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.

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.