How to prevent future crises – slowly tax debt, slowly de-tax equity
These graphs show what happened – private lending collapses, the government jacks up the monetary base (In the US in the last year, the monetary base has almost doubled from 600 billion dollars to 1100 billion dollars!) to keep overall monetary supply from falling off the cliff. (Read “The origin of financial crises”, an awesome book although I have quibbles with its views on EMH)
Losses get socialized through seigniorage – that is the government prints money out of thin air, and eventually the public pays through higher taxes and/or inflation.
This is not because of ethics or morality of bankers – taking “irrational risks” is rational here.
Enough about the problem. What is the solution. I think we have to suffocate fractional reserve banking/ the whole present day banking model. Now, if one could run fractional reserve banking without any government guarantees (FDIC in US, RBI in India) – its okay. But we cannot change that now. Declare today that there is no more government guarantees of bank deposits and there will be an economic crisis like never before.
So we must slowly but surely fix – and then reverse – the tax differential between fractional banking and other kinds of financial intermediaries (equity, corporate bonds, money market mutual funds etc). The biggest villains here are the corporate and the capital gains tax, and any kind of tax deductions for bank debt incurred by companies (specific rules obviously vary by countries)
Now this is obviously corporate finance 101, but its economic ramifications are huge – we end up having an inherently unstable system where there is always a lending multiplier much greater than 1 (generally around 10 or so), and moral hazards are legion.
If we slowly (say over two decades) reduce this tax differential and in fact put it in favor of equity and corporate bonds, the whole commercial banking world will wind up – but not super violently.
The remainder will be kind of what you see is what you get finance. (And once it has winded up, we could reduce the tax differential back to zero, and say that no more guarantees – deposit at your risk, no one has a god given right to a safe positive return after inflation)
Then if you want to invest – you have derivatives, equity, corporate bonds, and treasuries to choose from (in a rough high return to low risk order). If we do not say bye to today’s banks, it is difficult to see how we can stop baiting central banks to keep on loosening monetary policy everytime banks hit a wall (and then the cycle repeats itself – loose monetary policy props up “the fashion of the day” bubble, banks lend to blow the bubble, and then banks have crazy NPAs and losses. Rinse. Repeat)
