Tuesday, 16 April 2019
The flaw in deposit insurance.
Suppose person X lends money to person Y, or hires out something else to Y like a car or house. If Y fails to repay the item borrowed, is there any obligation on taxpayers to reimburse X?
Well the answer is clearly “no”. And why is the answer “no”? Well it’s because of a widely accepted principle that it is not to job of taxpayers to stand behind commercial transactions or reimburse those engaged in commerce if they make a loss.
Next, suppose person X lends money to person Y via a bank. That is, X deposits money at a bank with a view to earning interest (i.e. having their money loaned on by the bank), and the same happens: that is Y fails to repay the money. Plus let’s assume enough other borrowers fail to repay loans that the bank goes bust.
The same principle applies doesn’t it? That is, where X places money at a bank with a view to the bank lending the money on, X and the bank are into commerce just as much as where X hired out money (or anything else) direct to Y. In fact X is into commerce there just as much as if X placed money with a stock broker or mutual fund that invested in shares or corporate bonds.
Banks actually are intermediaries.
At this point, some readers may be tempted to object on the grounds that commercial banks are allegedly not intermediaries: that is, a commercial bank does not need a deposit from X before lending to Y.
Well, first that doesn’t in any way weaken the above point that when a bank lends money it is into commerce and is thus not entitled to taxpayer funded support if anything goes wrong with its money lending activities.
Second, while it is true that a commercial bank does have some freedom to create money out of thin air and lend it out, it cannot do that willy nilly. If a bank does engage in the latter “willy nilly” strategy, it will run out of reserves That is, the indisputable fact is that banks have to attract about as much money from depositors, bond holders etc as they lend out. Thus banks are to a large extent intermediaries.
To summarize so far, it would seem that government organised deposit insurance does not make sense in that it involves taxpayers standing behind commercial transactions.
However, it could possibly be argued that deposit insurance makes sense if it’s run on commercial lines. Well the first problem there is that it is debatable as to whether a GOVERNMENT run deposit insurance scheme (whether it’s deposit insurance or any other type of insurance) is a genuinely commercial operation: reason is that governments have access to almost infinitely large amounts of money if things go wrong. First, governments can grap near limitless amounts of money off taxpayers, and second, governments (along with their central banks) can print limitless money. And if that money printing leads to excess inflation who cares? If a government faced with large losses by banks prints excessive amounts of money to save those banks and causes excess inflation, at least government has made good on its promise to rescue banks!
A second problem with the idea that deposit insurance is OK if it is run on commercial lines, is that if government is going to have a Rolls Royce totally fail safe form of insurance for banks, that constitutes an artificial preference for or privilege for banks, in that there are a thousand other types of commercial activity, ranging from restaurants to garages and coal mines to aluminium smelters some of whom might like the idea of being insured against losses by a Rolls Royce insurer with an infinitely deep pocket.
To summarise, it looks like the arguments for deposit insurance do not stack up (as argued by the Nobel laureate economist James Tobin in his work “The Case for Preserving Regulatory Distinctions”).
However, that is not to argue that people are not entitled to a totally safe way of storing and transferring money. Clearly they are entitled to that. The point is that once they seek to have their money loaned out, i.e. as soon as they want interest, they are into commerce. They have crossed the Rubicon.
In short, the best system is where anyone who wants a totally safe method of storing money is provided with that option, provided their money is not loaned out. And that do you know? That’s full reserve banking: what James Tobin, Milton Friedman and some other Nobel laureate economists have long argued for.
Lending out “safe money” imparts stimulus?
A popular argument against the latter conclusion is that allowing “safe money” to be loaned out would be stimulatory, plus it allegedly cuts interest rates and encourages investment. Or put the other way round, the argument is that a ban on lending out safe money would raise interest rates and damage the economy (an argument put by the UK’s Vickers Commission, sections 3.20 – 3.24). Well the answer to that is that if stimulus is needed, that can be implemented at no real cost. 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."
Thus there is absolutely no need to subsidise banks or give them any sort of artificial preference to enable stimulus to be imparted.