Krugman.

I thought Krugman's column today made an interesting point about the creation of an alternate financing system and the economic equivalence of asset backed securities and bank loans in 1930. I had never really considered the point, but he being Paul Krugman super economist (seriously), I take his economic analysis fairly seriously. I've pasted it below in case you were interested.

Contrary to popular belief, the stock market crash of 1929 wasn’t the defining moment of the Great Depression. What turned an ordinary recession into a civilization-threatening slump was the wave of bank runs that swept across America in 1930 and 1931...

Banks exist because they help reconcile the conflicting desires of savers and borrowers. Savers want freedom — access to their money on short notice. Borrowers want commitment: they don’t want to risk facing sudden demands for repayment.

Normally, banks satisfy both desires: depositors have access to their funds whenever they want, yet most of the money placed in a bank’s care is used to make long-term loans. The reason this works is that withdrawals are usually more or less matched by new deposits, so that a bank only needs a modest cash reserve to make good on its promises.

But sometimes — often based on nothing more than a rumor — banks face runs, in which many people try to withdraw their money at the same time. And a bank that faces a run by depositors, lacking the cash to meet their demands, may go bust even if the rumor was false.

Worse yet, bank runs can be contagious. If depositors at one bank lose their money, depositors at other banks are likely to get nervous, too, setting off a chain reaction. And there can be wider economic effects: as the surviving banks try to raise cash by calling in loans, there can be a vicious circle in which bank runs cause a credit crunch, which leads to more business failures, which leads to more financial troubles at banks, and so on.

That, in brief, is what happened in 1930-1931, making the Great Depression the disaster it was. So Congress tried to make sure it would never happen again by creating a system of regulations and guarantees that provided a safety net for the financial system.

And we all lived happily for a while — but not for ever after.

Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free — partly by persuading politicians to relax the rules, but mainly by creating a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.

For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.

In fact, however, we were partying like it was 1929 — and now it’s 1930.

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills. And the result, now as then, is a vicious circle of financial
contraction.

I remember sitting around the dinner table that one night with all those finance professors and the SEC guy as they were lobbing a variety of hypotheticals at him about regulatory postures and outcomes. Two stuck in my mind in particular, both lobbed by the prof I'm working for, the director of the international finance program here at HLS. The first was about how the SEC had taken supervisory jurisdiction over Bear Stearns, and what would happen to the credibility of the SEC if Bear Stearns were to collapse. This was a week before the Bear Stearns implosion. (This is not relevant except to say that the market clearly wasn't expecting such a precipitous implosion at the time...)

The second asked what type of regulatory adjustments the SEC would make if, say, our economy were to suffer a market catastrophe on par with the start of the Great Depression in 1929. Startled at what seemed like an outlandish hypothetical, akin to a 1L asking a Con Law prof about the separation of powers in the face of all out nuclear war, I looked around the table to see if anyone had a professorial half-smile, or look of purely academic interest in their face awaiting an answer to the question. But there wasn't. The question was asked, received, and answered as if the situational presented a perfectly reasonable possibility.

I don't know that it's fair to read anything into that moment, but for a split second in mid-bite of froufy doof salmon, I got chills.