Trading Bank Runs for a Systemic Bank Failure

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 naïve 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 contracts.

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.

Politicians 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 bankers.

We 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.

April28, 2007

Gary 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.

Copyright © 2007