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Partying Like It’s 1929

by Paul Krug­man

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.


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