Paul Krugman writes:

[M]y main answer to Brad's question is that the events of 1997-1998 were, for me, a wake-up call. Before then I'd taken it for granted that central banks could always pump up demand, but Japan showed that the liquidity trap was a very real danger in a world in which inflation rates were fairly low.... I'd also assumed that bank runs were a thing of the past, but the Asian and LTCM crises showed that events functionally equivalent to bank runs could happen even if depository institutions - the denizens of big marble buildings with "FDIC insured" signs in their windows -- were protected. So I didn't take much comfort in the fact that a makeshift, cobbled-together set of measures managed to contain the crisis; it seemed all too obvious that the next crisis could be too big for improvisation to handle...

So what, in the long run, should the new regulatory and management system consist of?

Back in 1992 Larry Summers and I egged each other on to say that the target rate of inflation should be 5% per year--that anything less leaves you too vulnerable to a liquidity trap, and that as long as inflation is 5% per year it's hard to see any form of debt-deflation-credit-channel taking hold: even minimal principal amortization writes down the real value of debts and hence debt overhang very rapidly. Was this one of the (many) stupid things I have written in my career, or was it a really smart insight?...

We clearly need to extend the lender-of-last-resort umbrella to cover the shadow banking system--which means that someone has to oversee and regulate their portfolio leverage as well...

We clearly need to mandate that the Princes of Wall Street and Canary Wharf be paid not in cash bonuses and option rights but in restricted stock--to bail them into their institutions for a decade or so...

We clearly need to separate capital adequacy regulation from rating agencies that can be gamed in order to eliminate regulatory arbitrage...

But how do we impose capital requirements? Do we require that everybody unwind the derivatives in their portfolios and express them in a stocks-and-bonds-and-currencies basis, and then require monthly capital adequacy checks limiting their functional leverage to less than ten-to-one? I don't understand these issues well enough to have an informed view. And I don't see how I could implement a proper capital adequacy framework even if I were suddenly made head of bank regulation at the Federal Reserve...

And what, in the short run, is to be done with the crisis?

I am swinging around to (a) massive fiscal stimulus, plus (b) profit-making financial intervention: assign Fannie Mae and Freddie Mac to borrow from the Treasury and buy up mortgages at market prices until they have pushed the risky interest rate down to something reasonable. It's time for monetary policy to take on the role not just of managing the risk-free interest rate but managing the risky rate as well.

There is a big question here: is this possible? We know that the Federal Reserve can manage the riskfree rate without breaking a sweat. But I have Ricardian-equivalence worries about whether large scale government financial operations can actually move risky interest rates very far...