Failure is essential for a healthy free market. It's the only way to clear out the deadwood so capital and labor can be deployed more effectively.

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Small banks and credit unions are the heroes of Move Your Money, a campaign started by blog Publisher Arianna Huffington and former Senate Banking Committee chief economist Rob Johnson.

The idea is for Americans to register their disgust with the big banks by withdrawing their funds and taking them to community banks and credit unions.

The downside was on display Jan. 8 when regulators closed Horizon Bank of Bellingham, one of those “It’s a Wonderful Life” institutions, many of which are struggling in the aftermath of the great crash.

Horizon was the first bank to fail in 2010 on top of the 140 in the U.S. that went down the year before, almost all of them small.

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It won’t be the last. At the end of last year, 28 of the 95 banks headquartered in Washington state were operating under closer regulatory supervision.

Yet when Horizon was shut down, the system put in place during the Great Depression, though tattered, worked exactly as intended. The Federal Deposit Insurance Corp protected depositors. The bank’s assets and deposits were taken over by a stronger institution, Seattle-based Washington Federal. All of Horizon’s branches reopened for business normally. No bank runs, no panic.

The system also worked as intended this way: It let Horizon fail.

Failure is essential for a healthy free market. It’s the only way to clear out the deadwood so capital and labor can be deployed more effectively.

As economist Ludwig von Mises pointed out, failure also helps entrepreneurs gain information so that their next ventures have a better chance of success. FDIC guarantees were established to give depositors confidence after the catastrophic bank closings of the Depression but the goal was to manage failure rather than prevent it.

That’s not happening with the elite group of banks considered too big to fail. They received $700 billion in a direct bailout from the federal government, in addition to perhaps trillions in mysterious schemes from the Federal Reserve.

They’re raising fees on customers and preparing to hand out billions in bonuses this year, even as the financial system remains sick and at risk. They’re spending hundreds of millions more to prevent reform that would curtail the risky speculation that helped caused the crash.

As for small banks, they’re not always angels, either. Some are started by wealthy businessmen for the prestige of owning a bank or giving low-interest loans to themselves and their buddies if regulators don’t catch on.

Many that have failed became overly reliant on lending for a real-estate boom that an earlier generation of bankers would have rightly snubbed as too risky.

Many of these small banks also took bailout money, and a growing number are falling behind on the quarterly dividends they owe the government. My Seattle Times colleague Drew DeSilver reported late last month that four Washington-based holding companies did not make their November payments.

Still, America’s 8,000 small banks represent an important alternative to the banking giants, especially for small businesses that have trouble finding money elsewhere in the capital markets.

According to the Independent Community Bankers Association, institutions with less than $1 billion in assets make nearly a third of all business loans of $1 million or less.

Yet this sector’s struggles aren’t over. In addition to the pressure to raise capital and shore up their reserves, they face a growing problem with commercial real estate, which is overbuilt, overleveraged and often overrepresented on the books of these smaller banks. Horizon will have more company this year, especially if the economy fails to grow.

So failure has its costs, to communities, employees, small businesses and a strained FDIC. Still, it’s a necessary cleansing, but one that’s not happening in the larger banks.

The bailout no doubt averted another Great Depression. Yet without reform, further trouble hangs over us. Reform must include breaking up the biggest banks, restoring a wall between investment and commercial banking and rebuilding the middle tier of institutions the size of Seafirst and Washington Mutual.

One of the biggest reforms would be the idealized small-bank virtue: Making safe loans while serving customers. Too bad so many have failed on that count lately.

You may reach Jon Talton at jtalton@seattletimes.com