Tuesday, April 3, 2012

A new era of bank runs?

From the early years of the Industrial Revolution until the beginning of the Depression, bank runs were quite common. Every ten years or so there would usually be a banking panic which would generally result in an economic collapse. The result was a boom-and-bust cycle that can be seen in the first half of the chart on the right. After World War II, however, bank runs stopped happening, which was a big reason why the US enjoyed a long period of economic stability between 1946 and 2007 in which GDP never fell by more then 2% from year to year. The death of the bank run is generally attributed to FDR's New Deal reforms, which created the FDIC and significantly limited the degree to which banks could engage in speculation.

In 2008-2009, however, we saw a new phenomenon: the shadow bank run, which this New York Times columnist argues will continue to happen in the 21st century. The so-called shadow banking system--involving instruments of short-term credit that are not guaranteed or subject to the same regulations as traditional banks--now accounts for more than $15 trillion in assets, up from $4 trillion in 1990. Along with the trillion-dollar derivatives market, the shadow banking system can accumulate an enormous amount of short-term risk--not just for investors but for the entire economy. A rush to withdraw from money market funds or a sudden pulling of credit between banks can cause a crash just like in 1893, 1907, or 1929.

The solution is not to extend government guarantees beyond traditional banks, since that would create the possibility of bailouts that would dwarf the ones that happened in '08-09. But we need to figure out some way to better protect short-term credit so that we will not enter into a new era of bank runs and boom-bust cycles. A volatile economy like the one we had from 1890 to 1930 tends to hit the middle class and working class the hardest, leading to increased poverty, more economic insecurity, and more demand for welfare programs. Needless to say, that would be bad.