This article on the continued troubles in credit markets was informative. But it raised a puzzle. Call me naive, but why does Fed policy seem to assume that the only way to repair credit markets is to return to the status quo ante, circa January 2007?

Here’s how I think about what has happened these past 2+ years. I think in terms of a sort of flow chart, showing ways that savers can connect with borrowers:

Traditionally — i.e., before the 1980s — the public put its money in banks, and banks made loans to borrowers: thus the diagonal arrow from banks to borrowers represents traditional banking.

By 2007, however, much of this traditional channel had been supplanted by shadow banking: debt was securitized, and the securities sold to the public — the straight arrow across the bottom of the figure.

Then the crisis came. The public rushed for safety, which basically meant guaranteed deposits. One rough indicator is holdings of MZM — money of zero maturity — which is the sum of bank deposits and money-market deposits:

In effect, the public rushed back into the banks. But the banks weren’t willing to lend out these excess funds. Instead, they accumulated deposits at the Fed:

To prevent a complete collapse of credit, the Fed in effect recycled these deposits back into private credit via the TALF and other securities-purchase programs. So funds now flow all around the first figure, getting to the public via “Bernanke banking” (my term.)

Everyone agrees that this is a stopgap, and we want to get the Fed out of the business of private lending over time.

But here’s my question: why does it have to be a return to shadow banking? The banks don’t need to sell securitized debt to make loans — they could start lending out of all those excess reserves they currently hold. Or to put it differently, by the numbers there’s no obvious reason we shouldn’t be seeking a return to traditional banking, with banks making and holding loans, as the way to restart credit markets. Yet the assumption at the Fed seems to be that this isn’t an option — that the only way to go is back to the securitized debt market of the years just before the crisis.

Why? Are we still convinced that securitization is a far superior system to conventional banking, and if so why?

Inquiring minds want to know.