This Wall Street Journal article argues that had money market funds (MMFs) not been bailed out during the crisis there’d have been no crisis, or at least its severity would have been ameliorated. Quite.
One aspect of full reserve is that those who deposit money in banks or any bank like institution like MMFs, AND WHO want their money loaned on so that they can earn interest, have to bear the cost when the latter loans go wrong. Unfortunately we don’t abide by the latter policy at the moment, and the consequences are dire. As the article points out:
“Until then, most people thought that the value of each share in a money-market fund (MMF) would always be $1. Depositors thought that if they had, say, 1,000 shares in the fund, they could redeem them for $1,000. Yet the value could actually fall if the underlying assets lost enough value.
When depositors tried to withdraw their funds, Reserve started paying them 97 cents for shares that depositors expected to be worth $1—thus "breaking the buck." Investors in other money-market funds, fearing something similar, started redeeming their shares. In just one week in late September, depositors withdrew $350 billion from MMFs. As other MMFs sold commercial paper to generate the funds to redeem their customers' shares, the value of commercial paper fell further. One Federal Reserve economist quoted by Mr. Blinder recalled that "we were staring into the abyss" and "there wasn't a bottom to this." That led Treasury Secretary Henry Paulson to get President Bush's permission to set up insurance for MMF depositors. It worked, and the outflow from MMFs stopped.”
Yes, “it worked”, but at what cost to the taxpayer?
The article continues:
“Had the Treasury made clear that it would not bail out MMFs, then many of them would have also had to "break the buck." Once depositors knew there was no gain from getting their funds out early, the run on MMFs would have ended, thus stopping, or dramatically slowing, the plunge in value of commercial paper.”
That’s possibly a bit optimistic. A SUDDEN refusal to bail out “buck breaking” MMFs might have caused a worse panic. But what is indisputable is that once it becomes GENERALLY ACCEPTED that funds deposited in banks or bank like entities will FLOAT in value along with the changing or FLOATING value of the underlying loans / investments, then those “deposits” become very similar to shares in corporations or mutual fund / unit trust holdings. And a 10% drop in the value of the latter is not regarded by 90% of the relevant investors as a reason to panic.
As Mervyn King put it, “We saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis. Equity markets provide a natural safety valve…” (King’s speech: “Banking: From Bagehot to Basel, and Back Again.”