02 Oct 2008

Two Questions on the Conventional Bailout Commentary

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Two issues keep bothering me in all this bailout talk. (Well, actually there are about 202 things bothering me, but you get what I mean.) Up till now I have assumed I was missing something, but now that I am reading other people voicing my internal confusion, I feel more confident in proceeding…

(1) “Instead of putting the taxpayer at risk, the government should expand FDIC’s coverage from $100,000 to $x,000.”

Now this is problematic for a bunch of reasons. First, it still puts the taxpayer at risk, albeit in a different way. Second, it just perpetuates the whole moral hazard problem. You want depositors to be wary of dealing with a shady or risky bank. You don’t want them just to assume the government has taken care of everything.

But beyond these quibbles, I have a practical issue: If the new limit is fairly low–like $200,000 or $250,000–then on the margin, how much does this really reduce the risk of bank runs? For example, if you think bumping up the limit from $100k to $250k will make a difference, then that means you think there are people out there with checking account balances in between $100,000 and $250,000, who would rush to withdraw their funds at the lower limit, but who aren’t worried with the higher limit.

How many such people are there in the country? I can’t imagine it’s enough to be the difference between a bank run or not. Keep in mind, if you are thinking of a small business that has to do payroll etc., then it still is going to be a real pain if your bank is shut down by the FDIC.

I am open to correction, but my hunch is that the proportion of people who would panic at $100k but not at $250k, is rather low. I don’t see how the FDIC coverage increase does anything, unless you posit a mere psychological effect.

(2) “If the credit markets freeze up, it hurts more than Wall Street fat cats. Plenty of small businesses won’t be able to do their payroll.”

This too didn’t make any sense to me, but I wasn’t motivated to mention it until reassurance from small business owner Steve Fairfax:

None of the small business owners I know depend upon easy credit to make their payroll. When things get to the point where you need to borrow to pay your employees, the end is near. Most small businesses fail in the first few years, in large part because business is not easy, it is hard. Not everyone is good at it. But it is an essential part of free trade and the market economy that businesses fail, so that new, better ones can arise in their place.

Few small businesses depend upon easy credit. Banks are generally reluctant to lend to small businesses, with good reason. Most small businesses are funded by owner’s savings. Sometimes start-up money comes from loans by parents or friends. While I can understand that small businesses involved in building houses might profit from easy credit, the market is sending unmistakable signals that there are too many houses that are too expensive. Flooding the system with still more easy credit can’t be the cure, it is the problem.

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