In the aftermath of the Great Depression, we redesigned the machine so that we did understand it, well enough at any rate to avoid big disasters. Banks, the piece of the system that malfunctioned so badly in the 1930s, were placed under tight regulation and supported by a strong safety net. Meanwhile, international movements of capital, which played a disruptive role in the 1930s, were also limited. The financial system became a little boring but much safer.Krugman intimates in this passage a point he drives strongly home about financial globalization later: that it comes at great risk and calls for long-term restrictions and regulation. That is a point that free traders should take to heart, rather than placing blind faith in a somewhat contrived notion of freedom in globalized markets. The notion that any market can operate with no responsibilities other than those it defines itself completely bewilders me.
Then things got interesting and dangerous again. Growing international capital flows set the stage for devastating currency crises in the 1990s and for a globalized financial crisis in 2008. The growth of the shadow banking system, without any corresponding extension of regulation, set the stage for latter-day bank runs on a massive scale. These runs involved frantic mouse clicks rather than frantic mobs outside locked bank doors, but they were no less devastating.
What we're going to have to do, clearly, is relearn the lessons our grandfathers were taught by the Great Depression. I won't try to lay out the details of a new regulatory regime, but the basic principle should be clear: anything that has to be rescued during a financial crisis, because it plays an essential role in the financial mechanism, should be regulated when there isn't a crisis so that it doesn't take excessive risks.
Monday, December 08, 2008
The Pulitzer Prize winning economist connects the dots of history: