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Bank Runs and the Great Depression

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Here’s a letter sent to the New York Times:

Paul Krugman writes that “we used to have a workable system for avoiding financial crises, resting on a combination of government guarantees and regulation.  On one side, bank deposits were insured, preventing a recurrence of the immense bank runs that were a central cause of the Great Depression” (“Punks and Plutocrats [2],” March 29).  This claim is misleading.

Bank runs don’t just happen; they have causes.  In the 1930s those causes were serious missteps by the very institution – government – that Mr. Krugman wants to invest with even more power.

First, regulation limited branch banking and, hence, prevented banks from sufficiently diversifying their portfolio of deposits.  Second, U.S. banks were prevented from issuing their own notes, and so could not easily satisfy customers’ desire for higher currency-deposit ratios.  Third, government declarations of “bank holidays” heightened depositors’ worries and caused runs even on solvent banks by depositors who feared that the “holidays” would spread.  And fourth, the Fed allowed the money supply to contract by thirty percent.  (Canada, which had no central bank and did not restrict branching or prevent banks from issuing their own notes, suffered zero bank failures during the Depression.)*

Mr. Krugman’s enthusiasm for more government control over the financial system would likely be muted if his history weren’t so potted.

Donald J. Boudreaux

* For additional information on these details – and for a great deal more solid history and theory about money and banking – see George Selgin, Bank Deregulation & Monetary Order [3] (Routledge, 1996).

My good (and really, really smart) friend Ed Grass challenged my criticism of Krugman and insisted that bank runs were indeed a cause of the Great Depression.  I disagree.  While the increased money demand that runs both represent and contribute to did fuel the downturn, bank runs were more a symptom of underlying economic troubles than a cause of those troubles.  In just the same way that a high rate of unemployment further fuels an economic downturn, no one, I think, would identify high unemployment as a cause of the Great Depression.