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YOU DECIDE: Are banks different?

April 18, 2008

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

Dr. Mike Walden
Media representatives: For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

Many people take responsibility for and live with the consequences of their actions and expect others to do the same.

Indeed, the idea is embedded in many of our laws. If I carelessly back my car into my neighbor's mailbox because I was daydreaming, I'll be expected to apologize and pay for the damage.

It shouldn't be surprising, then, that eyebrows have been raised over some of the latest moves by the federal government - particularly the Federal Reserve - to deal with the nation's financial troubles. The Federal Reserve, or "Fed," has been providing large amounts of loans (in the hundreds of billions of dollars) to banks to keep them afloat and their doors open.

But many are asking, Why?

If a bank makes an investment that turns bad, why should a government agency help it? Shouldn't the Federal Reserve just let the bank fail and the bank's investors suffer the loss, just as you or I do if we make investments that turn sour?

The argument in favor of government helping troubled banks is based on the idea that banks are different, that they perform a crucial function in the modern economy. To see why, let's go back more than 100 years to the early 20th century, before the Federal Reserve existed.

Then, "bank panics" periodically occurred. These happened when enough people feared their bank would soon fail, so depositors wanted their money from the bank. But banks only keep a fraction of deposits on hand to handle normal day-to-day withdrawals, loaning out the rest.

Therefore, if a large number of depositors come to the bank wanting their money, the bank won't be able to satisfy everyone. Such a "run on the bank" can become a self-fulfilling prophecy and force the bank to close its doors. And with banks not able to make and service loans, the entire economy can grind to a halt.

Such was the case many times in the 19th and early 20th centuries, with the Panic of 1907 being the most severe. Worries about mining investments sparked a run on the banks and a 50 percent drop in the stock market. The crisis was only contained when some wealthy individuals organized a banking rescue that ultimately returned consumer confidence.

It was this 1907 financial calamity that directly led to the creation of the Federal Reserve System in 1913. The belief was - and still is - that banks are different, in that if several banks fail, a domino effect of financial fear can be set off that spreads to healthy and non-healthy banks alike, thereby threatening the entire economy.

So one of the main functions of the Fed is to serve as a financial backstop to banks. If a bank gets in trouble, the Fed steps in to keep the bank solvent and put a lid on financial fear. We saw the Fed intervene in just this way over the Easter weekend.

But, of course, these actions aren't without potential cost. To help troubled banks, either the Fed will print more money, thereby running the risk of higher inflation, or extend loans ultimately backed by taxpayers. In the second case, taxpayers are on the hook if the loans aren't repaid.

Critics say banks should be treated like any other segment of the economy: They should take their losses if things go bad. Plus, critics warn, knowing the Fed is always there as a safety net may motivate banks to make questionable loans in the future, for which taxpayers or the general economy may end up paying.

So in one way, the debate over banks, the Federal Reserve and responsibility is a question of costs. If banks fail, what is the cost to the general economy and to innocent bystanders? But if banks are propped up, what are the possible costs to consumers - through higher inflation - and to taxpayers?

It is a real "you decide" dilemma!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

Posted by Dave at April 18, 2008 08:39 AM