Saving private banks

Damien Grant's picture
Submitted by Damien Grant on Mon, 2012-02-20 04:12

My issue that I would like to kick around is should the state intervene in a banking crisis?

Fiat money is a given, let’s not debate that (start your own post). Assume the banks are in trouble. Helen Clark moved decisively to provide a bank guarantee that was extended to finance companies, the British and Australians did the same when Armageddon was nigh. Banks did not fail, mostly the state’s guarantee was not called in.

When it comes to Air New Zealand and General Motors, I think the answer is obvious, the state should let these firms fail. It does not matter that intervention as a success, it is wrong in principal.

However, a banking failure is a failure of a different magnitude. It is not only the shareholders of the banks who will lose; the economy as a whole will collapse. Or I’m pretty sure it will.

So, looking at the world view libertarian glasses, should the state let insolvent banks fail?


Damien Grant's picture

It is accurate to say there must have been assets in the Iceland banks as well as liabilities. I am not sure the process for how domestic depositors were protected so it is possible that these depositors were paid out first and overseas depositors were paid second, but I do know that the Iceland government went on a bit of a money printing spree.

However, the overseas investors in Iceland’s banks would have been a small fraction of those nations savings, but the domestic deposits represented a vast percentage of Iceland’s savings.

It would be interesting to see what would have happened if the state had just let the banks fail totally.

I wonder if we can arrange that somewhere, so we can see the effect?

I don't know the exact details...

Marcus's picture

...but when a company goes bankrupt, it doesn't mean there is zero payout.

Given how many people (and local Government) in the UK that had pension schemes tied up in Icelandic Banks, there is scant talk of the effects of it these days.

So either they got a pay out, or they were insured or perhaps they could just take it on the chin?


Damien Grant's picture

The Iceland central bank printed sufficient money to guarantee domestic deposits. Only overseas depositors were wiped out.

I agree with Iceland's decision here. No reason for Iceland taxpayers to bailout overseas investors but letting domestic accounts be wiped out would have tripped the country into chaos.

The contrast with Ireland cannot be more stark.

In the UK, there are many who argue...

Marcus's picture

...that bailing out the banks was the worst possible thing for the economy.

They always point to the real-world example of Iceland.

In 2008, all three of the country's major commercial banks collapsed and went bankrupt.

Today they have the resurrection of a viable, but sharply downsized domestic banking system built on the ruins of its previously gargantuan international banking system which the government was unable to bail out.

They also have GDP growth of 3.5% (the UK and Germany can only dream of this) and were one of the first of the European countries to come out of recession.

Yes the Icelandic Government did a lot of fiddling with the financial sector too (which they have subsequently reversed), but the major point is that the economy quickly recovered after letting their major banks go bust.

All the more reason to get

Mark Hubbard's picture

All the more reason to get rid of the fiat money, central banked planned economy: yes? And move to laissez faire.


Damien Grant's picture

I disagree that the deposit guarantee was a failure because of the cost of bailing out South Canterbury. If you think about the principle, it was a failure in itself, even if no financial institutions had failed, or if you have no problem with the principle you need to look at the counter factual; what would have happened without it?

I think that only the four Australian Banks would have survived, as money fled every non-insured institution towards the big four as they were covered by the Australian deposit scheme, and the four remaining banks would have been starved for cash, the currency would have tanked and there would have been shocking financial dislocation as creditors rushed to enforce their rights.

The economic carnage could have been much worse that the 1.5b spent on South Canterbury.


Damien Grant's picture

Fair point, you are the principal!

There is no difference. Banks, in principle, should be allowed to fail. To me this is crystal clear. What is less clear is is there a point where we say that the cost of the principle is too high and in the case of a banking failure what is the value of having a virtue?

To me there are two reasons why Air New Zealand and others should have failed. The first is that the government is using tax payers taken by compulsion to reward shareholders and creditors of Air New Zealand at the expense of other Airlines. Plain wrong.

The second is it creates a moral hazard, letting owners and managers of large businesses know the state will step in if need be, changing and distorting incentives.

However, for a banking crisis, neither fully applies. One bank failing can mean all banks fail, and a run on a bank is driven by irrational reef-fish mentality not a failure in the fundamentals of the bank itself, a bank cannot ever be totally safe from a run.

And the moral hazard is created by the nature of fractional banking. Banking executives and shareholders are often (but not always) eviscerated by nationalisation of a bank.

So, if you were the governor of a central bank. There was a run on Westpac, a press release is all that is required to stop the panic. Do you issue the press release, or do you let Rome burn?

I’m conflicted on this point, because I would issue the press release, but I would let Air New Zealand fail, and other than the economic fall out I cannot see the difference.

Answer Linz's question of and

Mark Hubbard's picture

Answer Linz's question of and on principle first, Damien.

It's always about principle.


Damien Grant's picture

I do dream of liquidating a bank! You have no idea how much that excites me. Best you do not shake my hand at the moment.

Free banking worries me because the incentives are all wrong. Bankers are meant to be conservative but if you think about fractional banking, you have $5 of your own money, $95 of other people’s money, if you lend it at 10% you get $10 in profit for $5 invested, every year! If your bank fails, you lose $5, your depositors lose $95. The risk profile is all wrong, which is why I like pointy headed central bankers with slide rules regulating the heck out of it. However, I see no conflict with that and banks issuing their own money. We can have Westpac dollars in circulation, along with BNZ dollars and Citi dollars: I would just want Alan Bollard peering into their balance sheets from time to time.

So, I think you are wrong in assuming that free banking assumes no banking failures. Businesses in a free market will fail (thankfully). If we had free banking, and we had Westpac issuing Westpac dollars, and Westpac fell over, what then?

What happens to an economy and a society if a major bank fails, or worse one bank failing causes a ripple of banking failures? Do we stand back and declare that the risk of moral hazard is so important we let the entire system crash, or do we suck it up and bail the bastards out.

Damien ...

Lindsay Perigo's picture

When it comes to Air New Zealand and General Motors, I think the answer is obvious, the state should let these firms fail. It does not matter that intervention as a success, it is wrong in principal.

It's wrong in principle as well.

However, a banking failure is a failure of a different magnitude. It is not only the shareholders of the banks who will lose; the economy as a whole will collapse. Or I’m pretty sure it will.

So what is the principle involved that justifies intervention in the case of banks but not airlines?

But Damien, by excluding the

Mark Hubbard's picture

But Damien, by excluding the real answer you've simply created a red herring of a thread.

If banks were set up on sound money - or something like my preference, free banking - then why would you assume a total bank collapse?

You wouldn't.

The way you've phrased the question, then the answer is a compromise such as how do you deconstruct the welfare state: given a central bank guaranteed fiat money fractional reserve banking system, then you could get systemic failure via a run on the bank - as the banking system we have now is essentially a fraud - so I guess it would have to be managed to avoid social chaos. I don't know how you do that though; it's not the Libz position it - welfare state destruction - can happen overnight.

The Deposit Guarantee scheme was actually a disaster, by the way: the unintended consequence was much of what the taxpayer will end up footing for SCF.

So ultimately, your question simply begs the question of why we need to break the current Western Keynesian paradigm and the sooner the better, move away from planned economies (including the central banking system) and to laissez faire ... although, having said that, starting in Europe, reality is already starting to do that.

Personally, I'm so fed up with the Western Police State, on the right day might just say, yeah, let it all fall over: so long as you can avoid violence, and outside of quelling that, the State keeps its hand out of the traditional levers it has to distort economies, I think the spontaneous order that does arise from free markets would in fact carry the day. So okay, you've talked me into it - I'll land your herring: yes, let them fall over, let's do away with Big Brother in markets and macroeconomics and trust in the best mechanism for peacefully ordering the complex needs and desires of all individuals in a society - free markets.

After all, look at what has happened in Egypt and Libya: it's not great, but considering where they started from, and watching a fascinating BBC program each Saturday morning on Middle Eastern business, despite the revolution in, say Egypt, underneath there is a free market rising, peacefully, with vibrant new businesses coming through. It is not dog eat dog. Free markets, can't beat them.

What's on your mind: dreaming of liquidating a bank?

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.