Wednesday, September 7, 2011

SNB, Currency Wars, and the China Peg

The currency wars are back. It was, of course, the neutral Swiss who fired the latest salvo in this "conflict" by announcing a minimum exchange rate target vis-a-vis the euro. This amounts to quantitative easing a l'outrance: the Swiss National Bank will print Swiss francs as necessary to buy up foreign exchange to hit its target. Markets certainly took note.

The dramatic impact of the SNB's announcement refutes claims that monetary policy is currently impotent. Even in a liquidity trap, a sufficiently radical monetary shock will undoubtedly jolt an economy back towards growth. But, as if often the case, there is a fallacy of composition problem here: everybody cannot devalue at the same time—right? Buttonwood of The Economist makes the case:
It seems that all countries would like to see their currencies decline bar the Chinese who will only let the renminbi strengthen gradually. Some currencies must rise, however, and the Europeans may not be too happy to see the Swiss trying to drive the euro up, especially if the Fed opts for a third round of QE.
Hence, the evocatively dubbed "currency wars", i.e. competitive devaluations. However, Buttonwood's fear that this will lead to a destructive game of "beggar-thy-neighbor" leads to a puzzling historical analogy. Again, from The Economist:
It is all a bit reminiscent of the 1930s. When countries went off the gold standard, they gained a competitive march on their rivals, increasing the pressure for such countries to leave the standard as well. If one country devalued by 10%, the next might do so by 15%. QE may similarly begat more QE.
Isn't this an argument in favor of currency wars? After all, abandoning the gold standard was effectively a prerequisite for reversing the precipitous decline of the Great Depression. Insofar as combatting the economic crisis of the 1930s required a coordinated international response, competitive devaluation acted as an organic catalyst for such collective action by prodding one nation after another to pursue more expansionary monetary policy. This was the invisible hand on the macro level. As Ryan Avent points out, all the better if the ECB or the Fed respond today with their own currency interventions; the global economy might just get QE all the way down, to recovery.

But what of China? Indeed, their currency peg to the dollar short circuits this potentially mutually beneficial game of competitive devaluation, and turns it into a zero sum one. Due to its capital controls, foreign governments cannot respond in kind to the Chinese government's currency interventions. This amounts to "stealing" demand from overseas. Ryan Avent argues, however, that this does not need to end badly:
Central banks can still print money, taxing the foreign government's ability to sterilise until it relents, and in the meantime supporting the domestic economy. Alternatively, a government in this position can use the free loans provided by the intervening foreign government to directly stimulate the economy, through fiscal spending and investment.
Put simply: QE can make a peg either impractical due to the inflation it would inflict, or impossible due to the limitless foreign exchange that would be necessary to sterilize inflows. The surge in Chinese inflation after QE2 would seem to confirm this viewpoint—except for the fact that China did not ditch its peg. Indeed, a country that considers a currency peg an integral part of its growth strategy will only jettison it as a last resort. China would rather hike interest rates or increase reserve ratios—which are obviously contractionary policies both domestically and abroad—than appreciate its currency.

Clearly, not all currency pegs are created equal. Consider Switzerland's de facto peg. If the ECB decided to embark on its own bond-buying program to counteract the SNB, the Swiss would presumably respond by printing more francs and increasing their own bond-buying. The result: expansionary monetary policy for both the Eurozone and Switzerland. China's capital controls and rigid defense of its own peg subvert this calculus: the United States buys bonds, and China raises interest rates. Rather than both economies giving themselves an economic boost, China curtails its own growth —which obviously has negative spillover effects for the myriad economies that depend on Chinese demand.

Of course, a determined Federal Reserve could overcome these obstacles, much as the SNB just did. If the Fed announced that it would pursue open-ended QE until the real exchange rate between the dollar and the yuan hit (and stayed at) an explicit target more in line with perceived fundamentals, it would almost certainly force Chinese officials to reassess their stance. A credible threat would be sufficient. But this ignores the modus operandi of modern central banks: only the threat of imminent deflation spurs them to embrace unorthodox policies. As long as core inflation creeps along near 2%, they consider it mission accomplished. It would take another drastic leg down before the Fed would countenance approximating anything close to such a seemingly radical policy.

The natural bias towards timidity among central bankers—at least when it comes to trying to create inflation—is perhaps the most compelling argument in favor of a so-called currency war. It forces stimulative action. Still, capital controls can complicate the advantages of competitive devaluation; a positive sum currency war can devolve into a zero sum trade war. It is well within the power of central banks to forestall such a breakdown, but unfortunately far too many still seem obsessed with Don Quixote economics. It is a dangerous moment. Will the Fed and ECB notice?

Tuesday, August 30, 2011

The Housing Bust, Deleveraging, and Zero

If the housing bust was the proximate cause of our Great Recession, why didn't the economy begin contracting until a year and a half after housing prices began to decline -- and well after the economy began shedding construction jobs? Indeed, Ryan Avent observes:
[T]he story in which the housing bust gave us the recession, because America suddenly had lots of houses and workers it couldn't use doesn't appear to fit the data. The economy muddled on despite the housing bust for two years, at which point, for some reason, all sectors suddenly decided that the outlook for growth was much worse than they'd previously believed.
But what about the story where the housing bust gave us the recession, because households underwater on their mortgages suddenly upped their savings rates, which was enough of a hit to aggregate demand to cause other households to save more out of fear as well? In short: the collapse of housing prices, rather than the collapse in demand from the housing sector, drove the recession.

The data certainly seems to conform with this general narrative. Here are owners' housing equity (blue) plotted against home mortgage liabilities (red) and the personal savings rate (green).

The now familiar tale of the financial calamity of the bubble decade emerges from this picture. The savings rate evaporated at the height of the boom as homeowners alternatively tapped home equity loans or counted on asset appreciation as a form of de facto savings. This reversed a bit when housing prices began to decline in the second half of 2006, but, still, personal savings only nudged up a modest amount.  Indeed, it was not until shortly after the value of outstanding mortgage debt surpassed owners' household equity in August 2007 -- a first for the post-war period -- that the savings rate began to spike. This deserves special consideration.

There is a peculiar psychology to zero, at least when it comes to net wealth. Karl Smith recently pondered the irrationality of our fixation with the number, but the reality remains: there is a fundamental aversion to going below it. That mortgage debt eclipsed household equity in late 3Q2007 does not, of course, tell us the exact percentage of households underwater, but it is a decent proxy for the widespread state of disrepair of household balance sheets -- a sad fact that has significant implications. Households (or corporations) whose chief financial asset and piece of collateral has pushed their net worth below zero drastically change their habits. It may be that no rate of interest can induce them to borrow more; they prefer to pay down debts instead in an effort to erase their financial holes. This was infamously the case during Japan's Lost Decade, when corporations deleveraged apace despite the ready availability of literally free money. 

Even so, why should increased savings from paying down debts act as a drag on aggregate demand? After all, basic economics tells us that banks and other financial intermediaries should recycle savings back into the economy via loans. Unfortunately, the wholesale mistrust that ruled financial markets, and the subsequent credit crunch, that was endemic from August 2007 onwards prevented this mechanism from functioning correctly. 

Banking problems reinforced three interrelated negative feedback loops, with the end result economic armageddon. The first among these related to foreclosures: when one (former) homeowner defaults on a mortgage, this depresses the value of their neighbors' homes. If these neighbors are left with negative equity, they are then unable to refinance their mortgages, and have a reduced incentive to not walk away. Put more clearly, foreclosures are contagious. Increased savings in response to this collapse in housing values was the second feedback loop. As first subprime and then prime borrowers set aside more money to pay their mortgages, this effectively sucked cash out of the economy due to banks not lending the money back out. Businesses reacted to this lessening of demand by slowly cutting back, which caused fear to spread, and savings to rise among workers. Finally, asset values kept falling as these forces worked their way through the economy, further impairing banks' capital. With banks looking to de-risk, they became even more reticent about lending. And so on, and so on.

Thankfully, the government (finally) moved to arrest this downward cycle. But could the Fed have mitigated the slump with aggressive, pre-emptive action? Almost certainly. If the Fed had eased to accommodate the excess demand for money that arose due to the collapse of subprime securities and other seemingly safe cashlike assets in late 2007, the panic in the financial sector would almost certainly not have been quite as acute. This is not to say, however, that there would have been no recession. Instead of  a precipitous decline in late 2008, perhaps there would have been a gradual one, as households continued deleveraging in response to falling house prices. Nothing short of a sustained burst of inflation that would simultaneously erode the real value of debts and, more importantly, reflate housing values would change this dynamic. Theoretically, the Fed could engineer such above-trend inflation over the medium-term if it was willing to embrace radical enough policies. A combination of institutional and political concerns make it difficult for the Fed to credibly commit to such a program. This is deeply unsatisfying, but no less true.

The lesson of our Great Recession is not only that central banks need to shed their discomfort in engaging in unconventional policies, but also that asset prices -- particularly those used as collateral -- are central to the economy. Ignore them, and their affect on private sector balance sheets, at our economic peril.

Saturday, August 27, 2011

Obama, Recess Appointments, and the Fed

Ben Bernanke could use some friends. Not just within the Republican party from which he has become... ahem, estranged (to put it a bit more diplomatically than Rick Perry would), but also on the Federal Open Market Committee (FOMC).

There are still two vacant seats on the Federal Reserve Board. The governing structure of the Fed is a bit abstruse, but what this means is that Bernanke has two fewer allies on the FOMC -- which votes to set monetary policy -- than would normally be the case. Maddeningly, Senator Richard Shelby (R-Ala.) has blocked President Obama's efforts to fill the empty seats on the Federal Reserve Board -- with the laughable excuse that Obama nominee and recent Nobel prize winner Peter Diamond is not enough of an expert in monetary policy.

It's not clear how much of Shelby's obstructionism is payback for the Democrats blocking conservative favorite Randy Kroszner's appointment to the FOMC during the Bush years, and how much is a matter of ideology. Nor is it clear if anybody would be acceptable to Shelby today. Indeed, part of Shelby's stated opposition to Diamond came from the latter's public support of QE2 -- which Mike Konczal points out would rule out Shelby voting for even Kroszner today. Already, one of Obama's two most recent appointees has dropped from consideration. It seems unlikely the spots will be filled in the near future.

Why does this matter?

The FOMC usually tries to reach a consensus in its policy decisions. Its last meeting was an outlier, with three dissenters opposing the mild change in communications that the Fed expects economic conditions to warrant keeping short-term rates at zero through mid-2013. Unfortunately, these dissenters subscribe to what I like to call Don Quixote economics: waging war against imaginary problems while actual ones persist. Indeed, with the ten-year implied inflation at just 2% -- and falling -- worries about potential stagflation are profoundly misguided, particularly given that the civilian employment-population ratio is worsening. This bloc of self-styled inflation hawks have succeeded in stymieing more expansionary policy, only relenting when inflation expectations fall below the Fed's tacit 2% target -- which, thankfully, averts complete collapse, but regrettably does little to promote robust recovery.

Two more dovish votes on the FOMC would obviously give Bernanke more latitude to push for unconventional policies, without having to worry as much about losing a vote to the inflation hawk camp. And clearly, the case for further monetary easing is made more urgent by Congressional Republicans not only blocking further fiscal stimulus, but also actually pushing for mild austerity. 

Of course, Obama could end this confirmation charade, if he wanted to. Indeed, I just want to say two words to the president, just two words: recess appointments. Senate Republicans have, predictably, attempted to prevent Obama from even going this route by holding pro forma sessions every three days during their recess, but as Think Progress points out, this is a legally dubious tactic. In a similar case in 2004, the Eleventh Circuit court ruled that there is no minimum time Congress must be out of session before the President can use a recess appointment. So why isn't Obama filling the vacancies on the Fed that urgently need to be filled?

There are no good reasons. The most plausible is that Obama is wary of appearing too partisan and damaging his brand as the most reasonable person inside the Beltway. This is a mistake. The only issue voters know less about than the FOMC itself is how its members are appointed. Republicans might score a few political points on Obama's "overreach" for a news cycle or two, but 14 months from now that will be irrelevant. What will be relevant is the state of the economy -- and with fiscal policy on the sidelines, the Fed is the last, best chance of generating faster growth.

Obama's re-election chances could very well hinge on whether he gets religion on monetary policy. Does anybody in the White House realize this?

Thursday, August 25, 2011

Behavioral Economics, Tax Cuts, and the Stimulus

Did the Obama administration outsmart itself when it came to the tax cuts in the 2009 stimulus?

Recall that the debate at the time centered on how much of the recovery act would be composed of spending programs versus tax cuts. Liberals argued that the ARRA should have been weighted more towards government spending, such as infrastructure, because it was more stimulative than tax cuts that would likely be saved instead of spent. However, a combination of practical (a dearth of shovel-ready projects) and political (wooing enough moderate Republicans to break the filibuster) concerns ultimately led to roughly 37% of the stimulus coming in tax cuts -- but there was a twist.

Tapping the insights of behavioral economics, the Obama administration tried to structure the tax rebates such that households would be more likely to spend them. Here is James Surowiecki explicating this strategy:
You might think that handing people a big chunk of change is a perfect way to get them to spend it. But it isn’t, because people don’t treat all windfalls as found money. Instead, in the words of the behavioral economist Richard Thaler, people put different windfalls in different “mental accounts,” which in turn influences what they do with the money. [....] 
The key factor in these kinds of distinctions, Thaler’s work suggests, is whether people think of a windfall as wealth or as income. If they think of it as wealth, they’re more likely to save it, and if they think of it as income they’re more likely to spend it. [....] 
So what does this mean for making a rebate work? If you want people to spend the money, you don’t want to give them one big check, because that makes it more likely that they’ll think of it as an increase in their wealth and save it. Instead, you want to give them small amounts over time. And you want the rebate to show up as an increase in people’s take-home pay, because an increase in steady income is more likely to translate into an increase in spending. What can accomplish both of these goals? Reducing people’s withholding payments.
Unfortunately, this may have been too clever by half. Politically, designing a tax cut so that households will not notice they are receiving it was a predictable disaster. Indeed, shortly before the 2010 midterm elections, polls showed that only one in ten respondents knew that Obama had actually reduced taxes for 95% of Americans. But there is an argument that this was perhaps a misguided economic policy as well.

One interpretation of our economic malaise is that we are still suffering from a debt overhang among households. The nominal shock of the housing bubble collapsing left many households underwater on their mortgages, and consequently drove them to begin paying down debt. Even with short-term interest rates parked up against the zero bound, there is a dearth of borrowers among households -- which also depresses business investment, since there are not as many profitable opportunities in an environment where consumers are retrenching. This economic weakness will persist until the private sector is finished deleveraging. The best the government can do is to simply avert complete collapse by borrowing the excess of desired savings over investment. This is Richard Koo's theory of the "balance sheet recession" (there is a counter-argument that if the Fed embraced more unconventional policies, it could stabilize nominal spending and end the slump, but that is for another post).

The data on household debt certainly supports the view that this time, the recession really is different. Indeed, for the first time in the post-war period, households have actually begun reducing the amount of debt on their balance sheets.

If the balance sheet recession view of our slump is correct, however, doesn't that suggest that it is better for households to save tax cuts rather than to spend them? Indeed, if growth will remain subpar as long as the private sector is deleveraging, then the quickest way to get past subpar growth is to accelerate the deleveraging process. There are three strategies for doing so. First, policymakers could simply write down the value of underwater mortgages to their current face value -- but this would necessitate recapitalizing banks as well, which is an obvious political non-starter. Second, the Federal Reserve could try to engineer above-trend inflation over the short-term to erode the real value of debts. Unfortunately, there is little support among the FOMC for such a proposition (not to mention that successfully orchestrating higher inflation would probably require such radical policies that even the most dovish FOMC members would be reluctant to try).

That leaves tax rebates. At the risk of sounding tautological, giving households money to pay down debts obviously speeds up the process of paying down those debts. The sums involved from the ARRA were not very large -- $400 for single-earner households; $800 for couples -- but the notion that it would have been a "waste" if households did not spend those checks misses the point of the balance sheet recession. Sending out lump sum tax rebates might have been the more efficient policy over the longer-term, since that presumably would have led to households putting themselves on firmer financial footing faster than they otherwise did.

To be sure, the government needed to spend money to provide a stream of income to the private sector so that it could save. But the Obama administration might have been better served thinking of the tax cuts as a means to hasten the rebuilding of household balance sheets, and of public spending as a means to set a floor under the economy, rather than conceiving of both as the latter.

The great irony is that an unconventional recession perhaps called for a conventional response on taxes.

Conservatives Do Not Care About Deficits

The greatest trick the Republican party ever pulled was convincing the world that they care about deficits. They plainly do not. Rather, the GOP cares about the size of government. Hence, their rigid insistence that any debt ceiling deal be composed entirely of spending cuts. And their lockstep opposition to a value-added tax (VAT).

The VAT is essentially a national sales tax. It is a hallmark of European welfare states given that is an efficient (if regressive) as well as politically palatable method to raise tax revenue. It is for precisely these reasons that the VAT is such a bogeyman for the Wall Street Journal editorial page crowd. Consider this latest broadside against the specter of a VAT:
We estimate that each percentage point of a U.S. VAT would provide Washington over 10 years with approximately $981 billion with which to launch new spending. So even a small VAT might help reduce the debt-to-GDP ratio. But by making reforms to entitlement spending less likely, VAT revenues would also lead to a permanent increase in spending to 24% or more of GDP (compared to the historic average of 20%). [...]
Translation: a modest VAT could reverse our medium-term budget problems, but conservatives prefer to "starve-the-beast" instead to justify rolling back Social Security and Medicare. There is nothing "conservative", in a Burkean sense, about this strategy. Indeed, this is pure Leninism: the worse, the better.

That the Republicans claim the mantle of fiscal conservatism after a generation of running up the debt on tax cuts for the wealthy not only demonstrates the post-modern nature of our politics, but also the milquetoast disposition of the Democrats. It's well past due for Obama to highlight the glaring hypocrisy of the GOP: conservatives do not care about deficits at all.

Wednesday, August 24, 2011

The Least Persuasive Tax Argument Ever

Who among us has bought a gift for a grandchild -- or any loved one, for that matter -- and not pondered the profound unfairness of not being able to count it as a tax deduction? It's galling. Forget that private equity managers only pay a 15% tax rate on the majority of their income -- this is the real injustice in our tax code.

Anyone who found themselves nodding at the above might have a future writing for the Wall Street Journal editorial page. The conservative temper tantrum over Warren Buffett's call for higher effective tax rates on the rich reached its apotheosis with the totally specious argument that taxes had actually increased on the wealthy in the last decade; the latest effort in the Wall Street Journal by former American Express CEO Harvey Golub is merely the least persuasive entry in this genre.

The usual canards get recycled fairly quickly. Golub begins with the de rigueur conservative talking point that Buffett should just pay higher taxes himself if he thinks his taxes are too low (which, of course, ignores Buffett's point about the broader unfairness of the loopholes that let the super-rich pay less as a percentage of their income than the middle class does).

This whirlwind tour of hackery makes its next stop at the Wall Street Journal's preferred three-card monte tax argument: that only those who pay federal income taxes have a "stake" in how the government spends money. It is certainly true that nearly half of all taxpayers do not pay federal income tax -- but that is only because this "lucky" majority is too poor to afford to pay much more after accounting for state, local and payroll taxes. Consider that in 2009 -- the last year before the temporary payroll tax cut -- that Social Security taxes raised 97% of the revenue that federal incomes taxes did. And the payroll tax is regressive. Indeed, is it fair that Warren Buffett pays exactly the same amount in payroll taxes as someone making $120,000 does?

Golub concludes with a rant against an assortment of spending programs, tax expenditures and some true head-scratchers (such as the aforementioned lament that donations to charities are tax deductible, but gifts to grandchildren are not). None of this vitiates Buffett's argument that the super-rich are "coddled" when it comes to taxes. Nor is it persuasive on its own merits. Golub's argument that his taxes should not go up until programs he disapproves of are eliminated or made more efficient is a weak dodge. Imagine the democratic dysfunction such a rule would invite if adopted as a categorical imperative.

Is this really the best the Wall Street Journal can do?

Tuesday, August 23, 2011

Subprime, Shadow Banking and Liquidity Shocks: Lessons of the Great Recession

Why did relatively trivial losses in AAA mortgage bonds nearly vaporize the world economy in 2008? It seems absurd on its face. After all, despite the financial carnage in the U.S. housing market, the losses only amounted to a small proportion of global assets and GDP. Ben Bernanke's assurances that subprime would be "contained" almost seem plausible. Of course, this ignores the role credit default swaps (CDS) played in not only magnifying the aforementioned losses, but also in obfuscating them: the labyrinthine web of such opaque, over-the-counter contracts left banks unsure of what both they and their counterparties were on the hook for. It's no wonder the interbank market froze.

The destruction of seemingly safe, cashlike assets -- and the resulting surge in the liquidity premium -- is the other part of the story. The past few decades have been marked by the rise of the so-called shadow banking system: securitization largely replaced traditional lending, while investors clamored to maximize returns on the putatively safe (but uninsured) holdings the unregulated system created. This was the great irony of the post-tech bubble economy: the juxtaposition of brazen, unhinged risk-taking among lenders with the extreme risk-aversion of investors. The financial alchemy of securitization and tranching (and sometimes re-tranching) reconciled -- indeed, facilitated -- these divergent aims for a time, before reality intruded.

Here is Steve Randy Waldman's incisive description of this dynamic:
[There was] a “giant pool of money”, specifically sovereign and institutional money, that was seeking out ultra-safe, “Triple A” investment, and sometimes agitating for yield within that category.... The investors in question weren’t, in fact, investors at all in an informational sense. To a first approximation, they paid no attention at all to the real projects in which they were investing. They were simply trying to put money in the bank, and competitively shopping for good rates on investments they could defend as broadly equivalent to a savings account.
What type of assets made up these quasi-savings accounts? Chief among them were AAA mortgage bonds, auction rate securities, commercial paper, and repo. Money-market funds that invested in these assets let retail investors get in the game too. The obvious appeal of these assets was that they were supposed to be as safe and as liquid as the cashlike assets that exist under the aegis of the regulated financial system -- i.e., T-bills and checking deposits (at least up to the FDIC-insured limit) -- while offering more yield. Unfortunately, this was a fantasy.

Losses and illiquidity migrated up the proverbial food chain of cashlike assets due to financial linkages and panic. This was an old-fashioned, albeit slow-motion, bank run on our modern financial system. The implosion of the AAA mortgage bond market first turned auction rate securities illiquid, as investors scrambled to sell the latter to make up for losses on the former. There were no buyers. The exposure of the banking system to its own subprime CDO dreck was the next accelerator. Worries about Lehman Brothers' solvency due to its toxic mortgage portfolio ultimately caused its funding in the repo market to evaporate -- and with it, nearly the remainder of cashlike assets in the economy.

Money-market funds were the next casualty. A few days after Lehman's bankruptcy, the Reserve Primary fund infamously "broke the buck" due to its holdings of short-term Lehman debt. A run ensued on money-market funds. Only a temporary government guarantee quelled the panic. The commercial paper market seized up next. This time, the Fed stepped in to lend directly to corporations. The ultimate fear -- that depositors might start a 1930s-style run on bank accounts above the $100,000 FDIC-limit -- led to accounts being insured up to $250,000 instead.

This wholesale demolition of cashlike assets naturally sent the premium for any remaining such assets through the roof -- or, in the case of Treasuries, to negative yields. This had disastrous implications. As Matt Rognlie points out, when the Fed Funds rate hits zero, the liquidity premium replaces T-bills as the effective benchmark for every interest rate in the economy. Hence, the yields on corporate bonds rose to ruinous levels in late 2008 despite the Fed's efforts to ease policy. The abyss beckoned.

Thankfully, policymakers managed to arrest the collapse. Capital injections into the banking system ended the run on cashlike assets. The Fed's credit easing program, i.e., QE1, pushed the liquidity premium down to normal levels by trading cash for illiquid assets like mortgage bonds. And the much-maligned ARRA not only put people to work and money in their pockets, but financing it also necessitated creating new cashlike assets: more T-bills. Recovery, however, remains elusive. The civilian employment-population ratio has not shown any sustained improvement since the recession technically ended in June 2009. Our economic hole is as deep as ever.

Could it happen again? In the short-term, it's difficult to see how another run on cashlike assets could develop given that the securitization machine is still idle. Treasuries are now essentially the only destination for investors to park their piles of cash -- which explains why yields continue to push down to historic lows. Of course, in the long-term, another panic in the shadow banking system is too possible considering that its basic financial architecture remains unchanged.

The rise of the "giant pool of money" has overwhelmed our financial system. Consider that in 1990 these piles of cash held by corporations and asset managers amounted to just $100 billion; today that sum has multiplied to $2-4 trillion. Any story purporting to explain why this has occurred certainly involves a fair amount of hand-waving. Some of the usual suspects include the move towards defined contribution pension plans; globalization and the subsequent decreasing share of revenue going to labor; the liberalization of markets as the Iron Curtain came down; and the centralization of financial institutions (note this does not even include the neo-mercantalist policies of the China bloc recycling their trade surpluses into dollar-assets). These gargantuan sums were simply too big for our insured financial system. Even with the recent move by the FDIC to permanently lift its limit to $250,000, only 33% of this money is held in deposit.

Deregulation and a stance of malign neglect allowed the shadow banking system to develop a seemingly safe place for these vast sums. Now that the illusion of liquidity has been broken, it is clear that right now the government must run mega-deficits to replenish the supply of safe financial assets for the private sector, and that some kind of reform is necessary to make our unregulated financial system safer.

As policymakers responded to the banking crises of the 1930s with deposit insurance, so must we too respond to our shadow banking crisis with some equivalent of the FDIC.