Capital Letters
Can We Really Do Without FDIC?
Warren Gibson’s otherwise interesting article, “Federal Deposit Insurance: A Banking System Built on Sand” (The Freeman, June 2010), contains at least three errors. One is that “the Fed, out of confusion, failed to inject new money” during the time of the Hoover administration. Not so. Federal Reserve notes increased by 25 percent, from $4 billion to $5 billion between 1930 and 1933; see Irving Fisher’s 1935 book, 100% Money, pp. 5-6. It was the $8 billion contraction in demand deposits that made the big difference.
Second, Gibson faults modern fractional reserve banking because “We think of banks as custodians of our money, keeping it safe for us and making it available whenever we need it. But present-day banks are not deposit banks.” Wrong. We deposit our savings—nonconsumed income. Money (cash) is only one of the media through which we make deposits. As Adam Smith well puts it in the Wealth of Nations, “money is the mere instrument of transfer.” The other instruments include electronic transfers and checks. Thus, so long as banks pay us back our deposits when we want them, they commit no fraud.
Third, he says that “Any benefit this system [FDIC insurance] provides is incidental to its real objective: to serve the cartel.” The claim is seriously misleading. A run on one bank may jeopardize the survival of all banks, including those with financially sound investments (assets), since no bank has enough cash to redeem its liabilities—pay all depositors. Thus, all depositors will lose some of their savings if a run on banks were to occur in the absence of deposit insurance. An economy’s growth also depends upon increasing savings to provide the capital (funds) businesses need for their investment. In the absence of the security of deposits created by the FDIC, the rate of savings with banks would be lower, hence the rate of investment. Therefore, besides saving banks from the hazards of bank runs and contagion, the public—depositors and businesses—directly benefit from the deposit insurance.
—James C.W. Ahiakpor Professor of economics, California State University, East BayWarren Gibson replies:
I thank Prof. Ahiakpor for his response to my article on federal deposit insurance and would like to respond briefly to his three objections.
On Fed monetary policy during the Great Depression, I rely on Milton Friedman and Anna Schwarz’s definitive A Monetary History of the U.S. in which chart 31 shows a decline in the money stock from about $45 billion in 1929 to $30 billion in 1933. Friedman summarized this as the Fed’s “disastrous mistake between 1929 and 1933, when it permitted the quantity of money to decline by a third and thereby turned a severe recession into a disastrous depression” (Money Mischief p. 208).
When I wrote, “We think of banks as custodians of our money, keeping it safe for us and making it available whenever we need it,” I was attempting to describe what I believe (perhaps mistakenly) to be the average person’s perception of what banks do. A dictionary definition of “deposit” is “that which is placed somewhere for safekeeping,” like depositing your jewels in a hotel safe, so perhaps bank “deposits” should be given some other name. I agree with Lawrence White’s and George Selgin’s view that fractional reserve banking need not be fraudulent; Murray Rothbard and others are wrong about this. I am not charging fraud but merely suggesting that fractional reserve banking is misunderstood by the general public and perhaps should be spelled out more explicitly to depositors. I also suggest that reserve ratios are too low compared to what would come out of a free-banking system, where market forces severely discipline both managers and depositors.
My statement that the benefits of FDIC insurance are “incidental to its real objective: to serve the cartel” was admittedly a bit hyperbolic. But in assessing the FDIC or anything else we have to ask: compared to what? Prof. Ahiakpor compares FDIC insurance to no insurance whereas my article suggested that private insurers would enter the picture. Private insurers would have incentives that would make a bank panic (a contagion of bank runs) extremely unlikely. They might, for example, adopt option clauses which were successfully used by free banks in Scotland in the 1800s. The FDIC, by contrast, does not eliminate risk but instead socializes it, and in so doing it politicizes, subsidizes, and de-incentivizes the banking system. Lastly, regarding his comment on saving and investing: Of course prosperity depends on saving and investment. But there can be too much saving. The right amount for each of us is the amount at which the marginal benefit of an additional dollar saved matches the marginal cost. Where there is a free market for investments, the overall saving rate is determined by the interplay of savers acting on their marginal cost/benefit estimates. Government interference such as subsidized deposit insurance can result in too much saving.
Comment by George Selgin on 25 August 2010:
Professor Ahiakpor’s claim that “A run on one bank may jeopardize the survival of all banks” is very misleading, for what “may” be true isn’t necessarily likely. In fact, runs on individual banks have seldom been contagious, and have seldom brought down other banks for any other reason. Spillovers have taken place, to be sure. But even during the 30s in the U.S., these were geographically very limited, and generally affected banks that were in fact pre-run insolvent or close to being so, as can be affirmed by reading Elmus Wicker’s detailed account. The general run of late February 1933 appears to have been a run on gold rather than evidence of a systematic loss of comnfidence in banks, so it doesn’t contradict my or Wicker’s claims. As for Ahiakpor’s suggestion that runs would be frequent and widespread without deposit insurance, it is sheer nonsense: many countries did without insurance for most of their banking systems’ histories, and apart from the U.S. no country had it until the late 60s, when Canada embraced it. Only later did other countries follow suit, mainly thanks to advice from American experts! The U.S. itself would have been better served by introducing branch banking in the 30s (or well before that) than it was by the creation of the FDIC, which amounted to a device for artificially proping up a flawed unit banking system.
Finally, Prof. Ahiakpor’s claim that the Fed must have injected money into the system during the Hoover years since the stock of Federal Reserve Notes outstanding rose rests upon a non-sequitur: the question here is whether the monetary base, which is currency plus bank reserves, increased. Looking at currency alone, and especially doing so when deposits are being withdrawn on a massive scale, misses the point.