Loss of savings, not size of national debt, causes bank panic and collapse

 

by Alfred Adask

 

As I understand it, in the US, the fractional reserve ratio is about 10:1 meaning that out of every ten dollars deposited into bank accounts, the bank holds one dollar in "reserve" in its vault to hand back to depositors and lends the other nine to borrowers.

 

The advantage of and even necessity for "fractional reserve banking" is that it prevents currency from being hoarded in banks, removed from the circulation, and thereby shrinking the money supply needed to keep the economy growing.  I.e., if I deposited $10,000 in my bank account and the bank kept the entire $10,000 in my account, the entire $10,000 would be withdrawn from the economy.  There'd be no borrowing or spending of any part of the $10,000.  The economy would tend to slow.  If you deposited $10,000 and the bank held the entire $10,000 in its vault, the economy would slow further.  If enough people deposited their savings into the banks and the banks retained all that was deposited, the economy might slip into a depression.

 

However, under fractional reserve banking, if I deposit $10,000 into the bank, the bank holds $1,000 in its vault and lends the other $9,000 to qualified borrowers.  Result?  90% of my savings continues to circulate in, and stimulate, the economy.  The economy tends to grow, expand and create a higher standard of living for all.

 

*  The danger in fractional reserve banking is that if an emergency arises when only 10% of the deposits are actually kept in the bank vault.  Therefore, if more than 10% of bank depositors want to simultaneously withdraw all of their deposits from their bank accounts, then there'll be a "bank run".

 

If enough depositors join the bank run, the bank will be unable to provide the funds owed to depositors since 90% of their deposits have been loaned out to others.  Once the bank is shown to be unable to meet the depositors' demands, the bank will be deemed to be insolvent and may be closed.  The remaining funds due depositors may be lost or at least rendered inaccessible for days, weeks or months. 

 

Although depositors might later be able to regain their deposits, during the bank run, 90% of depositors will be unable to access any of their savings.  During such an emergency, many people will lose jobs or access to government welfare, pension and subsidy programs.  Without access to their savings, bank customers may have no money to buy groceries, pay their mortgages, or get to work.  They'll tend to panic.  The economy will tend to collapse.

 

In a modern economy, fractional reserve banking is both necessary to stimulate an economy but also dangerous in that it could contribute to an economic collapse.  If an emergency causes all of a nation's depositors all try to withdraw their funds at once, they won't be able to access their funds.  They'll tend to panic, throw things, riot, set fires and shoot.

*  I don't know what the fractional reserve ratio is in Greece, but I've heard that some European countries run ratios of 23:1. I.e., out of every 23 euros deposited in some banks, the banks only retain 1 euro in the vault.  That means that if just 4.5% of the European bank depositors demand to withdraw their deposits at the same time, the resulting bank run could close the banks.

 

If the US fractional reserve ratio is 10:1, a catastrophic bank run would, on average, require 10% of bank depositors to demand funds at the same time.

 

If the Greek fractional reserve ratio were 23:1, a catastrophic bank run could result if, on average, just 4.5% of bank depositors demanded their funds at the same time.

 

Higher fractional reserve ratios (like 23:1) offer more "stimulation" to economies, but also make banks and even national financial systems more vulnerable to panic and collapse.

 

*  The threat of bank runs and "panic" is inherent in, and created by, fractional reserve banking.  I doubt that there's another fundamental cause for bank panics and financial collapse besides fractional reserve banking.

 

Therefore, bankers must be extremely prudent and responsible in their management of fractional reserve banking.  If they're not, any miscalculation could cause a depositor panic, bank insolvency, and even economic collapse.

 

Likewise, governments must be extremely prudent and responsible in their handling of national funds, revenue and debt.  If a government behaves irresponsibly and mismanages the economy (perhaps by going too deeply into debt), the public can lose confidence in the banking system and try to withdraw all of their funds from their bank accounts.  Again, under fractional reserve banking, only part of their deposits will be available for withdrawal.  Unable to withdraw all of their savings, depositors will tend to panic and push the entire economy towards depression and collapse.

 

*  As I begin to contemplate the relationship of fractional reserve banking to savings and possible bank runs and panics, I begin to see that, more than the Greek government's debt, the solvency Greek banks may be the real lynch pin in determining whether Greece has a "problem" or Greece faces a catastrophe.  

 

Why?  Because Greek banks hold Greek people's savings.   If enough Greek depositors demanded their funds from banks, the banks may be shown to be insolvent, forced to close, and thereby precipitate panic, riots, civil unrest, and even government overthrow.

 

From a psychological perspective, I'm beginning to suspect that it's not the size of the government's nationaldebt, per se, that can precipitate a bank run and economic collapse.  

 

Look at the true size of the national debt of the US government.  Some say it's not merely $18 trillion.  Some say it's really over $200 trillion.  Does anyone care?  Is anyone prone to panic because the national debt is over $200 trillion?  

 

No.  We are largely indifferent to the size of the government's debt.  If the national debt doubled to $400 trillion some economic gurus would scream like Cassandra but the vast majority of Americans wouldn't hear or care. 

 

*  However, we will panic in a heartbeat if we find out that someone has stolen, disposed of or restricted our access to our savings.

 

I don't care if I'm in debt for $1 billion or $100 billion.  But if you screw with my savings, I just might blow your head off.  I suspect that most people think the same way.  It's not the size of the national debt that will trigger a bank run and panic.  It's the loss of personal savings.

 

If so, that's why operation of the banks is so critical.  That's where most of us keep our savings.  If the banks fail and we lose our savings, we'll instantly go postal.  Dr. Depositor and Mr. Hyde.  Screw the damn toasters!  I want my money! (Savings)

 

This hypothesis could explain why most of the money dispersed under Quantitative Easing was given to banks rather than consumers.  The Federal Reserve may have known and believed that if the banks didn't have enough money in their vaults to deal with a possible bank run, the depositors would panic and go wild.  Perhaps that's why the Fed gave hundreds of billions of dollars to the banks rather than consumers.  Arguably, the Fed realized that the stability of the banking system is far more psychologically important than questions of national or even private debt.

 

In a world where most people are debtors, government could wipe out the existing debt and only a few people (creditors) would be upset.  The masses wouldn't riot if their debts were rendered void.  They'd cheer the politicians who wiped out the debts.  The creditors (primarily the rich and the elderly) would be too disciplined and few in number to riot.

 

Thus, we can eliminated the people's debt without causing an immediate panic.  But if we eliminate their savings, there may be Hell to pay.

 

*  Similarly, the potential chaos that could follow from the loss of savings in Greek banks may explain why the IMF and ECB wanted to provide more "emergency funds" to Greek banks even after it seemed that an agreement between the Greek government and its creditors would not happen.  The IMF and ECB were probably trying to increase the money supply in Greek vaults from 1 euro out of 23 deposited to 1 euro out of 10 or even 1 in 5. 

 

With more money in their vaults, the Greek banks would be less likely to be rendered insolvent by panicky Greek depositors.  By lending more currency to Greek banks (rather than the Greek government), bank runs would be less likely to prove the banks to be insolvent, less likely to destroy Greek depositors' savings, less likely to leave the Greek people penniless, and less likely to cause infuriated Greeks to riot.

 

*  The same might also have been said for Greek currency controls that prevented Greek depositors from withdrawing all of their savings at one time and restricted withdrawals to, say, €60 per day.  Fractional reserve bankers can't give depositors all of their savings.  But they do have to release some of the depositors' savings.  It's a dangerous game.  If the bankers miscalculate however much they give the bank depositors each day, the depositors might still riot and hang the bankers.  However, so long as bankers calculate correctly, they might give depositors enough each day to maintain the depositors' confidence that their savings are still intact-even though those savings are not entirely and immediately accessible

 

Likewise, closing the banks for several days or even weeks might help prevent the ruinous bank-run panics.   If the banks aren't open, there can't be a bank run.  Without a bank run, there can't be absolute evidence that the bank is insolvent and the depositors' savings are gone.

 

So long as the bank remains closed, the depositors can have hope, faith and/or confidence that, as soon as the banks reopen, the depositors will regain access to all of their savings.   So long as the depositors have some hope, faith and confidence that the bank is not insolvent, and they'll (eventually) be able to withdraw all of their savings, they'll be less likely to riot, firebomb the banks and start shooting government officers and employees.

 

There's no point to burning a bank to the ground while the bank still holds your savings.  It's only after it's been proved that the bank has lost your savings that depositors will be start to Google "How to make a Molotov Cocktail". 

 

Thus, if it ever becomes clear that bank depositors' savings are gone, the banks had better have good fire and life insurance policies because the emotional consequences of lost savings will be explosive.

 

The national debt, no matter how enormous, is only an interesting mathematical number.  That size of that debt does not inspire the emotions of panic and rage to same degree as the loss of savings.

 

*  Despite all of the tricks the banks might use to assure their depositors that their savings are intact, the fact may still remain that the debts (savings) due to depositors can't be repaid in full.  As Dmitry Orlov recently wrote in his article, "The Care and Feeding of a Financial Black Hole":

 

"anyone who knows mathematics can see that the United States is on the verge of collapse because its debt has gone exponential."

 

Mr. Orlov's statement was absolutely right, but his emphasis may have been wrong.  Even though debt and savings are mostly two sides of the same coin, panic is primarily based on loss of savings rather than the exponential, mathematical growth in the debt.

 

Very few care about the debt, but everyone cares about his savings.  A bum will kill you if you try to snatch his fifty cents.  A billionaire will kill you if you try to take his $100,000.  We just don't care about our debts, but we are fanatical about our savings.

 

*  It's true that, sooner or later, the mathematics of the US national debt will overpower politics.  Sooner or later, Greece, the US and the world will learn that we're so deeply indebted that the vast majority of the debts (including the savings owed by bankers to depositors) will have to be repudiated.  When the debts can't be paid, the correlative paper savings (bonds, pension funds, bank accounts, etc.) will also disappear.

 

When the people of Greece, the US or the world understand that their paper debt-instruments--their savings kept in the form of bonds, stocks, bank deposits, pension funds, etc.--are virtually worthless, that's when the panic, rage, riots, fires, shootings and chaos will begin.

 

Mr. Orlov's statement that "anyone who knows mathematics can see that the United States is on the verge of collapse because its debt has gone exponential," might've been more accurate if he'd written,

 

"Anyone who knows psychology can see that the United States is on the verge of collapse because its savings are about to go infinitesimal."

 

*  For the past five years, my principle focus in economics has been the magnitude of the national debt.  I'm beginning to think that I might better understand the economy if I studied it from the perspective of lost savings rather than growth of debt.

 

I'm beginning to see that while the mathematics and magnitude of the debt can tell us that some sort of economic collapse will inevitably happen, a thorough understanding of the correlative nature of savings and associated emotions may tell us when the collapse will take place.

 

This is a new hypothesis for me, but it's not new to the powers that be.  The federal government and Federal Reserve are constantly trying to shore up "public confidence".  They say that "confidence" is in the "economy," but I'm beginning to see that the most important measure of public confidence is in the security of the public's savings.

 

What is "confidence" besides a state of calm that is largely an absence of emotion?  Are you prone to panic so long as you remain "confident"?  Are you inclined to participate in a bank run so long as you're confident that your savings are secure?  I don't think so.

 

The "confidence" that the government and Federal Reserve want to preserve is confidence in your savings.

 

But, given that 90% of your savings have been loaned out to others, is your confidence in being able to access all of your bank savings ever truly justified?  No.

 

In fact, your confidence in your savings and in your bank is actually a confidence that your neighbors won't all try to withdraw all of their savings at the same time. 

 

Which brings us to government.  If government so mismanages the economy that the people all try to withdraw their savings from their bank accounts at the same time, we'll have a bank run, and then panic and economic collapse when people learn the truth-the banks don't hold more than 10% of "your" savings in the bank at any time.  Under the guise of fractional reserve banking, the banks are gambling with 90% of our savings.  That 90% isn't in the bank vault. 

 

It may be that the only thing that holds our financial system together is the false confidence that all of the savings we've deposited into the banks is available to be withdrawn at any moment.  100% of your savings isn't really in the bank.  90% has been loaned out.  Nevertheless, we have "confidence" that the 100% is in the bank and available for withdrawal. 

 

You can see why government would be dedicated to maintaining that false confidence.  Without that false confidence in the banks, the whole system can go belly up.   

 

*  Note that our "savings" are not confined to banks. Some save in bonds, some save in stocks, some save in their house mortgages, pension funds and So-So Security.  If my hypothesis (that the gov-co is determined to maintain public's confidence in their savings) is correct, then it would follow that the Fed and feds would do everything they can support public confidence in not only banks, but also the institutions of mortgages, bonds, stocks, pensions and So-So Security.

 

In A.D. 2007-2008, the public lost confidence in their savings in their homes.  That loss of confidence reportedly came within hours of collapsing the entire economy.

 

The gov-co also tried to maintain confidence in our major banks (and our savings) by declaring some of them to be "too big to fail" and giving them billions-presumably to withstand possible bank runs and avoid a resulting panic.

 

It's a commonly-held opinion that the prices on our stock, bond and commodities markets (where many of us save our wealth) are being manipulated and artificially supported by government and the Fed.

 

For me, these instances of government manipulation of our various financial institutions make more sense when viewed as evidence of government's determination to maintain public confidence in their paper savings vehicles.

 

I'm not saying that we should ignore debt and concentrate exclusively on understanding savings. I am saying that it's a matter of emphasis and completeness.  To study debt without reference to savings is incomplete.  To study the mathematics of debt without also studying the emotional power of savings may be likewise incomplete.

 

From now on, I'll try to perceive economics through the emotional microscope of savings rather than only through the mathematical telescope of debt.