Every so often, the Economist publishes a piece from its editorial board that is simply astonishing—and not in a good way.
Over the last five years, I’ve considered the British magazine, The Economist, my go-to source for information and analysis about international events and the global economy. The magazine’s extensive coverage and analysis of complex events is unsurpassed in the popular press, a likely explanation for the magazine’s popularity among business leaders and policy makers across the globe read it regularly. However, every so often, the Economist publishes a piece from its editorial board that is simply astonishing (and I don’t mean that in a good way).
In last week’s edition, the Economist published an essay and a shorter, companion piece claiming that “state subsidies and guarantees are once again corroding the financial sector and creating new dangers” (the pieces can be found here and here). I expected the articles to discuss the potentially dangerous moral hazard created by the existence of banks that are too-big-too fail. That is, when investment and commercial banks become so large that their failure would threaten global financial markets, and investors accordingly assume that the government will rescue the bank should something happen. This implicit assumption on the part of investors increases access to cheap credit and encourages excessive risk-taking. As the Federal Reserve Bank of New York explains, this phenomenon functions like a direct government subsidy. However, the Economist spends little time discussing the implications and dangers of implicit government backstops. It’s an issue that ought to be more frequently discussed.
Instead, the larger message of the piece is far more controversial and much more incorrect. The editorial board asks, “In America, a citizen can now deposit up to $250,000 in any bank blindly, because that sum is insured by a government scheme: what incentive is there to check that the bank is any good?” It appears that the Economist is questioning the value of commercial deposit insurance. It continued,
“But it has also meant a corrosive trend: a gradual increase in state involvement. Deposit insurance is a good example. Introduced in America in 1934, it protected the first $2,500 of deposits, a small multiple of average earnings then, reducing the risk of bank runs. Today America is an extreme case, but insurance of over $100,000 is common in the West. This protects wealth, and income, and means investors ignore creditworthiness, worrying only about the interest-rate offer…”
But, in criticizing commercial deposit insurance in the United States, the Economist is making an enormous mistake. In fact, commercial deposit insurance is invaluable and it helped prevent the 2008-2009 financial crisis from becoming a second Great Depression.
So, what exactly is deposit insurance? Deposit insurance is provided to all depositors in the United States. It insures individuals that should their bank go bankrupt, they will still receive their deposits up to a certain limit (in the US, the limit is $250,000). Most of the time, this policy is of no real consequence. The odds of a bank failing in a healthy economy are very low.
However, deposit insurance becomes incredibly important during a financial crisis like in 2008-2009. Imagine a world in which your savings were not guaranteed by the federal government. You wake up one morning and hear that one of the largest investment banks in the United States declared bankruptcy (let’s call this bank “Lehman Sisters”). The newscaster glumly explains to viewers that this is the largest bankruptcy in US history. Later that day, you decide to check the stock market. To your horror, it nosedived, erasing years of retirement savings. To make matters worse, financial experts are declaring that the global financial system was on the brink of “systemic meltdown” (FYI: this actually happened). Now, you begin to panic about the strength of your own local bank. Is it also on the verge of bankruptcy? You suddenly realize that if the bank does fail, your money will be gone. Acting on this fear, you–along with every other depositor–run to the teller and demand to withdraw all of your deposits immediately. However, because it does not keep all its deposits on hand at any given moment, the bank is unable to pay back every single depositors and so, it is forced to declare bankruptcy. Fears about the bank’s solvency became a self-fulfilling prophecy, leading to the bank’s eventual and inevitable failure.
This hypothetical scenario is known as a bank-run and it was one of the main reasons causes of the Great Depression. Take a look at this graph, which I pulled from this paper.
The wave of bank failures during the Great Depression caused credit to seize up for years on end, leading to protracted depression. In order to prevent this from happening again, the United States created the system of deposit insurance in 1934 and the results speak for themselves. Not only are traditional bank runs largely a thing of the past, but even when we do see significant numbers of bank failures, the consequences are nowhere nearly as devastating. This next chart comes from the Federal Reserve Economic Data (FRED) at the St. Louis Fed. While there was a large increase in bank failures during the 2008-2009 financial crisis relative to the recent past, it did not spiral out of control. There was no domino effect, causing even more bank failures like during the Great Depression. Much of the credit must be given to deposit insurance provided by the federal government.
As a result, the Economist is wrong to challenge deposit insurance as needless government intervention. While one may question the exact dollar amount the government should insure, the deposit insurance itself is an invaluable tool, as it effectively limits the panic in financial crises. The aftermath of the 2008-2009 financial crisis would certainly have looked a lot different if we no such program existed.
Ashesh Rambachan is a sophomore from Minnesota with academic interests in economics and mathematics. He is particularly interested in development, health care, and anything that falls under the umbrella of macroeconomics. When he is not reading the latest from the econ blogosophere, he spends most of his free time daydreaming that he can dunk a basketball.