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The banking business model of lending deposit account funds is effective in every situation except the one in which it is absolutely required to be effective: when there is a financial panic. In this way it is predicated on failure; it 'plays the odds' that not all of the loans will default and that not all of the customers will withdraw their money at the same time. Of course these risks are attempted to be controlled via government regulation, the so-called fractional reserve banking system.

The Great Depression was caused in major part because the banks had made a lot of risky loans to people playing the stock market. When the stock market crashed, not only did the individual stockholders 'lose it all' (unless they were lucky enough to sell fast) but the banks also suffered severe losses because many of their loans were now in default. In the panic that ensued all bank customers wanted to withdraw their money to make sure that it was safe. However, the bank had lost their money in risky loans; therefor, everyone in the United States was affected because of a bad banking business model.

Instead of people rightfully abandoning the failed baking business model, they instead allowed to government to convince them that it was 'capitalism' that failed, and that they should 'trust the banks'. The government encouraged people to trust the banks by subsidizing a risky banking business model via fractional reserve banking regulations, the FDIC, etc.

I admit however that I am not an economist. Is there something important that I have omitted or wrongly evaluated? It seems to me that the United State could enjoy stable, if slower, economic progress by a change in the banking business model (for example: charging a fee for deposit accounts and then using the fee money for loans instead of the deposit money).

asked Jun 20 '13 at 08:06

empiric's gravatar image

empiric ♦

No, it is mostly government intervention which causes the misallocations of money (and the inevitable following panic) in the market: Before the Great Depression there was unionisation, minimum wages - and mostly the injection of paper money (which was the source for the misallocation, like right now). Read

http://constitution.org/mon/greenspan_gold.htm - (when he was still on our side)

When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage.

(Jul 10 '13 at 11:33) lukas lukas's gravatar image

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Asked: Jun 20 '13 at 08:06

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Last updated: Jul 10 '13 at 11:33