Anatomy of the Bank Run

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This
article, from the September 1985 Free Market (that is, the
Age of Volcker), is also timely for the Age of Bernanke.

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.

Murray
N. Rothbard
(1926–1995) was the author of Man,
Economy, and State
, Conceived
in Liberty
, What
Has Government Done to Our Money
, For
a New Liberty
, The
Case Against the Fed
, and many
other books and articles
. He was
also the editor – with Lew Rockwell – of The
Rothbard-Rockwell Report
.

Murray
Rothbard Archives

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