Bank Runs & Deflation

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CaptainDan

CaptainDan

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If there was ever a perfect example of how bank runs can exacerbate deflation, the Great Depression was it. During no other time in American history did so much currency leave the banking system. To understand how and why this happened, we'll need to look at how banks function and a bit of history.

It's widely known that money that doesn't move, doesn't do society any favors. If money is stored in the banking system, at least the banks can use it to make loans. Money that's sitting under someone's pillow at home though - that's something different. Since it's not stored in the system, it can't be used for anything other than making purchases. And if it's not purchasing anything, well, it's just useless. Let me explain.

With fractional reserve banking, if a person deposits one dollar in their bank account, the bank considers the deposit a liability; it's got to eventually pay that dollar back to the person who deposited it. It doesn't matter if it's the same day or in ten years. It's considered a debt to the account holder. At the same time, however, after the bank creates the liability entry, it also creates an asset entry. Because of the rules of fractional reserve banking, the bank is allowed to lend out $9 for every $1 it takes in. So if I walked over to my bank and deposited $1,000, the bank would have the authority to loan out $9,000 immediately, based on my deposit.

This type of thing usually isn't a problem. During times of a well oiled and fully functional economy, banks can loan without hesitation or question. Because there are so many deposits and withdrawals every single day, the amount of money needed and loaned usually balances out. There are times when issues arise though. Let's look at what would happen if a bank run occurred.

Bank runs take place when bank depositors get nervous about their nation's currency. For whatever reason, people rush to their banks and make massive withdrawals. If enough customers do this in a short period of time, it can be catastrophic for the individual bank involved as well as the banking system overall. Why? Think about it. If $1 deposited can create $9 of currency in the form of loans, what happens when $1 is withdrawn? You got it, bank reserves need to be tapped to cover that amount of money. And if there are enough withdrawals and the reserves are used up, bank loans need to be liquidated. Back during the Great Depression and more specifically, in 1931, bank runs were overwhelming the banking system in the United States. So many people were withdrawing their money that a vicious cycle took place in the form of a currency collapse. Also, because so many people in the U.S. has deposited a good majority of money in their bank accounts, when it came time to run to the bank for withdrawal, much more came out than had ever before. It was almost as if all the trust banks had sold to the public ultimately became their undoing. During the Great Depression, bank failures were commonplace. In one month alone at its peak, over 350 banks in the United States failed. This number was on top of all the hundreds that had already and would eventually fail. The tragedy was, when a bank failed back then, depositors lost their money - for good. It was just gone. There was no federal insurance to protect anyone. So if a family had deposited 50 year's worth of earnings into a bank and that bank failed, that 50 year's worth of earnings evaporated. This was part of the reason so many folks rushed to pull out their deposits. They'd have to be stupid not to. And again, this type of behavior is what made the entire problem worse. A vicious cycle indeed.

So much money had flowed out of bank deposit accounts during the Great Depression that only a small fraction of it remained at the end. So, as they say, the more currency that flows through an economy, the more the level of inflation of the currency. The less currency, the less inflation. If the currency falls to rates that are low enough, deflation sets in. During the late 1920s and early 1930s, deflation had certainly set in. Things were not good at all.

It's often wondered why the Federal Reserve pumps so much currency into today's economy during times of recession or potential recession. It's exactly because of what has transpired in the past. While no one (normal) likes more national debt, to some, it's the only way to stave off a deflationary spiral. Have we had any instances of potential deflationary spirals in recent history? Think 2000, 2008, and 2020. If money hadn't been pumped into the system through many different arteries, times would be drastically different. The area of concern revolves around whether the medicine was worse than the disease though. What effect would all this additional debt and market intervention have? Only time will tell.

This post is part of a series: Guide to Investing in Gold & Silver by Michael Maloney
 
Bank Runs & Deflation was posted on 06-03-2021 by CaptainDan in the Economics Forum forum.

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