To understand that Wall Street crash a decade back, think of “It’s a Wonderful Life,” and the scene in the bank. Simply put, that’s what the Wall Street crash was, a bank run. It was also no more and no less than a bank run, even if we might want to color in a few of the details.
We have a system called fractional reserve banking. What this really means is, as Jimmy Stewart explains, that our deposits aren’t in the vaults of the bank, our savings and checking accounts are in the mortgage of the house down the road. If we all arrive demanding our money back at the same time then we can’t have it — it’s out there, not in the basement where they can go get it. It was wholesale depositors, not retail bank customers, who all arrived to get their money back from the Wall Street banks — which they couldn’t have, of course.
This is what nearly all of the support for the banks was from the Federal Reserve: Lending them enough cash so that they could pay it out to those depositors, who, once they knew they could have it, stopped worrying (yes, it gets more complex, but don’t worry about that) and the disaster was over. There’s nothing new or unusual about this, the risk we’ve known about for centuries, the solution was written down by Walter Bagehot in the 1850s.
A system of fractional reserve banking has this risk, it simply does. The reason we have this system, despite the risk, is that fractional reserve banking also does something else for us: It gives us maturity transformation. We can indeed go demand our money back any time we like. But the bank has lent it out on a 30-year mortgage. Our short term deposits have been turned into long-term loans — maturity transformation. The economist Brad Delong insists that banking is this borrowing short and lending long — if you do that, you’re a bank; if you don’t, you’re not.
The value of having that transformation, enabling people to be able to borrow for long-term investments, we think is high enough to put up with the risk of it all falling over once or twice a century. Hey, we may be right or wrong about that, but that’s what the rule of thumb is.
It’s worth noting that the banks nearly disappearing didn’t cause the recession. As the distinctly left wing Dean Baker — further left than Delong, who is merely a Democrat — has spent a decade rightly pointing out, falling house prices had knocked $7 trillion off household wealth. That was going to cause a recession whatever happened on Wall Street. Indeed, it was the underlying cause of that bank run.
Equally, there was and is nothing wrong with collateralized debt obligation, credit default swaps, syndicated loans, and all the rest. What was wrong was the banks holding onto a section of those syndicated loans, so that when the values fell, the bank run started. If end investors had owned everything, then we’d have had a recession (see Baker’s point) and no banks falling over. Dodd-Frank now insists that banks must hold onto a portion of their syndicated loans, go figure.
There are useful things that we’ve done, just and righteous things. Banks cannot leverage themselves up as much, borrow so much to invest, that is. They must hold more capital, the same thing said in a different way. It’s also true that we humans don’t do what just turned out to be so dangerous. We either find new ways to screw up, or wait until everyone who remembers that past mistake has retired before trying it again. Whatever errs on Wall Street isn’t going to be this specific thing for a few decades yet.
The risk of what happened is always going to be there in a fractional reserve banking system. We can ameliorate that risk, as we have done. We can set up systems to deal with it when it happens, that’s what the Federal Reserve is largely for these days. But that risk is simply there, built into the very fabric of the system itself. And as long as people want to borrow for longer than people want to save for, then we’re going to have to have that maturity transformed, thus we’re going to have to live with the risk.
That’s not really what anyone wants to hear. Too many think that there’s some method of having 30-year mortgages without this risk floating around the system. But, sorry, there ain’t. We can reduce the risks, but there will come the day when one or more banks fall over again. All we can do is minimize the pain when it happens.
Tim Worstall (@worstall) is a contributor to the Washington Examiner’s Beltway Confidential blog. He is a senior fellow at the Adam Smith Institute. You can read all his pieces at The Continental Telegraph.
