One can make excuses for the failure of the economics profession to foresee that the 2008 financial crisis would happen. It's much harder to make such excuses for much of the profession's failure to realize that such a thing could happen.

Banking crises are, after all, a theme running through much of modern economic history. Nobody should be able to call himself a macroeconomist unless he has a working knowledge of what went down in 1931, both in the United States and in Europe. And you don’t have to go back to the 1930s, either, as long as you’re willing to step outside the United States and core Europe. With the Scandinavian crises of the early 1990s, the Asian crises of the late 1990s, Argentina, and so on, there should have been ample reason to at least consider whether it might happen here.

Nor are crises a case of something that can happen in practice, but not in theory. Diamond-Dybvig [1983] isn’t a perfect model of what we’ve just gone through, but it is a canonical model showing how bank runs can happen — and it's hardly obscure. Nobody should be looking at the stability of a financial system without thinking to himself, “Hmm. Is there a way this system could experience a Diamond-Dybvig-type crisis?”

It's true that Diamond-Dybvig tells us that deposit insurance ends the possibility of bad equilibria in which everyone tries to pull out of the banks, creating a self-fulfilling prophecy of financial collapse. And I’m afraid that the way many economists read the paper was as an essay in economic history, a description of what could go wrong in the bad old days. But this was a crude mistake. In fact, a proper reading of the D-D paper, far from making the profession comfortable about the stability of our system, should have raised major doubts.

For the right question to ask after reading Diamond-Dybvig is, what constitutes a “bank” from the point of view of this model? And the answer is that it doesn’t have to be a big marble building with a row of tellers — that is, a depositor institution. As far as the model is concerned, a bank is any institution that borrows short-term and uses the funds to make longer-term, illiquid investments. And that, right there, should have led to the next question: what institutions do we have that fit this definition, but are not depository institutions, and are not covered by either deposit insurance or the regulations designed to limit the moral hazard that insurance creates?

If economists had followed that line of thought, they would have been led right to the risk posed by the rise of shadow banking. They would have seen that money-market funds and repos were functionally just like deposits, but without the safeguards. They would, in short, have realized that a 1931-type banking crisis was very much a real possibility in 21st-century America. But they didn’t.

Now, I’m increasingly of the view that what we’ve been going through is more than a banking crisis, that it's a more general balance sheet crisis. And I like to think that my own recent work with Gauti Egertsson trying to model that kind of problem [Eggertsson and Krugman 2010] helps to clarify the nature of such a crisis. But like the possibility of a banking crisis, this was a possibility of which economists should have been well aware. I’ve already mentioned the importance of balance-sheet considerations in analyses of the Asian financial crisis of the 1990s. And there is a long if somewhat thin tradition of focusing on leverage and its macro risks, running from Fisher [1933] to Minsky [1986] to Koo [2008].

And if you want your models formal with plenty of math, there's Kiyotaki and Moore [1997], which is a model of how falling land prices can force a reduction in spending by debtors — very much like what actually happened after 2008. I suspect, however, that the Kiyotaki-Moore paper failed to have much impact on policy analysis because it was set entirely in a real-business-cycle-type framework; more on that sort of thing in a minute.

The overall point should be clear: economists had good enough intellectual frameworks to have seen the risk of something like the banking and balance sheet crisis that burst upon us in 2008. But they ignored that risk.

My best answer is that they were caught up in the spirit of the times, with its faith in the wisdom of markets and of the financial industry. Nobody could deny the possibility of runs on conventional banks, which have happened so often in history. Few could deny that debt deflation had happened in the past. But to argue, or even to think about, the possibility that the old evils could manifest themselves in new forms would have been to question the whole basis of decades of policy, not to mention the foundations of a very lucrative industry. You don’t have to invoke raw corruption (although there may have been some of that) to see why this was a line of thought few were willing to pursue. And by not pursuing that line of thought, the profession fell down badly on the job.

Yet the profession's worst failure wasn’t what it failed to see before the crisis. It was what happened after crisis struck.