23 February 2009

No, a bank run is not an argument for a mixed economy

Curtis Schweitzer wonders what I think about this story and presents an argument in favor of a mixed economy over a fully capitalist one. The story amounts to this:

On Thursday (Sept 18, at 11am) the Federal Reserve noticed a tremendous draw-down of money market accounts in the U.S. To the tune of $550 billion was being drawn out in the matter of an hour or two. The Treasury opened up its window to help and pumped a $105 billion in the system and quickly realized that they could not stem the tide. We were having an electronic run on the banks. They decided to close the operation, close down the money accounts and announce a guarantee of $250,000 per account so there wouldn't be further panic out there.

If they had not done that, their estimation is that by 2pm that afternoon, $5.5 trillion would have been drawn out of the money market system of the U.S., would have collapsed the entire economy of the U.S., and within 24 hours the world economy would have collapsed. It would have been the end of our economic system and our political system as we know it.
Well, what I think is this. It does present an argument in favor of a mixed economy as opposed to a "fully" capitalist one. But it does so only on the hypothesis that fully capitalist economies have no means of preventing, coping with or withstanding the effects of bank runs.

What a bank run is

A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent. (I here overlook the question of how depositors come to believe the bank is in danger of insolvency.) As the run progresses, it acquires a momentum of its own, in a kind of self-fulfilling prophecy. As more people withdraw their deposits, the likelihood of insolvency naturally increases, which encourages further withdrawals. This can destabilize the bank to the point where it, indeed, faces bankruptcy.

How we had this run

The run in question here, and which has Curtis's interest, began, or was noticed, with a draw-down of money market accounts in the U.S. to the extent of $550 billion being drawn of these accounts in the matter of an hour or two. We are not told in the video to which Curtis links, what proportion of total money market deposit accounts in represented by the $550 billion, so, to be quite technical, we really don't know that it was a crisis. Clearly the Federal Reserve thought it was a crisis; I suppose we can assume the Fed knew what proportion of total money market deposits was represented by the $550 billion. (I personally avoid making favorable assumptions about the Fed. I'm not a fan. But I digress.)

We are not told who was drawing out this money, or why. But it does have the ear-mark of a run: a sudden and apparently significant withdrawal of deposits. But the video clip here includes neither an explanation of how this draw-down signaled a danger, nor an explanation of what a money market deposit account is. (Never fear: I know what a money market account is. For our purposes let's just say it is a deposit account at a bank, and therefore the sort of account significant withdrawals from which would constitute a run.) Apparently the draw-down constituted a danger because, we are to believe, despite knowing neither the banks in danger or their financial solvency, the banks did not have the reserves to cover the funds being pulled from these money market accounts.

Nevertheless, the behavior of depositors does constitute a run, so in all fairness we'll grant that single proposition.

How banks become susceptible to runs

But how can this happen? If one deposits one's money in a bank, that money should be there when one wants to withdraw it. By logical extension, if five hundred people deposit money in a bank, then all that money should be there even if all five hundred depositors arrive to withdraw all of their deposits. How, then, do banks face risk of insolvency just by virtue of having all deposits withdrawn?

It's something like this. Most banks practice a type of banking called fractional-reserve banking. Under this type of operation, banks retain only a fraction of their demand deposits as cash. What is not retained as cash is invested in securities and loans. So, if all the people who bank where you do all got together with their passbooks and totaled up the amount you all have deposited, including money market, savings, checking accounts, and (what the heck) IRA's, that amount might come to, say, $100 million -- chump change. But, let's say, your bank has taken half of that amount (i.e., $50 million) and loaned out half of that (i.e., $25 million) and, with the other half (i.e., $25 million), it has purchased stocks, shares of mutual funds and so forth. Of the $100 million dollars you and your fellow-depositors have placed with the bank, there is only $50 million in the bank. You can easily see that there is no way the bank could handle a sudden withdrawal of all its deposits. On any day your bank could only cough up half of what has been deposited with it. So, no bank has enough reserves on hand to cope with more than a fraction of deposits being taken out at once. (This is one reason for those pesky charges you pay for early withdrawal on some of your accounts.)

How banks can protect themselves from runs

Banks can employ several techniques to prevent, or cope with, bank runs. Individual banks may, independently of the rest of the economy:

1. temporarily suspend withdrawals (unless stupidly prohibited by law), called suspension of convertibility (in many cases the mere threat of suspension can prevent a run, which means the threat need not be carried out at all);

2. impose upon themselves a reserve ratio requirement, the higher the better, which limits the proportion of deposits which are lent out, making it less likely for a bank run to start, as more reserves will be available to satisfy the demands of depositors;

3. practice full-reserve banking, in which case the reserve ratio is set to 100%, eliminating the risk of a run because maturities of deposits and loans will be matched, avoiding vulnerability to runs.

Collectively, banks may:

4. utilize a central bank as a lender of last resort, guaranteeing to make short-term loans to banks, to ensure that, if they remain economically viable, they will always have enough liquidity to honor their deposits;

5. employ deposit insurance systems to insure each depositor up to a certain amount, so that depositors' savings will be protected even if the bank fails, removing the incentive to withdraw one's deposits simply because others are withdrawing theirs (however, depositors may still be motivated by fears they will lack immediate access to deposits during a bank reorganization).

How this run was managed

In general this run was handled utilizing a combination of the aforementioned strategies, specifically, 1, 4, and 5. In this case the Treasury, with its "pumping" of $105 billion into the system and guarantee of $250,000 per account acted as lender (or loan shark) of last resort, rather than the Fed. One wonders how this maneuver demonstrates the superiority of a mixed economy over a fully capitalist one. We have to assume that a fully capitalist system would be without ability to engage a lender of last resort, or even, given free enterprise, a plethora of lenders of last resort. (No point looking to the Great Depression as demonstration of the inability of a fully capitalist economy to handle bank runs. Our mixed economy goes back to The Progressive Era which began in the 19th century. And, if not then, certainly with the creation of the Federal Reserve in 1913.)

So, our Lord and Savior Big Government, saved us all -- the whole world, in fact -- from world-wide economic collapse. Or, did it?

On the averted economic collapse

"If they had not done that, their estimation is that by 2pm that afternoon, $5.5 trillion would have been drawn out of the money market system of the U.S., would have collapsed the entire economy of the U.S., and within 24 hours the world economy would have collapsed. It would have been the end of our economic system and our political system as we know it.”

It isn't enough to tell us where money was pulled out of. Unless the people doing all of this withdrawing were stuffing the money in mattresses or holes in the dirt, then it was simply moving from one segment of the economy to another; it wasn't being pulled out of the economy simply by virtue of being pulled from money market deposit accounts. The Fed may have known that money was leaving these money market deposit accounts, but did not, ostensibly, seek to ascertain where the money was going when it left those accounts. It is possible that a great number of banks might have failed as a result of insufficient reserves to cover all those withdrawals. That is one of the costs of foolishness and poor risk assessment. But the economy isn't just the banks. And, contrary, to the Congressman's assertion, you can indeed have an economy without banks. It simply depends upon the nature of the banks in question. What you can't have, without the sort of banking system we have, especially with our fiat – or credit – money system, is just the sort of economy the Congressman undoubtedly wants: a mixed economy, which is a government-dominated economy. This mixed economy might have collapsed. But cooler heads could quite possibly have led a shift to a fully capitalist economy, which is a truly, and fully, free economy.

Conclusion

This argument in favor of a mixed economy rests upon the saving -- if it truly was that -- of a mixed economy. It's looks like a sound argument: "See," it asserts, "we need a mixed economy as evidenced by the ability of a mixed economy to save itself." But it begs the question: it assumes that a fully capitalist economy would not have its own methods. Frankly, the bankers in a fully capitalist economy would be more highly motivated to create systems for avoiding, or coping, with runs -- perhaps even 100% reserve banking. For one thing, without the government stealing, or just creating, money and credit out of thin air, their bearing of the entire burden of risk would make the risk assessments very highly conservative. Moreover, without the politically correct loan requirements imposed upon lenders, at gun-point, lenders would probably not be as over-extended as their government requires them to be. But, again, I digress.

This argument also fails as an argument for a mixed economy because we don't really know if the economy was saved, or was even in danger of collapse. Those two claims have certainly been made. But, of course, the government is going to make such claims: its power rests upon a mixed economy. Ever see the movie Dragonheart? Dennis Quiad, a dragon-slayer-for-hire, and Sean Connery, a dragon, form a partnership, and the two begin defrauding local villages with staged dragon-slayings. The dragon attacks a village, Quaid offers to kill him for a fee, and pretends to spear the dragon, who then falls into a nearby lake and swims out of sight underwater.

That’s the government in a mixed economy: causing problems left and right, with its demands for politically expedient, rather than economic, decisions, and then rushing in like that lunatic, Teddy Roosevelt, charging up San Juan Hill to save the day.

One final note about "fully" capitalist economy: When you hear people refer to credit as "the life-blood" of capitalism you know you don't live in a capitalist economy. The life-blood of capitalism is capital.

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James Frank SolĂ­s
Former soldier (USA). Graduate-level educated. Married 26 years. Texas ex-patriate. Ruling elder in the Presbyterian Church in America.
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