krebscycle

Banks make money via statistics that allow them to lend out most of the money they have on deposit and keep just a small “reserve” in cash. Suppose 1000 people all deposit $1000 getting say %1 interest and the bank lends $900,000 to other people getting %8 interest while keeping $100,000 around to meet withdrawals. Over a year, the bank earns $72,000 and pays $10,000 plus its operating expenses. In general, withdrawals will be matched by deposits and borrowers usually don’t default so the bank can afford to have 90% of the money deposited with it out on loan. Things can get more complex, but the idea is that if the bank is smart, it can ride this statistical advantage to great profits. However over 700 years or so, societies have learned that this business model always fails in the long run. The quality of the banks operation (how good its loans are etc. ) is not visible to depositors until something goes wrong – at which point there is not enough money to pay back deposits. Second, and more dangerous, when there are business cycle recessions or panics or other unpredictable (but expected ) events, the model fails: more borrowers default and customers take money out without any counterbalancing deposits. The statistics are vulnerable to surprise – a problem for banks and nuclear power plants alike. But third, and most dangerous, bank  failures can easily trigger  large scale economic disruption. A business can’t meet payroll because its payroll money disappears in the bank failure. A supplier can’t get paid because the buyer’s money disappeared. A renter can’t pay rent because her savings account vanished. As a result more people and companies are forced to pull savings out of banks and default on loans – spreading a circle of failure.

By the late 19th century it was clear that modern market economies are so tightly interconnected that governments have to moderate the effects of  of bank failures to prevent economic disasters. The world economy is far more tightly connected now than it was 100 years ago when banks were smaller and more local and even then bank panics were sometimes international events. And bank size, even if we could control it, is not the critical variable. The S&L Crisis (not to mention the Great Depression) showed that 1000 small banks collapsing is not safer than 10 big banks collapsing  – both are potentially catastrophic

So every nation has a complex system of bank regulations to supposedly compensate for the first problem and deposit insurance plus central bank loan programs to compensate for the second problem. Banks can get short term loans from the central bank to keep from sinking under short term imbalances and depositors get their money back from some sort of government insurance if the bank fails. This model, after some fixes in the 1930s, worked reasonably well for decades, but its clearly not working so well anymore. And anyway, it’s not that great a solution because it involves  subsidizing big banks and bloating the finance sector – something people nostalgic for the New Deal often fail to appreciate.

Some argue that the solution is to both split up the TBTF banks and amp up the level of regulation. This seems more like nostalgia than anything else – and nostalgia for a system that doesn’t match our economy. Our modern financial system is different from the system of the 1930s and the one of the 1960s: more interconnected, billions of times faster, and harder to understand because of both globalization and technology. Global computerized finance is always going to be three steps ahead of regulation and incredibly difficult to police for risks. Fortunately, all the automation and computer technology allows us to solve the problem by replacing a large part of the financial system with simple government services.

Suppose the government provided citizens and businesses with bank accounts and electronic payment services. Let’s say, deposits of up to $100,000 earn 3% plus inflation and deposits over that amount earn nothing. Maybe IRAs can pay a little more. Furthermore, business and individuals can qualify for credit up to a certain amount based on statistical measures and/or with appropriate collateral.  In short, we could stop the practice of making  government banking  available only to banks. If you want to borrow more or earn more, then take your chances in the marketplace. But if you want to keep your savings, your cash deposits from your business, your operating funds, somewhere safe and convenient – go to the government bank.The government could do all this with less bureaucratic inefficiency than the current banking system requires. In the financial  panic of 2007-2009, the Federal Reserve Bank operated the commercial paper market without a hiccup – and made the government money. The plain fact is that the private banks do not add much value to the clearing/savings system – on the contrary they add volatility and overhead. And they also direct investment capital into destructive gambling activities. If we also ended another subsidy of Wall Street by giving all 401K savers the option of a no fee 10 year treasury bond plan, this proposal would significantly reduce the size of the financial sector.

If such a system were in place bank failures would lose their contagious effect because the core clearing functions of the financial system would just keep operating. Bank panics would be less harmful to the greater economy and would damp themselves out. And so, we could reduce the amount of government supervision of and support for the banking system. I suspect this would lead to the success of innovative financial institutions like peer-to-peer lending and networked bond markets.

The side advantage is that the government would not need to borrow money from banks to run. Consider that nations in the EU now are begging banks to buy their bonds – and the banks have money to buy the bonds only because they have deposits which they only have because the government guarantees bank deposits!  The current system is a scheme that only makes sense to bankers – but they could get real jobs.