Thursday, March 22, 2012

Bank Failures and the Great Depression

We have a banking system called "fractional reserve banking." The amount of cash held by a given bank is its reserves. However, banks carry *less* money than the *total* amount of money they theoretically hold on behalf of their clients.

Suppose a bank has ten clients, each with a thousand dollars in their account. Suppose the bank only holds onto two thousand dollars cash at any given time, instead of the full ten thousand. Where is the rest of the money? Tied up in investments the bank has made. This is how banks make money (apart from fees), they use your money to invest. Investment drives the economy, it's why restaurants and stores are built, it's why factories are built, etc., because somebody somewhere invested the money.

Anyway, they only have two thousand bucks for these ten clients. This normally works fine, because it is quite rare for every client of a bank to withdraw all of their money. If each client only withdraws a hundred here or there, AND at the same time they are depositing their paychecks regularly, then everything is peachy. The bank always has enough cash to supply their customers with the withdrawals they want to make. The bank still would technically owe each person the full amount of their money *if* they asked for it, but how often does that happen? People tend to let their money sit in the bank, accruing interest (or it's just safer than keeping your cash under your mattress.

However, if all of this bank's ten clients wanted to withdraw all ten thousand of their bucks, the bank would be unable to pay them (unless it could borrow the cash from someplace else). It only has two thousand, cash. If they can borrow the eight thousand, then fine, everybody gets their money (though the bank has lost its customers and owes money, but that's another story).

But what if they can't borrow the eight thousand? Then they can either limit the amount each person can withdraw (which may be illegal, depends on the terms of the contract the customer has with the bank, etc.), OR they can just give the customers their money on a first-come, first-serve basis.

Let's say all ten customers are in line, they all want to withdraw their money. The first guy in line gets his thousand bucks. The second guy then gets his thousand bucks. The last eight people are simply out of luck, the bank that owes them each a thousand bucks has just gone out of business, it has no more cash (again, this is assuming the bank can't borrow the cash from somewhere else).

Now let's say that you just heard that the situation I just described has happened. "Boy," you think,"I hope I don't get screwed out of my money. I better get over to my bank and get all of my cash out of there ASAP before my bank goes out of business!" So you get over to the bank but a hundred other people had the same idea and your bank is already out of business (again, assuming they couldn't just borrow the money). All over the country, people panic and make a "run on banks," trying to be first in line to get their cash out.

The fractional reserve banking system wasn't meant to handle this, the banks have to be able to borrow the cash or else they go out of business and their customers watch their hard-earned cash disappear. Forever.

In recessions before the Great Depression, when a run on banks would happen, banks did whatever they needed to show customers that their money was safe. If they could *encourage* customers to *not* withdraw all of their money, then they were okay and they (the banks) wouldn't need to borrow. Banks would put stacks of cash in their front windows to show how sound they were. A combination of these tactics and the necessary borrowing will usually stop a run on banks before it explodes.

To talk about how this affects the Great Depression though, we need to talk about the Federal Reserve (aka "The Fed"), the quasi-governmental bank that acts as the lender of last resort. In the scenario I described above, I kept saying that there would be no problem if the banks could just borrow the cash they needed. The first thing they'll try is borrowing from another bank, usually not the Fed.

However, during the run-up to the Great Depression, and *during* the Great Depression, the Fed made a series of major, MAJOR blunders. In fact, it was the Federal Reserve, not some stock market crash, which created the Great Depression. An economist named Milton Friedman won the Nobel Prize in Economics for demonstrating this empirically, and the current head of the Federal Reserve readily admits that the Fed was the fault of the Great Depression.

One of their big mistakes was to *not* lend money to the banks that needed it. Their (idiotic) view was "let these banks go out of business, it will get rid of incompetent bank managers." Unfortunately what happened is what something with ten minutes basic background in fractional reserve banking could have predicted: a major run on banks exploded all over the country. Banks failed all over the place, cash just disappeared from the economy, and major deflation followed. It was part of what they call "The Great Contraction," when the US money supply shrunk by a full third, and it was entirely due to the moves the Fed had made both before and during the Great Depression. The "stock market crash" was merely a symptom of the problem the Fed had created with loose monetary policy, and had the Fed not continued making bad moves, it would have been a normal recession, rather than a Great Depression.