4/02/2011: Can economy function with shut banks?

Last night on Vincent Browne's programme, Prof. Antoin Murphy (TCD) - an excellent scholar of economic history - stated that absent the Government Guarantee of 2008 and/or in the case of a 'default' by Ireland on its debts, the banking system will collapse precipitating the 'ATMs with no cash' crisis.

According to Prof. Murphy - such an outcome would be more disastrous than loading up some €185bn worth of banks debts onto ECB and our own CBofI and pushing Irish taxpayers into even more debt to the tune of ca €100bn.

I do not wish to engage (for the lack of time and space now) in the arguments as to which outcome (debt death spiral or cashless ATMs) is the worse one. Nor do I wish to argue here (for the very same reasons) as to whether a 'default' (I prefer - restructuring) of our banks debts will trigger a crisis leading to the total shut down of the banking system in the country.

But let me provide you with the following summary of the economist's opinion on the matter of an economy's viability in the case of a systemic banking crisis with no cash circulating via the banking system (a hat tip to B. Lucey):

Quote (original source here):

"Since banks create money under fractional-reserve banking, we would expect the closure of banks severely to disrupt the functioning of an economy. The Irish experience in 1970 an interesting counterexample. In that year, a major strike closed all Irish banks for a period of six and a half months. All the indications from the start, moreover, were that this would be a long closure. As a consequence of the strike, the public lost direct access to about 85 percent of the money supply (M2). Irish currency still circulated, of course, British currency was also freely accepted in Ireland, and some North American and merchant (commercial) banks provided banking facilities. Increases in Irish and British currency and in deposits in these banks, however, accounted for less than 10 percent of M2.

Somewhat remarkably, checks on the closed banks continued to be the main medium of exchange during the dispute. Despite the increased risk of default, individuals continued to be willing to accept personal and other checks. [The author] summarizes the situation as follows: “a highly personalized credit system without any definite time horizon for the eventual clearance of debits and credits substituted for the existing institutionalized banking system.”

According to [the author], it was the small size of the Irish economy (the population of Ireland was about 3 million at that time) and the high degree of personal contact that allowed the system to function. Stores and pubs took over some of the functions of the banking system. “It appears that the managers of these retail outlets and public houses had a high degree of information about their customers—one does not after all serve drink to someone for years without discovering something of his liquid resources. This information enabled them to provide commodities and currency for their customers against undated trade credit. Public houses and shops emerged as a substitute banking system.”

Presumably as a result of this spontaneous alternative banking system, economic activity in Ireland was not substantially affected by the banking strike. Detrended retail sales did not differ much on a month-by-month basis from average levels in the absence of banking disputes, and a central bank survey concluded that the Irish economy continued to grow over the period (although the growth rate fell)."

The paper referred to in the above citation is: A. Murphy, “Money in an Economy without Banks: The Case of Ireland,” The Manchester School (March 1978): 41–50.

Once again, let me repeat, I do not believe that such a cashless economy is a good idea, nor do I believe that the banks debt restructuring will lead to a significant disruption in supply of cash or access to deposits, especially if such restructuring is pre-planned, with liquidity buffers set in place by the CBofI. But I find it interesting that a superb economic history researcher - Prof Murphy - would argue the inevitability of something happening today which did not happen in the less financially and economically advanced 1970.

Yes, the conditions have changed - we are less personal of a society today than back in the 1970s. But we also have much stronger presence in the country of other banks and we have access to the global markets (currently shut by the insolvent banking system). We also have, presumably, our European partners, who can help, and most importantly - for now - significant funding buffer in the form of NPRF. The CBofI has printed enough cash already to cover a large share of our deposits (except it chose to dump this cash into the banks balance sheets instead). In fact, between CBofI cash printing for the banks and NPRF and pre-borrowed money, Irish state has potential access to more cash than the 80% deposits base for deposits at a risk of flight (those with demand withdrawal terms of <3mo and overnight).

Virtually none of these were there in 1970... and still, the economy did not collapse after losing some 85% of cash from circulation!