The psychology of contagion

Another interesting blog from Robert Peston...London Scottish, a small bank, has had its deposits fully guaranteed because of the risk of contagion if it were allowed to fail. It is too small to matter systemically in itself, but it is felt that the message it would send is too dangerous and would result in lots of other small banks having funds withdrawn to the point where many of them would collapse too.

It's a barely avoidable decision, the way Peston tells it.

But there's a big question here.

Where does it stop? First, all major (too-large-to-fail) bank deposits were implicitly guaranteed. Now, all small banks are guaranteed. You might think bank deposits are privileged. But what about deposits in credit unions or Christmas hamper schemes? They are quite like banks.

Now what if I have put money into some other kind of scheme - say a cash ISA. If that's not guaranteed, will people take all their money out of those?

What about other types of investment fund? Life insurance? Pensions?

What if I buy a bond from a car manufacturer?

What about if I lend money to a small private company?

What if I lend money to my nephew?

What if I buy shares in a company?

A year ago, nobody would have seriously suggested that any of these would be candidates for a government guarantee. If any particular one failed, it would be assumed that the particular investment (or the particular nephew) was a bad bet, and nobody would draw conclusions about the wider system.

But now, at least to some extent, expectations have changed. Not because of any fundamental difference in the operations of those businesses, but because people now assume a greater correlation between a group of companies than they previously did.

Oh no - my nephew has gone bust... we must withdraw our money from all nephews!

This is a creeping process - as each type of company is affected, the next type becomes contaminated. And even though it is a purely psychological process, it feeds on itself and the correlations have the potential to become real.

And yet it is neither possible nor desirable for the government to stand behind every debt in the whole economy. Perhaps we need some kind of firebreak - if the government pre-announced that it would not guarantee debts of a particular class of entity, one that is not at risk, it would affect expectations in other firms. And yet this in itself would create a problem - the very fact that the government announces (say) that the liabilities of oil companies are not guaranteed, might create a run on oil companies. Even though those liabilities are already not guaranteed!

The real answer is to understand the pattern recognition mechanisms that people use. Why is it that London Scottish Bank is not just an individual failed institution but an exemplar of a whole sector? What makes us think it is more similar to another bank than, say, to another company with Scottish in the name?

As Peston suggests, some clear principles about what will and will not be guaranteed, and over what timescale, might help with this. But it would be better still to create a conversation that distinguishes different kinds of company, different types of debt and still gives people an incentive to hold non-guaranteed debt.

Perhaps this is the time for that negative interest rate Brendan Brown was talking about. Hmm. Maybe not such a good idea after all.

Macroeconomics needs to be supplanted with a discipline of macropsychology. Like my fiscal salesmanship post last week, we need to find ways to make a clear case to a large population so that they don't enter into self-reinforcing, self-damaging behaviour. Anyone want to buy shares in advertising companies?