Joseph Stiglitz

... The Bloomberg article that came out a few weeks ago, about forget the TARP [Troubled Asset Relief Program], the reality is that there was $7.7 trillion that was lent or opened up to the banks in one way or another, low interest rate loans and everything else. Tell me what the conversation was, what the reaction of the administration was. ...

... Remember the bank bailout stretched out over a very long period of time. Data that's only become available more recently has revealed how deep the problems were.

The first clear symptom was the Bear Stearns bailout in March 2008. A lot of people were very worried after the breaking of the housing bubble. They were aware that banks had exposure. Many economists thought the likelihood that there would be severe consequences was very high.

[Federal Reserve Chairman Ben] Bernanke made a speech: Don't worry, the risks are contained. Those of us who listened to that really got even more worried, because it was clear that they didn't understand or that they were covering up.

The data that has come out since about lending in 2007 and '08 by the Fed shows that it was massive, that the financial system was going through tremors, and they must have known it. The Fed was lending not just to American banks but to banks all over the world, and in amounts that were really astonishing. ...

Talk about Bear Stearns. You have a problem with the way it was handled. ...

... One [concern] was that right after Bear Stearns was allowed to go, the Fed decided that it would start lending to investment banks. The Fed's charter had always been the commercial banks. The mantra in the deregulation days of the 1990s was investment banks should be left to do their own thing; commercial banks we ought to focus on. Investment banks can manage their own risk; if they go bankrupt, it's not going to have systemic consequences.

Well that story seemed to go by the wayside overnight when the Fed said no, investment banks are systemically important, and we will lend to them as if they were just like a commercial bank.

They saved Bear. Also it's been found out ... there was an extra $30 billion given to them to help them survive in the in-between while the deal was going through. How does that knock to hell the whole idea of moral hazard?

Clearly the problem with moral hazard had been festering in the financial sector for years.

We -- the United States government, the IMF [International Monetary Fund], the European governments -- had been bailing out these big financial institutions over and over again. We did it in the early 1980s with the bailout in Latin America. We did it in '95 with the bailout in Mexico. We did it in East Asia with the bailouts in Korea, Indonesia, Thailand. We did it again, the bailout in Brazil. We did it again in the bailout in Russia. We did it again in the bailout in Argentina.

There's a pattern here of reckless lending over and over again by these major, large financial institutions, and each time taxpayers bail out the banks; the banks get their money. ...

In America [Lehman Brothers Chair and CEO] Dick Fuld is not going to be too concerned ... that there's a chance that the government would ever let him go?

The moral hazard was so deep that I think there was a widespread perception that somehow all the banks will be saved. ...

Bear Stearns in a sense was saved; it was folded in to JPMorgan. But the shareholders, the officers lost a great deal, and they're very angry because if the Fed had extended the lending rights to Bear Stearns that had extended the next day to the other investment banks, they believe they would have survived.

Whether that's the case or not, I don't know. But certainly there was a very strange timing there of extending privileges on one date to some and not to another.

Rumors were going around about what was the reason, going back to one of the earlier Fed-engineered bailouts, Long-Term Capital Management at the end of the '90s. The story was Bear Stearns didn't play game, and they were going to be punished.

So a lot of people on Wall Street didn't really care that much when they went down because they thought they got their comeuppance.

That's right, but that also sent a warning: Maybe if you're not playing the game, the Fed picks and chooses, picks winners and picks losers. ...

There were rumors after Bear Stearns went down that Lehman was going to be next, and that's where you have the next moment of incredulity. The Fed seems to have been taken by surprise when Lehman Brothers went down. It seems to have been taken by surprise at the consequences of Lehman Brothers going down.

To many of us, this was a mystery. The bubble broke in 2007. That's when you should have started getting worried. You should have known what their portfolio was.

When Bear Stearns went down, the common wisdom was Lehman Brothers was going to be next. Shouldn't you have been looking at the full consequences if Lehman Brothers went down? Talking to people on the staff, it seems not to have fully appreciated the risks of what went on.

When it happened, the first line of defense they said was: We thought the market had time to adjust. Again this blind faith in the markets, just like markets manage risk -- they should have learned about that.

Then they said: Well, the markets were seeing what was going on. … Data on the freezing of the financial markets, interbank market in the period before this should have sent a clear signal that markets were not really well prepared.

So then they came to their second defense: We didn't have the legal authority to do anything. That also had seemed very funny, because two days later they bailed out AIG.

Now all of us thought the Federal Reserve was supposed to be dealing with commercial banks, and then they extended their purview to investment banks. But then AIG, an insurance company?

If they had authority to do what they did with AIG, clearly they had the authority to deal with Lehman Brothers. And if they didn't have that authority, wasn't their responsibility back in 2007, when the problems arose, to go to Congress and say, "We don't think we're going to need this, but just as a matter of precaution, please change this line in our authorization." They didn't do that.

In the end, you have to say they really didn't do what they should have done.

... Why? It seems to be to some extent that they were kicking the can down the road because of fear that they could create havoc within the market by looking into things too deeply. ... There was non-transparency, and to some extent one of the reasons for it is because they weren't asking for the material that they actually could have gotten their hands on. What was going on there? ...

... It was increasingly apparent that the deregulation environment that had been created by some of the same people who were now in jobs of responsibility, of supervising, advising the president-elect, they had created a system with a lack of transparency that made it very difficult to manage.

It was interesting that the role of ideology in economic models play in all this. Many of the economists who advised them believe that markets ... could manage risk, that the bank officers could manage risk on their own. They were very reluctant to have government interfere because that would interfere with the efficiency of the market.

What was so striking is that it should have been apparent that markets have repeatedly not managed risk. Markets just weren't invented in 1990, '95. We've had banks for a very long time, and banks have repeatedly mismanaged their risk.

But things have gotten worse because with the very large bank there is a problem economists call "agency," that the bankers, those who run the organizations, are rather distant from the shareholders and the bondholders. Their interests are quite disparate, and we've seen that. The bankers have done very well even though the shareholders and the bondholders have not done that well. ...

You look at the "too big to fail" banks, and you look at their incentive structures. They know that they're too big to fail, so if they gamble and win, they walk off with the profits. If they lose, they had a pretty sure bet that the taxpayer would pick up the losses. ...

... You feel that Lehman was mishandled. ... Should they not have let it fail? What else could have been done in that situation?

The issue of what to do with banks, financial institutions that owe more money than they can repay is obviously a vexing one, and we're supposed to prevent the problem occurring by having tight regulation, by close supervision. ...

When those two things that are supposed to protect us fail, in most democratic societies when you have large institutions what you do is you have to save the institution. But that doesn't mean that you save bondholders and you save shareholders. ...

The preservation of the institution is important, but not of those shareholders and bondholders. They didn't do their job of managing, monitoring, and they have to pay the price. They get the returns when things are well, and they have to pay the price when things go badly.

That's what we should have done in the case of Lehman Brothers, especially given that we didn't know what would happen if it fully failed. In that cloud of uncertainty, if the supervisors had done their job and our regulators had done their job and we knew the consequences, then you might say maybe we can have an orderly failure. But they didn't know, and that was irresponsible. ...

That was the fundamental mistake that was made by both Bush and Obama. They repeatedly saved the shareholders and the bondholders, and that's what causes moral hazard. Not only did we save the shareholders and the bondholders, we also saved the bankers. Many of these people still got their bonuses.

That's where there's such anger on the part of the American people, because they see their taxpayer money in effect protecting bonuses while they face the problem of unemployment and losing their home.

One of the situations a lot of people got angry about also was [Secretary of the Treasury Tim] Geithner's plan to save AIG paid 100 cents on the dollar to the counterparties. What say you of that decision?

I think paying 100 cents on the dollar to the counterparties in AIG was unconscionable. ...

It was interesting that the Fed was so resistant to telling us where the money went. They resisted Congress. They resisted when Bloomberg asked for the information under the Freedom of Information Act. Bloomberg brought them to court [and] won in the district court. The Fed had the gall to appeal, to say: We're both government. We're not accountable. ...

When we got the information, we understood why they didn't want us to have it. The largest recipient was Goldman Sachs, and two or three of the other large recipients were foreign banks. If the foreign banks were at risk, then why not have the foreign governments rescue the banks? ...

What's the philosophy that Geithner has that sent him down this path?

I think it was what economists and sociologists call "cognitive capture." He thought along the mind-set of the banks, and if you're a banker, the most important thing in the world is the survival of your bank. Not the banking system, but your bank. That became the issue number one.

They were told: If you let the shareholders, the bondholders go, it will cause havoc, and we'll never be able to raise capital again. Nonsense. Countries have had their financial system go into turmoil. Banks have gone bankrupt. If it's a profitable activity to lend, which it is, money will come in. ...

How surprising is it to you when Obama takes power that he names Geithner as the Treasury secretary, and he brings back [Larry] Summers? ...

He was told that appointing this team would present a problem, because even if they gave the right advice, it will be tainted. People will see it as reflecting the interest of the banks and people who were linked to the deregulation, to the flawed policies. You're bringing in the same plumber that caused the problem. ...

Of course the real risk was that they would not give the right advice, and that would turn out to be the case. I wasn't surprised, because at that point it was already clear where he was getting his advice from, who he was listening to.

The only thing that was perhaps a little bit of a surprise was the disjuncture between "Change you can believe in," the slogan, and the team that was put in place, which was, yes, change a little bit from the Bush team, but only a little bit.

What happened? His Cooper Union speech, his speech that he did to NASDAQ the year before were all very progressive in tone, were very much on the fact that we had gone too far, that we had deregulated markets that need to be dealt with. ... Why the change? ...

Remember, the Cooper Union speech was made during the primary and before he became chosen as the Democratic nominee. It was also done before the collapse of Lehman Brothers, and it was at that juncture that the advice came in very strongly from Wall Street: Don't rock the boat. Don't do anything that would disturb the financial markets, because that will have dire consequences for the economy.

Not a surprise that [if] a majority of your advisers come from financial markets, you see things through the perspective of the financial markets. If you had as your advisers people from the real estate sector, if you had from a group of representatives of homeowners, you would have gotten a very different set of advisers who would say, "The first thing you need to do is to resuscitate the real estate market," or, "The first thing you do is to save homeowners from losing their homes." ...

Despite the fact that he's got [Former Fed Chair Paul] Volcker standing behind him, that [Austan] Goolsbee is his right-hand man, that [Former SEC Chair William] Donaldson is there, that [UBS CEO Robert] Wolf is there, that other people that seem to be more progressive in their attitudes are surrounding him. Why do you think that is? ...

I think there is a growing sense among people in a variety of different fields that his gut reaction is don't-rock-the-boat conservative. That doesn't mean that he's not liberal on many issues, but it's moving in the liberal tradition and a liberal direction in a very slow, step-by-step way. ...

... There's a big meeting in December [2008], before he goes to the inauguration, where they decide on the stimulus number. ... How do they come to the numbers that they come to? Do they know that they maybe will only have one chance to do it? And do they get it right?

The issue of the size of the stimulus had been discussed with members of Congress very widely in the months even before the election. The basic issue was how weak was the economy? How large would the multipliers be? That is to say, for every dollar of stimulus, how much extra GDP would you get? How long was the downturn likely to be?

There were different views on all these questions. Those in the financial side, those who saw the problem as Lehman Brothers and thought that there was a little tremor to the economy, [said] you fix the banks, the economy goes back. They believe in free markets. Markets work well. We had a little bit of an accident. Let's not talk about too much in detail, but once we fix the banks, we're back and running.

From that perspective, all you needed is some short-term stimulus to tide you over until the banking system gets back to health. So you need a short-term, 18 months, 24 months, moderate in size. The normal restorative forces are pretty strong.

The other side saw the economy really facing a very severe problem. I was on the side of those who saw the economy facing a very severe problem, partly because I looked back at what the economy was before 2008. I thought the economy had been sick. I thought the economy had been on artificial respiration for several years, that the housing bubble had been keeping the economy going. You take away that artificial respiration and you have a problem. ...

What did you advise them as far as the stimulus?

... You would probably need 2 to 4 percent of GDP per year, ... [which] would be in the magnitude of $300 billion to $600 billion per year until it comes back. But that might not be enough given the severity of the problem.

We're filling a hole of consumption going down by 5 percent. We're filling a hole of investment in real estate going down. Who knows what's going to happen to the global economy? Trade figures had gone down more seriously than even in the Great Depression.

So the side here was on caution and that you needed to have a very, very big stimulus.

There's another side to this. The political side is saying, "What are you, nuts?" Why did they decide what they decide?

There was one more aspect to this, which was the design of the stimulus. Some kinds of [spending] have higher multipliers than others.

Unemployment insurance is a very good stimulus for two reasons: When you give people who are unemployed money, they spend it. Secondly, if there's no unemployment, you don't have to spend the money. You only spend it in tandem with the severity of the economic downturn. We call those automatic stabilizers. So that's a good way of stimulating the economy.

Tax cuts for rich people are very bad ways to stimulate the economy. They save a lot of it, and what they spend they often spend on vacations in Europe or someplace that doesn't stimulate the American economy.

Paying money to, say, Nepalese contractors working in Iraq doesn't stimulate the American economy. So the war spending was not very good for stimulating the economy today or obviously long-term economic growth.

What I saw as inevitable was the following: Unemployment was going to go up. States and localities are going to have tax revenues go down especially [because] many of them depend on property taxes. Property values had gone way down; they're not going to be able to raise taxes.

And they have a balanced budget framework, which means when the revenues go down, they cut back. That means you're going to be firing teachers, you're going to be firing healthcare workers, just at a time when we're going to need them even more.

So I said let's give a lot of money to the states and localities to make up for their shortfall caused by our bad macroeconomic performance in Washington. It's not their fault that the economy's going down; it's the fault of mismanagement in Washington, the Fed and the administration. So that was the second thing.

If we're going to give a tax cut, let's target to investment. Let's tell American corporations, if you invest in America, you'll get a tax cut. If you don't, your taxes are going to go up. So we provide incentives for more investment.

We didn't want to stimulate more consumption, because we've been overconsuming in America. That wasn't where we want to go.

If you had taken that kind of a program, it would have provided more stimulus per dollar spent and put us on a better course for the future. But that wasn't the direction that they took. What they did instead is basically say $800 billion over two years, Congress figure out where it goes.

What was the problem with telling Congress to do it?

They start compromising, and a third of it went to tax cuts, which didn't stimulate the economy very much. Some of it went to what they call shovel-ready investments that discredited the spending. It still stimulated the economy, but it discredited the program. ...

One of the points you make is that saving the big banks was not saving the small banks. The small banks are going belly up, and [they] were the ones that put money into the local, small businessman, which is where the jobs come from. ...

One of the problems is they never got around really to fixing the banking system and never really thought through what kind of banking system that was needed, especially right now, to stimulate the economy.

When the president went to the American people he said: It's not because we love the banks, but because we need to continue the lending.

But then they were so taken in by the mind-set of the banks, they said: Oh, but we aren't going to ask you to continue lending. You do it if you want to. But by the way, we're going to give you this money, and you can pay it out as bonuses or do whatever you want, because we wouldn't want to interfere with the workings of the free market -- even though of course a $700 billion gift is an interference with the workings of the free market.

They didn't put any conditions on lending, and they gave a disproportionate amount of the money to the very big banks that are disproportionately involved in speculation, CDSs [credit default swaps], derivatives, not in lending to small and medium-sized enterprises. When they lend, it's to the very big banks.

The very big firms now are sitting on a pile of cash. It's the small firms that lack the money, and the small firms can't get the loans, because they turn to the local, smaller banks, and in the mind-set of Wall Street, these aren't systemically significant. But you add up a lot of small banks and you have something that is systemically significant, at least to Americans who want a job.

By focusing on the big banks and not on the little ones, hundreds of these little banks have gone bankrupt. Hundreds more are in a precarious position. Lending is constrained, and inevitably that's going to impair the recovery of the American economy. ...

So should Bear have been let go? Should Lehman have been let go, but also in a smarter way?

What we did with Bear is we kept it alive but within JPMorgan. That was a case where we took the position of preserving the institution but not the shareholders and the bondholders.

But the way we did it was not transparent. The cost to the taxpayers almost surely was greater than was necessary. And I think there's a very heavy cost to our democracy when we don't do things in a transparent way.

In the case of Lehman Brothers, I think we should have followed the same kind of thing, save the institution but not save the shareholders, not save the bondholders.

And this inconsistent pattern -- AIG we should have done the same thing. When it came to the CDSs, part of bankruptcy is they wouldn't have been honored. They would have gone with everybody else. And if that put Goldman Sachs into bankruptcy, well that's part of the cost of letting the shareholders and the bondholders pay the price. It would not have gone into bankruptcy; it would have only meant the shareholders would have lost and the bondholders would have become the new shareholders.

Same thing in Citibank: If we hadn't rescued Citibank, there was enough long-term debt to have kept it going. It's only the shareholders would have lost and the bondholders would have become the new shareholders.

People will argue that if you had done that, if you had let all these things go in that way, then credit would have dried up immediately everywhere, that banking systems around the world would have stalled to a stop, that economies would crumble.

There is no evidence of that. The institutions would have been preserved, and in fact they would have had more capital, more equity if we had turned all of the debt into equity, over $300 billion in the case of Citibank. That's more money than the U.S. taxpayer put in.

It's an example of the kind of scare tactics that Wall Street has used repeatedly to get the money to hold up the American taxpayers, to hold up taxpayers in other Western governments. ...

You did advise early on. You were close to some of the major players. Why did they stop coming to you? Did you feel they were less interested in your input?

Part of this is understandable. When you're in the rush of making decisions -- and so many had to be made in such a short period of time -- there's a natural difficulty of reaching out beyond your inner circle.

On the other hand, from what one can gather, even people who were more formally in the structure, like Paul Volcker, were not brought in.

One interpretation is ... that the White House was much more interested in having well-defined and narrower set of views, get their position well established, and then open up slightly to other voices, but basically after the decision had been made. ...

... Let's talk about Dodd-Frank [Wall Street Reform and Consumer Protection Act]. ... Geithner and Summers are the ones that wrote the original legislation, as opposed to delegating it to Congress, like they did with the stimulus and healthcare. Why is that? And is this bill that was put forward aggressive enough? ...

It's very clear that the Dodd-Frank bill, which was stronger in some ways than the administration's original proposal, does not go far enough, and I think there's almost unanimity among the economics profession on this.

Two issues: One is the "too big to fail" banks. They're still too big to fail. They're even bigger, because part of the process of dealing with the crisis was to consolidate the banks. ...

The second issue is the non-transparent derivatives. [Sen.] Blanche Lincoln's [D-Ark.] committee regulates derivatives, reported out a bill that said that no FDIC-insured institution should be engaged in writing these derivatives. Makes absolute sense. Why should taxpayers be involved in this gambling instrument?

We're not clear whether derivatives ought to be viewed as insurance or gambling. If it's insurance, it should be regulated by state regulators; if it's gambling, it should be regulated by gambling authorities. But neither are banking.

Geithner and Bernanke opposed. Very interesting. Two of the regional presidents of the Fed said this was absolutely essential, wrote a very strong letter.

Bernanke and Geithner won, or to put it more accurately, the American people lost and the New York banks, the derivative-writing banks won, and we are now in a situation where we don't know our exposure to a lot of the risks. ...

They say there's now an ability to, in an organized fashion, dissemble a "too big to fail" bank, that's in the bill. ...

There was what was called resolution authority and living wills, plans for an orderly dissolution.

Two problems with that: One is that the living will describes what you would do in normal times, but in crises, your plan to sell off this asset or that asset or dissolve may not work because there's no buyer on the other side. The markets can actually just disappear. So what does it mean to have a living will when the markets can go into paralysis exactly when you need them?

Even more important was we didn't use the full legal authority before the crisis. The Fed had authority to regulate mortgages, didn't use that authority. The banks scared the American people. They put a gun at their head and said if you don't give us money, we're going to collapse and you'll be sorry, and America blinked. The banks, I think, would do it again.

So even though there's authority to resolve and almost a commitment to resolve, none of us are really sure that it will actually happen if the banks are really too big to fail. ...

Would Congress and would America allow them to bail out the banks again? Is there the political will in this country to allow them to do that again?

... I think there probably isn't. ...

... March 27, [2009] is the famous meeting where the ... CEOs go down to the White House and Obama basically says: "I'm the only one between you and the pitchforks." The bankers go away thinking that they're in danger, they don't know what he's going to do, and they end up coming out realizing that lo and behold, he's going to support us. He's asking for lending, but he's not going to force us to do it. He's asking for control of compensation, but it's all voluntary. What's the importance of that moment and how it defines what the philosophy of this administration was?

It was a clear signal that ... there would be basically business as usual, with a little bit of pressure of social responsibility. You might call it "do the right thing."

Why we would expect the bankers, who had not done the right thing for so long, to suddenly reform wasn't clear. And what happened in the subsequent period has not given us a lot of confidence.

But I think in the months preceding, most of what had been said suggested that he didn't want to roil the markets. He didn't want to disturb the banks. He wanted them on their side so that things were as calm as possible. ...

Geithner's the last man standing. A lot of the folks from the economic team have left or were pushed out. What does that say to you?

It certainly suggests that there's a working relationship between the president and the secretary of Treasury, but it is also very consistent with the view of the president wanting to keep markets calm. Having found a secretary of Treasury that has developed a relationship with the banking system, given them most of what they wanted, and the economy still not recovered, one could understand that one wouldn't want to disturb the financial markets at this juncture. ...

... Oct. 13, 2008 was the original meeting at the Treasury where [then-Treasury Secretary Hank] Paulson hands out the billions of dollars to all the different banks. ... Why couldn't they [agree] that a certain percentage of this was going to go to lending? ...

The so-called injection of capital that occurred in October 2008 had many strange things about it that I think could never be justified. They should have put conditions on the money that they were putting in. They could have said: Anybody who receives money can't pay out bonuses, has to use a fraction of this money for lending to small and medium-sized enterprises.

But there were other peculiar things about this. They said that all the banks had to take it whether they wanted it or not. And the reason they said that was they didn't want to signal that any bank was in particularly dire straits relative to others.

Now I thought we had an economic system where we have capital market discipline. Capital markets are supposed to make judgments about ... what's a good bank and what's not.

How do you make a judgment if you don't have information? And if the regulator has information that says you're about to go bankrupt, isn't that relevant to the capital markets? ...

[Former Wells Fargo Chair Richard] Kovacevich's point of view was he didn't want the money and he didn't think he should take the money because his bank didn't need the money. Do you have some sort of sentiment about that philosophy that he was pronouncing at that point?

... Unless you have an administration that's willing to be forceful with the "too big to fail" institutions, you don't have a real market economy. You don't have a level playing field. You don't have anything that resembles a market.

He may have been, in a sense, bluffing, saying: I don't need the money now. But by the way, I know that I'm too big to fail, and in three months' time if the markets turn out bad, I'll come back to you, but on my terms.

If we had an administration that had said: Take the money now, and if you don't take the money now under these terms, if you need to come back to us in six months' time, the terms are going to be very different, ... I suspect he would have taken it.

... Overall, how do you rate the decisions by the administration, by Geithner's Treasury Department and Bernanke's Fed?

If you judge the bailout by the fact that the banking system has survived, most of it, and that it's back paying bonuses, then you'd say it was a success.

If you judge the bailout on the criteria of has the banking system returned to lending, has the American economy been returned to health, has the problem of "too big to fail" banks been resolved, has the problem of non-transparency been resolved, you have to say we failed.

If you ask the question is the problem of moral hazard worse, you have to say we failed even more. Has the problem of the undermining of our democratic processes [been rescued]? You have to say we failed. ...

Let's talk about why Occupy Wall Street has captured so many people's imaginations.

I think it reflected a sense of dissatisfaction with the way our economic system had worked, but [it] was more than that.

After the crisis in 2008, Americans and people in other countries assumed, hoped, that the political system would rectify the problem, would figure out what was wrong and deal with it.

But then they saw that not only wasn't our economic system working, neither was our political system. What they saw was something that was viewed to be totally unfair. ...

There's a slogan that they chant: "They got bailed out, we got sold out."

I think that's to a large extent true, and you see it both in labor markets and housing markets. What I found so disturbing was many people in the administration were people who believe fundamentally in markets working well. ...

Give me a sketch of income inequality and where we stand today.

The level of income inequality is at a level higher than it's been any time in the recent past. You'd have to go back before the Great Depression.

You see the problem in every part of our income distribution. The top 1 percent garners for itself around 20 percent, one-fifth of all the income of our country. Some years it's even more, 23 percent.

The top one-tenth of 1 percent garners for itself a very large fraction of the on what goes to the top 1 percent. The top 1 percent of wealth holders have somewhere around 40 percent of all the wealth in the United States. The recession made all these things worse.

The average American, most of his wealth was in housing. Housing prices went down, and they lost a lot of what they got. Yes, the people at the top saw the stock market go down, and for a moment things weren't so good, but then it largely recovered.

Government policies were very active trying to recover the stock market. Very ineffective in getting the housing market to recover.

So the 1 percent got their money back.

And the rest of the country suffered. ... We have a middle class that's being eviscerated. Middle class jobs are disappearing. Jobs that used to be very good, like autoworkers, have seen their wages gone down by half, two-thirds. The numbers of people that are within 50 percent of the median, the person right in the middle, that number has gotten smaller. There are more people at the extremes. ...

What was the set of deregulations that particularly led to the problems that we have now?

... First, in the aftermath of the Great Depressions and the lessons we had to learn, there was a division between investment banks that took money from rich people able to bear risk and invest in high-return, risky activities, and commercial banks that took money from ordinary individuals, supposed to invest it conservatively, lend it to help create new businesses, expand ordinary businesses.

Two very different kinds of financial institutions -- and there were a whole variety of reasons for that separation, but the most important was we'd learned that when you bring these two things together, you have conflicts of interest, very bad behavior. ...

The second aspect was not so much deregulation but not adjusting the regulatory structure to the changing needs of a increasingly more complex financial system. So the other big mistake was that in the '90s these complicated financial products called derivatives -- things that Warren Buffett referred to as "financial weapons of mass destruction" -- had started originating. ...

The repeal of this division between investment banks and commercial banks led to [several] problems. First, the cultures of the two were very different. The investment banks were undertaking risky activities for rich people. The others wanted to be conservative. When you brought the two together, the mentality that prevailed was the risk-taking mentality.

So what we had was banks like Citibank, that used to be a commercial bank, buying all these risky CDOs [collateralized debt obligations] and other risky products which blew up, requiring again a massive bailout. ...

The second [problem] is you have conflicts of interest. When banks are both issuing new securities and lending, you have all kinds of risk to our financial system. You can lend to a company to make sure that it looks good, and you want it to look good because you just issued the shares. ...

The final problem was called "too big to fail," that when you allow these banks to get together you got bigger and bigger banks. ... If you let them fail, it has an enormous effect on our financial and therefore our economic system. ...

Underlying the whole crisis in 2008 was the number of ... subprime mortgages. How did innovative financial instruments or whatever you want to call them -- credit default swaps, collateralized debt obligations -- what did they contribute to the problems that we faced?

... It used to be that when you wanted to get a mortgage you would go to your bank. The bank would lend you the money. It would make a judgment about whether you could repay, because it would know that if you couldn't repay it would bear the losses.

But then there was this idea called securitization that arose that said they would originate the mortgage but then sell it to someone else, and that other person would have to bear the losses. But the idea was you put a lot of mortgages together and the probability that a very large fraction of them would have a problem at the same time was very low.

Except the reasoning behind this was flawed, because if there was a bubble, prices went up, then they would all go down. They would all have a problem. If the economy went into recession, many people would have a hard time repaying their mortgages.

So the underlying assumption that large numbers would [not] simultaneously be affected was just wrong. ...

In fact it was insured by the fact that they were forever putting more money into the housing market.

[The] securitization process itself is what fed the bubble, which in fact made it inevitable almost that there would be this problem of a large fraction of them collapsing, going into default at the same time. So they created the problem that actually brought them down. …

You needed to have the investment banks that would put these together, ... the CDOs and complex products. Now if you had thousands of mortgages in a product, no one could inspect to see whether each mortgage was a good one. It was all based on trust. ... So you created a system in which incentives were such as to make sure that the system failed.

Then you had the rating agencies being part of ... I would almost say a conspiracy. The rating agencies would look at these bundles -- they obviously couldn't look at each of the mortgages -- and they would say if you put together large numbers of mortgages that ought to have been graded each F, by putting them together they blessed them as if it was financial alchemy that converted lead into gold. In this case, it converted F-rated subprime mortgages into an A-rated security.

Why was that important? Because then you could sell this to a pension fund or to lots of other people who could only buy A-rated securities.

Then you had more money to send back to the originator to send back out and make more mortgages.

Exactly. And then make the price go high, and they'd look at this and say aren't we brilliant?

What was the role of the credit default swap in this machine?

The credit default swap became an important instrument because you could feel that you were actually insured against the loss, except for one problem: The insurance company was not really a good insurance company. It was gambling, so it didn't have the resource to back the insurance which it was riding. ...

The credit default swaps also had other functions in that they allowed, and CDOs allowed, the banks to do this outside of the view of regulators, even if one was assuming that the regulators would have been on top of it. ...

Lack of transparency and lack on understanding of what was going on was absolutely essential to the blowing up of our financial system. The regulators took at face value the insurance that was being written by AIG. AIG was effectively allowing the banks to print money willy-nilly. …

Did the regulators know generally where the credit default swaps were in the system, in other words, where the counterparty risk lay?

The way these over-the-counter credit default swap markets work is they are very non-transparent. In general, market participants could not see what was going on.

So if I were buying a share of Bank America or Citibank, there'd be absolutely no way that I could ascertain what was going on. There was no sense of market discipline, which is essential for the working of a market economy, no way that market discipline could be exercised.

We have really undermined the basic principles of capitalism, of a market economy. The regulators had the authority to demand that information, so in principle, they could have looked underneath this non-transparency. They could have said: You bought this insurance, but how do we know it's insurance? You claim it's insurance, but how do we know this company that you claim you have insurance from will be able to pay off?

In other words, is the insurer going to be solvent when there's a calamity?

Exactly, and that's why every state has regulations to make sure that insurance companies can pay off the insurance. It's a very regulated industry, because there's a long history of insurance companies taking advantage of people. ...

... What you're saying in the case of credit default swaps is they were in an unregulated space, so nobody was checking [whether] the buyers or sellers of these things would be solvent in the event of a calamity?

Exactly, and was a real dereliction of responsibility of the Federal Reserve, particularly Federal Reserve in New York, which is where a lot of this was going on.

How do you account for the fact that a lot of smart people made this miscalculation?

I think it has to be self-interest. They were captured by the financial market.

And making a lot of money?

Those in the financial sector were making a lot of money.

The regulators don't make any more money.

The regulators were what we call "cognitively captured." They spent all the time with the bankers. The bankers said: There's a wonderful party going on. Don't spoil it. We're smart people. Trust us.

You see that mentality reflected so strongly in the testimony that Alan Greenspan gave to Congress where he said: "There was a flaw in my reasoning. I thought that the banks would manage their risk better, and obviously they didn't."

But I think actually that that position was untenable and irresponsible, because you don't, as a regulator, just trust. Your job is to make sure that if they don't do their job, the consequences for our banking system, for our whole economy, aren't a disaster. ...

... Do we need so many banks? We have 7,500 banks in this country.

... The real point is that lending to small business is local. You have that local information. The big banks don't do a good job of having that local information to determine who is in this community that is good and who is bad. ... So having small banks is a good thing, but you have to regulate them just like you have to regulate the big banks.

One of the other phenomena we have witnessed is "vulture capitalists" going out and buying regional and community banks. Is that a good thing? ...

It depends on what the motive is to buy these banks.

Right after TARP got created, many people bought a bank because it allowed them to tap into money from the Federal Reserve, from TARP. So the government was giving away money through the banking system, and buying on the cheap, a banking license was a license to get that money.

Because you could buy it and flip it?

No, you could buy it and get access to TARP money or Federal Reserve money. Federal Reserve was lending money at a close to zero interest rate. You didn't have to be a genius to take zero interest rate money and put it in a bond, yielding a higher interest rate in relatively safe company and make money. ...

Is that bad for the communities?

It depends on what the bank does with the money.

So if they take it and invest it offshore somewhere, it doesn't do much for the community?

Exactly. If they take the money and lend it to small businesses in the community, then it helps uplift the community. But typically when a hedge fund is buying the bank, it's not bringing expertise in small business lending. It's bringing expertise in speculation, and that's probably not good for the community.

How do we think about what's happened in Europe and where we are today?

I think there were two pieces in the way in which Europe has been affected by what's going on in America.

One is that Europe bought a lot of our toxic mortgages. Some estimates put it at close to 40 percent. ...

Why did Europeans buy so many toxic mortgages?

They bought so many toxic mortgages for a little bit of the same reason as American banks. They were taken up in the deregulation movement in the same way that America was. These toxic mortgages yielded a little higher return. The rating agency says these are fantastic, AAA.

A basic law in economics is there's no such thing as a free lunch, but they thought they'd found something that gave them a higher return without greater risk. ...

The second thing of course is that when the American economy went down, it had global consequences. You have financial troubles and real troubles on both sides of the Atlantic, global economic downturn. But in Europe, there is a stronger social protection system -- better unemployment insurance, sometimes called a safety net, better health insurance -- so that when the economy went down, the deficit, the government went up. ...

Does austerity by its imposition ensure these countries are going to sink deeper into debt and deeper into recession and more likely default?

Almost surely austerity will mean that these countries' economic position is going to get worse. ...

Why not just break it up and let these countries go back to their own currencies and forget the euro? ...

The process of going from here to there is going to be very painful. Argentina tells us a little bit about what might happen. When Argentina left this economic arrangement where its currency was fixed to the dollar, it caused an enormous amount of trauma. ... Unemployment went up in excess of 20 percent. It was really a very difficult, traumatic problem for the country. ...

In the case of the break of the euro, the consequences in the short-run are likely to be even more traumatic. Contracts have to be rewritten, reinterpreted. There will be legal disputes of enormous magnitude.

But I think for many of the countries, if they manage their economy correctly, they will work their way through this problem and it will provide the basis of a longer-term economic growth. ...

And what will the consequence be for the United States?

... The consequences for our financial system are very hard to determine, partly because our financial system is very nontransparent, very interlinked with that of Europe. ...

You can see the volatility in bank share prices as the travails of Europe go on that say the markets are really very worried about the impact on our financial system. An economic downturn of the magnitude that might occur in Europe will inevitably have a very serious impact on our economy.

Our economy is not yet out of the woods. In fact the CBO [Congressional Budget Office] study that recently was published suggests that we will not be back to full employment, to fully realizing our potential, until 2018. And that's assuming no European crisis. If there's a European crisis, that becomes a rosy scenario. ...