Banking Panics and Long Recessions

This paper develops a dynamic theory of money and banking that explains why banks need to hold an illiquid portfolio to provide socially optimal transaction and liquidity services, opening the door to the possibility of equilibrium banking panics. Following a widespread liquidation of banking assets in the event of a panic, the banking portfolio consistent with the optimal provision of transaction and liquidity services during normal times cannot be quickly reestablished, resulting in an unusual loss of wealth for all depositors. This negative wealth effect stemming from the liquid portion of the consumers' portfolio is strong enough to produce a protracted recession. A key element of the theory is the existence of a dynamic interaction between the ability of banks to offer transaction and liquidity services and the occurrence of panics.