Interview with Paul Davidson, Regarding the Crisis

The following is an interview with Paul Davidson on the Global Crisis and how to end it. (1 February 2009)

Mecpoc: Let us begin with one major, currently debated question about the crisis: was the financial meltdown caused by bad policies or by private agents’ errors?  Some have argued that the U.S. Fed setting interest rates too low (below ‘Taylor rule’ levels) in the early 2000s was a recipe for disaster. Others have stressed that a misguided under-pricing of risk was the main factor that precipitated the crisis. Let me first ask you about interest rates: do you think low interest rates have harmed the U.S. financial system by encouraging excessive risky behavior?  And do you think central banks should, as a matter of principle, avoid lowering interest rates below a certain threshold to prevent that an excessive appetite for risk develops?

Paul Davidson (PD):  I don’t think low interest rates are a problem, certainly given our current situation.  I don’t think they are a solution either!  I prefer low interest rates currently rather than high interest rates, but this is not going to solve the problem.  It may make it a little easier to solve but it’s not going to solve the problem.

Mecpoc: So you don’t think the ‘Greenspan put’ has triggered the crisis?

PD:  No.  The cause of the crisis was different.  You should go back to 1977 when the US started to deregulate the banking system, and we permitted financial institutions which were not banks to invade banking territory. First, we allowed brokerage firms to create what we called money market accounts. These were checking accounts that paid slightly higher interest rates than the checking accounts in real banks, and this because checking accounts in real banks were insured, and the money market accounts technically were not insured but as we have now seen, in the US at least, when money market mutual fund ‘broke the buck’, when the value of the assets was less than the buck, the US government stepped in and insured the money market accounts as well, at least currently.  So it all starts in 1977 when we created money market accounts, which allowed investment banks and underwriters to invade the banking system and later on we allowed the banks to start underwriting securities, which allowed the banks to invade the underwriting system and so we started getting the mergers between banks and underwriters which ended up in 1999 with the repeal of the Glass-Steagall Act which opened the floodgates to underwriting things, selling them, and making a profit just for originating debt and that’s what caused the problem.  It was not the Greenspan ‘put’ or anything like that.  The Greenspan put did hurt the situation but it certainly was not the cause.

Mecpoc: So, if any bad policy laid the ground for crisis it was not the low interest rate policy of the Fed but it was rather the watering down of rules in the banking and financial system…

PD:  Yes, and the final act was the 1999 repeal of the Glass-Steagall Act. Remember: we had another financial euphoria in the 1920s when the stock market went up 500% in 8 years until it peaked in 1929 and then collapsed.  And the reason for the peak and then collapse was the same thing now: we had deregulated financial markets, banks could underwrite securities and this led to people investing in things that definitely they should not have been investing in.

We had margin requirements of 5% in those days, which meant for every dollar you invest you could borrow 19 dollars and that of course creates the possibility of a collapse when the market goes down.  Hedge funds currently, for every 100,000 dollars they invest they borrow 900,000 dollars so they are like the margin people of the 1920s.  So all we did was repeat history, perhaps on a bigger scale because the numbers are larger now.  But we didn’t learn from the 1920s and early 1930s.  When Roosevelt came in, they knew what was the cause: they set out hearings, called the Pecora hearings, and finally passed the Glass-Steagall Act which meant that financial institutions either had to be a bank and make loans (which were not liquid, you had to hold them in your balance sheet), or you had to be an underwriter. You couldn’t mix the two businesses.  That’s really the essence of the current collapse.

Mecpoc: Another explanation in the popular narrative is that financial investors made errors they could have avoided if only they had a better understanding of financial markets, or they had not been overconfident about their models of how to measure and manage risk.  Have investors played with fire?

PD:  That’s nonsense.  Of course, there are always people who don’t understand.  If you ask most people who invest in stocks what products do the companies make  they don’t know.  People invest in them because they want liquidity and want an asset that’s going to grow up in value.  It is true that the investors in CDOs and SIVs and all these exotic financial derivatives of the mortgage stuff were told by the sellers that these were as good as cash.  And after all, it was Lehman Brothers, JP Morgan, why would you doubt what they said?  Why would you doubt if they said so and the rating agencies gave AAA rating? What other information do you expect investors to have?  So, they had information, and information was wrong.  So, it’s not their fault, unless you want to say they should not have trusted the rating agencies and ought to look at every investment in the minutest detail, so I believe it’s nonsense.

Mecpoc: …This is related to the problem of the conflict of interest, and lack of regulation of rating agencies…

PD: Yes, it was the whole idea starting in the early 1970s with Milton Friedman when the Keynesians were killed and free market came back.  The argument was that free markets will always solve the problem: people who lie and cheat the market will punish them, so if the rating agencies don’t tell you the truth, they’ll get punished and nobody else will get punished.  Nonsense.

Mecpoc: Another explanation of the crisis goes beyond the conditions of the U.S. financial system, and takes into account the development of world financial imbalances, by which they mean the chronic and persistent trade deficit of the U.S. and a few other countries vis-à-vis the chronic and persistent trade surpluses of the rest of the world, notably East Asian countries including China.  Can you see this as a cause, or at least a symptom that the crisis was coming? Is there a connection?

PD: It merely made contagion easier.  What was happening was that foreign nations were buying U.S. and U.K. government securities and that merely meant that whatever happened in the financial markets of the local economies would now going to be transferred immediately to foreign nations.  And now people start talking about ‘decoupling’: getting one nation’s financial system not to affect the other nations’ financial systems.  So, it’s not a symptom, is a mechanism for contagion.

Mecpoc: Let us now turn on to the other major issue: how effective has been so far the policy response?  Considering first how central banks are dealing with the liquidity, banking, financial, and economic crisis.  Do you think their (the Fed’s, the ECB’s, the BoE’s, etc. ) response to restore healthy liquidity conditions was adequate and effective in preventing a worsening of the crisis and restore confidence?

PD: Central banks are finally recognizing, or maybe discovering is a better word, what the function of a central bank is, namely the central bank is the source of all liquidity in the domestic system. In essence, the central bank should be the lender of last resort or, as I would call it, the ‘market maker of last resort’ to make sure that any assets traded in public markets are liquid.  Unfortunately, they came too late so what they ended up doing is buying off what we call ‘toxic assets’ rather than getting in there early to make sure that the liquidity of these assets didn’t disappear.  These assets are called ‘toxic’ not because they are worthless in the sense that they may never generate a future cash inflow, they are ‘toxic’ because the market doesn’t know how to evaluate them. And some people say: well, the U.S. government is buying all this stuff from Lehman Brothers and Bear Stearns and so on… But I say that we are going to make a profit because over the long run enough people are going to continue to pay their mortgages or whatever backs these exotic financial assets so we will make a profit on it, which says that these things have a value, but we don’t know what that value is.  And the central bank has stepped in too late in allowing the market for these things to fail: a) they should not have allowed these markets to exist and b) having allowed them to exist they should not have allowed them to fail.

Mecpoc: With regard to the actions undertaken by the U.S. Treasury at the dusk of the Bush administration, how do you evaluate Paulson’s TARP Plan and its effectiveness.  Paulson said they committed to using the taxpayers money efficiently to restore capital flows.  Will the plan help preventing a worsening of the crisis and begin restoring confidence?

PD: First, it’s not taxpayers money! What happens is that the central bank is absorbing these assets and ‘printing money’ and thus taking the bad assets off and giving good assets.  So far as I know, nobody is going to see tax bills rise.  If anything, tax revenues are going to be down, not up.  It’s the central bank printing money to take care of TARP.  The TARP’s principle was ok but a) it was too late: it should have come 9 or 10 months earlier and b) it was managed terribly: among other things, they should not have allowed Lehman Brothers to fail. The other part is that those investment bankers who were given what we call ‘bailout money’ there were no stringent conditions attached to bailout money.  There should have been conditions attached to bailout money.

Mecpoc: Moving now to the dawn of the Obama administration., How do you evaluate the size of the fiscal package undertaken in 2009?

PD: I don’t think the Obama stimulus bill is sufficient.  I would say you probably need almost double that amount in the next few years and it pays to err on spending too much rather than on spending too little.  So I don’t think the Obama bill is sufficient.

Mecpoc: Beyond the fiscal stimulus, what key changes in financial regulation you deem necessary?

PD: To be explicit: We should distinguish what I call private financial markets from public financial markets.  A private financial market is where buyers and sellers, i.e., debtors and lenders, know each other and when the lender makes the loan, the lender is stuck with that on his balance sheet, so he doesn’t make the loan unless he has thoroughly investigated the borrower for what I call the three C’s of lending: Collateral, Credit history, and Character (is this a person or an institution that will, even if it has hard times, try to pay his loans off).  Those private markets should be separated from public markets where the buyers and the sellers don’t even know each other. Those markets ought to be tightly regulated and these markets should have what I call a ‘market maker’ in there to maintain liquidity and in the cases of stock markets and bond markets we do have market makers but in the case of all these derivatives investment banks organize it, but they don’t operate as market makers so if everybody wanted to sell, there is nobody who wanted to buy.  So we got to have a rule which says if you’re going to have a public market there’s got to be a market maker and in the U.S. the SEC would be the person who should insure that all public markets have market makers.

Mecpoc: Another ongoing theme and agenda item in political summits is international policy coordination.  Do you deem it necessary or at least a positive condition for policy effectiveness in restoring growth?

PD: Well, as long as we have the current international system of financial capital flows what one country does is going to affect the other country, so I would say you have to have some sort of coordination.  I would rather change the international payment system to something like the Keynes plan, or my IMCU plan which in essence says:  Any nation can do whatever it wants with fiscal and monetary policy to help the economy without having to worry about either poisoning a foreign country or a foreign country doing something poisoning  your economy, so we have to have an international system that commits decoupling by  any nation that fears that the foreign payments trade situation is deleteriously affecting the economy of the nation.  Other than that, if one  country gets out of line and expands too rapidly (as the U.S. is probably going to do) acting as an engine of growth, all that it will do is create more trade imbalances and cause more contagion when a crisis will occur.

Mecpoc: Do you see any other way to restore confidence?

PD: I can’t think of any. The important thing in a capitalist economy is to create profit opportunities. Given the current recessionary tendencies,  everybody is cutting back, and businessmen see profits falling.  There is only one spender who can create profit opportunities, and that’s the government. So, until you create enough profit opportunities to businessmen to be willing to expand production, increase employment, maybe even invest some more because the capacity is running short, things are going to get worse, not better.  And so fiscal policy has got to do it.  Interest rate policy even at zero won’t do it: there is no sense with borrowing money to build plant and equipment when you already have excess capacity.

Mecpoc: Do you think zero interest rates would be an ideal policy or you rather believe there should be a threshold below which interest rates should not go?

PD: I don’t think you can set any threshold particularly. I think the answer is that you have to see what aggregate demand is.  If the economy is in a mild recession, like some of the early ones we had, interest  rate policy can (if it’s a positive number, by reducing it) be sufficient to stimulate the economy, even if the government doesn’t spend.  So the answer is: you can’t make a rule about interest rate policy that will fit all possible circumstances.

Mecpoc: And, on the other hand, would a zero interest rates policy do any harm at all?

PD: Yes, it could do harm.  Suppose you had over full employment aggregate demand.  You could of course always extinguish it by raising taxes, but that requires legislation which can take some time, so you might get some built-in inflation tendencies before the legislators could do anything. Since interest rate policy can change very quickly (central bankers meet and push up the interest rate), interest rate policy is more readily adaptable.  So there is some advantage in interest rate policy.

Mecpoc: In conclusion: how to end the crisis?

PD: The two key aspects are financial market regulation (along the lines above) and now getting a reversal of the current situation—which is getting worse in the U.S. and elsewhere—by creating jobs primarily in the private sector. So even if we are talking about government spending it should be government spending not totally by hiring workers to work in the government sector but by creating jobs in the private sector through government spending: government purchases from private companies.

Mecpoc: Wouldn’t the workers hired by the state spend their income in the private sector?

PD: Well, that’s part of it.  Talking about federal government versus state and local governments, in the U.S. certainly education is a function of state and local governments primarily, and with their tax revenues going down we see huge cuts in college budgets and in public schools, and this affects the quality of education, increases the size of classes and so on and so forth.  So there obviously you do want to hire people who are in essence state and local employees.  So you can’t say don’t hire any government employees, but you want to hire them in areas where the government, rather than the private sector, is responsible for providing the service.