I must admit that I was a little worried a couple of days ago when the government moved to guarantee $20,000 per deposit account. For starters, this was an explicit guarantee and so woke up everyone to the fact that whatever guarantees we currently had were implicit at best. Secondly, while this might cover 85 percent of accounts and looked ‘fair’ the role of the guarantee was not to do this. Instead, we want a guarantee with ensure that sparks don’t become fires. And when it comes down to it, $20,000 caps cover a fraction of the kindling in the pot. Most of the deposits are by larger holders, businesses and yes, the additional payments people have been making into their home mortgages during the last decade of economic prosperity. If someone shouted ‘fire’ at a particular institution, those deposits would run and the bank or other institution would still be in trouble.
Some have argued that we do not need full guarantees because our banks are sound and depositor-priority will prevent runs. But this ignores paid-down loans. It also ignores the fear breeding on itself effect. Put simply, bank runs are worrying because they can be self-fulfilling. This is as non-controversial a proposition as you get in economics. Milton Friedman first articulated it and Diamond and Dybvig modelled it. Game theorists call this a coordination failure (something that happened to be the topic of my PhD thesis). Banks lend out more than they have in deposits. That is fine so long as the deposits do not get called. But if I and others (remember John Laws and the then St George Building Society) worry that they will be called, we race to be at the front of the queue by withdrawing first. Pretty soon, unless your bank manager is James Stewart and it is Christmas Eve, that fear has become reality for the bank.
This is the time when small fears can become big realities. But the government (or RBA) can stand in the role of James Stewart. By guaranteeing all deposits during these times, there is no need to translate fear into action. To be sure, an institution could get in trouble for other reasons (and so the guarantee will turn into real dollar payments by the government) but the guarantee stops the flight if someone should shout ‘fire’ without justification.
Today, the government is seeing the problem more clearly and talking about upping the guarantee. This is what has happened elsewhere in the world. Personally, I think that a full guarantee for the next six to twelve months is in order. If the banking system is as sound as the government says it is, this is a vote of confidence in it. Moreover, that move appears to have bipartisan support. That all makes my less inclined to start splitting accounts between family members or drawing down the home mortgage to put funds in other banks. But I would like to see a more definitive statement before markets open on Monday.
This, of course, would just be a short term measure. We need to think more clearly about the forms of guarantees and deposit insurance we have in this country. For insurance, I would like to see institutions and deposit insured pay a premium and can think of ways to do this. The problem is that right now, working out the long run funding issues is not a priority when we sit in a tinder box.
[See also John Quiggin]