Wednesday, 30 January 2019

A flaw in deposit insurance.

An alleged merit of deposit insurance is that it encourages saving (in the form of accumulating a stock of money held in banks), which in turn encourages banks to lend, which allegedly increases investment. There are several flaws in that idea. James Tobin in his paper “The Case for Preserving Regulatory Distinctions” pointed to several flaws. But the flaw I wish to highlight (not spotted by Tobin, far as I can see) is as follows. 

Absent deposit insurance, so called deposits held at banks are actually more in the nature of shares, in that those so called deposits can lose some or all their value (a third of all deposit money in US banks in the 1930s went up in smoke). So deposit insurance in effect turns shares into what might be called “genuine money”.

But assuming that prior to the introduction of deposit insurance everyone has their desired stock of genuine money (in the form of genuinely safe state issued money, i.e. base money) then after the introduction of deposit insurance, the “saver / lender” section of the population will have more than its desired stock of genuine money. Thus those people will try to spend away the excess, which will cause inflation, assuming the economy is already at capacity. That will cause government to impose some sort of deflationary measure, like raising taxes and confiscating a portion of peoples’ stock of base money.

But that means the “non saver / lender” section of the population will then have less than its desired stock of genuine money, thus it will resort to borrowing money.

To summarise, to a significant extent, the additional lending and debts that arise as a result of deposit insurance is caused by a perceived shortage of money which is caused by deposit insurance! To put that more starkly, a proportion of pay day borrowers paying a thousand percent, do so precisely because of a misguided attempt by the great and the good to encourage lending and debt.

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