That’s precisely what happened during the subprime-mortgage bust of 2008. Fear of defaults led repo lenders to demand extra collateral and refuse some securities entirely. “Fire sales” of securities that could no longer be financed sent prices plunging, aggravating losses and spreading distress. Investors fled money market funds, which in turn starved the commercial paper market and deprived companies of financing for their day-to-day operations.

To prevent a complete breakdown, the Fed had no choice but to go where it had never gone before. Officials scrambled to create myriad programs — and put up hundreds of billions of dollars — to support vast swaths of the non-bank financial system, including repo, money market funds and commercial paper. But central bankers faced a crucial limitation: There wasn’t enough collateral to lend against. The short-term debt had been used to finance assets and activities that went far beyond simple mortgage and commercial lending — including derivatives and hard-to-value structured investments. To avoid losses, central banks had to apply “haircuts”: A $100 asset might support only $50 in emergency lending, or none at all. Try as they might, they couldn’t lend enough to prop up everything. The result was a severe credit crunch that exacerbated an already deep recession.

After the crisis, legislators and regulators around the world introduced measures to strengthen the banking system. But they did little to address the proliferation of run-prone debt. To the contrary, in some cases the added scrutiny of banks — necessary as it was — has helped push activity into the shadows. Nonbanks now dominate mortgage lending in the U.S., and have fueled a rapid and precarious expansion in subprime corporate debt. Among advanced economies at the end of 2018, the assets of nonbank financial institutions that rely on short-term funding amounted to an estimated $41 trillion, or 89% of GDP. That’s up from about $27 trillion — 77% of GDP — in 2010, when many of the post-crisis reforms were adopted.

The result: This time around, as the battle to contain a global pandemic thrusts the economy into a deep recession, the financial fallout has compelled the Fed to expand its emergency lending to a breathtaking scale. In a matter of weeks, it has far exceeded the reach of 2008, committing potentially trillions of dollars to backstop everything from municipalities to junk-rated corporate borrowers. It has pledged to lend directly to companies if banks and capital markets pull back. It has gone global, creating swap lines to help foreign central banks backstop short-term dollar-denominated borrowing abroad, effectively becoming the lender of last resort to much of the planet.

No doubt, the Fed has done the right thing in the moment. Without its intervention, the economic damage would be much worse. But the need for such extraordinary measures reveals a deeper problem: Government has all but lost control over the creation of money. In good times, it allows financial institutions the freedom to create all manner of money-like instruments. In bad times, central banks must support those instruments, lest the financial system collapse. This implicit backstop establishes a dangerous incentive, encouraging institutions to fund ever more long-term investments with what amounts to federally subsidized short-term debt. Profitable as this may be, it renders the system ever more vulnerable to devastating runs.

Somehow, the government must reassert its authority over money. But how, exactly?


It’s a question that economists have long pondered. One solution, known as the Chicago Plan, would ban private money creation completely. Originally championed in the New Deal era by prominent academics such as Henry Simons of the University of Chicago and Irving Fisher of Yale, it would require financial institutions to hold 100% safe, liquid assets (such as government securities or reserve deposits at the central bank) against all short-term debt (such as deposits). Longer-term investments would have to be financed with long-term debt or shareholder equity.

This would eliminate the risk of runs, because cash would always be available to cover all short-term liabilities. Research suggests it would also smooth out the boom-bust cycles that emerge when financial institutions create excessive amounts of money. Some worry, though, that it would be a step too far, requiring a radical and costly reorganization of the financial system, and erasing some of the benefits that arise when the private sector assumes the role of connecting short-term savers with longer-term borrowers.

A less extreme approach would be to restore the government’s control over the private issuance of money. One version — proposed by Morgan Ricks, a professor at Vanderbilt Law School who worked at the Treasury Department during the 2008 crisis and as a hedge-fund trader before that — would limit the issuance of short-term debt to specially licensed banks, restrict investment of the proceeds to central-bank-approved assets and charge a fee for access to emergency loans.