Back in March of 2008, six months before the current financial crisis, Paul Krugman, in an ominously titled opinion piece for the NY Times (“Partying Like It’s 1929”), explained, in the clearest fashion that I’ve seen anywhere, what a credit contraction means. He said in essence that:
- In 1930, people pulled money from banks and put it into matresses,
- and in 2008, creditors are pulling money from loans and putting it into things like Treasury bills.
The result is the same. When people go to get a loan, there’s no money available, and ventures necessarily stall.
Here’s how Krugman put it exactly:
The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.
Mr. Bernanke and his colleagues at the Fed are doing all they can to end that vicious circle. We can only hope that they succeed. Otherwise, the next few years will be very unpleasant — not another Great Depression, hopefully, but surely the worst slump we’ve seen in decades.
Krugman also explained, in ways that now seem prophetic, what happened in the past, and what’s happening right now, in 2008:
Contrary to popular belief, the stock market crash of 1929 wasn’t the defining moment of the Great Depression. What turned an ordinary recession into a civilization-threatening slump was the wave of bank runs that swept across America in 1930 and 1931.
This banking crisis of the 1930s showed that unregulated, unsupervised financial markets can all too easily suffer catastrophic failure.
As the decades passed, however, that lesson was forgotten — and now we’re relearning it, the hard way.
To grasp the problem, you need to understand what banks do.
Banks exist because they help reconcile the conflicting desires of savers and borrowers. Savers want freedom — access to their money on short notice. Borrowers want commitment: they don’t want to risk facing sudden demands for repayment.
Normally, banks satisfy both desires: depositors have access to their funds whenever they want, yet most of the money placed in a bank’s care is used to make long-term loans. The reason this works is that withdrawals are usually more or less matched by new deposits, so that a bank only needs a modest cash reserve to make good on its promises.
But sometimes — often based on nothing more than a rumor — banks face runs, in which many people try to withdraw their money at the same time. And a bank that faces a run by depositors, lacking the cash to meet their demands, may go bust even if the rumor was false.
Worse yet, bank runs can be contagious. If depositors at one bank lose their money, depositors at other banks are likely to get nervous, too, setting off a chain reaction.
This is exactly where we are at today—and why Paulson, Bernanke, Bush, and the Congressional leadership are so tense.
Here’s the bank run scene from It’s a Wonderful Life :