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This should be obvious. A government run bank could in many ways be even worse than a privately run bank. One of the main reasons to privatize is to decouple the risk from the government itself. If the privately owned bank goes under, there is ideally a system in place to handle it smoothly. Banks go under all the time in the United States; the problem is with Banks who've reached the "too big to fail" status. If there were regulation that effectively ensured a bank that grew too large had to be split up (similar to how we deal with certain companies that become monopolies) the problem with "too big to fail" could be more-or-less solved.
A government run bank socializes all the risk, and puts the citizens on the tab when it goes under. In fact the ONLY difference between the Iceland banks and a government run Iceland bank is that they privatized the profits but socialized the risk. Because those banks believed that the CBI or the government would bail them out, it caused them to take risks that they might not have otherwise taken had they not believed the safety-net was there to catch them. A government run bank is in the same exact position, but add on top of that the likelihood of bad investments being made to please one politician's constituency or another, or just plain old fashion corruption, and you have a recipe for disaster.
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I've written a much longer post in the past about 1929 and the events leading up to and around it. I'll re-post most of that post here.
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When you deposit your money into the bank, you are given a promise that they will return it to you if or when you need or want it. A bank with many customers can usually count on being able to make good on their promise, because it is unlikely that -everyone- would want to withdraw all of their money at the same time.
However, eventually people do want to withdraw some portion (or even all) of their money. To counter this banks keep a part of it on reserve and loan the rest out. This in turn creates more money. There are additional methods at their disposal to do this as well.
Let's give an example. You go to your local bank and deposit $100. The bank has determined, in order to function optimally (i.e. make good on its promise to its depositors) it needs to keep 20% of all its funds in reserve. Thus, of the $100 you gave to your bank it keeps $20 on reserve and loans out the remaining $80. I now have the $80 loaned to me by your bank and deposit it into my checking account, which now tells me I have $80 in the bank. Your account still says you have $100. Together, we have $180 in the bank... but wait! There is only $100 to begin with, which means the bank just created $80 out of thin air! Correct. The same process continues as the bank takes my $80, reserving 20% ($16) and lends out the remaining $64, which is then redeposited to repeat the same process.
The lower the reserve requirement, the more money that is created. Creating this extra money causes price inflation when there is no compensating increase in goods and services .
To give a comparative example of how price inflation works imagine a game of Monopoly. All players start out with $1,500, and as they move around the game board they acquire property. When one player lands on another players property, they pay rent, which earns the property owner money. This money is then used to build houses and hotels, increasing the value of the property, costing the other players more rent when they land on it, with the eventual goal of one player bankrupting all the others.
Now, let's assume that all players of the Monopoly game started with $7,500 instead of $1,500. What is the consequence? Players will be able to build houses and hotels earlier in the game. A boom in building would result. When the starting money was only $1,500 the players might have to sell some of their existing properties to other players in order to get enough to build their hotels and houses on the remaining ones. When starting with the extra cash, property owners might not need to raise the money. Players without property would have to pay owners more in order to entice them to sell. Real estate prices would rise with the inflation in Monopoly just as they do in the real world.
The other side of the coin is price deflation. This occurs when the money supply decreases without a compensating loss in goods and services that people want. Banks can cause deflation by increasing their reserves. This keeps money out of circulation. In the Monopoly example, deflation would be simulated by the players having to return a percentage of their cash to the bank.
When players return money to the bank they are less likely to have the ability to afford the high prices of rent (generated by houses and hotels). If players try and sell their properties, they find them worth less money than it cost them to buy them. Real estate prices fall, just as they do in the real world.
This is more-or-less what took place last year. As people who bought homes could no longer afford their mortgage they began to default on their payments resulting in foreclosure. This in turn resulted in a drop in property values. When the news of the crappy mortgages sold to people who couldn't afford them spread, no one wanted to buy them. The banks got stuck with them on their books, meanwhile some of them were all chopped up into derivatives and sold off in bundles. This essentially meant that you could own 3% of 100 different mortgages. Those who bought the derivatives believed them to be safer than standard mortgages, because while a fraction of those who have mortgages will not pay them not everyone would default. This means you'd only lose a percentage of the mortgage derivatives you held instead of -all- of it had you owned the entire mortgage.
The banks were unsure how much the mortgages and the mortgage derivatives were worth, so in order to ensure that they could make good on the promise they had made to their depositors they increased their reserve. They were no longer lending. There was a credit freeze. There was serious danger of the banks going under as they had over leveraged. To avoid this and to get credit flowing again the government through the Federal Reserve began to pump the Banks with lots of cash. The Federal Reserve also began to print more money. This results in inflation.
Unlike our Monopoly example above inflation and deflation created by changes in the money supply does not effect everyone equally. When the bank or the Fed creates new money, it increases its claim checks on the wealth relative to everyone else. The bank is like a Monopoly player who gets more money than any of the other players to start with. If both you and I were bidding on the same property in Monopoly, and my cash pile increased while yours stayed the same, I would likely top your best bid and get the property.
When I am sure to outbid you with new money, the auctioned property will probably sell for a slightly higher price than it otherwise would have. The seller would thereby acquire some of the newly created money. As they spend that extra money, by outbidding other players for property or paying rent, it eventually defuses into the hands of some of the other players. However, several turns may pass before some players get access to the new money. Those who have no property may never get any of the new money. They are worse off relative to the other players than they would have been if no new money had been created at all!
In real life, the banks create money and use it first. Those wealthy enough to put up collateral can borrow the money and use it next. Since both the government and the wealthy are the biggest borrowers, they benefit at the expense of those who have little property and savings. When the government begins to deficit spend, it must first borrow the money, and when it does so it inadvertently redistributes the wealth from the poor to the rich.
The longer the other players of Monopoly wait to share the new money, the worse off those without it are. In real life, prices rise before wages do as new money is created. This is a double whammy. People who do not get the new money at all (anyone on a fixed income without savings or property) must contend with the rising prices WITHOUT an increasing income.
Those who get the new money last are worse off than if there had been no inflation at all. Inflation through new money creation -artificially- increases the claim checks on goods and services for the wealthy, but not for the poor. This redistribution of wealth to the banks and the well-to-do by increasing the claim checks (money) that these groups have is referred to as the inflation tax.
The United States banking system alternates inflation with deflation. Without alternating the cycles, inflation would run rampant. In nations that inflate rapidly, getting the new money even a few hours later than someone else makes a person very much worse off. That is why workers in such countries rush to buy goods and services as soon as they can receive their paychecks, finding no incentive to save.
Alternating inflation creates other problems as well. When the rate of new money creation slows, people and businesses cannot borrow as readily as before. Consumers cannot buy goods; businesses must cut back production; workers get paid less or are laid off. Those who have little to no savings find themselves unable to make their mortgage payments. As a result, banks foreclose on many more homes in times of deflation.
The same people who were hurt by inflation usually find themselves crippled by deflation as well. People without property and without savings suffer the most. Alternating inflation and deflation bankrupts those living on the edge. Creditors repossess the homes and belongings of these individuals. The rich get richer and the poor get poorer.
In 1914 the Fed received the exclusive monopoly to issue United States currency. As you have noted it is a private corporation, operated by its member banks which are also private. Before it's creation banks generally found they needed to keep roughly 20% or so in reserve so that they would have enough money on hand when their customers wanted to make a withdrawal. When the Fed came into being it lowered the reserve requirement. It keeps a portion of its funds in reserve (like a bank) and loans the rest out to its member banks. When money is loaned out, the wealth of the American people is used as collateral.
Lowering the reserves results in the creation of more money. When the Fed began to do this the money supply doubled between 1914 and 1920 and once again from 1921 to 1929. In contrast, gold in the reserve vault increased only by 3% in the 1920s. This meant the bankers would obviously not be able to keep their promise to deliver gold to depositors if a large number of people wanted to withdraw their money at the same time.
The money flooded the economy and business could not use all the newly created money the banks wished to loan, so stock speculators were encouraged to borrow. Many people got heavily into debt, just as happens in any boom as people mistakenly believe it will continue. They believe the growth is real but in reality only a "bubble" has been created.
In 1929, the Fed responded to this excess money by slowing the creation of new money and deflating the currency (increasing the amount it had in its reserves). People who had counted on renewing their loans to cover stock speculations or other investments found, due to the new scarcity of money, that they could no longer borrow. They were forced to sell their securities, and a stock market plunge ensued.
When people lose money they spend less on goods and services; this means business began to slow. With banks unwilling to renew loans, businesses began to reduce their work force. People nervously began withdrawing their gold deposits as banks in other countries quit honoring their promise to return the gold. Rumors circulated that the Federal Reserve would soon be bankrupt as well. This was true, because as noted, there was no way for its member banks to exchange the inflated dollars for gold.
Just as the money supply increases when people deposit their funds, the reverse happens when they withdraw them from the bank. The banks' failure to loan coupled with massive withdrawals, caused even greater deflation. People lost their savings and their purchasing power; in turn, businesses lost their customers and laid off workers. Each loss contributed to the next, resulting in the Great Depression. This is what was in danger of happening last year.
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