Trading Bank Runs for a Systemic Bank Failure

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The greatest
threat to bankers in the past has been the threat of the bank run
by their depositors. They take deposits from the public. They promise
all depositors that at any time, each depositor may come in and
demand currency. Prior to 1933, this currency could be either gold
or silver coins, as well as paper money. President Roosevelt unilaterally
abolished the right of American citizens to own gold coins. That
reduced part of the threat of bank runs, though not the major one.
Gold coins were no longer in widespread use anywhere in 1933.

The threat
still existed that depositors would demand currency. This was as
great a threat to the commercial banks in 1933 as the threat of
very rich people’s threat of demanding gold had been for the U.S.
government. The right of withdrawal of funds meant that depositors
had a powerful hammer to use against banks that had made bad loans.
Over 6,000 banks — all of them rural or small town — failed from
1930 to 1932. The public still held the hammer.

With the establishment
of the Federal Deposit Insurance Corporation (FDIC) and the Federal
Savings & Loan Insurance Corporation (FSLIC), both of which
are privately owned, but which have the implicit backing of the
U.S. government, the threat of a bank run against the entire banking
system was drastically lowered. Depositors believed themselves to
be secure from bank failures. The fear of a bank failure disappeared.

Then, in the
1960’s, the spread of credit cards to the general public changed
people’s attitudes toward holding currency. Master Card and Visa
mailed out cards to almost every consumer. Anyone could sign up.
There were subsequent losses when bad credit risks got cards and
overused them, and then defaulted, but the low initial marketing
costs of universal access to the cards were so low that the defaults
did not hurt the banks. Within a decade, the use of credit cards
by Americans was close to universal.

This eliminated
the last remaining threat to fractional reserve banks in America.
Ever since 1933, the public could not legally demand gold. Ever
since the 1930’s, the public lost its fear of individual banks failures.
Ever since the mid-1960’s, the public could not longer demand silver
coins in exchange for checks or currency. The public did not care,
so few people ever used silver coins.

Finally, Nixon’s
unilateral abandonment of the gold exchange standard in 1971 ended
the right of foreign governments and central banks to demand gold
bullion from the U.S. Treasury. This ended the last remaining threat
to the Federal Reserve System from depositors.

Defenders of
the traditional (government-guaranteed) gold standard are limited
to a tiny remnant of investors, most of whom lost most of their
investment, 1980—2001. Gold’s price fell from $840 (for one
day) in January, 1980, to $256 in 2001. This horrendous loss was
multiplied by two by the halving of the dollar’s purchasing power.
So, the remnant of gold bugs today are late-comers who bought gold
in 2003 or later. They know nothing about monetary theory. They
know nothing about traditional gold standard theory. They did not
suffer the losses suffered by defenders of the gold standard — very,
very few authors — who were writing prior to 1975, when gold ownership
was still illegal.

The academic
economists today are even worse. They reject the entire concept
of the traditional gold standard. They almost universally accept
the idea that a central bank is a good thing, and a privately owned
one is even better than a government-owned one.

This idea also
dominates the thinking of American historians. The only exceptions
are historians with training in Austrian economic theory. None of
them has written a high school or college textbook on American history.
(I am working on a high school textbook, which I hope will be in
print sometime in the next 12 months.)

So, it is today
nave to make the case that a threat of bank runs by depositors
in any way affects the commercial banking system.


There is a
threat to this system, but it is not the threat of bank runs. The
threat today is from the banks themselves. This is the threat of
a failure of the interbank payments system. If bank A cannot repay
bank B until bank C pays bank A, and bank C cannot pay bank A until
bank D pays bank C, the system is at risk. The failure would spread
to every bank on earth within a week — maybe less. Instead of the
threat of a few insolvent banks, the threat is now universal: a
systemic breakdown of the entire international banking system.

The magnitude
of this threat is incalculable. Without digital money, the world’s
economy would shut down overnight. It would be comparable to a nuclear
war. As one small example, if truckers could not fill their tanks,
they could not deliver the goods. But without credit cards, they
could not fill their tanks. So, everything we buy at a supermarket,
gas station, or company that sells goods would cease operating within
a day or two. They could not reopen.

What would
you do personally if you could not buy with a plastic card?

You could not
get money from an ATM. Your debit card would not work. Even if it
did work, what good would currency do you? No company could stay
open based on sales by currency. Even if it could, it could not
get re-supplied with goods.

How would you
get to work without gasoline? How would you mow your lawn?

Lights and
water would be available for a while. The government would keep
such services available. But soon the coal shipments would cease
to the power companies. Government controls would then have to direct
everything. The division of labor would contract. Bureaucracy would
run everything that ran. But how, if there were no digital money?
The capital markets would cease to operate.

Short of nuclear
war, this is the great threat to the modern world.


With the exception
of what I have written over the years, have you ever read a detailed
discussion of what would happen if what Alan Greenspan called cascading
cross-defaults ever occurred?

What I mean
by detailed is this: a description of the effects of a failure of
banks to clear accounts from each other. I have never seen anyone
else discuss this. I have been waiting for over forty years.

Adam Smith
in 1776 announced an observation which has become regarded as an
economic law: "The division of labor is limited by the extent
of the market." If the market shrinks, the division of labor

That is what
happened, worldwide, in 1930 to 1939. That event is called the Great
Depression. It resulted from (1) a hike in sales taxes on imported
goods (tariffs), (2) a contraction of the money supply due to bank
runs and bank failures (deflation), (3) laws making price competition
illegal (price floors), and (4) laws restricting capital investing
(the Securities & Exchange Commission and its state imitators).

The complete
failure of the interbank payments system for as long as a month
would be so catastrophic that it is not publicly discussed. This
is because, in a world with some $350 trillion in derivatives, yet
a world lulled to sleep by the government-guaranteed promise of
central bank intervention to keep the payments system solvent, there
is no known solution to the problem.

The problem
is politically unthinkable. It is therefore not thought about. The
problem is conceptually beyond the power of anyone to comprehend,
let alone solve. It is the problem of trillions of transactions
in the past and billions of them daily, all interlinked by the fractional
reserve banking system.

We all assume
by necessity today that the mixture of unregulated free markets
and government-licensed central banks and fractionally reserved
commercial banks is sufficient to keep a worst-case scenario from
happening. There is no logical way to prove that the system is safe.
There is no logical way to prove that it is inevitably going to
fail. All such speculation — in both senses — is a matter of highly
complex events that cannot be forecasted with precision.

We know this:
unpredictable events are more common than scientists thought as
recently as a decade ago. For example, almost all oceanographers
denied the possibility of hundred-foot killer waves that sailors
had talked about for centuries. But then, on January 1, 1995, an
off-shore North Sea oil drilling rig was hit by one, and there was
a laser record of this. Today, these waves are monitored by satellites.
They are numerous. Yet their existence was denied by the experts
prior to 1995.

The mathematics
of these waves are known. The math looks like the mathematics of
quantum theory — the statistical wave functions governing the subatomic
realm, which is not subject solely to Newtonian cause and effect.
The mathematics is non-linear. Huge effects seem to result from
causes that are small. The physical causes of these freak waves
are not known. There is no defense against them on the high seas.

These killer
waves do not threaten the shoreline, or so the experts think. They
do not cause chain reactions, or so the experts think.

We hope that
interbank payments failures will be like killer waves. We think:
"They are a disaster if your hedge fund has invested the wrong
way, but the derivatives system, like the ocean, has built-in checks
and balances that isolate such failures and contain them."
But we do not know this; we merely believe it and act as though
it is true. What else can we do?

If the derivatives
network had been built on a free banking system in which governments
had not promised universal protection against depositor-driven bank
runs, I would feel more confident about the derivatives system.
But this system has not evolved within a system of free banking
in a world in which governments force all fractional reserve banks
to honor contracts with their depositors. On the contrary, governments
have always retroactively legitimized the right of the fractional
reserve banking system to violate these contracts in times of bank
runs. This policy has become universal ever since 1939.


A central fact
of life is that risk and uncertainty are inescapable. Risk can be
dealt with through insurance. Uncertainty cannot be dealt with by
insurance. Its events are not part of any known statistical pattern.
The only protection here is from entrepreneurship: men’s quest for
profits in a world of uncertainty.

The problem
comes when politicians and bureaucrats pretend that they can reduce
uncertainty by treating it as if it were risk and therefore subject
to the law of large numbers. They assume that coercive government
policies can be imposed that transform uncertainty into risk, and
risk into insurable contracts. Government officials believe that
by using coercion to contain the politically negative effects of
uncertainty — systemic losses and even breakdown — they thereby
reduce uncertainty.

Austrian economic
theory tells us that this assumption is an error. These coercive
interventions into the capital markets do not reduce uncertainty.
On the contrary, they increase it. Their existence lures entrepreneurs
into making contracts based on a false assumption, namely, that
the government stands ready and able to overcome negative systemic
effects of the capital markets in allocating risk and also limiting
the effects of uncertainty. Entrepreneurs at the margin would not
make these contracts if they did not believe the assumption of government
competence in mitigating the effects of risk and uncertainty.

and voters have long believed that governments can and should intervene
to overcome the effects of systemic risk and uncertainty. Keynesian
economics is built on this assumption. So is monetarism with respect
to central banking. So is supply-side economics. Like oceanographers
in 1994, they all assure the public that tales of killer waves are
entirely mythical, that no such phenomena exist. So far, so good.


We live in
a financial world that is built on a mistake whenever it isn’t an
outright lie. This mistake is easy to state: "The government
can protect the public from the effects of prior government intervention
to thwart the right of voluntary contract." We have accepted
and encouraged the blessings of the division of labor. We have placed
our lives in the hands of entrepreneurs who allocate capital on
our behalf. Without the money-based, bank-based division of labor,
most of us would never have been born.

Without the
division of labor, we are dead men sitting. (Not many of us stand
for a living any more.) Yet the division of labor rests on digital
money, and this money has been created in terms of a false assumption:
the reliability of central bankers to overcome system-disrupting
deviations from the laws of probability. The experts have said,
in effect, that killer waves do not exist any more, and even if
they did, they would not be connected, that they would have no negative
systemic consequences that cannot be solved in a few hours by central

wish. We hope. We may even pray.

The day the
interbank payments system fails, your silver coins and gold coins
will not be worth much. Don’t put faith in them. They will not buy
what you will want when the trucks cease to roll. They are not money
today, and they will not be until after the economy shifts to something
to replace digital promises to pay.

28, 2007

North [send him mail] is the
author of Mises
on Money
. Visit
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible

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