The proposed haircuts on Cypriot deposits is seen by many (and presumably the Cypriot depositors) as a violation of the holy trust of deposit insurance. It is similar to Social Security being the "third rail" of American politics. Haven't we all "earned" our social security? Never mind that the actual social security payments involve transfers from current and future taxpayers. The same is true of deposit insurance. Shielding depositors from risk means that when outcomes are bad, funds are taken from current and future taxpayers.
Many economists believe that deposit insurance provides tremendous social benefits. It avoids the catastrophic consequences of a run on the banking system.
In my view, it is fundamentally "contractionary." That is, it reduces spending on output.
Of course, when deposit insurance was introduced in the U.S., it was in the context of a gold standard. If we imagine a simple gold standard, where all the currency was gold coins or gold certificates, then an increase in confidence in bank deposits would likely lead to a substitution away from currency and into deposits. This would involve a reduction in the demand for gold, and so a decrease in the equilibrium relative price of gold. With gold serving as the medium of account, this requires an increase in the equilibrium prices of various goods and services, including the resources needed to produce them, such as the money wages of labor. The actual market process that causes these prices to rise is increased spending on output, which leads to increased demand for labor.
In a gold standard world, the introduction of deposit insurance is expansionary.
I suppose that many are used to thinking of the process in reverse. Deposit insurance protects from the disastrous consequences of a loss in confidence in bank deposits. The result can be a run on the banking system, and a large increase in the demand for currency. With a gold standard, particularly a simple one where currency is made up of gold coins and gold certificates, this is a large increase in the demand for gold. The increase in the demand for gold results in a higher relative price of gold. Gold being the medium of account, that implies lower equilibrium prices for goods and services and resources like labor. The market process that brings that about is reduced spending on output and reduced demand for labor.
With a gold standard world, deposit insurance protects the economy from the catastrophic contractionary effects of a run on the banking system into golden base money.
However, there has been nothing like a gold standard for many years. To the degree that worries about bank deposits lead to an increase in the demand to hold currency, the quantity of paper currency can be increased to match the added demand. There is no need for any decrease in the level of prices and wages to cause the real quantity of currency to rise to the greater demand. There is no need for the market process that would cause those price adjustments, reduced spending on output and reduced demand for labor.
Of course, government- issued paper currency may be safer than deposits with no or uncertain insurance. But paper currency is costly to store, especially in large amounts. And guarding it from theft is also challenging. If government insured deposits are no longer a safe haven, it is true that some may choose to hoard more currency, but there is also an incentive to purchase other risky assets as well, including capital goods, and further to expand consumption, particular consumer durables.
When some kind of panic leads to a shift from holding risky assets to safe assets one approach is to increase the quantity of the safe assets to meet the demand. However, making the safe assets less appealing is another way to solve the problem.
For example, suppose people sell off their stock holdings and buy short and safe government bonds. It would be possible to have the government run a budget deficit and expand the quantity of those bonds. Or it might refinance the national debt, selling short bonds and using the proceeds to pay off long government bonds.
But there is another obvious effect that tends to solve the problem. The price of the bonds rises and the yield falls, making these short and safe bonds less attractive to hold. This tends to dampen the sell off in stocks by reducing the quantity demanded of the short and safe bonds.
With insured deposits, the same effect can occur by having a lower yield on them. If investors sell off stocks and accumulate funds in insured deposits at banks, one solution is to increase the quantity of deposits to match the added demand. Lowering the interest rate on deposits, however, in an alternative approach.
And, of course, restricting or eliminating deposit insurance will have the same effect as reducing the yield. It will tend to solve the "problem" of a shortage of bank deposits.
The same logic applies to government bonds. Suppose there is a risk of explicit default on the government bonds?
For example, suppose the central bank announces that the Krugmanite theory that there can never be an explicit default on government bonds is false. That it will not create money to fund deficits or refinance the national debt. If the government cannot come up with the funds some other way, it will be forced to default. This will make holding "short and safe" government bonds less attractive. That will help clear up the shortage of government bonds.
Now, I don't think it is a good idea to worry people about default on government debt needlessly. But I certainly reject a constitutional order that makes an inflationary payoff of the national debt a consideration. And while I am not opposed to making debt and interest payments constitutionally prior to any other government spending, I don't think tax hikes should be constitutionally mandated.
The government has "perfect" credit because it can print money to pay off its debts or has the power to tax? Not a government subject to appropriate constitutional limits.
Having a monetary authority (or central bank) issue the amount of currency demanded should be sufficient to avoid any contraction of spending on output. Of course, once all of the government's interest bearing debt is purchased, then any further expansion in the quantity of currency involves the government providing a safe asset, the currency, while purchasing more or less risky private securities.
However, there is no need to provide "perfectly safe," base money in extremely convenient forms. Certainly not deposit accounts (and certainly not ones that pay positive rates as has the Federal Reserve over the last few years.) No, only issue one dollar bills for people to hoard.
As a last resort, it would be possible to stop issuing the hand-to-hand currency and make the risky bank deposits the sole medium of exchange. As was done in the U.S. during he 19th century, the banks could suspend currency redemptions.
And what would people use for hand-to-hand currency? As I always mention, why not let the banks issue their own? People could use it to make small face-to-face payments, but no one would find it especially desirable to hoard. It would be just as risky as uninsured deposits.
Of course, Cyprus uses "the Euro" which creates some similarity to the gold standard of yore. Suspension remains a possibility, though I suppose that amounts to "leaving the Euro" at least temporarily.
But thinking about possible contagion in the Euro zone as a whole, it is not at all clear that a reduction in the demand to keep funds in safe bank deposits is necessarily a bad thing. Hoarding currency wouldn't help, but hoarding currency is not as convenient as leaving funds in government-guaranteed deposit accounts. And increasing incentive to invest in capital goods, or even to consume would be helpful.