Y2K and the Banks

The Y2K computer bug isn't like a natural disaster or mass disease. It is a technical problem with a technical fix that can be overcome with work and time. However, and without speculating about the ultimate fallout from the problem, the bug has exposed a very real and deep infraction that has long plagued the U.S. banking system.

Thanks to long-ago government interventions that redefined a bank deposit as a loan, modern banks only hold a fraction of the demand deposits in people's cash accounts. The rest is used as the basis for extending and pyramiding loans. If too many depositors demand their cash at once, which is their right, it would trigger a bank run, which in turn would lead to the so-called contagion effect, and runs on other banks.

Under this scenario, since most banks these days are considered "too big to fail," the Fed would have to run the printing press full time or they would go belly-up immediately. The result would be a dramatic deflation followed by hyperinflation.

Banks genuinely fear that this will be the result of public nervousness over Y2K. In February, a Southern California office of GTE suggested that its customers hold a month's salary in cash during the transition to the new millennium. The banking industry went bonkers, denouncing GTE for breaking silence on the question and attempting to reassure the public that extra cash holdings were unnecessary.

The point is this: whether or not it is prudent to withdraw money from the bank, why should the suggestion alone be enough to drive the industry into paroxysms of fright? It is one thing to desire someone's business. It is quite another to regard the perfectly reasonable actions of your customers as a mortal and systemic threat to the well-being of society as a whole. To understand why takes us to the heart of the great secret of modern banking.

Under genuinely sound banking, in which the money you deposit at the bank is held for safekeeping while you draw down your funds as you see fit, it wouldn't matter at all how many people withdrew funds or when. The analogy here is the grain elevator which is used solely for storage. Every customer of the elevator is free to withdraw the full quantity of his grain at any time because the proprietor must keep 100-pereent reserves on penalty of fraud.

So it is under the gold standard, in which sound banking could be divided into two kinds. With deposit banking, you retain full title to your gold and only use the bank as a storage warehouse. Paper money was a ticket that acknowledged your ownership of the gold. The tickets were accepted because the bank was trusted. Free-market competition ensured that reputable banks would not fudge their holdings and loan out what did not belong to them; indeed, banks would hold 100 percent reserves. With loan banking, on the other hand, the depositor surrenders his right to withdraw his money at any time and instead transfers title to the bank itself, which is then free to extend loans and earn (and pay) interest on the money.

Under today's fiat money, fractional-reserve system, all banking is treated as loan banking, and, with some accounts, banks hold no reserves whatsoever. As Murray N. Rothbard frequently reminded us, under the old rules of accounting, all modern banks are technically bankrupt all the time.

The only factor that suppresses that fundamental reality is consumer confidence. Deposit insurance, an institution designed to shore up a bankrupt system, contributes to the sense of confidence. Even small depositors' actions, like withdrawing a bit more cash, undermine that confidence.

Despite the appearance of stability and soundness, then, the foundations of modern banking are actually extremely precarious. It would only take the right kind of crisis, or perceived crisis, to throw the entire system into chaos.

Bank runs and the threat of bank runs serve a heroic function in a free society. They spur banks on to be more careful in the conduct of their business. We need more, not fewer, of them. The right to withdraw one's funds from the bank is not only an essential part of freedom; it is a way of reminding banks that they are part of the matrix of voluntary exchange in a market economy, even if they do benefit from huge subsidies from the Federal Reserve.

FURTHER READING: Murray N. Rothbard, The Case Against the Fed (Auburn, Ala.: Mises Institute, 1996) and The Case for a 10O Percent GoIdDollar (Auburn, Ala.: Mises Institute, 1991).