Capitalisn’t: The Aftermath

Luigi: Hi, this is Luigi Zingales at the University of Chicago.

Kate: And this is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, the podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: On the last episode, we discussed the lead-up to the financial crisis, and I shared some of my maybe sort of embarrassing stories about how I worked for Lehman, lost all my summer internship money, and then ended up dropping out of school and hitchhiking around. Luigi, I’m assuming that you were making a more productive use of time around the end of 2008.

Luigi: I’m not so sure that it was more productive, but I do remember I was in my office looking at the news. I was outraged when I heard that the secretary of the treasury, Hank Paulson, wanted to ask Congress for $700 billion to be used to buy assets from the failing banks. I remember that I was sitting in my office. I said, “That can’t be. That is really the end of capitalism as I know it, because this is the fact that when a business fails, it fails. When small banks fail, they fail. But when big banks fail, or are about to fail, the government comes in and socializes the losses.”

A system where you prioritize profits and socialize losses is the worst possible system on Earth. Actually, I remember at the time, and I already mentioned in the last episode about Allan Meltzer, Allan Meltzer was saying that capitalism without bankruptcy is like religion without sin, it doesn’t work.

I didn’t know about that sentence at the time, but I wrote a little piece with the very subtle title of “Why Paulson is Wrong,” and I started circulating it, and I got a lot of attention on that. Then, the next week, early in the week, I was so outraged that I started … At the time, Paola Sapienza was visiting Chicago. I was discussing with her, “We need to do something.” So, with her and then John Cochrane, who was my colleague at the time, we started a collection of signatures of economists against that version of TARP.

We quickly reached 300 signatures of major economists, including a few Nobel Prize winners, and I remember that during the debate Senator Shelby actually showed on camera the list of economists against TARP.

Kate: Is this something you frequently refer to as a mechanism to combat the government, is that you start petitions?

Luigi: Maybe this is my Italian background. In Italy, you petition all the time. I don’t believe in abusing those, but I thought that, in that particular case, that was important, because this was a topic that was pretty obscure to most people. I think that this reverse socialism where you socialize the losses is the worst kind of socialism.

Kate: So, did it work at all? Did your petition actually have any influence on what the government did?

Luigi: Actually, I think I would be a bit too full of myself saying that that was the fact, that made things change. But I have to say that there was enough opposition that, number one, the version of TARP that later was approved by Congress was modified. Now, it was still a bit of a gift to the major banks, in particular Citigroup. But the investment by the government came with a restriction, a restriction on executive pay. Surprise, surprise, when you restrict the executive pay, the executives really wanted to buy back those stocks as fast as possible. They did in June of 2009. So, I think in that sense, it was very successful.

Kate: TARP wasn’t just for the banks, though. TARP also involved the big automakers, and it also had a component to help support homeowners who may have gone through foreclosure. To put some numbers on the magnitude of the crisis that unfolded, the GDP shortfall ... So, in terms of the path that US GDP was on prior to the financial crisis and the amount that we lost by not staying on that path, is estimated to be about five or six trillion dollars. That’s relative to the roughly one trillion that was spent in stimulus. The unemployment rate went up to 10 percent in 2009. Then, finally, the median family experienced a household drop in income of about 8 percent. That’s on real terms, so in terms of how much they could buy.

Luigi: One of the things that was particularly scary at that time is the speed at which companies fired workers. It’s normal in a recession to have a reduction in employment. But the reduction in employment that came at the time of the Great Recession was abnormal by any standard, even by the standard of the large drop in GDP.

Economists are still wondering why that was the case. But the results were pretty dramatic, because unemployment, as you said, Kate, reached 10 percent. The possibility of finding a job for many people became a distant prospect. That was pretty devastating in a large part of the country.

The other thing that was very devastating is it took a long time for this unemployment to be reabsorbed. In a typical recession, you have that the sharpest is the downturn, the fastest is the recovery. However, when there is a recession due to a financial crisis, the recovery is actually quite slow.

What was very painful for the US economy overall is that the recovery, in spite of TARP, in spite of the stimulus package, in spite of the other monetary interventions we’re going to discuss in a second, was much slower than we’ve seen historically. So, a lot of people remained unemployed for a long period of time.

One thing that we know as economists is that long terms of unemployment tend to have permanent effects. People lose their skills, lose their willingness to go and look for a job, lose even their ability to work on a regular job at a regular time. So, it’s not that easy to reabsorb those people in the labor force after them being unemployed for six, nine months, or even a year.

Kate: Unemployment benefits and their extension were a component of the stimulus act, but it was a relatively small fraction of the funds dedicated. It was much smaller than the outright tax assistance. I think that there should have been, given the fact that unemployment rose to 10 percent, I think that some of that tax assistance should have been shifted over to the increase in unemployment benefits.

Luigi: But, to be fair, if you compare the United States to the euro area, they both were hit by a crisis in 2008. The United States recovered faster than the European Union. So, the other factor, and I think this is the right time to bring it into the picture, the other factor that delayed the recovery in Europe is the European Central Bank was slower in doing any form of quantitative easing. Kate, can you explain to our listeners what quantitative easing is, because everybody talks about it, but what actually is it?

Kate: Sure, so I think before we explain quantitative easing, we have to explain that the Fed cut interest rates to virtually zero, shortly after the panic ensued of the financial crisis. Cutting interest rates to zero is the Fed’s main lever of monetary policy. Those interest rates that I’m referring to, by the way, are pretty short-term interest rates.

Now, how much can the Fed actually do to help stimulate the economy once interest rates are already zero? In the traditional sense, the answer is not that much. So, this is where quantitative easing comes in. It’s sort of a form of the Fed also trying to push down interest rates. But not just in short-term securities, but in long-term securities. So, they purchase assets, typically longer-term government bonds. This purchasing is being done by the government. When there’s more demand for long-term bonds, the yields on those bonds go down, and that typically boosts the stock market. So, it’s another way of central banks trying to keep down yields and bonds.

Another thing that it does is that it helps prevent deflation. Deflation is really dangerous, potentially, because if prices are going down, and if interest rates are already zero, then people are incentivized to just hoard cash, right, because they’re not going to put it in the bank, because they’re not going to earn any interest on it. They’re also not going to spend it, because prices are going to keep going down.

Even though we haven’t actually experienced much of this sort of deflationary trap in the United States, there was a concern that it might happen shortly after the financial crisis. So, by buying longer-term bonds, the government through quantitative easing was trying to boost asset prices and prevent us from entering into this deflationary trap.

Luigi: Now, many people thought that quantitative easing was an extraordinary measure of monetary policy that was unprecedented, and even some people attacked the Fed as being kind of revolutionary and unjustified. In reality, as Kate said, this is just a continuation of ordinary monetary policy in a different way.

When you choose to keep inflation only at 2 percent, you find it hard to bring the level of real interest rates negative, because basically what happens is there is a demand and a supply of savings. The demand and supply of savings should lead to an equilibrium price of interest rates. However, if the demand of savings, i.e., the investments, are very low, it might be that the clearing price for this market is a negative real interest rate. How do you get negative real interest rates when you have low inflation? You have to have negative nominal interest rates.

The negative nominal interest rate is difficult to administer, because, as Kate said, people have an easy arbitrage. They can hold onto the cash and get the benefit of that.

Kate: Then, finally, we come to Dodd-Frank, which was the legislative branch’s approach to changing regulation after the financial crisis, and preventing a similar crisis from taking place in the future. The component of Dodd-Frank that people are most familiar with is the Volcker Rule, which prohibited investment banks from proprietary trading, or trying to make money on their own behalf, rather than on behalf of their clients.

The Volcker Rule effectively made most investment banks have to spin off or eliminate the proprietary trading components of their operations. There was also an entirely new government agency created, the Financial Stability Oversight Council, with a research arm that was part of it, which is dedicated to just making sure that huge crises, whether in the form of subprime mortgages or anything else, financially engineered products, didn’t happen again. It’s like a group of people who are just keeping their finger on the pulse of the economy, making sure there aren’t big systemic risks building up in ways that regulators don’t see.

Luigi: Two things. First of all, the Dodd-Frank Act is extremely large and has so many provisions that we can’t possibly do justice to them all. There are some that are definitely very beneficial, like, for example, the movement of most derivatives onto organized exchanges to make the system more stable. There are others that are more controversial. In particular, what I find very controversial is the Volcker Rule. The Volcker Rule is an attempt of the Obama administration to please the popular demand for the separation between investment banking and commercial banking. What goes under the name of an old law passed during the Great Depression, the Glass-Steagall Act, and the demand of banks to keep doing the same.

My interpretation of it, and you might disagree, Kate, but my interpretation is Geithner was very clever, trying to have the cake and eat it, too. He had a rule that was named after an impeccable person like Volcker, that in some sense gives the impression of catering to the people who want the separation between the two, but de facto does not do much, because it’s very hard to implement, because you’re right in saying that the Volcker Rule prohibits proprietary trading. The question is, what is proprietary trading? If I trade with my clients in mind, even if my clients did not give me an order, is that proprietary trading? The Volcker Rule will say no. So, in order to implement the rule, we really need to look at the intent of the trader, something very hard to do.

Kate: I think there’s two points to discuss about the Volcker Rule. One, whether it was actually effective. Two, whether it had anything to do with the financial crisis. In terms of effectiveness, I do think that the outright prop desks, the outright groups within investment banks whose sole purpose was to just make money for the investment banks, for the most part those disappeared, or they were no longer part of the investment bank. To your point about whether an individual trader can actually make any money for his or her own desk, even if trading on behalf of a client, yeah, sure. I do think that there are ways for them to make money. But I still think that compliance departments within investment banks were pretty careful to make sure that they weren’t at least explicitly violating the Volcker Rule.

I do think that the Volcker Rule was pretty effective in mitigating how much banks were trading on their own behalf, even if not completely effective. But I think the bigger question is, did it have anything to do with the financial crisis? The parts within investment banks that were responsible for financial engineering and subprime securitization weren’t really the proprietary desks of these banks. They were the desks that were devoted to purchasing these bad mortgages, bundling them together, and then selling them off to investors. Those weren’t necessarily those groups that were later eliminated. So, I don’t think that the design of the Volcker Rule necessarily had that much to do with preventing future similar crises.

Luigi: One of the causes of the crisis, according to many economists, was lack of regulation, or at least lax regulation, and regulation that was not apt to stand up with a change in the economy. However, the Financial Crisis Inquiry Commission came up with seven names of people that, in their view, had committed fraud. Two of these people were indicted, or potentially indictable, on two grounds. Those two people are Robert Rubin and Chuck Prince, both from Citigroup. The attorney general under Obama, Eric Holder, did not proceed against any of them, but in particular did not proceed against any of these two.

Kate: I think the question of whether fraud occurred at the level of the mortgage originators is much easier to handle. It’s sort of like with a drug ring. The guys on the ground who are selling the illicit drugs, it’s easier to prove that they are directly doing something wrong. In the case of the mortgage originators, I think that the fraud is easier to prove. There are some people involved in the process who absolutely should have been convicted and put in jail. At the higher level, at the financial institutions, it’s … in some sense they bore a bigger burden.

But it’s also harder to prove that they necessarily violated any particular law, because I think that their actions that were detrimental to the entire system were, in some sense, not explicitly illegal. They were creating these financially engineered securities that were dangerous and amplified risks. But everyone was doing it, and there was no ... I think there was also large fault on the part of the regulators who allowed this to happen. So, how can we really say, “Oh, it’s really their fault”?

Now, in the case of a couple people, Rubin and Prince, I’m not sure exactly what the Financial Crisis Inquiry Commission pinpointed as their exact fault. I mean, I get the sense that it was that they had a feeling that the market was about to turn. They still continued in their financially engineered securitization process. In some cases, they even took positions betting against what they were creating. That is immoral. But how can we necessarily throw someone in jail for doing something immoral that’s still legal?

Luigi: I think you’re too generous. I think that what the Financial Crisis Inquiry Commission found were violations of the law. If you refer somebody to a prosecutor for indictment, it means that you have a strong suspicion that there is ground for indictment. The fact the attorney general dropped the case without even trying, I think is worrisome. Just to make sure that we’re not picking only on those, there are a lot of other cases. For example, a whistleblower came out saying that Jamie Dimon, at the time and even today CEO of JP Morgan, knew perfectly well that some of the packages of securities that were done contained a lot of fraudulent mortgages. This was settled with a large fine to JP Morgan, but no particular indictment against Jamie Dimon.

I think there was a concerted effort of letting these things go. At the beginning, you can even understand that, because you are afraid that this might create more panic. But the fact that this was done even later I think was a disaster. I think that there is a big difference between the way Roosevelt dealt with the problem led by the financial crisis in 1929, and the way Obama dealt with the leftovers of the financial crisis 10 years ago. I think that the backlash that we have observed, the lack of trust in institutions, the lack of trust that justice applies equally to everybody, is a consequence, a direct consequence, of the fact that homeowners were forced out of their houses. Some of them even paid for the fraud they did when they had the application for their mortgage. Nobody else did.

By the way, I remember that in the fall of 2008, the beginning of 2009, I wrote an explicit piece to Geithner saying, “Look, we have saved the banks. Why don’t we try to do the same thing with homeowners?” After all, if I am a guy in Las Vegas who bought a house, and because I’m getting married, and because I have a new kid, because of whatever, and all of a sudden prices drop 50 or 60 percent, am I really a bad guy because I don’t pay the mortgage anymore? Or is it that I got hit by a tsunami, and honestly, I am not responsible for that tsunami? I should be helped in the same way, or even more, than the banks were helped.

The asymmetry that you help the banks but you don’t help people who generally ... not speculators who are buying five houses, but ordinary Americans who are buying the place where they’re living, and found themselves hit by a tsunami, the lack of support for them is what, in my view, created all this resentment.

Kate: I think that there should have been, and this is maybe an unpopular opinion, but I think that there should have been some foreclosures, to the extent that there was overheating in the housing market. There was too much subprime lending. People who bought McMansions with no jobs, no income and no family, for that matter, I mean, I think that there is some natural adjustment that should have taken place.

Now, for people who really needed homes, for people who were using those subprime mortgages to buy a primary residence, and for people who had jobs and a family, I think that there should have been assistance that went directly to them, and there was. I mean, there were programs that were designed for that. I just don’t think that they were designed well enough. I don’t think that there was enough funding set aside for them. But I do think that there was some political will for it.

Luigi: Yeah, at the end there was a little bit of help. It was, as you said, little, designed in a way not to make it easy, and did not work very well. I am the first one to say you need bankruptcy. You need bankruptcy for big banks. You need bankruptcy for individuals when they make a mistake. However, I don’t understand why, when it comes to banks, you say, “Oh, it’s better to intervene when there is a big crisis, because bankruptcy is so inefficient than we can benefit by fixing it.” The same is true for individuals. Bankruptcy isn’t efficient. When you foreclose on a house, you lose a lot of value in the process. When the fault, if you want, I know I use a moral term, but when the fault is not of the individual, when the individual has bought a house in Las Vegas and that house now is worth half what was owned before, and he has a mortgage that will basically waste his money for the rest of his life, why don’t you want to help getting this person out of it in a decent way?

Kate: I think we agree that they should have, and the government should have. I mean, I think we’re on the same page here. But I want to go back to an earlier point that you made about the Financial Crisis Inquiry Commission actually finding that people like Rubin and Prince had violated laws. What were the laws that they violated? What law says that Jamie Dimon is committing a crime if he knew that some of the loans that were going into the securitized products that he was issuing to investors, some of those loans had faulty documentation?

Luigi: That’s called fraud. If you know that you’re selling something that is sort of defective, and you don’t tell people, that’s called fraud.

Kate: But the people who were committing the fraud were the ones that were writing the faulty documentation. Right? They were committing fraud. Then, they were selling bad products to the investment banks. The investment banks were just the intermediaries who sold those bad products onto other people. So, if the investment banks had a vague notion that there was some fraud going on at a lower level of the chain, is that also fraud? I mean, I’m sort of playing the devil’s advocate here, but I think it’s a hard question. I think that we can’t just throw people in jail based on vague definitions of the law.

Luigi: If you know that you’re selling crap, even if you’re not the one producing it, but if you are repackaging fraudulent mortgages and you don’t tell people that these are fraudulent mortgages, you are committing fraud. Whether you are an intermediary, you are still an intermediary of fraud. Or when you mislead investors, you don’t reveal stuff to investors, that’s a fraud. I think that there are laws against that.

I’m not a lawyer. I did not do the investigation. But what I read is that there was enough evidence that in normal cases, you would have proceeded. But they did not want to proceed, in order to protect the stability of the financial system.

Kate: My position is that we should amend the laws to make them stricter.

Luigi: Yeah, but that’s a different question, because if you change the law, you cannot prosecute people after you changed the law, because you cannot prosecute for a law that was not in place at the time.

Kate: Exactly. I think that it was primarily the fault of our regulators and the legal system that existed earlier. I don’t think that we can look back on that and be like, “Oh, well, shoot, we should have had those laws in place that would have protected investors, and protected consumers, and we didn’t. So now, let’s just throw people in jail, even though it was really our fault for not putting those investor protections in place.” But there’s the deeper question of whether Dodd-Frank was effective in preventing another crisis.

Luigi: Yeah, I think that this is indeed the bigger question. Even more importantly, do we fear another financial crisis? Is any bubble leading to a financial crisis of the type we experienced 10 years ago? Or do we have a more resilient financial system that can withstand some shocks? Because the only thing that we can be sure of is there will be other shocks. As we said in the first episode, at the end of the day, these shocks were not that big to begin with. But they were amplified by a number of factors. So, the question is whether these factors are still in place, and whether there is a risk that a relatively small shock might lead to a big crisis like the one we experienced 10 years ago.

Kate: I think we haven’t yet talked about what’s potentially the biggest result of the crisis, or the biggest response to the crisis, which is that despite lack of regulation in this area, a lot of the products that led to the crisis completely ceased to exist. In terms of subprime mortgage origination, for example, I mean, it still exists, because some borrowers who have low FICO scores still should be able to get houses if they have an income. But the market fell from about $600 billion in 2005, to around $60 billion now.

I think that the order of magnitude shrinkage in the subprime mortgage origination market is something that I’m comfortable with. Maybe more importantly, the types of mortgage-backed securities that were being created by non-GSE, or non-Fannie-Freddie institutions, fell from over a trillion dollars to only $14 billion now. That market completely disappeared. So did these financially engineered products like the crap CDO-Squared and synthetic products that we talked about in the first episode. For the most part, they’ll all gone.

Those were not due to government intervention, but they were just because investors realized that those products were not fundamentally sound, and so the demand for them disappeared. But I don’t think that we’ve put in place sufficient regulation to prevent banks from engaging in similar, even though not identical, types of financial engineering in the future.

Luigi: I agree, and that’s the reason why, in the next episode, we’re going to try to explore where the next crisis is going to come from.