Principles of money.

 
Summary.

Everyone is entitled to a totally safe bank account at which to lodge money and to have that account underwritten by government.  In contrast, they are NOT entitled to let that money be loaned on with a view to earning  interest and still expect government to back them. Loans are a commercial transaction and it is not a normal job of government to rescue those who enter commerce and make mistakes. Ergo deposit insurance in the normal sense of the phrase is not justified. That argument actually backs the case for full reserve banking.

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 James Tobin devoted about 6,000 words to discussing whether deposit insurance was desirable in an article entitled “The case for preserving regulatory distinctions”. The paragraphs below are my stab at the same question (about 1,000 words). Needless to say I think my arguments and conclusion are clearer and more concise than Tobin’s – why else would have written this article?…:-)

1. Everyone is entitled to some sort of depository or bank where they can store money in a totally safe manner. Apart from individual people, many employers find that service of use.

2. That service costs a finite amount, and there is no reason people and employers should not pay for that service, in the same way as people and employers normally pay for the other goods and services they consume.

3. As distinct from storing money in a totally safe fashion, there is lending on money, or letting your depository / bank lend on your money. The fact of lending  on, or allowing your money to be loaned out is to enter the world of commerce. Taxpayers do not normally rescue those who make commercial mistakes, and there is no reason taxpayers should have to rescue those make mistakes when it comes to making loans.

4. There are various plausible but flawed arguments in favor of trying to make loaned out money totally safe. One is that money which is not loaned out appears to be a waste of resources. Therefor, so the argument goes, some people who do not lend out their money because of the risks involved should be encouraged to do so by offering them government run deposit insurance, e.g. along the lines of the Federal Deposit Insurance Corporation in the US.

As regards “waste of resources”, that argument is flawed because the large majority of money is simply a book-keeping entry which is generally accepted in payment for goods and service. But a book-keeping entry is not of itself a real resource. In contrast, and to illustrate, a house is a real resource, which if left empty for too long can certainly be argued to be a waste of real resources. 

In addition to “book-keeping entry” money, there is paper money (£10 notes for example). But the same applies there as in the case of book-keeping entry money: the cost of creating that money is negligible, thus if large amounts of it are stored, e.g. under matresses, rather than being in circulation, that is not a waste of real resources. Or as Milton Friedman put it,  "It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances."

5. As regards the above mentioned government insurance for deposits which are loaned out, one flaw in that idea is that it is perfectly possible to obtain PRIVATE insurance for deposits, just as private insurance can be obtained for cars, houses, ships and so on. Governments do not normally offer insurance for cars, houses or ships, so why should they offer insurance for deposits?

One answer might seem to be that only the state has a big enough pocket to deal with a large series of failures by depositories / banks. But the state only has that ability because it has COERCIVE powers, e.g. the power to grab extremely large amounts of money by force off taxpayers. Government also has the power to print money in limitless amounts, which may lead to excess inflation which  in turn amounts to robbing existing holders of money. Coercion again.

Thus if there is to be free and fair competition between banks and non-bank corporations and firms, i.e. a genuine free market, there is no excuse for the state giving banks and depositors the latter favourable treatment.

6. A classic illustration of the misallocation of resources that results from government run deposit insurance occurred in the 2008 bank crisis and subsequent recession.

That crisis stemmed from excessive and irresponsible lending. Irresponsibility is normally punished in a free market, and quite right. For example if car manufacturers invest an excessive amount in car manufacturing facilities, those car manufacturers and their share holders pay a price.

In contrast, in the case of the 2008 bank crisis, governments did everything they could to shield banks and depositors from their folly: depositors were rescued, and far from DISSUADING banks from lending so much, governments cut interest rates with a view to persuading banks to continue with what at least on the face of it would seem to be excessive amounts of lending!

7. Another flaw in the “have your cake and eat it / trying to make inherently unsafe loans totally safe” argument is thus.

Aggregate demand is related to the total stock of money held by the private sector. To illustrate, if the private sector has less than its desired stock, it will save in an attempt to acquire its desired stock, and the result will be Keynes’s “paradox of thrift” unemployment. Or put it another way, there must be some stock of money in private sector hands which results in a level of demand which brings full employment. Plus there will also be some stock of money which brings full employment in a “loaned on money is not insured by government” regime.

Now it might seem that if government does insure loaned out money there will be a number of benefits: e.g. the interest from additional loans will help cover the cost of running bank accounts and may even “more than cover” those costs, in which case account holders would get interest on their money.

Unfortunately the result of those extra loans is to raise aggregate demand, thus government on introducing deposit insurance would have to compensate by imposing some sort of deflationary measure, like raising taxes and confiscating a portion of everyone’s bank accounts. (I considered the latter argument in more detail in a Seeking Alpha article entitled “To enable private banks to create and lend out money…”.)

To summarise, the idea that government insurance of loaned out money brings benefits for depositors looks like a bit of a mirage: certainly that insurance enables depositors to earn more interest, but that’s at the expense of having a portion of their worldly wealth confiscated.

And that raises the question as to which is the GDP maximising arrangement: a “government insurance of loaned out money” arrangement, or second, a “no government insurance of loaned out money” arrangement.

Well it’s widely accepted in economics that GDP is maximised where market forces prevail, unless there is an obvious social reason for  ignoring market forces, as there is for example in the case of kid’s education  which is available for free rather than  on a commercial basis.

And as explained above, government insurance only manages to beat private insurance of loaned out money because of the coercive powers of government. Those coercive powers are not part of a genuine free market. Plus there is no obvious social reason for the increased amount of lending and debt that arises where loaned out money IS INSURED by government. Indeed it is widely accepted that the total amount of debt is excessive.

Conclusion.       Having government insure or stand behind deposits which are supposed to be totally safe and really are totally safe because relevant monies are not loaned on is justified. In contrast, government insurance of loaned out money is not justified.