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Mechanisms of market inefficiency are some of the most important and least understood institutions in financial markets today. A growing body of empirical work reveals a strong and persistent demand for "safe assets," financial instruments that are sufficiently low risk and opaque that holders readily accept them at face value. The production of such assets, and the willingness of holders to treat them as information insensitive, depends on the existence of mechanisms that promote faith in the value of the underlying assets while simultaneously discouraging information production specific to the value of those assets. Such mechanisms include private arrangements, like securitization structures that repackage cash flows from debt instruments to produce new financial instruments that are less risky and more opaque than the underlying debt, and public ones, like the rules allowing many money market mutual funds to use a net asset value of $1.00. This essay argues that recognizing these mechanisms of market inefficiency as such is a critical first step in devising policy interventions that achieve desired aims. This runs counter to the instincts of many market regulators, like the Securities and Exchange Commission, and academics who have often assumed that markets should be structured to promote information generation and efficiency. The essay further shows, however, that defenders of the information-insensitive paradigm have failed to provide a robust institutional account of how those mechanisms can remain robust across different states of the world or the government support required if they cannot. When an adverse shock or other signal raises questions about the value of the assets underlying an information-insensitive instrument, market participants can refuse, en masse, to treat those instruments as safe. Unless the government or some other actor can provide credible information about the value of the underlying assets or financial support that renders such information irrelevant, widespread market dysfunction can follow. When that happens, the very mechanisms of market inefficiency that had enabled a market to develop can exacerbate dysfunction. Following Ronald Gilson and Reineer Kraakman's admonishment that institutions always matter, this essay calls for the development of rich institutional accounts of how the mechanisms of market inefficiency work, when and how they can fail, and what these dynamics reveal about the role regulators should play in these domains.

This Essay is about mutual funds. Because of that, it may put many to sleep long before we get to the heart of the matter. I encourage you right now to stay awake, or at least keep one eye propped open. For embedded in this story about mutual funds, rent seeking, the challenge of separating the good and the bad, and the even greater challenge of respecting autonomy in an environment where so many choices seem to be bad ones, is the story of a judge. That judge is the Honorable Richard A. Posner, aka RAP, Dick, Professor Posner, the one to be feared, the one to be revered, the one who inspires, the one who causes many to perspire, and the one who somehow gets it right even when he is wrong (and he is sometimes wrong). It is a story of how he judges. It is a story of curiosity and truth seeking. It is a story of respecting process and precedent while not being overly constrained by convention or rules. It is also a story of constantly seeing things anew, even when that requires letting go of views that seemed true when first embraced. It is a story of positionality and insight, and law and humanity, and the perfection of embracing imperfection. It is a story of using stories to help others see, and the power and limits of such methods.

In a provocative new book, The Money Problem: Rethinking Financial Regulation, Professor Morgan Ricks argues that the government should reclaim control over money creation. Money, Ricks argues, is not just the cash in your pocket or the balance in your checking account. Instead, at least for purposes of financial stability policy, money is best equated with short-term debt. For most of the twentieth century, such debt was issued primarily by regulated commercial banks and insured by the Federal Deposit Insurance Corporation (FDIC), resulting in a fairly stable financial system. As a result of financial innovation, however, much of today's short-term debt is issued in the far-less-regulated shadow banking system – a market-based system of intermediation that serves many of the same functions traditionally performed by banks. Runs by money claimants in the shadow banking system were central to the 2007-2009 financial crisis (Crisis). The Dodd-Frank Wall Street Reform and Consumer Protection Act and other post-Crisis reforms, however, have done relatively little to shut down this unauthorized money creation. That, in Ricks's assessment, is a mistake.

What types of financial instruments get treated as "money"? What are the implications for financial regulation? These two questions animate The Money Problem: Rethinking Financial Regulation by Morgan Ricks and my review of his thought-provoking new book. The backbone of The Money Problem is a reform agenda that aims to give the government complete control over the creation of money equivalents. According to Ricks, the government should insure all bank deposits, no matter how large, and prohibit any other entity from issuing short-term debt. I question the efficacy, benefits, and costs of the proposed reforms. Both theory and history suggest that so expanding the government's formal safety would engender massive moral hazard while likely failing to achieve the purported aim of "panic-proofing" the financial system. I also worry about the foregone credit creation and other costs of eliminating money market mutual funds, sale and repurchase agreements (repos), commercial paper, and other arrangements that are pervasive today and would be outlawed under the proposed reforms. Nonetheless, The Money Problem could – and should – transform the ongoing debate about how best to promote financial stability. Ricks's core insight is that financial crises routinely emanate from changes in the types of instruments that market participants are willing to treat like money. The range of instruments accorded that status expands during periods of financial stability and contracts rapidly when the boom turns to bust, magnifying the adverse consequences of that change. His claim that government guarantees are the most effective way to staunch runs in the face of such a change is also persuasive. Combining these insights with a heightened appreciation of the inevitable dynamism of financial markets lays the groundwork for a different set of reforms. I argue that the government should be prepared to act as an "insurer-of-last-resort" to stem the spread of a budding financial crisis. This type of support, however, should be reserved for periods of systemic distress. More broadly, history suggests that the rise of private money, as embodied in the growth of shadow banking before the recent crisis, is endemic to finance. Rather than fooling ourselves into believing that a broad ex ante regime can eliminate private money creation, we should recognize its development as inevitable and devise a regime that is capable of responding as markets evolve.

Insufficient liquidity can trigger fire sales and wreak havoc on a financial system. To address these challenges, the Federal Reserve (the Fed) and other central banks have long had the authority to provide financial institutions liquidity when market-based sources run dry. Yet, liquidity injections sometimes fail to quell market dysfunction. When liquidity shortages persist, they are often symptoms of deeper problems plaguing the financial system. This Essay shows that continually pumping new liquidity into a financial system in the midst of a persistent liquidity shortage may increase the fragility of the system and, on its own, is unlikely to resolve the deeper problems causing those liquidity shortages to persist. This Essay suggests that when facing persistent liquidity shortages, the Fed should instead use the leverage it enjoys by virtue of controlling access to liquidity to improve its understanding of the ailments causing the market dysfunction to persist and to help address those underlying issues. When liquidity shortages persist, they will often indicate that market participants lack critical information about risk exposures or that they are concerned financial institutions or other entities lack sufficient capital in light of the risks to which they are exposed. Providing credible information and working with other policymakers to ensure the overall financial system is sufficiently capitalized are thus among the issues that the Fed should prioritize when facing persistent liquidity shortages. This Essay thus provides a new paradigm for how the Fed can utilize its lender-of-last-resort authority to prevent a nascent financial crisis from erupting into one that inflicts significant harm on the real economy. The heart of this Essay brings these dynamics to life through a close examination of the Fed's actions during the early stages of the 2007-2009 financial crisis (the Crisis). Using transcripts from Fed meetings and other primary materials, this Essay reconstructs the first thirteen months of the Crisis. The analysis reveals more than a year during which Fed officials could have taken an array of actions that may have reduced the size of the Great Recession and the amount of credit risk and moral hazard stemming from the government's subsequent interventions. The analysis also demonstrates specific ways that the Fed's lender-of-last-resort authority could serve as the type of responsive and dynamic regulatory tool that the Fed requires when seeking to restore stability during the early phases of a panic.

Insufficient liquidity can trigger fire sales and wreak havoc on a financial system. To address these challenges, the Federal Reserve (the Fed) and other central banks have long had the authority to provide financial institutions liquidity when market-based sources run dry. Yet, liquidity injections sometimes fail to quell market dysfunction. When liquidity shortages persist, they are often symptoms of deeper problems plaguing the financial system. This Essay shows that continually pumping new liquidity into a financial system in the midst of a persistent liquidity shortage may increase the fragility of the system and, on its own, is unlikely to resolve the deeper problems causing those liquidity shortages to persist. This Essay suggests that when facing persistent liquidity shortages, the Fed should instead use the leverage it enjoys by virtue of controlling access to liquidity to improve its understanding of the ailments causing the market dysfunction to persist and to help address those underlying issues. When liquidity shortages persist, they will often indicate that market participants lack critical information about risk exposures or that they are concerned financial institutions or other entities lack sufficient capital in light of the risks to which they are exposed. Providing credible information and working with other policymakers to ensure the overall financial system is sufficiently capitalized are thus among the issues that the Fed should prioritize when facing persistent liquidity shortages. This Essay thus provides a new paradigm for how the Fed can utilize its lender-of-last-resort authority to prevent a nascent financial crisis from erupting into one that inflicts significant harm on the real economy. The heart of this Essay brings these dynamics to life through a close examination of the Fed's actions during the early stages of the 2007-2009 financial crisis (the Crisis). Using transcripts from Fed meetings and other primary materials, the Essay reconstructs the first thirteen months of the Crisis. The analysis reveals more than a year during which Fed officials could have taken an array of actions that may have reduced the size of the Great Recession and the amount of credit risk and moral hazard stemming from the government's subsequent interventions. The analysis also demonstrates specific ways that the Fed's lender-of-last-resort authority could serve as the type of responsive and dynamic regulatory tool that the Fed requires when seeking to restore stability during the early phases of a panic.

In response to the greatest financial crisis since the Great Depression, the Federal Reserve (the Fed) took a number of unprecedented steps to try to minimize the adverse economic consequences that would follow. From providing liquidity injections to save companies like Bear Stearns and American International Group (AIG) to committing to a prolonged period of exceptionally low interest rates and buying massive quantities of longer-term securities to further reduce borrowing costs, the Fed's response to the 2007 through 2009 financial crisis (the Crisis) has been creative and aggressive. These actions demonstrated that the Fed is uniquely powerful among federal agencies, and its authority is even greater than most had previously appreciated. They also made clear that the Fed's actions can have significant distributional consequences, in addition to affecting the health of the overall economy. These developments have led many to suggest that the Fed should be far more accountable, or less powerful, than it currently is. Attacks on the Fed's power are not new. Vesting so much power in the hands of an unelected few inevitably raises questions about legitimacy, for which there are no easy answers. Using traditional mechanisms to make the Fed more politically accountable could substantially impede the Fed's capacity to achieve the aims assigned to it. Yet, as reflected in the demise of the First and Second Banks of the United States, ignoring these concerns can prove even more detrimental. In the United States, the outer limits of independence are delineated by the Constitution, but important questions regarding legitimacy and accountability arise far shy of the Constitution's outer bounds. Many of these issues are not specific to the Fed, and there is a robust body of literature examining these dynamics. Nonetheless, this article suggests that many of the forces that influence the degree of independence that the Fed enjoys in practice are largely overlooked in much of this literature. Those overlooked forces are "soft constraints," a range of forces that are not legally binding and that can even be a little fuzzy in application, but that nonetheless impose meaningful limits on how the Fed exercises its seemingly vast authority. This article illustrates the power of soft constraints by examining the role that two particular soft constraints – principled norms and the Fed Chair's concern with her reputation – have played in shaping Fed action over the last hundred years.