Interview with Randy Wray, Regarding the Next Crisis

The following is Part One of an interview with Randy Wray on the Global Crisis and the extent of the possibility of another crisis. It was conducted by students Inigo Garcia, Fahd Arnouk, and James Jasper, at Franklin College Switzerland for Mecpoc. (4 May 2011)

Mecpoc: One can hear many conflicting theories about what has caused “it” (i.e., the Great Recession). If you could pin point a major factor that triggered this major recession, what would it be?

Randy Wray (RW): If you have read John Kenneth Galbraith’s book, The Great Crash (1929), his argument was that the economy was so fragile it was just waiting for some event to cause the crisis. It doesn’t really matter what that was, it could have been anything, and I think that is also absolutely true of 2007.

It could have been anything that could have pushed us over. If you had to identify one thing, it was U.S. housing and sub-prime mortgages. The first event was that home owners were defaulting on their very first home payments, which had never happened and that tells you that there is something really wrong. This news came in early spring of 2007, and that is when you knew it was over.

Most people were not paying attention, so it caught policy makers (they claim) by surprise, and that may be true, I do not know. Professor Mishkin (then, a member of the Fed board) came to the Levy Institute in April to give a talk, when there was a lot of evidence already accumulating, and he did not mention the crisis at all. His whole talk was about inflation. They claim that they did not see “it” coming. Possibly true.

Mecpoc: So, you agree the housing and mortgage story was the trigger?

RW: I think that was THE event, but what is more important is that we had developed an economy that was vulnerable. The total sub-prime “universe” was less than two trillion dollars, not that much, it wasn’t that big relative to US GDP or total debt, and the number in default weren’t that high. So how could that have triggered a global financial crisis? It couldn’t have, except that we were extremely vulnerable so that almost anything would have triggered it.

Mecpoc: Why did we become so vulnerable?

RW: That is where Minsky comes in, and that is why I think Minsky’s analysis is by far the best. You have competing analyses. A lot of people focused on deregulation, and of course that played a huge role, but deregulation had been going on since the late 1960s. Some people blame the Fed–supposedly they kept the interest rate too low and that promoted speculation. I think that this is mostly wrong: low interest rates do not necessarily fuel speculation. We have extremely low interest rates in the United States, we have had some speculation, but low interest rates by themselves do not encourage speculation. In any case the Fed had already turned to raise interest rates in 2004, and most of the worst abuses in real estate markets occurred after 2004, not before 2004 when interest rates were actually very low. So the Fed started raising interest rates thinking that that would cool bubbles; of course it didn’t. Raising interest rates in a bubble won’t have much impact, because the prospective earnings in a bubble swamp any 400 basis points increase in interest rates—which would be a rather large rate hike.

Then there are people who argue that the cause was stagnant real wages in the U.S. and rising inequality. I think that plays a big role; that does help to explain why American households got so far into debt trying to maintain living standards. Wages had not risen since the early 70s, and so they were borrowing to buy cars and so on. And that, of course, is true. So, I think that explanation is a little closer to hitting something important.

And then finally, there is financialization which points to the rising role of finance in the economy, increasing leverage, increasing layering of debt on top of debt, and a greater share of GDP going to the financial system, going to interest rather than profit, and so on. And that all is true too, and I think that one is the closest to Minsky’s explanation, and that one is, I think, much closer to getting it right.

Minsky started writing about this in the late 1950s. He tracked the evolution of the economy, and argued that we were moving towards an economy where “it” could happen again. And he continually adapted his theory to take account of what was going on. His ‘financial stability hypothesis’ was more about the business cycle in the beginning, but later, by the end of the 80s, it was more about this transformation of the economy. So it is a long-term transformation, not a business cycle explanation. That is when he developed the stages theory, and called the current stage ‘Money Manager Capitalism.”

Mecpoc: How do you then see a way out of this system that you just described, this idea of financialization? Is there a way out of it?

RW: If we forget the politics, because that could be the barrier, the way out is to prohibit banks from securitizing. Banks should be public utilities, they should serve the public purpose. If they have access to government guarantees, government bailouts, Fed lending, they should not be permitted to do any securitization, because it completely defeats the purpose of a bank. A bank is supposed to do underwriting. You have to give them the proper incentive to do the underwriting correctly, and the proper incentive is they have to hold stuff on their balance sheet.

So I think that the whole idea of securitization was flawed from the very beginning and did not serve any public purpose. There is no legitimate, public purpose, reason why banks should move their stuff off their balance sheet. Now, if non-protected financial institutions want to securitize without any access to the government, then that is a different matter. So I am not saying securitization should be illegal, but banks shouldn’t be able to do it.

The political barriers though are very big. Banks want to securitize; they want to pump and dump; they want to dupe customers; and then they want to bet against the junk they securitize using credit default swaps. We won’t revisit the securitization issue until the next financial crisis.

Mecpoc: And when do you think that may be?

RW: It may be any day because we reproduced the conditions of 2007, so this is just like Galbraith said: we are just waiting for one event to set it off.

Mecpoc: Do you think that one more crisis would be enough for lowering the political barriers?

RW: Yes, because it is going to roll through the whole system. All we did was increase the concentration and increase the linkages among the top four or five banks. That is all we did, with the bailout and rescue, so we just made it worse. The next crisis will be worse than the previous one. It has been that way since the first postwar crisis in 1966. But this one will be the mother of all crises.

Mecpoc: In one of your recent articles, you mentioned that as early as this coming fall a new wave of defaults by borrowers could force institutions to recognize further losses. You also mentioned that fiscal policy could be the answer to this run of defaults, but taxpayers would not allow it to happen. Given this analysis, what are the real implications of the crisis we are currently immerged in?

RW: Almost all the debt that we had in 2007 is still there. Households have repaid a little bit, and they have defaulted on some, but most of it still exists. Meanwhile, households have lost their jobs, and a lot of them have lost their houses, which doesn’t mean they have lost the debt—in a lot of cases they still owe the money but they don’t have the house. And house prices have declined a lot, and they are still declining, so there is no way that households and firms are better off now than they were in 2007. In most ways they are much worse. So a wave of defaults on commercial real estate could be the next thing to hit, student loans or credit card debt could be the next thing to hit, and so the value of those assets gets downgraded. So that could be “it.” That is one way.

Another way could be that supervisors discover that you’ve got a major bank that is massively insolvent, that they have been cooking the books. There is no question that they have been doing this. So it could be Bank of America, or CitiBank. Most people think they are massively insolvent, so all you need is some information to get out. Then they get downgraded, and then you get another huge liquidity crisis. I don’t think that Congress is going to sit back this time and let the Fed do what it did last time. Indeed, Dodd-Frank outlaws most of what the Fed and Treasury did last time.

I am not an expert in Euroland, but many people think that European banks are much worse than American banks, so the problem could actually start over here, and that could easily spill over to the United States. So it could actually be Euroland that starts it this time. By the way, there is a very easy path from US money market mutual fund holdings of Eurobank assets to a global financial crisis. That is $3 trillion of extremely short term liabilities that are like deposits but not insured. Last time the US government extended the guarantee to all of them; Dodd-Frank outlaws that now. So a bit of a bump in Eurobanks can bring down that whole market—about twice the size of the subprimes that brought on the global financial crisis last time.

Mecpoc: We have been hearing a lot about the jobless recovery, in your opinion can you call a jobless recovery a recovery? Can it be termed a recovery if we are experiencing GDP growth that we had forecasted but there is nothing happening to unemployment?

RW: A lot of GDP is imputed, and we know that GDP does not measure welfare, so for decades people have tried to construct different kinds of indices as GDP doesn’t really tell you whether living standards are rising, or whether you actually have economic growth. So it is not a good measure in any case. If you have a highly unequal society, then it is even more misleading, because it could be, let’s say, that the financial sector is doing fine (which they claim it is) and paying very high incomes, and when that has become 20 percent of value added (which it is in the U.S.), that could be driving GDP growth. And that doesn’t trickle down to the rest of the population. You have the top 1 or 2 percent that are doing just fine because Wall Street is booming, so it is not a good measure.

I wouldn’t use unemployment as a measure, either. I would use employment as a measure. And until we are creating 300,000 jobs per months – every month – we are not in recovery. A 100,000 job growth number is not enough to do anything. 300,000 is what we did during the Clinton years, and we were not starting where we are right now, we did not have nearly as much unemployment as we do have right now, so 300,000 is a completely reasonable number in current circumstances. That is what we accomplished month after month in the Clinton years starting from a much higher number of employed (as percent of the population) than we are right now, so that is when I would say that we start recovering.

Mecpoc: What is your thought of the concept “The New New Deal?” Our concern is that Roosevelt’s “New Deal” was a great method to bring up employment after the Great Depression in which unemployed people were hired to do manual low skilled tasks, but they were not living in a such technologically based society as we are now, and we were wondering if you see this as a method that could help the U.S. reach full employment with the level of technological innovation we have right now as well as help improve the standard of living?

RW: I think the high tech sector is small, and it is not going to ever be large. It is true we don’t have as much low skilled manual labor, but we have more than you think – in construction, in public infrastructure investment – that does not have to be all high skilled. But what we need in addition to that, and what would create far more jobs is in public service. We are a service sector economy and not all of that is high tech services: we need people to take care of an aging population, that would create lots of jobs, and these don’t have to be high skilled jobs. You need people to take care of an elderly population, take them shopping, help them clean their homes, provide company to them. That is not high-tech and will provide far more jobs than high tech ever will. You need child care, you need help in schools, you need environmental clean up, not all that is high-tech and not all that is dangerous, as you need to be careful with hazardous waste and so on.

I think that the idea that Americans are under-educated and under-trained for the kind of jobs we can create is not correct. Americans are over-educated on average for the kind of jobs we have. Now, the government doesn’t keep track of this data, and that is unfortunate–they should be doing that–trying to estimate what percent of the labor force is over-educated or over-trained for the kind of jobs we have. The U.S. government actually used to keep track of that until the late 60s, and at that time, about 40 percent of the population was over-skilled already. The education standards have risen a lot since then, and my guess is that we still have a significant part of the labor force that is over skilled and over educated for the kind of jobs that can be created.

Finally, when you implement something like a ‘job guarantee employer of last resort’, you design the jobs for the kind of people you have. That is different from the way the private (for profit) sector works, especially if you have a very large pool of educated and highly skilled people. What they do is to use a college degree as a screening device. It is not that they need a college educated person for the jobs they are creating, but, as long as you have very loose labor markets, which we have, where you have millions of people who can’t get jobs, they will always demand high skilled and high education because they can. And they don’t need to design jobs for the population you actually have that are seeking jobs—instead they have low skilled jobs filled with high skilled workers. But with government creating a job guarantee program can explicitly do that.

Mecpoc: You mentioned that a lot of people are over-trained, can we then see that as an economic inefficiency as we are training people for jobs that do not exist?

RW: I wouldn’t at all. I don’t think that the colleges should be training students for jobs. I don’t think that is the purpose of a college education. I think that is – or should be – the sideline. I would try to continue to increase college graduation rates, but not with the view of training them for jobs created in the private sector–that is not the goal of a college. Maybe you need training programs on the side, and that could be done by the private sector or it could be done by labor unions. And you can have public-private partnership programs, and so on, so there could be a role for the government. Having highly educated waiters is good. Do restaurants need them? No. Does society? Absolutely. Even if the waiter does not need to quote Shakespeare or debate the Hobbesian view of society while on the job, society does need a populace educated in Shakespeare and Hobbes.