The Conscience of a Liberal | Paul Krugman | Talks at Google

I was asked to introduce Paul Krugman, but of course, that's kind of silly because you're all here. You must know he is already. So what I thought I would do instead is quote Paul Krugman. And he had a very nice entry in his blog a few days ago. He said, back when Hillary Clinton described Dick Cheney as Darth Vader, a number of people pointed out this was an unfair comparison. For example, Darth Vader once served in the military, but he had an even better reason why the comparison was invalid. The contractors that Darth Vader hired to build the Death Star actually got the job done. So it occurred to me after reading this that who is Paul in the Star wars trilogy? Han Solo, Luke Skywalker. You know, the beard gives it away. Yeah, I give you Obi Wan Krugman.

So I was sure. I was actually sure that I was going to turn out to be one of the Ewoks or something there. All right, so look, I'm here on what is. I'm here on book tour and I have a book, and I think a number of copies have been given out, but I'm going to indulge myself. So I have this book. I've given the book talk about 50 times in about 25 cities. So I'm turning this off. I'm not going to do a Rudy Giuliani and take a hold of my wife in the middle. So I have this book and I urge you to read it and especially I urge you to buy it multiple copies and maybe in the questions, some of the talks that come out. The book is very much about politics. It's about the long term. But I thought we were just talking about this over lunch. I decided to change and not to give the book talk. Instead, talk about what's worrying me, what's on my mind right now, and in fact, give an economics talk, because these are interesting times. There is apparently no such thing as the legendary Chinese curse. If anything, it may. About. May you live in interesting times. It may actually have Scott's origins. But anyway. But we do live in interesting times, and we're having a really, really interesting and fairly scary financial crisis. And so I thought I'd talk for a bit about what we understand, what I think I understand about it and what I don't understand and where we are, which makes it. I think it's pretty interesting. So you should know, by the way, that before I began writing for the Times, international economics is my home field and various strands. So, I mean, I started out writing these wonderful things you could do as an academic. My first work was about why is there international trade? Which is a small topic, but one of the other strands was that I invented currency crises. Not the thing itself, but the academic field actually in 1979 and ever since business has been good and I spent a lot of time doing traveling to Southeast Asia, traveling to South America, talking in the previous life. And I haven't done much of that since, in the last eight years since I began writing for the Times. And sometimes actually people from Argentina ask, you know, why aren't you writing about our things anymore? And I say, you know, I'm trying to save my own damn republic. But the. But now it turns out that we're having kind of an interesting, not quite a currency crisis. There's a currency aspect to it, but we're having a financial turmoil that is kind of up my alley. And we're having it right here. Or more accurately, we're having it mostly on Wall street, but we're having it anyway. It is in the United States and it's so it's actually, I know I'm making jokes, it is reasonably scary in a number of ways. But anyway, it's a very interesting situation. So let me talk about the economy right now because it is a. Not so much the economy at large, because there's some things I don't, you know, I'm not going to talk to you about freight car loadings and all of those things that are supposed to be early warnings of what's happening, but instead about the financial situation. Okay, so we have a financial crisis. I think you can fairly call it a financial crisis. We don't know how badly it will affect the real economy yet, but it's a very real disruption in the markets. And there are a couple of clues to it. First of all, it's just if you talk there are whole parts of the financial markets that basically just shut down. You can't sell asset backed commercial paper. You can't. There are types of transactions that normally occur a lot that are not occurring at all. There are yields, there are kinds of investments that are normally considered equivalent and should be arbitrage and should be just the same, just about the same yield that do not. So my favorite indicator, which I'm checking all the time, something called the TED spread, which is the difference between the three month Libor London Interbank offered rate where banks lend to each other in dollars and in London, except you know, it's really in cyberspace. But anyway, it used to be, but it's banks lending to each other and the three month treasury bill rate which is lending money to the federal government and those normally three month LIBOR should be 30 or 50 basis points, 3.3, 2.5% higher just because there's a little bit of, of risk involved but not much. And now it's, these days it's more than, than 2, 2 percentage points higher than, than the TED spread, which is kind of saying that, that banks reasonably, I think it's saying that, that banks lending to each other thinking that there's something like a 1 in 10 chance that the whole financial system will seize up and they will lose a lot of money on loans to each other in the next year. So it's a, there are these, you know, these spreads, they're saying there's a lot of risk in the system. How did that happen? The last time anything like this happened was in 1998 when long term Capital Management went bluey and there were a few weeks of terror. I actually happened to be at a meeting at the Federal Reserve of New York in 1998 when we looked at, oh, there we go, right in the middle of that and got a briefing from officials there and the then president of the New York Fed told everybody about this. And then somebody said well, what do we do about this situation? And this is in 1998. And he said pray. And in fact it was resolved quite handily back in 1998. And then in August of this year we had a return of financial conditions strongly reminiscent of September 1998. And as before, there was what looked like a pretty speedy resolution and things improved and then they got worse again. And so now if you go to the Fed they will show you charts comparing this crisis with 98 and they look the same for the first month and a half and then start to get worse again. And so we have this very serious, very serious, at least from the financial markets point of view. So let me tell you the story about how we got here and then mysteries about how we get out. So the story, okay, so we had an amazing bubble in housing in the United States. That story really begins with the tech crash at the beginning of the decade. So obviously dot coms all go bust and leading to us a lot of paper wealth disappears, consumption goes down. Even more important, telecom investment went way down. Turns out the bigger story in that recession is actually that there were all these telecom investments in fiber that at that point no one had any use for. And when those stopped, that was a big reduction in demand. And so the economy went to A recession. It was not by any means the worst recession that we've had by a long shot, but it was sustained. It was hard to get the economy really going again. And so the Federal Reserve cut interest rates and kept cutting them and eventually down to about 1%, down to 1% actually, on the fed funds rate. At the same time, the Federal Reserve controls very short term interest rates. The long term rates came way down too, partly because of the Fed's action, partly because something else was happening which was the money flowing in from abroad, huge amounts of funds coming in. We talk a lot about China, which is at that point was the biggest source there are now. Right now, if you look at it, it's sort of three parts. It's Japan, which is actually the part that sort of looks like it might be sustained. There's China, which is just weird. And there's oil exporting countries which are also acquiring a lot of dollars. And all of these countries pouring money into U.S. assets, primarily either U.S. government debt or debt of Fannie Mae and Freddie Mac, which are quasi governmental or at least are thought to be. So there's all this money coming in, all of which made interest rates low and made home buying kind of attractive. So people started buying houses and the prices started going up. And classic bubble. As the prices went up, people started to say, well, they're going to go up more. And that made home buying seem even more attract. Okay, so we developed a really impressive rise in home prices that was out of line with historical relationships. So you have various measures people look at. My favorite is to look at the. We have an index which is supposed to measure rent or the equivalent. Basically, it's basically a measure of what people pay in rent. So it's kind of an indication of what it costs to have housing, if you don't want to buy it, versus the price of housing. And that relationship has fluctuated in a fairly narrow range. Historically. It's actually. It's kind of like the price earnings ratio for stocks. Conceptually it's very similar. And beginning early years of this decade, it just moved way out of that range. So nationally it went to about 50% above its historical range, which is. But in a way that's misleading because it's very, very different across different parts of the country. So I once did these things. I said, you want to think of the United States as being two countries as far as housing is concerned. Part of it is flatland, which is where there's essentially unlimited land and no zoning constraints. You just build additional houses and the price of houses, the price of building a house, end of story. And that includes not just the Great Plains, but includes cities like Houston or Atlanta, where they just sprawl. And then there's the zone zone, which is places where land is scarce, where there are zoning restrictions, and where this bubble really took off. Only about 35% of the US population lives in those zone zone areas, but most of the home value is in those areas because they're the expensive places anyway. And when you look at zone zone regions, you find that you had prices going to 70%, 80%, 100% above what the historical relationships told you they should have been. Of course, here we're in one of the real worst areas were San Diego and Fort Lauderdale, but looked pretty bubblicious here, too. And to some extent, though not quite as much in central New Jersey, where I am. And so we had ended up with this situation with all of this money coming into the United States, low interest rates, huge housing bubble, which was in turn both leading to a lot of employment and construction, a lot of demand from housing, and also to a lot of consumer spending because people could and did refinance their mortgages as a way of extracting some of their increased housing wealth. So I actually summarized the state of the US economy in 2005, saying that basically, as Americans, we made a living by selling each other houses with money we borrowed, buying them with money we borrowed from China. That was kind of the description of the US Economy two and a half years ago. Okay. There's something in economics we call Stein's Law, which is after Herbert Stein, the economist, advisor to Gerald Ford, and father of the much less funny Ben Stein. And Herbert Stein's law is if something cannot go on forever, it will stop. And so this thing was going to stop, and it's been stopping in stages. It's. The housing bubble is deflating now across the country. It's at different degrees in different places, but it seems to be, you know, really, the sales have. Have come to a screeching halt. Prices are coming down. Houses are not like stocks. The price doesn't plunge to clear the market. What happens when demand slacks off is that a huge inventory of unsold houses build up and prices sort of gradually grind down, which is what's happening now. And a reasonable estimate is that the prices, at least prices relative to these fundamentals, prices in real terms, have got to come down around 30% nationally, which means much more in some regions. And so that's a big price fall. Now, some of it can happen simply if house prices fail to rise while overall inflation goes on. But for what it's worth, there's probably nobody here who remembers this. I was just going to say Southern California had a bubble and burst bubble in the late 80s and into the 90s that quantitatively looked sort of similar to what's happening to the United States as a whole right now. So the bubble just in Southern California is now national. If you look at what actually at the actual bubble in Southern California this time around, it's even, it's much bigger, but sort of the average numbers and that one, it took about, it was in fact a 30% real decline in house prices from their peak and it took about six years to get there. So six years of a deeply depressed housing market, gradual falling, grinding down of home prices gives you some idea of what kind of siege we're in for. Okay, now I can tell you one of those things that economists rarely get to say, which was I predicted this. I actually got this one. I made some big bloopers in my time, but this one I got right. I saw that the housing thing was a bubble. I think part of the reason it wasn't as clear as it should have been was that a lot of people were looking at the national averages, which were certainly out of line. But to really get a sense of how crazy it was, you had to look at the sub regional. You have to look at coastal Florida or Southern California to get a sense of just how far out of line things were. Okay. What I did not understand during all of this was how much havoc the bursting of the bubble would wreak on the financial system. And this is the thing that has come as a really, really alarming surprise. So. Oh, and I should say, by the way, the one piece that really has not dropped is, although is the financing of the US from abroad. Although there's been the dollar has fallen a lot against the euro, it has not yet fallen against the renminbi, the yuan, the Chinese currency, fallen much less against the yen. So there's still a lot of adjustment on that side to go. But that in some ways is the thing that worries me least. We are meanwhile having this thing on the financial side. So here's what, what's happening while we were all thinking about other stuff, okay, we had a. One of these days people are going to say when people use the words financial innovation, people are going to run screaming because it turns out that it can be a very dangerous thing. So, all right, once upon a time you bought a house with a loan From a bank, maybe a savings and loan. And the bank first of all would probably insist that you have 20% down and it would set an interest rate and you borrow for 15 or 30 years and that was it. And then the bank would hold onto the loan long since that stopped being the case. So loans, banks sell off the loan to someone else and really the loan is packaged together with a bunch of other loans and then shares in this, you know, this big basket of loans are sold. And that's the process of securitization. And actually that began a lot. A lot of the securitization was made possible by government agencies, by Fannie Mae and Freddie Mac, which would in fact subsidize insurer, make this whole process go. And they would however also have. There were fairly strict criteria. The government sponsored agencies, if you get into this stuff, there are three and four letter thingies, CDOs, GSEs, SIVs. It's Alphabet soup. But anyway, the government sponsored agencies have quite strict criteria. A certain amount of money down, the size of the loan can't exceed a certain amount. The terms have to be fairly standardized. So borrowers who meet all those criteria are prime borrowers. And what turned out happened in this decade was the rise of subprime loans to people who didn't meet the criteria. Loans that didn't fit all of that. And subprime is, there's always been some of it, but it really, really took off in the middle years of this decade. So if you look even at 2000, only about 8% of mortgage loans were subprime. But in 2004, 2005, 2006, it's 20% of loans were subprime. So just most of the subprime loans that you hear about were made in the basically at the height of the housing bubble. Which turns out to be really crucial for understanding how we got into this mess. How does that. Actually one of the things that I find amazing is why people were so willing to invest in this stuff. So what you had maybe I should back up. The housing bubble, it seems to me, is a lot less forgivable than the tech bubble of the 90s. The tech bubble, there was this amazing new technology, great stuff. It was sort of possible to imagine that every company was going to be the next Microsoft. There was some reason to think that all the rules might have changed, but housing hasn't changed that much. But nonetheless, people were able to convince themselves somehow that all the rules had changed on housing as well, that there was something all the old rules about what was prudent no longer applied. Actually, I just on the Times blog, I just suggested there should be a follow on to Stein's Law, which I decided to call Glassman's Law. Tell you about who Glassman is. The correlated to Stein's Law is if something cannot go on forever, if it goes on for a while, there will be people devising elaborate theories of why it can. And there are actually versions of this all over the place. So in the case of the US Trade deficit, there's a whole raft of theories about why in fact the US can buy twice as much as it sells from the buy twice as much in the world as it sells to the rest of the world forever and so on. And in the case of housing, there were all kinds of things. But anyway, who's Glassman? Glassman is the co author of Dow 36,000, that 1999 best seller. And the very day I posted that and suggested that as a corollary, I didn't know this, but I posted that early in the morning and later in the day it was announced that the Karen Hughes, the U.S. you know, selling U.S. views abroad, has resigned. And her new replacement, appointed on that day is James K. Glassman, the author of Dow 36,000. So this is to lend credibility to America and the world. All right, so financial innovation. What made subprime, which had always been something that was a very limited thing, what made that suddenly so attractive? And the answer was financial innovation, a way of packaging it. The question was, how can you, you know, who's going to invest in securitized mortgages that consist of all of these slightly flaky subprime loans? And the way that they dealt with that was the collateralized debt obligations. So there's a. You would take a basket of subprime mortgages and sell contingent claims on different pieces of the income stream. So people are paying their mortgage payments and you have these different pieces, tranches, by the way, the slice. But the term that people always use in the financial stuff is tranches. So you'd have a first tranche that would have first dibs on any income coming out of the mortgages. And then there'd be a second tranche which would get money only if you were getting full payments up to the amount contracted for the first tranche and then a third tranche and so on, sometimes up to, to 16 tranches. And the theory was that even if a lot of these loans went bust, there would still be enough money coming in to fill the first tranche. So that even though the underlying mortgages were kind of flaky. Through this engineering, financial engineering, you would have created something that was a pretty safe asset. And the other stuff people would buy because they were willing to take on risk. They, they would be offered high rates of return if nothing went wrong. And then accepting that might not go wrong, but that the primary, the top tranche would be a really safe asset. And the rating agencies agreed. So Moody's and Standard and Poor's and Fitch were willing to classify the top tranches of these things as AAA rated debt. And so it was a way to, you could then get respectable investors, institutional investors, funds that were holding the money for the Florida school teachers and so on, to invest in these things. Okay, so what happened? By the way, there's a memo that was circulating on Wall street which had a, describing a proposal for a new kind of collateralized debt obligation. And it became a collateralized overlapping. I probably shouldn't be doing this. It's going to go on YouTube, right? Any. The acronym turned out to be colostomy bags, which would be filled with structured high interest transactions. Okay, here's what actually happens. The real problem, part of the problem, actually there's been a lot of mis emphasis in this. People have been talking about, well, these were loans made to people who should not have gotten loans, which is arguable. But what turns out to be really the problem is not that. And there's actually some research now from the Federal Reserve of Boston showing this. What really happened was that this became, this whole process became a way of giving people a lot of lending to buy houses with little or no money down right at the peak of a housing bubble. And it's not just new home buyers, by the way. A lot of subprime lending involved people refinancing, people who already owned a home, refinancing to take out a mortgage that then came much closer to the actual value of the home. And that in turn would, to borrow up to that much. They'd end up going subprime. But so it ended up that it was mostly a way of getting, you know, lots and lots of debt. There's also appears to have been a quite substantial amount of essentially predatory lending people as Ned Gramlich, Federal Reserve governor, who died just a few months ago, but he wrote an anguished essay saying that the most complex loans, the most difficult to understand, are actually being made to the least sophisticated borrowers. Lower income people, often immigrants, were getting complex loans that had low teaser rates that suddenly shot up and complex terms. And they were so there were probably a lot of people who were being steered into products that were really just very bad for them. But in any case, the whole effect was to get a lot of people borrowing up to the hilt and borrowing up to the value of their homes, just at a point when home prices were way out of line with any normal concept of fundamentals. And then the bubble burst. And so you take right now we've had a, depending on which measure you use, but either a slight decline or a 5% decline. There are some data problems. There are two different widely used indices. They're not telling quite the same same story. But anyway, home prices are certainly on their way down. And you have large numbers of people who borrowed 95 or even 100% of the value of their home and bought it at peak prices. And the result is that you have a rapidly growing number of people who have negative equity, have home mortgages that are worth more than the house. This is bad. And first of all, it means that in non recourse states, which is a good part of the country, a non recourse state is where if you simply walk away from your house and the mortgage, end of story, the mortgage holder can't come after you further, that varies very much across states. But a non recourse state, if you have a house that, with a mortgage, if you have a $300,000 mortgage and a $200,000 house and you can't see any prospect at any time in the foreseeable future, the house will be worth more than 300,000, there's a strong incentive to just walk away. Or even if you are, if that's not the situation, if you're having a, if you're in financial difficulty for whatever reason, you lost a job, you're having your, you've had medical bills, I could give my sermon about universal health care, that's a different topic. You have, your teaser rate has just gone up and you really haven't thought about how you would pay the higher rate. If house prices are rising, you can resell the house and just escape gracefully, or you may be able to refinance and get yourself a breathing space. But if house prices are falling and you have negative equity, you can't do any of that. So the Boston Fed found that basically the rate at which home prices are rising or falling is the prime determinant of whether you have lots of foreclosures or not. And if you have a lot of borrowing that has put people at the point where they start to have negative equity. If home prices start to come down a little bit. Then you have lots and lots of foreclosures, lots and lots of mortgages not being paid. And foreclosing leads to big losses, not just because the house isn't worth the value of the mortgage, but also because the process itself. You end up having to sell the houses. The company that takes possession usually sells them at fire sale prices. And how big is this? Foreclosure rates are already at unprecedented levels. But if you do back, if you do some calculations, it gets really terrifying. So I actually had that in morning's Times. If you. We have some data on how many people had how much home equity at the end of 2006. And you can figure out from that if home prices decline by X percent, how many people will have negative equity, which puts them at high risk of foreclosure. If home prices decline 20% from where they were at the end of last year, we're talking about more than 13 million homeowners with negative equity. If they decline more than 30%, which is my number for what I think is going to happen, then we're talking about more than 20 million. We're talking about 40% of the homeowners in America having negative equity. So this is big stuff. And what's happened is that the, because the. Although we haven't had that many defaults yet, we had a lot, but not that many because the prospects of this have become so dire. These collateralized debt obligations, which were supposed to be the upper tranches, were supposed to be really safe, are clearly not really safe. So there is something called abx which is actually, it's not exactly. It's the price of insuring against default on these things, but it gives you. It can be read as what people expect to get on the dollar. So the ABXs on tranches that were further down, things that were rated double B, they were still at like 100% at the beginning of 2007. They're now typically 18%. So the lower rated tranches have basically become worthless and the AAA tranches have fallen from like 100 to around 70. And this is telling you that a lot of people who thought they were buying nice safe assets turned out they didn't know, but they were buying junk bonds and all of this stuff is out there now. Okay, but so far you could say, well, this is just money lost and people lose money. And if you try to work it through, even if home prices fall 30%, well, that's 6 trillion homes are about $20 trillion in value. So it's $6 trillion and 6 trillion here, 6 trillion there. As soon you're talking about real money relative to the economy that's still a bit smaller than the stock price bust at the beginning of the decade. So that it might not seem that severe. But in fact, people who are serious financial types are terrified. And the reason is that a lot.

Of.

This debt that has suddenly turned out to be bad is held by key players in the financial system. So you have banks and all this stuff, exposure we didn't know they have is coming to light. Banks, non bank financial intermediaries that do things that banks do but aren't formally called banks and of course don't have deposit insurance or any of that stuff are taking these losses and it's huge and we don't know where it is. So basically every week we get two or three institutions saying, oh by the way, we've got 10 billion of losses that you didn't even know we were exposed, but there we are. So an example of a non bank thing, this fund that Florida schools were using essentially as a bank account place to park their money until they needed it to buy textbooks and do building repairs and so on, turned out to have be contaminated with subprime debt. And all of a sudden the state had to stop withdrawals from this fund because people were starting to get nervous about it and pull out. And so it's as if they had all these school districts, had their money in a bank and suddenly the bank was closed, had to slam its doors. So that sort of thing is happening throughout the economy and it's really scary because it means that a lot of the lending in the economy is grinding to a halt. Some things are still going on. People are still able to borrow on their credit cards. Housing has suffered a terrific hit, but the rest of the economy is not yet showing clear signs of being in deep trouble. But people think it's going to be pretty bad because the whole credit mechanism has frozen up. So how does this get worked out? So everybody's model for this, everybody's model for how it's supposed to be is what happened in 1998. In 1998, again, I think a lot of people in this room were in grade school. But in 1998 we'd been having a series of financial dominoes falling all around the world. It had a crisis that began in Thailand, spread to Malaysia, Indonesia, South Korea, worked its way. It was really scary. And then in 1998 Russia defaulted on its debt and that triggered the collapse of Long Term Capital Management, which was a hedge fund that wasn't actually that big in terms of capital, but was incredibly leveraged and was all over the place. And the markets really froze. And that was when the president of the New York Fed told us that you should just pray for this thing to resolve itself. But actually it wasn't that they did better than that. The Fed orchestrated a rescue of, although it was done with private money, not taxpayers money, a rescue of ltcm. The Fed cut interest rates, extended money to banks through the discount window and Alan Greenspan and Robert Rubin went around looking very confident and the thing just faded away. The crisis just faded away. And that was supposed to be what happens when you have one of these crises. It's okay, you know, the Uncle Allen or now Uncle Ben will come in and soothe everybody and it'll all be all right. That's more or less what they tried to do in August. In August, when the markets really were started to seize up, the Fed lent a lot of money to the banks, cut interest rates, said we're dealing with the problem. And in fact a lot of these measures got better for a while and then they started to get worse again. And I think we're starting to figure out we actually understand why. And unfortunately understanding is kind of scary. So there's a distinction if you do financial stuff between liquidity and solvency problems. And if you read this morning's Times you already know my example. But anyways, let me repeat it for those who didn't think about. I had the First bank of Pottersville, which I think I suspect that 1 in 300 readers got the reference. It's a Wonderful Life from the movie. In the bad existence in which Jimmy Stewart never existed, the town is renamed Pottersville and it's Jimmy Stewart's bank. But anyway, imagine no deposit insurance. So you've got this bank and there's a rumor that the bank has made a terrible a big bad loan and has lost a ton of money and is basically in trouble. Even if the rumor is false, it can break the bank because if everybody tries to withdraw their money, banks don't keep all of your money in cash, they keep only a fraction of it. And they can't liquidate all of their other assets or they'd have to sell them at fire sale prices. The bank can go bust just because people think it's bust. It can be a self fulfilling prophecy. A bank run can break an even sound bank. But if there's a Federal Reserve it could solve that problem. It can provide the bank with liquidity, the ability to raise cash by simply extending a credit line for a little while. In fact, if it simply announces that it's extending a credit line, that might be enough to do it. Because if people, some people will be running the bank not because they believe the rumor about the bad loan, but because they think other people are going to run the bank and break it. So if you could just break that psychology by making it clear that credit is available, you can solve the situation. And that, roughly speaking, is, is what happened in 1998, this crisis which seemed to show that the Fed can always bail us out. But what if the bank really did make that bad loan? Then extending a credit line doesn't do you any good. Because the trouble is that what people are worried about at that point is not the fact that other people might run the bank. They're worried about the fact that the bank has actually thrown away your money on a really bad loan. And that's a solvency problem. And what we're starting to think right now is that this looks like a solvency problem. Basically in August, when the Fed pumped a bunch of money into the system, people sort of breathed a sigh of relief and the markets got better. And then more bad news about housing started coming out and more revelations of un. Not only of losses that you didn't know about, but of exposure that you didn't know about kept on coming out. And people said, oh, this is really not very good. And all of the evidence that people are very, you know that there are real risks out there returned, which leaves you in kind of a quandary. So the. By my count there have now been four high profile, we're going to save the financial system things since all hell broke loose in the summer. Last night I was informed that I could not in the New York Times say the phrase all hell broke loose. So we changed it to things started to go wrong is I think what it became. So first there was the Fed rescue of August and that worked for a little while and then stopped working. Then there's the super sieve. SIVs are special investment vehicles which are things that basically sell, borrow short term and invest in stuff like CDOs that are backed by subprime mortgages. And there was this theory that somehow the banks, which had created all of these special investment vehicles to invest in this stuff, could solve the problem by all combining together to create a super special investment vehicle which would buy the assets off the other. I never understood why that was supposed to work, but it was sort of a, it really has the, you know, rearranging the deck chairs on the Titanic feel to it. But anyway, and that one, but it was a very big thing for a few weeks and it sort of faded out and it's probably never going to happen, I think at this point. Then there's the Paulson plan, which was we're going to get the banks together, not the banks. Sorry. Part of the problem is we don't have banks. We have, you know, there are mortgage originators which made the loans and then sold them off. But. And they were going to establish a formula by which some mortgages that had mortgage rates that were about to reset, they're things that had a low teaser rate for two or three years and then reset, would postpone the reset. And the idea there is that there are supposed to be, there are some people, no doubt, who can't make the payments on their higher mortgage as the rate goes up. But it would actually be better both for them and for the owners of the mortgage if they were allowed to work out some deal of paying less that the costs of foreclosing would be greater than the cost of costs of giving them a break and letting them stay in the house. The question you would ask, especially if you've spent too much time studying economics, is, well, if there's an advantage there, why won't they do it anyway? And the answer probably is that, look, it's hard to do. It's complicated. There are actually not enough loan adjusters out there, not enough people. And given the way that everything is sold on and on, the ownership cleans, you can't get the people who own the mortgage together in a room to do this. So by establishing a kind of standard formula, the treasury might be able to get some of this. You know, it might do some good. But I actually tried to do back of the envelope and I cannot come up with any way this could be possibly worth more than a few billion dollars. And we're talking about at least 4, I'd say at least $400 billion of losses to financial institutions and all this. So it's just not going to be big enough to, to make a difference. And then we had, finally this week, the Fed came up with another rescue plan, which is basically a more complexly designed lending facility. And it's, we're trying to figure out exactly how this is different, but it doesn't make all that much difference as far as I can tell. I am entirely sympathetic to the efforts of the Fed. This is a very hard time. But you should know that I'm biased because before he was demoted, Ben Bernanke was the chairman of the Princeton Economics Department. So, Okay, how does all this end? That's the interesting question. First question, is this going to mean a recession? And let me say with great certainty, I don't know. And nobody knows because part of the problem is this is absolute havoc in the financial markets. But we don't know how much all this matters really. In the end, it's certainly bad for housing, but housing had already taken a huge plunge anyway. How much worse can it get? How much this interferes with the rest of business? We don't know. And there are signs that they used to be. When I studied international economics as a grad student, we had the grand old man, Charlie Kindleberger teaching the course. And he used to say about balance of payments numbers that there are so many ways to calculate them that you can be always optimistic or always pessimistic depending on your temperament. And that's a little bit the way the economic indicators look right now. So if I want to get really ominous, I can tell you about commercial real estate seems to be hitting the tank now. On the other hand, consumer spending. Apparently nothing can stop the American consumer. So. So I don't know. I mean, you know, right now I'd say odds of a, of something that will formally be called a recession are about 50%. But that's in a way there could be things that wouldn't actually be a recession, but would kind of feel like it. There could be recessions that would be sufficiently mild that it wouldn't feel all that terrible. I'd say about 15, 20% of something really, really bad, which is. But the truth is nobody knows. It's a. This is all uncharted. We never had this kind of financial mess before, so this is no precedence. How does it work out? I was trying to think about what precedents we have for this. And in the past 20 years there have been by my count, four big financial crisis type shocks to the US economy. Obviously other countries have had had their own problems. The 87 stock market crash, that was handled very easily, wasn't even a blip in terms of the economy basically because nothing much was lost except some paper gains that people had and had some impact on consumer spending. But the Fed was able to cut rates and the economy just sort of blew through it. Savings and loan crisis that finally sort of became manifest at the end of the 80s was in some ways like this. The savings and loans had made a lot of bad loans. They'd made a Lot of loans that they could not actually claim, but they were there. The debt, you might say, was held by depositors. It was not. They hadn't passed it on through all this complex chain of stuff. And the deposits were insured by the federal government. And so what the thing ended up being was that the federal government had to bail out the depositors. And that ended up costing $150 billion, which would be the equivalent of something like 400 billion relative to the economy today. So it was a big, fairly big cost to the taxpayers, but it didn't do that much to harm the economy. And it was not a question of, well, will Congress approve this money. We had already contracted to deposits were insured by the federal government. So there was no question. It was sort of an automatic thing to do that. Whereas if you were going to try and do something like that now and say, we're going to bail out the investors with four or five hundred billion dollars of federal money, oh, boy, you know, there's a lot of very undeserving investors that you'd be bailing. It'd be very difficult. Difficult to imagine it actually happening. 98, I've already talked about, which was. It turned out just a. You know, there was money lost in Russia. There was money, but it wasn't that much relative to everything. It was just a. Yeah. So the joke at the time was that we were, you know, people said, we're throwing money down a rat hole in Russia. And the answer was no, we're throwing it down a missile silo. But anyway, the. But it turned out that that was. Once people calmed down, which was fairly quickly, the thing went away and the tech bubble and its burst, which was more like 87, just paper losses, no real ramifications for the financial system. So now we have something entirely new. And so I'm trying to scope it out. I don't quite know. I mean, assume that we don't have a complete financial meltdown. Who knows, right? We might. But in that case, all the rules change that we just have a lot of trouble and it hurts the economy but doesn't destroy it. And it's kind of. It's very hard for me to see how we're going to do anything in terms of policy. We will. Can we bail out the investors? Hard to see exactly how that happens. Will we be able to do some financial engineering that makes the thing go away? Hard to see how that happens. So I end up with this story, but I'm not sure if this is right, that what happens is that the financial markets remain kind of crippled, hobbled, until house prices have fallen enough that they don't need to fall any further. And the banks and financial institutions have eventually been forced to reveal all of their losses and some of them go bust and the rest become, because they survived, become good credit risks again. And the thing. And life gradually returns to normal. But it's amazing. I mean, we managed. What strikes me, I'm just going to do Q and A at this point. What strikes me is the sheer sort of gratuitousness of the whole thing. I mean, you can. Again, coming back, you can understand. We had this technological boom bust in the 90s, which was. Well, you know, there was this thing called the Internet and it was very exciting and no one quite knew what it would turn into in terms of profits. And so it made sense in a way for people to get all excited and engage in some wild speculation here. There was nothing. It was just houses. And somehow we managed to convince ourselves or be convinced that, that everything was different. And we got this crazy, extremely risky financial structure built on top of it, and then the whole thing collapsed. And the people who sort of engineered all of this have now walked away in disgrace with severance payments of about 150 million each. And there we are. It's an incredible story and somebody. I'd like to see somebody punished, but I can't see that that's ever actually going to happen. Thank you. So how do we do this? Yeah. So, yeah, there look like. Yes. Is there a roving mike? So.

Yeah, I had a question that. That I thought was going to be off topic until you're closed. And it's basically the idea of people who profit by destroying value, which seems to be sort of the way the.

Bush administration does things. Yeah.

What's. What's the end game? I don't really see what's going on, except all these people are getting rich by causing damage.

Yeah, no, it's a. I mean, to a certain extent, you know, these are the days of when the big bucks in the economy are made in finance. Finance is the core. If you look at where does the top hundredth of a percent come from? Who are the people making really very large incomes in this economy? And it turns out that although there are captains of industry and creators of spectacular information technology firms in there, there are not very many. That's mostly not it. It's mostly people doing. Mostly people you've never heard of doing financial engineering on Wall Street. And there's very little evidence that it's Creating value. So I don't know why it persists. There's. It just. I think people keep on coming up with strategies that appear to make money for their investors for a few years and then crash and burn and end up not making money. But they do make a lot of money for the people who originate them. And then along comes another one. It's kind of a PT Barnum market sucker is born every minute. It's an amazing thing. And I don't know how it comes to an end. We just keep on. There seems to be no learning in this process unless we have real full financial meltdown, in which case we have what happened in the 30s with bank regulation and the. The financial markets being disciplined. But no, it's an amazing thing. I'm supposed to be selling my own book which is about none of this. But there is this great book though. But it's a. One of my classmates from grad school, Richard Bookstaber, went off to become a Wall street quant guy and he has a book called A Demon of Our Own Design, which is. He seems to have been on the scene for many of the financial disasters of the past 20 years. And what strikes me is that people. It is really a story of people devising supposed money making machines, each of which works for about two years and then blows up in the investors faces. And it's just one after another after another. So I don't know how it all ends. Yeah, yeah.

I just recently read what appeared to be a great book about the history of the financial crisis of 1907. Yeah, it was called the crisis of 1907, which is sort of like a bedtime reading if you want your kid to grow up to be a banker. Because JP Morgan saves the day.

Right.

But I was sort of curious. Do you have any sort of commentary on sort of what historical episodes are most like? What we're seeing with sort of the subprime meltdown. And is there anything we can learn from that?

Yeah, I mean the subprime meltdown first. First. I'm not sure you can find anything quite like it because we have this securitized financial system where banks. Where banks are replaced by these sort of vast networks of holding where there doesn't seem to be any center of control. So that's kind of new. But in terms of the underlying finance, it is likely the savings and loan crisis of the late 80s in the sense that there are a lot of basically unrecoverable lending or kind of like the great bank crises of 1930 and 31 which, much more than the stock market crash of 29, caused the great Depression. It's actually, this was just last night. I was thinking about the story I've been telling, and I suddenly realized there was a phrase that actually goes back to the great economist Irving Fisher trying to make sense of the Depression. Debt deflation. And what we're actually seeing here is a case of debt deflation due to the housing market. And so this is now, we hope it's a minor key version of 3031, but that's the closest example. 1907 was like 1998. It was a panic, a crisis of confidence. But fundamentally, the system was fairly sound. So if JP Morgan could corral everybody into sort of holding each other's hands for a little while and singing Kumbaya, the markets could recover, which is more or less what Alan Greenspan did in 98. We tried that. As I said, we tried that. I know it was. We did last summer. We did that in August. And the trouble was, although people calmed down for a little while, they fairly quickly realized actually there was very good reason to be afraid.

Thank you for that shocking vision of things to come.

Thanks. Okay.

I hope you don't mind me switching topics to stuff that might be more relevant to the book.

Maybe.

I don't know.

Sure, I'm happy. I haven't read the book yet. I do the reverse, actually. Normally when I give book talks, they. I talk about the book and then somebody wants to know about the financial markets. So this time we can do it the other way around.

Okay.

So I know you care a lot about inequality, and I wanted to ask which of two inequalities is more important to you or more important to you or more important normatively, if those happen to be different? I don't know, the sort of inequality between the rich in the US and the poor in the US or the inequality between the poor in the US and the poor in the rest of the world? The poor poor in the rest of the world. So bottom billion dollar a day kind of people without detailed definition of those.

Yeah, okay. No, on a human basis, the poverty of the Third World just swamps anything that happens in the US in terms of what to be concerned about. And if there was a world, you know, if I had to make a choice between improving the living standards of the poor in America and improving the living standards of the poor in Africa, clearly the poor in Africa, it's much more vital. But, you know, it's not a choice. And in fact, if you really look at what actually happens in terms of who gives aid, who actually supports development in the third world. It turns out that the societies that are most concerned with redressing poverty and inequality at home are also the ones that give the most foreign aid. So the US is incredibly stingy compared with other advanced countries. Sweden is incredibly generous compared with other advanced countries. So it isn't really a trade off. There's a question about personally what you should be working on. You know, it should, if you're someone who cares about inequality and you're, should you be working on global poverty or should you be working on domestic. And I think the answer is, you know, you just have to figure out what you can do best yourself. So, you know, Jeff Sachs is trying to do a lot for the third world. I don't think, I don't think adding my voice to it would make much difference. So yeah, I mean, sure, from the, from orbit the inequality between nations is vastly greater than the inequality within nations. But on the other hand, not to, you know, nonetheless, the fact that we have a very rich country with a lot of remarkably poor people in it is something to be concerned about.

So the obvious follow up question is, you know, I think I can take, you know, thinking looking forward to the presidential election in this country, right. I think I can sort of figure out on my own which political party and which candidates will do what for the inequality of the US rich to poor. But so tell me your opinion on which of the Democratic frontrunners and which of the Republican frontrunners will do the best job at raising the lot of the international poor, you know, taking into account not just amount of aid but trade and the other things that affect that.

Oh boy, hard to know. I mean, let's put it this way, it's hard to know because I think nobody's going to do very much when all is said and done. Right. In terms of aid. It's deeply unpopular in this country. It's, we would just. Based on historical experience, I would guess that any Democrat will end up giving more aid than any Republican just because the, of the inherent sort of ethos of the parties. The. But it's, but it's just, it's politically very difficult partly because the public has a, you know, a wildly distorted notion of how much foreign aid we give. Right. I mean I was, I've talked to, you know, highly trained professionals, but not in economics and they say, you know, we would have enough money to deal with our problems if we didn't give so much in foreign aid. And you know, but the truth is, of course, basically we give essentially nothing in foreign aid. So it's. But on trade issues, there is this question. If I thought that somebody was going to turn radically protectionist and shut off the, the ability of Bangladesh to sell apparel in the United States, which is the only thing that keeps them literally, I think, keeps their heads above water, then that would be a concern. But I don't think that's going to happen. There are some more protectionist noises from some of the Democrats, but I think we're not talking about anything that would be radically disruptive. So that's the story. And if you want to vote for a candidate on what they're going to do for Third world poverty, you're going to have a hard time because in the US Political process that just doesn't rate as an issue. Two more. Ok, I can only take two more, I'm told. Ok. So previously you said you weren't too concerned about the dollar's devaluation versus international currencies, but recently Iran said that they were looking to stop denominating their oil prices in dollars and move over to a different basket of currencies and urging other OPEC nations to do the same. Yeah.

Do you think that that would change.

Your opinion on the dollar's prices? Okay, no. And let's just talk about the. So I have, I actually have sort of multiple layers of indifference on here. So first off, what they denominate the price in doesn't matter at all. It's even at the most sort of shallowest level. You might want to ask. Well, yeah, but what do they accept payment in? The fact that the price might be indexed, it's not clear that they would accept payment in something other than dollars. Even so you can index the thing to the yen. But if it's. And then even if they accept payment in Euros, that doesn't mean that people are going to be having to have big bags of euros to pay Iran. Right. This stuff is done with wire transfers on bank accounts and there's essentially no green stuff involved. So there's very little effect on the holding of dollars. And even if people do switch out of dollar holdings, which I think is starting to happen and will happen more as countries diversify their reserves and so on and the dollar falls. How bad, of course, thing is that. So the cases where plunging currency are really disastrous are cases like Argentina in 2002. And the problem there was that Argentina had all of this debt in dollars. And so, and basically every company and many individuals in Argentina had debt in dollars and assets in pesos. And when the peso plunged to a third of its value, everybody went bankrupt. And that's the, that's the kind of thing. Now the United States, well, we also have a lot of debts in dollars. So but, but our assets are also in dollars. So if you actually look at it US balance sheets, when the dollar falls, the balance sheets of both the US as a whole and of US Corporations get better because they have assets abroad and euros or other currencies and they have dollar debts. And so they actually, the balance sheets, you know, the balance sheet thing is actually positive when the dollar falls. Inflation is a concern a little bit. Prices of imports go up when the dollar falls, but not as much as you might think. So this is. It turns out that a lot of foreigners tend to absorb when the dollar falls, they absorb a lot of the change in their margins so that the import prices don't go up all that much. And there is a question, I mean we have not seen. I was just conference on all of this stuff last week and we know that that's the case when the dollar falls against the euro or against the yen, that the prices of Japanese or European goods don't go up that much. We don't know what will happen if and when China allows its currency to go up. Will the, you know, the classic thing is that prices of German luxury cars don't go up very much when the Euro goes up. But we don't know what will happen to the prices of poisoned toys and tainted seafood if the yuan goes up. So this is a running joke now. We now have fair trade with China. They send us poison toys, we send them fraudulent securities. So there's an inflation issue and it's actually there's a little. But it's very hard. I've tried to tell a story about a falling dollar creating a crisis here and I can't. The US just doesn't look like the kind of economy for which that is a problem. Thank you. I think one more.

So we negotiated. So this is a kind of a two part. So first of all we're wondering is like if as your estimate or guesstimate or whatever the housing market falls by 30%, how can that not cause a recession? And secondly the given that there are regulations on things like how much you can buy on margin that are supposed to protect the financial system.

Do you.

Think we'll ever see regulations on like basically having to put a certain amount of money down to buy a house or straightening out these teaser rates that especially when there's obviously a bubble going on that maybe the Fed could do something to try to deflate it.

Yeah, okay. So the first. Okay, the thing is about housing is that the direct effect of plunging housing construction has already mostly happened and hasn't generated a recession yet. So it's so which is a surprise. I would have expected there to be a lot more direct impact just from the fact that home construction has gone down so much. One of the mysteries is that the. According to the US government figures housing construction employment in residential construction is down only about 5% from its peak, despite the fact that, that the amount of residential construction is down about 40% from its peak. And we think that's probably a mixture of things. Part of it is that many people employed in construction are sort of contractors who are self employed so they're not counted as unemployed, but they're just working a lot less. The other is that a lot of them are probably illegal aliens working off the books. And so they've disappeared. They can't disappear from on the employment rolls because they were never on to begin with. So, but, but still the, the thing is that it's. Given how that we've had so much of a plunge and it hasn't done that much to the economy, it's is not for certain it's going to slow the economy. Right. And if the US economy grows 1% over the next year that will cause the unemployment rate to shoot up probably to five and a half to six percent. It will feel like a recession, but it probably won't meet the National Bureau of Economic Research Recession dating Business Cycle Dating Committee probably won't consider it to quite meet the formal criteria for a recession. So that's the thing. Restrictions. Yeah, I mean I think the. Look, the fact of the matter is that in Edward M. Graham the late Ned Gramlich was calling for the Fed to at least establish guidelines of non actual regulations on subprime lending way back early years of this decade. And it's clear that they could have done that and they did not do it because Alan Greenspan said well first of all it is not possible to have a housing bubble and that markets would, would sort this out. So it was an ideological predisposition against doing anything. And I would think that it certainly would make a lot of sense to start thinking about some prudential regulations on all of this to limit these kinds of risks. Now what people always say is oh, but then you'd be closing off the channel for less advantage people to own homes, you know, and I actually was just ripped out from today's Wall Street Journal. Something, as the Deputy Secretary of the Treasury, I think, said something about we mustn't overregulate because subprime lending is so important to promoting home ownership for less advantaged people in this country. To which my argument is. But, you know, that actually didn't happen. Most of the subprime lending took place in 2004, 2005, 2006. Home ownership is already back down to the levels of 2003. Now. We had a little spurt in homeownership, and it was all a part of the bubble. And it's gone, right? Gone away all over again. So it never happened. Whether it's going to happen, Whether it should happen, whether it will happen, I have. I have my doubts. The thing that you should realize is that even after this administration is gone, I forgot to bring my little light. You know, I have the little countdown clock that says, you know, there are 403 days, six hours, and even if it is a Democratic president, Democratic Congress, Wall street still carries a lot of clout. And it may not. I'm not sure that we're ready yet to admit that sometimes the market is not right. But we'll see. I mean, the case for it will be quite strong because this is, again, if those worst projections come out, if we have, you know, 40% of homeowners in America with negative equity, I think that will concentrate a few people's minds. Thank you all.

Thank you.