Anatomy Of The Bank Run
March 23rd, 2008
This is an excerpt from Chapter 78 & 79 of Murray Rothbard's "Making Economic Sense"
Bank Crisis!
There has been a veritable revolution in the attitude of the nation's economists, as well as the public, toward our banking system. Ever since 1933, it was a stern dogma--a virtual article of faith--among economic textbook authors, financial writers, and all establishment economists from Keynesians to Friedmanites, that our commercial banking system was super-safe. Because of the wise establishment of the Federal Deposit Insurance Corporation in 1933, that dread scourge--the bank run--was a thing of the reactionary past. Depositors are now safe because the FDIC "insures," that is, guarantees, all bank deposits. Those of us who kept warning that the banking system was inherently unsound and even insolvent were considered nuts and crackpots, not in tune with the new dispensation.
But since the collapse of the S&Ls, a catastrophe destined to cost the taxpayers between a half-trillion and a trillion-and-a-half dollars, this Pollyanna attitude has changed. It is true that by liquidating the Federal Savings and Loan Insurance Corporation into the FDIC, the Establishment has fallen back on the FDIC, its last line of defense, but the old assurance is gone. All the pundits and moguls are clearly whistling past the graveyard.
In 1985, however, the bank-run--supposedly consigned to bad memories and old movies on television--was back in force, replete with all the old phenomena: night-long lines waiting for the bank to open, mendacious assurances by the bank's directors that the bank was safe and everyone should go home, insistence by the public on getting their money out of the bank, and subsequent rapid collapse. As in 1932-33, the governors of the respective states closed down the banks to prevent them from having to pay their sworn debts.
The bank runs began with S&Ls in Ohio and then Maryland that were insured by private insurers. Runs returned again this January among Rhode Island credit unions that were "insured" by private firms. And a few days later, the Bank of New England, after announcing severe losses that rendered it insolvent, experienced massive bank runs up to billions of dollars, during which period Chairman Lawrence K. Fish rushed around to different branches falsely assuring customers that their money was safe. Finally, to save the bank the FDIC took it over and is in the highly expensive process of bailing it out.
A fascinating phenomenon appeared in these modern as well as the older bank runs: when one "unsound" bank was subjected to a fatal run, this had a domino effect on all the other banks in the area, so that they were brought low and annihilated by bank runs. As a befuddled Paul Samuelson, Mr. Establisment Economics, admitted to the Wall Street Journal after this recent bout, "I didn't think I'd live to see again the day when there are actually bank runs. And when good banks have runs on them because some unlucky and bad banks fail . . . . we're back in a time warp."
A time warp indeed: just as the fall of Communism in Eastern Europe has put us back to 1945 or even 1914, banks are once again at risk.
What is the reason for this crisis? We all know that the real estate collapse is bringing down the value of bank assets. But there is no "run" on real estate. Values simply fall, which is hardly the same thing as everyone failing and going insolvent. Even if bank loans are faulty and asset values come down, there is no need on that ground for all banks in a region to fail.
Put more pointedly, why does this domino process affect only banks, and not real estate, publishing, oil, or any other industry that may get into trouble? Why are what Samuelson and other economists call "good" banks so all-fired vulnerable, and then in what sense are they really "good"?
The answer is that the "bad" banks are vulnerable to the familiar charges: they made reckless loans, or they overinvested in Brazilian bonds, or their managers were crooks. In any case, their poor loans put their assets into shaky shape or made them actually insolvent. The "good" banks committed none of these sins; their loans were sensible. And yet, they too, can fall to a run almost as readily as the bad banks. Clearly, the "good" banks are in reality only slightly less unsound than the bad ones.
There therefore must be something about all banks--commercial, savings, S&L, and credit union--which make them inherently unsound. And that something is very simple although almost never mentioned: fractional-reserve banking. All these forms of banks issue deposits that are contractually redeemable at par upon the demand of the depositor. Only if all the deposits were backed 100% by cash at all times (or, what is the equivalent nowadays, by a demand deposit of the bank at the Fed which is redeemable in cash on demand) can the banks fulfill these contractual obligations.
Instead of this sound, noninflationary policy of 100% reserves, all of these banks are both allowed and encouraged by government policy to keep reserves that are only a fraction of their deposits, ranging from 10% for commercial banks to only a couple of percent for the other banking forms. This means that commercial banks inflate the money supply tenfold over their reserves a policy that results in our system of permanent inflation, periodic boom-bust cycles, and bank runs when the public begins to realize the inherent insolvency of the entire banking system.
That is why, unlike any other industry, the continued existence of the banking system rests so heavily on "public confidence," and why the Establishment feels it has to issue statements that it would have to admit privately were bald lies. It is also why economists and financial writers from all parts of the ideological spectrum rushed to say that the FDIC "had to" bail out all the depositors of the Bank of New England, not just those who were "insured" up to $100,000 per deposit account. The FDIC had to perform this bailout, everyone said, because "otherwise the financial system would collapse." That is, everyone would find out that the entire fractional-reserve system is held together by lies and smoke and mirrors, that is, by an Establishment con.
Once the public found out that their money is not in the banks, and that the FDIC has no money either, the banking system would quickly collapse. Indeed, even financial writers are worried since the FDIC has less than 0.7% of deposits they "insure," estimated soon be down to only 0.2% of deposits. Amusingly enough, the "safe" level is held to be 1.5%! The banking system, in short, is a house of cards, the FDIC as well as the banks themselves.
Many free-market advocates wonder: why is it that I am a champion of free markets, privatization, and deregulation everywhere else, but not in the banking system? The answer should now be clear: Banking is not a legitimate industry, providing legitimate service, so long as it continues to be a system of fractional-reserve banking: that is, the fraudulent making of contracts that it is impossible to honor.
Private deposit insurance--the proposal of the "free-banking" advocates--is patently absurd. Private deposit insurance agencies are the first to collapse, since everyone knows they haven't got the money. Besides, the "free bankers" don't answer the question why, if banking is as legitimate as every other industry, it needs this sort of "insurance"? What other industry tries to insure itself?.
The only reason the FDIC is still standing while the FSLIC and private insurance companies have collapsed, is because the people believe that, even though it technically doesn't have the money, if push came to shove, the Federal Reserve would simply print the cash and give it to the FDIC. The FDIC in turn would give it to the banks, not even burdening the taxpayer as the government has done in the recent bailouts. After all, isn't the FDIC backed by "full faith and credit" of the federal government, whatever that may mean?
Yes, the FDIC could, in the last analysis, print all the cash and give it to the banks, under cover of some emergency decree or statute. But . . . there's a hitch. If it does so, this means that all the trillion or so dollars of bank deposits would be turned into cash. The problem, however, is that if the cash is redeposited in the banks, their reserves would increase by that hypothetical trillion, and the banks could then multiply new money immediately by ten-to-twenty trillion, depending upon their reserve requirements. And that, of course, would be unbelievably inflationary, and would hurl us immediately into 1923 German-style hyper-inflation. And that is why no one in the Establishment wants to discuss this ultimate fail-safe solution. It is also why it would be far better to suffer a one-shot deflationary contraction of the fraudulent fractional-reserve banking system, and go back to a sound system of 100% reserves.
Anatomy Of The Bank Run
It was a scene familiar to any nostalgia buff: all-night lines waiting for the banks (first in Ohio, then in Maryland) to open; pompous but mendacious assurances by the bankers that all is well and that the people should go home; a stubborn insistence by depositors to get their money out; and the consequent closing of the banks by government, while at the same time the banks were permitted to stay in existence and collect the debts due them by their borrowers.
In other words, instead of government protecting private property and enforcing voluntary contracts, it deliberately violated the property of the depositors by barring them from retrieving their own money from the banks.
All this was, of course, a replay of the early 1930s: the last era of massive runs on banks. On the surface the weakness was the fact that the failed banks were insured by private or state deposit insurance agencies, whereas the banks that easily withstood the storm were insured by the federal government (FDIC for commercial banks; FSLIC for savings and loan banks).
But why? What is the magic elixir possessed by the federal government that neither private firms nor states can muster? The defenders of the private insurance agencies noted that they were technically in better financial shape than FSLIC or FDIC, since they had greater reserves per deposit dollar insured. How is it that private firms, so far superior to government in all other operations, should be so defective in this one area? Is there something unique about money that requires federal control?
The answer to this puzzle lies in the anguished statements of the savings and loan banks in Ohio and in Maryland, after the first of their number went under because of spectacularly unsound loans. "What a pity," they in effect complained, "that the failure of this one unsound bank should drag the sound banks down with them!"
But in what sense is a bank "sound" when one whisper of doom, one faltering of public confidence, should quickly bring the bank down? In what other industry does a mere rumor or hint of doubt swiftly bring down a mighty and seemingly solid firm? What is there about banking that public confidence should play such a decisive and overwhelmingly important role?
The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks (mutual-savings and savings-and-loan) have been systematically engaging in fractional-reserve banking: that is, they have far less cash on hand than there are demand claims to cash outstanding. For commercial banks, the reserve fraction is now about 10 percent; for the thrifts it is far less.
This means that the depositor who thinks he has $10,000 in a bank is misled; in a proportionate sense, there is only, say, $1,000 or less there. And yet, both the checking depositor and the savings depositor think that they can withdraw their money at any time on demand. Obviously, such a system, which is considered fraud when practiced by other businesses, rests on a confidence trick: that is, it can only work so long as the bulk of depositors do not catch on to the scare and try to get their money out. The confidence is essential, and also misguided. That is why once the public catches on, and bank runs begin, they are irresistible and cannot be stopped.
We now see why private enterprise works so badly in the deposit insurance business. For private enterprise only works in a business that is legitimate and useful, where needs are being fulfilled. It is impossible to "insure" a firm, even less so an industry, that is inherently insolvent. Fractional reserve banks, being inherently insolvent, are uninsurable.
What, then, is the magic potion of the federal government? Why does everyone trust the FDIC and FSLIC even though their reserve ratios are lower than private agencies, and though they too have only a very small fraction of total insured deposits in cash to stem any bank run? The answer is really quite simple: because everyone realizes, and realizes correctly, that only the federal government--and not the states or private firms--can print legal tender dollars. Everyone knows that, in case of a bank run, the U.S. Treasury would simply order the Fed to print enough cash to bail out any depositors who want it. The Fed has the unlimited power to print dollars, and it is this unlimited power to inflate that stands behind the current fractional reserve banking system.
Yes, the FDIC and FSLIC "work," but only because the unlimited monopoly power to print money can "work" to bail out any firm or person on earth. For it was precisely bank runs, as severe as they were that, before 1933, kept the banking system under check, and prevented any substantial amount of inflation.
But now bank runs--at least for the overwhelming majority of banks under federal deposit insurance--are over, and we have been paying and will continue to pay the horrendous price of saving the banks: chronic and unlimited inflation.
Putting an end to inflation requires not only the abolition of the Fed but also the abolition of the FDIC and FSLIC. At long last, banks would be treated like any firm in any other industry. In short, if they can't meet their contractual obligations they will be required to go under and liquidate. It would be instructive to see how many banks would survive if the massive governmental props were finally taken away.
Northern Rock Bank Run
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