Banks and those who deposit money at banks are pampered welfare queens.

Depositors want to engage in commercial activity, i.e. have their money loaned out so they can earn interest. But at the same time they want their money to be totally safe! Bit of a joke that, isn't it?

I mean any normal investor or lender knows perfectly well that they run a risk: at worst, they might lose everything. So what’s the excuse for a taxpayer backed safety net for depositors?

Well I’ll deal with that a few paragraphs hence. But first it’s important to qualify the latter claim that depositor insurance is taxpayer backed. That is, it could be argued that deposit insurance (at least in the US) is not taxpayer funded in that the FDIC is self-funding.

That’s a good point. On the other hand, the FDIC only covers small banks, not large ones. And in the recent crisis the larger banks were rescued thanks to a trillion dollar loan by the Fed at derisory rates of interest. (To be more accurate, the largest amount loaned by the Fed at any one time, according to this source, was about one trillion, whereas the AVERAGE amount loaned (over approximately an 18 month period) was about $600bn.)

As to exactly who was rescued by the Fed, it was not of course just retail depositors: it was a mixed bunch – bank shareholders, bond-holders, very large depositors and so on. In short, it’s not just small retail depositors who are featherbedded by deposit insurance, in the widest sense of the term “deposit insurance”: it’s a range of other bank creditors as well. I’ll use the phrase deposit insurance and the word depositor in that wide sense from now on.

A second weakness in the claim that the FDIC is self-funding is that it’s plain impossible for any private sector insurer to give a 100% guarantee that those insured will be rescued when a loss occurs (e.g. when your house burns down or your car is stolen). Reason is that private sector insurers sometimes go bust. In contrast, everyone knows the FDIC, and similar deposit insurance systems in other countries, are backed by an almost limitless source of money: the taxpayer. And that ability of government to rob taxpayers in the event of the FDIC not being able to meet claims is not a free market transaction: it’s a subsidy of the FDIC.

To summarize, while deposit insurance is TO SOME EXTENT self-funding, it is not entirely self-funding: i.e. it relies partially in taxpayers.


The justification for deposit insurance.

Let’s now return to the question posed at the outset above, namely: “What’s the excuse for a taxpayer backed safety net for depositors?”

A common excuse is that the arrangement encourages lending and investment. Indeed that excuse was given by the UK’s “Independent Commission on Banking” (sections 3.20-3.24). Well there are a couple of problems there.

First, if taxpayer protected deposits at banks and hence bank lending is encouraged, that clearly increases lending, but it also increases debts. And in fact the world is awash with people (e.g. the UK’s former business secretary Vince Cable) who advocate more bank lending in one breath, and then deplore the recent growth in debt in the next breath.

Second, if a taxpayer funded safety net for depositors does in fact encourage investment, then exactly the same applies to ALL FORMS of lending, for example bonds issued by corporations and cities. Come to that, why not take it even further and have a taxpayer funded safety net for SHAREHOLDERS?

In short, there’s a big anomaly at the heart of deposit insurance which is this. If you buy bonds in corporation X there’s no taxpayer protection for you. But if you deposit money at a bank which in turn lends your money to corporation X, then you’re protected. I.e. deposit insurance is simply an artificial form of assistance for a collection of middle-men known as “banks”.


Is lending stimulatory?

Another apparent excuse for artificial encouragement for lending is that a rising level of lending / debt is stimulatory: it increases aggregate demand. Indeed Steve Keen produced a good video explaining that point. (I suggest starting at 12.45).

Well a rising amount of lending / debt is indeed stimulatory, as Keen explains. But first, debt is dangerous, especially when there is too much of it. As Keen explains, when a debt bubble deflates, the entire economy deflates, all else equal.

Second, if we have $Y less demand stemming from a rising level of debt, it’s the easiest thing in the world for any government with its head screwed on to implement $Y of stimulus so as to counteract the reduced demand stemming from debt.

To summarize, the idea that lending and debt are beneficial in that they can boost demand is not a brilliant argument.


So what’s the solution?

So how do we ensure that people have a totally safe way of storing surplus cash without the taxpayer being on the hook? Well the authorities in the US have recently solved that problem, at least in the case of the money market mutual funds (MMMFs).

MMMFs will shortly come in two varieties. First, where an MMMF promises depositors they’ll get 100 cents back for every dollar deposited, that money can only be lodged in a totally safe fashion: at the Fed or the money can be put into short term government debt.

Second, where MMMF depositors want their money put into something more risky (something which will doubtless earn more interest, like corporate bonds), then the relevant MMMF cannot make the latter “guaranteed to get your money back” promise. That is, depositors who want the latter more risky option will see the value of their stake in the MMMF float, as is the case with mutual funds which invest in a wide selection of corporate shares (unlike MMMFs which concentrate on relatively safe corporate bonds).


So MMMFs can’t fail!

MMMFs are banks of a sort. But soon they will be banks which cannot fail.

Certainly the above safe MMMFs can’t fail. And as to the riskier MMMFs / “banks”, if they make silly loans, all that happens is that the value of depositors’ stakes in relevant MMMFs falls: the MMMF cannot go insolvent. What more do you want?

That principle should be applied to ALL BANKS. That would make banks fail safe. Plus it would put an end to taxpayer subsidies for banks and depositors.