The Y2K computer bug isn’t like a natural disaster or mass
disease. It is a technical problem with a technical fix that can
be overcome with work and time. However, and without speculating
about the ultimate fallout from the problem, the bug has exposed
a very real and deep infraction that has long plagued the U.S.
Thanks to long-ago government interventions that redefined a bank
deposit as a loan, modern banks only hold a fraction of the
demand deposits in people’s cash accounts. The rest is used as
the basis for extending and pyramiding loans. If too many
depositors demand their cash at once, which is their right, it
would trigger a bank run, which in turn would lead to the
“contagion effect,” and runs on other banks.
Under this scenario, since most banks these days are considered
“too big to fail,” the Federal Reserve would have to run the
printing press full time or they would go belly up immediately.
The result would be a dramatic deflation, as people draw down on
their accounts and lending is restricted, followed by hyper-
inflation, as the Fed provided the liquidity necessary to keep
the banks afloat, and people fly from paper into goods.
Banks genuinely fear that something like this might be the result
of public nervousness over Y2K. Last month, a Southern California
phone company suggested that its customers hold a month’s salary
in cash during the transition to the new millennium. The banking
industry went bonkers, denouncing the telephone firm for breaking
silence on the question, and attempting to reassure the public
that extra cash holdings were
The point is this: whether or not it is prudent to withdraw money
from the banks, why should the suggestion alone be enough to
drive the industry into paroxysms of fright? It is one thing to
desire someone’s business. It is quite another to regard the
perfectly reasonable actions of your customers as a mortal and
systemic threat to the well being of society as a whole. To
understand why takes us to the heart of the great secret of
Under genuinely sound banking, in which the money you deposit at
the bank is held for safekeeping while you draw down your funds
as you see fit, it wouldn’t matter at all how many people
withdrew funds or when. The analogy here is the grain elevator,
which is used solely for storage. Every customer of the elevator
is free to withdraw the full quantity of his grain at any time
because the proprietor must keep 100 percent reserves on penalty
So it is under a real gold standard, in which sound banking is
divided into two kinds. With deposit banking, you retain full
title to your gold and only use the bank as a storage warehouse.
Paper money is a ticket that acknowledges your ownership of the
gold. The tickets are accepted because the banks are trusted.
Free-market competition, and punishment for fraud, ensures that
reputable banks do not fudge their holdings and loan out what
does not belong to them; indeed, banks would hold 100% reserves.
With loan banking, on the other hand, the depositor surrenders
his right to withdraw his money at any time and instead transfers
title to the bank itself, which is then free to extend loans and
earn (and pay) interest on the money.
Under today’s fiat-money, fractional-reserve system, nearly all
banking is treated as loan banking, and, with some accounts,
banks hold no reserves whatsoever. As economist Murray N.
Rothbard frequently reminded us, under the old rules of
accounting, all modern banks are technically bankrupt all the
The only factor that suppresses that fundamental reality is
consumer confidence. Federal deposit insurance, an institution
designed to shore up a bankrupt system, contributes to the sense
of confidence. Even small depositors’ actions, like a widespread
withdrawing of a bit more cash than usual, undermine that confidence.
Despite the appearance of stability and soundness, then, the
foundations of modern banking are actually extremely precarious.
It would only take the right kind of crisis, or perceived crisis,
to throw the entire system into chaos.
This is not something to fear or even regret. Bank runs and the
threat of bank runs, serve a heroic function in a free society.
They spur banks on to be more careful in the conduct of their
business. In a genuine market setting, banks would be no more
protected from failure than any other business. If we want to
restore that market discipline, we need more bank runs, not fewer.
The right to withdraw your funds from the bank is not only an
essential part of freedom; it is a way of reminding banks that
they are part of the matrix of voluntary exchange in a market
economy, even if they do benefit from huge subsidies from the Fed
and the Treasury. If it takes a crisis brought on by real or
exaggerated technical troubles to remind the banking industry of
that fact, so be it.