The banking crisis isn't over

What Congress did in the early 1930s, in large part in response to their perception of public demands for a safe payments system, was to guarantee deposits and abolish double liability. What are the practical implications of these measures? Without double liability, you probably would not scrutinize the management as closely.

If the system had these desirable features, why did it collapse? There are varied explanations, but three points are important. First, there was a general economic collapse in the real sector of the economy. There is nothing for the financial system to do when the real sector is devastated. Second, the Federal Reserve was restricted by law, and by accepted practice, from lending to banks in crisis to the full extent that it could have done so in principle. For example, the Federal reserve only could purchase from banks "eligible assets." These were short-term business loans (commercial paper) for the most part, or, in older terminology, "real bills." The Federal Reserve Banks also were required to hold 40% in gold reserves against the total of Federal Reserve Notes issued.

The third point is that, though there were bank collapses where everyone lost all of their deposits, in fact, people typically were paid off a fair amount eventually. No doubt there was a great inconvenience, but without a general macroeconomic collapse and the hamstringing of the Federal Reserve, the system might have survived longer.

What have been the long-run implications of the New Deal reforms? Very simply, what resulted was the savings and loan debacle. A report by the Presidential-Congressional Commission on the Savings and Loan Crisis pinpoints Federal deposit insurance as the major contributing factor to the S&L losses. Charles Keating and others notwithstanding, the report concludes that it was not crooks, but, rather, savings and loan owners who led to competition and overoptimistic economic growth projections and were responsible for most of the S&L losses.

What is a stake today is the future of banking. Still needed are the two functions that banks traditionally have provided--payments and lending. The question is whether banks with Federal deposit insurance are necessary in order to have a safe payments system and an efficient method of channeling funds between savers and borrowers.

The establishment of Federal deposit insurance inhibited the growth of alternative, non-insured lending institutions. In 1948, Henry Simons, a professor of economics at the University of Chicago and one of the founding fathers of the "Chicago School" of economics, wrote: "One reason for the persistence of banking is our lamentable failure to develop proper institutions for mobilizing the savings of middle-income families. If legislatures and economists were more concerned about giving us good, small investment trusts and less concerned about making bank accounts and life insurance safe and salable, we might get a better structure of financial organizations." Nevertheless, given the state of banking technology in the 1930s and the experience of the bank failures, the nation opted for a Federal government guarantee of deposits.