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deregulation bias, and a better way

This post was written in December 2007, bank reserves have increased about 1400% since then.

If you went back to 1940, grabbed an economist, and brought him forward to 2007, he'd want to know how the hell banks got so deregulated. He'd ask, "How can you possibly allow banks to hold only $42bn in reserve on $6645bn of deposits?" Back in his day it was common to require a reserve equal to 10% or more of deposits, compared to less than 1% today.

It all started with something called Eurodollars.

After World War II the world's economic system was formally based on the US Dollar, because the US had the strongest military, the strongest economy, and most of the world's gold deposits. People and institutions the world over began putting their savings in Dollars, because the Dollar was at that time a stable and liquid store of value.

As Dollar savings accumulated overseas, outside the reach of American banking regulations, multinational businesses discovered they could borrow Dollars more cheaply from unregulated non-American banks. Because at first these non-American banks tended to be located in Europe, these cheaper funds were called Eurodollars.

Most significantly, foreign banks lending Eurodollars had no regulatory reserve requirements. They did not have to set aside any cash in case of emergency. American banks were at a disadvantage, because they did have to set cash aside in case of emergency.

The rise of uninsured American money market funds in the 1970s made things even worse for banks. Money market funds could also pay more for deposits because they have no regulatory reserve requirements, because they are not "banks".

Faced with this competitive disadvantage from an unregulated "shadow" banking system, American banks repeatedly sent their lobbyists to the Federal Reserve and said, "We can't make any money if we have to compete with unregulated European banks and money market funds!"

Eventually, as the US was recovering from a recession during 1992, under the libertarian Alan Greenspan, the Federal Reserve ended reserve requirements on savings accounts and CDs. Although checking accounts still require reserves of about 3%, banks were allowed a loophole. Banks signed up their larger customers for "overnight sweep" accounts. These accounts look like and act like checking accounts, but each night the contents of the accounts are swept into temporary savings accounts that require no reserves. The next morning, the contents of the accounts are swept back into the checking accounts. This meaningless nightly shuffle allows banks to avoid the reserve requirement for their larger customers.

Hence, the current US banking reserve ratio of less than 1%. And now we find our banks desperate for new capital as they suffer huge losses from junky loans.


Could the US have taken a different path? How else could the US banking system have dealt with the competition of Eurodollars and money market funds?

We could've taxed interest payments to overseas lenders (currently there is no such tax), helping the competitive position of American lenders who do pay US tax.

We could've required US money market funds to meet the same reserve requirements as US banks.

It is possible to use government regulation to level the playing field, instead of dumping government regulation so that nobody has to follow any rules.


How else could government regulation help with our current economic troubles?

My #1 suggestion would be an import tariff on countries whose central banks intervene in currency markets to keep their currencies undervalued relative to the Dollar. This would help to rebalance the economic incentives that have been screwed up by foreign central banks.

Free trade is great when both sides follow the same set of rules. But when foreign governments undermine our competitive position via deregulation or currency intervention, our government needs to respond with taxes and tariffs designed to level the playing field, instead of deregulating our own industries.

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