I have already suggested that the subprime meltdown of 2007 can be regarded as a dramatic demonstration of the inherent instability of financial markets. Seen in this light, the crisis that followed might seem to be essentially no different, albeit broader in reach, than the collapse of bubbles in Finland, Sweden, and Japan in the early 1990s, the Asian currency crisis of the late 1990s, or the burst of the US dotcom bubble in 2000. [1] However, I believe that “this time is different.” Professional speculators, policy makers, and academic cheerleaders have uttered these words many times before in justifying ongoing financial bubbles (and consequent busts) on the basis of some apparently new features in market fundamentals; but this bust is different in the sense that the current global economic crisis made clear the inherent instability of capitalism and the purely speculative nature of money for the first time since the Great Depression. It has manifested itself in two different ways: first as the spectacular collapse of liquidity in financial markets, and second as a harbinger of the coming collapse of the dollar as a key currency in global capitalism. I will take up the collapse of financial liquidity first.

One of the biggest lessons of the Great Depression was that commercial banks must be regulated. To understand this, we need to look at the relationship between bank deposits and their liquidity.

When we economists measure the total amount of money supply (more precisely, M1), we count not just cash in the form of bills and coins but also such highly liquid forms of private debts as demand deposits at commercial banks. [2] To say that my demand deposit is “highly liquid” means that I believe I can go to a bank window or an automated teller machine and withdraw cash from my bank account whenever I want to. I thus keep my deposit confidently in the bank until I need it. Many other depositors leave their deposits in the bank as well in the belief that they too can withdraw them at any time. The bank taking the deposits therefore needs to keep only a fraction of the deposited cash on hand to prepare for withdrawals; it can lend out the rest. Much of the cash it lends out gets deposited again in banks somewhere else, and again the second bank is free to lend the bulk of the money out. Through this process, known as “credit creation,” my original deposit can generate an amount equal to many times—sometimes tens of times—its value in additional deposits that can be counted as money supply.

But how elusive this attribute of liquidity is, which demand deposits are supposed to possess! I believe I can withdraw cash from my bank at any time, because I believe that all the other depositors are also confidently keeping their deposits in the bank. But the only reason all the other depositors are keeping their deposits is they too believe they can withdraw cash from their banks at any time because they believe that all the other depositors are confidently keeping their deposits in the bank. This brings us back once again to Keynes’ beauty contest. The liquidity of demand deposits is supported by exactly the same bootstrapping process that supports money as money; just as money is money merely because everybody believes everybody else believes it is money, a demand deposit has liquidity merely because every depositor believes that every other depositor believes it has liquidity. If, however, the depositors all started to doubt the liquidity of their deposits, they would all rush to withdraw their deposits. The bank would quickly run out of cash, most of the depositors would be unable to make withdrawals, and the liquidity of the deposits would vanish without a trace. [3] This is a bust of liquidity.

In the financial crisis that struck after the stock market crash of 1929 many US banks, which until then had operated relatively free of regulatory constraints, suffered runs and went under. Not only did the money supply contract sharply; people’s liquidity preferences grew enormously at the same time. The resulting decline of aggregate demand transformed what might potentially have been just one of many financial crises into the Great Depression. Having learned the lesson of the fundamental instability of demand deposit liquidity and its huge impact on the aggregate demand of the real economy, in 1933 the United States adopted the Glass-Steagall Act as part of the New Deal. This act established a distinction between two types of financial institution: (1) deposit-taking commercial banks that were allowed to generate credit creating processes and (2) investment banks (securities companies) that were not. Commercial banks were covered by the Federal Deposit Insurance Corporation (FDIC), which guaranteed the safety of deposits up to $5,000 (now $100,000, and because of the ongoing financial crisis raised temporarily to $250,000 until the end of 2009). The commercial banks were also given access to the discount window run by the Federal Reserve Board’s, and in return were subject to reserve requirements and close supervision by the Fed to guard against speculative behaviors. Investment banks, by contrast, were free to take risks in pursuit of profits, provided they did not commit fraud and swindles, such as account rigging, false disclosure, and insider trading, all watched over by the Security and Exchange Committee (SEC). (There was, however, a loophole in the regulatory laws that exempted publicly unlisted private equity from most aspects of SEC supervision, allowing them to be totally speculative. This of course became the springboard for the enormous expansion of hedge funds from the 1980s on.)

Amid the wave of financial deregulations and innovations starting in the 1980s, however, there was a growing conviction among many financial market insiders, outside supporters of financial interests, and academic experts in financial engineering, who argued that the only regulation financial markets required was the SEC controls to prevent frauds and swindles. After all, the argument ran, was it not the very raison d’être of financial markets to securitize risks of any sort, whether they arise from real activities or financial transactions, and diversify them through market exchanges among a large number of people around the globe with a wide spectrum of attitudes toward risk? Financial markets, they argued, are therefore able to take care of risk on their own without government oversight or legal protection. Under the influence of arguments such as these, and relentless pressure from interest groups, the United States Congress effectively repealed the Glass-Steagall Act in 1999.

The twenty-first century brought the subprime mortgage meltdown in the United States. Subprime mortgages are housing loans extended to people who lack a steady income or have a poor credit rating. These people bought homes financed by loans that they could not reasonably expect to repay. However, they did so because they expected that the housing bubble would continue, enabling them to sell their homes for considerably higher prices. Banks extended them loans in the belief that they could average out the risk of default by bundling loans together into mortgage-backed securities. Financial engineering was then used to process the risks and turn the mortgage securities into complex derivatives, which were incorporated into investment portfolios and hedge funds and scattered around the world.

Even these extraordinarily risky securities, built on the dubious assumption that the housing bubble would continue indefinitely, were treated as if they were highly liquid instruments that could be cashed in at any time, and many people came to hold them with confidence—as a result of which, the securities became even more liquid in their eyes. This allowed commercial banks (now operating as investment banks), investment banks (now simulating hedge funds), and hedge funds (now indulging in more speculation than ever), to raise their leverage ratios further by selling more elaborate and hence much riskier derivatives around the world. Through the workings of this now familiar bootstrapping process, the financial market as a whole was enabled to create a huge amount of credit almost out of nowhere, as if it were a huge commercial bank—but without appropriate regulations.

Particularly fast growth was seen with credit default swaps (CDS). These are financial derivatives created by extracting the risk that the issuer of an original security will fail and packaging it as a separate instrument. Credit default swaps were hailed as the ultimate means of avoiding financial risk, and during their heyday in 2007 the volume of the CDS market was a massive $58 trillion—more than the gross domestic product of the entire world that year ($55 trillion). Yet, the data shows that a mere 1.5% (about $0.7 trillion) of these derivatives was in the hands of investors outside of financial markets. [4] In other words, nobody was actually covering the default risks of financial institutions and derivatives dealers; they merely took on each other’s risks and lulled themselves and each other into a false sense of security. When the housing bubble showed signs of slowing down in 2007, the bootstrapping process underlying CDS liquidity began to crumble. Suddenly everybody wanted to get rid of these derivatives, and soon started to sell off regular financial securities such as stocks and bonds as well. This amounted to a run on the financial market as a whole. The swollen supply of credit contracted almost instantaneously, and all that was left in the debris of the marketplace was the reality of defaulted mortgages.

Bank failures during the Great Depression showed that credit-creating banks need to be regulated. The recent financial market crash has highlighted the fact that credit is created not merely by commercial banks but by the financial markets as a whole through a bootstrapping process similar to the one supporting the liquidity of bank deposits. The biggest lesson to be drawn, therefore, is the necessity of introducing into the entire financial system a set of old-fashioned regulations on commercial banks, such as stricter supervisions by the Central Bank, account disclosures, minimum reserve requirements and/or adequate capital asset ratios. There is also a need for innovations in the regulatory apparatus to bring it in line with the extent of the net risks they might potentially exposing the general public to.

Ironically, the current global economic crisis has resulted in the total disappearance of pure investment banks from the United States. They have all either gone under or converted themselves into commercial banks. The Glass-Steagall Act has had its revenge.

[1] Graciela Kaminsky and Kenneth Rogoff, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” NBER Working Paper 13882, March 2008, for an excellent overview of qualitative and quantitative parallels across a number of financial crises from England’s fourteenth-century default to the current US subprime meltdown. See also Graciela Kaminsky and Kenneth Rogoff, “Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison,” American Economic Review , 98 (29), May 2008, and Graciela Kaminsky and Carmen M. Reinhart . 1999. “The Twin Crises: The Causes of Banking and Balance of Payments Problems.” American Economic Review Vol. 89: 473-500.

[2] To be precise, M1 consists of M0 or high-powered money (= cash + commercial banks’ deposits in central bank), demand deposits, certificates of deposit, and traveler’s checks.

[3] This bootstrapping process of demand deposit liquidity was formalized first by Diamond, Douglas, and Philip Dybvig (1983) ‘Bank Runs, Deposit Insurance, and Liquidity,’ Journal of Political Economy 91, 401-419.

[4] See http://www.bis.org/publ/otc_hy0811.htm