Richard Posner on the Financial Crisis
Nov 16 2009

Richard Posner, federal judge and prolific author, discusses the financial crisis with EconTalk host Russ Roberts. Posner (despite the title of his recent book on the crisis, A Failure of Capitalism) places most of the blame for the crisis on the Federal Reserve, inattentive regulators and the subsidization of risk. He also criticizes economists for complacency in the face of impending disaster. A recent convert of sorts to Keynesianism, Posner confesses some disillusion with the implementation of the stimulus plan and the expanding role of the Federal government.

John Cochrane on the Financial Crisis
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...
Vincent Reinhart on Bear Stearns, Lehman Brothers, and the Financial Crisis
Vincent Reinhart of the American Enterprise Institute talks with EconTalk host Russ Roberts about the government interventions and non-interventions into financial markets in 2008. Conventional wisdom holds that the failure to intervene in the collapse of Lehman Brothers precipitated the...
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.


Andy Kneeter
Nov 16 2009 at 11:39am

I found Richard Posner’s analysis of the economic meltdown incomplete. He accurately identifies certain causes (i.e. – low Fed interest rates), but practically disregards other critical elements (i.e. – moral hazard). He’s connecting the dots, while ignoring some important dots.

He’s befuddled by the poor regulation, but he’s ignoring the fact that all government entities are subject to powerful political influences & are bureaucratic. This is impossible to eliminate & it’s why the government is the worst way to run anything of complexity or importance. The more money it has, the greater the political influence & the worse the performance.

Predictably, he concludes that the old regulators were dumb & everything would be fine with smart regulators (those that agree with him). With an extensive history of profound government ineptitude & inefficiency around the world, I don’t understand how he thinks some smart guys are going to get it right for the first time ever.

Nov 16 2009 at 1:26pm

Shouldn’t a federal judge simply shut up about these issues, sit on the bench, do his job, and judge issues before the court? Not to sound so harsh, but if Posner wanted to try changing public policy, seems like he would have attempted to become a politician, or chosen any number of careers other than a judge. I thought, at least as an ideal, judges should avoid politically divisive issues outside the courtroom.

Lee Kelly
Nov 16 2009 at 2:01pm

As I argue in the book, banking is an inherently risky business, so you have to have regulatory controls, and you have to have a central bank that controls the money supply and interest rates and so on. – Posner

I wish banking were more of a risky business, because at the moment “regulatory controls” and central banks socialise much of the risk.

eric mcfadden
Nov 16 2009 at 2:20pm

Was he trying to keep it simple so that his audience would get his point? He should remember he is talking to people that listen to a weekly econ podcast and get hardcore with his arguments.
The other option is that he really believes the causes of this past recession are rooted in super smart ultra regulators just not being told to watch the really important things. The previous guests that were hard core law guys really impressed me, too bad this guy is a decision maker.

paul vreymans
Nov 16 2009 at 2:43pm

30:00 About the Housing Bubble:

“Still need an explanation for why it (the housing bubble) gets started. The Bubble started expanding in the 1990s, not the early 2000s. Depends on the market. In some cities, very little appreciation and very little collapse. In other cities, enormous appreciation in the early 1990s. Story is yet to be told what role government played….”

The most plausible explanation can be found in zoning and land use regulation, which very locally caused artificial housing shortages. This likely triggered the speculation. The speculation would however not have been sustainable without artificially low interest rates. It is a plausible explanation for the huge local differences and why coastal regions were hit worst.

Lee Kelly
Nov 16 2009 at 3:44pm

In my opinion, Posner is the most ill-informed guest that EconTalk has ever had — he was mistaken about some basic facts and concepts. EconTalk has had some economically illiterate guests, but they have always been aware of their ignorance and humbled for it. But Posner didn’t let his blatant lack of economic knowledge phase him; the number of non-sequiturs in his arguments were immense.

If ever there was a man who exemplified the fatal conceit, it is Posner — a self-assured, ill-informed, would-be technocrat. For me, Posner came across like this with virtually every other sentence. I would say that he should stick to being a judge, but frankly that scares me more than him being an economic pundit.

Nov 16 2009 at 4:49pm

We Brits like to pretend that we do humour better than you Americans however, Russ at 33 minutes when Ayn Rand is mentioned your comment of “ridiculous” is absolutely hilarious. That moment sums up the whole podcast for me. Fantastic.

Daniel Fullmer
Nov 16 2009 at 9:08pm

Posner was pretty dismissive of the optimal rate of inflation being negative. It makes perfect sense to me from a rational expectations standpoint. Anyone have some more reasoned criticism? The “downward spiral” argument doesn’t convince me.

Also, Posner’s story of the bubble sounded a lot like irrational exuberance to me: people were making money so they kept investing. That would only make sense if you believed past performance is a good predictor of future profits.

Nov 16 2009 at 11:17pm

Too Big to Fail is TOO BIG. End of Story.

Too big to fail is a form of monopoly power. Monopoly comes from market-breaking concentration of power, and that is exactly what happened in the financial sector. Regulators cannot effectively regulate companies with such power. At some point these institutions become able to bend the rules in their favor, and the market is no longer a level playing field.

Anti-trust actions have a bad reputation in libertarian circles, but there is one clear use for them. When certain companies get so large the government feels obligated to prop them up (large banks, General Motors, etc.), anti-trust regulation could actually help keep the government from introducing market distortions (bailouts) that are even worse than anti-trust actions.

Patrick Joyce
Nov 16 2009 at 11:20pm

Russ Roberts suggested that deflation, if anticipated, is no big deal. Posner rejected this out of hand. Looking at the real world makes it obvious that Roberts is correct. Prices for electronic items fall with predictably regularity. Buyers and sellers know this and make sensible decisions on what to produce and what to buy.

Nov 16 2009 at 11:48pm

Judge Posner has a crotchety charm, and I enjoyed the podcast. But is the judge too brilliant to see a contradiction in his putting much of the blame for the crisis on the poor judgment behind Greenspan’s discretion-based expansionary monetary policy early this decade on the one hand, and his derision of Milton Friedman for advocating rules-based monetary policy because such a rules-based policy leaves no room for discretion?

Nov 17 2009 at 12:33am

I agree with the other commenters, I really felt that Judge Posner was making no sense at all.

Nov 17 2009 at 1:58am

The wonderful thing about EconTalk is that you get exposure to such a wide variety of guests — most of whom know a fair amount about the topic — that you get a good feel for who is, er, unjustifiably confident in their views.

With Charles Calomiris’ interview still fresh in our minds, it’s hard not to think that today’s guest has a newspaper reader’s knowledge of the topic by comparison.

In fairness, I tuned out after 20 minutes, but I think that’s giving someone enough of a chance to establish basic credibility.

Nov 17 2009 at 8:09am

What I found disturbing is the fact he advocates (or maybe endorses is a better word) the flooding of the economy with the taxpayers own money.

As if this will give the consumer the confidence to spend the money that the government is not borrowing for them. I find this akin to adding more sand on top of a slab that you want to build a solid house on while digging a hole under it.

While I agree with a lot of what he says, (CfC and homebuyer tax credits are horrible ideas) I still think he misses the point about the solution.

I would have liked to here Russ ask one question, and it would be the same question to all guests on this subject.

What is the best way to promote private investment into productive economic/industrial activities?

Less government? Flat tax (or no income tax)?

Nov 17 2009 at 11:27am

Perhaps the problem is (at least in part) limited liability…

Scott S
Nov 17 2009 at 12:03pm

Posner is bizarre. He actually comingles free market activity with government regulation and calls it all “capitalism.” Then he comingles government interference, including the morally hazardous bail-out mentality, with “overly lax” reliance on market forces, and calls it all poor regulation. I could go on about his bizarre logic and unsupportable assertions. The bigger picture, I fear, is that the UofC has totally lost its footing with Milton gone and what’s left there is a bunch of liberal apologists back-peddling the free-market ethic now that it’s clearly to “blame” for our current downturn. And Posner’s incoherent ramblings are the result.

Nov 17 2009 at 12:33pm

Sigh… I have been really hoping for a Judge Posner Econtalk episode for a while. When viewing his accomplishments across his entire career, he’s arguably the second most distinguished econtalk guest ever (behind Milton Friedman of course… though I suppose Robert Lucas is also in the mix).

But his foray into macroeconomics has been mixed. This interview was no exception and its left me a bit disappointed in Judge Posner.

At the end of the day, Posner is not a macroeconomist. He is a legal scholar – and a very very good one – whose major accomplishment is bringing economic analysis into the courtroom where it is desperately needed. We might be better off hearing about Posner insights on anti-trust policy or the legal structure in the United States.

Nov 17 2009 at 5:27pm

I’m starting to get a bit tired of the level of bias in this podcast. I cannot help but feel that Russ Roberts is just itching to get the guest to say that had we left the markets to their own course everything would have worked out OK. I sense this in nearly every edition of the podcast and question that is posed to the guest.

I would really appreciate a more balanced podcast with fair and critical questions fired at all view points.

The relentless Fed bashing, and other criticisms fired at governmental bodies is making this otherwise excellent podcast come across as a moaning shop.

Nov 17 2009 at 6:01pm

James writes:

“Too Big to Fail is TOO BIG. End of Story.”

But is the federal reserve too big to fail? Do we need to break it into 12 competing banks that can issue currency?

George Elmore
Nov 17 2009 at 7:10pm

I was gonna write, but Lee Kelly has it all right. Somebody ought to send Posner a copy of Road to Serfdom, although he probably wouldn’t get it.

Nov 18 2009 at 1:16am

It good to hear two people with differing views talk to each other civilly. Thank you.

Nov 18 2009 at 10:38am

It is probably a measure of the influence of both that Freidman and Keynes are so widely known that their work is often misinterpreted. It is sad that someone of Posner’s intellect and stature who clearly understands Keynes better than most social engineers, who use him when it suits them, would also completely misunderstand Milton Friedman’s central thesis. Roberts refuted him well but diplomatically.

Nov 18 2009 at 10:48am

I found a couple things quite unsettling about Posner’s claims.

1. He seems quite convinced that these problems could be fixed if only the right people were in charge and doing what prescribes.

2. He is extremely confident of himself.

I’m reminded of the concept of the fatal conceit, as well as this quote:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design. – F.A. Hayek

Nov 18 2009 at 11:41am

One more thought. Posner claimed in the interview that the principle behind the recent massive stimulus made sense. I disagree completely.

Nov 18 2009 at 12:01pm

OMG Zombie Ponies!

I was stunned by this podcast, largely because I have found Posner’s work to be very intellectually stimulating in the past. He was a big part of the “law and economics” movement at Chicago that helped to put rational choice reasoning into the practice of law. What I heard on this podcast was a very pale ghost of the Richard Posner I once knew. It was noted at the beginning of the podcast that Posner published his book in May of 2009, and that raises the suspicion that he was just trying to hop on the “explain the crisis quick” bandwagon.

A key moment in the podcast for me came at about 17 or 18 minutes. Posner’s “solution” to the whole mess (or “avoidance of the problem”) came down to “if we just had smart people in the Fed then everything would be okay.” Or, as he argues a bit later, the Fed should just be paying a bit more attention. This is a dangerous and arrogant attitude that is common among the intellectual elite. “If they just got smart people like me into positions of power then everything would run great.” I was very disappointed to hear this.

Cody L. Custis
Nov 18 2009 at 12:25pm

Posner did a good job expounding the Keynesian economic view. Unfortunately, such a view rests on two very flawed assumptions.

First, as outlined in the discussion of negative inflation, Keynesian economics fails to realize that individuals hold cash when the real cost of holding cash is low as compared to alternatives, such as investment. Thus, cash hoarding is not a problem of nominal interest rates, but low real interest rates for alternatives.

Second, Keynesian economics fails to realize that when savings are equal to investment, government spending of savings reduces investment. Thus, savings are spent by the government, rather than invested in non – governmental activities. Programs like the Recovery and Reinvestment act result in hundreds of billions of dollars of investment which is not available to the private sector.

Nov 18 2009 at 1:20pm

This podcast is proof that lawyers don’t know what the hell they’re talking about (exception: Clint Bolick)

Nov 18 2009 at 2:28pm

I’m very much a “hobbyist economist” and am still learning so I have no comment about the validity of his arguments in that realm.

However, I am an experienced aircraft technician and I can tell you that Posner’s analogy in his attack on Dr. Friedman about pilots and their discretion being necessary for the operation of aircraft is inaccurate. To the contrary, were it not for the fact that public opinion requires the presence of pilots, the entire commercial air transport system could be automated and it would result in a safer and more efficient transport system.
Even as the system exists now, pilots rarely manually fly the aircraft (autopilots are nearly constantly on) and when pilots do make decisions and fly the aircraft, they do so with virtually mechanized responses that have been trained into them in hours and hours of simulator practice.

Nov 18 2009 at 2:40pm

In response to “Interested_listener’s” complaints about the level of bias in the podcast:

I have no issue with the host of a podcast such as Econtalk holding and expressing a position on an issue as long as the host does not deny nor attempt to conceal that bias. In fact, I wish all my teachers (and I do view Dr. Roberts as an informal teacher) would be as honest about their bias as it would allow me to better differentiate between opinion and fact. It has been my experience in undergraduate programs that the fervent attempt at intellectual honesty that Dr. Roberts displays is sorely lacking in most professors.

Nov 18 2009 at 6:43pm

This was a very interesting but at the same time, deeply disappointing interview. I was a long-time admirer, but was dismayed at the casually vague answers to some of your questions. Talk about hubris. I must say, you really kept your cool.

I don’t understand how one can title a book “failure of capitalism” and then honestly argue that it was really failure of government to control capitalism. My impression was the Presuppositions of Harvey Road idea that everything will be fine as long as smart people run the government. “Under smart leadership, the SEC will do fine,” he said. If only we were all as smart as Richard Posner, Joseph Stiglitz and Paul Krugman.

Thank you Russ for the wonderful service that EconTalk provides.

Richard Sprague
Nov 20 2009 at 4:54am

Unfortunately I agree that this is one of the more disappointing Econtalk episodes. I had looked forward to a good discussion, but Judge Posner came across as a crotchety old man unwilling to engage.

Here’s hoping that the Paul Krugman podcast will be better. 🙂

Gene Tudhope
Nov 21 2009 at 1:47am

[Comment removed for supplying false email address. Email the to request restoring this comment. A valid email address is required to post comments on EconTalk.–Econlib Ed.]

Some Rich Poser
Nov 21 2009 at 3:01am

I was deeply disappointed by this podcast (and I’ve never been disappointed before, even when I disagreed with the guest). Frankly it was a complete waste of an hour, filled with un-informed, economically-illiterate drivel (of the kind you hear on the news, radio, or hippie convention). But this is an econ podcast! The only thing that saw me through all 63 minutes was counting the logical fallacies…one after another, after another. Really – I don’t think Posner would have passed critical thinking 101, sure glad he’s a judge. I apologize for being severe, but Posner’s absurd combination of ignorance and hubris is inadmissible (and Russ is much too polite to call him on it). The only thing more disturbing than Posner’s disregard for the facts is his complete assurance he’s right in spite of them (“But it doesn’t matter!” 32:08). Posner’s central argument, not to mention nearly every other sentence, is a non sequitur, it just doesn’t necessarily follow. Kudos to Russ, who is always willing to hear another opinion and even challenge his own view, but come on…this guy is selling books and getting a microphone…definitely a failure of capitalism.

Jose Raul
Nov 21 2009 at 10:06am

I am surprised and dissapointed of Judge Posner suggestion that all we need are better “airplane pilots” at the FED that will make a better job in noticing the nexts bubbles. As if the dispersed knowledge is something that a better economist can harvest with accuracy.

John Davidson
Nov 22 2009 at 8:32am

It seems to me that having a Posner podcast was a very subtle move.

About the cheapest shot in the world is for Posner to charge that what happened was a regulatory failure. It was not, it was a legal failure, a failure of our court system of which Posner is a principal architect.

Federal banking regulators are a second line defense to excessive risk taking by an investment bank. The “primary” regulators are the shareholders. However, as everyone knows, shareholders are been stripped bare of any meaningful control over management. Look at Goldman Sachs, right now, where shareholders are unable to object to the bonus pool not being paid out in dividends.

The legal tool that has stripped shareholders of control is the business judgment rule, a judge made rule, of which Posner is a principal defender.

Recall Greenspans mea culpa. Not being a lawyer, he made no room for the possibility that management would do what it did.

Those who complain about “excessive” gov’t regulation don’t get it. The government is forced to take this indirect approach because it will not attack the problem directly, repealing the business judgment rule and empowering shareholders. Of course, that remedy would mean that trial lawyers could sue management, cross examine, etc. and anything that benefits trial lawyers is wrong, regardless of how much sense doing such would be

Nov 23 2009 at 1:02pm

Blaming Milton Friedman is plainly wrong, as well as a bit tacky.

If one forwards mortgage assistance programs and poor monetary policy (executed at the Fed’s discretion) as having a prominent role, as Mr Posner does, then blaming Milton Friedman, who deplored the existence of any mortgage assistance programs* and called for an end to central bank discretion*, makes no sense whatsoever.

* cf. Capitalism and Freedom, ch. 2-3, for one of many possible examples.

Ray Gardner
Nov 23 2009 at 2:25pm

It wasn’t a bad podcast, Judge Posner just didn’t comport himself well.
The manner in which he dodged the deflation topic and switched to another of Friedman’s ideas that he thought was “stupid” was sophmoric at best.
And this seemed to represent the entirety of the podcast.
But I wouldn’t call it a poor podcast. It’s a valuable service to have someone like this exposed for their lack of depth.

Nov 23 2009 at 5:56pm

First podcast I quit on. The only failure of capitalism, with respect to Mr. Posner, is the idea that his book may sell more copies than Mr. Robert’s.

John Rolstead
Nov 29 2009 at 10:13pm

Thank you Russ for what you do. I look forward to each episode.

Mr. Posner is a true Keynesian. He states that cash for clunkers won’t act fast enough, what we need is direct gov’t spending, like military service or CCC. But it must be on good stuff, not silly stuff, like tanks and ships. Kind of like Japan and Germany during the depresssion, now they knew how to stimulate the economy! Keynes said we should just build warships and then sink them, just spend baby!

The Milton Friedman slapdown was outragous. Posner says once bank to bank lending rate gets near zero, then why bother loaning? But if Fed lowers Fed Funds rate to 1/4 point, then banks will borrow from Fed as much money as they can induce borrowers to borrow. The Fed stepped in and bought troubled assets at face value with new high powered money. This saved the banks from declaring bankruptcy. Now how to get those pesky borrowers to borrow? Businessmen are nervous. They don’t know what the government will do next. So they wait for signs of sanity.

Now Russ, you state that paying interest on reserves induces the banks not to lend. But banks don’t lend reserves. That is why it is called high powered money(HPM). They make loans up to the inverse of the reserve requirement, currently 10%. So every 1 dollar of HPM means up to 10 dollars of loan dollars created. The actual mechanics of paying interest on HPM will be a controlled increase in the money supply, kind of like John Taylor rule.

– Lee Kelly makes greate point on Fatal Conceit.
– Emerich points out Posner contradiction.
– Cody Curtis shows how Keynesian spending crowds out private investment.
– Ray Gardner’s point about exposing speaker is the whole point of having guests like Posner on Econtalk. I thouroughly enjoyed listening to the Keynesian view of Posner. When he laughed instead of answering deflation question, you know he has not read Friedman/Shwartz A Monetary History of the U.S. where they show that from 1867 to the 1896 redemption of gold standard, we had rising productivity with deflationary prices.

I wonder how Dell computers does it in thier deflationary sector? They make a profit with constantly falling prices. Hmmm.

Ed Paxson
Dec 4 2009 at 10:30pm

I for one am glad that Roberts stood up to Judge Posner on his short sided and dead wrong beliefs on Milton Friedman. Posners silly belief that getting rid of the central bank is impracticable is laughable. He writes about the harm they’ve recently done yet he think their authority to do good overrules all else.

Milton Friedman never lectured Richard Posner on law. Posner shouldn’t lecture Friedman on economics. How cowardice it is to try to incessantly denigrate Friedman now that he’s gone. I assume he never took the opportunity to debate him when he had the chance otherwise he would have mentioned it.

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Podcast Episode Highlights
0:36Intro. [Recording date: November 2, 2009.] Indict capitalism for the crisis; book came out in May; forecast the worsening of things at the time. What is the source of the problem. Wouldn't say capitalism indicted in the book. Failure of the governmental institutionalism of capitalism: Federal Reserve and the regulatory system controlling financial business. Need that. Argue in book: Banking is an inherently risky business; have to have regulatory controls and a Central Bank that controls the money supply, interest rates, and so on. All part of the capitalist system, not just markets. Property rights, Central Bank. Totalitarian and socialist systems have worse problems but they don't have this particular problem of a banking system that can go awry. Real problem, one problem: unsound monetary policy by the Federal Reserve system in the early 2000s. Cheap credit, too much money. Interest rates fell very dramatically. Fed fooled by the fact that there wasn't much inflation as measured by the Consumer Price Index (CPI). But there was inflation--particularly in houses, other real estate, and the stock market. Asset price inflation, particularly in housing, creates a great danger for the economy because houses are bought with debt--80% mortgage, sometimes 100% mortgage. When you have a housing boom, the banking system becomes very heavily involved in housing, financing the boom. If the boom turns out to be an inflationary phenomenon, a bubble that just bursts, you can bankrupt the whole banking industry. That's essentially what happened. What reinforced the problem was that the regulation of the banking system, which is very fragmented in the United States, was just not up to the task of identifying these risks. The Federal Reserve, the Securities and Exchange Commission (SEC), and so on, just didn't realize that there was a risk of a housing bubble that might burst; and didn't realize that over the last several decades there has grown up a large banking industry, referred to as a shadow banking industry, of companies that do what is functionally banking but they are not regulated as banks--broker/dealers like Merrill Lynch, Lehman Brothers--they've all disappeared in one way or the other, become absorbed in other things--borrowing their capital and lending it. Didn't have Federal Deposit insurance. Were regulated by the SEC, which was very lax and doesn't understand banking. Great regulatory gap, which interacted with the low interest rates which were pushing the banks into more and more housing financing. Unsound monetary policy; lax regulation, regulatory inattention; and finally a very complacent economics profession which was lulling everybody to sleep by saying there's never going to be another depression, and if there's a recession the Federal Reserve can cure it painlessly, just lower interest rates which stimulates economic activity. Turned out last fall that that didn't work.
6:41Focus on the regulatory inattention. In book, forceful argument against people who claim that investors who were irrational or myopic, yet seem willing to put that picture on regulators. Starting about 2002, increasing in 2003 and 2004, increasing voices talking about the nature of housing prices being unsustainable. Why was it regulators' who are blamed as inattentive--why not the people who financed those investments? Seems like it was excessive risk-taking by capitalists, who are being portrayed as rational. How do you square that? Their risk-taking wasn't excessive ex ante: if you are a financier in 2003-2006 even, you see that there is tremendous demand for loans for houses; very profitable because interest rates are so low and you can borrow very cheaply in order to meet this huge demand. Now you know that of course there's a risk that there could be a big dive in housing prices and you're broke. Being told by the Federal Reserve and economists that there's no housing bubble; housing prices are rising because of fundamental factors of supply and demand and will continue to rise as long as it's a good investment. As businessmen, they knew they could be wrong. Taking a lot of measures like securitization to minimize risk. Can't be in business without taking the risk of bankruptcy. The problem is what's a risk of bankruptcy for an individual bank or individual broker/dealer can through this chain reaction effect that we saw last fall can bring down the whole economy. Responsibility of the regulators is to say to these banks: you're taking risks which are rational in terms of your goals, but you are creating a risk that you don't really care about because it's not a risk to your shareholders but to the whole economy. That's what you have regulation for. If businessmen thought it was their job not to take risks that would endanger the global economy, then you wouldn't need regulation. But businessmen just worry about their own company. Like pollution: We don't expect businessmen to worry about pollution because the pollution affects other people, not their business or consumers--maybe people a thousand miles away, acid rain. Business is profit maximization, not environmental protection. Same with banks. Their business isn't systemic risk, global economy, depressions. They'll take risks as long as they are being paid more than the expected cost of the risk.
11:25Puzzle: there is an externality; but in the case of pollution, all the costs are borne by the people downwind. Business can avoid those costs. In the case of financial institutions, many of them were wiped out or should have been. Moral hazard problem: If you thought you might be bailed out, you not only had an incentive to ignore the externality, you had an incentive to increase it. Sure, but no different from pollution. If you are paid to pollute, you are going to pollute more. Suppose you have pollution that actually does affect your own workers; but government says it will pay their medical costs. Question is: rational and profitable to make risky investments, always a question of the tradeoff. Regulatory failure: if you tell banks they can do whatever they want and will get bailed out, it's perfectly rational for them to take more risks. Whatever environment the government creates, the businessmen will adapt to that environment. Doesn't mean they won't make mistakes. Responsibility for creating the environment is the government's responsibility, which they failed to discharge. Lumping together two types of regulatory failure. One kind is not regulating them enough; the other is encouraging them. Big difference, both in historical valuation and prevention in the future. Don't see the difference. Can have stupid regulation because it's terribly lax or stupid regulation because it actually subsidizes foolish activities. Community Reinvestment Act (CRA), Fannie Mae, Freddie Mac--don't think they contributed critically. No question that the CRA, 1977, strengthened during the Clinton administration, Fannie Mae, Freddie Mac borrowed at low rates because they were assumed to have informal backing by the government--encouraged subprime mortgages. Regulatory encouragement of stupid behavior. The other is the failure to control the externalities that private behavior can create. Both regulatory failures. Going forward: set of prescriptions based on those failure? If correct that the basic problems were unsound monetary policy, regulatory inattention, and complacency on the part of the economics profession, all relatively self-correcting. John Taylor, Taylor Rule, simple rule for what the Federal Reserve should set interest rates, Federal funds rate. Supposed to look at a few factors. Taylor observed that in the early 2000 period, the Fed was greatly deviating from that rule. Taylor wanted it to be rising; Fed held it at 1% for three years. Fed should pay more attention to the Taylor Rule. Don't need a new institution; they just need a reminder that they need to worry about bubbles, have to be smarter. Obviously they are now alert to this problem. In the case of regulatory laxity: for commercial banks, Wachovia and City Group, the Fed, the FDIC, and the Comptroller of the Currency have all the powers they need; all they have to do is be more alert; ask, "What is this thing called a mortgage backed security?" Off balance sheet liabilities, credit default swaps: be more alert. Maybe we can't trust them to be more alert. Paul Volker has suggested that banks should not be allowed to engage in risky conduct, shouldn't be allowed to have divisions that engage in proprietary trading. That would be a structural reform; complicated; worth considering. Off-balance liabilities: create special investment vehicles in which to park these risky assets and don't show them on their balance sheets; the derivatives that they trade, credit default swaps, are off-balance sheet contingent liabilities--hard for the examiners to find out what the real financial situation of the bank is. Maybe all those liabilities should be put onto the balance sheet. Lots of little things that can be done. Focus argument: If the commercial banking industry is insulated from this high risk type of financial activity, then if the high risk people go bust again at least you have a safe commercial banking industry as a kind of backbone of global finance.
20:47Won't be much of a backbone if they are not doing anything risky. Crucial question: What kind of shadow banking system do we want? Used to be called investment banks. Already doing the same stuff. If we don't get rid of too big to fail, very different to be confident that those banks will be prudent. Does the bailout of those banks reinforce the risk-taking? If you have an implied promise to save these companies because of either their size or their critical interconnections if in a position to cause a chain reaction, then you have to worry about that. What's happened is that as a result of the events of last fall, the big 5 investment banks all vanished. Lehman Brothers went broke; Bear Sterns and Merrill Lynch were acquired by banks; Goldman and Morgan Stanley converted to bank holding companies. J.P. Morgan Chase is a real bank [i.e., not an investment bank). The other four all regulated now by the Federal Reserve; so the Fed now has the shadow or investment banks under its wing. Once you are under the Fed's regulatory control, their examiners have complete power over you. Hedge funds and insurance company funds aren't under the Fed and yet have vast resources and take a lot of risk. Apart from that, in the years to come, there will be new kinds of institutions: what to do? They will fall automatically under the regulatory control of the SEC, which historically had no interest; but now, after the huge failure last fall, good new director, trying to create a culture and procedures and expertise to control the systemic risk that a large investment bank could impose. Not sure we can do much more beyond that.
24:54Underlying or proximate causes of the crisis: Leverage was a huge part of it. When housing loans were requiring 20% down, there was not much of a problem. What role did the erosion of that play? Why did it erode? Not going to blame irrational exuberance. Why did lenders get so careless about requiring skin in the game? If house prices are rising, there is no reason to be as cautious in lending. If you are confident they will rise at a rate of 5% a year. If you lend someone a 100% mortgage, in four years he'll have a 20% equity. When prices are rising, you have low default rates; if someone gets into trouble, he doesn't abandon the house and have it foreclosed on. House prices had been rising for a long time; and kept rising. Bernanke and distinguished economists said it was permanent: rising population; restrictions by local zoning authorities limiting amount of land available for building new houses--indefinite price increase. There were people warning against it, but consensus view was that it was a very healthy market. Consumers want to get in on it--two houses--bankers catered to it. Greenspan, icon of fiscal rectitude, in early 2000 saying that he thought people should be getting adjustable rate mortgages--but that's risky. Especially when the rates are artificially low. Government failure. Next question would be: in many of these markets, the bottom third of housing in some cities was rising at double-digit rates starting in the mid- to late-1990s, well before Greenspan was holding interest rates artificially low. Those who argue for the cause being irrational exuberance, animal spirits, saying people just decided prices were going up. In the book, you reject that mania of crowds kind of argument. Why was that appreciation going on, given that the fundamentals turned out not to be true? Believe in bubbles; but don't think buying in a bubble is irrational. Ex post it was stupid; but inside, don't know when it's going to end. But what gets it started? The low interest rates. The big expense in buying a house is the mortgage, so if interest rates go down, a house is much more affordable. Supply can't increase fast enough. At some point it becomes self-sustaining because the prices kept rising even after mortgage rates rose. You see prices going up, so you say to yourself that other people are saying that prices are going to continue to rise and you don't want to miss out. Universal. As soon as the stock market started rising in April, read the newspapers; experts saying it's time to get on the bandwagon. Rational exuberance--didn't coin the term. Still need an explanation for why it gets started. Bubble started expanding in the 1990s, not the early 2000s. But the rate of increase was greater in the 2000s. Not so sure. Depends on the market. In some cities, very little appreciation and very little collapse. In other cities, enormous appreciation in the early 1990s. Story is yet to be told what role government played. Doesn't matter. Even if interest rates in the early 2000s didn't have much effect the Fed, if it had spotted the bubble, could have burst it by raising interest rates. It didn't. That's the great failure.
32:34That's not the way the book is being received. Being received as a recanting of Chicago free market economics. It is to a certain extent. Complacency of the profession: the belief that Greenspan, the great free market guy, Ayn Rand fan, that he had squared the circle; that he had by low interest rate policy managed to stimulate the economy but avoid inflation. That's a tremendous error, due in part to overconfidence in conservative economic policy--not even good economics. Even Chicago economists know there is such a thing as an externality. Can't just say that these bankers are intelligent and clearly are not going to take excessive risks. Of course if there is enough money in it they will take risks that are excessive from the overall economy's standpoint. Golden parachutes. To say that what makes perfectly good sense for the bankers makes perfectly good sense for the economy as a whole is a tremendous mistake. A bit unfair to Milton Friedman who is gone and can no longer defend himself to say that it is Chicago-economic trusting in Greenspan's discretionary ability to fine tune the economy. About half of Friedman's career was a monument to the dangers of Fed discretion. He has always argued--book with Anna Schwartz--that the Great Depression would have been just a recession if it hadn't been for monetary policy by the Fed. Theory. Bernanke and Greenspan: all you have to do to avoid economic trouble is when the economy slows down, make sure you don't reduce the money supply--which is what the Fed did in 1930. What happened last fall, September, when the financial collapse occurred, monetary policy proved to be totally ineffectual. Fed had begun reducing interest rates in 2008 realizing there was a problem; right after September 15 they pushed it way down, and pushed it down to zero with no effect. Why do you say with no effect? The banks now have $1 trillion in cash. When you force down the Federal funds rate, you get unlimited cash reserves for banks. What you don't get is lending. That's the great Friedman mistake. Disagree. True that there's not much lending; agree that they are holding excess reserves; but part of the reason is they are being paid. Scott Sumner podcast. Banks were paid to hold those reserves; Fed mitigated the impact of that. Not mysterious. The fix the Fed has gotten itself in: if the federal funds rate is zero, no bank will lend to any other bank because that's the secured interbank lending rate. We don't care about that. We do care about that because banks need to borrow reserves in order to make loans. The fear was that the interbank lending would completely close. By paying interest on the reserves the government encouraged the banks to hold onto reserves so they could do some lending. The problem would be that if you couldn't make any money lending, you wouldn't lend--you'd just buy Treasury bills. But you don't just lend to each other--banks lend to businesses. Critical question is would they lend to new businesses; they are worried about the future, so certainly anxiety and can accept the fact that banks were being more cautious, and they should be--but two things are important. First, the federal funds rate didn't go to zero, but to ¼ percent. Second, Milton Friedman's legacy: Friedman never advocated the federal funds rate. But he advocated things like deflation: the Fed should reduce the money supply every year by a fixed percentage. Ingenious but academic moon-gazing. The notion was that because you don't earn interest by holding cash, you hold a suboptimal amount of cash. Disfavor holding cash relative to other safe securities because you don't get any interest on cash. But if you have deflation, then the cash comes to be worth more in time. Utterly unworkable. Why? If it were expected it wouldn't be a big deal. Chaos. Another Friedman idea: instead of having the Federal Reserve you would have a fixed rate at which the money supply would expand. Not an entirely bad idea. If we'd had that we mightn't have had this recession. But if you have that and the economy does get into trouble, and you don't have a central bank, then you can be in really serious trouble--no flexibility to deal with an emergency. Crucial question is whether most emergencies are caused by that flexibility or by other causes. Crazy to say you are going to eliminate the Central Bank. Like planes without pilots--if you really trust your machinery.
43:31Recent article on Keynes; read the General Theory, probably the best summary of Keynes ever written. A lot of debate as to what Keynes really meant. Keynes has come to mean a certain set of things which are convoluted enough. Still troubled by it. Idea of government stimulus as a way to get out of the mess in the short run. Are you in favor, and on what grounds? In favor of the principle, beginning to wonder about the execution. Simplest way to think about it is that suppose you have a situation where people are afraid, banks are afraid, and there is a tremendous amount of hoarding. The amount of currency in the economy has increased a great deal. The sale of safes has boomed; people are keeping a lot of cash in their houses; the banks are hoarding. The amount of cash held by non-financial businesses has increased substantially. Also a lot of personal savings--more in personal bank accounts. The money is not being used to buy things in the economy. The government can borrow it and put it to work. That's the theory--substitute public demand for a terribly impaired and fearful private demand. People will be happy to lend to the government because the government isn't going to default. Perfectly good theory. Problem is, number one, the tendency is to institute these programs too late. This $787 billion stimulus should have been enacted last fall; instead it didn't get enacted until February 20, 2009; and now it turns out that because of governmental red tape it moves very slowly; and many of the expenditures are stupid and don't do anything. Want to use the money to put people to work. Don't want to use it to give them tax breaks because they may decide to hoard that stuff. Cash for clunkers program--give people money to buy a car. Some would have bought a car anyway. A lot will buy a car earlier--just moved consumption up by a month. Program was in August; in September a tremendous drop in purchases. Even if more purchases, you are purchasing from dealers' inventories. Don't get any production or hiring until they put in orders to replace those inventories. If they have swollen inventories, it may take a very long time before any rehiring of auto workers. If most of the stimulus is going to be spent next year in 2010 when the economy is recovering, then you have serious inflation problem. Principle makes sense. Some stimulus efforts in the 1930s. Germany and Japan recovered quickly from the Great Depression because they poured money into military expansion, which can be quite an effective stimulus. Puts a lot of people to work; drafting people reduces unemployment. Timing is critical, design of the program is critical. Don't think we've done a good job.
49:37Theory behind it. Taping this early November 2009; stimulus plan passed in February. A grand total of $120 billion of the $787 billion has been spent so far; two thirds of the $120 billion has been spent by the Department of Education, Labor, Health and Human Services. Not shovel ready projects. The Department of Transportation has spent all of $4 billion. Isn't surprising that a lot of construction workers are not finding their way back into the workforce. Theory and the Keynes article, you correctly pointed out, Taylor analyzed: in March or February of 2008 when George Bush was still President, he signed a set of tax rebates--$168 billion. Everyone concluded they were too little, way too small; market-oriented economists said they were rebates rather than changing incentives. Much of that was saved. Saved for rational expectations reasons--people anticipated future taxes--or for Keynesian reasons, animal spirits, hoarding. If we spend $120 billion, or $200 billion if the stimulus had been rolled out more quickly, the people who receive it are going to have the same incentive to be cautious about the future. They Keynesian multiplier isn't going to kick in any more via government spending any more than it would via the central bank pouring money into the economy. The distinction is between transfer payments and investment. If the government just borrows money and gives it to people, whether it is in the form of a tax rebate or tax credit or unemployment benefits or health benefits, then people may save a great deal of it, especially if they think it is a one-time thing. Genuine contribution by Milton Friedman: there is a great deal of evidence that people tend to save what is called transitory income--windfalls, non-recurrent incomes. If their permanent income increases--e.g., job promotion--then they adjust their standard of living and spend more. If it's just a windfall, win $100 in a casino, you are likely to save it rather than adjust your standard of living. The part that is saved doesn't do the economy any good. There is still a problem of what's spent, because what's spent is retail, which doesn't lead to any more employment. You bought it from the store's inventory. Maybe they'll replace it, but until then there won't be any more employment. The other problem is that the consumption expenditures people make when they receive these windfalls has no relation to the problems of the economy. The problems are centered in particular industries, like construction--very high level of unemployment in construction and manufacturing. About half of the lost jobs since December 2007. Varies across states. The idea was to get people to work. Roosevelt in 1933 created the Works Progress Administration (WPA) and the Land Conservation Corps. Within months they had hired millions of people--to do some painting and cleaning the sidewalks, not necessarily productive but put people to work. What we do now is bleak and not as effective. Increase in output in the third quarter is due in part to the $120 billion. What role did Roosevelt or the war play in the recovery? Open question. We don't have a consensus.
56:20Expansion of discretion in the economy by central government--obviously in the banks, and in areas not covered before: Special Master for executive compensation, role of the government in the auto industry, continued role of government in distorting the housing industry. What are your thoughts on where we are heading for the balance between government and centralized/decentralized decision-making? Does the Constitution have anything to say about it? No--things have changed so much since the 18th century, and really the Supreme Court has written a pretty blank check to the government. You never know. Supreme Court in the 1930s. Very unhealthy shift in the line between government and business. In particular, actually acquiring government control of General Motors (GM) by the government taking a majority stock interest very unsound. Similarly taken over Fannie Mae and Freddie Mac and AIG--these are really government companies. Essentially control City Group--owns about a third of the stock; throws its weight around with all the large banks. Compensation stuff. Also enormous increase in government expenditures--health care industry. These deficits will lead either to very high taxes, or to inflation or devaluation to try to wipe out the national debt. Worrisome about the current administration--and not a party thing because we saw the deficits surge during the Bush administration--the political system is extremely hospitable to expansions in government and extremely reluctant to finance them, so enormous borrowing. Not clear it's sustainable. Talk about the administration being serious about the deficit, but there don't seem to be any concrete plans for doing anything. If the national debt is entirely internal that's one thing, but 45% of the public part of the national debt is owned by foreigners. We're dependent on foreigners to finance our federal government and we're paying enormous interest costs every year to foreign governments and foreign investors; drain on American wealth. On track to continue growing unless we default; with inflation we would reduce the burden but weaken our standing with regard to the dollar as a reserve currency, which is a very profitable for our country. Might discipline future governments from borrowing so extensively. Powerful interest groups like the elderly who just want their benefits now and have tremendous political power. Co-blogger Gary Becker might suggest that the elderly care about their children, which might mitigate some of it, maybe.