Irish Liberty Forum

The Universal Socialisation of Banking Risk

with 6 comments

In a move which instantly multiplies the moral hazards and inefficiencies associated with our banking system, the Irish government has guaranteed the deposits and borrowings, estimated at around €500 billion, in Irish banks. The cover has an expiry date two years from now, but the probability of Ireland making a swift recovery from this crisis is now significantly lower.

The critical function of banks is to allocate capital according to where it can be used most productively, as expressed through the interest rates which people are willing to pay and the likelihood of these people to repay their loans. Banks should balance their desire to earn interest from making loans with the need to ensure that they have sufficient reserves to meet the current demands of their depositors and indeed pay interest to their depositors. These functions are hampered by interference with the interest rate and the enforcement of a government monopoly on the supply of money through the mechanisms of central banking. Yet so long as private, competitive banks exist within the structure imposed by the central bank, there can still be some degree of economic calculation performed by these banks.

Now that all private bank risk has been socialised by the explicit guarantee of bailouts, the need for banks and bank customers to calculate these risks accurately has just been thrown away. All mistakes will be paid for by the government. The implications for the efficient allocation of Ireland’s productive resources are simply awful.

If indeed we witness bank failures which require the Irish government to start coming up with some of this €500 billion, it could mean the bankruptcy of the State. We could be facing higher taxes for many years to come or, if the ECB is kind enough to print enough money to bail out the Eurozone financial sector, a hyperinflationary depression.

Truly, this cure is worse than the disease.

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Written by Graham

September 30, 2008 at 10:42 am

Posted in economics, Ireland

6 Responses

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  1. Just a thought:

    Wouldn’t a universal absolution of debt be an appropriate restart of the economic scenario at this point, especially in the US?

    It is a strategy that dates to ancient Hebrew tradition, where it was at one stage applied in 49 year cycles to resolve the accumulative complexities of a credit driven system.

    It will immediately enable the broad consumer base to start spending on strength of regular income, implying an upward revival of market forces, working its way up through retail, wholesale and industry, with credit facilities kicking in in due course.

    A debt free entity is a creditable entity, which is the fundamental factor about which the credit industry turns — the usual bad apples obviously excluded.

    This would be a simple and straightforward immediate solution, eliminating the impossible proper administration of gigantic proportions of the proposed 700 billion top-down bailout injection, which is a gamble at the best and will take time to filter down in effect to the ordinary taxpayer/voter. Imbalances in liquidity could be resolved by a combination of a tax strategy and an immediately restored credit environment –?

    Sebastian

    September 30, 2008 at 11:03 am

  2. To prevent this happening again, something similar to factoring/accounts receivable financing is needed so that financial institutions can insure against the risk of loan-defaults just as businesses can currently sell their debts to financial institutions for 98% of the cost, with the financial institutions having recourse to the bad-debtors. Currently factoring is not available for loan defaults owed to financial institutions. Regulations are needed to require such insurance to be taken out. If necessary it should – at least at first – be a State-owned insurance-scheme. That way the taxpayer will be in better shape to payout in the future if this happens again. As a moderate liberal, I dislike the spectacle of State-bailouts of financial instutions, and hope one day that the insurance-companies can bail them out instead, but we are not presently in a position where that is feasible. In that context I support what govts around the world are doing in guaranteeing deposits, though I am uncomfortable with nationalisations of banks.

    FutureTaoiseach

    September 30, 2008 at 11:44 am

  3. FT, I’m not sure if I follow you! Factoring is usually provided for relatively simple, small businesses who just want to outsource their accounts receivable functions and get some quick cash. Bank loans aren’t like typical business invoices which are sold in the process of factoring. But in a sense, factoring is sort of what has been taking place over the past few years as many banks have been selling their mortgages to different types of institutional investors. The risk has then been managed by these institutions in a variety of sophisticated ways.

    The problem was that the mortgages were significantly overvalued: losses were inevitable for whoever ended up holding or insuring them. A State-backed insurance plan for overvalued mortgages would just get cleaned out in this scenario and a probable unintended consequence would be the encouragement of even more bad loans. Just look at Fannie Mae and Freddie Mac! Bad loans on the Irish bank books will cause pain no matter what happens. In the end the only thing the government can do about it is to socialise the pain.

    Graham

    October 1, 2008 at 11:02 pm

  4. Just a back of the envelope calculation:
    (“guarantee” figure from http://www.rte.ie/news/2008/0930/economy.html)

    € 400,000,000,000
    /Divided by/
    4,400,000 population in the 26 counties.
    =============
    € 9,090,909,090 exposure per man, woman & child.

    Am I alone in wondering how this is seen to be credible even? Who’s in charge, Baron Von Munchausen?

    saoirsi

    October 3, 2008 at 6:16 pm

  5. ZOINKS! Ha ha, ha… aha… ha… yes, em, slippery decimal points… (ahem)

    €90,909 each?

    €454,545 per family of 5?

    Ah, well! Phew! That’s alright then.

    saoirsi

    October 3, 2008 at 6:23 pm

  6. […] of (take breath) 400-500,000,000,000 (I have to stop and count the zeroes each time… not so good at maths to begin […]


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