Blanket US deposit insurance is a bad idea

The U.S. Treasury and the Federal Deposit Insurance Corporation (FDIC) have announced that they will provide unlimited deposit insurance for business checking accounts. But unlimited insurance coverage for all deposits is not costless, would not address the main problems now undermining confidence in the financial system or encourage bank lending. In fact, it might even have the perverse effects of increasing moral hazard and destabilising the financial system, say Alan Blinder, former Reserve vice chairman, and R. Glenn Hubbard, former chairman of President Bush's Council of Economic Advisers.

Further, there is an international dimension. Policy makers in Ireland and Germany have given a 100 percent guarantee to bank deposits in their countries. Many in the United States are calling upon the government to follow these countries and insure all bank deposits without limit.

That's a solution looking for a problem, warn Blinder and Hubbard:

Because it would require congressional action, a 100 percent guarantee would give the impression of desperate lawmakers stepping up to the plate again -- after a rescue package whose goals and tactics have already shifted several times -- to take an action unprecedented in American history.

Rather than inspire confidence, this might just deepen the sense of panic.

It would pull funds out of other assets; money-market mutual funds would be first in line, and other instruments would quickly follow.

Would the U.S. government insure them all? There is no obvious place to stop.

An unlimited deposit guarantee in the United States would pull funds out of other countries, just as Ireland's guarantee led to an inflow of money into Irish bank offices in the United Kingdom.

Thus, we might wind up causing a "giant sucking sound" as deposits fled other countries for the sanctuary of the United States and FDIC. In a misguided attempt to create financial security at home, we might inadvertently make the world a significantly more dangerous place to live, say Blinder and Hubbard.

Source: Alan S. Blinder and R. Glenn Hubbard, Blanket Deposit Insurance Is a Bad Idea, Wall Street Journal, October 15, 2008.

For text: http://online.wsj.com/article/SB122403056396434697.html

For more on Economic Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=17

FMF Policy Bulletin / 21 October 2008