The Universal Socialisation of Banking Risk
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.