Visiting Scholar R. Glenn Hubbard

Yesterday, the Treasury and the Federal Deposit Insurance Corporation (FDIC) announced the second broadening of deposit insurance coverage within two weeks--this time, to unlimited deposit insurance for business checking accounts. Some want to go even further.

Hang on a minute. We think it is time to remember that unlimited insurance coverage for all deposits is not costless. It would not address the main problems now undermining confidence in the financial system. It might not encourage bank lending. In fact, it might even have the perverse effects of undermining confidence in the soundness of the FDIC, increasing moral hazard, and destabilizing the financial system.

It was a bad idea two weeks ago, and now there is an international dimension. Policy makers in Ireland, Germany and elsewhere have given a 100% guarantee to bank deposits in their countries. A few countries have gone even further, insuring nondeposit liabilities as well.

Yes, we want to reassure depositors--and we have. But we need to look before we leap. A country can get in trouble by guaranteeing more than it can afford. Iceland may be in that situation already. Since FDIC insurance has been the rock of stability up to now, the U.S. government should never do anything that calls into question the viability of the FDIC. Just yesterday, it was asked to do more than it has ever done before.

Despite these worries, voices in the U.S. continue to call on our government to follow Germany and Ireland and insure all bank deposits without limit. That's a solution looking for a problem.

First of all, because it would require congressional action, a 100% guarantee would give the impression of desperate lawmakers stepping up to the plate again--after a rescue package whose goals and tactics have already shifted several times--to take an action unprecedented in American history. Rather than inspire confidence, this might just deepen the sense of panic.

Second, 100% federal deposit insurance would pull funds out of other assets. Money-market mutual funds would be first in line--we've seen that happen already. But other money-market-type instruments would quickly follow. Would the U.S. government insure them all? There is no obvious place to stop.

Third, an unlimited deposit guarantee in the U.S. would pull funds out of other countries, just as Ireland's guarantee led to an inflow of money into Irish bank offices in the United Kingdom. The Irish-British deposit flow happened on a small scale; but the U.S. is the 800-pound gorilla of the world market. Even amidst all this chaos, money has been flocking to our shores.

Thus we might wind up worsening an odd sort of beggar-thy-neighbor game, causing a "giant sucking sound" as deposits fled other countries for the sanctuary of the U.S. and its FDIC. The implications for our international friends could be enormous. In a misguided attempt to create financial security at home, we might inadvertently make the world a significantly more dangerous place to live.

Memo to Washington: Take a deep breath and ask, "What is the problem that unlimited deposit insurance is meant to solve?"

It is not people lining up to take their money out of banks. There appears to be little banking panic among retail customers. It's true that banks are not lending, but not because they lack deposits. At bottom, they are not lending to customers because their capital bases are weak and because they are not lending to one another. Banks are not lending to one another because faith in their counterparties has evaporated. So rather than risk loss, they just sit on their hands.

That is why the major banking nations have recently agreed to coordinated actions designed to restore confidence in their financial institutions in two principal ways: by recapitalizing banks via direct capital infusions, and by insuring interbank transactions in, for example, the London Interbank Offered Rate (Libor) market. The U.S. joined these efforts yesterday.

Now that coordinated international action has finally become the rule rather than the exception, the last thing we need is a reversion to beggar-thy-neighbor policies.

R. Glenn Hubbard is a visiting scholar at AEI. Alan S. Blinder is a professor of economics at Princeton University.