Guarantee in The Age

I have an opinion piece in The Age today explaining the rationale behind the government’s move on deposit guarantees.

A guarantee against panic

Joshua Gans, The Age, 14th October, 2008.

A FEW days ago I did a strange thing. I split our household savings account into five (two adults plus three children) and was about to do the same at another bank. My intention had been to take money out of our home mortgage (which had equity in it) and spread it around accounts and banks. Why? Because last week the Federal Government looked like introducing a guarantee on bank deposits of up to $20,000 per account. I had no account with that much in it. But, just in case, I thought I had better have them.

This type of behaviour may be time-consuming but it is fairly innocuous. What is not innocuous was my definition of “just in case”. To be frank, I had no idea what precisely it was. I just knew that, if it occurred, I would be foolish had I not taken advantage of the Government’s guarantee. Fear, and not necessarily irrational fear, was driving my actions.

At the weekend, the incentives for this type of behaviour disappeared when the Government moved to guarantee all deposits in all accounts (not just $20,000 in each of them). I may look a little foolish holding all of these accounts (which will be soon closed) but I am the happier for it. The guarantee means that I no longer have to think about “just in case” actions and can get on with my normal life.

To see why this is, let us revisit the economic theory of bank runs. The starting point is the uncomfortable fact that “deposit” is a misleading word when used in the phrase, “depositing money in the bank”. We rarely do this. For instance, usually, when we get paid, our employer’s bank tells our bank that there is some money there if they want it. When we do put money in the bank, it does not stay there. After all, what would be in it for the banks? They lend it out and this happens over and over again. At any one time, should everyone want their cash back, the system could not give it them.

Just like Wile E. Coyote as he goes off a cliff, everything is fine as long as no one starts to focus on the fact there is no floor. But the problem is that there are times when people start to think about it (as I and many others did last week). Thus, even if our banks and financial institutions are operating soundly, this can change by virtue of a panic. It is just as if someone cries “Fire!” in a crowded theatre. Then there is a rush to the door.

To be sure, you want to get out if there is a fire, but in this situation, all you might observe is the rush and, in that case, you know you want to be ahead of others. Fear can breed upon itself and the existence of an institution in trouble can go from prophecy to reality.

A deposit guarantee works not by supporting failing banks, but by changing the rules of the game. Moreover, its role in this is about as non-controversial a proposition you get in economics.

“The insurance gives depositors confidence that their deposits are safe. It thereby prevents the failure or financial difficulties of an unsound bank from creating runs on other banks. The people in the crowded theatre are confident that it is really fireproof.” So wrote Milton Friedman in his free market opus, Free to Choose, back in 1980.

The guarantee gives people confidence that they can get out of the fire safely — you have to go far to the right indeed to find those who dispute having this underlying foundation for our banking and deposit-taking system.

Given this, it is perhaps surprising that Australia has drifted along for so long without an explicit guarantee. No one really thought the Government would let a big bank fail. But that was no real comfort for smaller institutions that provided long-term competition against them. Even last week there were some who were saying that such guarantees were not needed because our system was currently sound. And following the policy change, others have argued that it just shifts risk to the Government. Both views are misplaced. They are based on a notion that only institutions that are unsound can be subject to runs. In fact, the way in which a guarantee changes the rules of the game actually eliminates the risk of unfounded panics.

There is more to be thankful about in the way the Government has approached policy. For starters, when faced with real issues of confidence, they changed course on their previously stated $20,000 policy that likely would have done more harm than good. In addition, they didn’t just guarantee deposits, they also put guarantees on the funds banks lend to each other. Third, the Government injected another $4 billion into the other way our institutions get their money to fund home loans — residential mortgage-backed securities. This was a way of ensuring that all financial institutions benefited from the new foundations of our system. Finally, the policy announced is not open-ended, being for three years. That will commit the Government to finding a real, out-of-crisis, way of guaranteeing deposits.

One final remark concerns the political process. Last week Malcolm Turnbull put pressure on the Government to increase the deposit guarantee and inject more liquidity in the system. The Government then looked above politics to make sure it did the right thing. And then the Opposition moved, unlike their US counterparts, to ensure that the policy had quick passage through Parliament and could work to provide confidence from day one. From my perspective, the way this has happened has reduced the political risk to economic management in Australia and is something that we all should applaud.

Joshua Gans is an economics professor at Melbourne Business School. For recent research on liquidity, go to aussiemac.org

One thought on “Guarantee in The Age”

  1. “A few days ago I did a strange thing.” You weren’t the only one, not strange at all by that measure. I’ll bet Kev and Tess felt the impulse too, but realised they didn’t have enough kids’ accounts to decant into.

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