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Previously publishedhere.

 During the fiscal crisis, the Federal Reserve Bank and the Treasury stepped in to take over many of the functions of the banking system. They showed they could do the job cheaper, better, and at less risk to the public. Extending this service would free up the rest of the market economy from our bloated financial sector and reduce the size and complexity of the regulatory system. The same forces that  defeated the Depression era bank regulation system - globalization, technology, the development of the shadow banking system and so on - have also made it possible to replace much of what those banks do with a simple public utility that would cost the public less and open up markets. The Federal Reserve Bank is the bankers bank, but there is no good reason it could not offer services directly to the public as an optional alternative to private banking.

The problem with depository banks is that the business model is  unstable. The banks accept deposits from companies and firms and then lend most of that money out at higher rates. A bank that can attract deposits for checking accounts and savings accounts that get low or no interest and that can turn around and offer mortgages at 6%, can be very profitable. In general, once the deposit base has built up, bank customers will deposit as much money as they withdraw, so the bank just needs to keep a small fraction of the deposit money on hand. But that "in general" is not the same as "always" . Some day by chance maybe more than the expected number of withdrawals will come in and the bank won't be able to pay. Or the bank will make an error on who it lends to or get too greedy or there will be a recession that causes people to default on loans and draw down deposits more than usual. Chances are that eventually the bank won't have enough cash to meet withdrawals and, without some quick rescue, depositors will panic and all try take their money at the same time, putting the bank out of business. Worse, bank failures are infectious: when the first bank collapses perhaps a business with an account at the bank will lose its funds for making payroll so its employees won't be able to pay their mortgages at a second bank which will also tip over - and so on. And, in practice, banks tend to screw up in packs, making the same mistake at the same time: for example, wildly overestimating the ability of homeowners or real-estate developers or small businesses to pay just as boom turns into bust, and all falling over together.

By the late 19th century it was clear that modern market economies are so tightly interconnected and banks are so failure prone that governments have to regulate banks and moderate the effects of  of bank failures to prevent economic disasters. So every "advanced" nation has a complex system of bank regulations  and deposit insurance plus central bank loan programs. Banks can get short term loans from the central bank to keep from sinking under short term imbalances and depositors get their money back from some sort of government insurance if the bank fails. Regulators try to keep bankers honest and prudent. This model, after some fixes in the 1930s, worked reasonably well for decades but its clearly not working so well anymore. And anyway, it's not that great a solution because it involves  subsidizing big banks and bloating the finance sector - something people nostalgic for the New Deal often fail to appreciate. The government guaranty for bank deposits and access to Fed loans allows banks to get capital from depositors cheaply precisely because they are so low risk. The system intrinsically gives a subsidy and advantage to bigger and bigger banks. And as the system increased the size and concentration of the financial sector, the increased political power of bankers led to weakening regulations and oversight which was amplified by changes in technology and world markets.

Our modern financial system is different from the system of the 1930s and the one of the 1960s: more interconnected, billions of times faster, and harder to understand because of both globalization and technology. Global computerized finance is incredibly difficult to police for risks. Should the government be in the position of judging whether a massive risk analysis  program at an international bank is correctly adjusting for probabilities over positions in 3 continents in 20 currencies on 100 time scales and with thousands of customers? Why should the public be a party to the risk of that portfolio at all? Fortunately, the same automation and computer technology that makes banking be so hard to regulate allows us to solve the problem of bank volatility in a much simpler way.

Suppose the government provided citizens and businesses with bank accounts and electronic payment services. Let's say, deposits of up to $100,000 earn 3% plus inflation and deposits over that amount earn nothing. Maybe IRAs can pay a little more. Furthermore, business and individuals can qualify for credit up to a certain amount based on statistical measures and/or with appropriate collateral.  In short, we could let citizens and non-bank businesses also  access  government banking. If you want to borrow more or earn more then take your chances in the marketplace. But if you want to keep your savings, your cash deposits from your business, your operating funds, somewhere safe and convenient - go to the government bank.The government could do all this with less bureaucratic inefficiency than the current banking system requires. In the financial  panic of 2007-2009, the Federal Reserve Bank operated the commercial paper market without a hiccup - and made the government money. The private banks do not add much value to the clearing/savings system - on the contrary they add volatility and overhead. And they also direct investment capital into destructive gambling activities. If we also ended another subsidy of Wall Street by giving all 401K savers the option of a no fee 10 year treasury bond plan, this proposal would significantly reduce the size of the financial sector.

Such a system would have required a massive government agency 40 years ago but electronic banking enables a lightweight solution.  Instead of trying to fight the changes to the world economy that are due to globalization and automation and advances in statistics that permit some quantification of risk, this proposal is to exploit those changes and use them to simplify the system. We would still have private banks, but bank failures would lose their contagious effect because the core clearing functions of the financial system would just keep operating. Bank panics would be less harmful to the greater economy and would damp themselves out. And so, we could reduce the amount of government supervision of and support for the banking system. The current regulatory and insurance system makes the rest of the economy pay for the risky nature of depository banking. The end of the subsidy would lead to the success of innovative more efficient financial institutions like peer-to-peer lending and networked bond markets or reinvented mutual funds. These might not generate as many $100million+ fortunes for finance CEOs, but the nation can live without so many Hank Paulsons and Dick Fulds without much sorrow.

There are at least two important side advantages. One is that when the government wanted to increase the money supply, instead of buying bonds from bankers, it could just raise the interest rate on citizen deposits - or even just deposit a little money in each citizen's account. That would be a more efficient and fairer way of increasing the money supply.  The other advantage  is that the government would not need to borrow so much money to run. Those deposits would represent the public's investment in new railroads and schools and research and development and health care for old people: increasing national prosperity. Consider that nations in the EU now are begging banks to buy their bonds - and the banks have money to buy the bonds only because they have deposits which they only have because the government guarantees bank deposits!  The current system is a scheme that only makes sense to bankers - but they could get real jobs.


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