The daily headlines report new financial woes in banking, real estate and construction. The audience of news junkies may believe that the U.S. economy is poised on the brink of deep recession and economic disaster.
The reader should be skeptical of the gloom that pervades the press. There has been little change in the armory of economic protection that in the past kept recessions reasonably mild.What has changed is the public's conviction that this armory is worth the cost.
To get a truer picture of financial disaster, one has to go back to see what it was like in the bad old days before federal deposit insurance. Financial crises were characterized by bankruptcies and bank failures.
The banks failed when their loans were not repaid. Depositors were left high and dry, and in an attempt to protect themselves, withdrew their funds in cash before the banks had a chance to close their doors. Those depositors who didn't make it in time suffered a loss of wealth.
In those days, financial crises could be brought on by a variety of shocks to the banking system: a stock market collapse, a depositors' run on the banks or a dose of tight money imposed by the central bank in order to protect its reserve of gold.
The financial problem we have today is only a distant cousin to the crises of the past. This financial malaise was not brought on by the Federal Reserve acting in defense of a stable price level, or in an attempt to halt the depreciation of the foreign exchange value of the dollar.
The most likely cause of the present crisis was the failure of banks and property developers to halt the new construction unleashed during the 1980s. The problem is being aggravated by the zeal of federal bank examiners whose insistence on the restoration of hypothetically sound capital adequacy ratios is pressuring banks to cut back loans.
The outpouring of new construction is characteristic of a banking system that heretofore had not been restrained by risk. The villain of the piece is federal deposit insurance.
Insurance of savings and loan deposits, combined with deregulation of interest rates and lax supervision of loan portfolios, induced individuals to place their money with S&Ls that promised high interest rates. Billions of dollars were poured into real estate and junk bond investments that have now gone sour.
But we must not forget that federal deposit insurance will also serve to insulate the economy from the troubles of the banking system.
As a result of deposit insurance, there need be no contraction of the money stock and no wave of bank withdrawals. With no repercussions on the money stock, today's shakeout in banking and real estate is unlikely to cause a general economywide depression. There will certainly be a loss of capital value in bank stocks, and a number of banks will be forced to merge.
This places great pressure on the federal budget because the government is obliged to make good the difference between the shrunken market value of bank assets and deposit liabilities in failing institutions. But deposit insurance will prevent it from generating a deep recession.
There are unlikely to be repercussions on the foreign exchange markets or on the foreign exchange value of the dollar. Because of federal deposit insurance, foreign holders of bank CDs and other bank liabilities are confident of the liquidity of their holdings.
A reform of the deposit insurance system is needed to prevent a repetition of the investment binge we have just experienced. So long as Congress and the executive branch will not allow bank depositors or bank creditors to suffer from bank failures, our financial system will continue to experience these bank investment binges.
The reason is that the depositor and creditor have no incentive to monitor the quality or performance of banks, and therefore no incentive to deny capital to banks that take undue risks.
But a depositor will pay no attention to his bank deposits or CDs. His deposits and CDs are safe, because the federal government will bail him out if the issuer defaults. This is an invitation to excessive risk-taking on the part of banks who can attract funds by offering interest rates in excess of the market. If the investments fail, the banks' owners risk only their thin slice of equity. The loss falls on the taxpayer. If the investments pay off, the owners' thin slice of equity earns a high return. Taking good years with bad, when bank liabilities are insured by the government, a bank charter is a license to print money.
It is clear that the system has to change, and the sooner the better.