Friday, December 18, 2009

If you give a monkey a scalpel, will it do neurosurgery?

The hardest thing about predicting 2010 is that the academic economists who direct policy makers have no idea what they are doing, and therefore could do anything. Exhibit A, the gloriously wrong Scott Sumner:
I am increasingly of the view that moral hazard is the central problem with our financial system. This is partly because I was already leaning that way, and partly because I found Charles Calomiris’s recent interview on EconTalk to be quite persuasive. Most people don’t think of it this way, but in 1934 we essentially nationalized the liabilities of the entire banking system. We teach our students that when you deposit $5000 in your bank account you are actually loaning $5000 to that bank. Not true. You are loaning $5000 to the Treasury, and they are re-loaning the funds to the bank. And the Treasury absorbs the losses if the bank defaults.

John Allison also wants to get rid of FDIC and Too Big to Fail policy. These are good ideas. But when you take a closer look, Allison falls into the same trap as many other libertarians; he is too dogmatic.
The FDIC is about the only thing that works right, and even it is not implemented correctly as it should have no cap, and thus put the unstable and dangerous money market fund out of business.

The thinking behind this nonsense is that banks somehow lend out deposits, and therefore depositors, like other investors, should be more careful about where they put their money. Unfortunately for Scott, and everyone else in a University, banks do not lend out deposits. Banks CREATE deposits by making loans. Therefore, risk management must happen at the moment of credit creation. Banks should make loans that will get paid back.

Banks are the instrument by which the Govt enables the private sector to create money. Their Equity is private capital put in first loss position to try to force good investment decisions. Deposits should be as safe as giving the money back to the Treasury for safe keeping.


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