– So, today, we’re talking about
crisis, crash and response. So just to remind us of where we were in September of 2008. – [Narrator] This is gonna
be one of the watershed days in financial markets history. – [Narrator] It was a manic
Monday in the financial markets. The Dow tumbled more than 500 points after two pillars of the street
tumbled over the weekend, Lehman Brothers, a 158 year old firm, filed for bankruptcy. – I don’t think anyone really expected a bank as big as Lehman to, you know be in a position that it’s in now. – [Narrator] Brought down
by bad mortgage investments. Lehman which has 25,000
employees will be liquidated. – Am starting to another job. – [Narrator] Meanwhile, Merrill Lynch, fearing it could be next,
agreed in an active desperation to a shotgun marriage
with Bank of America. Merrill, the country’s biggest brokerage with 60,000 employees has been battered by nearly $50 billion in
mortgage related losses. – It is definitely a
very, very difficult time and it’s not gonna get better quickly. – [Narrator] So in just six months, three of the five
biggest independent firms on Wall Street have now disappeared. Bear Stearns, which collapsed last spring, Lehman Brothers and Merrill Lynch, Treasury secretary Henry Paulson tried to reassure investors today, – The American people can remain confident in the soundness in the resilience
of our financial system. – [Narrator] Paulson
attempted to broker a deal to sell Lehman over the weekend. But unlike the buyout
deal for Bear Stearns, the government would not offer
any financial guarantees. – I never once considered
that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers, – it would have required an $85 billion subsidy to keep afloat. – [Narrator] Insurance
giant AIG is the next name on the list of troubled companies. It’s looking for $40
billion in bridge loans. Veteran trader Art Cashin believes there could be more casualties. – This is the fifth time
we’ve seen this movie. And you sit on the edge of your seat and you yell at whichever character it is. Don’t go into that woodshed
it was they keep going in. – So, he was understating things
that of course at the time, anytime the treasury of
the secretary comes out on national television to assure you that the financial system
is fundamentally sound, you know that people are panicking, and they indeed were. They were speculating at that time, the AIG bailout would cost $40 billion, it ended up costing four times that. And the crisis just stumbled on. And you know, this is one of many pictures one could. This is just the Dow
Jones Industrial Average, and you can see there
by the end of September when banks were failing faster
than people could count them. And Hank Paulson, who you
saw there, Henry Paulson, he had been a former head of Goldman, and indeed he had led the group of bankers in the run up to the financial crisis that I told you about some time ago, who came and petition the SEC, under the tutelage at that time of congressman Christopher Cox, on arguing that the biggest banks, those with assets in excess of 5 billion could have relaxed capital requirements because they were so big
that they could self insure he was by now Secretary of the Treasury. And the reason this turns
out to be a significant date is that he had come to Congress
on the 29th of September, asking for 700 billion to bail out failing banks. And they had come with it
an extremely brief request for a blank check. And, of course, the congressional committees went crazy. And even though the Bush administration had assured them that it was a done deal, and Congress would vote it up, they didn’t vote it up. They voted it down. And, the net effect of that was
that the following day, the Dow lost another 700 points and the catastrophe just kept on going. And of course, it wasn’t just the Dow. If you wanna get some sense of how rapidly wealth was evaporating, this you can see here from
the peak to the trough, basically $16.4 trillion in
household wealth disappeared. So people were absolutely stunned. They didn’t think this could happen. I mentioned to you in an earlier lecture, Ben Bernanke’s famous speech
about the great moderation that where he had speculated that the regulators
had finally figured out how to tame the business cycle, and that things like this, we’re not going to happen again. And just to give you a sense, I should say, everybody prime sufficiently
spoke that three days later, Congress did pass a version of the TARP bailout. And, with much more regulatory oversight and a promise, which turned
out not to be worth the paper, it was written on that this
wouldn’t support institutions that were paying bonuses. We’ll hear more about that shortly. So Congress had passed, had passed the bailout. And later that month, just to give you a sense
of the intellectual shock, that was going through the elites, Alan Greenspan, who had been chairman of the Fed until 2006, and widely a being called the maestro and the greatest genius. This is him, later in that same month, just two, three weeks after Congress had finally
adopted the legislation, talking to the House Oversight and Government Reform Committee. [narrator] General with status… – Those of us who have
looked to the self interest of lending institutions to
protect shareholders equity, myself especially, are in a state of shocked disbelief. Such Counterparty surveillance
is a central pillar of our financial markets state of balance. If it fails, as occurred this year, market stability is undermined. – You found a flaw in the reality… – Flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak. – In other words, you found that your view of the world your
ideology was not right. It was not working. – Precisely. No, that’s precisely
the reason I was shocked because I’ve been going
for 40 years or more, with very considerable evidence that it was working exceptionally well. – where do you think
you made a mistake then? – I made a mistake in presuming that the self interest of organizations, specifically banks and others, was such as that they were best capable of protecting their own shareholders and the equity and the firm’s. – So there you have it
from the maestro himself confessing how shocked he was, What I wanna do today is look at the 2008 and subsequent choices, first in historical perspective, and then we’re gonna bring to
bear some of the instruments that political economists
used to talk about regulation, in thinking more analytically
about the choices. So just to give you a sense of how this was unfolding, of course, this was
unfolding over the summer and fall of 2008 when we were in the midst of a presidential campaign. And Barack Obama had
been the unlikely winner of the Democratic nomination
against Hillary Clinton and was now doing battle
against senator John McCain, who was the Republican. And, during the height of the
crisis in September of 2008, when actually John McCain
had suspended his campaign, but Obama famously said, well, you need a president can do more one thing at a time, so he didn’t suspend his campaign, but he came to Washington, and here you can hear him
opining on the circumstance. – Late this afternoon, I
talked to Senator Obama about the bailout and his concerns. – Well, it’s not exactly clear. What happened was when
I left Florida, landed, I had heard the news that
in fact the deal was there. People are not obviously
happy that we got here in the first place and we
shouldn’t have gotten here in the first place. It’s a consequence of speculator greed, but also Washington not paying attention, and regulators being asleep at the switch. So there’s resistance. But there had been at
least some core principles that were met. I think that from the
Democratic perspective, we just wanna make sure
that this is helping the small businessman make his payroll, people keeping their
money market accounts, that we don’t see a cratering
of the credit markets that could end up leading
to enormous job loss. And obviously, it’s pretty
frustrating for Democrats, having seen the mismanagement
that’s been taking place over the last several years, to feel like we’ve gotta step
in and get something done. But that’s how I think
many of us feel that, that we can’t worry about how we got here. Now we’ve gotta take some serious steps. – We can’t worry about how we got here. Now we’ve got to take some serious steps. And that we’ve very much
reflected the attitude that Obama and the Obama White House brought to this problem. He, and if you can read all the pop books about the early years of
the Obama administration, too big to fail is one excellent one run siskins confidence, man is. Another, But basically, they assume that the people who were in the midst of the crisis were the people that knew how to fix it. And I should say right off the bat, they were not wrong about this, in many respects, as we will see, but this meant that Obama took on people who had been greatly
implicated in the deregulation of Wall Street over the previous decade and a half people like Larry Summers. And he appointed as his treasury
secretary Timothy Geithner. who often would be attacked
in congressional hearings as being in bed with Wall Street banks and being accused of being
a former investment banker, in fact, it wasn’t true of Geithner. Geithner had never been a banker. He had always been a bureaucrat, he had been chairman of the New York Fed until Obama appointed him as
Secretary of the Treasury, and so Geithner, took responsibility
for fixing the problem. And he did work very
closely with Wall Street. And as a result of this, he very much took this attitude that we shouldn’t worry
about how we got here. What we’ve got to do is think about how to get out of it. And Obama, bet on him to the extent that produced
some considerable grumbling in the administration. And just to give you a sense, the following March now President Obama out there defending Geithner’s efforts, particularly after the huge scandal had erupted, that not only was AIG the
insurance giant being bailed out, in, as I said, some multiple of what had been speculated
a few months earlier, but they were paying
bonuses to their executives. So the administration was very much back on their heels and
here’s President Obama, defending Geithner. – [Narrator] With anger
mounting over the bonuses awarded to AIG executives, The President is defending
his administration’s handling of the fiasco. – Nobody here drafted those contracts. Nobody here was responsible for supervising AIG and allowing themselves to
put the economy at risk. – [Narrator] AIG paid out $165 million in bonuses last weekend. The federal government has propped up the failed insurance
giant with $170 billion in taxpayer money. And angry president says
the buck stops with him. Ultimately, I’m responsible. I’m the president of the United States. Nobody’s working harder than this guy. He is making all the right moves, In terms of playing a bad hand. – [Narrator] Despite
assurances from the president, Some has speculated that Geithner’s job could be in danger. In part because he couldn’t persuade AIG to cancel the payouts. – So there you have it. President Obama had
embraced the TARP bailout as a candidate, and indeed, the version of it that had been passed on the third of October in 2008, it was when George W.
Bush was still president had to be passed up
substantially by Democrats. Most Republicans in the
House voted against it. And so the incoming administration was very closely
associated with the efforts to bail out the banks and to
protect the bankers and again, just to give you a
sense, a week after that, Obama came out onto the White House lawn and defended Geitner. Here you can see here you can see him being raked over the coals in a congressional committee hearing. – Just last month, AIG paid
343 employees of AIG FP, their financial products division, that created the financial
hole that AIG is in. And in turn a multi billion dollar bill for American taxpayers of 56
million dollars in bonuses and are slated to pay an
additional $162 million in bonuses to 393 participants in the coming weeks. And there’s more. A further bonus payments totaling
approximately 230 million are due to 407 participants at AIG Financial Products
Division in March 2010. This makes no sense to my constituents. This company claims to be
on the brink of disaster, and it’s handing out bonuses. – I just wanna point out
that compensation practice across the financial services industry over the last years and decades, just got out of whack
with basic fundamentals and people were paid for risks that weren’t captured in compensation. And part of what we do to
make sure this kind of crisis doesn’t happen in the future is to change those basic incentives, and there’s gonna be a role
for government doing that. Now, it’s very important
that we make sure that we’re providing exceptional
assistance to these firms, that that assistance is going again to achieve the objectives
of these programs. Not to reward the kind of executives that got us in this mess. I’m deeply committed to that objective. And we’re gonna be as
careful and responsive as we can to the concerns you have, so many Americans have about how these resources have been used. And I just want to say
that the judgments made by these boards of directors
and senior executives across parts of the finances have just caused a lot of
damage to public confidence in the quality of their judgment. And they have a deep
responsibility and obligation to make more careful
judgments going forward. But we’re not gonna
depend on them to do it, we’re gonna make sure
that there’s conditions that come with our
assistance to assure that. So we’re gonna figure out how
to apply these new provisions in a way that is carefully
designed as possible. Obviously, we want these businesses to achieve the objectives of what we did in the AIG, we want them to be able to run their business and restructure, so we’re in a better
position going forward. And, that’s why this is sort of hard to do. – So that gives you a flavor of him trying to explain why they
had to bail these banks out even though they were, in this case, AIG even though they were
paying these bonuses and it, in fact had been a big
fight in the White House, Obama had been appalled by it and demanded that they find a way to claw them back. But Geithner and Summers and others said these are contractual obligations. We have to enforce contracts,
we can’t renege on them. And so that view prevailed. And so this was the
catechized, if you like, behind the way in which
the Obama administration essentially owned the regulatory
response to the crisis in ways that would be costly
for them and their successes in ways that they couldn’t
appreciate at the time. Now, I said I wanted to supply
some historical perspective on this response, to the crisis. And of course, this is the
biggest financial crisis since the Great Depression. So the place to compare it with, or the events with which to compare it and worth a little bit of reflection, is how is the response to the depression. So, in 1932, Franklin
Roosevelt won the election, and by the time, by the time he won the election, in fact, the Hoover administration, people tend to run Hoover
and Coolidge together, by the way, big mistake. Hoover was a quite a much more enlightened person about macroeconomics,
among many other things than his predecessor had been, and if you read the literature
on the Hoover administration, one of the things you
learn is that by 1930 30, 31 the administration was
actually trying to implement much of what FDR would subsequently do. We can call it Keynesian because the General Theory wasn’t published until 1936. But essentially, many of the sorts of measures that would subsequently be adopted by the Roosevelt administration
were being pushed. American agriculture
had been in a recession for over a decade before the crash of the
stock market in 1929. They had much higher unemployment through the most of this period, topping 20% and they were looking for ways to spend money and stimulate the economy and after the election, Hoover begged Roosevelt to do what we just saw Obama doing
after the 2008 election to endorse in the name of
rescuing the American economy to endorse the proposals that the administration was pushing, which he knew. Roosevelt agreed with many off, and Roosevelt flatly refused. He said, this is your government. This is your crisis, you deal with it. And we should also remember
that this is in 1932, when the new administration
didn’t take office until the following March, so we’re really talking about
a five month interregnum during which Roosevelt
left the administration essentially twisting in the wind and made it much more
difficult for them to, to see, to implement the sorts of proposals
that would have stimulated the economy or at least what
most people and certainly in the Hoover White House thought would stimulate the economy. Finally in March of the following year, Roosevelt came in and passed a lot of what we now think of as the first New Deal. And that’s I think I said to you, when we were talking about welfare states, the early part of the New Deal had a lot of business acquiescence, if not business support, partly because of a fear
of communist influence in American trade unions and
a worry that American workers might indeed start to conclude
that they had nothing to lose but their chains and so there was some
thought among business elites that they should support the New Deal at least at the beginning, by 1935, that was pretty much over. If you look the Glass Steagall Act, which had been passed in 1933, which I’ll say a little
bit more about shortly, they were already beginning
to lobby against it and undermine at the Wagner
Act, protecting unions, which was part of the raft
of legislation in 1935, immediately drew very hostile
reactions from business. And the Social Security
Act was also producing, lobbying to cut back its implementation, especially in the south. And so there was a real
confrontation by 1935 between the Roosevelt
administration and business and far from working with business to try and end the depression. I’ll give you a snippet of FDR’s famous Madison Square Garden
speech in October of 1936. And I should say this is
after the administration concreted type, contrary
to the usual outcomes had picked up large numbers of seats in the midterm elections in 1934. And so they had big majorities
in the House and the Senate. And this is FDR, campaigning, speaking in Madison Square
Garden in October of 1936, and a runner to his reelection. – [FDR] We have to struggle
with the old enemies of peace, business and financial monopoly, speculations, reckless
banking, class antagonism, sectionalism, war profiteering. They had began to consider the government of the United States as a mere appendage to their own affairs. And we know now that
government by organized money is just as dangerous as
government by organized mob (crowd cheering) Never before in all our history, have these forces been so united against one candidate as they stand today. They are unanimous in their hate for me, and I welcome their hatred. (crowd cheering) – [FDR] I should like to have it said of my first administration, that in it, the causes of selfishness and of lust for power met their match. I should like to have it said, (crowd cheering) – [FDR] Wait a minute, (crowd cheering) – [FDR] I should like to have it said of my second administration that in it, these forces met their master. (crowd cheering) – So there you have it. FDR and he did indeed he
coasted to reelection. Again, keeping huge, significant
majorities on Capitol Hill. And the contrast with
the Obama administration is pretty stark. Again, if you go back and
read the popular books about the administration. Actually the bankers were stunned that more was not demanded of them. When they met with various officials from the administration, they were quite taken aback
at how how little was in fact, being demanded of them. And particularly in these areas
of executive compensation, which were obviously going
to be politically toxic in the way they turned out to be. But before we leave the Great Depression and the Roosevelt administration, it is important to say that
Contrary to popular belief, among many on the American left, actually, the New Deal did
not end the depression. The New Deal policies were
not particularly effective. And indeed if you look at
another big recession in 1938 What really ended the
Depression was World War Two. The war economy ended the
depression is now today the pretty widespread
consensus among historians. So even though it politically
of course what FDR did was absolutely brilliant, it’s not clear how effective the new deal was in dealing with the depression. That’s not to say it
wasn’t desirable policy for longer term reasons to
build a social safety net and a welfare state. But it was not an, the Roosevelt
administration did not have any policies that worked
particularly to end depression. And indeed, if you are
a hard boiled Keynesian, he was quite haphazard. He had two brains trust one
in Columbia that was much more what we would think of as proto-Keynesians and then hard money people in Harvard giving him conflicting advice. And he was something of a push-me-pull-you and he was in 1938, they actually they reduce spending. So it’s not as if they had sort of the keys
to the policy solutions. And from that point of view, if you could say that the Roosevelt response to the Depression
was perhaps brilliant politics and important for the
longer run in but was not a particularly effective solution to the depression, maybe nothing would have been but certainly what they did wasn’t. So let’s now come back
to 2008 and the response. And there were several
pieces to the response. The first is that the Fed under the direction of Geithner and others really did, they stopped the US and
global liquidity meltdown. I underlined global on that slide, in deference to Adam Tooze’s excellent book crashed published about a year and a half ago, in which he documents to a degree that had not been fully appreciated before how much the Fed not only
bailed out the US economy, but he created global liquidity over a period of a number
of years in Europe, in Asia, in particular, trillions and trillions of
dollars of liquidity was created. Partly because the
Europeans found themselves unable to do it. The, one important takeaway
from the financial crisis is that in one respect a lot
of mantras about globalization and transnational institutions and so off, turned out to be vastly
exaggerated in that the international financial institutions did not have a very big role in fighting the financial crisis and in Europe, the European Central Bank couldn’t coordinate on policies. This is basically to Tooze’s story. And so it felt to the Fed that
could act as a unitary actor to essentially create and
maintain global liquidity until the crisis finally subsided. And so as a technical matter, preventing this great recession from turning into a great depression, a lot of the credit does
indeed belong to the Fed and the truth is that
the real financial crisis in the US system was three or four days when it really looked
like the whole place, the whole thing might go to pieces then there were a lot of chronic problems and subsequent aftershocks and so on. But the fact is that the Fed took actions that nobody could have contemplated taking if they had been anybody to take them during the Great Depression. Then a second piece of the response was the piece of legislation called the economic emergency
economic Stabilization Act better known as the TARP 700 billion. That was finally enacted, as I told you, at the beginning of October in 2008. And that was largely for bailing
out insolvent institutions for which merges could not be arranged or sweetening the pot in
order to facilitate mergers of financial institutions that otherwise would have gone bankrupt. Then that the next big
piece of the response was the Obama stimulus, the American Recovery
and Reinvestment Act, so called, which started out
being priced at 787 billion, but ended up costing
more like 830 billion, and that was stimulus money, Keynesian stimulus money to
try and get the economy going. And then, of course, the last piece of the response was financial services reform. The Dodd Frank law, Wall Street Reform and
Consumer Protection Act passed in July of 2010. We will not be able to
dig into all of this in today’s lecture and
the central question I wanna talk about which fits
into the arc of the course, is what do these responses to the crisis reveal? What could have been done
differently, if anything, and what were the downstream
effects of the way, in fact, they did respond. But first, I want to
introduce some concepts from political science
and political economy and use them as if you like lenses for thinking about regulation
and regulatory reform. This is a course after all,
in which we’re trying to keep political science honest
by bringing history to bear but also using the analytical
insights of political science to think about historical developments. I wanted talk about the
three main perspectives on regulation and then
we’ll take a closer look particularly at the Dodd Frank legislation from the point of view of these. So the first, which I’m
calling technocratic regulation really goes back to Pigou’s
economics of welfare. He was one of the most
famous welfare economists of the early 20th century. And this is when welfare
economics was thought of as an explicitly normative enterprise. If you open the economics of
welfare and start reading it, the first few paragraphs are all about how to organize the economy, for improving the national welfare. And a lot of Pigou’s work
was about regulation. But there’s a certain innocence to the whole tone of that book, in that he assumes that
there are right answers to regulatory conundrums
whether or not to regulate it, how to regulate. And that they can be implemented by somebody called a legislator. And indeed, a lot of the
early economics work. If you go back read papers from that era, when they talk about regulation
they will in their models, they’ll be a legislator
who is going to do this or not do this, that and the other. And so, the idea is that there are
certain kinds of situation where the economist
technician can figure out that there’s definitely a
problem in the market system, and the regulation can fix it. And indeed, there are some
examples of regulation, where it’s pretty clear what
the technocratic answer, in fact is. So one very interesting
example in American history is that we used to have
heavily regulated airlines. And the federal government justified this, on the grounds that it was
interstate commerce, right? Planes fly across state lines. But there was a lot of
suspicion that these regulations were mostly serving the
interests of the airlines. And then a number of academics
had the brilliant idea they found what we might
call a natural experiment, which was that there are two states that are sufficiently
large, Texas and California, that they have big, big airline routes that
don’t cross state lines, and so therefore, were exempt from the FAA’s regulation. And they did a bunch of empirical studies which showed that the
the airline’s operating only within Texas and California, were way cheaper and way more efficient than the regulated ones. And so it was a kind of
lay down hand demonstration that we shouldn’t be
regulated these industries at least in the way we were and whatever benefits they were serving, they were not serving the
interests of the consumer. And these studies provided
a considerable amount of the ballast in arguing
for airline deregulation and turning airplanes into
instead of play things for the wealthy sort of buses with wings, which is what we have today. Other areas where technocratic
regulation gives you the right answer is where there are unambiguous
market failures. For example, insurance markets, if you do not require people to have collision insurance, the problem is that
the people who would go and want to go and buy collision insurance are the risky drivers with no assets. And they’re the people
that insurance companies would not want to insure. So if, you know if you’re very safe driver, and you can self-insure you
wouldn’t want to do that. And so if it weren’t mandatory for people to buy auto insurance, insurance markets would
end up pricing it’s so high that most people wouldn’t buy it, then the markets would unravel. So this is the this is the idea what sometimes called adverse
selection by economist you got adverse selection means that the people the companies
don’t want to insure are the ones who want the insurance and the people that they would
wanna insure don’t want it and they certainly not
going to buy it at the price that the companies are going to charge. Similar arguments get made
about health insurance that only sick people would go and buy a share of insurance voluntarily. And so that would price the market would price it out of
the reach of most people. So these are the sorts of areas where you have unambiguous market failures because of adverse selection. And as a result, this case
technocratic case for regulation. Another is deposit as insurance in banks. So if you think about how
banks make their money, people in an era when banks paid interest, of course, people would deposit
their money in the bank and get paid a certain interest rate. The bank would then lend out the money to people who were investing things and the bank would make its
money on this spread, right? That’s, I’m not talking
about a badly managed bank, I’m totally completely
well functioning bank. That’s what banks do. That’s what they’re there for, right? But of course, it all assumes that not everybody is going to come along and take out their money at once. Because they don’t have the money. They’ve lent the money, right. So, that is what but what a
well functioning bank does. Now if you have a panic, and this is what happened
during the Depression, if you have a panic, and people start to believe that the bank is gonna go bankrupt, then everybody’s gonna go and take that money out of the bank because they don’t want to
lose their money, right. And so you’re gonna get a
run on the banks, right. And this is part of among the things that happened during the Depression. And indeed, part of that we think of Glass Steagall for other reasons, but the financial reforms
of 1933 one of the things they did was create deposit
as insurance, right? Because then if everybody’s told no, if the bank goes bankrupt, you’re gonna be covered up to it was until the
financial crisis up to $100,000. Then people, they know the
government’s gonna protect them and they’ll leave their money in the bank and you won’t get the bank run. Again, so this is there’s a clear technocratic case here
for regulation, right. These are not hard calls,
One might say that. Though I would add that notice sometimes the technocratic solution
creates new problems. So if the government is
insuring the depositors, then it means the banks can gamble with other people’s money because the bank knows the
government’s gonna bail out their depositors. They’re not gonna go bankrupt, so they can be more risk-embracing than they might otherwise be. And so you might think that
they have to regulate them. The way in fact that was handled
when they created the FDIC was they made the banks
finance the bailout funds. So the banks had to essentially,
pay a tax that funded the insurance of depositors so that the banks are
internalizing the risk, if you like, of providing it. Though, as it turned out,
during the financial crisis, it rapidly became obvious that 100,000 wasn’t gonna be enough
to stop runs on banks. And so the government in
the middle of the crisis just increased it to 250,000. Which, among other things made it obvious that if push comes to shove, actually the taxpayers
are ensuring the deposit so doesn’t solve, if you like, the moral hazard that the
banks have to be risky, if they now know that even if the deposit
insurance is insufficient, Uncle Sam will come to the rescue. So when we think about even
if it’s a non ambiguous case for regulation, doesn’t
mean that there’s a solution that’s not gonna generate
tricky problems of its own. There are also hard cases. So if you imagine yourself to be a senator or a congressman or congress
woman sitting in a hearing and in walks Paul Volcker, former Fed chair, extremely
distinguished economist and says, we’ve gotta separate commercial
from investment banks. We cannot have investment
banks, investing their own money while also being fiduciary
for people who deposit funds this had been what had been
done in Glass Steagall, and had had been undone in the run up to the financial crisis. And Volcker was firmly of the
view that some version of this needed to be reinstituted
so that the investment banks would not end up having
the sort of incentives that for example, Goldman,
turned out to have during the housing crisis, which I will talk about on Thursday, when they unloaded
mortgages that they knew were going south on their own clients, conflict of interest between
the fiduciary obligation to their clients and
their attempt to protect their balance sheets as investors. So you have Volcker coming in saying this has gotta be stopped. And then you have Tim Geithner, you know, the genius from the administration who saved the world economy
coming in and saying, this is a terrible idea. We should not do this, it interrupts the way
in which markets work because investment banks often
have to do market making, they have to facilitate transactions, which sometimes means
buying and holding assets from somebody who wants to sell them until you can find a buyer. And he’ll give a long
speech about why in fact, we shouldn’t have what subsidy came to be known as the Volcker Rule. And you had the senators sitting there or the congressman or the congresswoman. Do you think these politicians have the slightest idea who’s right? (Audience laughing) They’d have absolutely no
idea who’s right, right? You know, and you could line up distinguished economists on
both sides of this question, and the politicians are going
to have to decide what to do. But in fact, these technocratic hard calls that often elude the people who
are actually making the law. And then there’s In addition, even if you have a good
technocratic regulation, will the government
actually have the capacity to implement it? Again, if you think when back to as I said in 2004, and 2005, when the big banks persuaded
the federal government to ease up on their capital requirements, they said in return, we’ll
open our books to you. But in fact, Christopher Cox had I think it was four or five
regulators or maybe six, whose job was to watch more
than $4 trillion in assets, and they simply didn’t
have the capacity to do it. So, while it is true, that there is sometimes clear cases for regulation on technical grounds, we shouldn’t think you can
ring the politics out of it or that the process of implementing it doesn’t create issues that subsequently will come home to roost in difficult ways. But I think if you wanted the poster child for a technocratic regulator,
it would be Tim Geithner. And just to give a give a sense of this, here he is five years
after the fact ruminating on the actions that he took. – I think a lot of people still feel that the banks should have
been made to pay in some way, – Yeah – Either in terms of restructuring, less executive compensation. Some cases, some people
shoulda gone to jail. – I think everybody feels that way. – Do you feel that way? – Well, I feel like it’s a complicated thing. You know, there was a
terrible amount of abuse, and fraud and bad behavior, and damaging and dumb things
that people did in this crisis. And I think Americans definitely deserved a stronger enforcement
response, and its completely… – I wanna know what you think, I mean… – and I think – You saw this up close
better than anybody. Does it surprise you nobody went to jail? – It doesn’t surprise me
no one’s going to jail. It doesn’t surprise me. – [Narrator] What may have
been immoral or unethical, he says, was not illegal. Geithner would become a lightning rod and TARP, the $700 billion rescue package he helped push through to save the banks would take much of the heat. Banks have paid back
the loans with interest, but the cheap money they were lent allowed them to reap billions in profits as homeowners struggled. – These banks were
still taking huge bonus. – That was terrible. That was terrible. It was outrageous and killed us. – [Narrator] But Geithner
argues that even though it appeared the arsonists
were being rewarded, the banking system had to be secured. – In a financial panic, there
is enormous collateral damage. They’re deeply unfair and
tragic in that context. So the first imperative is to make sure you make the system stable not because you care about the banks, or you wanna protect
them from their mistakes, but because if you let the lights go out, the system will collapse around them. – Do you worry about
defending your legacy? – I feel, I feel very
confident that we made some very good choices and
the best choices we could in the circumstances of the time. – So there you have that
it’s not that he thinks these people were good or that they didn’t do terrible things. But that’s not his job. His job was to save the system, and this was the way to do it. So the short of it is
that technocratic theories of regulations ignore the
ways in which power, politics and ideology shape outcomes. So a second perspective on regulation goes back to Chicago economist
by the name of George Stigler not to be confused with Stiglitz, who is a famous economist writing today and Stigler pays attention in his work and this is hugely influential to the distribution of
power in the economy. And he says, well, what is a regulation? A regulation is actually a valuable thing. And so it’s gonna have a price. He thinks like an economist. And what a regulation is, is
basically the capacity to use the government’s monopoly
on power to get something and powerful groups are gonna use it if the government is available. So even though he’s a Chicago economist, generally thought to
be heavily pro market. Basically, what is his theory
of like regulation is that big firms, producer interests are gonna dominate what regulations get made. Big firms that going
to, to use terminology we’ve used earlier in the course, the big firms in an
industry have a K group. They can coordinate in
order to get the regulations that they want adopted by politicians. They can coordinate,
they can lobby for them, they can spend money to get them. And that’s what they will do. Whereas for small firms and consumers, it’s very hard for them to organize, and it’s gonna be unlikely that they’re going to get their way. So, as a as a causal matter,
we should expect the big firms to dominate the regulatory process. In Stigler’s mind this is a reason for avoiding regulation altogether. Which is something one inference one could draw from it. But, there are others, which
we’ll get to in a minute. So if you want examples of this, it would be airline day regulation in the first place, right? It served the big airlines
to get these regulations to protect their markets, and so they regulated to get them. Taxi medallions in New York City. Before the advent of Uber, a New York City taxi medallion was worth a million dollars. Today, it’s not even
worth $100,000, right. Again, until the changes in the market eroded, eroded the monopoly is just that the taxi
medallions had created, they functioned as huge barriers to entry. And indeed in many European countries still big fights that they
in Madrid for example, Uber is outlawed. Again you have a taxi monopoly protecting, protecting itself. Also in the I mentioned to you earlier that the erosion of Glass Steagall. So Glass Steagall was passed in 1933. If you read Ron Chernow
is the house of Morgan, one of his many brilliant books. You among themes that
Chernow recounts in that book is the relentless efforts
to get rid of Glass Steagall almost from the moment
that it was enacted. And the truth be told when it
was finally repealed in 1999. At the end of the Clinton administration, there was virtually nothing left of it. So again, the big financial institutions
had used their lobbying power to get regulations that
serve their own interests. So very different than the
technocratic theory of regulation here’s, the argument is
the big players shape the regulatory landscape, and if you wanna know how
it’s going to play out, look at what their interests are because they are the ones
who are going to prevail. A third perspective on regulations, takes off from the observation, well politicians need money,
but they also need votes. And so they’re gonna have to trade off, trade off attending to lobbyists
and attending to voters, the two most important pieces
here by Samuel Peltzman, from the 1970s, and a more recent one
prompted by Dodd Frank by a Columbia economist,
by the name of John Coffee and so, so the idea here is that politicians can’t completely ignore voters. But so when will they attend to voters because the thing about voters sentiment is that it’s sometimes intense,
but it’s very intermittent. Voters get outraged by something and focus on it for a short time. But then things change, there’s something else in the headlines, and it moves on. So Coffee call it called it a kind of sine curve of regulation. So when voter anger is
that a high fever pitch, you might be able to, or
concern is that a fever pitch, you might be able to enact a regulation that you will not be able to
enact at a different time. And most of the time, consumer interests are latent, but they’ll become manifest. But of course, if the producer groups, the big players, the Stigler people know that, their motto just needs to be all we have to do is wait, right? And so the examples that
that immediately come to mind are gun control legislation. Every time there’s a school shooting, this is whipped up, rage by voters, that something has to be done something has to be done
and politicians all say something has to be done. But the NRA keeps its head
down and a few weeks later, the news cycle has moved on, and you come down the same curve and you don’t need to pay
attention to voter interest. Support for disaster relief. It’s the same kinda thing. In the midst of a disaster, there’ll be huge pressure to support, spending money for disaster relief, but once the disaster or the
headlines about the disaster are over the support dissipates. This is why Amartya Sen makes the point that you don’t get famines in democracies. That’s true. But you do get chronic poverty, right, because crises generate
voter interest and attention, whereas chronic problems tend not to. So this is the voter orientated model that’s gonna tell you
politics and ideology gonna matter some of the time. And, but much of the time, you’re gonna in fact, have
the big producer groups get what they want,
regardless of the politics and regardless of the technocratic merits. So if you think about Dodd Frank, it was a major overhaul of
banking regulation in the US of capital requirements,
how much capital banks have to hold, and of the
government’s resolution authority, what power the government
has to unwind troubled banks. A few things to say about, first of all, it was enacted in the
spring and summer of 2010, before the midterms, and that meant actually they enacted it even before the commission
that they had appointed to analyze what had gone wrong in the financial crisis had reported. And the reason they did that was that, unlike 1934, the vast majority of the time, the party in the White House loses seats in the midterm elections. They didn’t know they would
actually lose control, but they knew they were gonna have they’re gonna be less well placed to pass legislation
after the 2010 midterms. So the whole thing had to be concentrated into a very short period of time. This was not a bill Republicans
were going to support, and they knew it. The White House knew it. And so they essentially had to do what to write this bill in
over the course of 2010, and get it enacted in
the summer of that year, which is what they did. It was subject to intense lobbying before, during and after passage. But it illustrates all three of the models that I’ve been talking about. And you can see how the different ones give you an insight
into different aspects. So one of the nice things about
this book by Alan Blinder, who had been on the Federal Reserve as an economist at Princeton, is that he has a four-page
table in this book After the Music Stopped, which summarizes the whole Bill and just, I’m not gonna go through all of it, but on the left column is the issue and then the key aspects
of what the debate were, then the Treasury proposal, and then what was finally enacted. And the point is that that
Treasury proposal very much reflected the interests
of the of the industry because the industry has lobbied
the Treasury very heavily. And the takeaway from the chart, I’ll post all four pages
of it for you to look at is that on virtually
everything of importance, the Treasury got what it wanted, essentially what the Treasury
had negotiated with the banks was what wound up in the law on the too big to fail, on systemic risk, on various other things. And as I said, I will post these so that
people can look through them. But on virtually all particulars, the Treasury got what it wanted signaling the Stiglarian theory looked pretty good. When President Obama signed it in July, the industry was unhappy
with some pieces of it. They had essentially
lobbied to stop the bill for as long as they could, and then to weaken it once they saw a bill was definitely going to pass. And Scott Talbot, the chief lobbyist for the
financial services Roundtable, the day the bill was signed, he said, this is halftime. And, so where did they fail? Where did the industry
not get what it wanted? So one issue was the issue of proprietary trading, I’ve already talked about
the so called Volcker Rule. And what was interesting
about how they wound up with the Volcker rule was the following. They had lobbied to kill
it and they had killed it. And you might remember that in 2008, Nine, Senator Kennedy from Massachusetts died. And this was at a time when there was increasing
anger in the in the grassroots of the Democratic party
with the degree to which the Obama administration was being solicitous of the banks and had let the AIG
bailouts go, and so on. And so there was a special
election in Massachusetts. The most liberal state in
the Union often said to be. Was it Ronald Reagan, who called it the People’s Republic of Massachusetts it was some conservative
politician called it the People’s Republic of Massachusetts. Anyway, shock. The Democrats was so dispirited, there was very low
turnout and a Republican, a Republican, a truck driver, since come and gone, actually won the senate seat and Obama was, so the pop book say was sufficiently spooked by this, that they decided they had to do something for the base of the Democratic Party. And they put the Volcker Rule back in essentially outlawing proprietary trading. And so that’s how it wound up in the bill. The other area where the
industry didn’t prevail was in the consumer protection area. There, the feeling was sufficiently strong in the White House that predatory lending had to be stopped. This was Elizabeth Warren
who was by the way it was in the White House in 2009 and 10. And this was the central
thing she had been pushing and was non negotiable,
there was gonna have to be consumer financial protection. The industry hated it. They lobbied and lobbied
and lobbied to stop it. And when they couldn’t stop it, they essentially, they worked with the folks from the Treasury to create
an administrative structure that was almost completely unworkable. Alan Blinder in his book, and he certainly no flaming radical describes it as a Rube Goldberg machine. And it was not given cabinet status. It was contained within the Treasury, it reported to Congress. The first few years of
its operation produced huge turnover personnel because
they were so demoralized. So there you see, you see the interplay between the Stigler and the Peltzman Coffee views. In fact, the lobbying the lobbying was to just incredible. And one of the interesting things is more than a billion was spent. But, one of the interesting things is, you can see on this chart here is that much of the lobbying will
occurred after the bill passed. So the bill passes here, right, and you can see the financial
lobbying of the fed, the Treasury and other
regulatory organizations actually increases. Here’s a New York Times
breakdown of money spent lobbying after, after the
passage of the legislation. You might think, Well, why? Isn’t a game over once the
legislation have been passed, and actually not, for example, on the Dodd Frank law. I happen to be friends with somebody who at that time was a partner at Goldman. And the day the bill
passed, I said to him, so does this mean Goldman is out of the proprietary
trading business for good? He said, it’ll be five years
before it’s clear whether we managed to kill that or not. And so what you look at is, when Congress passes a law,
that’s just the beginning, then they have to, the
regulators have to write rules. And this is where a lot of
the lobbying actually occurs, partly because of the
Coffee curve of regulation. Voters are on to the next thing now. Nobody’s thinking about Dodd Frank. Nobody’s thinking about the Volcker Rule. And so you have, they publish
a potential regulation, you have a comment period, they got 8000. the vast majority, long detailed
comments from the industry. Financial lobbying groups met
with regulators 400 times, 78% almost 80% of all
the meetings they had. They had to keep pushing back the rule because they couldn’t get it written. And so the second time they
had another comment period, they got 17,000 comments, again, the vast majority, the vast majority of
them from the industry, proposing amendments
that would essentially make the rule unadministrable, particularly would make
it virtually impossible for a regulator to tell the difference between genuine market making where a bank buys and holds some assets
that a client wants to sell in order to find another buyer,
from when they buying them for their own purposes
and on their own account. And it was finally, is partly repealed for smaller institutions in
the Trump reforms of 2018. And just to come full circle
on the Stiglarian theory. Once Trump came into office, the Republicans had been
campaigning for years on repeal Dodd Frank, repeal Dodd Frank. This is terrible thing that
Obama administration has put in, but you would start to see articles like this one in the Wall Street Journal. Guess who’s defending
Dodd Frank, they said. This is December 2016, a
month after Trump’s election. There, the Wall Street Journal Op Ed page says there goes
another liberal fantasy and progressive law. Giant banks hate Dodd Frank
and would like nothing more than to return it to a
regulatory Wild West. So why is it been so hard since the Republican election sweep to find a Wall Street CEO Who favors repealing Dodd Frank. JP Morgan’s Jamie Dimon,
Lloyd Blankfein of Goldman have urged against repeal
and other banks CEOs are suggesting policy small ball rather than wholesale reform. Blankfein who will have former colleagues as senior policymakers in
the Trump administration, in particular is in a position to encourage significant change. But last year he, this is Blankfein, explain why that’s not
in Goldman’s interest. After describing how
regulatory costs have helped raise the barriers to
entry in his business higher than at any time in modern history, Blankfein forecast more opportunities for global giants like Goldman, to gain market share as
only a handful of players will likely to be effective, will be able to effectively
to compete on a global basis. So this is the Stigler theory, up in lights that the
Dodd Frank has now become a massive barrier to
entry for smaller firms. Likewise, the much hated
much despise much criticized Consumer Financial
Protection Bureau last week the journal weighed on the presidents of four trade associations
representing banks and credit unions also
urged deregulatory restraint and pushed for very minor reforms. So when we think about
the missed opportunities, what could have been done
differently to some extent, and you get this from the popular books? The Obama administration came in there and was sort of drinking
out of a fire hydrant, things were happening so fast, they really had very little choice. To some extent they were
a victim of weak parties. This is something I’m going
to talk much more about in the remaining lectures of the course but one difference if you
think back to the 1930s, The parties were much stronger. And in 32 and 34, the Democrats were in a
very different position to enact FDR’s reforms than was the case in the response to the financial
crisis where I told you, the Bush administration had to work with congressional Democrats
to get TARP enacted. And the Obama administration
knew that it had tiny window of opportunity. And it was it was not gonna
be able to do very much and by the way, the Trump administration ran into the same thing
when they sought to repeal much of Dodd Frank, they
ran into massive resistance to repeal in the senate
perhaps from senators who were being supported
by some of the people that were being talked about in the Wall Street Journal op-ed piece I was talking about. But I wanna end by just talking
about elite complacency. I showed you this picture at the beginning of today’s lecture of the collapse of the stock market and the vanishing of 16.4
trillion of net worth. But what I didn’t say is if you look, what was the case two years later, two years later and more
than half of the wealth had already come back. And if you look at the financial sector, if you look at the stock markets, This is France, Germany, Japan, UK and the US in light blue, you can see that a decade
after the collapse, the stock markets had all come back and indeed we I believe
we had a record high on the Dow yesterday. So from the point of view of the of people in the financial services industry or upper middle class people, their 401k said come back. For them this crisis was long
over for many such people. And I think what that ignored was the increasing divergence between that recovery for people in the financial services sector with significant retirement assets and other assets in stock markets, and the real economy that
was playing itself out in Middle America and over much of Europe, where you can see that the jobs deficit was much deeper after this
crisis and lasted a lot longer. You can see that long
term unemployment that is people who are unemployed for
more than 27 continuous weeks was at higher levels and today, to this day, remains at high levels than for more than half a century. And housing, more than 10 million houses
would be foreclosed upon in the decade following
the housing market, which is the subject I’m
gonna talk about next. But this, this divergence
between the fortunes of people living off the financial economy and the rest of America and by the way it’s not only America. This is the Algo-America
welcoming refugees into Germany also greatly underestimating the angst out there outside of the political
and economic elites, and that angst is what
would be coming back to bite in 2016. Okay, we will talk about the
housing crisis on Thursday. (soft music)