A Libertarian’s (Unexpected) View of the Bailout of the Banking System

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Bailouts of the banking system create social tension. Eventually, bailouts introduce so much risk into the system that failures and bailouts become too costly for society to bear. The government creates draconian rules trying to prevent them in future, which in turn kills innovation and the formation of new businesses, and the result is a stagnating economy.

Today, I am going to share Part 2 of the spring letter I wrote to IMA clients. You can read Part 1 here.

We have a fractional reserve banking system: For every dollar banks lend out, 85 cents comes from deposits and 15% from their own equity. The problem with deposits, as we saw in the SVB case, is that depositors are fickle – they can ask for their money back at any time.

If half of the country were to withdraw their deposits from their banks, we would not have a banking system or an economy. Banks lend depositors’ money to others. There is an inherent imbalance of liquidity in the banking system that we never notice, which is absolutely fine as long as banks have proper reserves, do not experience losses on their loans or investments that exceed their reserves, and, most importantly, society believes in the continuity of the banking system as a whole.

Bank runs occur when depositors lose their confidence, show up at the bank, and ask for their money, depleting the bank’s reserves (equity) and forcing it into bankruptcy. At the beginning of the 20th century, bank runs were a common occurrence, leading to the establishment of the Federal Reserve in 1913. The Fed was created to act as a lender of last resort to help prevent bank runs from occurring.