John Cochrane on the Financial Crisis
Feb 2 2009

John Cochrane, of the University of Chicago, talks with EconTalk host Russ Roberts about the financial crisis. He talks about the origins of the crisis, why the Troubled Assets Relief Program (TARP) was flawed from the beginning, why mark-to-market accounting isn't the cause of the problem, argues for letting banks fail, and makes the case against the large increases in government spending.

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Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Johan Sigfrids
Feb 2 2009 at 10:03am

It is always funny to hear Americans talk about Europe in such ultra-generalized terms. Of course, this doesn’t mean Europe might not be in dire economic straits, but at least I know that the American economists won’t be able to make sense of it. 🙂

Feb 2 2009 at 1:48pm

I thought the main problem the Fed saw in allowing financial institutions to fail was the interrelatedness of the various investment vehicles that these institutions had on thier books.
In regards to this problem does anyone have any information on how this situation {complexity of the investments} played out in the Lehman Brothers bankruptcy?

Feb 2 2009 at 1:59pm

Prof. Cochrane is an excellent economist. He is one of the best freshwater economists since milton friedman. I guess that his finance background accounts for his deep understanding of macroeconomics. Instead, De Long and Krugman with their rather silly response to his note on fiscal stimulus epitomize the bad state of contemporary macroeconomics. As Barro says: as if macro has made no progress since 1936!

Feb 2 2009 at 3:11pm

This was another very good podcast. I think we all really know why Keynesianism continues as a force even though it was discredited long ago:

1. Politicians and academic elitists like the idea of directing spending to areas they favor. They figure John Q. Public is a dolt who, at best, went to a community college and can’t begin to understand what’s really in his own best interest. Why, some of these people even use incandescent light bulbs!

2. Keynesian economics is what middle-aged policymakers were taught when they went to school. These ideas may have started to be discredited in earnest in the 1960s, but they were still standard in textbooks in the early 1980s. It’s easier for people to hold on to discredited ideas than to acknowledge that what they were taught was wrong. (You mean to tell me I paid $100,000 in tuition to an Ivy League school and got the wrong info?)

Dr. Cochrane’s comments on the TARP program were very good. Just today, I read a very interesting piece by Paul Kasriel, Chief Economist of Northern Trust, outlining how bad assets could be separated from banks while preserving a great deal of market-based efficiency. Brother Russ may want to consider having Mr. Kasriel as a guest. Here’s a link to the piece:

Feb 2 2009 at 5:55pm

I love EconTalk — but today I was less than impressed.

I did like the talk with Cochrane, but his reasoning regarding the stimulus was less then convincing.

He assumes saving to be a fixed amount, instead it is an endogenous variable. If the government borrows a dollar and spends it, it does NOT necessarily follow that somebody else will invest a dollar less. That’s a first year’s student mistake!

Krugman and DeLong had some longer explanation on this point:

Feb 2 2009 at 6:52pm

Good PodCast,
However I think Mr. Cochran down plays “Free Market” out right fraud to much.

According to Webster: Fraud
1 a: deceit , trickery ; specifically : intentional perversion of truth(credit default swaps as legal instraments) in order to induce another to part with something of value or to surrender a legal right.

A legal loop hole to circumvent mortgage insurance (and the regulations surrounding them) and calling it a “credit default swap” is inmho, free market thievery at it’s zenith.

I see the Free Market purists seem to be the first ones in the Gov’t bail out line…how typical.

Privatize profits and socialize losses! What a country!!

Now watch these same brainiacs, dectate back to the Gov’t “Don’t over-regulate us!”

I am not even sure more regulation is what is needed… Perhaps some corrections are needed.

ENFORCEMENT is and without question, WAY over due…

Now, where did I put my blood pressure meds…


Feb 2 2009 at 9:51pm

Great job Russ.

Very interesting that you and your guest touched on the key difference between the Keynesians and Austrians at the end: If the money is to be spent where is it coming from whether public or private. Digging into the first principles of that issue is at the heart of the difference, between the schools.

I encourage you to find a Keynesian willing to really dig into that question. And an free marketeer as well.

Feb 2 2009 at 11:48pm

I am sorry but this was the worst interview ever. Before the first 2 minutes are up we are told blame goes squarely on “people who invested their money with out reading the fine print”. I seriously take this explanation as insult to my intelligence.

No one to this day has any idea what the fine print of OTC derivatives, MBS and CDO’s says. The fine print is in Hieroglyphics and the markets are frozen still because of these “ingenious” inventions that the Wall Street wizards came up with to make their billions off the backs of the hard working productive Americans. The same ones now homeless because they didn’t read the fine print. The ones you want to lay all the blame onto.

It’s all the fault of the person least knowledgeable about the system?
Layman borrowing 1 trillion dollars poorly doesn’t explain the lenders lending the money. When in the past would a lender make such a horrific loan if they where going to stay tied to the risk? On what basis would a lender make such a poor loan? Did the lender read the fine print??? Did the MBS issuers read the fine print? How bout the the packagers of CDO’s, the Hedge fund managers and the institutional investors. Did they all read the fine print on these loans? Oh and the credit rating agencies? But everyone acted the way they did to skirt regulations? AIG leveraged 100 to 1 because of regulation? You have an excuse for everything.

If all that happened was 1 trillion dollars worth of primary loans failed we would have paid that off with the TARP. But the damage was multiplied 50 o 100 fold by Unregulated Wall Street Cowboys making money hand over fist while doing the opposite of what they were entrusted to do. They were to allocate capital and manage risk. They mis-allocated capital and placed it at extreme risk. They were the surgeon or pilot equivalent that we entrust our lives to and they were working while intoxicated.

I can write no more as furious as I am. This is an insult and if you honestly believe the things you say I find that very sad.

Russ Roberts
Feb 3 2009 at 12:03am


I think it was an idiomatic expression on Cochrane’s part rather than a literalism. He meant people bought invested in assets they didn’t fully understand.


Russ Roberts
Feb 3 2009 at 12:05am


Actually Cochrane has defended himself against the charge. See his web site for details.


Feb 3 2009 at 12:15am

A challenge to any willing.

Here are two diagrams on how banking works for your consideration. Look at them both and explain the current crisis using either diagram. Is it possible to explain the crisis using both diagrams?

Feb 3 2009 at 12:30am


I considered that but even so during the talk we here how the rating agencies can’t be perfect??? So how is the average investor reading the fine print supposed to know? The average person is supposed to read the fine print on investments made using MBS, OTC derivatives? The best of the best have know idea what these things are worth even today.

Most of my investments are in moderately conservative index funds and I still have lost the equivalent of what I pay in taxes over almost 10 years time. I’m quite sure me spending 10 hours a week reading fine print and prospectus would have made no difference.

The only lesson I can take away is to NEVER invest in anything but bonds and individual stocks because there is no way I could EVER be sure of what Wall Street snake oil was going to hit the markets next.

Feb 3 2009 at 12:58am

I kind of agree with muirgeo on this issue. when Cochrane says that it was all buyer’s fault that they did not read the fine print or did not think about taking the loans they could not afford even though they were told that they could with such low interest rates etc. I do think that an average small investor or buyer does not have time or knowledge to read all the fine prints and do research on every investment. That is why you need more regulatory agencies to look out for these people. for example,you buy a medicine as an average consumer and turns out that it was fatal and you died because some of the constituents were not what were on the label. Now should you be blamed for not taking it to your lab to test every component before taking it. ( I hope Cochrane does that) or should you have a regulatory agency to take care of this.
now you might say that oh well it is a free market if the company is making sub standard product it will close down eventually, but remember the damage has been done, you are dead….

Feb 3 2009 at 1:51am

This was one of the least stimulating Econtalk sessions I’ve heard — two academics with similar views nodding in unison, patting each other on the back and warming their hands as the global economic system goes up in flames.

For anyone in the mood for a meaty discussion on the current crisis, I recommend listening to the audio of an American Enterprise Institute event held last week called “Bust, Bankruptcy, Bailouts: What Should We Do Now?”

Russ briefly mentioned fear as a force in today’s markets. I think what Ricardo Caballero and Oliver Blanchard have written very recently, as well as the responses, have been enlightening.

I recently listened to the Econtalk session with Robert Shiller and really enjoyed it. He’s got a new book out this spring, with George Akerlof: Animal Spirits:
How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism
. Tom Keene of Bloomberg mentioned in his reports that trust was very much on people’s minds last week in Davos. How about having Shiller as a guest again? That would be a treat.

Feb 3 2009 at 3:34am

Loving the generalized slant against Europe (I believe “knee jerk” in the technical term?).

Now I’m no expert but it sure doesn’t look like ALL Americans live in nice big houses close to their place of work, either.

At least in Europe we have parks for poor people to go to and frolic.

On a completely different note, I would very much like to hear a podcast discussing the “Buy American” clause in the latest stimulus package (even if Obama should veto it, I’m not sure how things stand with the package at the moment).

The general move towards more protectionism in several countries is quite worrying to me, but Posner seems to be in favour of it!! (post on Protectionism in a Recession) Maybe you could get him on?

Ethnic Austrian
Feb 3 2009 at 4:05am

Russ claimed that no single market-oriented economist was for the stimulus. Last week, Russ mentioned having talked to anti free market economists on the show. Did I miss something? Has a marxist been invited to the show?

Who are these market skeptics, Russ keeps talking about? They can’t be Brad DeLong, Joseph Stiglitz, Paul Krugman or Dean Baker, since they are all clearly pro market. I would go so far and would call them libertarian in comparison to almost all politicians and the general public.

What has always puzzled me about Austrian leaning economists, is how quickly they switch from the assumption of people being stupid, not reading the fine print, being subject to herd mentality, not understanding markets or the evils of governement spending to the assumption of them being good accountants who carefully adjust their spending to expectations of future tax increases. Most people don’t know how much they are paying on income tax, gasoline, food, sales tax, etc.

Pro bailout economists make a similar mistake though. I seriously doubt in this notion of “confidence building” by governements. That may have worked back in the newsreel age.

About stimulus vs. investement. Given that americans, (but similarily the brits, the irish, the icelandics and spaniards) directed huge sections of their economies to build exurban McMansions of questionable build quality and energy efficiency as well as gaz guzzling SUVs, whatever the governement is doing with their stimulus package can’t be too bad in comparison.

This is why I subscribe to my own spaghetti theory of economics. Let both the private sector, as well as the governement throw spaghetti at the wall from time to time. Some of that stuff may actually stick and prove to be useful in the long run.

Feb 3 2009 at 7:24am

I’m not sure I understand the part at the end about the “problem with Europe” (It’s not the main topic of the podcast so I can understand why you didn’t spend much time on it).

What problems are Europe going to encounter while “integrating the next generation of workers” that the USA isn’t (genuine question, not some kind of anti-USpro-EU rant)? I’m just curious as the “my friends live in a small apartment far from downtown” point seems a bit unrelated (and if it were somehow related it’s a bit of a generalisation).

Feb 3 2009 at 8:22am

Cochrane states his friends in Europe have small apartments and live far from thier jobs while he has a big house and lives close to his job. This statement is proof of what? Gimme a break.
It does appear that if the interviewee shares Russ’s ideology a lot of fluff gets by without being questioned.

Feb 3 2009 at 12:54pm

Hi Russ

As always I really enjoyed the interview. I was wondering whether it would be at all possible to have Paul Krugman come onto the show sometime? It would be interesting to talk to a feverish Keynesian about the current crisis and it would be specifically interesting to talk to him about the incentives that drive economists to take very public stands on issues.

Thanks again for the podcasts, I really enjoy them a lot.

Feb 3 2009 at 2:21pm

Hi Russ,

Long time, first time… (I am a fan)

This interview stuck a cord with me because of the conviction of John Cochrane to the point of dogma. Your previous podcast tried to address this issue (“Truth and Economics”); Yet, your very next podcast seems to proceed based on the fact that there is only one “truth”. Keynesian economics was not proven to be false in 1960. It is still argued vigorously to this very day.

How about you moderate a debate between an Austrian and a Keynesian?

Feb 3 2009 at 4:15pm

Ok, my blood pressure med’s are at work and I have to give kudo’s to Muirgeo for putting the fine point on the issue. Well Said!!

“The best of the best have know idea what these things are worth even today.”

Again, agreed. I have read two articles by Nobel winning economists who don’t know…and admit it!

Real “Truth in Economics”

But I add this thought Muirgeo… Did the big investment banks actually drag the MIT grad that wrote the algorythms behind the OTC derivatives?
If so did they understand the “REAL NATURE” of what they were doing and so brought in the lawyers to create the legal means to change the name from Insurance to Credit Default Swap?

That legal manuvering might end up in the courts of this land a great deal more than it is now. Human greed and fraud may well take the place, of what Russ calls “clever instruments”.

Time will tell. The “Free Market” is clever indeed.

Again, terrific posts Muirgeo!


Jeremy P
Feb 3 2009 at 4:53pm

I really do enjoy your podcasts, and my economic beliefs are almost entirely in-line with yours. However, this was my least favorite podcast ever. I wonder what Nassim would say about this. Nobody knew what any of these fancy, shmancy derivatives meant or understood the risks involved. Version 1.0 worked, until it didn’t. Version 2.0 will work; until it doesn’t. Should “we” bail the banks out? No. Should “we” bail any other industry out? No. But this problem is way too complicated to blame on a failure of the individual to act rationally. Where was Cochrane before the collapse? I could not have predicted the extent of the collapse, and nobody knew the exact causes. These financial instruments don’t work, and hindsight is always 20-20. Where was your new found skepticism, Russ. I really appreciate that and think it improves your discussions; I think you should have questioned his assumptions more vigorously. I would like to see this guy debate Taleb, who would be better competition than any of the Keynsians.

Feb 3 2009 at 5:40pm

Great podcast. I too was a bit surprised that Cochrane put much of the blame on the buyers. I certainly think they share the blame, but I think the picture is incomplete without taking into account the extent to which the government subsidized poor decisions, i.e., the pressure put on banks, Fannie, and Freddie to expand their subprime portfolios. Individuals would not have made such foolish mistakes if the government hadn’t been strong-arming the mortgage industry into increasing their loans to “under-served” markets.

Also, I was a bit puzzled by the assertion that fiscal policy has been discredited for over 40 years–this within two months of having had guests who were unapologetic Keynesians–Fezzari and Rauchway. I do wish, Russ, you had asked Cochrane to refute some of Fezzari’s key pointsi.e., that increased savings on my part is exactly offset by decreased savings by the restaurant owner or whoever would have gotten my business. I don’t believe it but I’m not certain why it’s wrong (my priors guide me here!). It certainly seems like “Kenesian” economists are getting plenty of press. James Galbraith (yes, JKG’s son) has been all over the place according to an interview I just heard on Bloomberg, talking about the demise of Friedmanism, monetarism, and market failure and the vindication of government programs!

Feb 3 2009 at 5:51pm

In relation to the dicussion on whether or not the stimulus will affect AD [e.g. to what extent does Ricardian equivalence hold]. In response to John Cochrane, Russ argued that Keynesians believe that people just aren’t that rational. But the sophisticated Keynesian response is that many people are credit constrained because capital markets are not perfect. If you have binding credit constraints then the stimulus increases AD and is welfare improving in a second-best sense.

Paul Downs
Feb 3 2009 at 9:41pm

Here’s something that puzzles me extremely:

(Quote from synopsis): supposedly by buying up just a few hundred million of them you would increase the liquidity and it would somehow help all of these things…. Can’t make $13 trillion worth more by buying up a little of it.

Isn’t this exactly how markets always work? For instance, I hold shares in Company X. On a given day, some small percentage of Company X’s shares trade, at some price. And instantly I and all other shareholders are told that our shares are worth that price, no matter that the price would change if we all tried to sell them. As long as we all believe it it seems to work. As soon as we all stop believing it then it doesn’t. There is a vast institutional framework encouraging us to think that our shares have the same value as recently traded shares – for instance mutual fund statements – when there doesn’t seem to be any inherent reason to believe it. Can anyone explain this to me?

It seems to me that the problem with the bailout is really one of confidence – if government’s spending promotes a proportional rise in confidence then it is likely to work, and if it doesn’t it is likely to fail. This is why no one can prove whether it will work or not, because you can’t empirically measure confidence. Relating this to last week’s discussion: economics has a lot more in common with religion than we are happy to admit. Once you accept a certain theology, or viewpoint, then you can build a large rational framework supporting it, but at its root is faith.

Paul Downs

Feb 3 2009 at 10:11pm

Economics and religion do indeed share alot, and I agree more so than most would like to admit. However, you suggest faith in economics and religion have in common the root source of faith.
Faith is the root of religion, “greed” is the root of “Free Market” economics. Now, I may have faith that greed works, or even that “Greed is Good” as Gordon Geeko suggests in Wall Street.
Consumer confidence is shattered in proportion to the rate in which fraud (Greeds little brother) is exposed. I have no faith that the Messiah will swoop down and clean this mess up…but I do have faith that eventually greed and the free market (with some help from the taxpayers) will.
Because once all the dust settles, and folks start going to jail… The world will start to spin again, and greed will set things straight- after all we ALL can’t stop making money or care about those that don’t forever can we?…Then we can all go back to church and feel good again!

Jeremy R. Shown
Feb 3 2009 at 10:26pm

This was my first econtalk and it was a mostly positive experience.

Much of Cochrane’s insight was thought provoking. Particularly the notion that banks lend in order to sell.

One item that struck me though, was the assertion that WAMU’s failure really wasn’t one because much of it’s operation was back in business the very next day. This seems a bit pollyanna-ish given the fact that announced layoffs will affect 21% of its workforce of about 43,000.

Mark K
Feb 3 2009 at 10:54pm

The comments by Shu and muirgeo are laudable. Cochran’s perspective to ‘place blame’ on ‘you’, whoever that is, was a ridiculous exercise in unregulated market apologetics. What he misses, and apparently what Russ misses, is that the people who ‘carelessly put their money at risk’ are the people who trusted the system. All our financial lives we are advised by a barrage of media financial gurus and private advisers to BUY and HOLD a diversified stock portfolio because in the long run they outperform all other investment categories. Most investors do so through institutional investment vehicles, which are usually retirement plans that hold many types of mutual funds. We entrust our money to these managers because we presume that they are the experts, whereas the rest of us must continue to live our lives, working during the day and tending to family life at night. To say that we make ‘stupid’ decisions because we ‘did not read the fine print’ is insulting and moreover a preposterous position. The fine print should read, “you don’t know what this stuff is worth, and neither do we!” We understand that there is downside risk, but many of us think that the reason to invest is to achieve a better rate of return than a savings account while having the side benefit of helping companies we buy to actually produce forward looking or better products. What a novel idea. These jokers on Wall Street, who according to Russ made ‘innovative’ products like credit default swaps, showed us unregulated free market capitalism in all its glory. This is what you get when there is no watchdog. Forty percent of US profits were in the financial industry in recent years, and they kept it all, while our retirement accounts have diminished. And Russ, people do not have perfect information when it comes to rating agencies. They hope it is more like Consumer Reports than the Chinese gymnastics judges, but apparently you thought, incorrectly I might add, that we all knew credit rating agencies were bought off by the companies rating them. I am with muirgeo: no new money of mine will go into mutual funds, because these Wall Street Masters of the Universe will eventually find another way to game the system and make off with trillions of dollars.

Feb 3 2009 at 11:41pm

This is a great thread, for a real stinker of an Econtalk session IMHO. (Cheers Russ, wouldn’t be here if I didn’t appreciate your efforts but you knew that because I’m here.)

Regarding the comments on Europe: don’t expect Americans with strong libertarian biases to have any competence beyond the US. Understand and accept how severely this restricts their overall competence. (P. J. O’Rourke may be the exception that proves the rule, or just a guy whose books are bought by the unexceptional.)

I’d like to recommend another podcast on the crisis: James Koo on “Great Recessions – Lessons Learned from Japan”. Don’t bother with the video, get the audio and the PDF which alone is very worthwhile.

This is one guy’s take on what we’re up against. He worked for the Fed during the Latin American bust-up and in Japan during their mess. Listen carefully to how he compares the Latin American crisis (we kept it all hush-hush, took 15 years to work it out, didn’t cost the taxpayers a dime) to the S&L crisis. Then ask yourself again, what is macro really?

Feb 3 2009 at 11:46pm

i guess i’m surprised so many people got their feelings hurt when cochrane suggested people bought things they didn’t understand. how many of you went out and purchased mbs securities (or subprime debt originated by countrywide)? bought or sold cds protection? entered into swap agreement with an investment bank? my guess is none. if you bought a house with a fancy mortgage you didn’t understand (or couldn’t afford), he’s talking to you. if you bought a lot of subprime mortgages, he’s talking to you. if you bought a cmo sqaured, he’s talking to you. if you admitted you didn’t understand bank or homebuilder stocks and bought index funds instead, i think it’s safe to say he ISN’T talking to you. the idea is that if you don’t understand the details of a specific investment, even if you think you do, you shouldn’t invest. that’s why index funds are a good idea. i think muirego said it best when he said he’s only buying stocks and bonds b/c he doesn’t trust wall street products. if he, or anyone else, did buy mbs or whatever and got burned, i think that’s a good strategy.

paul downs – equity markets don’t work based on a few transactions up front that set the price and that’s all. the original tarp plan wouldn’t work, he’s saying, b/c if the rest of the market participants don’t agree with the prices treasury paid, they won’t come with demand. the market only functions if there is some kind of perpetual demand that persists after the government purchases are made.

jeremy shown – wrt wamu, remember: he was referring to the “it’s a wonderful life” idea of bank runs causing them to fail. the major operations of the bank continued. just because people lose jobs doesn’t mean it failed. obviously, wamu was brought to that point b/c it was doing something wrong. when companies have bad strategies, they often are forced to cut employees. in the sense of banks, though, if its depositors are whole and its depositing/lending ops keep going, it didn’t fail.

Andy Phillips
Feb 4 2009 at 9:55am

“Maxim writes:… [Cochrane]assumes saving to be a fixed amount, instead it is an endogenous variable. If the government borrows a dollar and spends it, it does NOT necessarily follow that somebody else will invest a dollar less. That’s a first year’s student mistake!”

The dollar already invested in the government obligation can’t be invested in, e.g., commercial paper. What part of this are you missing?

Mark Bryan
Feb 4 2009 at 4:27pm

I too am disappointed that he dodged the question near the end about the investor just sitting on the cash. OK yes, maybe it’s complicated. In that case get him back, or get someone else – devote a whole podcast to it! It seems to be the nub of the whole thing…

Feb 4 2009 at 9:08pm

“Much of Cochrane’s insight was thought provoking. Particularly the notion that banks lend in order to sell.”

Yeah indeed this blew me away too. Would any banker have said this…. could any banker have said this pre Glass-Steagall Act? That’s the problem in a nutshell and as far as I can tell the banker still wants to do mmore of the same.

What am I missing?

Feb 5 2009 at 12:29am

The dollar already invested in the government obligation can’t be invested in, e.g., commercial paper. What part of this are you missing?

Yes but alternatively it “can’t” be stuffed in a mattress anymore. Isn’t the key question how often the dollar comes out of e.g. corporate bonds/equity, versus how often the dollar comes out of the mattress?

And since USG debt is considered very safe, it is more like putting your money in a mattress. So perhaps we should expect more “crowding out” of the mattress “investment vehicle” than of e.g. corporate stocks/bonds.

Surely there’s empirical data to settle this question. Surely the economists have been talking about this for years and have amassed a solid amount of data on government debt crowd-out of private investment. Right? Please?

Andy Phillips
Feb 5 2009 at 9:41am

The amount of money extracted from mattresses by the opportunity to invest in government bonds is approximately zero since virtually no one stores currency in mattresses, and those that do are unlikely to be persuaded to give up their insanity by the increased availability of government bonds.

Some consumption may be foregone in order to take part in the opportunity to invest in government obligations (and that small part directly offsets a small part of the resultant government spending stimulus) but it is clear to me that most of the investment will be of funds that would otherwise be otherwise invested. Mostly in better ways.

Gary Rogers
Feb 5 2009 at 10:42am

Another great podcast, but I had the feeling that you were getting close to some insightful answers but did not quite get there. Some of the things that I felt were missing are:

  • I liked the quote by Professor Cochran: “We make loans to sell not to hold.” I think it says a lot about the way banks work today, but it also highlights one of the problems. I would like to have heard you discuss the lack of incentives for the lending bank to make sure the borrowers are creditworthy when they sell the loan without having to be responsible for its ultimate payback. It seems that this is a systemic problem that did lead to many of the loans that should never have been made.
  • I also liked your question about why a disruption in a small segment of the capital markets caused such a major breakdown of the system. Professor Cochran correctly responded that it was the combination of risky positions and borrowed money to make the investments that was the real problem. I personally believe that our current situation is much simpler than most economists make it out to be. While everyone is pointing fingers at the housing crisis and regulation, the real culprit is too much debt that makes us unable to cope with what should be minor disruptions.
  • I think both of you missed some of the problems with mark to market rules. Using market prices sounds sensible but has problems when there is not a real market. If there was a market for these securities we would know how much the government should pay for them. And, lacking a market, the panic creates a virtual run on the banks when assets are marked down to artificially low values.
  • The opposite of mark to market is not to “light some incense and wave some dead chickens to come up with a number.” These securities are based on a cash flow that can easily be evaluated. If the cash flow is reduced through nonpayment of loans, there would naturally be a reduction in the present value of the cash flow. If there is no reduction in cash flow, there can be some type of disclosure rather than a reduction in value. The key is to mark assets down based on real conditions, not panic.
  • Comments about the commercial paper market were very enlightening. I thank Professor Cochran for the insight.
  • I wish there was more said about the “Paulson Panic.” You covered the ill-conceived idea behind the TARP but did not mention the panic that it created. If you look at the LIBOR/OIS spreads there is a significant increase in the second week of August 2007, which is about the time banks would be evaluating the change in mark to market rules that was coming in November 2007. The real spike, though, came when Hank Paulson held up the U.S. taxpayers by demanding 700 billion dollars or the financial system was going to collapse. Most people panicked when they were told the financial system was about to collapse. The rest panicked when they realized how incompetent the people running the financial systems are. This was no more excusable than screaming fire in a crowded theater.
  • You also ask a very good question when you ask what we should have done. I think the fed’s efforts to add liquidity to the financial system were correct. The FDIC also has done a good job and needs to do a good job handling insolvent banks, liquidating their assets and getting them back into the private sector. I think mark to market should have been changed back in 2007 when it was discovered as a problem. On the other hand, I think the tarp and stimulus are both wrong. Our problem is too much debt throughout our economy and it needs to be slowly worked out. None of the proposals on the table today discuss this real problem. Time will take care of the panic and we can expect a natural recovery in a few years, but right now our government is making things worse and I see no end to the downturn. I like Arnold Kling’s reference to banana republic economics.
  • The discussion about all the Keynesians coming out of the woodwork is both important and interesting. I hope you continue this discussion in future podcasts. I enjoyed the talk with Steve Fazzari and learned a lot with that episode. It seems like Keynesians are able to completely discount the fact that borrowed money needs to be paid back some time in the future.

I really enjoy these podcasts. Keep up the good work!

Feb 5 2009 at 11:59am

Good call; I guess the closest relevant alternative is not a “mattress” but rather a savings account, money market account, or CD. However, with a failing banking system, additional deposits in a savings account or CD will not automatically be passed through as loans or bond purchases. Right? So in other words, the alternative havens for money actually don’t necessarily cause increased purchases of corporate bonds or equity.

The risk profile of USG debt is relevant here, yeah? So what you are displacing is probably alternative investment vehicles with a similar risk profile? And these are probably not corporate bonds, except maybe of very very solid companies.

Michael Smith
Feb 5 2009 at 4:14pm

Mark K wrote:

These jokers on Wall Street, who according to Russ made ‘innovative’ products like credit default swaps, showed us unregulated free market capitalism in all its glory.

The notion that we have an “unregulated free market” is false.

If we had an unregulated free market, the organizations and individuals that made stupid investment decisions — those “jokers on Wall Street” — would now be bankrupt, to be replaced by more competent organizations and managers. Instead, under the current system, they are “bailed out” — at your expense — and allowed to continue operating.

If we had an unregulated free market, the investment rating agencies that rated securities containing subprime loans as “AAA” would be disgraced, bankrupt and out of business — no one on earth would deal with them any longer — they wouldn’t be able to pay people to use their services. Instead, under our current system, not only are all those rating services still in business, the S.E.C. requires that all issuers of investments use those rating agencies.

If we had an unregulated free market, no one would be forcing bankers to make riskier loans than they wish to, as is currently done by legislation such as the Community Reinvestment Act and threats of lawsuits from organizations like ACORN and from the Federal Government‘s Justice Department (Clinton‘s DOJ filed 13 major lawsuits against banks for failure to lend to “minorities“).

If we had an unregulated free market, there would be no central banking entity in charge of a fiat money supply with the ability to:

a) Make vast amounts of credit available at below-market interest rates.

b) Follow such a persistent policy of inflation as to convince virtually everyone in the country that purchasing a house is “a good investment”.

c) Eliminate ( or at least significantly reduce) risk aversion by guaranteeing bankers that they (the Fed) will always be there as “lender of last resort”.

d) Condone and make possible a preposterously over-leveraged fractional reserve banking system under which banks currently hold total reserves of only about 4% and are thus extremely vulnerable to any sort of a run or loss of confidence in the bank.

If we had an unregulated free market there would be no quasi-government entities like Fannie and Freddie and the FHA to insure that trillions of dollars of that cheap credit made possible by the Fed was directed into the residential housing market, producing an unsustainable boom in housing construction, which, when it ends, leads inevitably into an economic bust.

If we had an unregulated free market, the Federal Government would not now be contemplating looting the American taxpayers of another trillion dollars or so to pay off various special interests that helped the latest collection of looters get into power.

We don’t have an unregulated free market. We have a “mixed economy”, with a few elements of capitalism struggling under the weight of literally thousands of pages of rules and regulations and dozens of government agencies interfering in virtually every aspect of our economic lives.

And under this set-up, it is you, the “little guy”, the individual who doesn’t have a powerful lobby in Washington to get the rules bent in your favor — you, who cannot command an audience with Congress to beg for your personal bailout — you, who can do nothing as government uses your funds to save the incompetent and the dishonest from the consequences of their own actions — it is you who gets screwed.

We don’t have an unregulated free market; we have an out-of-control government intent on looting us blind.

Feb 6 2009 at 1:01am

Michael Smith wrote:
“We don’t have an unregulated free market; we have an out-of-control government intent on looting us blind.”

Goverment intent on robbing us blind, and Wall Streets already robbed us blind…

So let me guess… The gov’t should do nothing in the face of this calamity?

I think I’ll have to join MK, Wall street is INDEED full of jokers (not to say that Congress does not have it’s fair share) sooo… throw in a few clowns, stir up the pop corn fellas, cause the Tax Payers have front row seats in this Circus!

You layed before us your mussing about how we do not have unregulated markets, but you did not answer the question at hand in MK’s thought.

Pray tell us Michael, what regulations were governing “Credit Default Swaps”?????

I will stand by for that answer, as I am truly intrested in how you spin that…


Lee Kelly
Feb 6 2009 at 1:40am


The regulator of the financial market should be profits and losses.

Bad investment products are purged when they fail to bring competitive returns, and good products prevail in their stead. Fraud ought to be punished by the authorities, but even without justice the market will shun criminals.

One way or another there will be regulation, either via the market or government. Politicians do not just add more regulation, but usually prevent the market’s own regulatory processes from working. Do you want resources being allocated by ordinary people (voting every day with their dollars), or by central planners (sometimes voted for once every four years)?

Regulation is a good thing. Life would not exist without the complex regulatory systems in the body, but much of what the government proferrs as regulation is really anti-regulation. It perverts the systems which maintain order and balance.

Andy Phillips
Feb 6 2009 at 8:48am


Well, no, and no. If money invested in savings accounts, money market accounts, or CDs were not reinvested no one would offer them. Banks don’t keep mattresses, or vaults, full of cash, either. And only some of the purchasers of government debt will restrict themselves to similar risk profiles. It’s a dynamic situation. In the absence of a substantial increment in government borrowing low-risk debt will provide a lower return and the investor may find the sweet spot in the risk-return ratio is, for him, at a different risk level. Or he may choose the zero-risk investment option of retiring debt. But the debt holder whose debt is repaid will also reinvest, usually.

It’s all pretty much a wash until someone spends the money on goods and services. That’s the ball you have to keep your eye on. The problem with unnecessary government borrowing is the low quality of the resultant government “investment” and consumption, and the way it displaces private investment and consumption.

Andy Phillips
Feb 6 2009 at 9:03am

Gary Rogers –

What on earth do you mean by “not a real market”? If you think that estimating the future cash flows from these instruments is something that can be done “easily” it is particularly hard to understand why arbitrage does not assure a fair market price. It’s not as if there is no cash available. There’s all that disbursed TARP money for one thing. There’s not much hidden value here — just incentives not to recognize losses.

Dr. Duru
Feb 6 2009 at 9:08am

Hi Professor Roberts,
I enjoyed this interview, but I have a few questions (maybe some have already been answered in the volumes of responses above!)

1. Seems to me that you and Cochrane blame the government as the fundamental cause of the current crisis. Did I understand you correctly on that?

2. I would have liked to hear what your theories say to do in the face of rising unemployment. Sure, we can fix the banks with free market principles…and in that time unemployment continues expanding. Do you expand unemployment insurance and assume that the business cycle will work itself out eventually and bring unemployment back down after the financial system stabilizes?

3. I was very surprised to hear the claim that standard economics has for 30-50 years repudiated fiscal stimulus as a way to address economic contractions – that econmists have accepted that fiscal stimulus does not work. I would have liked to hear more speculation on why it is then that so many people in the public sphere are such strong adherents and why numerous (Keynesian?) economists and analysts have been calling for immediate and massive stimulus.

Finally, after scanning some of the commentary above, it is clear to me why economics has so few solutions to the biggest and most important problems of common folks. It is no wonder that “solutions” always fall into the hands of politicians who have motivation and incentive to act, to do something rather than nothing, and to move rather than stand still in endless debate. I would love for us to establish a “Supreme Court of Economics” that would provide final rulings on economic “law”…now THAT would be something!

Feb 6 2009 at 2:08pm

I think Mitt clarifies this for me at least..

The opinions expressed in this commentary are solely those of Mitt Romney

“In the final analysis, we know that only the private sector — entrepreneurs and businesses large and small — can create the millions of jobs our country needs. The invisible hand of the market always moves faster and better than the heavy hand of government.”

I totally agree, however that “invisible hand” of the free market is my point of contention Mitt… Pick pockets are known for having this skill well honed!

What a country!!
The opinions expressed in this commentary are solely those of Shu.

Andy Phillips
Feb 7 2009 at 8:25am

Dr. Duru writes, “1. Seems to me that you and Cochrane blame the government as the fundamental cause of the current crisis. Did I understand you correctly on that?”

Dunno about Roberts and Cochrane, but consider the following: “There are 57 million, approximately, mortgage loans in the United States and fully 25 million or 44 percent are nonprime. That’s roughly double the estimates that a number of people were making pre-September 2008, and it also startled a lot of people to find out that Fannie Mae and Freddie Mac had ten million of these 25 million loans or about 40 percent of the total. Then you throw in FHA, which has another three and a half million or another 14 percent and you’re looking at the federal government having direct involvement in well over half of the total of subprime and Alt-A lending or nonprime lending.” And, later, “…70 percent of all mortgage debt has now been nationalized or guaranteed by the federal government.” And it’s getting worse. “FHA, in the last quarter of last year, 25 percent of all loans, and they’re usually three percent or four percent. So their volume is going way up. Their systems can’t handle it. And Fannie Mae and Freddie Mac basically account for the rest; 97 percent of all the loans made in the last quarter of last year were done by Fannie, Freddie, or FHA…”

Andrew McConnell
Feb 7 2009 at 9:28pm

Dear Russ,
I appreciate your show and your attitude.

I think you would really appreciate an OUTSTANDING podcast/investigation that NPR News conducted in collaboration with This American Life on the Mortgage crisis:

Brutally honest accounts are given from a Morgan Stanley employee and from loan officers. It reveals a critical part of the story of Mortgage-backed securities.

To understand parts of this complex problem, this is a MUST-listen. Please don’t miss it.

Regards, Andrew.

Feb 8 2009 at 4:20pm

Dr. Duru,

While Dr. Roberts can likely answer for himself, I will attempt my own personal answer for “some of the commentary above.”

1. It appears to me that Roberts and Cochrane believe that the Government had a substantial role in the cause of the crisis. This would be supported by high market proportion that of holding of mortage debt, the favorable tax treatment of household debt and the new ability to favable tax treatment of home equity loans.

2. Cochrane and Roberts do state their theory of what to do. Libertarians would not in a large way do anything drastic about unemployment benefits, because it would to some extent provide disincentives regarding finding market opportunities where the currently unemployed can contribute value. Nor would libertarians support lower interest rates to subsidize housing cost. It would be desirable for housing prices to fall to their actual market value. Note that if lower prices were allowed many people to buy homes. Those current real estate sellers with unrealistic restrictions on homeownership will suffer because they are not qualifying people witht the ability to pay.

3. Calls for stimulus from Keynesians come because it is convenient and many would like to think that it is that easy. We americans always do the right thing but only after trying everything else. I would suggest Roberts’ Bueno de Mesquita podcast on incentives to understand why so many support it. Also don’t forget the substatial effort in action now to acquire part of the stimulus package. Those who have hope of getting free money certainly are not going to speak poorly of the entire program.

4. As for discussion, it is a good thing that helps shape better policy.

Feb 8 2009 at 9:36pm

Your discussion opens with the comment that there was no free market but rather government intervention which created the housing bubble.
No mention of the fact that that the credit derivitives which Buffet called the “financial weapons of mass destruction” are part of the massive unregulated credit derivative market.
Does that mean that government regulation of this market would have made things worse?

Christian Habeck
Feb 9 2009 at 11:45am

I usually enjoy EconTalk. Even though I sometimes don’t agree with the premise, Russ Roberts is an intellectually honest interviewer who tries to get to the bottom of the issues and almost always yields some gems for the listener.

I am not interested in apportioning blame, but rather in understanding WHY the blow-up involving mortgage-backed securities happened. Let’s find the model assumptions that were flawed and evaluate the models against empirical evidence. In this respect, this PodCast was the weakest that I have heard recently with shoddy metaphors and free-market ideology that couldn’t just look at empirical facts without supplying spin and standard economic orthodoxy. For instance, absolving the credit rating agencies of any blame because the average investor should have discounted their AAA ratings is a strange leap of logic indeed. If the right approach to AAA ratings is along the lines of “Well, you know how the rating agencies are and this is probably baloney anyways” I wonder why these agencies exist in the first place? Particularly if their actions have real consequences with stop-loss orders that mandate compulsory sell-offs if AAA ratings change downwards. The last few minutes of the PodCast moved in right-wing fantasy and make-believe land that made me laugh, excoriating Europe once again on account of some mythical and abstract free-market tenets, while plainly ignoring hard evidence of quality-of-life polls. I don’t care much about my nominally much larger salary that I and my wife take home here in New York, when real tangibles like health care, child care and retirement prospects are much better In Europe. Given these actually existing quality-of-life advantages, I think I can tolerate the theoretical impurity from a free-market standpoint. My future house in Europe might not be as big as in the US, but it probably has less risk of foreclosure there then here.

Feb 10 2009 at 6:06pm

1] How were 50 sets of more stringent state banking and lending laws superceded without the monopolist with guns influence FNMA/FHA in court case after court case, and even USSC case?

2] How were the instruments ‘securitized mortgage bundles’ possible without the implied backing of SEC Exempt, Agency Rated FNMA?

3] While the real estate bubble was inflating, who was supposed to say ‘no! Stop! ?’ Not FNMA/FHA — it was there policy to expand ever greater credit. The theory was at one time that it was lack of access to credit that was keeping poor folks poor, and the nation, via strong centralist federal monopolist with guns power, conducted that experiment on most of the nation, as a whole, in a massively singular OneSizeFitsAll SinglePoitnOfFailure experiment. Not CountryWide– they along with FNMA/FHA were saluting the flag and doing Gods Work. Not the folks getting the tear off credit. Not any of the two past POTUS, both of whom had an incentive to continue to tout ‘the highest % of home ownership in history — while the bubble was inflating.

In fact, any ‘The Economy Czar’ who would have effectively tried to say ‘No! Stop! while the bubble was still inflating would have been redline painted as a meanie.

Perfect Storm, nobody to say ‘no.’ Not government, not business, not citizens.

Think about it. ‘We’ as a nation shepherded precisely that portion of our citizens least able to bear the title ‘last investors into the bubble’ into precisely that role. ‘We’ did it out of greed, ‘we’ did it out of self interest, and ‘we’ did it even out of well meaning public policy. The villian in this Perfect Storm was the OneSIzeFitsAll, single point of failure nature of the experiment. Had this been 50 state experiments erunning in parallel, and not one massive singlualr federal national experiment, the entire event would not have made it past P8 of any local paper.

Mixed Economizers are supposed to be on the lookout for the danger of ‘monopolies’ in our economies; what is it about handing them guns that makes them suddenly invisible to our ‘mixed economies’ radar?

Wasn’t the purpose of our ‘mixed economy’ federal government to protect our economies from ‘entities too big to let fail, by detecting them and devolving them before it is too late? When did it become the function of our federal government to instead prop up entities ‘too big to let fail?’

JFKs entire federal budget was about $100B dollars. A dollar isn’t a dollar, but … we just through more then that at AIG, a single entity in a nation of 300 million bewildered folks. How are they doing?

Are we nuts, or is this just the new serfdom, waged by an out of control CronyFest on the Potomac?

Feb 10 2009 at 6:39pm

Failure can’t be subsidized into success.

Let failure fail, let success succeed. Not unless we actually want more failure, and less success. For sure, we shouldn’t be punishing success to reward failure. That is insane.

It makes no sense to prop up a 17.5 million unit/yr auto industry in the face of a 10-12 million unit/yr market demand. Let displacement happen. Our economies really aren’t sending us the signals ‘do more’ of that which the government is trying to prop up. Tell you what, I’ll even pony up a new name for whatever comes out of a displaced Detroit after all this. Let President Obama put the ‘O’ in ‘detritus,’ and we can call what remains from the displaced wreckage and decay ‘DetrOitus.’

Compassionately apply Hayek’s ‘safety net’, but that isn’t propping up resources for demand that doesn’t exist. Job training, job creation incentives, extended safety net, sure enough. But constructivistly ‘running the economies?’ Even ‘green’ economies? Are we nuts?

The current tribal insanity is responding as if the Berlin Wall went up in ’89, not fell down.

It’s not ‘The Economy’, stupid; it’s ‘the economies,’ stupid. Carville’s too cute by half little bumper sticker has all but sucked all of our brains dry.

When it comes to our economies, it is ‘United we stand, divided we fall.’ Not, ‘United it stands, divided it falls.’

We seem to be light years from getting that. It sure is not how we build bridges, including, to the futures.

Feb 15 2009 at 9:32pm

Thanks, that was a very interesting read. The history behind the facts…

Feb 22 2009 at 6:56am

First of all, some of the buyers of these things were not idiots, but supposedly professionals. I don’t think he was blaming pensioners but pension fund managers.

Secondly, we do blame people in other areas when they make poor choices. Would muirgeo not blame a patient who used a witch doctor for treatment? (But medicine is so complicated…)

Oh, and when you buy and index fund, you know that you are buying the market, which protects against individual firms’ mistakes, but if the whole market crashes, well, why is it not clear?

Mar 5 2009 at 6:26pm

Setting aside the debate from the 22nd, this podcast infuriated me. For a lot of the reasons mentioned above, but the complete rejection of Keynsian economics was uttered in a single phrase, loosely, “There’s been no evidence of keynsian economics working in the last 50 years.” That’s true. But what they neglected to mention, is the last time any serious money was spent on public works projects was sixty years ago. And it did work. The TVA, among others brought the south into the 20th century for Chrissakes! The WPA, employed 3 million people alone in its first year. The reason there has been no Keynsian discourse in the last 50 years is that the Chicago School you’re so proud of bulldozed it. America’s infrastructure is crumbling. It needs to be rebuilt. There’s no better time. Not only because of the possibility of a major stimulus to the economy. But also because goods and services are cheaper now than they’ve been in sixty years

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Podcast Episode Highlights
0:36Intro. History, how financial system got into the mess it's been in. Wall Street. Characterized as free markets failed, but we don't have a free financial market, very regulated. Government encouragement to invest in houses rather than stocks and bonds. People investing without reading the fine print; promises of gold mines should be looked at carefully. Borrowing that shouldn't have happened. How so many people made so many mistakes; feedback loops, some broken by government intervention, some broke normally; in this case things went not just badly but disastrously. All for people being able to make stupid decisions and government not bailing them out. Call for regulation. A lot of blame going around. Look hard at each link in the chain, hard to blame people other than those carelessly putting their money at risk. If somebody offers you--you don't have a job or downpayment, if value of house goes up you get to keep it but if it goes down you lose nothing, foolish not to take it. How about the mortgage issuers? People buying those mortgages weren't looking hard at it. Promises of return without risk. Hard to blame the intermediaries. People bought these mortgages because they were triple-A rated. Not stupid people buying junk, innovative, creative aspect that appeared to insulate buyers from risk. But they were wrong. Why? Mortgage-backed security was a wonderful idea, share risks around the world. Hedge funds in Germany buy Kansas mortgage, take small risks. What does a rating mean? If you are promised 5% more than Treasuries and not take any risk, you are asking some agency to come give you a gold mine. Some risk, your job to look. Expect rating agency to read carefully but they can't explain risk. Greedy and stupid people who bought. Even AAA rating doesn't mean no risk.
9:01Competition in rating agencies would help a lot. Some problems were devised as ways to get around silly regulations as opposed to sharing risk around the world optimally. Example: institutions are regulated, can only hold AAA-rated securities. Safe portfolio: take diversified portfolio and make them safe. Each security doesn't need to be AAA individually. People had an incentive to get things branded as AAA. Junk debt, 1980s, really stock. No economic reason to hold only triple-A stuff. Surprise: banks were holding back equity tranches: take a bunch of mortgages, put them in a pool, have agreement that when they start losing money, equity tranche is first to lose. Banks kept riskiest parts, so were writing insurance instead of borrowing and lending. If you hold the first tranche, the toxic tranche--usually banks borrow from depositors and lend it out for houses. All that is left with the bank is the little bit that is risky, saying to the people who bought the less risky part that they are taking the risk. Banks do a lot of explicit writing insurance, credit guarantees. Normally when banks borrow and lend they take the risk that something will go wrong, treated in a regulatory way more harshly than writing insurance; did the writing insurance part to get around a lot of regulation.
13:45Many different financial institutions: standalone hedge funds, hedge funds within banks, brick and mortar FDIC guarantee-deposit banks. The big commercial banks in trouble now turned out to be ones that had a lot more mortgage risk than anybody thought. Banks were to sell the risks off as mortgage-backed securities; but through the tranching system them ended up with more risk. Typical neighborhood bank is doing fine, but get rid of the whole thing or keep it on their books and keep servicing it. Subprime originators, like Countrywide--pure intermediary. What did it have at risk? Was keeping some of the risk. Really stretching this business, in some cases actually fraudulent. Sometimes originators covering more than the cost of the house--closing costs. Only earn extra return for taking on some form of systematic risk.
17:45Deleveraging. When a sector of the economy goes bad, people who invested in it lose money. Could have a bad quarter, a bad year--but this time, out of business. Why did such a small sector have such a destructive effect? Why didn't Bear Stearns and Merrill Lynch just have a bad year? They had borrowed a lot of money. If you borrow to make investments, then a little bit of loss can mean you can't repay your debt. Why did people lend these institutions money on an ongoing basis? Very active, very, very short-term market. Investment banks are not regulated banks, could do what they wanted. Borrowed every night. Every day had to borrow money to pay off the old money. Everybody wants the illusion of not taking risk because he can sell on the way down. Fallacy of finance: can't put in a stop loss order and not have risk. People lending to them thought they are just lending overnight, so they could just refuse to renew the loan if they get any trouble. Recipe for disaster. Leads to a run. That's what happened to Bear Stearns. You'd say, okay, we never said it was perfect, make a mistake, this part of the financial world made a set of bets that was riskier than it appeared. Cascade: financial market, overnight market, credit default market stopped almost entirely. Why? Banks trundling along. A lot of the credit markets are not working. Version 1.0 of the software had a bug in it. Example: Municipal bond markets--tax free, so they usually pay lower than Treasuries. Now paying more than Treasuries. People are afraid they are going to default, but interest rates too high for that. University of Chicago just sold municipal bonds at 6%, implies over 20 years, 50% probability of default. Sign of market where people are either very afraid or market isn't working well. Most municipal bonds are held by funds, which require that they be insured by an insurance company with AAA credit rating. Insurance companies got downgraded to AA, so funds had to get rid of municipal bonds, dumping them on the market; investors who were used to buying funds now have to buy them individually, which is a very difficult thing to do. Hard to get a good price. Quirky detail in the structure, hard to float bonds.
26:23Municipalities will struggle, rolling over debt hard. Commercial paper market frozen. Hard to match receipts to outflow, costs up front, revenue comes later; businesses borrow to make that match. Point of commercial paper market is that it lets companies smooth things without having to go to banks. You have to pay your workers on Friday but cash doesn't come in till next Wednesday, short term loan. In the fall, the commercial paper banks were issuing froze--no such thing as "froze" for economists, just supply, demand, and a price. But investors worried that banks would go under and demanded a price that banks weren't willing to pay because banks knew they could always borrow from the Fed. So banks stopped trying to borrow from the commercial paper market, high interest rates. Rest of commercial paper market: Big non-financial companies having a field day. The money is there and is being lent at low rates. Kraft Food. People with a little less credit rating face very high interest rates. People with money to lend are very averse to holding any risk. Lending hasn't stopped--they've made a distinction. Auction securities, etc. So, if companies that are not in the financial sector are still able to borrow, maybe okay, we shouldn't have a depression, but we hear that the entire financial system is in disarray. There is really disarray but it's not really in the banks. "We don't lend to hold, we lend to sell." Loans may get made by a bank but it's packaged and sold. That's not working now, real problem. When Paulson was worried about what to do with the $7 billion, worried about car loans, etc. Munger on middlemen podcast. These loans couldn't be bundled. Why are we worried? Got into this mess by borrowing, so isn't it a good thing if there's less? Why encourage more? The fact that lending has gone down is not necessarily a sign of problems. Savings will increase, prudence. Suppose gas sales are down. Might be we are in a recession and people just don't want to buy as much gas. Doesn't mean anything is wrong with the oil industry. So we would expect loans to be down now anyway. Gas sales might be down because supplies got tighter. Worry is: suppose some of the refineries blew up. Middlemen system in credit markets has blown up. Hard to turn oil into gasoline right now. Maybe everybody's massively risk averse but hard to see why it should be so off the charts. Warren Buffett: When everyone is greedy, be fearful; when everyone is fearful, be greedy. Are people not buying corporate bonds because they don't want to take the risk or because the way they are used to doing it through a fund isn't there? Hard to tease out, some of both. Hopeful signs: system of intermediaries is rebuilding, but lots of stuff is having a government guarantee slapped on it. Hedge funds are being started. Good pools of mortgages, student debt, etc. Building new refineries. Government could nationalize the credit system for a generation. Finding it fun to be in.
37:15What is role of mark-to-market accounting? In principle the idea: you're a business and you have some assets and some loans you have to pay back. What are your assets worth? Mark to market: When there is a market price, we should write the value of your assets at that price rather than its historical cost or a made-up number. Seems sensible. Alternative is accountants wave some dead chickens and come up with a number. If price of assets falls, you have to tell the world. Close the company down. Schizophrenic: half the time tell us it's mark-to-market accounting that's the problem and other half tell us banks have all these assets on the books that they don't know how to value and are secretly worth less than their accountants are telling us. Either it's marked to market and the assets aren't worth anything, or there are assets that would be worth less if they were marked to market. Can't have it both ways. Isn't it true that marking on your books at market rate, if I'm a bank holding a bunch of these equity tranches; we know they are worth less than I paid for them because of the default rate; not sure how much they are worth either because they are worthless or there is a lot of anxiety, which may be the same. Bank now has to write down its assets so is not satisfying its capital requirements, forced to sell off assets to make their balance sheet healthier; spiral occurs. A lot wrong with that story. If you think that's the problem, you don't have to change the books. You can change what you do with the piece of information. If you think the market is sending the wrong signal, don't have to close the bank down. Bank appears on paper to be in distress. The anti-mark-to-market people say it's not really in distress, worry about toxic assets, we should not force them to mark to market and they'd be healthier. You don't have to cook the books. Just change the capital requirements. Suppose you lent me money and I was paying you back regularly $100 per month. Economy goes bad, worried I might lose my job. To sell this asset, you'd get a lower price for it; expected flow of $100 is not going to be $100. But I'm still paying you, so you are not in immediate trouble. Value of loan on open market has fallen, but no reason to close you down. Should we write a new set of books that says my loan is good because I'm still paying you? No. We want the information that this bank is holding loans that are questionable. Should we close you down today as a result? Maybe we shouldn't. Need to think about chance of experiencing problem in the future, maybe need to set aside a little more capital as a result. Deleveraging: banks can and do issue capital all the time. When they write down the value of loans they can sell new equity. Look at the numbers and they do. Banks can also fail. Bedford Falls, NY. When a bank fails, the people, the computers, etc. are back in business with somebody else's name on it. WaMu--the week of the TARP. Later that very week it was taken over and back in business the next morning. Investors in the bank fear bank failure, but modern failure means the operations keep going. Contagion of fear.
47:22TARP. Last fall Congress gave $700 billion in two steps, toxic asset relief program--Troubled Asset Relief Program. Government would buy up the troubled assets to take them off the books. That lasted a week. Opposed by various economists. What would have been better? Original TARP idea even loonier. Not just to buy up assets from banks. Wouldn't work. Holding on books at $.60 on the dollar and they are only worth $.30; if you buy them at $.30 you aren't doing anyone a favor because now the bank has to mark them down to market. Wouldn't be enough in bank to cover its debt. If buy them at $.60, transparent subsidy to bank's shareholders. Told that even if we bought them at $.60, taxpayers might make money because they could go back to $1.00. Original TARP, idea was that the government would buy not just from banks but from the open market from anyone who wanted to sell them; supposedly by buying up just a few hundred million of them you would increase the liquidity and it would somehow help all of these things. Argument was that prices were artificially low. Demand curve was nearly vertical, stir lake a little bit. Can't make $13 trillion worth more by buying up a little of it. Realized that wasn't going to work. Buying stuff from particular banks was a transparent subsidy. Instead bought stock in a bunch of banks to "recapitalize" them. Argument for it was taxpayer needs to get something in return. Banks have lost money, so now they don't have as much capital as they used to have. Can just issue more stock and get more capital. Idea was government would give the banks this stock and everything would be hunky dory. They got the capital, though, and they still don't want to make loans. Can't sell them; and making shaky loans is a bad idea. Problem was not that they had a constraint of capital. Gas in the tanks, but no electricity in the pumps. Claim was that the government would give them electricity; discovered that there was some other reason gas wasn't selling.
55:52What would have been more effective? Problem we have now is that people are scared. Lack of confidence in the future, innovation is slowing, risk-taking is slowing. We don't have a model for creating confidence. More than confidence: supply and demand and the things that make them go together. One reason people are scared is they don't know what huge program will come down the line. In one auto bailout loan, government wipe out all the loans of the senior creditors. How can bank every do anything again? Citibank more trouble, British banks. Bad banks eventually have to get closed down, but with government as a stock holder that won't happen. Bank of America got TARP injection. Merrill Lynch. Hard for Bank of America to borrow more. Why? All about what the government's going to do with it, not about the business operations. We overly fear bank failure. Economic equivalence of bankruptcy is not so terrible. Risk-free haven: savings and checking accounts. If you invest in a bank we expect you to keep an eye on it. Don't want to live in a world where people who buy bonds and stocks shouldn't have to worry about their risk. We don't want the ATM machines to fail for a week. Economic equivalent of letting them go.
1:01:50Current state of macroeconomy. Suppose we spend $1 trillion, skeptical of Keynesian model that that will work. How do we pay it back? Could print it up and drop it from helicopters. We know you'll get a little boost in output and then an inflation of Latin American proportions. Could borrow the money and intend to pay it back. Nothing in the last 50 years of economics that says that is going to work. If refineries are busted, paying people to drive around is not going to fix it. Becker and Posner blog: resurgence of Keynesianism, when last 30 years have mainly been a rejection of that. In macro we've understood why those ideas are wrong. People when deciding what to do today think about the future. Keynesian would say, as Fazarri podcast--animal spirits are causing people to be anxious about their spending, so that's why the government has to step in. Difference between professional and personal opinion--may be same thing. Modern medicine in the journals, leeches. So in the 1970s, post-1962 with Monetary History of the United States, models started to say there wasn't much intellectual basis for Keynesian models. How much evidence? What if no taxes this year? Most people would worry that taxes the next year would be large, might save a lot of the money. Keynesian argument: counting on fooling people as the centerpiece of government policy. Government smarter than individuals, not good track record lately. Podcast with Robin Hanson: priors. In current debate, opposite views. Philosophy. Mankiw Keynesian but free market, against the stimulus. Where is the money going to come from? Has to be borrowed. The guy you are going to borrow it from, what was he going to do with it instead? Keynes ignored that. Investment didn't matter to Keynes. Isn't that person just sitting on the money right now? Some government spending is good. It's just not a "stimulus." Moves money from what I was going to do with it to what the government is going to do with it, doesn't say that government spending is bad. More like Europe or less like Europe. Drive around suburbs around the big cities, on edge of low growth precipice, not visible to American tourists.