Here’s a thoughtful write-up by Brad DeLong on Paul Krugman’s new (actually updated) book now cheerily entitled The Return of Depression Economics and the Crisis of 2008. I haven’t read the book, although I plan on doing so. Agree with him or not — and I frequently don’t — Professor Krugman’s often well worth reading. In the meantime DeLong’s piece is an excellent primer both on why cycles turn bad and on some ideas (skewed Keynesian, naturally, and, no, that’s not always a dirty word) for dealing with the current crisis, but the section that most grabbed my attention was this passage on the role of banks:

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.

That’s spot on. And while we’re on the topic of banks check out Matt Yglesias’ thought-provoking comments on the ‘big bank’ problem. You don’t have to share Yglesias’ politics to wonder if some banks’ decision to spend their TARP money (so to speak) on buying up other banks is entirely the way to go. On the other hand, small is less beautiful than Yglesias may think. Over at Mother Jones (Good heavens!) Kevin Drum’s riposte to Yglesias (who is also claiming to be channeling Hank Paulson, sorta) hits the spot:

…the world needs big banks. Large multinational corporations just aren’t going to do their banking at a small community credit union, after all. They want to deal with a big money center bank that has plenty of lending capacity, expertise in a wide variety of areas, and branches around the world. You just won’t find that in a small bank.
And then there’s the interconnectedness problem. Bear Stearns wasn’t really all that big (a fraction the size of Citibank, for example), but the Fed rescued them because they were afraid of cascading counterparty risk if they failed. Later they let Lehman Brothers fail, and they discovered that their fears were well founded. But how do you regulate that?
The modern world is a big place, and there’s no way to turn back the clock. Big corporations and big banks are here to stay, whether we like it or not. Frankly, Paulson sounds to me like he’s trying to mouth some feel-good words that he knows will never be taken seriously but make him look like he’s getting tough on Wall Street. I’m not buying it. For my money, I keep coming back to the same thing: leverage, leverage, leverage. The key is to regulate leverage to reasonable levels and to regulate it everywhere. If it walks like a bank and quacks like a bank, then it’s a bank and its leverage ratios should be regulated. That’s what will keep banks from being too big to fail in the future, and this time around we shouldn’t allow Congress or the SEC to toss off a few bland platitudes and then do nothing serious about it. Leverage is where the action is.”

Leverage is where the regulatory focus will need to be. The trick will be to do this in a way that is neither stupidly heavy-handed nor is such as to add to the miseries of our current credit contraction. Nope, there are no easy answers.