Like military historians shaking their heads over the hubris of the Maginot Line, future historians of economic thought will make the regulatory structures that failed us in the financial crisis of 2008 and its aftermath seem like follies. They might perhaps, like tourists of the battlefields, marvel at the sturdy fortifications that were erected to guard against the dangers that had overwhelmed us in previous crises and admire the single-mindedness with which we were determined to avoid repeating the senseless casualties inflicted on us in the Great Depression. But they will wonder how we could have put so much faith in the solidity of our central banks and market-friendly financial regulators. It will come to seem obvious in retrospect that by the 21st century the nature of the threat to the world financial system had changed, just as it seems obvious in retrospect that by 1940 the trench fighting of the Great War would be superseded by blitzkrieg. But will this insight help us weather the next crisis any better? Will it really help to reflect continually on the naivete of the architects of the system that has just so spectacularly failed?

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The answer is no. There are important lessons to be learned from the crisis. But we'll learn them better if we realize that the intellectual and political architects of the system that failed us were not naive at all, but immensely clever and subtle; it was their cleverness and subtlety that undid them. And that is bad news for all of us, for naivete can give way to learning, but cleverness has no obvious higher state.

The Imaginot Line, as I'll call it, was an idea about how to protect our economy, not a physical construction. It was a system of institutional and (as we can now see) ideological defenses against financial crisis erected over a period of decades beginning in the 1930s. It had three main components, and what was subtle about the system was that while none of the components seemed impregnable on its own, the whole appeared vastly stronger than the sum of its parts.

The front line of this defense was deposit insurance, and it was a response to the widespread perception that the U.S. banking crisis that began in 1929 was the result of panic on the part of household and small-business depositors and that the cure for panic was insurance. Although more than 5,000 U.S. banks failed in the three years from 1930 through 1932, in 1934 only nine banks failed. It seemed obvious that the introduction of deposit insurance in 1933 was responsible for the improvement, and deposit insurance for small depositors in retail banks is now virtually universal in regulated financial systems around the world.

The second line of defense in the Imaginot Line was a system of financial regulation designed to cope with an obvious flaw in the first line of defense: the moral-hazard problem. Banks with insured depositors have no incentive to be prudent, and the depositors have no incentive to take prudence into account when choosing where to park their money. So a complex system of financial regulation was put in place, based in particular on capital requirements -- in effect, mandating that a minimum proportion of a bank's assets be contributed by shareholders whose money is explicitly at risk. The purpose was to ensure that banks did not use money from insured depositors to take risky one-way bets and did not use the high returns from such one-way bets to compete against each other for deposits. Because the danger was thought to come only from the insurance of retail depositors, the risks of similar behavior by institutions courting large professional investors were not believed to matter; after all, these investors would shoulder their own risks.

One consequence was the growth of the unregulated "shadow" banking system, including in particular the so-called "repo" markets that provide the same sorts of services for large corporations that ordinary bank deposits provide for individuals and small firms. By the late 2000s in the United States, these repo markets were estimated to be as large as, if not slightly larger than, the regulated banking sector, with assets estimated in 2008 at about $11.5 trillion, well over $30,000 for every American man, woman, and child. But as we now know, the professional investors did not shoulder their own risks. The failure of the system was unimaginable, which meant that its participants were incautious and when fear of catastrophe loomed, the consequences of their incaution would be borne by others, notably taxpayers and the unemployed.

The third line of defense in this structure was central banking. Of course, central banks long predate the 1930s, but from the 1930s onward their official mandate has been to keep prices stable and promote a level of output consistent with reasonably full employment. The weight given to price stability increased in most countries over the postwar period, except in Germany, where it had already been high because of the memory of the Weimar hyperinflation. Price stability also came to be seen as the permanent goal of central banking, whereas maintaining output came to be considered a matter for occasional firefighting rather than permanent tinkering.

A growing perception that central banks would go wobbly on inflation led to a movement for their political independence, formalized in the establishment of the independent Bank of England in 1997 and the European Central Bank in 1998 and more informally entrenched in the United States since the 1980s via a cult of personality created around Federal Reserve Chairman Paul Volcker and his successor, Alan Greenspan. (The cautious and inscrutable utterances of the latter became so much the stuff of legend that great joy was caused by the report that when he first proposed marriage, his future wife had no idea what he was talking about.)

This third line of defense dovetailed in a very sophisticated way with the first two. For it's not that financial regulation was governed by a blind faith in efficient markets -- had that faith been absolute, there would have been nothing for regulation to do -- but that we believed independent central banking was the bulwark allowing us to live with any weaknesses in the first two lines of defense. The idea of central bankers as austere, incorruptible, ever watchful, and in some sense married to the job was an integral part of the package.

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