Paul Krugman writes:
Search for security: One of the truly amazing things about the current financial environment has been the way investors are parking their money in government debt, even at very low yields, because they’re afraid to lend to private entities that may be holding toxic waste.
And it’s not getting better. Here’s the yield on one-month U.S. Treasury bills, which is back down close to its low from the August panic.
Tthe implicit overnight bankruptcy probabilities implied by these spreads are remarkable. As I said before, the odds that any given major bank borrowing Eurodollars will collapse tomorrow have gone from something that you expect to happen roughly once every 3000 years to once every 500 years.
Paul Krugman thinks that we now face not a liquidity crisis to be solved by flooding the system with liquidity and thus pushing down interest rates on safe assets but a solvency crisis that can only be solved by recapitalizing the banking system. I say: why take chances? Do both. The Fed should ease monetary policy and the Fed and other regulators should require financial system recapitalization.