On this episode of the Capitalisn’t podcast—the last in a three-part series on the 2008–10 financial crisis—hosts Kate Waldock and Luigi Zingales look at recent volatility in the markets and try to predict the cause of the next financial crisis with help from prominent economists Robert Shiller and Lawrence Summers.
Speaker 1: Do you worry about another crisis?
Speaker 2: Well, there will be one some time.
Kate: Hi, I’m Kate Waldock from Georgetown University.
Luigi: And I’m Luigi Zingales at the University of Chicago.
Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.
Luigi: And, most importantly, what isn’t.
Kate: On today’s episode, we’re going to be doing economists’ favorite thing, which is to predict when the next crisis is going to hit.
Luigi: The running joke about economists is that predicting is hard, especially about the future.
Kate: Yeah. In order to minimize the amount of opining that Luigi and I would have to do in this episode, we went out, and we made a couple of calls to prominent scholars who perhaps are better equipped—or at least more willing to talk about—this issue of where the next crisis will come from.
Luigi: We reached out to Bob Shiller, who not only has a Nobel Prize but also has the privilege of having called the recent real-estate bubble before it burst, so he has some claim to fame in terms of predictive ability.
Kate: We also called Larry Summers, who is the former secretary of the treasury of the US, also president emeritus of Harvard, and who’s also spent a lot of time working in the policy world, particularly as a key advisor to Obama during the financial crisis.
Robert Shiller: “Where the Next Crisis Will Come from and Why,” by Robert Shiller. It’s hard enough to answer where previous crises came from, let alone do that for the next crisis. Part of the problem is that the big crises are the result of a confluence of factors. Little fluctuations in the economy become big if 10 or 12 small factors become big and important all at once. So, there is not a good tellable story of the cause. The explanation of the crisis has to take the form of a list of factors.
Many of these factors typically involve new narratives that become contagious and go viral. The concept of a housing bubble went viral starting around 2005, and this eventually crashed the housing market. Nicola Gennaioli and Andrei Shleifer have a brand-new book, A Crisis of Beliefs, that attributes the financial crisis to a change in fundamental beliefs. I would say they are right, but would add that the change in beliefs is mediated by newly viral narratives.
The next crisis is inherently difficult to describe, since there are so many new directions future narratives could take. Combinatorics, working with lists of relevant subjects and words—bubble, bank run, oil crisis, trade war, and on and on—suggest an astronomical number of possible mutations of our existing narratives. These will be experimented with by countless people, and something new and different will emerge as contagious.
Kate: Can I just say that Bob Shiller has the warmest voice of anyone that I’ve ever heard?
Luigi: Can I say that he punted the question a bit?
Kate: I mean, yeah. He didn’t give the most direct answer to the question, but whenever I hear Bob Shiller’s voice, I want him to be my grandpa. I want to make gingerbread for him at Thanksgiving and just listen to him talk around the fireplace. He’s just got such a nice voice. I don’t even know how to make gingerbread. All right.
Luigi: More seriously, there are two, I think, powerful insights here. The first one, which is maybe kind of obvious but important, is that you don’t know where the next crisis is going to come from, because if you knew, you could to some extent avoid it. So, there is this element of unpredictability that’s inherent to a crisis. And—
Kate: Can I just step in there?
Kate: I mean, yes, obviously, that’s true for markets. The market can’t predict a market crisis, because then the crisis would have happened already, but individuals can predict crises just as long as enough people don’t listen to them.
Luigi: Yeah, so it’s possible that somebody might sort of spot it, but it’s hard for the system overall to spot it, because if it does, it does not unfold as a crisis.
Kate: OK, sure.
Luigi: The second important point is that there is an element of irrational beliefs in crises. I think that one of, in my view, limitations that classical economics and the dominant paradigm, until the crisis, are responsible for is to have eliminated completely what in jargon goes as a Hyman Minsky moment, from an economist who died in 1996 who was very much into the history of crises and what causes crises. He was emphasizing the rational component of crises, and, as a result, became a sort of non-grata basically in mainstream economics.
If you go and look at the textbooks of macro until the crisis, nobody was citing Minsky, and today everybody does cite him because of that.
Kate: Yeah. I would characterize it . . . I agree with him, but I think most of the irrationality comes before the crisis. It’s that people get irrationally exuberant about things and then it’s only when they wake up because the system has become so bloated that, actually, that’s when they become rational, and that’s what sets off the crisis. I think it’s two sides of the same coin.
Luigi: I actually disagree here. I think that there is a moment of rationalizing the crisis itself. Kindleberger, who cites Minsky, was an economics professor at MIT and wrote a famous book about manias, panics, and crashes. Actually, he uses a German term, which is Tür schlosspanic, which means “door shut” panic. Basically, what happens in a . . .
Kate: I love the German terms.
Luigi: In a room when you try to get out, and you fear that the door is going to close, and then everybody panics. I think that represents very well what happens at the peak of a crisis. Another description I heard, which I think is very funny, is the Minsky moment. It’s like Wile E. Coyote and the Road Runner when they chase each other, and at some point they go off the cliff, and they keep going for a little while off the cliff, until they realize they are off the cliff. Then, they start to precipitate. I think that crises have this element that you are . . . Of the euphoria before, the euphoria that pushes you off the cliff, and then there is the moment you realize you’re off the cliff. That’s what is called in jargon the Minsky moment, and that is when you have the opposite, which is the panic.
Kate: All right, next up let’s hear from Larry Summers.
Larry Summers: I’m Larry Summers. I’m the president emeritus of Harvard, and the former secretary of the treasury. I think a main lesson of history is that important aspects of the next crisis are likely to be things that we don’t anticipate, and that we don’t foresee right now, because if we foresaw a crisis there’d be selling pressures, there’d be various mechanisms that would be either accelerating the crisis or forestalling it.
As I think about the risks in the current global environment, I would highlight the risk that central banks overtighten, because they’re not fully internalizing the lags between tighter monetary policies and its impact on the economy, and that that leads to an economic downturn with important financial consequences.
The second risk would be the risk that we saw too often with the internet bubble, with the housing bubble, that complacency becomes a self-denying prophecy, that after a period of tranquility, after a period of rising markets, people come to think that it’s safe to borrow in order to invest. They come to invest less in reliance on the fundamentals of an asset, and more in reliance on their ability to sell it to someone else at a higher price. At some point, the music stops and matters unwind.
A third risk is what will happen in China and in emerging markets, which have accumulated, in some cases, very substantial quantities of leverage. In the case of some emerging markets, very substantial quantities of dollar debt, and therefore are at risk of an economic downturn.
The last risk, which I think is very real, is the geopolitical risk at a time when we’re seeing substantial emergence of what used to be called great-power rivalry between the United States, Russia, and China. A time of substantial, potential instability in the Middle East, on the Korean peninsula, and so, political and security developments could also be a source of uncertainty and risk to financial stability.
Kate: Maybe I’m a little biased, but I agree with everything that Larry said. I think he actually pinpointed certain areas of the economy that we should be worried about. In particular, I completely agree with him about his concern about overtightening.
I want to share a little bit of the history of recessions in the US. The recession in 1949 followed monetary tightening. The one in ‘53 followed monetary tightening. The recession in 1957 followed monetary tightening. In ‘60 it followed monetary tightening, and in 1969 it followed fiscal and monetary tightening. Then there was the recession in 1973. It partially followed monetary tightening, but it was mostly about the oil shock. There was a brief recession in 1980 that was really followed by monetary tightening. The one in ‘81 was a mixture of the oil crisis and monetary tightening. 1990, there was an oil shock, we had accumulated a lot of debt, but it also followed monetary tightening.
And then, the more recent ones have been a little bit different. The 2001 recession was the bursting of the dot-com bubble combined with 9/11, and then, obviously, the more recent financial crisis had more to do with the subprime mortgage market, but I think there is enough of a history there that we should be a little concerned about actions of the Fed, and whether Jerome Powell is going to raise interest rates too quickly when the fundamentals of our economy actually aren’t strong enough to support that.
Luigi: But I would like to distinguish between the normal business cycle and real crises. For instance, the one you describe . . . Most of the ones you describe are recessions in the post-World War II period that did not really have the aspect of a major economic and financial crisis. They were just business-cycle fluctuations, which, I agree, most of them were caused by a tightening of the Fed, which was trying to prevent a rise in inflation. But when we look at big crises, the 1929 crisis, the financial crisis in Japan in 1990, and in east Asia in 1997 and ‘98, then we look at the last financial crisis in 2007, 2008, these are kind of different in nature from your normal business-cycle recessions.
Kate: Yeah. I totally agree. I think what I had in mind for this episode is where the next recession is going to come from, not necessarily the next major crisis.
Luigi: I think that it’s more interesting to try to speculate what the major crisis is going to come from, because here, even if we are unable to tell exactly where it’s coming from, I think using some of the insights that Larry Summers gave us, which are very much in line with what Hyman Minsky gave us, we can trace some characteristics that will help us spot the beginning of the next crisis.
Hyman Minsky has this view that everything starts with what’s called displacement. A moment where you create some enormous profit opportunities that change the way people invest normally. That tends to generate a lot of excitement and a lot of lending in that direction. Think about the dot-com bubble, where a lot of people lent for new telecommunications, or the real-estate bubble, where there was a lot of lending related to real estate. This is the moment where you start by lending on fundamentals, as Larry Summers said, and then you start to stop lending just on fundamentals and lend against expectations of future increases in prices.
This is where the Wile E. Coyote moment comes, because you lend against future increases, and as long as those future increases come and everybody expects them, you can keep going. But then, there is the moment in which you start to doubt that they’re going to come, and once you doubt, you don’t want to lend, and that makes those doubts reality.
Kate: So, do you think there’s evidence that we should be worried about this right now?
Luigi: Not necessarily yet, but I think that we need to watch out for this kind of phenomenon. Certainly, there was this phenomenon in the bitcoin market until recently, but I don’t think it’s big enough to create a major crisis.
Kate: I think that this is something we should be worried about right now, particularly in the leveraged loan market. The term leveraged loan, or leveraged lending, refers to loans that are made by banks or groups of financial institutions, to borrowers that have pretty bad credit ratings, particularly below double B. This market has been taking off ever since the financial crisis. According to CVC Credit Partners, it’s doubled since 2011 globally. I think it’s worth over a trillion dollars, and that’s in terms of loans that have been made to already very highly levered, risky borrowers.
I think that part of what’s been driving this is, well, at least in the past couple years, is the Trump tax cut. I think, if anything, that should make us really worried, because what you would expect from the tax cut is sort of the opposite of what happened. Part of the reason that debt is attractive relative to equity is that there’s a tax benefit from it, and so, if the marginal tax rate is really high for corporations, then relative to equity, debt seems pretty attractive.
When Trump cut the marginal tax rate for corporations from 36 percent to 21 percent, it should have made debt relatively less attractive. But what it did was that it infused companies with a ton of cash. Some of that they paid out to investors, so it infused investors with some cash, and some of that they held on for themselves. I don’t think that the investment opportunities were as plentiful as Trump made it sound like they would be.
Instead, all that cash rushed into the buyout market, where companies were trying to acquire one another, or make deals with one another, and they’re just sitting on all this, what they call, dry powder. I think that that has been ramping up deal activity, I think it’s been pushing down yields, I think it’s been leading to an influx of money lent to a pretty dangerous sector, and I think that we should absolutely be worried about this.
Luigi: You’re right, Kate, but the big question in my view is to what extent a crash in the leveraged loan markets becomes a major financial crisis. I think this is the aspect that neither Larry nor Bob analyzed. To be fair, we didn’t ask them to analyze it, but what they didn’t stress are the mechanics through which a relatively small hit becomes a major source of instability. After all, ironically, if you look at the real-estate market, particularly the subprime real-estate market, in 2008, it was a relatively small sector. We’re talking about $1.5 trillion, which, of course, is a lot of money, but even a major loss in that market shouldn’t, in a normal situation, lead to a financial crisis.
After all, when the dot-com bubble exploded, there were a lot of people who lost money, but there wasn’t really a major financial crisis afterward. I think the loss was bigger in terms of magnitude than the loss in the real-estate market in 2008. So, the mechanics that lead from a small loss to a big financial crisis is actually debt, and, in particular, short-term debt. There is a colleague of mine, Doug Diamond, who stated that financial crises are everywhere and always the problem of short-term debt. This, of course, is a bit of playing with a famous sentence by Milton Friedman that said, “Inflation is always and everywhere a monetary phenomenon,” and I think that he’s by and large right. Short-term debt plays a crucial role, because in the moment in which . . . In the Wile E. Coyote moment in which you are panicking, if you are locked in with long-term debt, or with equity, there’s nothing you can do. But if you have the chance of having some short-term debt, what you do is try to get out, to get to the famous door, as fast as possible. That’s where the crisis starts, because everybody tries to get through the door, and not everybody can.
Kate: Yeah, and to reiterate the role of short-term debt in the past crises, the past major crises we’ve seen of this century. During the Great Depression, it was bank deposits. You and me having our money in a bank and being able to pull it out right away. As we discussed on the first episode of this series, the nature of short-term debt for the most recent financial crisis was a little bit different. It was more about banks lending on a short-term basis to one another in what’s called the wholesale funding market, which is a little bit more opaque than a typical bank deposit, but, in a way, it was just as risky and susceptible to runs as the typical deposit was in the 1920s.
Luigi: And, in most international financial crises, actually international creditors, short-term international creditors, try to pull out of the country, and when they all try to pull out of the country at the same time, what you generally have is a major devaluation of the currency and a financial crisis. That’s what Argentina is going through as we speak.
Kate: Yeah, I have to admit in terms of the short-term funding perspective, I don’t think that we have any serious problems. I think that a lot of the issues with wholesale funding that were present in 2006, 2007, have been remedied since the crisis. I think that banks are fundamentally safer. I don’t think that we have a major crisis or depression looming. I do think that there are elements of our economy that could trigger a recession in the next year or two, but I don’t think that it will be anywhere near as bad as the financial crisis.
Luigi: I’m not an expert of China, but as Larry said, I think that the Chinese financial system is a system that is probably likely to experience a major financial crisis in the near future. Part of the reason is because there’s a lot of short-term funding, and the other reason is because there is a huge amount of opacity.
The other aspect of a crisis, the Wile E. Coyote moment, is also when you realize that the system is not as safe, or is not following the rules you expected the system to follow. In the 2008 financial crisis in the United States, I think people realized that, actually, mortgages were not made as they thought they were made, and that led to a panic—what else is there? In Wall Street, there is this famous story of the cockroach theory. For people who live in high-rises in New York, they know when you see a cockroach, there are many more to come. So, when you see something problematic, then you start wondering what is the next shoe to drop.
Kate: What’s tough to predict about China is that the state has its hands in everything in China. They might not exactly know what’s going on in the shadows, but they have the power to step in and bail anyone, or anything, out if they wanted. I don’t think the concern about moral hazard that existed here in the US during the financial crisis is as strong in China, because, by definition, they are supposed to be involved in everything. They’re supposed to own everything. I do think that if there were a short-term funding panic in China, then the government would step in, it would bail out whoever needed bailing out, and then it would probably engage in the slow and lengthy process of trying to reform the system, which I do think that it has been trying to do. They’ve at least been working on reforming the bankruptcy system to get rid of some of the zombie state-owned enterprises that are basically defunct, but are still on banks’ balance sheets. It’s hard to predict how much of a panic could ensue in China, because the government could prevent the panic from happening.
Luigi: You raise an excellent point that I would like to return toward the end of this episode, because I think we need to think about not just where the next crisis is going to come from, but also what can be done to prevent the next crisis to unfold. I think that you suggest that if you have a very capable and very powerful government that intervenes very massively, it might be able to stop a crisis, with some other consequences. I’m not saying that this necessarily is a panacea, but I think it’s—
Kate: I was going to say, Luigi, are you calling for a very capable government to intervene in all financial situations? All distressed situations?
Luigi: Not necessarily, but I think that in the situation of panics, having a government that is capable, and with deep pockets and credibility, I think is a big issue. I speak as an Italian who has a government who is not very powerful from that point of view, because there’s not a deep pocket, it cannot even issue its own currency, because only the European Central Bank can. So, it is potentially subject to a run, in terms of the banking system could be subject to a run. I think that if I have to predict the next financial crisis, I think that the euro system seems like the most likely one, and Italy probably the culprit.
Kate: OK, but going back to the United States, something that has captured a lot of attention in the past few years is that student-loan debt has skyrocketed in the past decade. In particular, since 2004, it’s more than tripled in the US. Do you think that this a potential source of concern?
Luigi: Yes and no. I think that there is indeed an overlending in this direction. I think that, to some extent, an overlending that is very similar to what happened in the real-estate crisis, because at the time you had very aggressive lenders that didn’t particularly care about the ability of the borrower to repay. In a sense, that’s exactly what student debt is about, because the lenders know that the debt cannot be restructured in bankruptcy, so they push this onto the students as much as possible. For many students, the cost really exceeds the benefits they receive, especially in a world that is becoming more and more unequal.
The median student does not get enough from the future income after college to pay for the debt. Is there a possibility of major losses in that market? Absolutely. Whether this will transform itself into a financial crisis, I think that’s less likely to be the case.
Kate: I basically agree with you on this one. I think that student-loan debt is certainly concerning, and I think that it may lead to issues in the future. I don’t think that those issues will necessarily turn into crises, because student loan debt isn’t as systemically risky as, let’s say, subprime mortgage debt. I do think, though, that student loan debt will have adverse consequences on the economy from an aggregate demand perspective. 2004 was really the inflection point when we saw the total amount of student-loan debt really start to balloon. If you think about it, if you were starting college in 2004, you are just turning 32 right around now. Thirty-two is the average age of the first-time homebuyer. I don’t think we’ve really seen the effects of student-loan debt yet, I think that we’re just starting.
Luigi: I think you’re right. I think, in part, we’re already observing this as we speak. People are getting married less, and home ownership is down, and I think that the demand for some durables is down. Some of the effects are already in place today, and, as you said, they might have macroeconomic consequences that slow down growth. Whether this is transforming itself into a major crisis, I don’t see it coming, but it certainly will impact the economy in a negative way for a long time to come.
Can I try something quite different in terms of potential risk?
Luigi: If you wake up in the morning and you realize that a major bank, or a major securities house, etc., has been hacked, and you’re not sure that you can get your money back, I think that everybody will try to reach out to their online account and try to get their money in some safe place. The question is, what is safe at that point? That could be indeed a major financial panic.
Kate: All right. What about the trade war? This has also been discussed widely in the news. Do you think that that’s going to have a significant drain on our economy?
Luigi: I think that it potentially could, if it really is pushed to the limit. I think it has the appearance of being a lot of noise, with very little substance, in the sense that, after denouncing NAFTA as the worst deal on the face of American history, the history of America, President Trump seems to have agreed to the renewal of NAFTA. That, of course, cannot be called a renewal, but is a completely new agreement, that is not that far off, with some marginal improvement, by the way. I think that there were some marginal improvements, but . . . I think he barks more than he bites. That’s my impression. I’m much more concerned about a political deterioration in terms of a military confrontation or a cyberwar than I am about a trade war.
Kate: I agree with you on this one, too. Particularly that Trump’s bark is worse than his bite, but I also think that trade between the US and China is not as big as people make it out to be. It’s only 3.2 percent of world exports. Yeah, the trade war will lead to slight increases in prices for the US consumer. I don’t think it’s necessarily going to trigger a recession.
Luigi: So, Kate, I think that everybody says that a financial crisis is hard to spot in advance. So, what can be done at a government level, or even at the individual level, or the corporate level, to prepare, to make sure that the next shock that inevitably will come, will not transform itself into a major financial crisis like the one we experienced 10 years ago?
Kate: I think in terms of preventing a financial crisis, it’s incumbent on the government to make sure that it knows what’s going on, and that deposits or short-term funding are relatively stable. In that regard, I think that we’ve made improvements since the financial crisis. We’ve got the Financial Stability Oversight Council, and a lot of the provisions of Basel III, which are new provisions that regulate banks and investment banks, have made the funding and liquidity of investment banks more stable.
Having said that, I think another thing we should have learned from the financial crisis is that new types of engineering, or new types of financial securities, that we didn’t even know existed maybe five, 10 years ago, are something that the government should be worried about. I think there is some of this going on in the corporate loan market. I think that we should be careful to make sure that the financial sector can’t just dodge the regulations we have in place by coming up with new types of vehicles that exist in the shadows.
What about you?
Luigi: I think that central bankers have been trying to develop tools to face new crises that go under the name of macroprudential regulation. The idea is all these major crises started with an explosion of debt, so if we monitor what leads to this explosion of debt, and we have instruments to prevent that explosion, or moderate that explosion, then we can prevent or deal with the new financial crisis.
I think there is some element of truth in that. However, as we discussed in a previous episode with Paul Tucker, there are also some dangers, because if the macroprudential regulation leads to determine who can borrow and who cannot, it becomes, really, a centrally planned economy. So, to what extent can you change the requirement for lending against . . . For a house, for example, and can you change the down payment based on the cycle and based on the location? So, if I say that in your neighborhood of Washington, all houses should be purchased with a 60 percent down payment, that’s quite intrusive. This is what, actually, has been going on in New Zealand, they’ve started to put some requirements first on the country overall, then on just the capital, Auckland. They didn’t go down to the quarter level, but you can imagine they might. I think that that’s a serious concern.
Kate: So, just out of curiosity, have you changed the composition of your wealth, or your investments, in any way to reflect your views on whether there will be a crisis or a recession coming in the next couple years?
Luigi: No. I have not, but I don’t want to give advice. I am a terrible investor and I don’t think people should learn from it. You know the expression that the children of cobblers don’t have shoes, that’s exactly my model of investing, so I don’t think that I want to give listeners any investment advice.