New crisis, old-time remedy

If the everybodies want liquidity in their portfolios but the private market cannot turn durable capital into directly useful cash, Krugman argues, the government should step in and do so: It should directly or indirectly buy the long-term bonds that underpin our social investments in exchange for cash that it prints up fresh for the occasion. A confidence trick? Yes. A potential source of inflation? Possibly. But it works.

And if the government then finds that the everybodies are still not happy with their portfolios because they want not just short-duration liquid assets but safe ones as well, then the government needs to launder the money: to itself assume partial or complete ownership of risky banks and portfolios, and finance its purchases by issuing its own safe debt backed by its full faith and credit.

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Others have done it

As Krugman writes, we know how to do this: Sweden did it in the early 1990s, investing as much in its banks in proportion to its economy as $500 billion would be for the U.S. today. Japan did it in 1998, investing the equivalent of $2 trillion when scaled to the U.S. today. And as a next step, Krugman recommends a "good old Keynesian fiscal stimulus": When the private market will not provide enough demand to keep America near full employment, the government should think of something that needs to be done and hire people to do it until the economy is back near full employment.

And, when push comes to shove, Krugman believes that we do understand how to vaccinate the system against at least the most virulent strains of the disease. It is fine for banks and other financial institutions to promise their depositors and investors that their money is liquid and safe though it is in fact invested in the durable and risky capital of the economy: That is what banks do. The danger comes when they do it too much: promise too much liquidity and too much safety. The answer has been clear for a century: Rein them in. Krugman's principle is: "[A]nything that . . . 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" -- that is to say, if things turn out badly, the entire financial sector won't freeze up.

The dot-com crash did not threaten to produce a depression because the venture capitalists did not claim to be providing liquidity and safety. The East Asian crisis of the late 1990s did cause a small depression because East Asia's banks had borrowed in dollars and lent in baht when the regulators were not watching. And the problem this time is that we did not understand the degree to which all the mortgage finance companies, investment conduits, MBS vehicles, CDO tranches, monolines and other non-bank financial players that had taken on the role of banks -- of making long-term durable risky investments yet promising those who contributed the funds that their funds were liquid and safe -- without being regulated like banks.

We won't make this mistake again.

At least not for a generation.