What happens when a lot of money suddenly disappears and the banking system collapses? The answer my friend is the Great Depression. When the stock market crashed and banks failed, the economy went into a recession. The economy finally recovered when money was used to fund World War II. There are a few parallels to the current situation with the difference being that hopefully we have learned from history. FDIC insurance was created to add security, so that people can safely put their money in the bank without it disappearing if the bank collapsed. The banks failed, because everyone tried to withdraw money, decreasing the amount of money the banks had on hand to lend.
If we look at the timeline for the current crisis it starts with interest rates being lowered and lending rules being relaxed. This enabled people who otherwise would not be able to buy property to do so. When demand exceeds supply the prices go up. This lead to the appreciation of real estate values. Unfortunately those people could not afford to continue paying interest only loans at low interest rates. There is no such thing as a free lunch. People pocketed money on this bait and switch tactic, so they didn’t care. Since property appreciated, people also took equity loans against their property. This is when things started getting dangerous. This stack of cards was getting ready to fall. Once the Fed raised interest rates, people began defaulting. Banks started losing money, lots of money. In order to stay in business if you’re losing money is to loan money to continue paying your bills. If you can’t loan money to pay your bills, you have to go bankrupt. Most people go to the bank or some investment firm to loan money, but those people can only loan money if they have money to loan. The banks needed money and a lot of money, but they had no one to borrow it from. Now they are falling like dominoes.
This wouldn’t be so bad, but unemployment is also high. When people don’t have jobs, they can’t spend, so the economy suffers further. When the economy lags, people get laid off. This sends the economy spiraling downward. The only way out of this is the creation of new jobs by war or whatever. Hopefully whatever.