Friday, 10 February 2012

The big FDIC anomaly.

If you invest in the stock exchange or your own business, there is no government sponsored insurance for you. And quite right: engaging in commerce is laudable, but the risk is entirely yours. You might make a million, or you might lose your investment.

In contrast, if you deposit money in a bank, and the bank lends to, or invests in businesses or mortgages, you get government sponsored insurance: (FDIC in the U.S., and something similar in most other countries).

Now why does government sponsor (or even subsidise) the insurance of commercial activity in the latter case but not the former? There is absolutely no reason.

Of course those who deposit money in banks want to have their cake and eat it: they want 100% safety plus the nice rates of interest that come from investing in commercial activity. And banks are more than willing to accommodate this “have your cake and eat it” activity – as long as government sponsored insurance is there to underwrite the charade.

This charade should be closed down. Depositors should have to come clean: they should be given the choice of 100% safe accounts, and in contrast, accounts where their money is invested in businesses, mortgages, etc.

Money in safe accounts should not be invested: it should not even be invested in government bonds since the value of the latter can rise and fall. Perhaps the money should be deposited at the central bank, where it will earn little or no interest.

But depositors WOULD HAVE instant access to their money, since the money has not been locked away in some business or mortgage. Plus there is a good argument for offering government sponsored insurance for this money. There is possibly no STRICTLY ECONOMIC argument for this insurance, but there is certainly what might be called a “human rights” argument: i.e. everyone should have the right to a 100% safe bank account.

In contrast, there is no reason for government to organise insurance for money in “investment” accounts. Nor is there any reason to allow depositors instant access to their money: the money has been locked away in businesses or mortgages. That’s where the money is. Investors in General Motors cannot all withdraw their investment at once, so why should those who lend to banks who in turn lend to General Motors have instant access to their money?

Bank runs.

One big advantage of the above “two account” system is that it would greatly slow down bank runs. As regards 100% safe accounts, there would be no reason for depositors to take part in a run because their money is safe. But if they wanted to take part in a run, they’d get their money.

As to those with investment accounts, they just can’t have instant access their money. So they COULD take part in a run, but the run would take place more slowly than under current arrangements.

The non-existent deflationary effect.

An apparent disadvantage of the above “two types of account” system is that it places restrictions on what can be done with money. And that would certainly have a deflationary effect, all else equal.

But that deflationary effect is easily countered simply by expanding the total stock of money. Various governments / central banks have implemented a HUGE rise in their monetary bases over the last two years in response to the credit crunch, so expanding the stock of money is not difficult.

Of course the twits in high places in the Western world have channelled this extra money into the pockets of precisely the section of the population LEAST likely to spend it: that is the rich. Doh! But that’s a minor technical point. The important point is that channelling extra money into the pockets of the population at large is not difficult.

Or as Milton Friedman put it in Chapter 3 of his book “A Program for Monetary Stability”, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

Maturity transformation.

Astute readers will have noticed that the above system curtails maturity transformation: that’s the ability of banks to borrow short and lend long. Indeed, the above system could be taken to the extreme of outlawing maturity transformation. That could be done by forcing banks and shadow banks to match the maturity of the loans they make to the maturity of those with investment accounts.

So would banning maturity transformation do any harm?

Well the basic argument for maturity transformation is that allegedly makes more efficient use of the money deposited at banks. But the flaw in that argument is that money is simply numbers in computers. Thus making efficient use of money is a totally different kettle of fish to making efficient use of buildings or machinery.

Put another way, viewed from the perspective of microeconomic entities (households and firms), it makes sense to make efficient use of money. But this idea breaks down at the macro-economic level. That is because, as pointed out above, expanding the total stock of money costs nothing.

P.S. (c.9.30am same day). The above system also largely disposes of the implicit subsidy that banks get: that’s the artificially low rates they can borrow at on account of government guarantees. This subsidy was estimated by Britain’s Independent Banking Commission Final Report (p.130) as being well over £10bn a year in a NORMAL year (i.e. bank subsidies in the recent credit crunch years have clearly been higher).

Second P.S. (same day). Far as I can see from this paper by Andrew Haldane, the implicit subsidies that banks get are larger than their profits. (See just before his conclusion.) LOL.



  1. In the UK we should just remove the FSA deposit protection scheme.

    100% secure deposits are available at National Savings and there is no reason it couldn't offer the basic current account functionality (as used to happen when National Girobank existed).

    I'm struggling to see how private banks can offer better money transmission mechanisms than that.

  2. Cash "safety" should include safety against inflation. A bag of coins in the 19th century largely maintained its value - or even gained (tax-free) because some things (e.g. rail travel) got cheaper.

  3. Sackerson,

    I’d favour a limited amount of inflation proofed savings per person. That would protect the less financially astute people who wanted to save for retirement, for example. But hoarding large amounts of cash serves no public purpose: in fact it leads to potential instability if too many people decide to spend their savings at once. So I wouldn’t allow millionaires to have very large sums protected from inflation.

    Also I wouldn’t allow instant access to the inflation proofed savings. If those claiming to want inflation proofed accounts for long term savings are being honest, then take them at their word: don’t let them have instant access. Assuming they are being honest, they won’t mind losing instant access. Plus removing instant access reduces the amount of potential instability: too many people spending their cash at the same time.

  4. And yet, for the first time in the 35 years since they started, Index-Linked Savings Certificates were taken off the market on 19 July 2010, and only re-offered in a 4-months-long window in 2011 (early May to 7 September). This is precisely the product that meets your specifications, and clearly the government has no interest in the plight of the small saver.


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