Last week Thursday, I wrote a post about the Wizard of Oz. And how the Wizard of Oz has to be one of the most satisfying allegorical tales of monetary reform. Read it here: The Wonderful and Economic Wizard of Oz.

Although it was all wrong.

Because if the Wicked Witches were really the East and West Coast bankers, and Dorothy and her merry troop were really the poor downtrodden Americans fighting for the right to use the Silver Standard, then that story would really have ended with:

• New and more powerful bankers witches.
• Specifically, Good Witch Glinda – that wily proponent of the silver standard, who “lacks the power to overcome the Wicked Witch of the West” herself, but would happily watch her own particular pretties go and fight the good fight.
• She might well have stepped into the gap as the new Big Bank.
• Fly, my pretties, fly.
• *cackle*

And/or the Wizard of Oz would have saved the original Wicked Witches with a bailout.

Anyway, as a general summary, the general American circumstances that gave rise to the Wizard of Oz tale:

• The failure of the Argentinian wheat crop in 1893 had led to bank runs in the United States.
• And then America went into depression.
• The proposed solution: cheap money (in the form of silver dollars).

I kind of skimmed over the process of how bank runs cause depressions – so I’m grateful to Justin, who asked if I could expand on that.

Some background information that you’d need to bear in mind…

The Fractional Banking System

Contrary to popular belief, most of the money in the world is not money. It is credit.

Let me give you an example of the scale involved.

Scenario:

1. Let’s say that the Central Bank has printed $100 worth of notes, for usage by the general public.
2. The Central Bank buys a government bond worth $100 (ie. the Central Bank lends that $100 to the government).
3. The government then uses that money to pay for things.
4. The Central Bank says to the retail/commercial banks “You have to keep 10% of any deposits that you receive – in cash – in case any one of your depositors needs some cash.”

What happens:

1. The contractors that received the money from the government deposit their $100 into the commercial banks.
2. The commercial banks then say to themselves “Oooh – $100! Well, we obviously need to keep $10 in cash. But let’s lend the $90 out to earn interest!”
3. At this point, the banks have $10 in cash and $90 in loans outstanding (assets) – all financed by that first $100 in deposits received (liabilities).
4. The borrowers go and spend their $90.
5. The people that just got paid go and deposit their $90 in the bank.
6. The commercial banks then say to themselves “Oooh – $90! Well, we obviously need to keep $9 in cash. But let’s lend the $81 out to earn even more interest!”
7. Now the banks have $19* in cash and $171** in loans outstanding (assets) – which were financed by $190*** in deposits received (liabilities).
   *$10 original + $9 new
   **$90 original + $81 new
   ***$100 original + $90 new
8. And you’ll notice that the banks have just “created” a further $90 of money?
9. But this process continues, because that $81 in new loans will be come back as deposits, 90% of which can be used to give out more new loans, which will also come back as deposits, and so on…
10. …until the banks have to keep all $100 in cash to make up that 10% reserve requirement.
11. By then, the banks have $100 in cash and $900 in loans outstanding (assets) – all financed by $1,000 in gross deposits received (liabilities).
12. The fractional banking system created $900 of new money out of the original $100 printed by the Central Bank.
13. And you should notice that this is a function of the liquidity reserve requirement?
14. Total Money Created = Money Created by Central Bank ÷ Reserve Percentage

In practice, that doesn’t happen so neatly. There are slowdowns in the circulation of money, and people don’t deposit everything they receive (they spend some of it!). But the general rule of thumb is that new money created by the Central Bank generally gets turned into between 2 and 4 times that original amount through the reserve multiplier process.

The Other Thing About Banks…

Banks face awkward liquidity constraints. And this is mostly a function of time:

• Depositors generally want to be able to access their money whenever they want (so the Banks have very short-term liabilities);
• But borrowers want much longer-term loans – 30 year mortgages and 5 year car financing and revolving lines of credit, etc (so the Banks have long-term assets).

That disconnect between assets and liabilities means that the banks are particularly vulnerable to shaky public trust. If too many depositors demand their money all at once, then the bank will fold. And when banks fold, borrowers get a bit lax with their repayments – because wouldn’t you try to get written off as a bad debt as well?

People know this.

It’s why there are liquidity reserve requirements – so that the bank’s depositors have some peace of mind around their ability to draw on their savings whenever necessary.

But even so, almost the minute there is even a hint of instability, depositor money floods out in an ill-considered rush for the door.

Just consider the impact that this would have on the fractional banking system…

Bank Runs and the Fractional Banking System

Looking at the mechanics of that example above, in good times:

1. The depositors think that they’re worth $1,000, with that money all safely in the bank.
2. Meaning that there is $1,000 of money circulating in the economy (mostly being transferred between bank accounts).
3. In reality, $900 of that is actually credit.
4. But that’s okay – because good times!

But then let’s say that there is a bit of a panic – some poor investment decisions, a bubble popping – that sort of thing. People get worried about the credit quality of all the lenders.

So depositors start drawing money from the bank. In fact, let’s say that they just drawdown on $50 in cash (a 5% drawdown).

What happens?

• The bank now has $50 in cash and $900 in loans, funded by $950 in deposits.
• Awkward.
• The reserve requirement demands that there be $95 held in cash (10% of the $950 in deposits)!
• So the banks stop lending, in order to get back to meeting its 10% reserve requirement (the proverbial credit crunch).
• But how are these loans to be paid? Out of the deposits that are already at the bank.  So in order for $10 of loans to be repaid to the bank, $10 will have to be withdrawn from a deposit account (it’s the multiplier effect in reverse).
• The end point is that the bank still has $50* in cash (ie. half the real money in circulation – the other $50 is somewhere in a mattress) and $450** in loans, funded by $500*** in deposits. Still not quite enough – but getting there.
  *$50
  **$900 less $450 collected
  ***$950 less $450 collected
• At this point, there is $500 in bank deposits and $50 in cash (the cash withdrawn by the panicked borrowers) floating around in the economy. That is, $450 of the money supply just disappeared – in much the same way that it was created.

In terms of the economy:

• Lenders have lost access to credit.
• And 45% of the money supply just disappeared.

What happens when you have less money chasing the same amount of goods and services?

Cutbacks. Firings. Deflation. Depression.

And that’s just assuming a 5% drawdown!

If the depositors tried to drawdown 15% of their money:

1. Firstly, they wouldn’t be able to. Because that’s $150 and the bank only has $100 to spread around.
2. So the bank would fold – or it would have to be bailed out.
3. Either way, the bank certainly wouldn’t be lending.
4. And the depositors wouldn’t be spending the money that they extract either (I mean – by virtue of the fact that they’re savers, they’re already inclined to not spend).
5. So the creditors/spenders would be forced to repay their loans. And the depositors would be squirrelling the collected money into mattresses.
6. How would the creditors repay their loans?
7. By selling off their assets. So you get a general decline in asset prices.
8. Which would make many of them unable to pay off their loans in full.
9. The whole system goes into brain-freeze.

It’s why governments involve themselves in bailouts.

Because failed banks can cause other banks to fail in the mass hysteria (AKA contagion).

And, almost by magic, the whole thing can become a real self-fulfilling mess.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.