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The Anatomy of Crisis
73
word "deposit," when used to refer to a claim against a bank.
If you "deposit" currency in a bank, it is tempting to suppose
that the bank takes your greenbacks and "deposits" them in a
bank vault for safekeeping until you ask for them. It does nothing
of the kind. If it did, where would the bank get income to pay
its expenses, let alone to pay interest on deposits? The bank may
take a few of the greenbacks and put them in a vault as a "re-
serve." The rest it lends to someone else, charging the borrower
interest, or uses to buy an interest-bearing security.
If, as is typically the case, you deposit not currency but checks
on other banks, your bank does not even have currency in hand
to deposit in a vault. It has only a claim on another bank for
currency, which it typically will not exercise because other banks
have matching claims on it. For every $100 of deposits, all the
banks together have only a few dollars of cash in their vaults.
We have a "fractional reserve banking system." That system works
very well, so long as everyone is confident that he can always get
cash for his deposits and therefore only tries to get cash when
he really needs it. Usually, new deposits of cash roughly equal
withdrawals, so that the small amount in reserve is sufficient to
meet temporary discrepancies. However, if everyone tries to get
cash at once, the situation is very different—a panic is likely to
occur, just as it does when someone cries "fire" in a crowded
theater and everyone rushes to get out.
One bank alone can meet a run by borrowing from other
banks, or by asking its borrowers to repay their loans. The bor-
rowers may be able to repay their loans by withdrawing cash
from other banks. But if a bank run spreads widely, all banks
together cannot meet the run in this way. There simply is not
enough currency in bank vaults to satisfy the demands of all de-
positors. Moreover, any attempt to meet a widespread run by
drawing down vault cash—unless it succeeds promptly in re-
storing confidence and ends the run so that the cash is redeposited
—enforces a much larger reduction in deposits. On the aver-
age in 1907, the banks had only $12 of cash for every $100
of deposits. Every dollar of deposits converted into cash and
transferred from the vaults of banks to the mattresses
of
depositors
made necessary the reduction of deposits by an additional
$7 if
74
FREE TO CHOOSE: A Personal Statement
banks were to maintain the prior ratio of reserves to deposits.
That is why a run that results in hoarding of cash by the public
tends to reduce the total money supply. It is also why, if not
stopped promptly, it causes such distress. Individual banks try
to get cash to meet the demands of their depositors by pressing
their borrowers to repay loans and by refusing to renew loans or
to extend additional ones. Borrowers as a whole have nowhere
to turn, so banks fail and businesses fail.
How can a panic be stopped once it is under way, or better yet,
how can it be prevented from starting? One way to stop a panic
is the method adopted in 1907: a concerted restriction of pay-
ments by the banks. Banks stayed open but they agreed with one
another that they would not pay cash on demand to depositors. In-
stead, they operated through bookkeeping entries. They honored
checks written by one of their own depositors to another by re-
ducing the deposits recorded on their books to the credit of the
one and increasing the deposits of the other. For checks written
by their depositors to another bank's depositors, or by another
bank's depositors to their depositors, they operated almost as
usual "through the clearinghouse," that is, by offsetting the
checks on other banks received as deposits against the checks on
their own hank deposited in other banks. The one difference was
that any differences between the amount they owed other banks
and the amount other banks owed them was settled by a promise
to pay instead of, as ordinarily, by the transfer of cash. Banks
paid out some currency, not on demand, but to regular customers
who needed it for payrolls and similar urgent purposes, and simi-
larly, they received some currency from such regular customers.
Under this system banks might and did still fail because they were
"unsound" banks. They did not fail merely because they could
not convert perfectly sound assets into cash. As time passed,
panic subsided, confidence in banks was restored, and the banks
could resume payment of cash on demand without starting a new
series of runs. That is a rather drastic way to stop a panic but it
worked.
Another way to stop a panic is to enable sound banks to con-
vert their assets into cash rapidly, not at the expense
of
other
banks but through the availability of additional cash—of an
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