Krugman on banking:

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.

Of course, regulation is bad!

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.

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.

"Complex" is one of those words you want to put your hand on your wallet when you hear it, just like "innovative."

More on the shadow banking system from Nouriel Roubini, who's been on the money so far (Lord Eschaton got me to read him, and he's horrifying but fascinating). First, more gory detail on the shadow banking system:

Today we are facing a massive margin call on highly leveraged US capital markets and a massive de-leveraging of the financial system following fire sales of marked to market assets in vastly illiquid money markets, credit markets and derivatives markets.  We are thus close to the last steps of my 12 Steps to a Financial Disaster. Each of these 12 steps is now underway and the only question is not whether such steps will take place but rather how severe they will be and how big the losses will be.  We are now observing – with the Bear Stearns episode as well as with the collapse of the SIVs, the losses on money market funds and the collapse of hedge funds and highly leveraged funds – the beginning of a generalized run on the shadow financial system.  

And - as discussed in my 12 Steps to a Financial Disaster - the financial losses are now spreading from subprime to near prime and prime mortgages, to commercial real estate loans, to consumer debt (credit cards, auto loans, student loans), to leveraged loans, to muni bonds and writedowns from the impairment of the monolines' insurance, to corporate loans and bonds whose defaults will surge soon, to the massive losses in the CDS markets.

The Fed response to this run has been to provide the Bear Stearns bailout and provide both liquidity and swap of illiquid and toxic assets for safe Treasuries to the non-bank primary dealers. But these radical and risky actions of the Fed  - as the collateral for this lending is now toxic – are not achieving their goals: in the short run the risk of a run on a Lehman may have been reduced; but what is happening in the money markets and in the agency markets shows that the Fed can only affect partially liquidity premia, not credit premia; and spreads are widening for a wide range of money markets and credit markets because of widening credit spreads driven by sharply rising counterparty risk.

The lack of trust of financial institutions in their counterparties is surging in spite of all the Fed actions as panic is setting in money markets and credit markets.  Thus, providing access to a dozen broker dealers who are primary dealers does nothing to ease the credit risk and liquidity/rollover risk of thousands of US and global institutions that are part of the shadow financial system. In a mark to market world many of these highly leveraged institutions – including large broker dealers other than Bear Stearns – are effectively bankrupt and no Fed action can rescue them. And the run on the shadow financial system has barely started.    

And as for policy:

This government intervention would not be aimed to prevent the necessary adjustment of asset prices; it would be aimed at ensuring that the necessary adjustment is not disorderly.

Such radical policy action includes a government plan to purchase – at a significant discount to minimize its fiscal cost – hundreds of billions of dollars – possibly trillions – of mortgages, effectively a nationalization of mortgages. Once purchased by the governments at a significantly discounted price these mortgages could be restructured to reduce their face value, reduce the interest rate on the mortgage and allow distressed but solvent borrowers to avoid foreclosure. To limit borrowers’ moral hazard only truly distressed borrowers would qualify: i.e. no condo flippers, no second home borrowers, no early default borrowers; only borrowers that were likely to be subject to deceptive and/or predatory lending practices. Only this formal nationalization of mortgages will start to stop the foreclosure disaster and jingle mail tsunami ahead of us. The fiscal costs and lenders’ moral hazard risks of such a plan can be significantly reduced if action is taken early and if the price at which the government buys mortgages from lenders is low enough.

This plan also include a formal nationalization Fannie and Freddie as the ongoing farce of pretending that these insolvent institutions are private sector firms is being revealed: at market value these institutions are effectively insolvent and government decision to increase limits for non-conforming loans, to increase caps on their portfolios and to reduce their “excess” capital are now revealing that these are not private institutions: they are rather effectively public institutions that are – in spite of their massive problems – being used to bail out the mortgage markets. So lets end the farce of deluding ourselves that these are private firms: if these bankrupt institutions need to be used for public policy purposes – as they may need to – let us formally nationalize Fannie and Freddie – and put transparently on the public sector balance sheet the costs of bailing out the mortgage market.

This plan would also include the closing and/or nationalization of banks and other systemically important financial institutions that will fail in droves during the current financial crisis (they can then be privatized again after proper restructuring as many countries did after their banking crises). Again moral hazard distortions can be minimized by wiping out 100% the shareholders in these institutions and firing – with no sweet severance packages - all the reckless senior management that created this mess.

Claiming the Bear Stearns was not bailed out because the current shareholders got only $2 per share is disingenuous: this was a massive bailout as the Fed put $30 billion of cheap credits in the pot: without this massive financial support not only the shareholders would have been wiped out 100% as they deserved to (rather than keeping the option value that the government support will recover in due time the value of their shares); but also many of the creditors of Bear Stearns would have experienced massive losses as Bear was insolvent and unable to pay such creditors with its impaired assets. Instead the $30 bn Fed support represents a major subsidy for JPMorgan and a major bailout of Bear’s creditors. Effectively the Fed has taken on its balance sheet the entire credit risk of $30 of toxic securities held by Bear Stearns. So, this Fed bail out is an explicit case of using the disastrous Japanese model of a “convoy system” (healthier banks taking over zombie banks with the help of lots of public money) that led to a decade of economic and financial stagnation.

A market solution to this crisis does not exist; those who believe in such markets solutions are deluding themselves as markets left alone will melt down and enter into the mother of all meltdowns, margin calls, cascading collapse of asset prices, massive credit crunch and liquidity seizure and severe economic recession.

So government intervention is necessary not to avoid the unavoidable massive losses and bankruptcies and the unavoidable fundamental adjustment in asset prices. It is rather necessary to avoid a financial meltdown where asset prices fall much more than justified by economic fundamentals and the credit crunch and de-leveraging of the financial system is much more severe than the necessary one that will occur regardless of any public intervention.

And just to bring this back to the campaign for a moment: If this truly is a 1929-style moment in history, there's no fucking way I want Obama in charge. I want somebody who gets the policy minutiae. And I want somebody who doesn't dog whistle on Social Security, because that's the biggest pile of money around, and you know these guys want to get their hands on it. Shock Doctrine, doncha know.

NOTE Nice work taking impeachment off the table, Leader Nance. Now we've got an executive branch that's regarded on all sides with a complete lack of trust.

UDPATE Sterling Newberry was a very smart post (duh) on all this:

Most people think of the 1920's as a decade of uninterupted prosperity, the reality is that there were four downturns that began in the 1920's: January through July of 1920, part of a double dip post-World War I Recession, May 1923 through July 1924, October 1926 through November 1927, and, of course, August 1929 through March 1933. In all this cluster of recessions from January of 1920, through the end of 1929 lated 53 months of 120. Or roughly half the decade. In all of the time that the Republicans had an easy domination of the White House from March of 1921 through February of 1933, the economy was in contraction 74 months of 144, or again, about half. What made people remember the decade as prosperous was the massive upswings of the booms. In 1920, the estimated GDP of the US was 609 Billion dollars, with a per capita GDP of 5,721 - or about what China has right now. By the end of the decade it was 7,099 dollars per capita, and 865.2 Billion dollars. Even with all the recessions, the spurts, years like 1921, 1922 and 1929 until the down turn, made large strides, while in other years, GDP per capita was basically flat.

One reason for the casino mentality was, then, the fact that much of the time people were staying in place. In 1923 GDP per capita was $6,350 and by 1928, five years later, it was $6,771 dollars. A Bush-esque crawl.

The whole experiment of the Bernanke Federal Reserve is to get 1927 right this time: bail out the banks enough without regulation.

Which is, I suppose, re-assuring. 1927 sounds a hell of a lot better than 1929:

What is happening right now, in effect, is an attempt to change the monetary basis of the United States.

Bernanke has now allowed brokers to borrow directly from the Federal Reserve, and created a series of instruments which, in effect, allow the creation of money based on speculatively held money. Bernanke's moves in the last few days have, in effect, created a new basis for the US currency. It is one that has been building for some time.

This change was inevitable, and predictable. Sooner or later the American Dollar must be based, in a global economy, on the global evaluation of our production. However, the question, as with every previous monetary order, is whether the pieces fit together. Presently, they do not.

The reason they don't is because there is no narrow channel which keeps the powers that be from leaning too far in one direction. There is no consequence for those temporarily in power from simply spewing dollars in every direction, and letting those that they do not like pay the costs. That is what is happening now, the coalition of farmers and oil men that held Bush in power, are doing very well. The defense contractors have made out very well, and those that loan money to the government are doing well. Those that are being bailed out have seen their share of national wealth and income skyrocket.

The key is not re-regulation, but a Nash equilibrium, a state where no group can unilaterally improve its position at the expense of others. This state is the challenge for the next administration. It will require a fundamentally different political order, as the great overturns of monetary basis in the past have been based on different constitutional orders to both create, and navigate, the narrow channel which their monetary system rests upon.

The pieces must interlock to the regulation of the financial system, and they must end the disequilibrium where the wealthy can dump risk on others, and take the profits for themselves.

Funny. That's exactly what a system of checks and balances would do. As Madison says in Federalist 51:

It is equally evident, that the members of each department should be as little dependent as possible on those of the others, for the emoluments annexed to their offices. Were the executive magistrate, or the judges, not independent of the legislature in this particular, their independence in every other would be merely nominal. But the great security against a gradual concentration of the several powers in the same department, consists in giving to those who administer each department the necessary constitutional means and personal motives to resist encroachments of the others. The provision for defense must in this, as in all other cases, be made commensurate to the danger of attack. Ambition must be made to counteract ambition. The interest of the man must be connected with the constitutional rights of the place. It may be a reflection on human nature, that such devices should be necessary to control the abuses of government. But what is government itself, but the greatest of all reflections on human nature? If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself.