A bank run is the process of a bank’s insolvency, where it can no longer repay depositors. Today, however, banks are able to avoid this obligation through the credit provided by central banks. Even though there is a legal requirement for reserve deposits, this practice has become virtually obsolete. Instead of holding depositors’ money, banks respond to withdrawal demands by borrowing from the central bank.
Fractional reserve banking is a system in which banks hold only a small portion of deposits in reserve while lending out the remainder. This practice has historically led to banks taking excessive risks and facing frequent insolvencies. Governments have used these failures as justification to centralize the banking sector and seize full control over the money supply.
Banks should not lend out depositors’ money without their explicit consent. However, through contracts signed without the customers’ full awareness, this practice has become widespread. Depositors believe their money is safely stored in the bank, when in reality, it is being lent out. The proper approach would be for banks to establish investment funds and only lend the money of voluntary lenders. Otherwise, lending out deposits amounts to nothing short of fraud.
Modern monetary systems are built on the continuous creation of money by central banks. If central banks were to stop printing money, banks would once again be reliant on deposits. However, the current system is built upon an ever-expanding money supply and the bubbles created by inflation. These bubbles, inflated by artificial interest rates disconnected from market conditions, are destined to burst.
Prosperity is achieved not by increasing the money supply but by increasing production. During Andrew Jackson’s presidency in the United States, the closure of the central bank made it difficult for banks to expand across state lines due to regulatory hurdles. Yet, the government responded by insuring deposits, allowing banks to take on even more risk. Whereas previously individuals would assess the riskiness of a bank’s reserves before depositing their money, now they simply say, “The government guarantees our funds,” enabling banks to print money more recklessly.
This expansion of credit has led to larger bank runs, crises, and depressions. It was not only fractional reserve banking but also the government’s subsidies, particularly to the railroad and oil companies, that continuously inflated the bubble.
From the latter half of the 19th century onwards, the banking and currency systems became increasingly centralized and monopolized by governments worldwide. Critiquing this process using the term “market failure” requires relying on invalid a priori assumptions.
Take, for example, the Great Depression of 1929: it was the result of an artificial credit expansion (fractional reserve banking and subsidies). As interest rates were manipulated and the economy grew based on temporary demand, the bubble eventually burst when the market began to correct itself, unable to sustain the inflated growth.
When interest rates do not arise from market conditions, high-interest investments are made in projects that are deemed beneficial and profitable by society. This lays a foundation for long-term, sustainable growth. However, when credit is made accessible to all by lowering interest rates, even individuals who would not normally borrow or invest take out loans.
Between 1920-21, the Federal Reserve continually pursued a policy of expanding the money supply, leading to an unprecedented increase in the American money supply. This expansion was not limited to the U.S., as European markets were also flooded with credit.
The agricultural sector was another beneficiary of these abundant loans, leading to an overproduction of agricultural goods that the market did not need, resulting in prices falling below their natural levels.
When the crisis struck, many people who had borrowed at low-interest rates and made investments found their growth coming to a halt, leading to widespread bankruptcies. Farmers were unable to sell their products, and many were forced to dump their crops.
The crisis of 1920-21 followed a similar pattern. During World War I, the Fed expanded the money supply to facilitate the wartime credit flow, but as the loans extended to Europe re-entered the civilian economy, inflation surged, and by 1920, yet another bubble had formed and burst.
President Harding addressed this crisis in a manner that differs drastically from the interventionist measures typically advocated by modern policymakers and Keynesians. Instead of intervening, he allowed deflation to take its course, and within a year, the crisis was resolved.
This was how the economic crises of the 19th century were addressed prior to the Great Depression. Once the economy recovered after just one year, the Fed quickly lowered interest rates and resumed its policy of monetary expansion, which led to the Great Depression by 1929.
Both mild and severe inflation are harmful. The damage they cause varies only in degree. Whether inflation erodes purchasing power slowly at an annual rate of 2% over time or causes havoc by increasing 200% over six to seven years, the outcome is disastrous.
As Ludwig von Mises noted, all of these crises stem from inflationary actions imposed on the market and driven by fraudulent means.
What prolonged the Great Depression was not the failure of the market, but the interventionist policies of the Hoover administration, followed by the Roosevelt administration, which prevented the market from recovering and correcting the errors created by government interventions. What could have been resolved in one or two years was instead drawn out for 10-15 years due to their meddling.
