inside the meltdown

Martin Feldstein


An economics professor at Harvard, Feldstein served as President Reagan's chief economic adviser from 1982 to 1984. On Feb. 6, he was named to President Obama's Economic Recovery Advisory Board. This is the edited transcript of an interview conducted on Dec. 16, 2008.

Editor's Note: Martin Feldstein serves on the board of a number of companies, including AIG.  In this interview, he declined to speak in detail about AIG or his role at the company.

“You have a bank the size of Citigroup with a $2 trillion balance sheet, and you invest $25 billion in them. What's that going to do?”

What did you think of Alan Greenspan, [chairman of the Federal Reserve Board, 1987-2006], at the time he was leaving office?

Greenspan had a really good record over a large number of years. His most memorable decision was recognizing that the productivity growth in the late '90s was stronger than the rest of us understood. So he allowed the economy to expand more, allowed unemployment to come down more, allowed incomes to rise more than I think others making monetary policy at the time would have done. I think that's really probably, more than anything else, what gained him his reputation. ...

What was the bold thing that Greenspan did? ...

Deregulation was one of the most important things he did. That looked better at the time than it does to some people now. My sense is that deregulation gets a bad name. It was deregulation without adequate supervision by the bank supervisors and by the SEC and others. Deregulation was a bold step. It allowed banks to broaden their activities; it allowed banks to operate in national markets in a way they hadn't before.

But in terms of the growth of the economy, when the unemployment rate was coming down in the late '90s, and a lot of people were saying, "Well, we've got to slow this economy down; we can't continue to grow at this rate," Greenspan said, "No, what's really going on now is not excessive demand, but a more rapid productivity growth than we've been accustomed to in the past, and therefore the old speed limits don't count. We can grow at this faster rate and still have low inflation."

That was true for a number of years there. And so we got more years of growth, more declines in unemployment, higher real incomes than somebody without his judgment ... would have allowed.

Was there a mistake that he made, something he missed?

… He may have kept it going too long. He certainly kept it going longer than most of us, including myself, would have wanted, and yet he was right for most of that time.

So where was he wrong? ...

I think [Greenspan] was wrong in the early part of this decade, when fearing deflation, fearing of falling prices, he brought down interest rates very dramatically and announced that interest rates would be held at a low level. The advantage of that, he thought correctly, was that it would bring down medium-term rates. ... But by promising that those rates would be kept low for quite a while, he brought down longer-term rates. That, in turn, brought down mortgage rates; that stimulated the housing market and took us away from the deflation that he feared.

He explained at the time that it was a balance of risks. On the one hand, if you didn't do something like this, there was the danger that the price level would continue to decline. Since you could only bring interest rates down to zero, if the price level was actually falling, the real cost of funds, meaning interest rates adjusted for inflation, would be greater than zero, and the economy could slow more and we could deflate faster, and so the real interest rate would be even higher, and we'd be in a trap from which the Fed could not rescue us. So that was the risk on one hand.

But there was also the risk that if you lowered interest rates a lot, it would lead to inflation. And he said: "There are these two risks, and I have to make the judgment about which was the greater risk." And he said, I think correctly, that between those two risks, the greater risk was deflation, because if we had moved back up to an inflation rate of, say, 4 or 5 percent, well, the Fed knows how to cure that problem.

What he didn't take into account was the risk of a rapid rise in asset prices. ... And it's the asset bubble, particularly in housing, but also in the stock market, that has become a major problem for us now in the ending years of this decade.

[What are the tools available to the Federal Reserve?]

What the Fed does is called monetary policy, and more recently might be called credit market policy. What the Treasury does -- taxes, tax cuts, tax increases, spending -- is called fiscal policy. ... Monetary policy means changes in interest rates, changes in the money supply. It's what the Fed does.

Credit policy -- we've seen recently the Fed providing all kinds of credit and credit guarantees, offering to buy commercial paper and things like that. The Treasury can also engage in credit policies, providing guarantees to money market mutual funds as they did. And fiscal policy, actual outright purchases of goods and services, spending on everything from transfer payments to defense, that's the job of the Treasury and the Congress, of course. ...

Seems like we always heard about Greenspan, but Treasury secretaries were not in the headlines in quite the same way.

No, that's a very important point. Until this recent downturn, economists would say -- I would be one of them -- that fiscal policy ought to aim at the long run. We ought to get our tax incentives right; we ought to spend money on the things we need to spend money on, but we shouldn't be using fluctuations in taxes or fluctuations in spending to try to stabilize the economy. That's the job of the Federal Reserve and of monetary policy. ...

What's happening now is really an exception to what we've done over the last several decades, and it's an exception to what the textbooks would say, because we are in a very different kind of recession now than we've been in for the entire postwar period.

Unlike anything you've seen in your life?

Unlike anything I've seen or anything since the Depression that I've studied. So it's a very different kind of downturn that requires us to go beyond the traditional tool of monetary policy and to use fiscal policy, to use government spending and tax changes to stimulate the economy.

We're out a little into terra incognito?

We are, but again, I think we have little choice about what needs to be done. I think the Federal Reserve under Ben Bernanke has tried to do everything that was in the textbook or outside the textbook. They've been very bold. Nobody will accuse Ben Bernanke and this Federal Reserve of not trying everything. But there's only a limit to what the Federal Reserve can do. Indeed, many people would think they've gone beyond the normal limits of what a central bank should do. And so it really is up to the Treasury; it's up to the government with the backing of the Congress to do more if we're going to get out of this very serious downturn. ...

Did you know about these sort of sophisticated, fancy instruments, all the credit default swaps [CDS] and --

Yeah, I knew a lot about those. ...

[What are credit default swaps, and what role did they play in the crisis?]

A credit default swap is a kind of insurance policy. A bank makes a loan to a company; it's a concern that it's a large loan. ... It says either I have to sell off some of this loan to others, or I have to find some way of getting a guarantee or getting somebody who will back up this loan in case it defaults.

So it buys what is called a credit default swap. It buys a kind of insurance policy that says if that loan fails, then the people who have sold the credit default insurance will pay up the amount of default to the first bank. So it's a very good idea because it allows banks to make loans to institutions they know and yet not have to bear all of the risk, and it does it in a very efficient way.

The trouble is that once this good idea got going, people realized that this could be used not just to provide insurance for somebody who made a loan, but any two people who had different views about the likely solvency, the ability of Ford Motor Company to pay the interest on its bonds, could agree to buy and sell a credit default swap. And so we ended up having vastly more credit default swaps outstanding than there were really insurable interests, people who had the initial claims; $62 trillion of credit default swaps were out there. And anything anybody had any risk on, there was an opportunity for people to take a gamble on that, in some cases to protect a position, in other cases just because two consenting adults wanted to gamble with each other.

It was a casino.

It was a market. We have lots of markets. We have puts and calls on stocks where you don't have to own the stock to buy a put or a call. And so it's not different from a lot of other markets, but it was very, very, very big.

And once defaults began to happen, then a lot of institutions that had sold this insurance were in trouble because they had to pay up to others who were the recipients of this, who had bought the insurance. And it wasn't just somebody who had an insurable interest, somebody who had made a loan or held a bond, but somebody who was just speculating on the risk that that particular default would occur.

And it wasn't just Joe paying Peter and Peter paying Bill; some of those institutions went bankrupt. When they went bankrupt, they couldn't pay. So half of the transaction paid and the other half didn't pay, and that added to the chaos. ...

So what did you think?

I thought, and spoke about it at a Federal Reserve conference in the summer of 2007, that this combination of credit default swaps on mortgage-backed securities, that all of this was a potentially very, very dangerous combination; that the decline in house prices that had begun in the summer of 2006 was because of these mortgage-backed securities and because of the derivatives based on these mortgage-backed securities, that this could do tremendous damage to the balance sheets of financial institutions.

You knew how broad the problem was? ...

Yes. Once you understood that that was out there, then you had a pretty good idea that this was a very serious problem, and that as house prices came down, we would see more mortgages becoming greater than the value of the house; we'd see more people with less equity in the house, with negative equity in their homes, meaning their loans would be greater than the value of the house, and that that would cause very serious problems. ...

Things are happening with the banks around then, too, yes? There's a kind of credit crisis starting?

... The credit crisis in the banks, the unwillingness to lend to each other and to others, really reflected the fact that there was a lack of confidence on the part of the banks in the creditworthiness of other financial institutions. And why? Because everybody knew that everybody else had these mortgage-backed securities and fancy derivatives based on these mortgage-backed securities. They didn't know how much, but what they knew was that those things were not worth what they claimed to be on paper, and therefore the danger was that another institution to which you lent wasn't going to be able to pay you back. ...

So the easiest thing for a financial institution was to say: "Thanks, but no thanks. I don't want to lend to other financial institutions." So our credit markets really froze up, and lending stopped.

What are the implications that suggest themselves?

One implication is that if we don't fix this, the economy is going to be in very serious trouble; that it's not just a problem about the financial institutions, because if the financial institutions won't lend, then if we don't have credit, then businesses can't borrow. If businesses can't borrow, they can't invest, can't get to the demand for equipment. We don't get the productivity gains and growth that comes from that. If households can't borrow, then the consumer spending freezes. ...

So while we had excessive borrowing, excessive leverage by households, and to some extent by businesses until 2007, once this problem became clear to the financial institutions, we had a freezing up in the availability of credit.

When you know, does Bernanke know?

... It's very hard to know what they actually know, because in part they don't want to alarm the public; they don't want to alarm financial markets.

But I think it's fair to say that they underestimated the magnitude of the problem. They didn't really begin cutting interest rates in a serious way until early 2008. And at that point, they recognized that this was serious, and rates started coming down very quickly.

But if you know it, are you alone in this world?

No, I wasn't alone. But people have different views, and many people said at the time: ... "This is a problem with subprime mortgages. That's just a small part of the mortgage market. The mortgage market is a small part of the credit markets more generally. Therefore, it's a self-contained problem, and it will work itself out."

That was wrong. It was wrong because the problem was a more fundamental one. It was that credit in general had been badly priced. People were giving out loans too generously to not just subprime borrowers, but other borrowers. We saw many loans, 90 and 100 percent loan-to-value ratios. We saw share prices which were very high relative to underlying earnings and dividends. But it took a while for market participants, including officials, to recognize that.

Where were the regulators? Where were the people supposedly watching this?

The bank supervisors from the Fed, from the controller of the currency part of the Treasury, from the state banking, their job is to make sure that the banks have adequate capital and that they have quality assets appropriate for a banking institution.

They were asleep at the switch. They really did not adequately evaluate the quality of the assets. They said: "Well, look, some rating agency has said this mortgage-backed security, this complicated synthetic thing that has been put together, is a AAA security. Well, that's good enough for us if it was good enough for Moody's and S&P to put that Good Housekeeping Seal of Approval on it."

And when it came to capital, we kept hearing that the banks were well capitalized. Basically what the banks did, in order to conform to the capital requirements, was to set up these off-balance-sheet entities, these so-called special-purpose vehicles, which somehow were not subject to the same kind of capital requirements as the rest of the bank's balance sheet.

So yes, they technically conformed to the capital requirements, but you would think that a savvy, even not a brilliant, supervisor -- and we're not talking about Ben Bernanke; we're talking about the staff that are out there in the trenches -- they should have recognized that there were all these off-balance-sheet accounts which were somehow undercapitalized, and that if anything started to go wrong, the banks would find themselves with inadequate capital.

You said they were asleep at the switch. How can that be?

How did it happen? They went in, and they looked at the assets, and they saw that these were highly rated assets, AAA mortgage-backed securities. They asked themselves about the off-balance-sheet special-purpose vehicles. The banks could reply, "Well, under the international banking rules, the so-called Basel rules, those don't have to have as much capital as ordinary on-balance-sheet obligations." Mortgages are allowed to have half the capital of loans to AAA companies. So these are strange rules, but the supervisors didn't make them up.

And you can then say, well, why in the world did the international banking folk come up with these rules? I suppose they looked at history and said: "Well, mortgages have been very safe assets, while companies are not so safe. And we have to have rules that were in many countries, and so we can't have different standards for a AAA U.S. company and a AAA German company, so that's the way we do it."

These mortgage-backed securities that were rated AAA were a relatively recent invention of the financial engineers. They could take a group of low-quality mortgages and create out of that a series of bonds, of mortgage-backed securities -- that's a fancy way of saying bonds -- some of which were considered very risky, but others were considered very safe.

This is a CDO that you're talking about now?

Yeah, it's a particular form of collateralized debt obligation. Let me describe a very simple way in which this might work. You take 1,000 subprime mortgages; each one of those is a risky security. But you know they're not all going to fail, so you agree on the following thing: Somebody will get the payments on the first 100 to fail. So if none fail, he gets full interest on whatever the obligation is. But the first 100 to fail are his problem, that institution's problem. So that's very risky. He knows that. He says, "I'll only buy that security if you give me a very high interest rate," and that's agreed.

But the chance that there will be more than 100 failures is pretty small. So the next 100 to fail is considered a different security, and that security carries a lower interest rate … therefore the fellow who's got the 201st mortgage, very low. So that's already probably a AA or a AAA security because it's so unlikely based on history that it would fail.

So you take these tranches -- these slices -- one after another, and by the time you get to the third or fourth slice, people would say: "Well, there's no chance at all based on the history that we have examined that there will be any defaults there at all. That is better than a AAA bond; that is better than a U.S. government security." And so those things were called super senior debt.

So the idea was that they created these different-quality mortgage-backed securities out of a pool of otherwise look-alike, very poor-quality underlying mortgages.

One of the problems was that when they did this, they based this rating, how likely or unlikely it is that these will default, on very recent history, last five years or so. Well, those were five wonderful years for the real estate market. House prices were going up, in some years at double-digit rates. So it was very unlikely that there would be defaults on individual mortgages, and therefore, things looked much better than [they] turned out to be.

Once house prices peaked and started coming down, then we began to see very substantial defaults, and the thing that triggered the crisis in the middle of 2006 and on into 2007 was that there were many more defaults on subprime loans than anybody expected, because all of these ratings were based on a favorable period in which house prices were rising, and now we were in an unfavorable period in which house prices were falling.

So instead of going back 20 years and saying what's the worst year, what's the best year, and finding a good average that way?

Right. But the rating agencies, in their defense, would say the world is always changing, and so we look at the recent past because the distant past may be very different. Well, it turns out that the future may be very different from the recent past as well, and that's where they got it wrong. ...

Some people say there wasn't enough regulation, there weren't enough regulators out there. Other people say there were plenty of regulators out there.

I would change the word "regulator" to "supervisor," and yes, there were a lot of supervisors, but they obviously were not asking the right question. They were looking at the fact that others more technical than themselves had evaluated these mortgage-backed securities and given them AAA ratings or super senior ratings. And so they, the supervisor on the ground in the banks, could say: "Well, we're not supposed to dig down more deeply into these complex securities. Somebody else has done it for us, and we'll take their word for it." That was the mistake.

There were also in these processes lots of people who say to us: "I'm at a party. The punch bowl is there; I'm not going to leave the party." ...

People get drunk doing that. [William] McChesney Martin was chairman of the Federal Reserve back a number of years ago, [from 1951 to 1970], who said the job of the Federal Reserve was to take away the punch bowl when the party is just getting good. He was talking about it in terms not of individual securities but of an economy that could be overheating. And so it was the job of the Fed to slow the economy down to prevent inflation. But you could use that same analogy here and say the supervisors should have done something; perhaps even the Fed in its monetary policy should have done something to slow down this housing bubble. ...

When you see storm clouds gathering in 2007, are you seeing them specifically around Bear Stearns?

Not specifically. ...

So you're looking at the world. Is your worry as specific as Bear, Lehman [Brothers], Merrill [Lynch], Goldman Sachs, private investment banks, or is it they'll fall first and then something will happen? Are you creating doomsday scenarios in your mind, or calculations?

Not company by company, not company-specific ones, but [at] this talk that I gave at the Federal Reserve Bank's conference in 2007, I painted this picture in which we were going to see what was already beginning to happen: that there would be a lack of confidence by financial institutions in each other, and therefore unwillingness to lend, and therefore a totally dysfunctional credit market. And so it didn't matter what the names of the institutions were or even whether they were investment banks or commercial banks; they were going to have a hard time getting credit, and they were going to be unwilling to give credit. ...

They're all just kind of circling each other, I suppose, and worried about each other. When in that incredible week in March Bear Stearns goes from pretty good liquidity, I guess --

They said they had lots of liquidity, right. But then nobody wanted to extend or roll over liquidity to them, didn't want to keep giving them liquidity, and that's how they got in trouble.

Why didn't they want to give it to them?

Because, again, you weren't sure. You're a financial institution; you need liquidity; you need to be able to pay your bills. If you give some of your cash to another institution, and they promise to give it back to you, well, that in the old days was good enough. But now you weren't sure that the people you were about to give it to would be able to give it back to you next week or next month when you needed it. So you said: "It's not worth doing. I'll hold onto it. I want to be liquid."

Are you surprised at how fast Bear Stearns went down?

... Once you think about the way in which liquidity goes away, ... it's not surprising. Once people are afraid to lend, then the spigots get turned off and there's no money available. And all these institutions depend on being able to get liquidity, being able to get credit quickly from each other.

... Were you surprised at all that the government was involved in the brokering of a marriage between JPMorgan and Bear Stearns?

... No. If you go back to a decade or so earlier when we had the S&L problems, savings and loan problems, the government did a lot of marriage making. It went around findings savings and loans that were in trouble and found others that were healthy that could absorb them. So it's not at all unprecedented. ...

What do you think the rationale was for saving Bear Stearns? Was there a valid argument to let them go?

No, I think these institutions -- and you're going to ask me about Lehman next -- these institutions are so interdependent that there are so many credit lines and credit-related instruments, like credit default swaps, out there that the failure of one of these institutions has very widespread repercussions. So the fact that they could prevent that in the case of Bear Stearns by getting JPMorgan to take over the entire balance sheet, all of the risks, except for a relatively small amount that the Fed agreed to take onto its balance sheet, was a sensible way of preventing what could have been a very harmful episode in the financial markets.

So the counterargument, which is let them go; let the market wash itself out?

This was letting the market work with a little help. In other words, this was not the government taking it onto its balance sheet; it was the government providing some relatively small piece of guarantee for a small part of the money that Morgan put up. So Morgan and its people went in and looked at the entrails of Bear Stearns, all of their assets, all of their liabilities, and said: "This is a good business, and it's worth our having. The assets exceed the liabilities, but there are some pieces of it that are very risky. Maybe it will all work out, but we'd like to have some guarantee on this" -- I think it was [the] $30 billion piece of it. And the Fed said, "Yes, that's worth it to us to provide that guarantee."

So far, months later, the Fed has recognized, I think, $2 billion of losses on that. The magnitude of the losses that could have occurred had they allowed Bear Stearns to fail could have been much, much bigger. ...

The conservatorship of Fannie [Mae (Federal National Mortgage Association)] and Freddie [Mac (Federal Home Mortgage Corp.)], again, a surprise that this step would be taken, or a necessity?

I think it was a necessity. These were government entities. They were a strange, inappropriate hybrid of a government lending institution and a privately owned -- that is, shareholder-owned -- company. So between the two of them, they had $5 trillion of either outright liabilities, bonds or guarantees, which the federal government was guaranteeing, and yet they were out there to make profits for their shareholders. Quite unusual -- nothing like it elsewhere in the economy. Their purpose on paper was to facilitate lower interest rates and the spread of mortgage availability to low-income individuals, but because there were no creditors watching, of course, why would you care what risks they were taking if you had a U.S. government guarantee? They were able to take outrageous risks, and that's what we saw happen.

And they contributed to the problem in a sort of big and fundamental way.

They did, yes.

So then, by early September, Lehman is in big trouble. It's almost like a replay of Bear Stearns except the government decides not to help them.

Again, not being an insider, I don't know everything there is to know. The Fed and the Treasury have said about Lehman that they did not then have the legal authority to take over Lehman. Unlike Bear Stearns, where they could find a private buyer, there was no private buyer for Lehman. ... And they did not have the TARP [Troubled Asset Relief Program] at the time, and so there was no way that they could save Lehman, they said.

Now, could they have? Could they have found, with the help of their clever lawyers, a way around it? I don't know. But it was certainly something that had very adverse consequences in global capital markets. ...

... Some say the entire Lehman circumstances, the overlay is the idea of moral hazard brought to bear: Look, we've just got to send a message to the Street that this excess, these fat cats can't just live off the government. It's not going to work if we do this.

We'll never know. At least I don't know, and perhaps at some point we will get a more detailed accounting from the insiders. But at this point, they are sticking to their story that the Fed didn't feel that this was something they could just take onto their balance sheet with all of the potential losses associated with it. And the Treasury was not in a position to say, "Well, that's OK then; we will guarantee those losses." So in that sense, it was very different from Bear.

Can you give me a definition of moral hazard?

Moral hazard has nothing to do with morals or morality. It is that people will respond, institutions will respond, to incentives to take risks or to do other things that are inappropriate because of the incentive structure.

So, what's a good example of that? If people have very good insurance, they may be less careful about locking their car when they park it, because if it's stolen, well, the insurance company will pay for it. An economist would say that's an example of moral hazard. If they didn't have that insurance, they'd have locked the car.

So translating that into Wall Street, if you think you can take very big risks as a financial institution and in the end get saved by the Federal Reserve or the Treasury coming along, then you're going to take very big risks. You're not going to bother to lock the car. And so that's the moral hazard that they worry about.

I don't think you could convince the people at Bear Stearns that what happened to them represented an example of getting away easily. The senior executives of those firms were completely wiped out; many of the less senior executives lost all of their deferred compensation, their shares and everything, and their jobs. So it wasn't at all obvious that you had to have an outright failure to punish people so that they wouldn't succumb to the temptations of moral hazard.

How surprised were you by the events of that Tuesday, then? Lehman goes down on Sunday night, and the stock market is kind of up on Monday, and by Tuesday, everything kind of stops. Money stops.

Absolutely amazing. Around the world, people said, "This is a new world we're in." And people just said: "We're not sure what's going to happen. The government is clearly not going to be there to protect us the way we thought they were a few days ago."

That's the moment, isn't it?

I think so. I can't say to the hour, but people around the world tell me that they felt it in the days after the Lehman collapse.

What did they feel? What is it?

They saw a lot of losses happening immediately. Securities that they thought were worth 100 cents were worth nothing. Banks that were dependent upon those securities saw that they were taking big losses, and they had thought that if something like this happened, that this institution would be deemed to be too big to fail and that the Fed or the Treasury would come in and rescue them.

Now, of course Lehman was not a bank; it was an investment bank. It was not a member of the Federal Reserve, and as a member of the Federal Reserve in principle, it might have been able to go to the Fed and ask for a line of credit. But in the old days, if it didn't have an adequate amount of quality collateral to post, it wouldn't get that credit. These days, collateral standards, both here and in Europe, have been relaxed dramatically. But they may not have had even that much. In any case, they weren't eligible because they were an investment bank. And as we've seen, other investment banks have now rushed to convert themselves into commercial banks and to sign up for the Fed so that at least as long as they have what the Fed would deem to be adequate collateral, they would be able to get lines of credit.

So Merrill jumps into Bank of America. Merrill goes into Bank of America, right? And Goldman and Morgan Stanley basically become commercial banks to protect themselves?

Right. So we worried for a long time about how the Fed would regulate investment banks. We don't have any investment banks, so that problem has gone away.

Gone forever, maybe.

In a sense. I mean, other institutions will come to play the role of investment banks. We'll have to give them a new name. Maybe we'll call them investment banks eventually again. ...

Then there's the TARP moment, the bailout moment. Paulson and Bernanke come to Congress. Finally Congress enters our story. Where have they been through all of this?

They've been leaving it to the Fed.

As usual?

Yeah. I mean, this is, again, a very different thing. It's not fiscal policy; it's not monetary policy. It's a kind of credit policy and going beyond the risks that the Fed can appropriately take. So the Fed looks correctly to government to say, "Yes, you can do these things and we will take the risk, or we will just do them."

[Was Bernanke uniquely prepared for this because his research was on the Great Depression?]

There's a lot of relevance to it. But it certainly is a different world now. It's a globalized world. It's a world of capital markets rather than banks. ...

There really are two sets of problems. One is the modern analog of the collapsing bank in the 1930s, and that's the fact that all these financial institutions are frozen and won't lend to each other. So that isn't the problem of the '30s, but it is the financial-sector side of the story.

The other side is this fact that unemployment is rising rapidly, that with the destruction of household wealth, consumer spending is going to fall very rapidly, and something has to be done to replace that. And that's the fiscal part of this that the Obama administration will turn its attention to.

But nobody really knows whether any of that stuff is going to work?

It's very hard to imagine that it won't work to some extent. The question is how much they do, the form in which they do it. Those things will determine how effective it is. In the 1930s there were a lot of programs, but there wasn't that much government spending. We had programs to stabilize prices and programs to protect unions and programs to do this and do that. But until the Lend-Lease programs of developing military equipment to lend to the British and others got going, and until we went into World War II, the economy still languished with an unemployment rate of over 10 percent.

So the government has to get involved -- that's the one thing we all sort of know -- and involved in big ways?

We at least think that that is the lesson of history with respect to this. We've gone as far as we can with monetary policy. Credit policies are stopping things from spinning down. It's hard to see what you can do other than either government spending or really massive tax cuts of one sort or another.

And making all this money, trillions and trillions of dollars, worried about inflation? It seems inevitable, yes?

Not inevitable, possible. Depends on how the Fed undoes this money, takes it back later on. After all, they don't drop it from helicopters; they do buy assets. They either buy government bonds or they buy private bonds in exchange for money. So they've got those, and when the time comes, they can sell them, put them back into the market and take that money back out.

That's the hope? That's the plan?

That's the implicit plan.

Let's back up just for a second. ... When Paulson and Bernanke sit in [Speaker of the House] Nancy Pelosi's office with all the heads of the House and Senate and [Chairman of the House Financial Services Committee] Barney Frank [D-Mass.] and [Chairman of the Senate Banking Committee] Chris Dodd [D-Conn.], and they say, "If we don't do something about this by Monday, there is no economy," was it hyperbole or a genuine fear?

I'm sure it was a genuine fear. Whether it was correct or not, I don't know. Well, I suppose the answer is it was not correct because they got the $700 billion, they didn't do much with it, and the economy is still here. It's not getting better, but it didn't disappear. ...

Did you think TARP was a good idea?

No, I did not. No, I said that at the time.


Remember, the TARP started with a strategy that they were going to buy back these impaired securities, these mortgage-backed securities. There were $2.5 trillion worth of negative equity securities, so they didn't have enough money to buy them back, even if they could pinpoint and target them. The way they were going to buy them back, by so-called reverse auction, that couldn't possibly work with as much [of a] heterogeneous group of securities as was out there.

And they didn't deal with the fundamental problem, which was that house prices were falling. The decline in house prices was creating an incentive to walk away because people had more and more negative equity in their homes. And in the United States, unlike every other country in the world, if you have negative equity and you want to walk away, you walk away, and in general, they cannot take more than the house itself. ... Unlike the rest of the world, where people know that the creditors will take whatever other assets they have and then will attach their future wage income, here it led to, and would continue to lead to, defaults and foreclosures, pushing prices down. And this original plan for the TARP did nothing to deal with that.


Because that would have been a bigger, more complicated thing to do than to go and buy securities.

Now, in fact, they never did buy many securities, because they decided it was too hard. So they changed the strategy, and TARP II was [designed] to inject capital into the banks. And that they did do, because that was very easy to do. You've got 10 people in the room, and you can hand out $250 billion or something close to it. But that didn't do anything either, because that wasn't really the problem. And again, they didn't do anything to deal with the true root cause of this, which was the downward spiral and the potential downward spiral in house prices associated with growing negative equity and the lack of recourse on loans.

Seems a little bit like they were just kind of veering from thing to thing?

They were making up new things that they thought would help. In each case, they had a story, a reason to think it would help. But in fact, quantitatively, it didn't make sense.

You have a bank of the size of Citigroup with a $2 trillion balance sheet, and you invest $25 billion in them, what's that going to do? It's not going to do much. It's not going to make Citigroup look more creditworthy to others. If you were nervous about how much they were underwater before, $25 billion isn't going to change things very much, and it wasn't going to induce them, Citi, to go and lend that money out, because they're trying to get as much liquidity as they can. So these were bad ideas. ...

The film airs in the middle of February, but here we stand: Is it possible that we just don't know what to do; that it's bad enough, that it's new enough, that it's big enough, that it's worldwide enough that we just don't know what to do?

In February, we're going to think we know what we're doing. We're going to hope that it's going to work. But we're certainly not going to be sure that it's going to work.

What do you mean?

At this time, we know that the Fed has brought the interest rate down essentially to zero. We know that the Obama administration has introduced a massive and unprecedented peacetime spending program. What we don't know is how successful it's going to be. And we can hope that this program is going to substitute for a lot of the private demand that has been lost because people are cutting back on consumer spending; construction is down; business investment is down. But we really can't be sure of how much additional stimulus is actually going to come from these hundreds of billions of dollars of spending commitment by the new administration.

I mean, the fact is we've never been here before.

That's true. Well, we haven't been here since the 1930s.

posted february 17, 2009

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