Bank-runs are simply the collapse of the network effects surrounding credit

The bank runs in Greece have been on my mind the past few days and in order to properly think about what is happening, I have been gathering my thoughts on the nature of bank runs in general.

  • Network effects are powerful because they have momentum.
  • This momentum works in both directions: both when the network is growing as well as when the network is collapsing.
  • Since network effects can collapse on themselves just as easily as they can grow upon themselves, people often label the collapse of any network effect as a “bubble.”
  • But bubbles are actually the collapse of unsustainable network effects. Not all collapsed networks are bubbles.
  • Money and, more broadly, credit are subject to network effects.
    • (Indeed, modern money derives all its value from the network effect.)
  • Banks are systemically dependent on the network effects of money and, in particular, credit.
    • All money is credit, and credit is just another word for trust.
    • In other words: The more people trust a bank, the more trustworthy that bank becomes.
  • Bank runs are simply the collapse of the network effects surrounding credit, as people lose trust that their deposits can be withdrawn.
  • This is why, like all other network effects, bank runs are self-fulfilling, contagious, and very difficult to stop once they have started.
    • Because if everyone does withdraw their cash, there will not be enough cash to go around.
  • And this is why the role of the central bank (which can create as much cash as it wants) as the lender-of-last-resort is so crucial to financial stability.

The European Central Bank has said that it will not act as the lender-of-last-resort to halt the Greek bank run. The interesting question now is whether the bank run will spread into Italy and Spain. And what the European Central Bank will do about it.