Interesting article by Tyler Cowen in Business Day, New York Times:
(Tyler Cowen is a professor of economics at George Mason University)
Since the end of World War II, economists have generally thought that runs on banks were dead, at least as a phenomenon in advanced nations. In the United States, for example, bank deposits are insured by the Federal Deposit Insurance Corporation, and, as a last resort, the Federal Reserve can back deposits by printing money.
The new complication is that bank deposits are no longer the dominant form of modern short-term finance. The modern bank run means a rush to withdraw from money market funds, the disappearance of reliable collateral for overnight loans between banks or the sudden pulling of short-term credit to a troubled financial institution. But these new versions are in some ways still similar to the old: both reflect the desire to pull money out of an endeavor — and to be the first out the door. And both can set off a crash.
These newer forms occur in the so-called shadow banking system, involving short-term financial credit not guaranteed by the deposit insurance umbrella. It now seems that the 21st century will resemble the 19th and early 20th centuries, with periodic panics and runs on financial institutions, perhaps followed by deflationary collapses. In the euro zone, these problems have plagued banks and entire countries, like Greece and Portugal. The “country as bank” is a new and not entirely reassuring catch phrase, and it shows that the problem goes beyond the private sector.
Some economists, like Ricardo J. Caballero of the Massachusetts Institute of Technology , have called for extending governmental guarantees well beyond traditional bank deposits. That would check the problem, but at what cost? In a larger financial crisis based on insolvency, our government would face intolerable financial burdens, as happened in Ireland when its government guaranteed bank debts.
A broader government guarantee would also spread the moral-hazard problem to an even larger class of financial transactions, raising the odds that the guarantee will someday have to be paid out. In any case, bailouts for creditors are already politically unpopular, and are unlikely to be expanded.
In short, no promising financial path is before us. It’s good that the American economy seems to be recovering, and this may shove some problems into the future. But banking and finance remain a mess at their core. Welcome to the 21st century.
Full original article here: http://www.nytimes.com/2012/03/25/business/the-bank-run-updated.html