David had a lot of interesting things to say, but to me the most fascinating was in relation to the short-term capital markets, particularly overnight repo.

People sometimes ask me how I saw the bad stuff of 2007 and 08 coming, and the answer, for the most part, was by observing unusual occurrences in swaps, overnight repo, etc. Malpass makes the key point that, although the capital markets don’t get a lot of attention from people who focus mainly on the stock and bond markets, they’re critical to the daily functioning of the economy.

Here’s what he said that is interesting: nowadays, because of heavy government interventions throughout the financial system, you wouldn’t necessarily notice disruptions in capital markets. I would add this further interpretation: Because it’s now been proven that the government won’t let anyone above a certain size fail, a lot of stress is being masked.

Everyone in government has always insisted that no one is too big to fail. They even gave a reasonable facsimile of believing that, in the 1998 crisis.

What’s different now is that, protestations to the contrary, the govt PROVED in 2008 that they won’t let anyone fail. That expectation is now baked into the cake.

And there are even more substantive things in play. The Fed’s extraordinary interventions since 2008 are still part of the fabric of the capital markets.

The very last thing the Fed ever wants to see again is the kind of extreme disorders that affected repo and CP during Sept 08. They will be proactive about preventing anything like that in the future.

That’s good in a way, I guess, but it imposes a heavy penalty on the economy, in the form of severely distorted financial markets. As David points out in the podcast, these markets are not doing an optimal job of providing capital to the economy.