Don't Make Me Break My Foot Off In Your Ass

I've basically quit reading the Economist because while they always have one eye sticking out, the rest of their head is constantly buried in the sand.  Witness the glittering gem-like logic of this reasoning:

Yet there was a common ingredient in most failures: an over-reliance on wholesale borrowing. As the Western banking system has expanded over the past two decades its assets have grown to about 2.5 times its deposits, forcing firms to seek other types of finance. Bear Stearns and Northern Rock, largely reliant on short-term borrowing, faced the modern version of a "run" when their counterparties refused to roll over debts. Most other banks suffered some loss of confidence, forcing them to turn to funding from the state.

Unsurprisingly, regulators think that forcing banks to find more secure funding, along with more capital, will make the system safer. The Basel club of bank supervisors is considering new liquidity rules, as are many national regulators. New Zealand has already drawn up concrete rules (see article). It is not clear how far this can go. There can be no return to an idealised past where only a dollar deposited in a bank would be loaned out. To force banks to rely only on deposits would require a big shrinkage of their balance-sheets, with devastating economic implications.

So ... the basic model is obviously unstable, and recently resulted in a thunderous crash heard round the world, but it would be dangerous to move towards a safer system?  I see.  Jolly good old chap.  Another gin and a stiff upper lip and we can follow Chuck Prince's advice and keep dancing.  Ponzi was a small time schmuck by comparison.

Now that Big Finance has been nursed back to rude health by suckling at the teat of Big Government, nobody sees to mention anymore that this unstable funding is still real money.  Arguably, that money should never have been printed up (inflation is always and everywhere a monetary phenomenon, it just manifests itself sometimes as price inflation and sometimes as asset inflation).  But now that it exists, it has to go somewhere.  The issue at hand is whether you force the unstable wholesale money that is liable to panicked flight back into the old FDIC regulated deposit system that we set up after the last snafu.  If you force the holders of that money to either genuinely put it at risk (without an implicit government backstop) or to put it in the safety of a regulated banking system and accept lower returns, then you can make the systemic parts of the system less liable to runs at the same time as you allow the non-systemic portions to fail if that's what they deserve. 

Deleveraging is real, both for the banks and for consumers, but the problem is compounded by this half guarantee.  If you encouraged the creation of new banks that could absorb the wholesale money as normal deposits, rather than trying to prop up the old banks by re-guaranteeing their slippery funding, you could have less aggregate deleveraging at the system level because you would have cleaner and more transparent balance sheets that could safely tolerate higher leverage.  Naturally, this is politically impossible, and is exactly the opposite of what we're doing.  The economic implications of banks in general relying on deposits is much less devastating than if the banks that currently monopolize the system are forced to go back to relying on deposits and we allow them to keep their monopoly.  In other words, the current banks have convinced us that they are the only possible banks.  There was a moment in March when some smart people were talking about starting over with the banking system (Buiter and his good bank solution was one of the best ideas in my mind) but then the government got its con job mojo working and foreclosed on any possibility of change.  They consider this to be "success".  And it's pretty clear who succeeded.