Tuesday, June 25, 2013

WSJ article advocates fail safe and subsidy free banking system.

This article in the Wall Street Journal yesterday by Prof. John Cochrane advocated the sort of banking system which tends to be advocated by full reserve enthusiasts, like me, Laurence Kotlikoff, etc. That’s a system under which it is plain impossible for a bank to SUDDENLY fail. Though a slow decline is perfectly possible.

The system also involves no bank subsidies (though Cochrane didn’t mention that, far as I can see).

As Cochrane says, “At its core, the recent financial crisis was a run. . . .  In the 2000 tech bust, people lost a lot of money, but there was no crisis. Why not? Because tech firms were funded by stock.”

Later he says, “Runs are a pathology of financial contracts, such as bank deposits, that promise investors a fixed amount of money and the right to withdraw that amount at any time.” Spot on.

And: “Institutions that want to take deposits, borrow overnight, issue fixed-value money-market shares or any similar runnable contract must back those liabilities 100% by short-term Treasurys or reserves at the Fed. Institutions that want to invest in risky or illiquid assets, like loans or mortgage-backed securities, have to fund those investments with equity and long-term debt. Then they can invest as they please, as their problems cannot start a crisis.”

Couldn’t have put it better myself.

Or in the words of Mervyn King, “…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, and when they suffer sharp falls, economic policy can respond. But when the banking system failed in September 2008, not even massive injections of both liquidity and capital by the state could prevent a devastating collapse of confidence and output around the world.”

Or in the words of George Selgin, “For a balance sheet without debt liabilities, insolvency is ruled out…”. (That’s from his book “The Theory of Free Banking” which is available for free online, though I couldn’t find the URL while writing this post. Doh!)

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