The European Crisis has rekindled interest among economists in the possibility of a negative feedback loop between bank solvency and sovereign fiscal capacity. The idea is a simple one. Many sovereigns have implicitly or explicitly guaranteed the financial liabilities of their banking sectors. In most advanced economies, and many emerging markets, bank deposits are insured by the central government. Some have posited therefore that a string of bank failures could therefore bankrupt the state.
The evidence for theory at first appears compelling. Spain and Ireland entered the financial crisis with relatively low public debt loads. (36.1 and 25 of GDP respectively). But the implosion of the banks in both nations and the ensuing bailouts made markets jittery. Both countries saw their borrowing costs skyrocket in the wake of crisis, and were forced to turn to international lenders for assistance. (ECB inaction in 2010 and 2011 didn't help either)
Given these cautionary tales, it's not surprising that some have called for radical reform. Laurence Kotlikoff has essentially proposed the abolition of deposit banking in the United States. Instead, banks would split into two separate businesses. Some banks would become payment banks. They would take deposits, hold the cash for safe keeping, and effectuate payments, but make no loans. Other banks would also take deposits and lend money, but they would be uninsured. Consumers could choose where to keep their money; 'safe' payment banks that paid zero interest, or risky, uninsured lending banks which offered higher returns. Proponents of this plan claim that in eliminates the need for deposit insurance.
Sadly, ideas of so called 'limited purpose banking' fail to address what money actually is in a modern economy. A bank deposit is nothing more than a spendable promise. The bank promises to convert your deposits to physical cash on demand, or to allow you to transfer your deposits to other parties in payment. In the United States, the Federal Deposit Insurance Corporation insures the deposit liabilities of the banks. If the bank can't pay you your money when you ask for it, Uncle Sam will. However, here it is crucial to remember that bank deposits themselves are money, because they can be used as payment. In fact, 97 percent of the money in the United States is in the form of bank deposits and not Federal Reserve Notes.
The promise that the United States makes, that bank deposits can always be exchanged for physical cash has nothing to do with state solvency. The government is merely making the guarantee that bank deposits will always be convertible to small green pieces of paper we call dollars. Because the US Government has the sole authority to print US dollars, it is impossible, for economic reasons, for the United States to default on this guarantee. Nor would massive bank runs and a firing up of the printing press risk hyper-inflation, because the quantity of money would be essentially unchanged. Rather one form of money (bank deposits) would merely be converted another(cash).
Tragically, countries like Spain and Ireland gave up their ability to make this kind of ironclad promise when they abdicated their right to print their own money. Neither Spain nor Ireland have the right to produce Euros. The markets quickly imposed harsh discipline on these nations when it become apparent that massive financial bailouts were necessary to stave off economic disaster. Of particular note, neither the US and UK faced sovereign debt crises despite of the fact that both nations had bigger deficits and debt levels going into the crisis, and implemented large, unprecedented bailouts. This can only be explained by the fact that the US and UK borrow exclusively in their own currencies, and insure bank deposits denominated in those currencies. And in sharp contrast to Spain and Ireland, public borrowing costs fell. Yields on US and UK government bonds plunged (despite huge increases in public debt) as the Federal Reserve and the Bank of England slashed interest rates.
Financial regulation is important to prevent the boom and bust cycles and speculative bubbles that we get with lax underwriting standards. Today, the FDIC and other deposit insurers play a key role in limiting the excesses of the banking sector and promoting financial and economic stability. But, at least in nations which have prudently retained their monetary sovereignty, no bank failure could result in national bankruptcy.
