by Paul Krug­man
THE NEW YORK TIMES

If Ben Bernanke man­ages to save the finan­cial sys­tem from col­lapse, he will — rightly — be praised for his heroic efforts.

But what we should be ask­ing is: How did we get here?

Why does the finan­cial sys­tem need salvation?

Why do mild-mannered econ­o­mists have to become superheroes?

The answer, at a fun­da­men­tal level, is that we’re pay­ing the price for will­ful amne­sia. We chose to for­get what hap­pened in the 1930s — and hav­ing refused to learn from his­tory, we’re repeat­ing it.

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.

This bank­ing cri­sis of the 1930s showed that unreg­u­lated, unsu­per­vised finan­cial mar­kets can all too eas­ily suf­fer cat­a­strophic failure.

As the decades passed, how­ever, that les­son was for­got­ten — and now we’re relearn­ing it, the hard way.

To grasp the prob­lem, you need to under­stand what banks do.

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.

Mr. Bernanke and his col­leagues at the Fed are doing all they can to end that vicious cir­cle. We can only hope that they suc­ceed. Oth­er­wise, the next few years will be very unpleas­ant — not another Great Depres­sion, hope­fully, but surely the worst slump we’ve seen in decades.

Even if Mr. Bernanke pulls it off, how­ever, this is no way to run an econ­omy. It’s time to relearn the lessons of the 1930s, and get the finan­cial sys­tem back under control.