Felix Salmon: "Amar Bhidé is a smart man with a very stupid idea"

http://blogs.reuters.com/felix-salmon/2012/01/04/why-we-shouldnt-guarantee-all-bank-deposits/

Where do I begin? 

Felix S: "I can answer that question in one word: Ireland. That country’s blanket government guarantee of all bank deposits was the single dumbest decision of the global financial crisis,"

Virtually all Western governments implicitly or explicitly guaranteed all bank deposits (and other forms of short term cash, such as money market funds) in 2008.  The Irish government's intervention was unique: under intense pressure from the Germans  (because the Landesbank held large chunks) the Irish government assumed responsibility for bank bonds, compromising its own solvency overnight.

I agree this was “dumb”; but it has nothing to do with whether or not deposits should be guaranteed.

Felix S. "there’s a world of difference between a liquidity crisis and a bank run. A liquidity crisis is when banks don’t lend to each other; a bank run is when depositors withdraw the money they have on deposit and move it elsewhere."

Says who? Deposits are deposits--whether is Jane Doe depositing her pay check, IBM deposits its surplus cash, a bank lending to another banks (that’s called an interbank deposit, Felix) or even a small business securing a loan that's then "deposited" in its bank account (in fact deposits created by loans have exceeded the deposits of savers since about the mid 19^th century)

The panicky withdrawal of any of these deposits threatens a run/panic/financial collapse, call it what you will. And indeed historically the withdrawals of wholesale deposits, particularly interbank deposits have been the far more dangerous.

As the Comptroller of the currency wrote in 1909, the panic of 1907 wasn’t the result of “the lack of confidence of the people in the banks, but more to a lack of confidence of the banks in themselves.”

(I had this line in the draft of my op-ed, that had to be cut for reasons of space)

It is therefore crucial that all deposits, especially wholesale, interbank deposits be guaranteed.

Felix S. “That’s the whole point of fiat currency: it is what it is. You can buy stuff with it.”

Buying stuff with paper currency now comprises a tiny proportion of commercial transactions – the medium of exchange. The overwhelming proportion of payments take place through the banking and unfortunately the shadow banking system (eg transfers from money market funds).

As Homer Jones (of the FDIC) wrote in a 1938 article in the Economics Journal, “if deposit insurance is to be justified, it must be on some grounds other than the mere provision of additional security to certain members of the population… The soundest grounds for deposit insurance are the facts that a great portion of the liabilities of the commercial banks are payable upon demand, and that these demand liabilities of the commercial banks constitute the chief element in the circulating medium of the country.”

Jones also made a compelling argument for comprehensive insurance that I have pretty much recycled in the op-ed and in my book: If deposits remained partly uninsured – in 1938 only 43 percent of deposits in FDIC insured banks were covered -- panicky withdrawals wouldn’t be fully discouraged. Presciently, Jones predicted that “in the light of past experience the Government will probably not in the future permit failure of the very large banks-the banks which hold the bulk of the uninsured deposits. If this is true, the depositors in these banks have what is in effect 100 per cent insurance at the present time. But in the absence of official recognition of the fact the Government bears the risk or cost without the maximum social benefit.”

Finally Felix S. “Let’s try to work out how on earth he arrived at this rather crazy notion.”

From an extensive study on the history of U.S. deposit insurance is how. Now going through library stacks and mounds of historical material may not suit a prodigious writers schedule. But there is a shortcut: Read chapters 10, 11, 13, 14 of a Call For Judgment (you have a complimentary copy already.) The history might even be helpful in understanding how the banking system works.

In an update, Salmon grudgingly concedes the blooper in his dramatic lead off (“in a word, Ireland”). Its true, he acknowledges “that Ireland guaranteed all bank debt, not just deposits… But if there’s an unlimited government guarantee on bank deposits, then banks will simply fund themselves through deposits and not through bank debt at all.”

Not unless capital requirements are abolished.