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September 11, 2012
The Dismal Science
by Adam Smith

At the end of the movie Mary Poppins, the father, Mr. Banks, goes to the bank where he works and faces the bank’s directors and punishment for the actions of his children. The head of the bank goes through a long explanation and then states that because of Mr. Bank’s children there was a “run on the bank.”

Before the 1930’s, a run on a bank was common. Banks take in deposits and then loan out a portion of the deposits. The banks make money based on the spread between what they pay in interests to depositors and what they get paid in interest from loans they make. As Jimmy Stewart tried to explain in It’s a Wonderful Life, banks do not have all the deposits in their vault. If all depositors go to a bank and withdraw all of their money, then the bank will default.

Prior to the creation of the Federal Deposit Insurance Corporation (FDIC) in 1933, when there was a run on a bank, the first people in line would get their money, but at some point the bank would run out of money and the rest of the people in line would lose all their money and entire life savings.

This is why old people used to stuff money in mattresses; it could be safer than in a bank.

Contagion could be described as irrational pessimism. In a town, there may have been three banks. One of the banks may have made risky loans that put the viability of the bank in question. Once the word got out, there would be a run on the bank. Of course some people would lose everything and people would then wonder about their money in the other two banks. Remember, if you are first in line you get your money. There would be a run on the other two banks for no good apparent reason and those banks would go under. This is contagion and is very destructive.

With the creation of the FDIC, most people in the United States have no memory of people running to their bank and frantically trying to withdraw their money. The FDIC insures deposits in a bank up to $100,000. This insurance is paid for by the banks and helps create stability in the financial sector.

But does this mean contagion, or irrational pessimism, is gone? Hardly.

Consider the most recent financial crisis. Mortgage companies were bundling mortgages (Mortgage Backed Securities, or MBS) and selling them to various banks and financial institutions. This practice went on for several years. And then the housing bubble burst and people were defaulting on their mortgages and nobody knew what the MBS were worth (if anything).

This created doubt about the viability of banks and investment houses such as Goldman Sachs and Lehman Brothers. The Federal Government, fearing a complete collapse of the financial sector, pumped hundreds of billions of dollars into the banks. Fear gripped the entire economy, and we went into a recession where millions of people lost their jobs (and we still have not recovered).

We all lived through it. It was scary, and everything the government and others tried to do did make sense at the time. It seemed we were fighting for our lives.

Two quick points. First, the MBS were created so that 20% of the mortgages in the bundles could go bad and the MBS would still hold its value. Since the time of the crash, economists have been unbundling the MBS, trying and see what they were worth. The number of mortgages that had gone bad in the MBS … 20%.

That’s right. The MBS in reality had not lost their value. The banks were not going to go under. There was no real crash. The crisis was created by perceived weakness and runs on the banks. Contagion had caused the crisis.

Yet we still live with the results of the irrational pessimism. Currently, there are 23 million people in the United States that are unemployed, underemployed, or have given up looking for a job.

I hope by now you understand the dangers of contagion. Then you will also understand why the debt in Greece, Spain and Italy matters. Defaults by those countries create doubt about the viability of the banks that carry the debt. This creates doubt about banks that carry the debt of banks that are carrying the Greek debt. At that point nobody really knows which banks can and will survive, and we have another financial crisis.

You will hear some experts say the debt of Greece is not large enough to cause a crisis. Just remember, the last crisis never really had to happen either.

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