Economists trail mainstream media in understanding role of deposit insurance in modern banking system

In the past week, articles in both the Telegraph and the NY Times have embraced this blog's ideas on the role of deposit insurance in a modern financial system.  This puts them miles ahead of the economics profession.

In a recent NY Times column, Nobel-prize winning economist Paul Krugman lays out the economists' view on why banks need to be bailed out.

Just to be clear, Spanish banks did indeed need a bailout. Spain was clearly on the edge of a “doom loop” – a well-understood process in which concern about banks’ solvency forces the banks to sell assets, which drives down the prices of those assets, which makes people even more worried about solvency. 

Governments can stop such doom loops with an infusion of cash; in this case, however, the Spanish government’s own solvency is in question, so the cash had to come from a broader European fund. 

So there’s nothing necessarily wrong with this latest bailout (although a lot depends on the details). 

What Professor Krugman describes as a 'doom loop' is the classic formula for a run on the bank.  While the 'doom loop' is well understood, it has not existed in our financial system since the 1930s.  It was ended by FDR's administration with the creation of deposit insurance.

Deposit insurance severs the relationship between a bank's solvency and the depositor's perception of the safety of their money.  So long as depositors believe that the guarantee will be honored, they don't care whether a bank is solvent or insolvent or whether a bank has positive or negative book capital levels.

Why should they care as it is irrelevant to whether they can get their money out?  What matters is their belief in the ability of the sovereign to honor its guarantee.

The bank runs that are occurring in the EU are a direct result of increasing doubts about the sovereign's ability to honor its guarantee.  These doubts reflect

• The reduction in the sovereign's financial condition that results from borrowing to inject money into the banks (note:  this doesn't improve depositor confidence as they don't care about bank capital levels); and

• The threat by policymakers of forcing a country to convert from the euro to a less valuable currency (note:  depositors understand that forced conversion of their savings will result in their losing a sizable percentage of the value of their savings).

These increasing doubts and their related bank runs are a direct reflection of the choices that policymakers and bank regulators are making.

It would be easy to end the bank runs, simply make different choices.  Choices that take advantage of the deposit guarantee.

It is this feature of a modern banking system that allows banks to absorb all the losses on the excesses in the financial system and protect the real economy.  Banks can absorb these losses because depositors don't care about the bank's book capital level.

The choice of adopting the Swedish model with ultra transparency takes advantage of the deposit guarantee and ends the bank runs.  In addition, it removes the burden of the excess debt from the real economy.  This in turn leads to the economic growth that Professor Krugman has been calling for.

I suspect that Professor Krugman will support the choice of the Swedish model with ultra transparency.  After all, he observed

Put all of this together and you get a picture of a European policy elite always ready to spring into action to defend the banks, but otherwise completely unwilling to admit that its policies are failing the people the economy is supposed to serve....

Whatever the deep roots of this paralysis, it’s becoming increasingly clear that it will take utter catastrophe to get any real policy action that goes beyond bank bailouts. 

But don’t despair; at the rate things are going, especially in Europe, utter catastrophe may be just around the corner.