Anger

People are angry at the banks. People feel like the banks got us into this trouble, and you say it's the regulators. ...

It's not just the regulators, and it's not just the banks. There's an underlying sociological phenomenon which is what really got us to think there would be a crisis, and that's this: Middle-class America has been totally left behind for the last 15 or so years. Median income, adjusted for inflation, has gone nowhere.

But everybody wants to live a little bit better each year than they did before, and the solution that American families found to that dilemma was to borrow more. Along about '04 and '05, which is when the securitization of mortgages really took off, there would've otherwise been a big problem with other forms of credit.

What happened was, what would've been a medium-sized problem then got rolled into a gigantic problem because of the securitizations, the pop up in real estate values, and the change in loan-to-value.

People didn't run up credit card debt, they just used their houses as ATMs.

Yeah, and there were literally dozens and dozens of instances in each of the banks we bought where what was the reason the guy took out a mortgage? He wanted to buy a new car. Or he wanted to do something else, buy a boat, buy a vacation home, take a trip. Those are strange reasons for putting a mortgage on your house, but the people didn't feel they had an alternative.

And they were marketed that.

They were marketed that way, but they were receptive because it's natural to want to live a little better each year than you did the year before.

What got us going on the subprime thing was we said, wait a minute. House prices can't go up forever. They've already been spiking way above the long-term trend.

Second, the family indebtedness is getting out of proportion. Then with all these teaser rates, that was an accident waiting to happen. That's again something where government could've stepped in.

... 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.

There's anger in the streets, and there's this feeling that Wall Street was bailed out but Main Street wasn't. What was the attitude about how do we deal with this perception? And ... they weren't dealing with one of the hearts of the issue, which is the problem of housing and the mortgages under water. What is the debate within the halls of the Treasury building and White House?

There was no question it was incredibly frustrating that so shortly after repaying the government that compensation started going up as quickly as it did. I thought that showed poor judgment on the part of the banks. ...

We did not bail out Wall Street and leave Main Street hanging. Everything we did, we did with the purpose of helping Main Street, we did with the purpose of preventing the economy from turning into the second Great Depression. And some of the things that we had to do were terribly unpopular, and our predecessors, terribly unpopular. We knew it was going to be, but it was necessary.

We all had that recent experience with Lehman Brothers, where on the day that event happened, everyone's 401(k), everyone's IRA, businesspeople saw their businesses freeze; home values went tumbling. Every citizen of this country was deeply, negatively impacted by that event.

So if you're going to take steps to prevent that kind of pain for the country, the unfortunate fact is that you have to do certain things which are going to stabilize the financial institutions. If there had been a way to prevent the economic pain and the pain to households and businesses without taking these steps to stabilize those institutions, we would have done it. No one could figure out a way to do that.

Let's begin with Occupy Wall Street. What impact do you think they're having and [what] do you feel that they will spawn these ideas into the next few years?

I really don't think Occupy Wall Street is having much of an impact, and I'm not sure that it will. …

One of the problems is that the Occupy Wall Street movement tapped into a vein of emotion that just wasn't going to last forever. It lasted for a brief period of time and it didn't result in a change in policy. I think Wall Street was very effective in waiting out that surge of emotion. And so, I'm not optimistic that there will be changes in the long term.

But haven't they tapped into something fundamental, that 1 percent of this country are really going to continue to exploit and benefit from the wealth of this country, and 99 percent will be stuck?

I think that is true and it is fundamental. But what also is fundamental is that the power structure of the way that we're governed is set up to benefit those 1 percent. And the way that campaigns are financed, the way that money is spent on lobbying and politicians is such that the 99 percent really doesn't have much of a chance, particularly when it comes to Wall Street. There just isn't an aggregation of interests that has been able to match the really focused, concentrated efforts by Wall Street to lobby and influence really both political parties.

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. ...

The question of bonuses and compensation. This has a lot of people, rightly perhaps, very upset. How do bankers justify these bonuses in your view?

To some extent the bonuses are justified and can be justified if they reflect someone's contribution to the company.

The problem is with the incentive compensation schemes -- which I think the regulators have focused on like a laser beam in the last couple years -- which encourage immediate profitability without regard to longer-tail or even shorter-tail risk.

I would argue that the system was flawed in the sense of not tying compensation to risk and ... not having clawback provisions. ...

Tell me about your theories then on how financialization has sort of changed everything.

... Money originally was something very simple. It was a mechanism for exchange. So I gave you money, you gave me some real things like food, water, or whatever. ...

Somehow in the last 30 or 40 years, ... what we did was we take money but use it in a different way. Money in the form of debt in particular we used as a way to drive economies. And it's a different level. So individual lives, we basically borrow money to buy things which we can't afford. And that whole rise of debt was very much a phenomenon from the '70s onward. ...

The second element about that, which is really quite important, is if you actually look at the way we use money, speculation and debt certainly drive the economy on an individual level, but on a global level, countries get financialized as well. ...

So they start to drive countries in terms of as an industry. But most importantly, it also looks at how trade takes place. There's quite a lot of controversy in the relationship between China and America, but one essential element of that is a financial element. China sends goods to the United States, but the United States doesn't have money to pay for them.

What happens is when the payment is made, China lends the money back to the United States in the form of buying government bonds and other forms of debt. The entire cycle is very much like what we call vendor financing, where the seller of the goods actually finances the purchase.

That's happened between America and China, but it's also happened in Europe between Germany and ... the Southern European countries. That's essentially a part of what we do. Every transaction now has a financial element. ...

That's how entirely the world changed, and finance started to become a way to drive economies. And there's nothing wrong with debt. Within limits, debts are very sensible, because all we do with debt is basically accelerate consumption, so instead of saving over a period of time to have the money to buy something, we buy it today and pay it back over time.

But essentially that depends on two criteria which are crucial. One, when we borrowed the money, we need to have the capacity to pay it back. In other words, we have to have the income to pay it back. And the second is that if we bought something with it, that has value, and that value is maintained over time relative to the value of debt. Those two rules are pretty simple, basic rules of lending.

Fundamentally we've forgot all about that, because what was happening as we were accelerating consumption because we could borrow it to buy today, the economy kept growing; the prices of everything like houses and assets kept going up. So we somehow mysteriously assumed that we didn't need to worry about how to repay this debt, because what we'd bought with it would get more valuable and we could select to pay it off, except it was just a Ponzi game, because the game would go on and prices would go on as long as we could keep borrowing to pay that back.

Basically we were borrowing from the future, and unfortunately, there is no more future. We are at the future, and we don't have the income to pay back the debt. The things we bought with the debt are no longer worth as much as the debt, and that's a fundamental problem of financialization. ...

And one of the fundamental aspects of financialization was it sort of propelled a small group of people into positions of enormous power and authority: bankers. You know, when I started life in banking, banking wasn't exactly a glamorous profession. It was basically a simple profession, very much like being an executive at an electrical company or some sort of utility. You provided some sort of essential services.

But then as finance became crucial to driving the economy, banking became a much more esteemed profession and much better-rewarded profession. But bankers also gained enormously in terms of power. ... They became almost the only people with the knowledge and the power to drive the economy.

And to some extent we believed in that, and it was quite an extraordinary shift from what I call real engineering to financial engineering. We originally drove the economy by real businesses, you know -- productivity, innovation, all those types of things which we understood.

We now somehow believe that finance sort of drives everything. And curiously, in the crisis, our answer to this was not to go back for financial engineering to real engineering. It was more financial engineering. So we have different money games of printing money, quantitative easing and so forth.

It's as if our taste for finance has completely changed the way we think about the world. There is no way for us to seemingly go back. And we've got this strange economy. Eisenhower talked in the 1950s about the military-industrial complex. In the last 20 years, we've created the governmental-finance complex in running the economy. And fundamentally, this crisis was an opportunity, in my view, to change that, to revisit that question, ask questions like, how much debt is good? What is the role of finance in our economy? What is the role of banks in our economy? Do we want them to be more like utilities, matching borrowers and savers, providing safe payments mechanisms, providing rudimentary risk management tools?

It was a historical opportunity to revisit that, instead of which we haven't revisited any of that. Basically we continue to go down this path of assuming that financialization is the answer to everything, which in my judgment it's not. But the problem is, the only way we can do that is we have to accept that much of our growth is being driven by this financialization.

All the evidence is that roughly half the growth in the United States over the 10 years to 2007, 2008 was driven by debt. And that's probably true of many countries in the world; certainly in Europe we're seeing the same thing. We have to accept lower growth; we have to accept lower living standards; and nobody, it seems, can confront that reality. And we lack the political leadership to do that.

But I suspect it's very hard. And Fyodor Dostoyevsky in The Possessed has this wonderful line, which I always recall: "It's very difficult to change gods." And in the modern age, our god was finance, except it's turned out to be a very cruel and destructive god.

... There are various hearings that took place in 2010 on [Capitol] Hill. Many bankers were brought in and read the riot act. How has Wall Street reacted to that?

I think Wall Street reacted with a mixture of both shock that they are seen as such villains, but in a number of the senior bankers who really think this through, after the initial shock wears off, begin to understand what the causes of the indignation, the outrage are. ...

People are angry at the whole financial system. They call it Wall Street, and they hold Wall Street responsible for engaging in risky trading, in building up lots of leverage, and then taking us all down.

They do. It's a widespread view.

It's not accurate?

I don't believe that the major banks can be held solely responsible for what happened. They played a role. So did housing policy in this country, which made no sense. So did various governmental policies, which in retrospect at least were ill-thought-through.

You don't wind up with a crisis of this magnitude because of one subset of the economy. There had to be many contributing pieces. ...

We've just come through another year and seen bonus pools up, lots of compensation for bankers. People are bitter. They're not seeing any results on Main Street, but yet the bankers seem to be doing just fine and making huge bonuses. And those bonuses don't do anything to quell the risky behavior of the past.

... The major point is that in large part due to the banking agencies, but also due in some part to self-discipline, these bonuses now are much more closely tied to risk, and in particular clawback arrangements, whereby if it turns out that the bonuses were earned and the work turns out after a year or two or three, to have been less profitable or actually incurred losses, there can be clawbacks of the bonuses.

There is much more attention being paid to the relationship between the risk incurred and the size of the bonus. I'm sure it is far from perfect, but I think there are major efforts being made.

Why not have a compensation system that gets rid of bonuses and just ties people's income to their performance?

The irony here is that's the way it largely used to be, and Congress in its infinite wisdom decided that if you did it that way, it would be subject to a much higher tax level. That really is what led to the bonus system being a far greater component of total compensation. ...

... Right now, we have people camping out all over the country proclaiming themselves the 99 percent. You're part of the 1 percent, clearly. Who should we be helping here?

I think the 99 percent need help, and I'll tell you what my biggest worry is now. ... Our educational system is failing the middle class and lower middle class and below people. The only way for people to close gaps and to, more importantly, bring the lower people up, is education. ...

We're moving into a world that's more and more complicated, more and more technologically oriented. Our kids are falling farther and farther behind. That's the real tragedy in what's going on in America. ...

Are you sympathetic with Occupy Wall Street?

I'm very sympathetic with the causes of it. I think it's extreme hyperbole to blame Wall Street for all the ills of the world, but I'm sympathetic with what caused it, which is they are in a warp that they can't really get out of very effectively. But I lay that at the feet of the educational system. ...

The Occupy Wall Street movement is a scream for fairness. What they see is a bonus system, high levels of compensation in the financial industry, and a financial collapse, and the epicenter of that was Wall Street.

I understand that they should be angry with parts of Wall Street, but I think the politicians have done a very clever job deflecting the share of the blame that should belong to them over to be just Wall Street. That's the part that I object to.

Also, if you look at the signs the Occupy Wall Street people are carrying, a lot of them say, "I need a job." That's what they really want, and that's what they deserve. But if you're not qualified to get a job because your school system has failed you, that's not a Wall Street creature. Wall Street didn't wreck the school system. ...