Bailout! — Brian Romanchuk

by
Mike Norman
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So not exactly a bailout. Equity and corporate debt will be wiped out as of the currently announced policy, not bailed out. Only the depositors will be made whole. This is consistent with "capitalism," since it is equity and bond holders that are supposed to shoulder the risk. 

While customers' making deposits are actually customer loans to banks, most people do not realize that they are actually making loans to the bank by making deposits. Rather many think that deposits are "money" held for safe keeping that is set aside in vaults, which is not the case. Others think that their deposits are lent out by banks in making loans. Neither of these perceptions of banking are true.

Many if not most people confuse this regarding banking, since they think of "money" in terms of thing that is stored in the bank for safekeeping or else lent out. But "money" is based double-entry bookkeeping, where it shows up as one party's asset and another party's liability on accounting records. 

Banking is based on the bank making loans (customer liabilities, bank assets) and creating deposits (customer assets, bank liabilities), and taking deposits (customer assets and bank liabilities). Extension of credit creates an asset for the bank in the form of loan, and those loans are subject to non-performance and default risk, which affects the solvency of the bank. Customer deposits do not enter into it, since the bank creates a deposit corresponding to loan when the loan is approved. "Money" is created by banks simply by recording entries in the appropriate accounting records (the bank's books). Apparently a lot of people can't get their heads around this. 

Central banks create their respective currencies similarly in accordance with the government mandate — in the US, the Federal Reserve Act. In a digital environment, "money" is created by stroking keyboards and exists on spreadsheets (the respective parties books in terms of double-entry).

Central banks were a logical extension of the development of banking. If customers lose trust in a bank, a bank run can occur and if large enough, now bank can withstand it based on its own liquidity. This was the reason for the the creation of the Federal Reserve by the US Congress in 1913. The Fed would act as lender of last resort to prevent a banking crisis that could lead to a financial collapse and ensuing depression. Thus, the government became the provider of liquidity based on its constitutionally granted power of money-creation — the US, the US Constitution, article 1, section 8.

Trust based on this liquidity provision is a principal reason for deposit insurance, along with rules that allow for bank nationalization, which is usually temporary, occurring Friday after close with the institution opening under new management on Monday morning. Without this trust, reluctance to commit deposits would be a result. So it is not merely government generosity or paternalism. Nor does it affect taxpayers adversely in a sovereign system in which the government has a monopoly on its currency-issuance.

In the case of insolvency leading to bank closure (banks don't go bankrupt like other firms but are taken over by the feds), bank liabilities are at risk, including uninsured deposits. Guaranteeing all deposits at the federal level, with the government having a monopoly over currency issuance, would obviate that risk in the case of bank deposits. In return, banks would be subject to strict oversight regarding credit operations. 

As Warren Mosler has said many times, bank regulation should focus on the asset side (credit creation) rather than the deposit side. Bank regulation should focus on credit operations. Making the federal deposit guarantee unlimited would serve to protect all depositors as a matter of optimizing the banking system by increasing trust while reducing system risk.

A lot of the noise now is about the bailout of depositors being at the expense of taxpayers, with frequent reference to "taxpayer money." MMT shows that that so-called taxpayer money doesn't exist in the current monetary system. "Money" is not a thing but rather the creation of accounting. A currency is the unit of account adopted by a sovereign. 

Many people apparently reify the concept of "money" based on the origin of banking in taking deposits of precious metals, chiefly gold and silver, and lending these deposits out based on "fractional reserve bank." Under this system, banks did not have the resources to cover deposits in the case of a run without calling in loans of gold and silver they had made from the deposit base. This was impractical. That system no longer exists as the dominant form of banking in the contemporary world. As a result, this perception — misperception really — is not congruent with reality.

The fact that it is necessary to explain this is an indication of how widespread this misperception is. Quite revealing actually. MMT still has a lot of work to do in educating the public including economists and financial professionals. Readers of this blog likely know all this already but everyone can help in spreading the word to others. This "crisis" presents an opportunity to do so.

This is not to assert that a "crisis" cannot lead to an actual crisis. If misperception of reality leads to deterioration of trust in the system then a real crisis could develop, since most large financial systems are subject to systemic risk ("knock-on effects"). For this reason, the US government is acting to get out in front of it by acting promptly, and rightly so.