The flight to safety has gone to historic extremes, as highlighted today by the plunge in three-month U.S. treasury bill yields to levels not seen since 1941 (0.02%). Thats one sign of how serious things have become. This is a seven-standard-deviation event unfolding before our eyes.
It was once thought the U.S. had banished financial panics and great depressions thanks to measures put in place after the 1930s. Of note, deposit insurance for bank customers would ensure no repeats of the disastrous runs on banks that caused a one-third contraction in the money supply during the Great Depression.
But in recent decades, a second, unregulated financial system was allowed to develop alongside the regular banking system. It consisted of investment banks, hedge funds, mortgage-finance companies and other entities that operated with a decided lack of transparency and disregard for risk in the pursuit of profits.
Investment dealers leveraged their capital 30 times or more compared to the 10 times or so permitted regulated banks. Financial engineering produced ever more esoteric and complex instruments. Off-balance-sheet assets were common. And the expansion occurred without the safety net of a deposit insurance program — opening the door to a run on the unregulated sector should it ever stumble. Now the stumble is here and one wonders if it could yet have the same effect of contracting the money supply as the banking crisis of the 1930s did.