Financial Panics and Bank Runs Before Deposit Insurance
Although state banks served the needs of many Americans, they were unit banks serving local communities. Although their banknotes served as a convenient form of money, the value of those banknotes depended on the reputation and integrity of the bank and on the distance from the bank, since the banknotes were mainly redeemable by the banks that issued the notes. Most people obviously did not want to travel long distances, especially in those days, to redeem the banknotes, although note brokers provided a useful service by buying the banknotes at a discount, then presenting the accumulated banknotes to the issuing bank for redemption in specie. The First Bank of the United States also redeemed the notes of state-chartered banks.
The redemption feature was necessary because otherwise no one would accept the banknotes for money. If a bank failed to redeem any of its notes, word would soon spread, causing a run on the bank where depositors would pull out their money while the bank still had silver or gold, for when it ran out, its banknotes would become worthless and the holders of these banknotes would lose their money. This would contract the local money supply, causing unemployment and business failures.
What limited the effect of a bank failure was that almost all banks were unit banks, with no branches; hence, there was no economy of scale that would give any single bank an advantage over others, and since banks were so profitable, they had a lot of competition. A bank's influence was also limited because its notes became less valuable with distance, since people outside of the bank's area would be less familiar with it, and have less faith in its notes, and, in any case, would have to travel to redeem them. So if a bank failed, there were other banks in the area that also issued banknotes, which prevented a total collapse of the local economy. Having at least several banks in an area may not have been efficient, but it was safer than having only one.
Without adequate banking regulations, banks started issuing more banknotes than what they actually had specie for. So bank owners not only leveraged their capital by loaning out money that had been deposited, but they increased their leverage enormously by lending out money that they created! Needless to say, this increased the number of banks and greatly increased the money supply, which fueled speculations in land, eventually causing panics and depressions.
Before the advent of deposit insurance in 1933, the United States had experienced many booms and busts that were largely created by banks. Financial panics often accompanied or followed busts, resulting in bank runs that worsened the economy. While the details of these financial panics differed with each incident, the fundamental problems that gave rise to them are few and easy to understand.
The history of banking can best be viewed as a series of changes in business practices, technology, and regulations, for these factors determine the overall structure of banking and banking services.
Before the 16th century, banking consisted mostly of holding deposits or valuables, and making loans. In Greece and Rome, religious temples served as banks, because they often had treasuries and held valuable items for its members. They could also make loans to people that they knew, which solved the problem of the informational asymmetry between lenders and borrowers. Moneychangers in 14th century Italy exchanged foreign currency for domestic currency for Italian traders. However, it is the evolution of banks and banking beginning in the 16th century that best illuminates how banks work today.
The 1st and foremost technology that allowed the beginnings of modern banking is the printing press, which allowed many copies of an identically printed paper to be made in exquisite detail — an absolute necessity for printing currency or receipts that could be exchanged for commodity money, such as gold; otherwise counterfeit money would destroy the value of paper currency or receipts, which would have limited the supply of money and prevented that very modern banking practice—fractional reserve banking.
Gold, Goldsmiths, Fractional Reserve Banking
In the 16th century, the goldsmiths of London began the practice of holding the gold of depositors and issuing receipts for the gold. The receipts started to be used as currency because people accepted them as a means of payment since they could be traded for the gold held by the goldsmith. Then goldsmiths started making loans with the receipts, and in the 17th century, after realizing that only a small number of people traded their receipts for gold at any one time, started making more loans than what they had in gold, the beginning of fractional reserve banking—lending out more money than what is actually held at the lender's premises. Eureka! Goldsmiths discovered that they could create money!
Fractional reserve banking increases profits but also increases risks. For if any goldsmith fails to redeem its receipts in gold, word will spread causing those receipts to lose value as money, and every receipt holder will run to the goldsmith, trying to redeem them.
People put their money in the bank to keep it safe and to provide payment services. However, no one would put their money in the bank if they could not withdraw it on demand. However, since only a small fraction of a bank's total reserves were needed for withdrawals most of the time, banks could also practice fractional reserve banking, lending out more money than what it possessed to earn income.
However, if the bank's customers had any doubt about its financial stability, they would run to the bank to better their chances of being able to withdraw their money—otherwise they would lose it. They would run because banks had a first-come, first-serve policy. The bank would allow depositors to withdraw their money until the bank ran out of funds. After that, the bank would close, causing everyone else to lose their money.
Naturally, people are greatly concerned about the safety of their funds, and, furthermore, they had no way to determine whether a bank is financially sound or not, so if they thought that a bank failure was due to general economic conditions or something else that could affect other banks, there would also be run on other banks, even ones that were financially sound, causing their failure.
Booms, busts, and bank failures were common in the 1800's and early 1900's because banks were loosely regulated and rarely examined, which was a recipe for disaster considering that they could print money.
Booms and Busts
Economic activity depends heavily on the money supply. However, there is an optimum supply of money that allows an economy to operate at maximum efficiency and with maximum employment—too much results in inflation and speculation and too little, in deflation and unemployment. Inflation occurs because the money supply is increasing faster than the supply of goods and services; when people have more money, their demand for goods and services starts increasing, which increases prices.
Deflation can result when people start to worry about their finances, so they stop spending to conserve their money. This decreases the demand for goods and services. With fewer sales, businesses cut back on new investments and lay people off to conserve their own money. Since demand falls faster than supply, deflation results—in other words, money becomes more valuable over time so people keep it longer, which causes even more deflation. For an economy to maintain efficiency, it must have a means of controlling the supply of money and the money must expand along with the economy, but no more.
But before the establishment of the Federal Reserve in 1913, the United States did not have an effective means for controlling the money supply. Although barter, such as corn and tobacco, was first used in colonial America, commodity money, in the form of gold or silver coins, soon became more prevalent. Commodity money then served as the basis of banknotes, which was printed mostly by state banks, with the general presumption that commodity money was backing the banknotes.
The problem with commodity money, such as gold and silver, is that its supply cannot be precisely controlled since it depends on being able to find and mine it. Hence, the supply of commodity money has little correspondence to an economy's need for money. Instead, the money supply depends on mining activities and balance-of-trade surpluses and deficits. Balance of trade mattered more in the past because such trades had to be settled with commodity money, usually gold. If a country suffered a serious deficit, its commodity money would be shipped to the countries that have a surplus, draining the local money supply.
And if the supply of commodity money cannot be controlled, then banknotes based on commodity money likewise cannot be controlled if every banknote was actually backed by commodity money—but it wasn't.
The entity that can print money benefits directly, since the cost of printing money is considerably less than its face value. Although it has been well recognized for centuries that the printing of money must be carefully controlled, governments around the world, lacking knowledge and effective controls or simply because they had no other choice, have had difficulty in controlling the supply. Furthermore, before the advent of free banking in the 1840's, bank charters, which were legally required to start a bank, were given by the state's legislators—hence, it was given to people for political favors, many of whom had little knowledge of how to run a bank and not a few didn't allow ethics to get in the way of profits.
For instance, in colonial America, state banks were the main printers of banknotes, which was the currency at that time. People would deposit specie, which were gold or silver coins, at the bank and receive banknotes that they could keep as cash. This system worked only as long as depositors had faith that the bank could exchange banknotes for specie on demand, for if there was even a whiff of doubt about that, the resulting bank run would cause its failure. Nonetheless, many bankers took their chances. In fact, so-called wildcat banks purposely located in remote places to make it more difficult to redeem their banknotes for specie. But bank failures were still common, and the spread of fear—contagion—affected even well managed banks. Bank failures not only caused the depositors to lose their money, but the bank's notes became worthless, causing a loss to anyone holding them. This contracted the local money supply, resulting in loss of business, deflation, and unemployment.
In the latter half of the 1800's, most banknotes were printed by national banks that first appeared during the Civil War, and were backed by government bonds held at the Treasury in Washington, D.C. To reduce the thousands of state banknotes circulating, the federal government taxed state banknotes at 10% of their face value annually. This caused many state banks to become national banks by adopting a federal charter. However, many state banks would not convert because restrictions on federal banks were greater.
Some state banks started creating money, however, through another innovation at the time, checking accounts. When a state bank lent money to a customer it simply credited the customer's checking account, even if there was no banking capital or deposits to back it up. The lack of regulation allowed many state banks to do this, but, eventually, they would have to fail.
Creating money created booms and bank failures caused the contraction of the money supply, resulting in busts, but another cause of booms and busts is the outlook of the people. When the money supply is expanding, people are excited, confident, brimming with enthusiasm. They readily spend money, even borrowing, because they are confident about the future.
Naturally, prices keep going up, and this sometimes fuels speculations in land and stocks, when people buy at high prices in the hope of selling at even higher prices. Of course, eventually, there are no more buyers and so prices collapse.
Then depression sets in, both economic and psychological. Prices continue to fall, fear replaces greed, and the downward spiral begins. As prices drop more and more, people sell, forcing prices down even more. Pessimism sets in, and the people start hoarding their money because they don't know how far prices will drop or if they will still be employed. In fact, unemployment rises because businesses can't sell their products or services and because they, too, must conserve their money.
This causes deflation, when money becomes more valuable because prices of everything are continually dropping. Even the people who have jobs and money withhold spending, waiting for the market and prices to hit bottom, which causes even more unemployment and more contraction of the economy.
Lender of Last Resort and Deposit Insurance End Bank Runs
Nowadays, bank runs rarely occur. In 1913, the Federal Reserve Act was enacted, which finally gave the United States a central bank. One of its purposes was to be a lender of last resort, which would lend money to a bank that needed it, using the bank's assets for collateral. This helped to prevent runs based on the fear that the bank would run out of money, but it didn't prevent bank failures caused by mismanagement or bad economic conditions, so banks continued to fail, but it was only a fraction of them in any given year.
Even after the stock market crash of 1929, bank failures were not much more common than before, but bank failures started increasing because economic conditions continued to deteriorate.
In the United States, both the Federal Reserve and the federal government would be instrumental in accelerating bank failures. During the worldwide depression, countries were withdrawing gold from the United States, and the Federal Reserve acted to maintain the gold standard by raising interest rates and contracting the money supply, which, of course, exacerbated the deflation and unemployment that were already taking place. The federal government, concerned about balancing the budget, passed the Smoot-Hawley tariff in 1931, greatly increasing tariffs on imports in an attempt to stimulate the local economy. This caused not only retaliation by other countries, but greatly increased taxes when people needed more disposable income rather than less. Bank failures accelerated, both in the United States and in Europe, and people rushed to get their money out.
After Roosevelt was elected to the Presidency, the Glass-Steagall Act was signed into law on June 16, 1933, creating the Federal Deposit Insurance Corporation (FDIC), which insured bank deposits for up to $5,000 per depositor. Henceforth, bank failures caused by bank runs were no more, although booms and busts would continue. After all, people still experience greed and fear.