In the spirit of the holiday season, I recently watched the classic film It’s a Wonderful Life. Starring the drawl-voiced James Stewart, the movie depicts numerous hardships faced by small town loan man George Bailey. The film is well-renowned for presenting joy and hope around otherwise dismal circumstances. For its critical acclaim, it received five Oscar nominations and regularly places at the top of “best of all time” lists. Poor box office sales upon release were made up for in decades and decades of praise.
It’s a Wonderful Life is a great film because unlike the quasi-amoral pop motion pictures of today, it contains various lessons on the topics of family, community, duty, doing right by others, and humility. But around Christmas time, many economic commentators take to penning missives on another issue they see contained in the movie: fractional reserve banking. It is certainly true the practice of banking with fractional reserves is a great tragedy that befalls our current banking system. But this masterpiece of cinema is often wrongly described as presenting the financial dangers of borrowing short and lending long.
The common narrative goes like this: in Bailey’s early adult years, as he is preparing to go off on a honeymoon with his new bride, panic sets in. There is a run on the Building and Loan Association which has been in his family for years. Depositors desperately attempt to reclaim what little wealth remains in their accounts. Many economic-minded viewers regard this as a sign the bank operates as a fractional reserve institution – meaning short term deposits are used for long term loans – as there is not enough cash on hand to satisfy customers.
As Bailey tries to calm the ensuing crowd, he has to explain why exactly the money is not readily available. “You’re thinking of this place all wrong, as if I had the money back in the safe,” he tells onlookers. “The money is not here….your money is in Joe’s house…and the Kennedy house…,” Bailey exclaims while imploring the crowd to give him time. Finally, he appeals to the logic behind his business practice: “you’re lending them the money to build and then they are going to pay it back in two years best they can…” Many take this as an admission of fractional reserve banking. But it turns out the beloved townsfolk did agree to a certain time constraint on making withdraws. As Bailey reminds the crowd, they accepted a 60 day waiting period for retrieving their cash. When one gentleman expresses anger over having to wait nearly two months for his money, Bailey politely explains “that’s what you agreed to when you bought your shares.”
The problem is, the people want their money now and don’t seem to give a damn over the contract they agreed to. This isn’t fractional reserve banking. It’s fear driven presumably by deteriorating economic conditions. The film’s antagonist, Mr. Potter, plots to buy up the shares at a heavy discount in order to take over Bailey’s properties. To subvert this conspiracy, Bailey and his wife use their honeymoon savings to appease their customers for the time being. It’s an act of personal sacrifice to save his family’s legacy, and one Bailey is remembered for in the future.
Had It’s a Wonderful Life presented a clear-cut case of fractional reserve banking, it would have given viewers a great demonstration on why pyramiding credit is the equivalent to playing Russian roulette. As Harvard economist Gregory Mankiw explains in his bestselling textbook Essentials of Economics:
Although you have probably never witnessed a bank run in real life, you may have seen one depicted in movies such as Mary Poppins and It’s a Wonderful Life. A bank run occurs when depositors suspect that a bank may go bankrupt and, therefore, “run” to the bank to withdraw their deposits.
Bank runs are a problem for banks under fractional-reserve banking. Because a bank holds only a fraction of its deposits on reserve, it cannot satisfy withdraw requests from all depositors. Even if the bank is in fact solvent (meaning that its assets exceed its liabilities) it will not have enough cash on hand to allow all depositors immediate access to all of their money.
Bank runs are not nearly as prominent as they once were thanks to the advent of federal deposit insurance. While it’s not given a precise date, the panic in It’s a Wonderful Life presumably occurs at the height of the Great Depression. In the period following the stock market crash on Black Tuesday until President Roosevelt was inaugurated in 1933 and declared a national bank holiday, thousands of banks failed across the country. A good portion of the money supply was veritably wiped out as whole parts of balance sheets had to be written off. The gushing of bank failures finally receded to a dripping point when Roosevelt took the reins of the banking system via outright socialism. The Federal Reserve pledged infinite amounts of credit creation to shore up the banking system. Essentially, FDR took the Emanuel-esque advice of never letting a good crisis go to waste. His actions succeeded in calming the country down. It was too late for the fictional George Bailey however.
After the Federal Deposit Insurance Corporation was established in 1933 by Congressional diktat the public was finally able to disregard any suspicion of losing their life savings in a panic. From then on, Uncle Sam would simply rob their neighbors to make up for any banking shortfalls. The kind of bank run witnessed in It’s a Wonderful Life is now seen as an anachronism. As economist Gary North explains,
“A bank run today is not the old-fashioned kind that we see every Christmas season when we watch “It’s a Wonderful Life.” That was a pre-FDIC bank run. A bank run took place in the Great Depression when depositors, who had been promised payment in currency on demand, exercised their contractual rights.”
George Bailey’s predicament seems to be the product of both historic conditions and fear caused by the prevalence of fractional reserve banking. While he runs a relatively sound business model, his efforts are undercut by the overwhelming fraud that was occurring in the banking sector. Fractional reserve banking is based on a conflating between two types of contracts: mutuum and deposit. Whereas a mutuum contract, which dates back to antiquity, involves the lending of fungible goods to be paid back after a specific period, a deposit contracts involves lending goods available on demand. Bailey’s Building and Loan Association seems to operate with mutuum contracts – which the community of Bedford Falls totally reneged on. Most other banks function by using demand deposits to finance longer term loans. The result is a mismatch of funds.
Fractional reserve banking is, above all, illogical. And since law should be based on the rational and logical understanding of humanity and matter, it doesn’t make sense to hold certain transactions as fraudulent and others as not. If farmer Joe commits a crime by misrepresenting a bailment of straw in his silo, then banker Bill does the same when misrepresenting deposits to his customers. As U.S. Supreme Court Justice Antonin Scalia wrote in his famed Lawrence v. Texas dissenting opinion, “the people, unlike judges, need not carry things to their logical conclusion.”
It’s wrong to misinterpret It’s a Wonderful Life as an example of fractional reserve banking. George Bailey’s family business seems to engage in banking proper. Even so, he still hits a snag thanks to the economic conditions of the time. Of all the lessons contained in It’s a Wonderful Life, the economic fact-of-life that there is a cost and risk for everything is not given enough consideration. The economic free lunch is like Santa Claus – it doesn’t exist. The movie concludes on a memorable line as the youngest Bailey happily proclaims “every time a bell rings an angel gets his wings.” The same can be said of a fractional reserve banking system, in that every time a deposit is made, someone gets duped.