While all too common a century ago, bank panics have largely vanished from the modern economic landscape thanks to government deposit insurance (Federal Deposit Insurance Corporation). Because such insurance guarantees bank deposits, customers are less concerned about losing their deposits and thus likely to panic if problems emerge.

A Panic Contraction

Bank panics triggered economic downturns by reducing the amount of money in circulation. Before the advent of deposit insurance, the run on a bank was likely to deplete the bank's available reserves, causing it to fail and making any remaining deposits worthless. When such bank runs spread throughout the economy as bank panics, a significant amount of the economy's bank deposits literally vanished.

These lost deposits reduced the economy's stockpile of financial wealth and, more importantly, the supply of available money. With less money in circulation, less output was purchased, meaning production, employment, and income all declined. This was, and continues to be, one sure recipe for a business-cycle contraction.

Some Notable Panics

The bank panic of 1857 was the result of European speculation in the construction of the U.S. railroad system. When the speculation investment bubble burst, the panic began. The 1869 bank panic was triggered by the first of several stock market collapses known as "Black Friday." The panics in 1873, 1893, and 1907 were caused by ongoing financial conflicts between farmers and bankers that, among other things, also gave rise to the Populist political movement. The bank panic of 1907 was noteworthy for inducing Congress to create the Federal Reserve System, which was officially established 1913.

A Thing of the Past?

So far, so good. But can bank panics happen again?

The key is keeping the banking public calm, keeping them assured that their financial wealth is not at risk even if banks fail. The banking public did remain relatively calm in the 1980s because federal deposit insurance worked. Insured deposits remained safe. The public had no reason to panic.

However, the federal deposit insurance system was stretched and strained during this decade. The Federal Savings and Loan Insurance Corporation, which insured the deposits of savings and loan associations, was stretched to the point of breaking and had to be merged with the healthier Federal Deposit Insurance Corporation. Had more banks failed, then the Federal Deposit Insurance Corporation might have been stretched to its limits as well. The only recourse would then have been direct support from the federal government, that is, using general tax revenues.

Unfortunately, total bank deposits far exceed government tax collections. Should the economy and banking industry once again experience problems similar to the 1930s Great Depression, the federal deposit insurance system might be strained to the breaking point. The federal government could lend some tax support, but not a lot. It too could be quickly strained to the limit.