Should we get rid of deposit insurance?

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The other day I spoke with University of Chicago economist Raghuram Rajan. Rajan made a big splash at Jackson Hole back in 2005 when he stood up in front of a room full of prominent economic policy makers and gave a speech about all the risk that was building up in the financial system. He said we could be headed for serious problems. The crowd scoffed. He was entirely right.

Rajan has a new book out in which he argues that during the post-crisis clean-up we’ve been failing to take into account many of the underlying dynamics that led to collapse. As a consequence, the worldwide economy is still under threat. Some of the fault lines, as he calls them, are old hat: various countries’ trade surpluses and deficits, for example. Some are much more provocative. For instance, he argues that the easy credit which fed the housing boom was partly the result of U.S. politicians not wanting to take the time to more substantively address the problem of growing income inequality. Here’s a snippet from our conversation:

You write that growing income inequality in the U.S. fed the housing and financial crises. How so?
People at the 90th percentile of income distribution, typically your office managers, are pulling away—in terms of income—from people at the 50th percentile of the distribution, typically your grocery shop clerk or manufacturing worker. Much of this is because of education. People with high school degrees and those without high school degrees are falling behind those who have a bachelor’s degree and those who have higher degrees. The educational system hasn’t kept up with the demand for highly skilled workers, and housing credit was an easy solution to that problem. People looking at their rising house prices pay less attention to their stagnant paychecks. This wasn’t Machiavellian, but it was the path of least resistance. Bush called it the ownership society, and Clinton called it affordable housing, but they both focused on making loans for housing.

Is there historical precedent for using cheap credit as a political palliative, as you call it?
Absolutely. Both across countries and within the United States. In many ways, farmers toward the end of the 19th century were falling behind the rest of the population. A big piece of the Populist platform was to push for more credit. The result was a tremendous expansion of banks in the early 20th century. Some would argue that the immense extension of credit to the farm sector in the 1910s and 20s was a precursor to the Great Depression.

So what’s a better way of dealing with income inequality?
To tackle the problem at the source. A large part of the population doesn’t have the skills to compete in the modern economy. It’s partly that they haven’t kept pace with the technological change that’s happening, and it’s partly that people in the rest of the world are competing with them now. Being unskilled in the United States is a recipe for a life of stagnant wages and lots of uncertainty; we need to provide better skills to the population. One of the numbers that I cite, which is frightening, is that the fraction of people graduating from high school hasn’t increased over the past 30 years. But it’s not just fixing the schools, it’s about families and the communities kids grow up in. It’s a very big social problem, and that’s why politicians say, “It’s going to take too long to tackle this, let’s try something else.”

The entire Q&A will be going up on, and I’ll link to it once it does. (UPDATE: Here it is.)

In the meantime, I thought it might be interesting to toss out another one of Rajan’s less-than-mainstream ideas: getting rid of deposit insurance. This didn’t make it into the Q&A, but we chatted about it briefly.

Rajan’s argument is that deposit insurance ensures a steady flow of cheap financing to banks—it’s essentially a government subsidy. The bigger the banks grow, the more subsidy they get. It’s a back-door way of encouraging largeness.

Now, Rajan is not one of those economists who thinks having really big banks is inherently a bad thing. As he points out, after the Depression we thought have thousands of geographically dispersed small banks was the problem.

Nonetheless, he is against government gently nudging banks to get bigger and bigger, as, he holds, it does through deposit insurance. So we should get rid of it.

Well, not entirely. If we had no deposit insurance, then everyone would flock to the banks deemed the safest—probably the big ones. In order to preserve the very important presence of smaller, community banks, they would still get to offer deposit insurance for their accounts. Eventually, though, as deposits at a bank grew, that would phase out. Banks could still offer savings and checking accounts, but they’d probably have to pay people more in interest to attract their money. As banks grew larger, so would their cost of capital. That would act as a natural break on growth.

When I first heard this idea, I was pretty opposed. That was partly because I am wary of one of Rajan’s corollary arguments—that deposit insurance isn’t nearly as important to individuals now that they have the alternative of investing in super-safe money market mutual funds. Maybe I would have bought this before the financial crisis, but, as you may recall, the Reserve Fund “broke the buck” because it held commercial paper from Lehman Brothers. When that happened, such panic ensured that the FDIC rushed in to guarantee money market mutual funds.

Although I suppose you could argue that the government would do that again. And that a once-a-generation government guarantee would be better than an on-going one.