So, this is going to be a very sour reading of what has happened in Cyprus this weekend. It will also be a very partisan one, possibly even a partial one. But if Milton Friedman and Anna Schwartz were right in their insistence that it was actually the Federal Reserve that caused the Great Depression (which is something that Ben Bernanke himself has insisted that the Fed will not repeat) then one way of interpreting what has happened is that the European Central Bank has just set us all up for another Depression. The trigger is that “tax” of a little over 6% on all depositors.

This isn’t an analysis that you’ll be able to get all economists to sign up to. But the basic story told by Friedman and Schwartz in “A Monetary History of the United States” was that the 1929 crash was indeed a serious crash. But it would not have led to the Great Depression without the Federal Reserve making some serious mistakes. Two of which were to allow the intertwined collapses of both the money supply and the banking system. Given that it is the banks that create credit and thus the wider money supply they are, to a great extent, the same thing.

The actual process was the series of bank runs that happened through the early 1930s. The problem is that in a fractional reserve banking system banks are inherently unstable. The fractional refers to the fact that when you deposit $100 with one they don’t then keep that $100 in the safe. They take a guess at how much they need in the safe (OK, it’s an informed guess, but it is a guess) for when people turn up demanding their cash and the rest of it they lend out to other people. This is how companies, mortgages and business loans are financed (please, we don’t need to go into “ but loans finance deposits” and all that: it might even be true but it’s irrelevant here).


Thus banks are inherently unstable institutions. There’s even an architectural thought that the reason that bank buildings are always so imposing is to fool us about this inherent fragility.

What Friedman pointed out was that in the early 1930s many banks were indeed bust. But many more were not in fact so: they were brought down by people thinking they might be and thus turning up en masse to demand their money: a bank run. The solution to which is to have deposit insurance. The government, via the offices of the central bank, agrees to fund banks with as much cash as they need in order to be able to pay off depositors. It’s slightly more complex than that but not much. There are limits as to how much any one depositor can get back for example.

So, we had a problem, bank runs, brought on by the simple nature of fractional reserve banking. We have a solution, deposit insurance. Something which isn’t free by the way. The FDIC certainly charges the banks for it in the US and depositors pay it by getting a lower interest rate than they otherwise would.

And we pretty much didn’t have bank runs after we had deposit insurance. We certainly didn’t have retail bank runs (those much larger commercial depositors, who weren’t insured, did kill a few banks, but we didn’t see crowds of retail customers fighting for their life’s savings outside shuttered branches).

But please note the central part of Friedman’s argument. Yes, there was the crash. Yes, there would have been a deep and painful recession as a result. But the tipping of that recession into depression was a result of the cascading series of bank failures in the absence of deposit insurance: that led to the calamitous shrinking of credit and the money supply.

So let us now look at Europe and the eurozone. Certainly there’s been a crash (or even a Crash). We’ve so far avoided the depression part (although not everywhere. Greece is certainly in one, Spain possibly and looking out my window at rural Portugal I see certain signs of a reversion to a non-cash economy.) but the important question is whether we manage to continue to do so?

Clearly, there are more ways to get into a depression than just cascading bank failures. The end point of all out war is another just as an example. But, again if we buy Friedman’s explanation, we know that cascading bank failures will cause one. And the way not to have those is deposit insurance. So, what have they just done in Cyprus? They’ve removed deposit insurance. They’ve therefore just removed our defence against bank runs and thus cascading bank failures.

Yes, I do know, they’ve called it a tax: but here we’ve got to make reference to that duck thing. The difference between a 6% or more “tax” on your bank deposit and a failure of the previously agreed deposit insurance to protect your deposit is quackery enough that it’s a duck.

As I’ve said before the importance of this is moot at present. It depends on who believes what. If the citizenry believe that they don’t have deposit insurance any more (whether we call this a tax or a duck) then we will see more mass withdrawals from banks and we will see more bank failures. And cascading bank failures are exactly the thing that will tumble us into a new depression.

I had actually thought that we’d seen peak stupidity already in this euro crisis. The state guarantee by Ireland of all bonds and deposits in Irish banks. Note, they guaranteed absolutely without limit. That has oft been marked as an incredibly silly thing to do by people vastly cleverer than I am. But my worry is that this Cypriot decision is even worse. Even if this “tax” is never used again, even if it really is a one off, some significant portion of the populace simply aren’t going to trust government protestations of deposit insurance in the future. Which will, inevitably, lead to cascading bank failures.

My worry is that some future Friedman, some monetary scholar of the future, will write in her history of these times that it was this, this one action, this one moment, that was the gibbering insanity that crashed the system for a decade or more.

Yes, this is very gloomy, quite possibly much too so. But one of the strangenesses of this age is that the Federal Reserve is on record as stating that Friedman’s analysis of the early 1930s was pretty much spot on. Unfortunately, the European Central Bank is well known as never having quite bought that analysis. And they’re most certainly not acting as if they do.


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