Paul Krugman writes:
Don’t Be Narrow-Minded: I see that Greg Mankiw seems to favor narrow banking: require banks to hold all their deposits in liquid, short-term assets, thus obviating the risk of financial crises.... I’d argue that this is all wrong, on two levels: if it were possible, it would do away with the main purpose of banks, and anyway, it’s not possible....
I think of the whole bank regulation issue in terms of Diamond-Dybvig, which sees banks as institutions that allow individuals ready access to their money, while at the same time allowing most of that money to be invested in illiquid assets. That’s a productive activity, because it allows the economy to have its cake and eat it too, providing liquidity without foregoing long-term, illiquid investments. If you were to enforce narrow banking, you would be denying the economy one of the main ways we manage to reconcile the need to be ready for short-term contingencies with the payoff to making long-term commitments...
Let me focus on Krugman's first objection to narrow banking. It helps, I think, to ask the economist's question: What is the market failure? What is the market failure that would justify narrow banking--which means using the fist of Leviathan to shut down the maturity-transformation industry? Why not let those who promise that they can turn long-term illiquid risky sow's-ear investments into short-term safe liquid silk purses carry out their trade?
The answer, I think, is that two things are going on, both rooted in saver psychology. The first is herding in financial markets, which means that savers' and financiers' demand for safe, liquid, short-term assets fluctuates wildly and unpredictably. The second is that there is a strong demand for safe assets which is a demand for safe assets--and that means that the price of safe assets with respect to consumption goods cannot fluctuate, for if it did fluctuate then they would not be safe assets, would they?
Back before the industrial revolution this was not a problem, for the capital stock of the economy was overwhelmingly composed of consumption goods of one sort or another. If Antonio, Renaisssance-era merchant of Venice, faces a sudden shift in his investors' portfolio preferences as they want more safety and liquidity, with a sigh he unloads the silks of China, the spices of Indonesia, and the perfumes of Arabia from his ships and distributes them to his investors. But once you get canals, railroads, and cotton mills on a large scale you cannot do that anymore--you cannot deleverage the economy as a whole rapidly by consuming your existing capital. That is why it is no accident that the modern market-driven financial crisis and the industrial business cycle start in 1825, as the British Industrial Revolution enters its heyday.
So once the Industrial Revolution has come we have a problem. We can solve this problem through narrow banking--through shutting down the maturity-transformation market by saying, "sorry, we simply cannot create safe assets to meet your demand." Or we can solve this problem by having the government--that is, taxpayers in general--act as lender-of-last-resort, that is provide insurance against their own unstable psychology to savers and financiers. The second--if it can be done--seems to me to be better: it offers higher utility, for it responds to a market failure not by shutting down a market and throwing all the utility it generates away but rather by using the government to repair the consequences of the market failure.
Or, to quote from chapter 17 of John Maynard Keynes's General Theory of Employment, Interest and Money:
Unemployment develops, that is to say, because people want the moon;--men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. a central bank) under public control.
I do hope, someday, to have an important and valid insight that is original--that was not anticipated by Smith, Ricardo, Keynes, or Akerlof. But even I can see that my chances are not good...