Deregulation

You've been quoted as saying that you thought maybe to some extent the Lehman lesson was overlearned. What'd you mean by that?

I think one of the mistakes that policy-makers can make when it comes to financial market oversight is to worry that these institutions are so fragile that if we put down any rules of the road, they'll go to Europe, or they'll go to China, or they'll shut their doors and that'll be it. And that's a kind of overlearning this Lehman lesson, such that you treat these folks with kid gloves.

And ever since Adam Smith, the founder of modern capitalism, it's been widely known -- and I think we've forgotten this, but it should be widely known -- that financial markets are actually inherently unstable. And if you believe that they can police themselves, which was a very much Greenspanian kind of belief that started to dominate over the last few decades, you're going to be right back where we were, with the same kind of credit bust-and-boom cycle that have taken this economy down more than once now.

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. ...

You were close to some of the members of the economic team around Obama during the [2007-8] campaign. ... The housing bubble had basically burst already in 2007. What was the conversation within the campaign? ...

There were several problems going on simultaneously. ... One problem that no one could ignore was that we had gone into recession [in] December 2007, and unemployment was increasing. A question was, how deep would the downturn be? How [high] would the unemployment be? ...

What had precipitated the recession was the breaking of the housing bubble. ... In the years preceding the breaking of the housing bubble, a disproportionate source of growth in the United States was related to the real estate sector. Forty percent of all investments were in real estate.

But even more, Americans were using their house as a piggybank. In one year alone, almost $1 trillion was taken out in what were called mortgage equity withdrawals, and that was sustaining consumption. Savings rate had gone down to zero. It was clearly unsustainable.

And if the American household couldn't consume at that level, if they went back to what you might call a more rational, normal level of savings -- going from zero to 5 percent GDP or something like that -- that would be an enormous deflationary pressure on the economy. The economy would be pulled back.

So the housing sector was critical both for the economy and for the well being of most Americans. If the housing didn't recover, ... millions of Americans would lose their home, which turned out to be the case. ...

There was a third problem, and that was finance. The financial system had been excessively deregulated. ...

In the early days of the crisis, it was very clear that those in the financial sector, including those that were advising the president, wanted to pretend that there was just a little bit of a perturbation in the housing market. It had gone down; it'll go up again. It was just a temporary aberration.

But those of us who looked at the data, people like Bob Shiller who studied the housing market, said no, there'd been a bubble. You've been living in fantasyland, and the price declines that you've seen are not going to be reversed any time soon.

Unfortunately it appears as if the Obama administration paid more attention to those who were the dreamers that the market would come back [than] to the realists who said no there'd been a bubble, and you've done some pretty bad lending, and now you're going to have to face the consequences.

Now we're four years after the breaking of the bubble, and housing prices are still 30 percent, 35 percent below what they were at the peak. Some places 50 percent. In some areas housing prices are continuing to fall. So that was a very fundamental misjudgment that had implications for everything that went on after.

One of the implications was they never put together a program to address the Americans who were losing their homes. They never did very much to stop the foreclosure movement. A small program, $75 billion was set aside, $2 billion was spent to help homeowners. It was clear that it wasn't given the priority. ...

That led to what?

That had both economic and political consequences. The political consequences were that a very large fraction of America came to the view that the Obama administration was on the side of the bankers and not on their side. How can you give all that money to the bankers who caused the crisis and not help a lot of ordinary citizens who were the innocent victims of predatory lending, of all these shenanigans? ...

Many of these homebuyers were first-time homebuyers. They took out the mortgages on the advice of the mortgage brokers, of the people in the financial sector. They sold them these financial products that exploded.

Now you could come to one of two conclusions: Either that the financial sector didn't know what it was doing, or the financial sector was out to maximize transaction cost, maximize their profits, and exploit the innocent homebuyers.

Which side do you fall on?

Both. I think actually they didn't really understand risk. We've seen that over and over again. They called themselves experts on risk; they didn't understand it.

But the thing is, they're profit-making organizations. They were out to maximize profits, and they saw some people who they could exploit. ...

... 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. ...

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. ...

What were the things that were being deregulated? ...

The first thing that was deregulated was banks' ability to borrow, what rates they paid, what they could lend, at what rates they could lend. ... Banks became much freer in terms of what they could do. ...

But part of that also was two or three controls. Banks generally have a small amount of shareholders' money, and they borrow the rest. And traditionally, because banks make loans which could go bad, they had to hold a large amount of share capital. One of the crucial things that happened was that amount of share capital has gradually reduced.

Part of this was interestingly a sort of feedback loop from deregulating markets and introducing new instruments which we call derivatives or risk management techniques, because people felt with these instruments, because you could manage risk, you didn't need to have these buffers to the same extent that you did. Because you could take risks but then distribute it to other people, you didn't need these buffers.

And that's what actually happened, is the amount of capital that banks had to hold got less, and so banks became able to create more and more credit. They could make more loans. ...

Also new products proliferated. There were obviously new types of loans, things like credit cards to individuals, new types of mortgages. People loaned differently. You could also borrow against the equity in your house. ... In this world, borrowing became much more acceptable, much more available.

Then there was these much more esoteric products that we introduced, things like swaps, options, futures, securitization, all sorts of products which were either about managing risk or creating new investment opportunities for investors, where traditionally they could only buy shares or government bonds or a very limited range of assets.

This was almost revolutionary, and it was almost like a new frontier in finance when all these things were happening simultaneously. It was a very exciting time to be involved in finance because there was no rulebook, and as we worked through that period of history, we were almost making the rules as we went along. ...

Describe [the] world of banking in the mid-70s. Is it still sort of George Bailey banking? ...

... The first image I got was when I went to work the first day, the guy I used to work for actually, when he got to work, took off his shoes and put on slippers, and he took off his coat and put on this jumper or sweater. It was a very homely affair, and we were highly regulated.

Basically the government told us or the central bank told us what rate we could pay our depositors and even who we could lend to and what rate we could charge. So it was a very limited world where our role was really like a social role.

We took deposits, made loans on the other side. We facilitated payment mechanisms. We did a little bit of trading, but it was tiny because there were limits on what we could trade and how much risk we could take. So it was almost a social utility is the way I saw it. ...

Gradually and very quickly all of those controls fell away, and so what we saw was a much more deregulated commercial business with new products, basically a completely new world of banking that opened up.

What sparked that change?

I think you've got to go back a little bit in time to the 1970s. The '70s was a period of great difficulty for the global economy. Oil prices rose, ... and we entered a period of quite deep stagnation. There was no growth; there was high unemployment; it was high inflation.

And at the end of the '70s, what happened was there was a change in the political environment with the election of Margaret Thatcher, the conservative leader in Britain. And in the United States, Ronald Reagan came to power [in] 1980, defeating Jimmy Carter. ...

Both Reagan and Margaret Thatcher started to take away controls, and the idea was that if we took away all these controls, the economy would become more vibrant and grow. And part of that was the deregulation of banking, and gradually the increased ability of banks to lend to people who hadn't traditionally qualified for ... loans became almost a catalyst for driving the economy.

I'm not sure anybody sat down in a dark smoky room and plotted this, but as the deregulations went one by one and the economy started to grow, people took this as cause and effect, that this deregulation of the financial system, deregulation of other parts of the economy, was actually generating this growth, increases in living standards and the prosperity. ...

The bottom line on Dodd-Frank is can Washington actually regulate what Wall Street in the end does?

There is a concern that Wall Street will somehow always outflank the regulators. I'm not sure that history sustains that proposition.

When people look at the first part of this century, ... we were really talking about a whole deregulatory environment. So it wasn't that Wall Street could get around regulation; it was that Washington was pulling away from regulation.

In my view, with good regulation, good regulators, it will be extremely difficult for Wall Street to evade, but that has to be comprehensive regulation. We referred earlier to the shadow banking system. You can't have a big segment of the financial system outside of regulatory purview.

What you also need to do is to end a view which is incredibly penny-wise and pound-foolish, and that is to cut the budgets of these regulatory agencies. People don't go into that for the money, but they do need the staff and they do need the resources.

... Looking back at those years, why did we go in that direction so strongly that we put ourselves in this dangerous situation?

It's a terrific question as to why we went to this deregulatory mode. I think it was perhaps hubris that everything had gone so well, and it was a political philosophy for some people. But it was even then difficult to explain and now close to impossible to explain.

... Does Wall Street understand now the need for regulation?

The key leaders on Wall Street do understand the need for regulation, certainly for the right type of regulation, which has to be robust but also enlightened. Regulation for regulation's sake makes no sense.

Dodd-Frank, does it make sense? Will it change anything?

I've always thought that there was both a good Dodd-Frank and a bad Dodd-Frank.

The good Dodd-Frank was the administration's original proposal, which will change things in a number of ways. You will have better capital, better liquidity, better resolution opportunities, some of the systemic risk conductors will be eliminated, a more comprehensive regulatory overview, an office of financial research, many good aspects of Dodd-Frank.

The bad aspects were the add-ons. Whenever you get a piece of legislation like that, it becomes the inevitable Christmas tree to hang all the ornaments on, and there were a number of provisions which I think ultimately will prove to be detrimental. ...

... What's your point of view about Greenspan coming back and apologizing for getting it wrong about deregulation?

... I admire anybody who can admit mistakes, because that's a fairly rare quality. And in retrospect certainly, I think they did get it wrong by letting it go too far.

There was a lot of regulation which made no sense, and therefore cleaning that out was the right thing to do, but I don't think you can have a financial system or economy like we have without any regulation. ...

We went from 1933 until 2008 without a cataclysmic meltdown like we witnessed and went through. The argument is that somehow we had been protected by the Glass-Steagall [Act]. You reject that idea.

I do reject that idea. Let's look at the timing. By the early 1990s, the Federal Reserve had already permitted banks to engage in significant securities activities. By 1997, the last barriers to security activities had been removed. And it seems like if that was the cause, it took an awful long time.

Ten years.

... I really don't think that the removal of those barriers had much to do with the problem. ...

... But isn't it true that ... taking away the regulation since the 1970s, through the Reagan era, all the way up to the repeal of the last vestiges of Glass-Steagall created a culture of risk-taking that we need to get away from?

I think we need always to control risk, to regulate risk. But we also had 750 banks, roughly, fail, which were medium-sized and small banks that had nothing to do with securities activities. They took risk, but risk of a different sort. ...

The question to me is not trying to get risk entirely out of the system, because then you have an unproductive financial system, but it's managing and controlling risk. ...