Money Sage (archive)

Negative.

No matter how bad things get, they would be WORSE BY ORDERS OF MAGNITUDE HAD IT NOT BEEN FOR FRANKLIN DELANO ROOSEVELT. What do we mean? What we mean is: DEPOSIT INSURANCE. For all the nonsense about markets taking care of their own problems, correcting themselves, etc. the bottom line is that such "natural" liquidation comes at a very, very steep price. And what is this price? DEPRESSION AND DEFLATION.

Let us consider briefly the aftermath of previous bubble bursts. One of the most famous of these is the South Sea Bubble of the early 18th century. The expansion of this bubble to insane levels led to a financial collapse and to capital losses which, by some accounts, produced an ECONOMIC DEPRESSION in England which lasted for perhaps 60 YEARS! The collapse of the Mississippi bubble in France led to straitened economic circumstances which may be viewed as the possibly decisive, long-term source of the overthrow of the social and political system of France which occurred in 1789 and during the subsequent years of the French Revolution.

In the American experience, bubble bursts have produced a number of serious economic depressions over the course of our history, characterized by massive economic loss, pain, and "lost years." The most familiar is, of course, the most recent: the Depression of the 1930s. This Great Depression, we need to point out, occurred DESPITE the existence of a central bank which possessed -- but did not utilize -- tools to at least contain the severity of the collapse.

The Depression of the 1930s was NOT caused by the stock market crash, although that was the event which catalyzed the economic downturn. The decisive point occurred when the banking system started failing. The single most important event, in our judgment, was the failure of Credit Anstalt, the largest bank in central Europe. Plans to rescue this great bank were scotched for political reasons. The failure of this institution generated a domino effect in the European banking system, with consequences heard round the world. The concomitant failure of an ever-larger number of American banks produced DEPOSITOR PANIC. This panic forced the collapse of virtually the entire banking system, thereby insuring conversion of recession and partial liquidation into a global depression and deflation of unprecedented proportions. Ultimately, Hitler came to power and world war ensued.

Depositor panic not only causes massive and domino-like bank failure, but it also sucks the esential liquidity out of the financial system and thus guarantees economic collapse.

It will be very interesting to see how much protection to the financial system and the economy the combination of deposit insurance, aggressive central bank intervention, and government bailout by bits and pieces will afford.