By 1930, numerous banks in the USA were failing. The stock market crash of 1929 made the American citizens nervous and susceptible to rumors of financial breakdown. There were bank-runs which caused long queues outside banks as people were waiting to convert their bank credit to cash currency. To prevent the conversion, banks closed their doors, sometimes temporarily and sometimes permanently. If the bank closes its doors, it does not necessarily mean that the bank ceases to operate as a business, it means that virtual Bank Credit cannot be converted to real currency issued by the government. Many banks also ceased to operate as businesses. The following graph shows a contraction of the Money Supply, both in M1 and M2, but notice that the Currency did not decrease. Government-issued cash currency actually increased. Be careful when talking heads say that Recessions and Depressions are caused by a fall in the Money Supply. It is the Bank Credit component of the Money Supply that falls. The bank collects loan repayments at a greater rate than it is issuing new loans. The decrease in the Money Supply is entirely a bank related issue. The government plays no part in this. Note that citizens were converting Bank Credit into real government money, demonstrating that they trusted government money, more than Bank Credit.
The contraction of the Money Supply made it very difficult for businesses to sell their merchandise and factories reduced output and cut back on their workforce. Millions of American workers became unemployed. Many citizens tried to withdraw their deposits from banks as cash. The graph does show a small increase in cash. By early 1933, at least nine thousand banks had failed. Some suggest that this was a move started by rumour by some large banks to eliminate smaller banks.
A close look at the above graph tells an interesting story. The Currency increases by the comparatively small amount of about $1 billion but the Money Supply, M2, decreases by about $14 billion. Contrary to what you may think, very little bank-credit was converted to currency. The fall in M2 is much more dramatic than can be attributed to conversion of Bank Credit to Currency. The Currency component is fairly consistent. It is the Bank Credit component that changes dramatically. There is an M2 drop from $46 billion to $32 billion. This is a 31% drop, during which time Currency rose from $4.75 billion to $5.72 billion which is a 20% rise. Demand Deposits fell by 35% from $22.7 billion to $14.8 billion. Demand Deposits is the Bank Credit in business and individual bank accounts and is a better reflection of the health of the economy. I pose the question:
It goes back to where it came from: Thin air. In recessions, banks cut back on lending and continue collecting repayments. Money in bank accounts is used to pay off debt to banks, so bank balances fall and debt falls. The money disappears as fast as it was created when loans are created. The money has no physical form and did not come from from the central bank. the result is a fall in the money supply. In the great Depression, the banks not only cut back lending to very low levels whilst still collecting repayments, they actually called in loans both nationally and internationally. This totally hammered the money supply. It is not popular to cast blame on the banks but they created the situation that started the problem. Before the stock market crash of 1929, share prices were rising rapidly and so they lent heavily so that citizens could by shares with borrowed money. Prices were rising quickly, so more and more money was created and lent for the purpose. It is strange for people not to realise that it was the very lending that caused the prices to rise. Pumping more money into a market with limited supply will cause the rapid rise in prices until prices have reached some peak where the lending slows and confidence disappears, whence a rapid price fall occurs as everyone tries to sell their investments. A crash ensues. The stock market gets the blame and the government get blamed for not controlling the situation and being slow to rectify the problems caused by lending for speculation. Lending for speculation should be banned.
It is not government Cash Currency that is causing a Depression, but a decrease in Bank Credit. It is banks that cause Depressions by changes in their lending practices. Some say that banks do this purposely so they can appropriate real wealth. It is quite possible that they have difficulty persuading the general public to take on more loans. It is the fault of Citizens for relying on bank-credit to finance the nation instead of using government issued money. The government then acts to restore confidence in these private corporations that precipitated the problem in the first place.
A 'bank-run' or a 'run on the bank' occurs when a large number of bank clients withdraw their deposits. Clients queue at the door and request that the Bank Credit listed in their bank account be converted to government issued cash. The general reasoning is that the clients lose confidence in the bank and believe the bank may become insolvent. A herd mentality develops and more people try to withdraw their money. Banks typically only keep a small percentage of their customer's balance in the form of cash. The volume of cash it keeps is generally sufficient to meet the demand for daily conversion to cash. To be fair on the banks, no business will cope with a rapid change to it daily business and the banks do have assets but they are all tied up in long-term loans.
When a run starts, the bank generally has to request more cash from the central bank and occasionally has to close its doors temporarily. The doors remain closed until freshly printed notes arrive from the central bank by the fastest transport available or the panic subsides. Sometimes the government will declare a bank holiday to give the banks time to obtain the necessary cash. However, sustained withdrawals will destroy the bank as the bank relies on people not withdrawing their money. The whole concept of modern banking relies on people putting their money in the bank and not withdrawing it. A bank clearly cannot operate as a bank if people withdraw all their money. The green and red graphs, shown in earlier chapters, demonstrate that the banks have enough assets to cover the liabilities. The loans the banks make are repayable at a time in the future. The problem with banks is of a different nature. Firstly, there never was the cash in existence to match the Bank Credit. In Australia in 2015, there was about $67 billion cash notes in existence. The total Money Supply was about $1760 billion.The assets listed by the banks largely consist of their loan portfolio, which is the money owed by clients. However, these debts are uncollectible because there isn't the volume of money to pay these debts.
Australia had the beginnings of a run in 2008. 'Note Printing Australia' had to rapidly create new notes for the central bank, which were rapidly distributed to banks. Confidence was restored.