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the economy was plagued by recurrent liquidity crises. A wave of bank failures would taper down a while, and then start up again as a few dramatic failures or other events produced a new loss of confidence in the banking system and a new series of runs on banks. These were important not only or even primarily because of the failures of the banks but because of their effect on the money stock. |
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In a fractional reserve banking system like ours, a bank does not of course have a dollar of currency (or its equivalent) for a dollar of deposits. That is why "deposits" is such a misleading term. When you deposit a dollar of cash in a bank, the bank may add fifteen or twenty cents to its cash; the rest it will lend out through another window. The borrower may in turn redeposit it, in this or another bank, and the process is repeated. The result is that for every dollar of cash owned by banks, they owe several dollars of deposits. The total stock of moneycash plus depositsfor a given amount of cash is therefore higher the larger the fraction of its money the public is willing to hold as deposits. Any widespread attempt on the part of depositors to "get their money" must therefore mean a decline in the total amount of money unless there is some way in which additional cash can be created and some way for banks to get it. Otherwise, one bank, in trying to satisfy its depositors, will put pressure on other banks by calling loans or selling investments or withdrawing its deposits and these other banks in turn will put pressure on still others. The vicious cycle, if allowed to proceed, grows on itself as the attempt of banks to get cash forces down the prices of securities, renders banks insolvent that would otherwise have been entirely sound, shakes the confidence of depositors, and starts the cycle over again. |
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This was precisely the kind of a situation that had led to a banking panic under the pre-Federal-Reserve banking system, and to a concerted suspension of the convertibility of deposits into currency, as in 1907. Such a suspension was a drastic step and for a short while made matters worse. But it was also a therapeutic measure. It cut short the vicious cycle by preventing the spread of the contagion, by keeping the failure of a few banks from producing pressure on other banks and leading to |
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