors matter for the determination of output and economic growth beyond the short run. Outstanding examples are the con- tributions by Marx (1894) on the role of credit for economic expansion and instability, by Schumpeter (1912) on the generation of credit "out of nothing" as a precondition for investment finance by innovative entrepreneurs triggering an economic upswing, and Keynes's (1933 [1987]) plea for a "monetary theory of production", as well as his clarifi- cations of the role of finance generated and provided by banks for economic expansion (Keynes, 1973).

Fisher effect

The Theory of Interest (Fisher, 1930) is grounded in neoclassical economic thought. According to Fisher (ibid., p. 495), the interest rate is determined by three conditions: (i) market equilibrium; (ii) "at the margin of choice", the equalization of the rate of time preference with the market interest rate; and (iii) the equalization of the "rate of return over the cost" with the market interest rate. The equilibrium interest rate is therefore determined by real (non-monetary) variables: the rate of time preference that determines savings (an upward-sloping function), and the marginal return on investment that deter- mines the demand for loans (a downward-sloping function).

Friedman rule

There is some terminological variety, and hence confusion, in the academic literature and the economics profession regarding "the Friedman rule", which should rather read "the Friedman rules". Indeed, there are at least three distinct meanings, or versions, of what has been referred to as the "Friedman rule" (or "Friedman's rule"). These three versions basically correspond to the evolution of Milton Friedman's own ideas on the appropri- ate rules to govern monetary (and fiscal) policy. He himself admits the contradictory prescriptions to policy makers embodied in his earlier and later work, for instance in the heading and content of his concluding section, "A final schizophrenic note", of one of his major essays (Friedman, 1969, pp. 47-8).

Financial crisis

The global financial crisis of 2008-09 led to some questioning of the neoclassical orthodoxy on the grounds that it had failed to foresee this momentous event (see The Economist, 2009; Krugman, 2009; Colander, 2010). Such criticism is justified. The main- stream's principal notions - the rationality of its homo oeconomicus, the self-balancing propensity of markets, money's neutrality, and macroeconomic models devoid of any sig- nificant role for finance - all combine to make it conceptually hard to imagine how finan- cial crises may ever develop from within the growth dynamics of capitalist economies. If financial crises arise at all, in this view, they do so as exogenous shocks in response to which asymmetric information problems between lenders and borrowers (for instance, adverse selection and moral hazard) intensify to the point of destabilizing credit. (An early proponent of the information-asymmetry school of financial crises is Mishkin, 1991.) Corollary to this benign view is a theory of finance known as the efficient-market hypothesis (Fama, 1970), according to which financial markets always price the various claims correctly, making it impossible to conceive of sudden financial-market crashes as a recurrent feature.

Financial repression

The term "financial repression" (FR) was introduced by McKinnon (1973) and Shaw (1973) in order to analyse State intervention in financial markets. For these authors, banking interest rate regulations (such as corridors limited by ceilings and floors for both loans and deposits), lending rates of development banks or public commercial banks below the "market" rate, reserve requirement ratios or capital controls are some examples of how governments and central banks "repress" free market forces and block the efficient adjustments of the loanable funds market. Of course, the monetization of fiscal deficits is also a type of FR, but because it is related to government expenditures, it has other implications. Let us therefore focus strictly on monetary and financial policies.

Federal Reserve System

The creation of the US Federal Reserve System was enacted by the Federal Reserve Act on 23 December 1913, as a response to the severe crisis of 1907, "to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes" (Board of Governors of the Federal Reserve System, 2014, Official title). It was the third attempt to create a federal central banking system, after the First Bank of the United States (1791-1811) and the Second Bank of the United States (1816-36) failed.

The US Federal Reserve's duties fall into four general areas: conducting the nation's monetary policy, supervising and regulating banking institutions, maintaining the sta- bility of the financial system and containing systemic risk that may arise in financial markets, and providing financial services to depository institutions, the US government, and foreign official institutions (Board of Governors of the Federal Reserve System, 2005, p. 1).

Fiat money

Keynes (1913, p. 26) famously remarked that the Indian rupee was "virtually a [bank]note printed on silver", by which he meant to suggest two things: that the intrinsic value of the silver did not determine the monetary qualities of the rupee - or even its purchasing power - and that, being a banknote, it was subject to the decrees of the Indian govern- ment. The rupee was indeed a means of payment, not because it was silver, but because government fiat declared it so. If this is the case for a silver coin, then most or all money may be, at least in part, fiat money, because of government decree.

A long tradition has distinguished money of intrinsic value (that is, money based on precious metals) from paper money and bank money. The former monies are "real", and the quantity and value depend on the working of markets; the latter are "fiat money", based on State declarations, and therefore subject to the whims and interests of inher- ently unreliable politicians. But perhaps these forms of money are not so distinct; perhaps fiat money also reflects the markets, and real money rests in part on the rules and policies of the State (Bell and Nell, 2003).

Financialization

Financialization is a term that has gained widespread usage in the critical economics lit- erature since the early 2000s, and especially in the aftermath of the 2008-09 global finan- cial crisis. However, the term lacks a clear, agreed-upon definition, and its precise use and form have been ambiguous. At a general level, it refers to the increase in the size, impor- tance and power of financial markets, transactions, institutions, motives and financial elites in the functioning of the economy in the post-1980 era. Some describe the finan- cialization process as a shift from productive activities to financial activities, while others emphasize the dominance of finance in general over economic activities (see Epstein, 2005). In this framework, financial activities include borrowing and lending activities as well as dealings in financial assets such as stocks, bonds, derivatives, futures, and other types of securities. These activities are distinguished from non-financial activities, which include the production and distribution of goods and the production and distribution of services that are not directly related to financial activities.

Fear of floating

The term "fear of floating" was first used by Calvo and Reinhart (2002). It refers to the fact that a country, having officially set a floating exchange-rate regime, uses its monetary policy instruments to smooth the exchange rate of its currency, thus avoiding the prob- lems of high variations of it in the foreign-exchange market. According to the authors, fear of floating has been a widespread phenomenon in the international monetary system since the 1970s, especially in emerging countries.

After the collapse of the Bretton Woods fixed exchange-rate regime, nations had to choose between the option of carrying on with exchange-rate fixity or moving towards a flexible exchange-rate regime. Several financial crises in the 1980s and 1990s spread the idea that soft peg regimes - that is, fixed exchange rates with some degree of varia- tion - were destabilizing for emerging countries, so they had to let their currency float in the foreign-exchange market. International Monetary Fund (IMF) statistics seemed to confirm the implementation of this guideline: few countries remained on a fixed exchange-rate regime, whereas the free-floating option became gradually preferred to that of intermediate regimes.

Fractional reserve banking

The expression "fractional reserve banking" describes a banking system where a par- ticular bank's liability, namely deposits, is used as means of payment. Deposits become means of payment when they are made transferable, either by cheque or by note, which is a cheque payable to the bearer without reference to the depositor against whose deposit it was originally issued. In this system we can distinguish two kinds of money: (i) legal money, issued by the central bank and held by both banks and non-bank agents as reserves, which are known as "narrow money", "high-powered money" or "monetary base"; and (ii) bank deposits, that is, bank money. The sum of these types of money is called "broad money".

Federal Open Market Committee

The Federal Open Market Committee (FOMC), the main monetary-policy-making body for the United States, has embodied since its creation a shifting balance of political, academic and operational concerns. The Federal Reserve Act of 1913 rested essentially on the so-called real-bills doctrine in its effort to create a sufficiently elastic monetary system for the nation. This vision entailed the creation of a liquid private market in acceptances. After the model of European central banks, the US Federal Reserve (Fed) would provide elasticity to this market through management of the discount rate for acceptances. By 1935, however, the power of the US Federal Reserve branches to affect economic and financial conditions through open-market operations had been proven, and the US Banking Act of that year confirmed the shift with the formal constitution of the FOMC.

After subsequent adjustments, the FOMC consists of the entire seven-member Board of Governors of the Federal Reserve System, along with five of the twelve US Federal Reserve Bank branch presidents. The Governors are appointed by the president to stag- gered 14-year terms, while the Fed presidents serve on the FOMC under a regional rota- tion structure (with weight toward New York above all, Chicago and Cleveland jointly second, and the other nine branches third), reflecting a complex political balance between central, regional, and local interests in the US banking system. Though this design sug- gests the representation of a diversity of views, in practice dissenting votes (though not infrequent) are rarely enough to upset the high level of consensus on the FOMC (Wynne, 2013).