The economist looks at the run-up and reaction to the financial crisis.

Question: Should we have let insolvent banks fold?

Dean Baker: In an orderly way. I mean, we did have a problem. If you go back to September of 2008 when Lehman went under and the financial markets froze, that was a problem. I wouldn’t say that was a good thing. We don’t want to see that happen again. I’ll say 2 things about that.

One, that was not the end of the world—I don’t want to be there again, I’ll be real clear about that, I don’t want to be there again—but it was not as though the world was about to end. We would’ve been in an unpleasant circumstance where if things kept going down that path, the Fed basically would have had to step in and take over the banks. They actually had a plan to do that in the ‘80s when Latin-American debt had left many of the big money center banks on the edge of insolvency. And as I heard from the former head of the FDIC, the Fed at that time had a contingency plan that, had Mexico or one of the other big debtors outright defaulted, it would simply step in and take over the banks. Presumably, we have looked at that sort of situation. That would have been good but the idea that the economy just would have come to a screaming halt and that we would all be sitting here without being able to use our credit cards, not get access to our money in our bank account—that might’ve been 24 hours, something like that, a scary period but the economy would not have ground to a halt. So the worst case scenario, just to be clear, it was not that we would all be sitting here with a 21st century economy but no means of payments. That would not have happened.

The second point is we have a lot of mechanisms, a lot of safeguards that were put in place post-Lehman. So we now guarantee deposits up to 250,000 dollars. We guarantee all money on interest bearing deposits. We guarantee money market mutual funds. So there are a lot of safeguards in place today that were not in place back in September of 2008. So if we have a controlled bankruptcy of a Citigroup, of a Bank of America, I’m fairly confident that we can get through it. I can’t say for certain that we won’t have the sort of panic that we had back in September but I think there are good reasons to believe that we won’t have that. And again, even in that very worst case scenario, which I don’t think would happen, but even in that very worst case scenario, we are prepared to deal with that with extreme measures, which, again, none of us want to see. But I think the risk of that might be better than just giving as much as a trillion dollars to the banks.

Question: Why didn’t economists predict the housing bubble?

Dean Baker: I think what you have is a situation where there is enormous pressure for conformity and certainly among economists. So when you had top economists, certainly Federal Reserve Board Chair Greenspan and Bernanke, his successor, saying there was no bubble and many other prominent economists agreeing with that view, most economists didn’t want to step out of line and contradict them. Or for the most part [economists] probably never even looked at it closely. I was out there talking about this since 2002. There are a few others, not a lot, but we are easy enough to ignore. So I think most economists are relatively narrowly focused on their careers and picking a fight with the Federal Reserve Board Chair generally isn’t the best way to advance your career.

To take the flipside of this, if you ask who has suffered a price, who has lost their job, or let’s put it more narrowly: who’s missed a promotion because they didn’t see the housing bubble? You will probably be hard pressed to find anyone. So looking at economists the way economists would look at other people, you would ask: what is the structure of incentives? Well, the structure of incentives that go around talking about a housing bubble just doesn’t pay because, one, you could be wrong. I was pretty confident of what I was saying but none of us are perfect so you could be wrong in which case you’ll be a laughing stock. And in the meantime, if you go the other way, if you just say the same thing that Alan Greenspan says, no one holds it against you. So you take a really big risk by stepping out of the line. There is very little obvious pay off. I mean, I get some more interviews or whatever but I haven’t gotten rich off this. And if you just say the same things as everyone else, you basically bear no risk and no consequence.

Question: Why aren’t investment firms using TARP money to create new loans?

Dean Baker: It doesn’t surprise me they’re not lending out the money. We were given many, many different explanations for the TARP [Troubled Asset Relief Program] at the time they were trying to push it through. Basically, they were throwing everything against the wall and seeing what would stick. What made sense was that you had banks that were on the edge of insolvency and needing money to keep from going under, and I think that was true. And in that context, it’s not the least bit surprising that they’re not anxious to lend money. They have to build up their lost reserves. On top of that, one of the big reasons why they’re not lending money is that there aren’t good debtor options out there. So they’re not seeing people come to them who look like a good credit risk right now so they’re going to be very hesitant to lend money. So that’s not all that surprising to me.

Now, Goldman Sachs’ story is one that’s really amazing. They’re saying that they don’t want [TARP money], that this is no way to run a business. That’s what Lloyd Blankfein, the CEO, said at Goldman Sachs. Well, no, it’s not. But on the other hand, you just took $12.9 billion of public money given to you through AIG. You did business for the bankrupt company so you’re out of luck there. But the federal government stepped in and said, No, we’re going to honor AIG’s obligations even though we have no legal or moral obligation to do that. And we handed them $12.9 billion through AIG no strings attached. On top of that, he borrowed $25 billion with an FDIC guarantee. I haven’t looked at the market spreads closely but I have to believe that must save him at least two percentage points against what he would have to pay if he didn’t have a government guarantee, so that comes to $500 million a year. On top of that, he has access to several different Fed lending facilities. We don’t know how much he’s borrowed from there but what that means is he could count on getting money from the Federal Reserve Board at a lower rate than he would pay through the market almost without limit. I assume at some point Ben Bernanke, the Fed Chair, would say, I’m not going to lend to you, but certainly you can get tens of billions of dollars, if not hundreds of billions of dollars without limit. So he’s telling us, I’m happy to get money through all these three channels that have no strings attached but when it comes to your TARP money, there’re strings attached, so, no, I don’t want it. Well, yeah, I understand him wanting to do that but I don’t have much sympathy for that. So I’m more inclined to say, fine, give up all your money, give us back the $12.9 billion, repay those loans that you took out with the FDIC and swear off going to the Fed windows. Then [you can have] no strings attached. But this is classic nanny state. He wants the money, he doesn’t want the strings. We would all like to have that but most of us aren’t CEO at Goldman Sachs.

Recorded on: April 28 2009