Revisiting the 2008 Financial Crisis

to this session on the 2008 financial crisis ten years after the fact which we've been discussing quite a bit here for the last few weeks as everybody else in the country has been doing it and we thought this would be a great opportunity to tell you a little bit about our conclusions and to get your feedback and questions and comments and criticism so so much we're going to go for about an hour here on the stage and then and break up and go to next door to have pizza or just talk more generally so you're welcome to do that as well so I'm John Taylor and we're from George Shultz you know Ferguson care in Hawke's Bay Darrell Duffie and John Cochran we're each going to make a few short remarks about causes panic recession and some lessons and I'm gonna quickly start off because my responsibility was more on the causes side and so I focused a lot in my research in the presentation in the last hour discussions on the role that monetary policy had in causing and bringing about the financial crisis I examined what happened in 2003 4 & 5 in particular when by many calculations the interest rates of the Fed were held very low by historical comparisons and studied that carefully over the years and saw that that led to excesses sometimes called searching for yield because that rate was so low maybe excess risk-taking to get a higher rate excesses that spread to the housing market and one of our colleagues Monica PSAC explored that in great detail about the excesses in the housing market and it brought a housing boom on like you've never seen before and an ultimate ultimate collapse and as I was happening loans were being issued very favorable terms but turned out to be very risky themselves so in a way that was the beginning and it also spread very quickly for I think for obvious reasons also spread internationally you can trace the impacts of the Fed on other central banks around the world even at that time in Europe so some of their problems were related to that as well and what what Monica Lupe's AZ did and her research her presentations is traced those low rates that particular period to the excesses in the housing market and can trace particular sectors and and sees that as a real real problem of course that is static explanation is not stressed by the Fed very much I've had debates about that with Greenspan and Ben Bernanke and others although I think to some extent the current Fed is moving in a different direction one more thing I'd say of my contribution to this was what happened on fiscal policy as the recession got going and we've studied this a lot and it seems that the specific stimulus packages first passion o8 when Bush was president and later oath Obama really didn't do much good the money just went into people's pockets it really wasn't really much effect on the economy and we have a lot of data on that to show you it's there's debate about it and one thing I'll just conclude with I've noted in the 10 years which we've all been working on this at least since then is that the inevitability of time shapes people's news may be originally it was financial reports or early researchers then you have people writing stories who were in charge at the time they have a different view and so now we're just beginning to sort of sift through all this and hopefully get to a an explanation or several explanations which are helpful for creating lessons or learning lessons for the future so I'll stop there and turn it over to George Shultz who has had so much experience in a cabinet and in research and in universities anxious to hear what you say I think John has given part of the reason why we had the crisis but in a sense a deep reason is the I think pretty well justified notion in all societies that home ownership is a good thing so in this period there was an effort to encourage it very strongly by Freddie Mac Fannie Mae and Freddie Mac and they encouraged low Long's to spread home ownership these loans were very risky because if there was any dip in the house prices the people didn't have the ability to pay back the loans so they started to spread very widely and then the big banks got in on the act I might say as you said that not only Fetty and Freddie but the Federal Reserve kept interest rates very low so it encouraged this process the big banks got in this by securitizing these looms thinking mortgage rate mortgages are safe but then it turned out they weren't so if they were now holding large amounts of debt that wasn't good and this was a big problem then what happened then it became clear first of all in the case of a bank called Bear Stearns that this bank couldn't handle its situation and so through a odd process Bear Stearns was bailed out in the sense that they're at they're bad assets were taken over by the Fed and JP Morgan acquired the balance of it and then a bigger company called Lehman Brothers also was under pressure and that was a big effort to bail out Lehman Brothers but in the last-minute regulatory glitches prevented that from happening and so Lehman Brothers failed almost sort of suddenly a sudden bankruptcy like that is very different from an orderly run bankruptcy so that was very disruptive and so a sense of panic he emerged and the Federal Reserve Chairman and the Secretary of Treasury went to the Congress and they said the sky is flowing we have to have a huge amount of money to deal with these bad loans and they acquired the money although everybody knew there was no way to purchase the bad loans because no one knew how to put a price on them the nominal price was obviously not the real price so what should be the price No so they wound up with the money going to the big banks that were thought to be in an uneasy position and other bailouts took place so I think the result of all this is you violate three fundamental principles that need to be kept in mind one is accountability it wound up that there was not accountability number two is a sense of competence are the people competent running things that was violated number three trust you have to have trust that the people doing things know what they're doing and that was violated so I think the net of all this was a very bad episode and we still pay the price for it because the bailout mentality is in people's minds and encourages people to take risks that they otherwise wouldn't take so we've got to get back to a day when the bailouts are not in the picture where competence is rewarded and Trust returns my own thinking is affected by a personal experience I had back in 1970 when I became the first director of the Office of Management budget I found that a large financial company called the Penn Central and mismanage its affairs it was about to go bankrupt and the head of the Federal Reserve a giant of a man named Arthur burns thought that if that happened it would ruin the financial system so I'm sitting there arguing I think so so I Margar Arthur havethey is saying what am i doing arguing with Arthur burns about the financial system he knows everything but anyway along comes a man named Bryce Harlow which was Heep the savviest political counselor in Washington and he said mr. president in its infinite wisdom the pencil has just hired your old law firm to represent them in this matter under these circumstances you can't touch this with a ten-foot pole so there was no bailout and what happened the financial system was strengthened because everybody had to look at their whole card and say hey we better get ready we're not gonna get bailed out but Arthur did the thing that was very important in which the Fed can do namely he flooded the market with liquidity so there was no liquidity crisis he saw to it that there wasn't the result of letting people fail keeping them accountable made a big difference thank you George you know well that's the non-economists on the stage I'm going to begin with the Queen's question imagine see the Queen and in December 2008 visited the London School of Economics and asked why I didn't know what I see it coming and I was very offended by that question because I had seen it coming but most of 2006 writing op-eds about subprime mortgages I spent some of 2007 thinking about what a liquidity crisis might look like in January 2007 I wrote it's perfectly possible to imagine liquidity crisis too big for the monetary authorities to handle alone governments would need to step in federal bailouts for the likes of Goldman Sachs may seem unimaginable to us now but financial history reminds us that such events do happen and liquidity can add much more quickly than it previously flowed that was a long time before Lehman Brothers went bankrupt and I published the ascent of money several months before the Queen asked that question as you can't write a book overnight and the whole point of the book was to explain a major financial crisis to the lay reader I think I can claim to have done a not bad job as a financial historian of seeing it coming the ascent of money offers six explanations for the biggest financial crisis to hit the world since 1929 one that I think we would all agree on the under capitalization of banks and we'll hear more about that so I won't dwell on it another point that hasn't been mentioned was the way that structured financial products like collateralized debt obligations proliferated and rating agencies insisted that they were triple-a rating rated when they really were nothing of the kind since they were based in part on subprime mortgages in many cases monetary policy here I'm channeling John Taylor had been loose for most of 2002 to 2004 in a way that really wasn't defensible there was funny stuff as George Shultz has mentioned going on in the u.s. real estate market the derivatives market 0.5 had created a whole bunch of rather opaque contingent liabilities that hadn't been there before and then finally I think you have to include in the explanation China and what we used to call global imbalances in particular the great flow of Chinese capital into the US economy in the form of a kind of vendor finance so my own view is that you can't explain the financial crisis without reference to those six things though you can certainly argue about their order of importance and I didn't put undercapitalized banks first by accident the catalyst was the Lehman Brothers bankruptcy but the crisis had already begun it was obvious in 2007 that there was a problem if you were paying attention because the resetting of adjustable rate mortgages fed straight into a series of minor financial crises so I I think it's sometimes the case that people exaggerate the importance of the Lehman bankruptcy which can't be seen separately from the other institutional crises of of 2008 what's fascinating to me and I focused in my presentation in this year's on the panic was the way that the Fed tried very hard to recover from the Lehman bankruptcy but failed because a chain reaction had begun that it was actually really impossible to stop and that chain reaction included for example the freezing of the commercial paper market the blowing up of clap of the the credit default swap market and then of course the revelation that in fact the fiscal authority might not step in when the first tarp vote in September the 29th went against the tarp bill let me add a couple more points and then I'm going to hand over to Caroline Hobbs be the second big question about the crisis is why it didn't become a great depression Paul Krugman and others kept insisting that it was going to be a great depression and it looked like it was turning into one for certainly the first six months after September 2008 if you were following barrier icing greens work with Kevin or Roark who were comparing the events of 2007 ate with the events of 1929-30 it was absolutely terrifying but it wasn't a depression and I think there are three reasons for that one and we can debate this in a moment was monetary policy the second to a lesser extent was fiscal policy by these policies I'm referring to the United States but there was a third reason why the world did not go into depression that has received much less attention and that was China's stimulus which was the six for stimulus much much more successful than the u.s. stimulus and had massive spillover effects bailing out any economy in the world that was heavily reliant on commodity exports for example it was a global financial crisis I like the fact that Australians call it the JFC it very quickly as John mentioned became global and the reason it didn't become a depression I think was also global there's a third question which is why was the recovery not faster that's a very different question from why wasn't there a Great Depression but Caroline can answer that third question much better than me thank you I'm Caroline Huxley I'm labor and public economists when we think back to the Great Depression it started with a financial crisis as well in 1929 and a lot of Labor economists believe that one of the reasons that lasted so long was that it had follow-on effects in the labor market which failed to readjust and reallocate people to new jobs people adjust much more slowly than does the stock market or other capital markets and it's often difficult for them to give up one job in which they thought they were productive move maybe move to a different place in fact and move into a new job where they're going to be more productive people just the Great Recession is in many ways as great as it was because although it started with a financial crisis that is not that dissimilar to financial crises we have had otherwise labor markets really did not adjust quickly as a result of as a result of the financial crisis leading to a much longer recovery a much slower recovery and in many ways the recovery that has never completely occurred despite the fact that we have low unemployment rates I'm going to tell you about a few statistics that suggest that the labor market is still not fully adjusted so one of the things that happens at the beginning of a financial crisis or of a recession is that employers who have had workers who are not as productive in their as their wages would indicate often use that as an opportunity to kind of clean house get out get some of their workers off their rolls decide not to hire new workers change the work arrangements so that is very important for workers who are let go at that point in time to readjust and find themselves any jobs how do we know whether that readjustment has occurred well there are several indicators that we can look at and all of them look quite bad from the point of view of the Great Recession the first one is the labor force participation rate the labor force participation rate is someone saying to the government when asked yes I am trying to find a job I'm interested in having a job that means you're participating in the labor force the labor force participation rate fell very sharply during the Great Recession immediately following the financial crisis and it has never really recovered it fell it has recovered just a little bit but it is still much lower than it ever has been in recent years in the United States so that's a suggestion that there are a lot of people out there who do not feel that it is worthwhile to look for a job or participate in the labor market and disturbingly the labor force participation rate has not only fallen for people who are very close to retirement that's kind of a normal thing during recessions that if I'm 62 say or I'm 60 and I become unemployed during a recession I might think it's not worthwhile looking for a job again because I'm pretty close to retirement the labor force participation rate has also fallen for really prime age workers like 35 year olds and that's a that's a significant problem in addition if you look even if you look at people who are participating in the labor market you will see that they are so they're saying they're looking for a job that not only are they less likely to have a job but conditional on having a job they're working fewer hours a year and that also fell very sharply during the Great Recession and really has not come back again that's another indication that people have not found their most productive use in in the labor market and it's a great drag on GDP growth which is essentially a function of how many work hours there are in the United States times what the productivity of weech work hour is so if you have work hours fall in total it's very difficult to have high GDP growth another indication that there the labor market has not reallocated well and I think perhaps the single most disturbing one is that some of the flow out of people working has been into the disability program and again this is disturbingly among prime age people where it's really not believable that the cause of the increase in disability is that suddenly lots and lots of 35 year olds and 40 year olds have become much more disabled than they were before the disability program has been somewhat on a long-term trajectory of growth but it grew quite rapidly during the Great Recession and it really has maintained that higher level the reason I say this is very disturbing is that for all intents and purposes when someone becomes classified as disabled in the United States they usually stay that way for the rest of their lifetimes and retire go straight into retirement from the disability program so even small changes in the disability rate among prime age people say a 35 year old that means 30 years of being in the disability program and not working and there are there's quite a bit of evidence that actually people who are disabled parents are more likely to have children who don't have very much experience at the labor market and may themselves have more difficulty holding a job so even small changes in that program can be quite disturbing another indication that the labor market didn't adjust very well is that although the federal government did try to help a lot of people go back to school during the Great Recession that definitely happens during every recession is that people go back to school we we do not see that all of this going back to school seems to have produced people moving into sectors that were higher employment growth sectors or moving into jobs where they were likely to find higher wages or moving into jobs that were more likely to be in the tech sector or in the information sector or other sectors that were relatively fast growing in fact what we saw was that many people did go back to school many of them went to for-profit online schools the modal person who went back to one of these schools was actually around 35 36 years old so we're not talking about 18 to 20 year olds going back to school we're talking about people in their mid 30s and early 40s going back to school and the evidence suggests that one most of them left without ever getting a degree or certificate of any type a credential of any type but also that their earnings really did not grow after having gone to these schools and they were not successfully moving into jobs in more high growth sectors so lots of going back to school financed by the federal government but it looks like it was more of a holding tank for people who were underemployed than it was something about trying to reallocate in the labor market and the final indication that the labor market has really not adjusted very well is that although people are not always fully aware of it not every labor market in the United States suffered very much from the Great Depression there were some metropolitan areas that had unemployment rates that remained very low throughout the entire recession there were other labor markets that had unemployment rates that were as high as about fifteen percent well you really want people to leave the places with the unemployment rates of fifteen percent and go to the places with the unemployment rates of three or four percent we really didn't see a lot of that migration during the Great Recession and that's disturbing because that's part of the way in which people move themselves from less productive activities to more productive activities which is what we would like to see I guess I just want to say one thing about this and that is I think I'm less unless optimistic than most of my fellow economists here because I am concentrated very much on the labor market where I see a lot of indications that the Great Recession to some extent still continues I think we have things have improved we all know that the unemployment rate is low but part of the reason it's low is that a lot of people have dropped out of the labor market and I think we ought to think about the consequences of that for the long term having such a large share of Americans not participating my name is Darrell Duffie I'm a financial economist and I first want to say I'm just amazed to see so many of you here on a Friday afternoon the last day of classes of the quarter last Stanford day of the year and I guess that means that the financial crisis must have been a pretty formative event that affected a lot of lives and and that there's still curiosity to try to understand what happened what went wrong and I want to bring your attention after we've talked about monetary economics and we've talked about housing markets and labor markets I want to refocus attention back to the core of the financial system where the giant banks are the famous you know as as Neil mentioned Lehman and that big shock how do we get to that point where those giant banks were in such bad shape and and when they toppled over cause such damage that we're all still interested ten years later and well there are many many lessons to be learned the one I want to focus on is too big to fail and for I'm sure you've all heard about that before the financial crisis and I've reviewed a lot of primary source documents letters investigative internal investigations congressional testimony and so on and to the best that I can figure the regulator's in this country assumed that these large banks would look after themselves that was called market discipline the idea being that if you didn't have enough capital then no one would lend you money and if they wouldn't lend you money wouldn't matter if you wanted to get in a big risky balance sheet they wouldn't let you well that didn't work and the reason was too big to fail these banks it was correctly assumed at the time that if one of these banks were to fail that it would cause a crater on the economy and as neil has already described the the impact not just of Lehman but of the threat that these big giant banks would collapse and crater the economy and creditors before the financial crisis said to themselves that they'd never let that happen the government wouldn't let it happen they'd the government if necessary will bail out these banks because surely they wouldn't cause a crater on the economy and that that was proven to be false but while that presumption existed creditors were happy to lend money to these giant banks at rock-bottom interest rates very cheap sources of funding they were getting they were able to borrow money almost at risk-free interest rates as though they were like they had no risk at all because the creditors believed that if the banks would get into trouble the government would bail them out well though that cheap sources of funding the ability to borrow money at almost no no higher interest rates than then a Treasury let's say that was like jet fuel to their business plans they now had the ability to grow enormous balance sheets with very cheap sources of funding and they did assets in those in the largest nine US banks tripled in size between the turn of this century and the doorstep of the financial crisis tripled since then things have changed the idea that the government will bail out a large bank has been disposed of or at least in the minds of the creditors they no longer give credit to the idea that they will get bailed out if the bank gets in trouble so now when sophisticated institutional lenders consider the interest at which they're willing to lend money to a giant bank they know or at least they presume but they if the bank gets into trouble they'll be forced to take a loss and because of that they're charging much higher interest rates and because of that the banks are not growing their balance sheets by leaps and bounds every year pretty much flat since the financial crisis there is not a big boost of leverage or asset growth in the in the banking sector one of the contributing reasons to that return or partial return to market discipline is legislation in the dodd-frank Act that at least in theory gives the government the ability to force the creditors to take those losses without necessarily causing a crater on the economy by just telling the creditors sorry you no longer have any debt claims on this Bank we'll give you some equity instead the same idea thankfully is wending its way through legislation to change the Bankruptcy Code for big banks John Taylor and our former law school colleague Ken Scott led a group of economists and private sector legal experts which designed a new chapter of the Bankruptcy Code which did just that it essentially forced the large creditors to take losses rather than the government and the presumption of too big to fail while it's not gone away entirely has been pushed down the banks are much better capitalized and even so their cost of borrowing relative to risk-free borrowing rates have gone way up how could that possibly be reconciled by anything else than the decline of too big to fail the decline of the view that the government will always step in and save the creditors that's a very important lesson as I said there are many more but in the interest of time I'm going to pass the baton to to my colleague John Cochran I'll start with just in some way a little introduction this is the capstone of several sessions we've had organized mostly by John Taylor to think about on the 10-year anniversary the lessons of the financial crisis and the subsequent Great Recession and we've had a great series of discussions you can find slides and other materials on the Hoover website somewhere you have to be fairly good at sleuthing websites but under events and Hoover website I think you could find us and there you'll see lots more than each of us got to talk for like an hour over the last couple weeks and now we're down to five minutes which for academics is just torture and and the kinds of things we've talked about chronologically are the what of the things in the lead up housing China Fed policy and so forth let's set the system up to be fragile why what were the events of the panic itself what was the roles of government policy of some perhaps unwise speeches made by our leaders and so forth in in the were the mechanics of the panic why was there such a recession you may say it's obvious but as a matter of economics it's not so obvious why banks having a little bit of trouble the banks all stayed in operation but why did financial trouble with banks lead to people in Nebraska losing their jobs why did that recession not turn into a Great Depression as as Neil brought out my view on this is largely because the Fed did not screw up which it did in the Great Depression and and they learned their lessons and didn't repeat the same mistakes just a good thing why then was the recession so unbelievably long-lasting and here there's kind of a debate between supply and demand if you will endless secular stagnation versus the kind of sand in the gears that stops the economy from healing Caroline showed you some of what I agree with as well as the sand and the gears version of there's a lot of problems with well-intentioned government policies that give people incentives that keep them from working getting better jobs moving and so forth and then which I'll close with after my second set of comments where's the next crisis coming from things better now have we learned all our lessons sadly no the one thing I'd like to highlight from from my own thoughts on this is what is the central lesson of the crisis and and for that end think what was different about this in 1999 so when the tech the tech boom turned into a bust the nation lost about the same amount of value as was lost in subprime mortgages up until the language crisis so the the size of the shock was about the same yet in 2000 when the stock market crashed we had a little bit of a recession and a lot of people who were here and thought that their startup was worth a hundred billion dollars found out that no they're they're gonna have to work like the rest of us for a while but it was a by and large a minor event contrast that 2008 where we had similar similar underlying losses but then that just turned into a financial conflagration and a recession from which we have not recovered in many measures our our GDP went down relative to trend and we're we're finally growing a bit but we haven't gained back the 10 percent we lost well there's a big difference the tech stocks were stocks if you had invested your money in a tech stock or an institution that bought tech stocks and the tech stock loses a lot of money what happens the price of your investment goes down you lose a lot on the on the on the statement and what can you do about it go home drink a whiskey that's all you can do about it Ramon your sad fate that you didn't sell yesterday while someone's doing what happens when a bank gets into trouble ha ha well banks borrow four terms as Daryl showed us on the eve of its failure Lehman Brothers was invested in mortgage-backed securities now mortgage-backed securities even the worst one they're very safe assets they are far far safer than some you know whatever your friend who's doing a start-up in Palo Alto has invested in their extremely safe assets their diversified portfolio of loans you can lose 5% 2% maybe it's not this big horrible risky thing why was that the source of risk well layman Brothers was financing its portfolio of mortgage-backed securities thirty to one leverage with overnight debt every morning for every one dollar of their investors money put in they had to find $29 of new money to pay off the people they borrowed $25 from last night is literally like like like running your house with gasoline in the basement I mean no wonder one morning those borrowers said we're done and then they couldn't pay off at 10 o'clock in the morning they couldn't find new guys to pay off the old guys so there was a run it was a run not in the classic sense you know Jimmy Stewart and the people coming to get their money or a little michael banks and so forth of a bank but the mechanics were exactly the same and if you want to find the mechanics read Darrell's failure mechanics of dealer banks in exquisite clarity will tell you exactly how how the fancy dealer banks act just like what you saw in Jimmy Stewart now what's the answer to that the regulatory answer after 10 years of strum and Drang I think we're finally figuring out the one central answer is not send in a bunch of regulators to make sure that the assets are even safer so that you can finance them 30 to one with overnight debt the answer is risky investments need to be financed like the tech stocks were financed with investors money where if it's a risky investment and it loses value that your statement goes down in price and you can't run and say give me back my money now and if you can't do it instantly you're out of business that's the mechanic that caused the crisis so capital is the salvo ball wounds and I think we're figuring that out so where are we now capital is a good deal higher there's rough numbers from 5% it's now 10% in my view 10% is nowhere near enough 10% it's good enough for a while and capital is under under attack as bankers don't don't like it they like to goose up their their returns so looking forward where are we there we have more capital to banks but the inevitable erosion as the pain of the event fades the inevitable erosion is is underway I hope it I hope it doesn't go too far where will the next crisis come from I think it's something we need to talk about I don't know I'm nowhere near as good as Neil as you know reading the tea leaves of history but I'll tell you my own worries when I get up at two o'clock in the morning where do you looking for a crisis where is there a lot of debt not equity loans that can't be paid back really shady accounting off-balance-sheet credit guarantees somebody is gonna you know go ahead and borrow and I'll I'll pick up the deal and a lot of short-term debt being rolled over and over and where is nobody asking any questions I would say that describes sovereign debt we all as partly as a result of the crisis we're now the the developed world's at 100% debt to GDP ratios state governments have pensions that they have no idea how they're gonna pay off the US government has no idea how they're gonna pay off its debts Europe is also China strikes me as a place where there's all sorts of debts phony accounting and who knows what's gonna happen if they run into a serious downturn and once again the banks are stuffed with it to this day European regulators cannot bring themselves to say that Italian and Greek bonds might be dangerous assets for banks to hold so the banks are stuffed with the sovereign bonds if the sovereign bonds go under the banks go under as well so that's what keeps me up at two o'clock in the morning more capital would solve that problem as well but at least gives you something to worry about so from there maybe we should go on to our questions yeah thank you oh I think you could welcome some questions there's people with with mics that are coming Ric right in the middle in the back they're being raised and raise your hand if you have another one all right so the ascent of money was pretty solid so thanks for that I was slogging through Adam Tuesday's new book called crashed he's at Columbia now I guess and I grabbed you know I just started college during the 2008 crash so it's a little bit of a personal obsession I'm always wondering about what's going on and he crafts this story that there was sort of like this behind closed doors the Federal Reserve innovated to become the global lender of last resort in a way that most people still don't really understand and I'm still trying to wrap my head around that was that a grand strategic master stroke or a nefarious thing or like what's the deal with that and how should how should we think about that well first let me say that Adam enthuses book his admirable attempt to write a history of the financial crisis but it's quite early days to do that and he relies quite heavily if you look at the footnotes on what I'll call the New York Times Financial Times version of events so there are some parts of his argument that I have big issues with particularly as treatments of the European crisis where he takes the kind of poor poor Greek Greeks approach wicked Germans but on the issue of the Fed swap lines I think he's right and he's not the first person to make this point in the very early phase of the crisis International Cooperation was extremely important because the contagion spread fantastically quickly from the United States it was a crisis made in America but already by the end of 2008 it was clear that its impact would actually be greater in other countries the impact on output in a whole slew of economies in Asia and Central Europe was much greater than it was and later on as to's shows the impact in southern Europe would be much greater than anything experienced in the United States the fact that the Fed was able to provide dollar liquidity on a money to the other major central banks and indeed some of the minor ones I think was quite important in preventing the 1929 2:31 scenario because part of what happened then was not only did loads of banks fail in the United States but started to fail everywhere in the world not least in 1931 in Europe so is an important point it's not nefarious the reason that it was somewhat shall we say low key and not widely publicized was I think with good reason the Fed feared that there would be congressmen complaining that the Fed was playing this international lender of last resort role so it got very little coverage at the time but the scale of the operation was large and I think it was extremely important in preventing the crisis intensifying even more than it did others may disagree I remember watching the vice chairman of the Fed Don Combe testifying in Congress and getting raked over the coals over these central bank swap lines with congressmen interrogating him very aggressively about why the Fed would ever be lending dollars to a foreign country when the United States was was in difficulty I completely agree with the point that you made it was very important to provide that liquidity and I just broadened the point a bit to the distinction between bailout which was the nationalization of banks or the provision of government capital to increase the capitalisation of banks when they might fail on the one hand versus the proper role of the central bank which is not to provide capital but to provide liquidity something at Neill emphasized so that when a bank couldn't sell assets at a fair price in order to rebalance itself the Fed would take those assets as collateral and lend the bank money which is a different thing than a bailout now during the depths of the financial crisis there was a gray area and the Fed had to go right to the limits of perhaps even beyond and if you put in a few places of that gray area between liquidity support and bailout but I would say that it was very important for the Fed to provide liberal amounts of liquidity to to the US and foreign banking system with dollars at a time such as the failure of Lehman just as it failed to do after the 1929 crash causing an enormous depression so these swap lines were to foreign governments which is in some sense safer than foreign banks because you kind of know they're good for it and you can debate whether they should have a lender of last resort function of the Federal Reserve but if you're gonna do it don't debate that during the crisis that's like saying we can either have a firehouse or we can all have fire extinguishers in our houses but if you've if we've told you there's a firehouse then when the fire comes you better call the fire department don't say well where's your fire extinguishers questions hi so I also grew up in financial crisis you know and definitely impacts how I think about the economy and my question goes towards to the institutional incentives and how those underlie the financial crisis specifically around ratings agencies and also institutions regarding investigating fraud which was you know a big part of a lot of the settlements afterwards how do we look at changing that to make sure the incentives are lined up correctly so these types of risky behavior that sometimes been you know purchase on fraud don't happen again I could try rating agencies because I was on the board of Moody's which is one of the world's largest rating agencies from the month after Lehman failed until earlier this year and you're right there is an incentive problem because as as most of the people here know when someone wants to borrow money and they asked a rating agency to give them a grade just like those of us up here on the stage do for the students in the audience they get paid by the same person they're grading and that is a conflict of interest and the rating agencies it's actually not easy to tell whether that conflict was responsible for the bad ratings that they gave those mortgage-backed securities that failed if you look at their ratings they gave to corporations before the crisis they performed exactly as one would expect and they definitely got it wrong in the housing market and can be blamed for not understanding the big risks in the housing market I'm not sure that they succumbed to that to that conflict of interest but as I just mentioned at least four up until recently I was myself conflicted on that after the crisis Congress tried to find another way so that they wouldn't have the rating agencies wouldn't have to get paid by exactly the people that they were rating and they tried many options and none of them would work in Europe of the option it was tried was we're gonna have a government reading you can see and we're gonna have the government rate everything and that obviously presents a conflict when the European government as a whole is going to be rating the Italian government bonds for example so so far no one has found even despite how bad the conflict of interest is no one has found yet a better model and let me suggest one this is a problem of regulations so if banks were funded by issuing equity or other floating dollar claims if they weren't there wasn't this debt and regulation issue then they wouldn't be brought the problem is the banks the banks want to take risk because they're as Daryl said they're taking risk with government guaranteed funds the people that they're investing in want to issue risky securities so they want to get together and make this risky bet but the government's saying no no no you have to have triple-a securities well the obvious thing okay the government says we need triple-a I want to buy something risky you want to sell me something risky we have to make it look triple-a so the government gives the stamp of approval you can see what's gonna happen here if the incentives are aligned where where it's just what the rating is just like a Yelp star or a consumers report thing and not to help you satisfy some regulatory requirement that is annoying to both parties then the problem won't be there can I had one thing a very bad explanation of the financial crisis which has become quite popular I would say that the popular narrative is about the crisis as they currently appear in let's say the broadsheet newspapers generally wrong and one of the popular ones is that the crisis came about because of deregulation and and can somehow be traced all the way back to the 1980s and 1990s this is terrible financial history because the really striking feature of the crisis is that it emanated from the most regulated institutions the problem was there was lots of regulation it was super complicated regulation it wasn't very effective there are many agencies who were supposedly responsible for the banks and the mortgage market and a recurrent theme of I think our conversations has been that the excessively complex regulation is actually the disease of which it pretends to be the Cure and one of the big problems that the post crisis response has been if the crisis was the result of deregulation let's have lots of regulation and hugely complex statutes not least dodd-frank resulted the Basel Accords on bank regulation are vastly longer and more detailed than they were in their first iteration and this I think is is a really good example of how learning the long the wrong lessons from the crisis could in fact lay the foundations for the next crisis I just wondering how much of the root cause of the crisis is just that when something hasn't happened in the last 50 75 years people start to assume that it won't happen and then lend against it so you know in whether real estate or sovereign debt or stocks when there's lending against something because it hasn't had a massive crash in the last 50 75 years does that then become a root cause for regulators to make certain assumptions and the two parties who are trying to get together and do risky things to make some assumptions that stability breeds complacency and this Minsky is written a lot about that what's curious to me I don't think that was as much of an issue some people think but the people who write most of the complacency created instability or the central bankers it's very interesting to me to read what people are writing about this crisis after the fact and then the history is changing it's already been 10 years but many of the people who are writing about what happened are the people in charge and and I give I gave an example about my my view about instability actually cause to some extent by the central banks the former governor of the Bank of England the former governor of the Bank of Canada is now governor bank whose Bank of England both wrote pieces exactly opposite that said no the it occurred because of all this complacency out there I just think there's very little evidence for that but it's part of the debate it's going on the complacency came from the feeling that home ownership is a good thing so you wound up with home ownership with people who had debt that was underwater suppose you had gone about handling the crisis by the president's a explaining what happened and saying we still think homeownership is a good thing and we're gonna bail out nut banks and so we're gonna bail out the people around the host so they don't get foreclosed on and they can hold their own homes that would have done a good job an area where I do think there was if you look at the ratio of home values to rants going into the financial crisis and the Great Recession they were really only consistent with the idea that home prices would just keep going up forever and ever and ever and so I do think there was complacency I think people said well look it they've been going up for a long time so why should they not go up again next year and the year after and so forth and so on and that you had to sort of believe that to justify those house prices and then as soon as house prices started to fall of course those expectations couldn't be maintained and house prices since they those expectations have been built house prices it was a cycle that was hard to break and because people had had the expectation that their house prices would keep going up people were willing to lend to subprime borrowers who put very very little down because it really doesn't matter if your house price is going to keep going up and up and up you'll end up with home equity even if you start off with almost no equity right well once your house price falls you're underwater right away so I think it I think in the housing market or the house lending market there was a lot of complacency or or at least the belief that what has gone up for the past 20 years will just keep going up also worth adding that this is why financial history is really really important because most people in the markets were just basing their observations on their own lived experience the people running the investment banks had unbalanced got into finance in around 1982 they had absolutely no personal experience of anything resembling 1929 practically nobody did the only way you really knew what was going on was if you'd actually studied the Great Depression and I used to routinely ask audience is this size of financial professionals how many people here have read Milton Friedman and Anna Schwartz is financial monetary history of the United States and it would be two on average and these are the people running the financial institutions in the front suppose it is complacency then what do we do about that going forward and our regulators are telling us we've learned our lesson we're gonna be tough we're gonna take that five times bigger rulebook and we're gonna every int is gonna be crossed well if it was complacency last time you can count on complacency next time so that sounds like a very bad way to go think do things going forward that's why changing the system so it isn't so fragile it seems like a much better and more durable approach to it than just counting on we won't be complacent next time because they're still not reading their history you know just curious do you see any relationship or similarity between the Fed pressure pressuring the lenders to lend to people that weren't qualified really to get house and and then having them fail and the current issue with student loans and those perhaps not being paid back either do you find that that is a similar situation and anyway I just like to hear your answer thank you yes there's a lot of similarity in fact if you think that the u.s. government was encouraging poor lending in the mortgage market you ought to be a lot more worried about student loans because student in the and the home lending market there was some amount of underwriting in other words when you went out to borrow the lender did look at your credit score and did look at what home you were borrowing and there was an appraisal and the loan that you were given was a function to some extent of your income and expectations about your future income and so on with student loans there is no underwriting whatsoever a student can be the best qualified student in the United States who very clearly is going to get a wonderful college education and will be easily able to pay back his or her student loan and that student will get exactly the same loan terms as a student who was failing all of his classes in high school and barely managed to get a high school degree or a GED there's no difference in the loan terms given to those two types of students one type of student is predictably not going to be able to pay back the loan the other type of student is going to be able to pay back the loan we in fact are very good at predicting whether a student can pay back a loan just by looking at what their like going into college and they got exactly the same month the student loan crisis is entirely concentrated on a certain set of students who we can protect have a high probability of not being able to pay back and we more or less no one would lend to them if the federal government weren't insisting a very very concentrated problem essentially students at institutions like this always pay back their student loans there are other institutions where almost no one pays back their student loans and so it is a if the mortgage market were as messed up as the student loan market it would have been even worse so we have to have to stop here but you're welcome to join us in the next room for some pizza and more questions and more discussion so thank you so much for coming

Channel: Hoover Institution

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Id: m8iDruFP0Kg

Length: 58min 6sec (3486 seconds)

Published: Sat Dec 08 2018