As may get the feeling by now, I am not a fan of Austrian Economics. I support their stance on freedom and property rights but not their constant trashing of the government and call for unfettered capitalism. It is likely that the ideology will never gain any major support in any democratic system, except under duress (such as during a major war or super-high unemployment or some such thing.) To see why, consider what Mike Shedlock of MISH's Economic Analysis blog, who happens to be an AustEcon supporter, says about FDIC:
Instead of spreading a small number of small bank failures out over a large number of years, a large number of big failures are all clustered together.
If this is not an asinine model what is? Note this is a failure caused by regulation. There should not be an FDIC in the first place.
This view is nothing unique to Mike Shedlock and has been expressed by others such as Jim Grant and Jim Rogers (not sure if Rogers is an AustEcon believer.) So I'm not trying to single out Mike Shedlock; instead, I'm attacking the whole ideology that is against deposit insurance.
Does anyone know what happened before FDIC insurance?
No, we didn't have a paradise with few bank failures and losses. Nope! In fact, it was a horrible environment where bank failures were very common. In fact, if you looked at history over several hundread years, one will conclude that bank failures before FDIC insurance was even worse.
Yes, more of the losses accrued to the stockholders and bondholders (whereas now the bondholders seem to be protected by the government.) So it was more capitalist in punishing those whose firms made mistakes.
However, a conveniently ignored fact is that depositors almost always lost money. Guess who the depositors are? Some average guy off the street, like you and I. Even the best citizen who did their utmost job to determine if a bank is safe (a very difficult task even if you were an bank accounting expert) before dealing with the bank, had no chance. Losses were rampant and the average person literally lost their life savings with little recourse. Even worse, back then, was how farmers, who weren't even middle-class since the middle-class wasn't as big in the 1800's, often lost whatever money they had whenever there were bank failures.
To make matters worse, one bank failure often led to bank runs on all the other banks (since deposits were never safe* anywhere.) There were so many well-run banks wiped out by bank runs based on rumours and wild speculation (possibly started by competitors and other nefarious sources.)
As for the fat tail risk, that's unavoidable in my opinion. That's why the government handles this stuff. The nature of booms and busts means that you will have huge losses in a short period of time during the bust. This is nothing new and has been happening for the last few thousand years. Other than charging enough premiums to make sure you have enough money to cover losses, you really can't do anything. Criticizing the fat tail aspect of deposit insurance is kind of like someone criticizing an insurance company insuring against earthquakes for the fat tail risk. Of course there is fat tail risk—that's the nature of earthquakes!
It's amazing to me that people who already know all this (and know way more than me) call for such a ludicrous system. I am strongly against removal of bank deposit insurance. If someone wants to criticize, do so for the types of institutions that are covered. For example, should Iceland really insure off-shore deposits by Icelandic banks? That's a debatable point. Otherwise, it's like going back to the stone age.
* Some of the same people arguing against deposit insurance often argue that banking should not be fractional reserve banking. That is, under fractional reserve banking, the bank only holds a portion of the assets as reserves (i.e it lends out more than it has.) Only lending out exactly equal to deposits is very pimitive and practicaly no ecnomist, other than the few who propose that system, ever support it. Nearly all of modern history has involved fractional reserves. I'm not going to go into why only lending what you take in as deposits is inefficient in this post but maybe in the future.