Paul Krugman on the financial instruments of the future.

Question: How has the Global Financial System Changed?

Paul Krugman: I think the biggest thing is that we have this new banking system that is not your father’s banking system. I mean, we have an idea of what a bank is. A bank is a big marble building, with a sign on the window that says, FDIC Insured, right? And you go in and get cash or you deposit cash, and those things still exists. More like shopping malls, storefronts than big marble buildings, but they still are ordinary banks, but, at this point, most of what, at least on the eve of the crisis, most of the banking activity was going on in this economy was things that didn’t look like that. They were things that actually had no storefronts or no big marble building. They were things like asset-backed commercial paper funds or money market funds, or auction rate securities. All of these institutions that prefer, you know, they were giving people what they thought was a way to park their cash with ready access to it, but they were paying higher interest rates than banks paid, and in return they were then lending that money out, and it will look like banks to people, except that it turned out they weren’t the safest banks. They weren’t regulated, they weren’t, they didn’t have a safety net. They certainly didn’t have insurance, and this thing, which people called the shadow banking system or the parallel banking system was, on the eve of the crisis, it was bigger than the conventional banking system and it’s now imploded. It’s just basically shriveled up, and that was what we didn’t understand. I mean, there were hints of it, but no one, I think, until the crisis hit realized just how big this was and how fragile it was.

Question: What company would be recognized as a shadow bank?

Paul Krugman: It’s not that easy because these things are not that visible. So, you know, there are a lot of money market funds. People probably have some money market funds in mind, and many people have money in money market funds. I guess I have some, and, you know, what is an A.G. Edwards money market fund, which is now, thankfully, insured because the Fed moved in to rescue it, but, you know, I think any money market fund was part of this. Asset-backed, or actually auction rate securities, which is a classic, because that was a $350 billion, you know, bank, in effect, that wasn’t called the bank… those were mostly set up by banks you’ve heard of. They were set up by Citibank or, in some cases, by the investment banks, but typically they were set up by Citi Group or JP Morgan, but they were not guaranteed by them. It wasn’t part of the regular thing, and so people had this thing, money in these institutions, these arrangements, and didn’t realize what they were actually getting into. It’s a lack of obvious brand names, and that’s part of the problem.