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No, Virginia, Nothing Is Really Risk Free

Monday, July 8, 2013

It is impossible to make riskless deposits out of the inherently risky business of banking. But governments everywhere insist on trying to do it anyway.

The financial world confronts us with ineluctable uncertainty and risk. Its future is unknowable, not only for borrowers, lenders, and investors, but also for governments and central banks. No matter how hard anyone might try, risk cannot be made to disappear; it can only be moved around. 

People all over the world long for their bank deposits to be risk free. Governments attempt to satisfy this longing by creating deposit insurance and by bailing out depositors and other creditors of failed banks. Of course, as in Cyprus this year, the government itself may be broke. Historically speaking, this is a common occurrence: there have been more than 250 defaults on government debt since 1800, up to the notorious defaults by Argentina in 2002 and Greece in 2012, which gives us a long-term average of about one default on government debt per year.

Governments constantly strive to promote “confidence” in the banking system, whether or not such confidence is warranted. They wish to induce what we might call “deposit illusion” — that the safety of deposits is unrelated to the soundness of the banks’ assets. But the inescapable fact is that deposits fund banking assets, which are inherently very risky, and these assets are subject to periodic losses which are unexpected and of magnitudes previously not even thought possible.

Banking disasters are rather frequent in financial history, and doubtless will continue to be so in the financial future. The United States has had two housing finance collapses in the last three decades. The International Monetary Fund identified 147 banking crises around the world since 1970. Carmen Reinhart and Kenneth Rogoff’s international list of banking crises since 1800 is 45 pages long.

The inescapable fact is that deposits fund banking assets, which are inherently very risky, and these assets are subject to periodic losses which are unexpected and of magnitudes previously not even thought possible.

In fact and in principle, it is impossible to make riskless deposits out of the inherently risky business of banking. But governments everywhere insist on trying to do it anyway. Therefore, they are often put in the position of desperately wanting to bail out depositors by moving losses from the banks to the taxpayers, as has been the case once again in this cycle in many countries, including, of course, the United States. But the taxpayers are the depositors. The risk has merely been moved to a different form, not eliminated.

Can a bank go broke and be unable to pay its depositors at par? Of course. Can an insurance company go broke? Of course. Can a government default? They often have. Can a government deposit insurance fund fail? Yes. Virtually every state-sponsored deposit insurance plan in American history has gone broke, and so did the U.S. government’s Federal Savings and Loan Insurance Corporation (FSLIC) in the 1980s. Its failure was financed by the government’s borrowing, including issuing 40-year bonds. The taxpayers will be paying on these bonds until 2030. In other words, for 17 more years, they will still be paying for the failure of two decades ago. Today, the government’s Pension Benefit Guaranty Corporation is admittedly deeply insolvent.

Is there absolute safety anywhere in the financial world? Nope.

But it is often said that once you have established a fiat currency-issuing central bank, like the Federal Reserve in this country, the government, through that central bank, can print up all the money it needs to pay off however many losses and however much debt it incurs. This is true in nominal terms, but it does not make the debt risk free. By relying on money printing, the government depreciates the value of its currency, reducing its purchasing power. In other words, it generates inflation and devaluation. All deposits are now worth less than they were before and have suffered real losses. Again, the risk is not eliminated, just moved to a different form.

A once-famous newspaper editorial of the 1890s pronounced that “Yes, Virginia, there is a Santa Claus.” But can the government, as Santa Claus, put freedom from all financial risk in your Christmas stocking? No, Virginia, nothing financial is really risk free.

Alex J. Pollock is a resident fellow at the American Enterprise Institute.

FURTHER READING: Pollock also writes “How Much Have House Prices Really Fallen?” “Financial Innovation — Illusory and Real,” “The Housing Bubble and the Limits of Human Knowledge,” and “Entrepreneurs, Risk Managers, and Uncertainty.” Steve Conover discusses “Putting the Debt in Context,” while Arnold Kling analyzes “Regulating Risk.” Abby McCloskey describes “The Changing Tune of Austerity (and how 2023 Could Bring an Encore).” James Pethokoukis says “The U.S. Has More Austerity than Europe. So why is America Doing OK?” Edward Pinto advises “Let’s Not Repeat the Same Mistakes That led to the Housing Bubble,” and Peter J. Wallison cautions “Don’t Be Fooled About Low Rates and the Housing Bubble.”

Image by Dianna Ingram/Bergman Group

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