Scott Sumner once said that this crisis was caused by economists who were confused over the basics of supply and demand. I believe this is just one half of the story. Economists were also confused over the definition of bank reserves. Textbooks say that bank reserves are liabilities of central bank, by changing the interest rate on reserves central bank can control the money supply. But in modern banking practice a much wider set of assets are reserves that are important in the determination of money supply. This causes two big problems - regulators are unable to correctly apply the money multiplier model in practice and they make serious mistakes. Banking practitioners find money multiplier model unrealistic and are attracted to inferior macroeconomic theories. Fortunately Gary Gorton is coming to the rescue:
"Institutional investors and nonfinancial firms have demands for checking accounts just like you and I do. But, for them there is no safe banking account because deposit insurance is limited. So, where does an institutional investor go to deposit money? The Institutional investor wants to earn interest, have immediate access to the money, and be assured that the deposit is safe. But, there is no checking account insured by the FDIC if you want to deposit $100 million. Where can this depositor go?
The answer is that the institutional investor goes to the repo market. For concreteness, let’s use some names. Suppose the institutional investor is Fidelity, and Fidelity has $500 million in cash that will be used to buy securities, but not right now. Right now Fidelity wants a safe place to earn interest, but such that the money is available in case the opportunity for buying securities arises. Fidelity goes to Bear Stearns and “deposits” the $500 million overnight for interest. What makes this deposit safe? The safety comes from the collateral that Bear Stearns provides. Bear Stearns holds some asset‐backed securities that are earning LIBOR plus 6 percent. They have a market value of $500 millions. These bonds are provided to Fidelity as collateral. Fidelity takes physical possession of these bonds. Since the transaction is overnight, Fidelity can get its money back the next morning, or it can agree to “roll” the trade. Fidelity earns, say, 3 percent.
Just like banking throughout history, Bear has, for example, borrowed at 3 percent and “lent” at 6 percent. In order to conduct this banking business Bear needs collateral (that earns 6 percent in the example) – just like in the Free Banking Era banks needed state bonds as collateral. In the last 25 years or so money under management in pension funds and institutional investors, and money in corporate treasuries, has grown enormously, creating a demand for this kind of depository banking."
"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008