Are you really going to have us believe that the insurance of small depositors is a principal cause of financial crises?
If so, let me invade the sanctity of your Libertarian Ivory Tower for a few minutes with a few practical truths.
First, when financiers (and other businessmen) make catastrophic errors, it is not because they have said to themselves: “It doesn’t matter if we make a loss. Some of our creditors are partially insured.”
To blame deposit insurance for financial crises one needs to make the bizarre, stupendous, preposterous, other-worldly assumption that directors of financial institutions are prepared to jeopardise all of their shareholders’ funds BUT ONLY if some of their creditors are partially protected!! Only wacko laissez-faire fundamentalists could seriously swallow that one.
The real problem of finance – and of capitalism in general – is the well-documented human tendency to systematic over-optimism. When financiers (and other businessmen) make catastrophic errors, it is because they have said to themselves: “We are not going to make a loss.”
Secondly, your own evidence contradicts your hypothesis. If deposit insurance (introduced in the US only in 1934) were the principal cause of financial crises, then how did all the previous financial crises develop?!
Third, the implication that small depositors could somehow assess the riskiness of complex financial institutions is a fundamentalist libertarian laissez-faire fantasy. You may recall that during the GFC, not even other financial institutions could assess the riskiness of financial institutions!!
When a crisis environment develops (and it will not be apparent at the time that it is a crisis environment; that will become apparent only in retrospect) there is no way small depositors will be able to assess credit risk. They (and indeed the systematically over-optimistic financiers) will not even be aware there is a credit risk.
That is why financial crises occur! If people were aware they were at risk, they wouldn’t be at risk.
Fourth, there is no such thing as a choice between “deposit insurance” and “no deposit insurance”. When a crisis erupts, the corrupt politicians will do what the corrupt politicians always do: they will move to protect the interests of the politically powerful (with The Rentier’s Friend cheering them on in the background).
What this means in practice is that “too-big-to-fail” institutions will be bailed out ad hoc while the politically weak will (metaphorically) be left to die in the streets.
That is precisely why many too-big-to-fail institutions loathe formalised deposit insurance. In the absence of formalised deposit insurance they enjoy de facto insurance from their corrupt political mates . . . for which they pay nothing! It’s a freebie which helps to entrench their market dominance.
Fifth, in terms of throwing out the baby with the bathwater, the removal of deposit insurance would mean either a re-creation of Great Depression preconditions in which inevitable bank failures lead to economic collapse, or a move toward a highly concentrated finance industry with the ever-more-dominant too-big-to-fail institutions enjoying de facto insurance free of charge.
There’s no prize for guessing which one The Rentier’s Friend is campaigning for!!
Finally, there is some evidence of a relationship between deposit insurance and financial crises. But it is not mediated by moral hazard amongst depositors. The moral hazard lies with the corrupt politicians and their influence on loosening regulation. The relationship between deposit insurance and financial crises is mediated by lax regulation.
Under the system of purely elective government, the corrupt politicians are lobbied by their finance industry cronies to loosen regulation. It is the corrupt politicians who - believing that they themselves are insured against any political backlash by deposit insurance – are more inclined to give their cronies the dangerously looser regulations they crave, and thereby set the scene for the next crisis.
The real protection against financial crises is a) to have a democratic system of government which governs on behalf of the people rather than on behalf of corporate lobbyists, b) to avoid the creation of too-big-to fail institutions, and c) to have proper regulation.
On the first score, you might look to the track record of the democratic Swiss who have managed largely to avoid the financial crises of the corrupt and undemocratic United States (notwithstanding the size of their finance sector and – nowadays – its unavoidable entanglement with the rest of the world).
Of course, The Economist could never allow itself to arrive at that conclusion.
It is, after all, The Rentier’s Friend!
Was reading Tacitus' Annals and found the following:
The curse of usury was indeed of old standing in Rome and a most frequent cause of sedition and discord, and it was therefore repressed even in the early days of a less corrupt morality. First, the Twelve Tables prohibited any one from exacting more than 10 per cent., when, previously, the rate had depended on the caprice of the wealthy. Subsequently, by a bill brought in by the tribunes, interest was reduced to half that amount, and finally compound interest was wholly forbidden. A check too was put by several enactments of the people on evasions which, though continually put down, still, through strange artifices, reappeared. On this occasion, however, Gracchus, the prætor, to whose jurisdiction the inquiry had fallen, felt himself compelled by the number of persons endangered to refer the matter to the Senate. In their dismay the senators, not one of whom was free from similar guilt, threw themselves on the emperor's indulgence. He yielded, and a year and six months were granted, within which every one was to settle his private accounts conformably to the requirements of the law. - Tac. Ann. 6.16
So laws were made and then broken, so everyone was given time to clean up the mess. So more regulation:
Hence followed a scarcity of money, a great shock being given to all credit, the current coin too, in consequence of the conviction of so many persons and the sale of their property, being locked up in the imperial treasury or the public exchequer. To meet this, the Senate had directed that every creditor should have two-thirds of his capital secured on estates in Italy.
Increased regulation brought nothing but law suits:
Creditors however were suing for payment in full, and it was not respectable for persons when sued to break faith. So, at first, there were clamorous meetings and importunate entreaties; then noisy applications to the prætor's court.
Unitended consequences, so the smart money sat on the sidelines:
And the very device intended as a remedy, the sale and purchase of estates, proved the contrary, as the usurers had hoarded up all their money for buying land. The facilities for selling were followed by a fall of prices, and the deeper a man was in debt, the more reluctantly did he part with his property, and many were utterly ruined.
Seeing his friends go down in falmes, Tiberius Julius Caesar Augustus then:
The destruction of private wealth precipitated the fall of rank and reputation, till at last the emperor interposed his aid by distributing throughout the banks a hundred million sesterces, and allowing freedom to borrow without interest for three years, provided the borrower gave security to the State in land to double the amount. Credit was thus restored, and gradually private lenders were found. The purchase too of estates was not carried out according to the letter of the Senate's decree, rigour at the outset, as usual with such matters, becoming negligence in the end. - Tac. Ann. 6.17
And of course those with the right connections got off in the end as no one enforced the rules. It is all so familiar.