Full Government Backstop of U.S. Deposits Would Do More Harm Than Good (April 6, 2023)

Japan illustrates the dangers of full deposit guarantees, where excessive fiscal spending undermines monetary policy

By Lisa Beilfuss
April 6, 2023

Discussion around a government backstop of all bank deposits highlights an underappreciated problem. Fiscal policy continues to undermine monetary policy, with the feedback loop threatening U.S. economic and financial stability.

The U.S. government action to ensure all deposits at recently failed Silicon Valley Bank and Signature Bank has prompted calls for a full government guarantee of $17.5 trillion in commercial-bank deposits. Roughly 43% of those deposits, or about $7.5 trillion, aren’t insured by the Federal Deposit Insurance Corporation. After fully repaying SVB and Signature Bank depositors, the FDIC has just over $105 billion–roughly equivalent in size by assets to the thirty-second largest U.S. bank–remaining in its deposit insurance fund for future failed-bank resolutions.

There are valid reasons to rethink the current FDIC insurance cap. First, it is outdated. The cap of $250,000 had in 2008 the purchasing power of what is now $350,000. Second, proponents of a blanket deposit guarantee say that regional-bank bleeding won’t stop if depositors perceive a two-tier system where deposits at the biggest banks are implicitly guaranteed by the government while deposits at smaller banks aren’t. The point isn’t insignificant; small banks account for about a third of all banking-sector deposits.

But a decision to fully backstop deposits isn’t a simple choice between preventing or inviting bank runs. The issue is at the center of an increasingly dysfunctional relationship between government spending and Fed policy, where burgeoning budget deficits rely on easy money and then constrain the central bank’s ability to navigate business cycles. Scant conversation around the gap between trillions in bank deposits and the FDIC’s insurance-fund balance highlights how entrenched deficit spending and money printing have become in the U.S., desensitizing some policymakers, economists and investors to the costs of a full-deposit backstop.

Consider how economists Asli Demirgüç-Kunt and Edward Kane outlined the consequences in a 2002 paper examining the proliferation of deposit insurance worldwide. Explicit deposit-insurance schemes can, in the short run, seem like a costless way to avert bank runs. But deposit insurance puts institutions at greater risk of failure because depositors are less incentivized to monitor their banks and proactively manage their deposits, they warn. Bankers in turn take on greater risk because they know their principal is protected even if risky borrowers default. The economic costs of compromised market discipline and financial fragility are far greater than the direct costs associated with the government running an insurance enterprise, Demirgüç-Kunt and Kane say.

The deposit debate in the U.S. isn’t a new story, and Japan offers a cautionary tale. When the Japanese government backstopped all deposits in 1996 after multiple bank failures, depositors’ confidence quickly improved, says Masami Imai, an economics professor at Wesleyan University. But because the move reduced the urgency among banks, regulators and politicians to address root problems, it set up a full-fledged banking crisis two years later. Imai says it wasn’t until 2001-2002 that the government finally cleaned up a large number of weak, small banks that wouldn’t survive the expiration of the blanket deposit guarantee.

Economists Luc Laeven and Fabian Valencia say that of public funds deployed to address Japan’s banking crisis, only about half of the money was recovered. That isn’t to mention the pair’s estimate that Japan lost output equivalent to about 18% of GDP in the three years after the crisis started. the outbreak of Japan’s banking crisis.

Quantitative easing, first introduced by the Bank of Japan in 2001, has complicated the interplay between fiscal policy and monetary policy. Massive bond buying with rates on the floor enabled excessive fiscal spending, with the ballooning deficit underpinning inflation and inflation diminishing the government’s debt burden. As the government, and the overall economy, became hooked on easy money, higher interest rates became a bigger threat. The dynamic was easy to ignore until inflation surged in recent years.

Thomas Cargill, an economist who spent years working at the Bank of Japan and Japan’s Ministry of Finance, blames full deposit backstops for decades of economic and political instability in Japan. He says the intervention fueled irresponsible fiscal and monetary policy that exacerbated the problems politicians and policy makers said they would fix.

“When you extend government guarantees, only bad things happen,” Cargill warns, adding that you eventually get to a point where the center won’t hold. “It doesn't mean you shouldn’t intervene, but you have to be very, very careful.”

The idea that U.S. fiscal policy is undermining monetary policy is more than theoretical. Solomon Tadesse, head of quantitative equities strategies North America at Société Générale, has quantified the impact of growing fiscal deficits on the Fed’s ability to affect the economy through monetary policy.

Apart from the fact that fiscal spending undermines Fed tightening by replenishing liquidity and reinforcing inflation, Tadesse says there is a falling ceiling before policy tightening induces a recession. That means ever-larger Fed asset-buying programs are inevitable as rates hit the zero bound more quickly and stay there longer. And as the central bank’s balance sheet grows, it gets harder to unwind it–effectively leading to indirect monetization of government debt.

Tadesse uses several measures to quantify the impact of fiscal policy on monetary policy. First, he measures the potential degree of fiscal debt monetization through the ratio of federal debt held in the Federal Reserve system as a percentage of GDP. He says the measure has historically ranged from 3-5%. At the end of 2021, it stood at 25.1%. He meanwhile defines the monetary policy space as the maximum fed funds rate at a tightening peak during a monetary policy cycle.

Together, those measures create Tadesse’s monetary tightening to fiscal monetisation ratio (MTFM), which he uses to project the path of monetary policy. His conclusion: Overall monetary tightening (rate increases plus balance-sheet shrinkage) in the current cycle can’t have gone beyond a total of about 300 basis points without inducing recession.

The policy rate alone is already in a range of 4.75-5%, with the lagged effects of monetary policy just starting to bite. One way to square that reality with Tadesse’s findings is that a hard economic landing will be harder than many anticipate–creating the need for more Fed intervention that supports the very deficit spending that fans inflation and undermines the Fed’s ability to fight it.

And thus the full deposit backstop debate should be put in appropriate context. The desire to prevent bank runs is sensible, but the cost of the government backstopping trillions in deposits is higher and more complicated than many investors, taxpayers and government officials may appreciate.