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This afternoon on behalf of Harvard bookstore I'm pleased to welcome journalist John Cassidy for the eggs for an examination of his latest book How Markets Fail the logic of economic calamities and How Markets Fail one of our leading business journalists takes on the global financial crisis. The current recession and a host of economic theories to explain how we got where we are today and how we need to correct misguided thinking in order to get us out. Kircus and a starred review of the book called How Markets Fail To quote an elegant readable treatise on economics in current headlines. Cassidy delivers on the promise of his title but it also offers a clear eyed look at economic thinking. Over the last three centuries he shows us how the major theories have played out in practice often not well he writes with terrific clarity and a finely tuned sense of moral outrage yielding a superb book. John Cassidy has been a staff writer for The New Yorker since 1995 writing articles such as the current economic crisis. Alan Greenspan and the Iraqi oil industry at the New Yorker over seven years ago Mr. Cassidy authored in an article there entitled The greed cycle how the financial system encourage

corporations to go crazy. Previously he was a Washington bureau chief and business editor at The London Sunday Times and deputy editor of The New York Post. Mr. Cassidy's first book Dot Com on how America lost its mind and money in the Internet era it was published in 2002. I'm so pleased to have you here with us today. Please join me in welcoming John Cassidy. Thanks thanks very much everybody for coming out on a actually quite pleasant winter afternoon. And thanks very much to have a bookstore for inviting me here. Been thinking about writing a book on How Markets Fail for many years. But my wife always put me off saying nobody's going to buy a book without negative a title. It turns out she might be right we'll say. But after the financial crisis of a couple of years ago I thought. I should really get sit down and write this book I mean after all there are so many economic problems out there from you know inequality poverty repeated

financial crises global warming urban blight you name it. You know lots of problems out there which rarely get addressed in straightforward economics books of the sort I learned economics in and I'm sure some of you did so I thought you know that is definitely a market for a most skeptical view of the economy. And then it seems to me that the financial crisis itself provided a sort of the story example of markets failing being various explanations put forward for what happened over the last couple of years. I would say there are probably three or four of them. The most common one for the men on the streets perspective I'd say is that it was all criminality and greed sort of made off a some really large you know bunch of greedy Wall Street bankers. God took the economy down with them. Second theory has been put forward is that this was some sort of mass psychosis. This sort of outbreak of collective insanity. Some very respected behavioral

economists have sort of made this suggestion that you know a lot of psychological traits evolve in herd behavior. And collective irrationality which help explain this people people in the housing market forgot the idea that prices could ever go down. People on Wall Street turn to blind eye to the risks etc.. It was basically an exercise in sort of crowd psychology of work. The third theory that's been put forward mostly on the right is that this was essentially a government failure. There are various forms of this theory the most common one is that it all goes back to the government intervening in the housing market back to 1979 in the Community Reinvestment Act. And then Joy in the 90s the Bush administration joined in 2000 the Clinton administration both put pressure on Fannie Mae and Freddie Mac and the other agencies to buy up subprime mortgage securities. So the argument is ultimately it was the government distorting the housing market that was the problem. There are three main theories I think of what a brain

what happened. I don't think any of those is particularly persuasive. I think there's an element of each of them that not none of them is completely untrue. Obviously there was some criminality was seeing people being sent to jail for criminality and probably should probably should. More of them should probably be sent to jail. And clearly there was a sort of overconfidence and what economists now call disaster myopia. So psychological factors did play a role. The government I don't think I think the government role has been exaggerated I think it's a sort of way out for the right and people who define the free market gives them an excuse they say oh well you know we're in the market after all it was the government. But if you go and actually look at the studies they show that only about 10 percent of the subprime mortgages that anything to do with Fannie Mae and Freddie Mac they didn't buy any of them or they didn't buy any more than the government see them. This was overwhelmingly a private sector phenomenon 90 percent of the subprime securities were originated by private companies sold on Wall Street to private investors. It was a private sector phenomena more than anything else. So I don't

find that persuasive either. My theory as I say as I've already said is that this was basically an enormous market failure and a failure of ideas really ultimately a failure of misapplied free market ideas. So they tend the way I sort of frame it in the book is I start off with Alan Greenspan. Who came to be the sort of apotheosis of this free market ideology of the last 20 or 30 years. Start off with him appearing before Congress this time last year and admitting that this idea that he did have an ideology and that it was a free market ideology obviously anybody who's read any of my stuff would already know that was written extensively about is sort of links to wind round etc.. But he said look everybody has an ideology this was my ideology and in this instance it failed. I relied on the self-interest of the bankers and other people in the financial community to not get as into the sort of mess they were. The argument was you know financial Marxist self-regulate saying because it's

in the interest of bankers to avoid the sort of blow up with that we've had today they basically would do a good job managing risks. Greenspan said you know I believe that it served me well for 40 years and I did it ultimately failed. So you go to my book is an attempt to explain why it failed. And I apologies when I do this is as essential seen as ultimately a failure of ideas. I try and trace this free market ideology where did it come from. What does it miss out. And then how can we explain the crisis through it. So the first that the book is actually taken up with a history of free market thought going all the way back to. To Adam Smith like many other people who studied economics in college I managed to get all the way through undergraduate school and graduate school without actually reading The Wealth of Nations although everybody always pretends they've read it. If you actually sit down and read it you find out it sort of twelve hundred pages of pretty dense prose. And there are a lot of short summaries you can rate. But I actually thought I'd better go back to the saucier and actually read it. So I read it pretty much

from back to front and I came away actually with a sort of new found not new found. Lot of admiration for Smith. I think the basic free market idea has a lot in it. This is not a book saying you know we need to abolish capitalism or free markets. I think Smith explained in two or three very pithy ways why free markets ultimately probably do a better job than any other system we've come up with for just creating wealth. I'm not saying a very good distributing wealth but just creating wealth. First one is the division of labor which Smith talks about the pain factory. Those who are familiar with it. If you get one guy to try and make a nail story an American for a pin or a nail I always get mixed up I've been in America so long I don't know which was British an American anymore. But anyway he called it the pain factory. You know if you get one work at a time I can nail my taking all week. If you get 20 workers all doing specializing in one of the individual tasks such as cutting the metal sharpening the and attaching the head to it you get an enormous increase in productivity in a few people can make tens of thousands of nails in a

week. So we see a very simple example but the division of labor spread across the entire global economy has produced enormous productivity growth not just the division of labor the other aspect of free market which Smith identified which again I think is true is that you get rewarded for success and punished for failure not always on Wall Street it doesn't necessarily work out like that you often get rewarded for failure. In general if a business produces things the restaurant produces meals people want to buy a hotel you know provides a good service they do well they can make profits. If they do badly they produce shoddy goods they go out of business. That's a very simple feedback mechanism but essentially something which is lacking in most other economic systems like feudalism or socialism or communism. So if you put those two things together they a feedback mechanism from the profit motive and division of labor. What you get is this incredible productivity growth machine. Again if you go back to the sort of early 19th century people were very worried about you know mass starvation Malthus. People think he

was you know how can he possibly thought that at the time. But a lot of people thought that at the time because there was no sign of this incredible burst of productivity growth that we've had since then which is the basis of you know basically modern civilization I think so free markets I think basically good good for producing wealth. We've seen that in recent years for the shift in India and China towards free markets. You know I think the latest World Bank figures out that 600 million people since 1995 have been drugged out of probably poverty in those two nations. Now we can argue about the poverty or the poverty limits are and whether that's too high or too low but it's beyond beyond doubt to be an enormous economic growth in both those countries a lot of people have been taken out of poverty. So that's sort of two strikes for Adam Smith. But what I also discovered in the Smith which I just hadn't realized is that he was actually very skeptical of some elements of the free market especially bankers which for some reason I'd never seen referred to anyway. He actually has a

section where he describes a local bank in Scotland where he was from which lent too much money to all the to all the local businessmen lots of local businessman then went out of the local business man would just have shimmy shammy started schemes we didn't have any basis to them. They went south. They couldn't repay their loans. The bank went bankrupt. And through the entire local economy into a recession which if you think about it is exactly what's happened on a sort of global scale in the last couple of years. So Smith said because of that. Even though he was general against generally favorable a safe leave the market to the markets on devices he made an exception for banking. And actually I read a quote from him which as I say sort of shocked me when I when I read it he said he favored banking regulate he said such regulations may no doubt become citizens in some respects a violation of natural liberty. But these exertions of naturality of a few individuals endangered the security of the whole

society are not to be restrained by the laws of all governments of the most free as well as the most despotic rule. The obligation of building party walls in order to prevent the communication of Fire is a violation of natural liberty. Exactly of the same kind with the regulations of the banking trade which I hear proposed but it is equally justified. So there was Smith basically making an argument in 1776 were fine on a quite strict financial regulation. What happened I think after he also made arguments for the government promoting public and defending the country. But that's pretty well-known the financial regulation argument I don't think is very well known. So I started I was Smith I done what I do is then sort of trying to explain how his ideas which I think basically were quite sensible was sort of perverted over the course of a couple of centuries. I won't go into details but taking you through a drop of what economists call general equilibrium theory which is very boring and dense. And then the Chicago School which is a bit less boring and

spend a bit of time on that. Milton Friedman if you go read Friedman which as which I also did you'll see that he actually says most of these ideas I mean are you know Tim Smith. I'm just regurgitating them. But I think what he did what Smith What Friedman did and the and his followers is they took them too far. But two specific examples of this which again a quite complicated but there's one theory called the efficient market hypothesis which is basically the financial markets always get things right. The second theory called rational expectations hypothesis is the hypothesis that everybody smart enough to sort of foresee the future all systematically foresee the future. They don't make errors. Those quite complicated mathematical theories took over a lot of economics in this sort of 60s late 60s 70s and 80s and had a lot of influence on policy. The whole idea of the free market financial markets a self regulating them can be left to their own devices the intellectual underpinning of that idea is this Chicago school efficient markets theory. So I spend a bit of time explaining

that. And then in the second I call that tradition I call utopian economics. It seems to me it's not largely based on reality it's based on a utopian view. The second third of the book I then switch and try and trace an alternative sort of economic history of economic thought what I call reality based economics the idea that markets can fail in various ways is not a new one not a new one at all as we saw going back to Adam Smith. He said you know the banking sector can fail. But throughout history throughout the last hundred years also a lot of economists many of them assert who told across the road. I've also come up with various theories of how markets fail. I start off with just a couple of examples. Global warming. Most people don't think of global warming as an economic problem they think of it as a technological problem. Or maybe you know a geographical problem or something. I guess not geographical mainly technological but actually it's basically an economic problem. And what's the economic problem. It goes back to an English

economist the last century. Arthur Cecil Pigou who came up with this idea of economic spillovers which is the idea that what happens in one market can affect what happens elsewhere. The young example he used was of. It was obviously the early 20th century was of a railway setting up say between New York and Boston that provides a lot of valuable services to the people writing it. And that determines what prices of the tickets they charge etc. the private benefits of the people riding on the train are reflected in the in the price. That's all well and good. The problem is what about if in those days it was steam trains. What about if the steam trains going through the countryside which are just came through this morning and sparks fly off and set the whole local woodland or local feels a blaze who bears the cost of that. A local farmer or whoever it is isn't the cost of this spillover from the railways activities not incorporated in the price system is the basic problem. That was a very small example but. It's actually very profound because what he says is that private markets are very good at balancing

private costs and private benefits. But very bad at balancing social costs and social benefits. And that's what we have in climate change. All the people who are burning the greenhouse gases power stations SUV owners etc. they're paying the full cost the full private cost of their activities you know they have to buy the fuels etc. The market does a good job of reflecting the private costs but the social costs of their actions i.e. the I'm assuming for now the scientific consensus about global warming is correct. The social costs in terms of rising temperatures which are going to be borne by future generations. The private market misses those out completely. So what Dick you said was that what we need a way to address that is to basically use taxis. He called them extraordinary restraints but it's basically a way of correcting the market failure by forcing the polluters in this case to pay some of the costs of that business. Obviously they face quite high taxes quite high carbon taxes. They're going to cut down on carbon emissions.

So that's a form of market failure and a solution. There's lots of other forms lots of a lot of them have to do with information problems in health care for example the topical example. What's wrong with health care. Well we see a lot wrong with it but to do things that can be traced to sort of basic economic problems. One is an informational asymmetry. The people buying coverage if you go out and try to buy coverage on an individual basis you know a lot more about your health your health record than the company does who you're trying to buy the policy from. They therefore suspect that you are either chronically ill or have a good likelihood of becoming chronically ill if you're out trying to buy individual coverage. Very hard for you to persuade them that's not the case. So as a result of the information asymmetry cooperate corporations are in the business of making profit from selling from selling health insurance are very reluctant to take on individuals at reasonable cost. That's the basic reason why private insurance for individuals is so high. They figure that you know the risk pool of individuals is going to be

very talented and. They basically try all they can not to offer individual coverage that only offered an extortionate rate. On the other side of the market that's one informational problem. The other side of the market there's an issue of moral hazard which is another piece of economic jargon. Basically that means is that once you're insured for anything you don't have any incentive to worry about the costs. And that's essential to any insurance system. Think about health care. Once you paid your health premiums or somebody else has paid them for you if it's employer based as most of us have the fortunate ones do. We have very little incentive to worry about the cost of treatment. So you know if you have a headache you go to the doctor he says Well I think it's just migraine you say what it might be a brain cancer how about getting a scan just in case. And the doctor's not paying for it either so you probably go along with that. Turns out you know this sort of system you know we get massive of a use of medical resources and massive cost inflation. They're both economically driven problems both forms of market failure. So we've got

global warming. We have. Health care too is a big issue today and of course the financial crisis. So the third part of the book but the second part I go through a sort of history providing some of the famous economists who come up with various theories of market fairly of figures too. I also focus on John Maynard Keynes and Hyman Minsky and this goes to my sort of theory of what went wrong in the financial markets are we doing about five minutes. My basic theory of what went wrong is that it was what I call rational irrationality at work. What does that mean. It means that the people involved in the subprime industry from the start of the chain the people who were taking out mortgages right through the people who issued the mortgages to the Wall Street firms who were securitizing the mortgages to the credit rating agencies who were rating the bonds to invest is this end of the chain who were buying the securities.

All of those people were acting quite rationally and rationally in their own self-interest. Given the incentives they faced so from an individual basis it's rational I argue but it adds up to collective insanity we get enormous property bubble enormous credit bubble which busts and plunges the global economy into the biggest recessions in C-130s. So it's collectively irrational. So that's the idea rational irrationality. You can trace this idea back it's not the phrase I may have come up with but they actual idea itself is actually quite an old one and goes back to Keynes as I say who compared a lot. For investing and activities in the financial markets to beauty contests this is a bit of a sexist analogy but not in the 1930s was sexist. In the old in those days they used to have newspapers used to print pages full of photographs of go pretty girls and it was a contest you wrote in and

said who you thought was the prettiest. And if you if you know it was them or if your choice was the most popular. You want to price. So how do you play that game. Now if you were only a classical economist what you would do is you will look at the women and decide on the basis of you know how they look who's the prettiest. But actually that's not going to win you the prize. What you have to think is which woman is the average opinion going to think the prettiest. So you're thinking about how other people are going to play the game. And then if you're really smart you think well I'm not going to think about how average opinion of things is who's a pretty as you got to think about what average opinion thinks that average opinion is going to be the prettiest. And then you can have an infinite recursion as Cain said. Some people play to the fifth in the six degrees. It's ultimately instead of the whole free market idea is that people buy stocks bonds whatever on the basis of fundamental values. And if things move out of whack with reality well with a vacant reality arbitrage has come in and push prices back to their proper levels that's the

efficient markets hypothesis and in a nutshell what Keynes said and what some of the people at Harvard actually formalized in the 1990s including Larry Summers although he is seems to have forgotten some of it since then. It was this idea that it can be rational to surf the bubble if you're an investor rather than if you think you're a hedge fund or just some rich guy trying to make money which they do. The two of those things are essentially the same thing. When you see it really see the stock market going up and you think it's overvalued you have a choice you can either sell out now you know and try to push the prices back to back to reality or you can say well chances are this looks like it's a bubble forming. People are getting excited about it in the papers. Which markets are buying now and then sell out before the fools find out to form the name for this on Wall Street it's called the greater fool theory. And you know you buy and sell to a greater fool. And I think it helps explain a lot of what was happening in the market. It seems to me the Wall Street banks. One stupid

and they were a necessary evil. Just given the incentives they faced. It was very difficult for them to stay out of the market. Example I cite the Citi Group which is now a basket case obviously but from 2002 about 2005 Citigroup actually acted quite responsibly. Didn't wasn't a big player in subprime mortgages it did have a small subprime division but much smaller than all of its rivals. But that caused the problems because this market was incredibly profitable for years. So all of his rivals were making big profits. Start of 2005 the board came the board of directors came to the chair of the company. Chuck Prince and said Look Chuck we're falling behind. We need to increase our risk profile get into some risky areas that's where the profits are. You know we can't be left behind. Now what could Prince have done at that stage. He could have said look Citigroup has just to all go to great institutions or risk the entire future of the company on issuing loans to people who basically can't afford them. You know it's all going to come across.

When you read that really wasn't an option for him because he was already a he was already under pressure because they were falling behind everybody else and B he was incentivized with these enormous as everybody else on Wall Street with these enormous stock options packages. So Hollywood is rational all you really cared about quite rationally was getting the stock price up for the next few quarters in that sort of environment the sort of. The rational thing to do is to go with it and join in. It's almost impossible to stay outside. We saw that in the in the technology bubble about which I wrote my earlier book about the stock market bubble with the analysts. There were a lot of analysts on Wall Street who thought that these Internet stocks were crazily overpriced. But by the time the bubble bust almost all of them had lost their jobs because telling the investors to stay out of the market was a terrible terrible business decision for the for the individual firm because they would just move to the rival. So basically there's this sort of you know logic of the market which drives it to craziness once you get a speculative episode going

is my argument. Then at the end of the book having sort of laid out that argument I try and say a few things about what should be done about it and I'm happy to take some more questions about this. But the basic There are two basic points I make. Number one whatever regulations you set up whatever system you set up. We need the fundamental need for a sort of intellectual counter revolution I think we need to overturn this proposition which somehow has been entrenched for last 20 or 30 years that the market always gets things right. I think I think you know the markets sometimes get things right and sometimes is a very good job. But you know there's a big difference between sometimes and always. So it just seems to be as I say in Washington especially when you talk professional economists they say well we always knew about market failure of course you know but they didn't do a very good job of telling the politicians about this because whenever you especially in a financial sector with you know with the trying to argue against the

Greenspan line was very very difficult as I found out myself for 10 years also. It was just a sort of intellectual consensus that the market got things right. So I think that's the that's what we base they have to change in this book is an attempt to try and contribute to that change. And the second thing is just we have to whatever their policies are are introduced. They have to take account of incentives. The whole problem is that the market sometimes gives bad incentives. Adam Smith Milton Friedman Friedrich Hayek were completely right when they said the is the essence of free markets is that the prices act as signals and people react to incentives where they got it wrong I think was in saying that the price signals that sent out were always the right ones. Pretty kayaker I wrote of an article in New York about years ago famously called the The market a telecommunications system and the prices of the signals. I think he was exactly right. The problem is the signals as I say sometimes are the wrong ones. Once prices depart from reality they the signal a sense of people is

that you should join in this insanity rather than trying to correct it. That's not just on Wall Street. We see that in the housing market for example when house prices start rising. You know we all I mean I've done this myself you know we start getting jealous of our neighbors who are making quick killings and the temptation is you know join in. There's easy money to be made. So it's very difficult to overcome that. So I think any form of regulation or new laws which are introduced you know I've got to take that into account is no you know yours just saying we're going to ban this that or the other. These guys on Wall Street in other places is smart they'll come around with ways to game most most regulations. We have to think carefully you know how it's going to affect the incentive structure. That's pretty much as I say I'm quite happy to take questions on any individual's work. What Obama's doing what the Fed's doing is anything more sort of concrete. My book as I say is mainly a battle of ideas.

But I do have views on more specific things. OK I'll repeat the question. Question is does Ben Bernanke you deserve reappointing as Fed chairman. Cassidy votes yes he does. Why is that. I think Bernanke a did a terrible job between 2005 and 2007. He basically followed Greenspan's policies he was one of the architects of the credit bubble. He made the argument back in 2003 2004 that you know we should keep interest rates low the real problem was coming from China they had they had an excess supply of savings. So that was why interest rates were low it was the Fed's fall. That was the rationale the Fed used for keeping interest rates too low for too long kept mortgage rates down because the speculative bubble from which everything else flowed. So. But he failed to make it I'm afraid. But I think you did pass the final. Once they realized the entire financial system was in danger he basically threw the ole Roe rule book out the window and tried a whole series of what

for the federal quite controversial things. The idea of reducing interest rates and pumping money into the economy that was just standard sort of fed practice. But all these special lending programs that the. That he introduced which actually turned out to be quite effective if they hadn't been tried before. So I think he did a reasonable job of sort of preventing wholesale wholesale calamity. And I think the other thing is and I think he deserves so is that did a bad job made a good job you would say well it's 50/50. The reason I think deserves reporting is I think he is actually sort of repentant for the past mistakes and I think he is determined to introduce some regulations I think it once he wants it to be his legacy is the sort of Fed chairman who cleaned up Wall Street a bit. I might not be able to do that. But I think given that he did a good job of the last year or so we should give him a chance. Well the question is the question is why does it make individual sense to participate in the bubble. Is it because you can get in and out before before. The answer

an individual level is yes. You think most people think they can. Obviously if everybody tries to get in and out of the same time the bubble collapses. That's what happens at the end. But there is a period of it. There is a period in which you can get in and out. Chuck Prince actually was very the go back to the chairman of Citigroup if he interviewed him a few a couple of years ago before the bubble burst and said you know you're taking big risks. Things are looking a bit shaky are you going to pull back from these markets. And he said no no as long as the music's playing we have to keep dancing. What he was saying was that basically investing on Wall Street management is a form of musical Chazz which Keynes It also said. Actually I don't know if Prince was directly quoting chains or was just channeling him. But that's what it is it was one of these bubbles get going and is like a game musical chairs. And as you know if you play musical chairs you know you can get the seats out there available for some of the time. So a lot of people made a lot of money on the upside and got out in time. So I mean the technology bubble a lot of the hedge funds. So if the bubble quite skillfully and got out before the

bust. So that's why I think it is rational on some level to participate as an individual. I mean it's easy for Warren Buffett to sit out the bubble because he's already a billionaire. You know another billion here that doesn't really matter to him if you're a if you're a you know Mexican immigrant in East L.A. and with a very low paying job and suddenly you have the chance to buy a home for $300000 with zero down. You know you basically being given an option by the bank on the rising house. Housing market seems to me you know they've given you a 90 percent loan plus a 10 percent piggyback loan to pay the equity. What are you risking. You know. No printed in nitrate. Some people should have them you're right but it would. Whether whether he would have been the chair the chairman of Citigroup when the bubble burst. I don't know. He would not look like a hero I agree. Fidelity is actually interesting case because at the same time the contra fund was sitting out the bubble are learn this in my last book you know Jeff Fenech who was managing a gallon fund was went heavily into

tech stocks and then after him who took over also went heavily into tech stocks. I mean I think that was basically the end of the Magellan Fund right when it collapsed in 2002. So you know you can you know show sensible statesman should stay out of the market but I think what you find is you know there aren't many of them around once the bubble really gets going. It's a very good question. I mean when I said the Bernanke in the Fed did a good job I don't mean they got everything right. I think they gave Wall Street. I think. The strategic choice to bail out the banks was the right one just because we tried going the other way in the 130 S. And we also tried it with Lehman Brothers and you know things didn't look very good. And they certainly didn't turn out very well in the 30s. So the option of just some people in Chicago still do think we should just let the whole system collapse and everything would have been fine in a few weeks. Maybe they're right but I'm glad we didn't run the social experiment because I say to some extent we run in the 30s where the Fed allowed bank after bank to collapse and it didn't work out very well.

But the question then is how do you bail out Wall Street. And there I think Treasury and Fed both you know. They deserve a lot of the criticism they've got because they had a lot more leverage than they realized. The banks were prostrate at that stage Goldman was about to go out of business as Morgan they all were about to go out of business if they couldn't raise money. We were proved we the taxpayer were providing them a lifeline and we should have charged them a lot more for it than we did. So I think that's a legitimate a legitimate argument. The banks are now repaying the loans and they're claiming well we gave the taxpayer a good deal they made 10 20 percent on their investment over a year. That's a completely fallacious argument. At the time they got these the top money they couldn't raise money anywhere else. The implicit interest rate they would have faced was sort of infinity. So 10 or 20 percent is nothing. Taxpayers should the Fed should have said we're going to do what they did in England basically to be fair to the British when I think they took a much tougher approach. They said sure we're going to bail you out but the taxpayer is going to take 60 70 percent of the bank and we're

going to hold onto it for a long time. So if the shares come back you know the taxpayer will benefit. So I think that as you know that's right. I think we should have bailed out Wall Street but I think we should have been a lot tougher about it. Well and Geithner especially say is the time that was just such a big crisis they didn't know what they were doing. You know things are happening so quickly it was all snowballing. I think that's a bit of a cop out. You know I think they could especially in the AIG case the famous AIG case where they agreed to pay everybody out of power on the CBS's sorry for the jargon but they basically just agreed to by law all the people who were in hock to AIG 100 percent. I think they could have easily you know give them a 50 percent for example and it turns out that Goldman was one of the big beneficiaries. So that's caused all these conspiracy theories. I just don't know the answer to whether it was a conspiracy but it was a it was just it was a bad financial decision by the government I think. Well to some extent I mean I think what he's referring to probably were various things which weren't in place

which Frank's legislation and the Obama legislation do put in place the ability to wind down big banks. The FDIC didn't really have the big commercial banks they could do it. But Lehman Brothers or Goldman Sachs or Morgan Stanley. All right but it either there are various ones so they didn't have the capacity. That's why they had to bail them out they couldn't do there wasn't a sort of special bankruptcy provision which the government a government controlled bankruptcy. It's being termed the regulatory oversight. You're right there were a large element of the financial system which was just outside the regulatory system. Derivatives being one example. But also mortgages largely were regulated either because they're regulated at the state level and the state regulators are completely overmanned in California I think there will I think there are 11 regulators that regulate in the entire mortgage industry. And that's where most of the big mortgage companies like Ameriquest and Ameritrade new century and Countrywide they

were enormous in California and the reason they cooperated there was just because they realized that the state legislation was so weak. So that will change under the legislation. Mortgages will be overseen by this new Consumer Product Safety Commission. So I think that's a good idea. Derivatives they go some of the way towards regulating them but bank is giving Wall Street a pass on some sort of Geithner is giving Wall Street a pass on some of them some of the overcounted derivatives i.e. the more complicated ones. They can still trade those among themselves. I think those exceptions should be I think they should all be forced to trade over the council. I mean if you're asking me basically do I think they regulated the proposed regulations go far enough. My answer is No I don't. I tend to be of the Paul Volcker view that we should consider an actual split up of the financial system a sort of not really a return to class to go but a sort of 21st century version of Glass-Steagall where you'd have a safe financial sector which sort of oversaw consumer deposits

brokerage accounts et cetera that would be government guaranteed. If those companies got into trouble that be a sort of explicit or semi explicit government guarantee that they can go bankrupt. But in return for that they'd be heavily regulated. They'd have high capital requirements. They'd be regulated like a utility. So you have a utility banking system. And on the other side people like Goldman Sachs or other would say well we don't want anything to do with us fine. They could get what the people call casinos the casino aspect of the banking system they would be allowed to carry on but there'd be an explicit sort of Law same where you know there's no bailouts you get into trouble you know by yourselves. Now you might not be credible you're going to say it but I'm not going to happen. Not going to happen no but the question is whether it be credible I think it might be credible because the financial market if people really believe they had a chance to go under that are much more reluctant to lend the money. So Goldman people would have trouble expanding their balance sheets in this way. It's not going to happen because the lobbying

power obviously but if you're asking me personally what I think should be done I think we should sort of appoint Paul Volcker as the new treasury secretary and let what he's doing pretty good shape and let him take of or else I mean go back to previous question you know if it's been somebody else. I mean if you bring back Paul Volcker I'll take Paul welcome back. I don't think a lot of this would have happened if local was still the Fed chairman. You need to bank he's a banker. So he understood how these you know the need to need a thief to catch a thief sort of thing. He understands how banking works. You know in the 1930s we brought in we brought in Eccles who run a bank in Ohio and send out when the greatest Fed chairman ever. So if they can find somebody like that by all means. You know. Possibly you know I think he's a bit I mean he said they want to consider I have some reservations about his role as

ICC chairman. But anyway but if they could find somebody like that I I would agree. But as you say realistically that's not going to happen I don't think. And with all the political impact it's been on health care I think we'll be lucky if we get any sort of financial regulation through early next year. So at this stage I'm thinking well you know if it's the Obamas it's been like health care if it's Obama's regulations or nothing I'm in favor of Obama's regulations. Yeah I know it's an interesting case and actually a lot of traveling around the country a bit to publicize this book a lot of people have made that argument so many What's happened to our manufacturing base. You know we I think the financial sector has got too big. Nobody's really said that in the U.S. in the U.K. some very eminent people have made this argument including the governor of the Bank of England and the head of the Financial Services Authority. You know at some point the financial sector rather than serving the rest of the economy starts to sort of feed upon it. And I think we got to that stage and in some ways the

problem with a days. If I was Larry Summers I would say well OK you know there's got to be a maybe and so much but where's our competitive advantage these days. And he would argue that you know that America's competitive advantage is in financial products and financial engineering and that you know these banks do produce a lot of foreign earnings for the U.S. and to sort of it's a mercantile East argument. If we if we start really knocking down Wall Street it will just be given competitive advantage to the Germans the British the Japanese or whoever. I don't agree with that. But you know it I think it allies a lot of the reluctance of the administration to really get too tough with Wall Street. They think it's they say it's like you say what's good for General Motors is good for America. Now it's what's good for Goldman Sachs is good for America. Not necessary Goldman because they're so unpopular but you know what's good for JP Morgan Chase is good for America.

Things work about yeah. I mean there are some people the argument sorry here is that the banks haven't actually dealt with a bad debt problem that is still sitting on their balance sheet so we're going to end up like Japan presumably that. I think. There are some very respected people made that I was on a panel with common Ryan the other night who's an icon of Mr. Martin and she made this argument. I think that's something that clearly there was an accounting dodge earlier this year when they allowed them to call these assets to market. But Mark to Market was having some pretty disastrous effects because he starts a downward spiral because he markets a market then they're short of capital so they have to sell. Prices keep going down you can get a downward spiral with Mark to market. You need somewhere in between maybe six temporary suspension of mark to market during the crisis and then reintroducing it. The argument my argument why I'm not quite so pessimistic because of common Ron Paul Krugman in these people is.

I think that the government's recapitalization banking system is actually proving quite effective. It's not a very pretty process to watch. Because all these guys who got us into the mess and are making big bonuses again but the government they don't say it out loud. But the Fed and the Treasury their entire policy is based on making allowing the banks to make big profits again so they can rebuild their capital ratios so they can go out and lend to people. So we don't get into the credit crisis you know and that's actually they are lending again but they they are building their capital ratios quite effectively largely due to monetary policy. They can borrow money from the Fed at 0 percent excuse me and then invest it in treasuries at three and a half percent. That's why Bank of America can afford to repay the government because the government's basically given them the money. You know they it's it's a free thing. So. Cut a long story short I think the banking sector in the US will recover more rapidly than the Japanese banking sector. That's why we won't have 10 years of Japanese

problem. My worries are more on the other side that it will prove too successful and we'll get another bubble in something or another. Because interest rates are too low. And as for the loss of free money running around. So I'm on the sort of inflation side of things rather than the deflation threat. Good question. Yeah I mean to have the question is why. What was the role of hedge funds in this we haven't heard much of them since the Long-Term Capital Management crisis back in 1998. It's right the hedge funds just were not particularly active in so prime mortgage securities they didn't have the distribution capacity. Some hedge funds obviously hedge funds some of the credit hedge funds blew up because they were buying subprime but they weren't. These these these products weren't distributed through the hedge funds. Now does that mean hedge funds you know fine. No I mean I think what happened effectively is the Wall Street banks turned into hedge funds. I mean I remember writing about long term capital and it was considered a great great great scandal at that stage with LTC I was gay at

12:32 I think it was best turns at the end of 2007 was good like 35 to 1. Merrill Lynch was good 30 toward these big Wall Street banks that effectively turn themselves into hedge funds. So there was a hedge fund crisis they were just. You know hedge funds disguised as investment banks. I think these would be my answer. So you know I mean leverage was the big problem it just came about. It came about in the in the in the inside of the financial system rather on the rather than on the periphery. Now they were big customers but not now enormous I mean the biggest buyers ironically of a lot of these securities turned out to be European banks because for some complicated regulatory reason they didn't have to take big capital charges for buying subprime loan loans under the balck capital rules. So that's why there was a bit of mystery too until I realized why when the subprime market collapsed in the first bank first buying that

went under was a German lenders Bank and. And it's because they it was financially in their interest to buy all the securities. So what was happening is Merrill Lynch Goldman Sachs whoever were buying all these mortgages from Florida California wherever turned them in securities and then send in their salesmen off to Europe to sell them to German bankers. It was very clever you know. And again while it lasted it was very lucrative. And I think we're out of time yet so thanks very much everybody for joining us.