Wednesday, December 31, 2008

The Place Of Government Guarantees In Avoiding Bank And Calling Runs

I want to briefly talk about the causes of this crisis before the silly explanations like lack of regulations and complex investments win day, as they surely will, guaranteeing that this system will go on and even implode again in the near future, although hopefully not to the this extent.

I want to ask a simple question: Does FDIC Insurance on individual accounts help prevent bank runs? Bank Runs being a result of depositors running to the bank to get their money out before the resources of the bank run dry, leaving a number of depositors to lose their money. If you think that FDIC Insurance is stupid, illegal, unconstitutional, a gift to moral hazard, doesn't help stop bank runs, and should be gotten rid of, then my points going forward won't matter to you. I do, however, address this position at the end of the post.

Now, our current crisis is a Calling Run. As the credit rating of a business goes down, investors or creditors that can demand money from the business do so, forcing the business to sell assets or borrow to fund these calls, which leads to a further deterioration of the finances of the business and a further downgrade, which leads to more calls... Now, if better regulations and higher capital standards are all that is needed to stop runs, why do we need FDIC Insurance? Surely higher capital standards and better regulation should suffice to stop a Bank Run. You see my point.

In the current crisis, the flight to Treasuries was in lieu of an explicit government guarantee concerning their assets. Investors fled into explicitly guaranteed, and hence liquid investments, since they can be priced, and even fled from implicitly guaranteed investments. In other words, investors fled to an equivalent of the FDIC. Simply put, you need government guarantees about losses to stop a run. Regulations and Capital Standards won't suffice. Well, they could, but they would be incredibly onerous and high, making them impractical, so, in effect, you need government guarantees to stop runs.

In the current crisis, it has all been about the extent and particulars of government guarantees. Certainly the gyrations of government actions have led to problems, but only in the sense of not making the extent of the guarantees explicit and particular. Anyone who believes that we could stop this crisis without government guarantees, like US Treasuries, is wrong.

From my analysis, it's clear that regulations and capital standards are not sufficient to stop a run. They might have effected this crisis in some manner, but explaining the crisis by seeing what has just occurred and writing laws that might have prevented it is of very little use, and has no real explanatory power. It's a help going forward, but, taken too particularly, it will result in a set of rules and laws that very smart people will manage to elude.

What to do then going forward?
1) Put in some sort of FDIC Insurance for these investments
2) Accept that runs might occur, and do your best to preclude them and be prepared for them
On 2, I say," good luck". Wishful Thinking at its worst. This is what will happen naturally.
On 1, what can we do? I suggest Bagehot's Principles. We need a LOLR I'm sorry to say in the modern world. All that we can do is make the guarantees explicit and adhere to firm standards going forward. But there is no practical solution without LOLR guarantees. They should be robust enough to preclude Calling Runs. One solution would allow some minimal use of FVA as opposed to MTM in supervised cases, with a government guarantee.

For libertarians, I'm sorry. This is the best that we can do for you. However, by averting Runs, we can avoid the kind's of crises that usher in enormous government intrusion. That should prove sufficient to the practically minded.

Finally, to the FDIC abstainers, a Burkean response. We don't have the FDIC for James Grant. We need it for:
1) Our actual Investor Class, which feeds on government guarantees and intervention.
2) Much more importantly, and let me put this in terms that the Investor Class can understand, in order to stave off social rebellion. A system that leads to mass unemployment, low wages, a very wealthy upper class, is not stable. Telling average workers to accept the pain of recessions and depressions is going to eventually lead to trouble. They don't have to. In other words, some people believe that we live in a world where such events as rebellions cannot occur. Of course, some people live in a world where depressions cannot occur. As a good Burkean, I know that isn't our world, and the bonds of civil society must allow compromise in order to stave off societal dislocations.

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