Economics

Anatomy of the bank run

This article by Murray Rothbard was recently featured at Mises.org.  It originally appeared in the September, 1985 edition of The Free Market.

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.

4 comments to Anatomy of the bank run

  • There is another fraudulent element inherent to fractional reserve banking, not mentioned by Rothbard. It’s that banks, 1, accept money from creditors (depositors and bond holders), 2 promise to return the exact sum deposited (maybe plus interest and maybe less bank charges), and 3, invest or lend on that money in ways that are not 100% safe.

    Of course that strategy works nine years out of ten, but it’s stark staring obvious from a three minute examination of the history of banking that there are years when it doesn’t work. The solution is to outlaw the above promise. And that’s what full reserve banking does. That is, under full reserve, those who want their bank to lend their money on, get no guarantee of getting their money back: they effectively get a share in the above mentioned loans or investments.

    Re Rothbard’s claim that FDIC type insurance leads to “chronic and unlimited inflation.”, that’s a bit over the top. The FDIC was founded in 1933 and I wouldn’t describe the average inflation rate since then as “chronic and unlimited”.

    • Keith Goodenough

      With reference to Mr Musgrave’s “a bit over the top” comment, Rothbard was using the term ‘inflation’ correctly as applying only to the money supply, not the ‘inflation’ of a notional general price level as purportedly measured by the CPI and used as a term of art in discussions on television. The latter is almost meaningless in view of the almost infinite variety of goods available and their differing price fluctuations. I say “almost” because it is certain that the income in US dollars required for survival today is far greater numerically than that so required in 1933. With respect to the inflation of the money supply, that is, true inflation, Rothbard was also correct. Since 1933 it has been indeed chronic in the sense of being more or less continuous, and indeed unlimited. Even in the days when paper was necessary for printing money there was no discernible limit on the number of zeros that could be printed on it, as we no doubt shall shortly see while on this road to Zimbabwe via Argentina. Of course, electronic bookkeeping has now enabled, in addition, truly unlimited money creation. I am somewhat surprised that it should be necessary to provide this explanation on a Cobden Centre web page. There must be hundreds of charts on the web showing the growth of the money supply.

      Keith Goodenough

  • Paul Marks Paul Marks

    A very good post.

    I do not know what Ralph means by investments that are “100% safe” – there are no such things (certainly not government debt – which is often, falsely, described as “safe”).

    If someone wants their savings kept safe – they they should PAY THE BANK for looking after them.

    If people want INTEREST for their savings – then do not use the word “deposit” (see the book “Money, Bank Credit and Economic Cycles” on that) just tell the truth.

    You are LENDING THE BANK MONEY (your savings) which it, in turn, will LENT OUT.

    Neither you or the bank has the money – the borrowers have it, till when(and IF) they pay it back (with interest).

    Of course a bank’s balance sheet (“the books”) is not laid out like that.

    Indeed one could say that the paper work of a bank is designed to deceive.

    The CASH of a bank is like the capstone of an INVERTED pyramid – with a vast amount of debt (of smoke and mirrors, magic fairy dust from the castle in the air) sitting on it.

    • True: there is no such thing as 100% safety. I should have said “about 99%” safe.

      Re Paul’s point that bank balance sheets are designed to deceive, that is supported by p.16 of Robert Peston’s book, “How do we Fix This Mess?”. He said that the head of Lloyds told him that it would have gone bust in the 1980s if it had been “forced to tell shareholders and creditors how much of its lending to the region (South America) it would never get back”.