Taking Economics Seriously by Dean Baker

Author:Dean Baker [SPi]
Language: eng
Format: epub, pdf
ISBN: 9780262014182
Publisher: The MIT Press

3

The Big Bank Theory

WALL STREET BANKERS, ALONG WITH the rest of the players in the financial industry, like to think of themselves as swash-buckling capitalists. They battle cutthroat competition with one hand and oppressive government bureaucracy with the other. In reality, however, the financial industry is deeply dependent on the government. Far from the rugged, go-it-alone types they wish they were, they are more like well-dressed, coddled adolescents. And this is true in good times and bad.

The industry’s dependency takes five main forms:

1. the explicit safety net provided by government deposit insurance;

2. the implicit safety net provided by “too big to fail”;

3. the special privilege of being the only untaxed casino;.

4 the invitation to raid state and local governments for fees;

5. the right to change contract terms after the fact.

These dependencies are entrenched, and, despite loud protests to the contrary, the removal of government from the financial sector is not really on the agenda. The industry wants government regulation, just not in a way that curtails its profits. As we have already seen, the issue is not and never has been the free market versus government regulation. The real question in financial regulation is whether regulation will be structured in a way that advances the public interest or in a way that allows the financial sector to prosper at the expense of the rest of us.

PERHAPS THE MOST IMPORTANT FINANCIAL reform to come out of the Great Depression was federal deposit insurance under the super-vision of the Federal Deposit Insurance Corporation (FDIC). The FDIC protects banks from the sort of runs that led to the bank failures of that era.

Banks typically keep only a small portion of their customers’ deposits on reserve, and, even then, lend most of it at interest. This practice is reasonable because customers are unlikely to want all of their money at the same time. In fact, there may be as much money deposited as withdrawn on any given day.

But if depositors become concerned about the health of the bank, they may rush to pull money out. Those at the bank first will be able to get their money. Later arrivals will be out of luck, as the bank’s reserves will be depleted. Thus, before federal deposit insurance, runs were a logical response to the fear of bank failure.

The FDIC completely changes that logic. By insuring the bank’s deposits, the FDIC eliminates the incentive for depositors to rush to withdraw their money. They know that their funds (up to the insured level) are safe.

The FDIC lent an enormous amount of stability to the system, and the benefits are shared by depositors and banks alike. However, government insurance means that the market does not offer the normal discipline against risky behavior. Typically, a bank making highrisk loans must offer high interest rates in order to assuage wary depositors. But if the bank has government insurance, depositors need not worry about losing their money thanks to others’ unpaid loans. Thus, insurance allows the bank to attract deposits at relatively low interest rates and still incur high risk on loans.

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