Chapter 17

Strengths and Weaknesses of the Financial System

IN THIS CHAPTER

Understanding the magic of fractional banking

Recognizing the gains from leverage

Confronting the coordination problem

Comprehending systemic risk

Beginning in late 2007, U.S. financial markets entered a period of heavy and increasing turbulence. Sixteen months later, the S&P 500 had lost more than 50 percent of its value, and many well-known firms had declared bankruptcy. It was widely and accurately recognized as one of the worst financial crises the U.S. has ever experienced.

But it was not the first. In fact, America’s history is one of almost regular financial market disruptions. Panics, as they are typically called, flared up in 1819, 1837, 1857, 1873, 1893, 1907, and of course, in the mother of all financial crises, the 1929 stock market and banking collapse that ushered in the Great Depression. Though less prominent, the 1980s and 1990s witnessed a number of financial shocks, too.

Yet despite this history, the 2008–09 crisis came as a surprise — not just to people on Main Street but to many on Wall Street as well. Looking back, it’s easier (but not necessarily easy) to see what happened. Looking forward, it’s nice to think that we’ve solved the problem. But the long history of financial panics suggests that we’ve not seen the last of them.

In this chapter, we consider the gains that modern banking brings to society and the potential for crises that all banking systems face. We also consider how ...

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