Econ Buff Podcast #5 with Ryan Mattson
Dr. Ryan Mattson talks with me about the 2008 financial crisis and the aftermath. Dr. Mattson gives a brief summary of the timeline of the crisis and response. We discuss what caused the crisis, how previous policy was involved, and what shaped the response. We explore the zero lower bound and how that has changed the monetary policy tools at the FED’s disposal. The role of incentives in financial markets is examined. Finally, we explore how Dr. Mattson views the use of monetary aggregates in monetary policy analysis.
Transcript
Stitzel: Hello, and welcome to the Econ Buff Podcast. I'm your host, Lee Stitzel. With me today is Dr. Ryan Mattson, a two time-to-time guest now. Ryan, welcome to the Econ Buff.
Mattson: Yeah. Thanks Dr. Stitzel, it's great to be here.
Stitzel: So today our topic is the financial crisis - a topic certainly too big for one episode to…
Mattson: Yeah.
Stitzel:…encapsulate - but we're gonna try. I think there is a lot of room for a nice summary of what's going on. Because when you go to the literature, even literature aimed at more casual observers, it gets so granular so quickly. So with…
Mattson: Hmm mmm.
Stitzel:…that in mind, I'd like to kick off with just a quick summary (which is not a fair question to ask you) but just a quick summary of the crisis. Can you start us with that Ryan?
Mattson: Sure and I'm gonna kind of hijack that question just a little bit already.
Stitzel: Yeah.
Mattson: Because I want to do both the crisis and then the aftermath. Because I feel that's a part of I think what you're looking for here. But to summarize of what's going on with the crisis: you had these asset-backed securities, or mortgage-backed securities, that were these new financial vehicles; [whereas] that you could put a bunch of mortgages into a security that paid off. And this increased liquidity in the United States [as] it allowed for more liquidity service [and] more monetary service (actually if you get on a higher level of what money is). You had these moral hazard issues coming up with no income/no asset loans. The fact that people were getting mortgages and loans much easier with less background [and] let's look into what they had [just] in case things went wrong. And all these kinds of problems, usually here with the granular level (with a micro level), come from this issue of moral hazard (and the issue of what incentives people have). And they're matching up. But we need to remember that those programs that were brought up. But, you know, being able to loan to low-income households so that they could get a house -- those weren't started as programs to be, you know, hey
we're gonna make money off of this. Those were started as – well, we know that kids who live in houses do better in school [and] have better market outcomes. So hey, if we make it easier for low-income households to get that asset, [and] if we make it easier for them to get a house, then we'll get these. And the economy was booming, so people had an incentive to keep that kind of risky lending going, and generated this liquidity which people liked. The main problem comes in with the financial crisis is that, you know, it could have been (it really could have been) say a garden-variety correction in terms of, you know, the households that went bankrupt, or the assets that suddenly became toxic. But it was coupled by this run on what's called the shadow banking system (which will we'll probably get into in a bit here) and that exacerbated the problem.
Stitzel: So already we've seen some of the problems, right?
Mattson: Hmm mmm.
Stitzel: We're gonna face some of the problems that all the literature that's come before us. How do we talk about this thing, and say things like: mortgage-backed securities liquidity? How do we tackle all of those things? Of course, the target audience for a podcast like this are not people that's completely new to economics. So I want to feel free to have that discussion. I do want to encourage the listeners to bear with us. We're gonna unpack things like: what does mortgage-backed security mean, [and] we're definitely gonna unpack what the shadow banking system means, sort of how you can understand that. But if I can summarize quickly what you've said, right…
Mattson: Hmm mmm.
Stitzel:…is we have these government policies designed to do something noble, which is to get mortgages and homes to people with lower income.
Mattson: Hmm mmm.
Stitzel: And that had this -- I don't know if we should call it a side benefit, [but] you can weigh on weigh in on that in a moment…
Mattson: Hmm mmm.
Stitzel:…of this increased liquidity (which is just more money). Money isn't the way to say that -- flowing through the whole system…
Mattson: More monetary service provided.
Stitzel:…in the financial system…
Mattson: Yeah.
Stitzel:…which is a good thing, probably. Maybe there's downsides [which] we can talk about that later. That's the fundamental, sort of, thrust here. Now we're gonna talk about bank runs, because I think that's a critical component of this is [that] bank runs is an old problem, right? Bank runs is a problem that dates all the way back [and] you maybe/you could even tell us what the what the initial, right? But even when we first had central banking in the United States, that was one of their principal concerns, right?
Mattson: Sure.
Stitzel: The nature of what a bank run is has really changed, right? And so, Arnold Kling calls this like a new era (I forget exactly the terminology he uses), but like a new/the new bank run, right? So we'll get into that. So transition us from here's this broad thrust, right? We have policies that want to encourage…
Mattson: Hmm mmm.
Stitzel:…low-income households to be able to get mortgages and homes.
Mattson: Hmm mmm.
Stitzel: That carries inherent risk. But we also get this increased liquidity. Now we have a bank run on the shadow banking system, which we're gonna unpack later.
Mattson: Right.
Stitzel: Take us to the next step now that we have the broadest oversimplification…
Mattson: Sure.
Stitzel:…that we can.
Mattson: So, I mean, and this is --- I wouldn't kind of get it -- that this really is a very big simplification of and almost a mythologizing of it. [But] there is a YouTube speech by Milton Friedman where he talks about the myths of the Great Depression. And he starts off by saying that The Great Depression is subject to a whole lot of myths of: it was caused by the greed of these people; it was caused by the failure of regulation; it was caused by a failure of private firms and private business by their greed, by their riskiness, and things like that. And then he goes on. And this is a quote that I did write down because I use it in teaching Money and Banking and Principles Macro as well. He then corrects this myth and says: “The Great Depression was produced, in my opinion, by a failure of government by a failure of monetary policy; was produced by a failure of the Federal Reserve System to act in accordance with the intentions of those who established it. The Great Depression was produced by a failure of the Federal Reserve System, despite knowledge of the right course of action.” And I don't think he's off the mark in terms of what happened in 1929. And I think that that's very similar to what happened in 2007 and beyond.
Stitzel: So if I can take a quick aside. I remember reading somewhere, you know, a list of questions. You can go ask your high school science teacher to sort of throw them off and mess them up, right? So ask them: oh why is the sky blue? And they're gonna say: it's the shortest wavelength. And you say: O.K., but violet is the shortest wavelength [so] why is the sky not violet, right? I don't know the answer to that, because I'm not a physics professor. What I suspect [is] high school teachers are not gonna necessarily know that answer. Maybe it's way more…
Mattson: Hmm mmm.
Stitzel:...well known than I understand. If we had a version of that question for economists like “what caused the Great Depression” might be one of those.
Mattson: Yes.
Stitzel: And so one of the things that I think the field should get a lot of credit for is: we did not make that mistake this time around, right? And so in as much as we… [stops short and says to Mattson] O.K., you're looking at me like I'm wrong.
Mattson: No, no, its.
Stitzel: Maybe it's just too far back.
Mattson: Hmm mmm.
Stitzel: It doesn't seem like there is this kind of story and depth to what caused The Great Depression, in that…
Mattson: Hmm mmm.
Stitzel:…if a student asked me in class tomorrow what caused The Great Depression, I would be loathed to even try to answer that. And maybe I'll steal your Milton Friedman quote here so I at least have something in my bag.
Mattson: Yeah.
Stitzel: That doesn't seem to be the case with this crisis, right? People have nitpicked it from every angle in a way that I don't think, correct me if I'm wrong…
Mattson: Hmm mmm.
Stitzel:…and I don't think happened is to the same degree with The Depression.
Mattson: Well, I'm gonna argue the other way then. So to kind of, kind of go back to this idea of the mythology of it. So what a lot of people see is -- as, you know, the greed of these actors and taking these risks (a lot of people say) -- well, there was a moral hazard problem. And, you know, that this has a role for these regulations that were kind of in the past set up in 2008. Some, but both, some of the regulating and the deregulating that was going on. But starting and, you know, in the early 20th century we had this deposit insurance on normal banks. We had these regulations on how banks could behave so that if something goes wrong, [then] the government set steps in [and] ensures all the deposits of people up to two hundred fifty thousand dollars, or three hundred thousand dollars, or something like that and there's no longer a bank run. Now we had no system set up for that (for the shadow banking system), and that was supposed to be a plus of the shadow banking system. There was supposed to be that risk to get the higher return. We didn't want people in there regulating. But there became these other issues of [like in] 1997 it was long-term capital management [that] went down., and they ended up with a certain amount of a bailout that happened. And then we started seeing this implicit guarantee showing up from the Federal Reserve and the federal government that O.K., we're not gonna officially insure your deposits, but if you screw up big enough, then we're gonna step in. And this is another part of that story that goes into creating the 2007-2008 [Financial] Crisis of these people who felt that, you know, -- if we grow big enough, or if Lehman Brothers amasses too much risk and leverage -- they are so large, they're so big, that we cannot let them fail and therefore they will get a bailout. And so then we've effectively (the phrase is) privatized their gains and socialized their losses.
Stitzel: Right.
Mattson: So there's this moral hazard..
Stitzel:…fear of systemic risk.
Mattson: Yeah. So then we have, well O.K., so Lehman Brothers was acting greedily, and they were, you know, making all of these risky moves. Well that's what they had the incentives to do –that the credit rating agencies were going in and saying yeah, these are O.K.. Everyone was looking at these and saying this is O.K.. And in fact, we're increasing this liquidity. And that's similar to, you know, the riskiness that people were taking on in the 1920s. A lot more people were getting into the stock market, which, you know, now it seems like most people kind of know what they're getting into with the stock market. Hey it goes up, it goes down. So if you don't have the risk appetite, you get it. Well, you know, at the same time you had this this issue where, you know, bond rates are lowering and people are wanting more returns. I'm talking about the 20s.
Stitzel: Yeah.
Mattson: I'm not talking about, you know, 2006-2007. We're saying that..
Stitzel: Yeah. Rings true.
Mattson: Yeah. …the returns to store of value [of] assets, the safe assets, that are kind of you know going down and getting kind of boring. And then you think well the stock market's gone up, you know, X percent each year [and] maybe I should be putting my stuff into that. Or maybe you're thinking of: hey, we should put our pensions into that. And then you've got these mortgage-backed securities. This is new financial innovation that's…
Stitzel: Now your talking about 2008.
Mattson: Now we’re talking about 2007-2008.
Stitzel: So back up then.
Mattson: Sure.
Stitzel: Cuz when you said, you know, the bonds are low and then let's get into stock market, I thought you're talking with the 20s.
Mattson: Yeah.
Stitzel: Which seems like an element of both time periods...
Mattson: Yes. Yeah.
Stitzel:..to me
Mattson: I was going with both at the same time O.K. but so…
Stitzel: And then, now we have this innovation in the securitization rough mortgage-backed securities.
Mattson: It's giving higher returns. People on average pay their mortgage. On average this was working out. So if you splice up a few thousand mortgages and put it into this new asset (that you sell on a new market like a stock), then you get this increase in liquidity that will generate monetary service at a higher level for, you know, big level financial firms like Lehman and Goldman Sachs. And it's rated as safe. So their incentives were lined up. They were behaving/they weren't behaving in a greedy way. They were behaving in the way that they were supposed to behave, given the incentives.
Stitzel: The picture that you've painted is very reasonable, right? Mortgages are safe. Let's take a bunch of [them] and put them into a single asset (or parts of a bunch of them) and put them into single asset. That seems like diversification. That seems safe. Let's trade these things around. This is the hot new commodity.
Mattson: Yeah.
Stitzel: Nothing sounds bad or wrong about that. Now, I think some people -- and maybe this is sort of a mysterious part of the thing – that will argue there's a level of complexity that came with the mortgage-backed securities that people didn't understand and therefore we're rating them safe. And I'd like to talk about the rating process here in a moment. But they seemed like safe assets.
Mattson: Hmm mmm.
Stitzel: That didn't seem crazy. And then there turned out to be problems with that. And that's sort of what, you know, that's the spark that set everything off, probably, is that fundamental idea. But I want to return a little bit. So I made the argument, O.K. well, economists maybe don't know the story of The Depression that well. And you're saying it's really not that complex.
Mattson: Hmm mmm.
Stitzel: It's this risk search. People are looking for it (not risk search) -- a search for return on their money. They don't put it in a bond that's gonna get a low percentage. Yeah, O.K. this stock market thing seems cool. Let's do that. And then what then caused the oscillation, or whatever happened there in the market, that then caused a problem? Is it [that] people got into the market didn't know what they were getting into, [and] got spooked, and then we have a consumer confidence problem?
Mattson: Sure.
Stitzel: Or what happened there?
Mattson: They got spooked and they stampeded out, right? I mean, you had something, you know, a brought up about how bank runs are different. I mean, they are and they aren't. Basically, all a bank run is: is you've got a bunch of depositors who take all their money out for the liquid that they can get..
Stitzel: Yeah.
Mattson:..for the cash that they can get.
Stitzel: Yeah.
Mattson: So now, you had these people who had a lot of store of value in these asset-backed securities/mortgage-backed securities [who were] getting afraid. And we want to pull our value out of that. And, of course then/you have then this market force that's driving these prices down and down, and turning them into, you know, these kinds of toxic store of value medium of exchange assets. And this happened on such a large scale in 2007-2008 that Bernanke, Paulson, and Geithner --who was Bernanke's Federal Reserve Chairman [and] Tim Geithner was the Secretary of the Treasury under The Obama Administration [and] Hank Paulson was Secretary of the Treasury of The Bush Administration --- they likened it to a forest fire. And so it was (you can imagine that I guess the metaphor with this) is its a flash fire that happens. And it should have been the role of The Federal Reserve (even according to Milton Friedman here with when you talk about the Great Depression, it's the role the Federal Reserve) to come in with fire trucks, and the hoses, and put out the forest fire (or, you know, do the whole helicopter drop in), right? So the problem with 2007-2008 is not that we had these mortgage-backed securities/asset-backed securities. That's financial innovations. It's happened all the time over the past hundred years. And yes, we've had these swings in it and these back and forth business cycles that happen with it. But like Friedman is pointing out in 1929, look, wasn't the stock market crash that caused The Great Depression. The long period of lower productivity/higher unemployment -- it was the Federal Reserve's reaction and failure to do something about it. And Ben Bernanke, who is a Great Depression scholar, agrees with this outcome. Most macro-economists agree with this outcome. This is from Milton Friedman's [A] Monetary History the United States [1963]. 2007-2008: forest fire starts again. Everyone thinks we know how to solve it, because this is what's worked for 2001; it's what's worked for in the 1980s; [and] it's what worked in the 60s and the 70s. Oh well, 70s are a different story. But O.K., well…
Stitzel: So the 70s is The Savings and Loan Crisis.
Mattson: 70s is stagflation.
Stitzel: Stagflation.
Mattson: Yeah.
Stitzel: So then 80s.
Mattson: So the 80s be the Savings and Loan Crisis.
Stitzel: So things worked fine then. So when Arnold Kling…
Mattson: Yeah.
Stitzel:…looks back, right, he says the seeds of The Savings and Loan were sown in the wake of The Depression.
Mattson: Hmm mmm.
Stitzel: The seeds of 2008 were sown in the wake of Savings and Loan.
Mattson: Sure.
Stitzel: We have these interceding problems…
Mattson: Yeah.
Stitzel: Right? And so if we can harken back to the first time we had you on the podcast here, and you said, you know, there's a difference between a recession like we had in 2008…
Mattson: Right.
Stitzel:…unlike The Depression then there are with what you've called run-of-the-mill (not contractions I forgot what word you have)…
Mattson: Contractions, yeah I think.
Stitzel:…run-of-the-mill recessions, right? And so we can let me sort of fight that fire…
Mattson: Yeah.
Stitzel…like it's a localized fire and then this turned out to be something bigger.
Mattson. It was bigger. It was bigger, but the tools they used weren't right. So imagine, we got the forest fire going on. And then Ben Bernanke shows up with a garden hose.
Stitzel: Well, and that I think is part of the question.
Mattson: Right.
Stitzel: Because it doesn't to a casual observer it doesn't feel like the response to The 2008 Financial Crisis was disproportionately small.
Mattson: Right.
Stitzel: Right.
Mattson: Because you hear about the 2 trillion, 3 trillion dollars of quantitative easing.
Stitzel: Exactly. Quantitative easing.
Mattson: And the zero lower bound. And this is where, again the Friedman quote is important, because especially that last sentence where you have the failure of the Federal Reserve System, despite the knowledge of the right course of action. The Fed knew what they should have done. The problem is, and you can see this in the work of William Barnett [and] of Apostolos Serletis. You can see that people who generally study monetary aggregates will say: well, the Fed didn't actually expand the money supply. The Fed lowers the interest rates by expanding the money supply. They make money easily available that lowers interest rates [and] makes lending available. So not only is the Fed creating money by what they do, -- is they'll buy short term bonds and push money out into the system into the banks -- the banks will then lend that money. And that goes [into] that whole, you know, if you deposit your hundred dollars at a bank, [then] they lend out $90. And that creates 90 more dollars of monetary service. So in the same way, if the Fed is going to enact 2.3 trillion dollars worth of quantitative easing, [then] that goes through the banks. And the banks have to lend it to create that money. And that goes through not just the banking system, but then part of it goes through the shadow banking system. The problem is when the banks don't lend it out. And so yes, we have this wonderful 2.3 trillion dollars of quantitative easing that's supposed to go in 2008-2009. And I'm sorry -- I’ve prepared, so I've got some graphs. But I love these graphs. So we'll try and post something up. But you have it.
Stitzel: We'll make these available.
Mattson: You know, the end of quantitative easing was somewhere around 2014-2015. And excess reserves (what banks kept above and beyond their deposits) was 2.3 trillion.
Stitzel: So we…
Mattson: Sure.
Stitzel:…hinted at this last time…
Mattson: Hmm mmm.
Stitzel:…that I had you on -- which is what's going on? Why don't we make this mechanism clearer? This is the argument that I was making…
Mattson: Hmm mmm.
Stitzel:..right? Is every/all of the traditional policies of the Fed work really well if banks go around lending off all of their excess reserves, and that they stay at that required ratio.
Mattson: Hmm mmm.
Stitzel: Then the Fed mechanism for increasing liquidity is very straightforward.
Mattson: Hmm mmm. Yeah.
Stitzel: Fundamentally what happened in the wake of the crisis -- oh wait we've talked about the cause [and] now we're talking about the fall out -- is the Fed thought it was increasing liquidity.
Mattson: Yes.
Stitzel: It did not because of this breakdown in the mechanism that goes from…
Mattson: Yes.
Stitzel:…funds being made available to funds being limited.
Mattson: And, this…
Stitzel: So we've already talked about this a little bit on the podcast.
Mattson: Yep.
Stitzel: And I think it's extremely important. Because if you remember, right, when I when I brought that up I said: why not make this mechanism cleaner? Why not go forward and, you know, deal with these zero lower bound policies differently such that you keep that mechanism nice and functioning cleanly? And of course, if I remember right, you had an answer that basically said: well, they have a different strategy in mind. Do you want to unpack that a little further here?
Mattson: So yeah, in terms of the zero lower bound, what the Fed was able to do was they were able to credibly say: look we're exploding the monetary base [and] we're driving interest rates down to zero. Because the Fed Funds rates, hey now, down to 0.25 percent for a long amount of time. The problem is, is well that's a signal of the Fed expanding the money supply. If you, first of all, monetary base is not a good measure the money supply. When you hit the zero lower bound with interest rates, you no longer have any information about what money supply is actually doing. So what some macro-economists do is we turn to the monetary aggregates. But M1 and M2 don't take into account these interest rates. They don't price currency different from the savings accounts. They lump them together and quite literally add an apple and an orange, and say, O.K. well, it was just fruit.
Stitzel: It's a quantity, right?
Mattson: Yeah it’s a quantity issue. If you turn to Barnett…
Stitzel: That's mind-boggling to me.
Mattson: Yeah.
Stitzel: Right. Yeah it seems like we would really want to measure money…
Mattson: Right.
Stitzel…with a dollar not a quantity.
Mattson: Sure, yeah or, you know, and a dollar in in your pocket is different from a dollar in a savings account; which is different from a dollar in a repurchase agreement or commercial paper which is the one of the instruments in shadow banking. So what William Barnett did in his book: Getting It Wrong (2011), in his research from the 1980s [and] the 90s to now, (and this data is freely available at the Center for Financial Stability) you can look up this graph. And you'll see that what we have in terms of what's happening with the actual money supply -- that measures both the shadow banking system (what these unregulated firms are producing in terms of liquidity service as well as the banking system), as well as the public money provided by the government -- is, yeah we have this money supply growing to the top of about 8.85 percent; [whereas], is what's called the Divisia M4 Minus Measure [and] it includes repurchase agreements and commercial paper for that shadow banking system measure. The height of the growth of that was March of 2008. So we're in the middle, or we're just starting into the recession caused by this financial crisis. And suddenly after March of 2008, the broadest measure of money supply contracts and it goes negative. So we actually have the supply of money shrinking in The United States economy. By the time it keeps going negative, by March of 2010, it continues this for two full years. It goes negative for two full years. And at its lowest point was 7.25 contraction in the month of March of 2010. And only after 2010. does it recover. Well, by this point the “recession” is already over. 2008-2009: we've had the slowdown in productivity, as we are going into the worst parts of the recession (which is what you don't want to see in the graph of like a monetary policy graph), you want to see in the recession those monetary aggregates jump up. You want to see the Federal Reserve pumping money into the system. You want to see interest rates dropping down. And O.K., we see interest rates dropping down to that zero, but then we get no more information of what's going on with the actual liquidity supply. And what's going on here is this shadow banking run is continuing its damage. So if you look at -- so commercial paper is I think a really good example of the “shadow banking system.” Imagine Apple has got, I don't know, they've got some extra cash on hand that they want to, you know, hey, that
they're holding on to this before they make payroll at the end of the quarter. So hey, let's create a bond. This is a corporate bond. And, you know, let's put that out in the system. Let's get some interest rate from it. Hey we get paid back in three months anyway, and then we make payroll. We've got a little
extra return from it. I'm great that that entire system, you know, before really the big growth of it in 2005-2006 was about 1.5 trillion dollars. Corporations were putting out 1.5 trillion in these commercial
paper assets -- these corporate bonds. And then it bumped up to about 2 trillion, 2.3 trillion just before the recession, and then it collapses.
Stitzel: The corporate bonds?
Mattson: Corporate bonds.
Stitzel: Wow.
Mattson: Commercial.
Stitzel: That is enormous.
Mattson: Yeah these are large numbers. But then the shocking thing, the horrifying thing, is it drops within almost a year down from 2 trillion to 1 trillion. It just completely halves. And that has, you know, if you go on..
Stitzel: So help us out here.
Mattson: Yeah.
Stitzel: So simultaneous to the mortgage-backed security problem…
Mattson: Hmm mmm.
Stitzel:…do we have any idea but the linkage between those two things? Or…
Mattson: So…
Stitzel:…some underlying kind of cause?
Mattson:…that would be kind of the panic. Because you have with the shadow banking system then people may look at, you know, first of all we're dropping interest rates. Maybe there's just not enough return anymore on commercial bonds. But at the same time, most people don't know the difference between asset-backed security and a corporate bond, or a money market mutual fund. It all just looks scary, and O.K., we're gonna come out. Like the East Asian Crisis in the late 90s, not all Asian countries were facing these debt crises. But investors looked at that and said: I don't think I know enough about this anymore [and] I want to pull my money out. So in the same way, the shadow banking system with repurchase agreements, commercial paper, [and] asset-backed securities, it looked bad to everybody. So whether it was a good asset or not, people pulled their money out. And we have not recovered from that. We're still at, say, about 1 trillion in commercial paper.
Stitzel: So, commercial paper literally fell by 50 percent?
Mattson: Fell by 50 percent.
Stitzel: And its been that way for decades?
Mattson: And its been that way.
Stitzel: Unbelievable.
Mattson: Yes.
Stitzel: Wow.
Mattson: Yeah. And it's still that way today.
Stitzel: As we sit here today?
Mattson: As we sit here today.
Stitzel: That’s the note. @27:22
Mattson: Yeah.
Stitzel: So was there some sort of irrational exuberance going on in the commercial paper market that got it to that point? Or there's something about the structural change in the way that the financial..
Mattson: Sure.
Stitzel:…system has operated in the fall out of 2008 that caused that?
Mattson: Well it started out again and, you know, in terms of, you know -- again I've got to go with Friedman on this -- we had this this kind of business cycle bump that was bad. And then the reaction to it did not produce the results that we wanted. So, in terms of commercial paper then, businesses are looking at their decisions on revenue. And maybe things are bad, and they have this cash, and they need to make payroll next quarter. But they want to make sure to make payroll, because they hire some fairly expensive engineers. And if you don't pay engineers, they leave.
Stitzel: So one of our lessons, and any good micro class, is that the first thing that firms should be trying to do is covering their variable cost principle -- among which is paying their labor.
Mattson: Paying their labor.
Stitzel: Because your doors shut down when all your labor leaves, right?
Mattson: Yeah.
Stitzel: Right.
Mattson: Yeah. So we have that. We have that crisis uncertainty. But what's continued with that -- actually I think in large part due to this zero lower bound interest rate -- is that commercial paper, which is very responsive to the Fed Funds rate, you can you could put them up on a correlation graph. And there's this just nice line that goes through [with a] very high correlation between the two of them. If there's no return on that commercial paper, then there's no reason to just not hold cash. And so then, we have throughout 2013, 14, 15, 16, [and] 17 people talking about [how] Apple is sitting on huge amounts of cash. Warren Buffett is sitting on huge amounts of cash. Why? Because they don't want to extend that store of value. Because where they going to get returned for it?
Stitzel: So one of the things we've covered so much ground -- and there's so many lessons already in here I'm very pleased with the way that it's going – [and] one of the things that I think is interesting at this point is [that] you've mentioned incentives multiple times.
Mattson: Hmm mmm.
Stitzel: But it strikes me as you say this about commercial paper, that it's different. Maybe I'm wrong about that. It strikes me that the policies that we mentioned earlier, such as deposit insurance and the moral hazard that comes with the potential bailouts, does not exist in the commercial paper market.
Mattson: No.
Stitzel: Which is really, that’s shadow banking?
Mattson: Hmm mmm.
Stitzel: That's what we talked about…
Mattson: Yes.
Stitzel:…unregulated?
Mattson: Well, do…
Stitzel: What you call it, unregulated…
Mattson:..do you..
Stitzel:…financial firms?
Mattson:..do you want the federal government to ensure a corporate bond that Apple puts out? And that's Apple's decision, right? I mean that should/they face the loss and the reward from that.
Stitzel: So a classically trained economist like me would say no. I think your casual observer as you say why not? And I think that's where it's important to reinforce this idea that these things like deposit insurance among a trained economist [that] it's very clear that perverts incentives. When I teach this in class every single time I teach it…
Mattson: Right.
Stitzel:..somebody comes back to me and says there's no way that this is a big deal. There's no way that this…
Mattson: Hmm mmm.
Stitzel:…and I say, well it's actually a trade off, right? Do we think it stems bank runs? And it does that very well, I think.
Mattson: Hmm mmm. Hmm mmm.
Stitzel: But it also breaks some of that incentive structure that we think would make for a healthy financial system.
Mattson: Well, so I think I would take issue with the word perverts. But and I think that's where maybe you and I will come in a different look. I think because pervert has this kind of weight to it of negative. I think it changes the incentives. I'll go with that. But for a banking system -- so I would come at it from I want the banking system to be as boring as possible -- when I deposit $100 in my savings account, I want that low rate of return because I'm not expecting anything else. But/and that's where I would say: hey deposit insurance yes. It fulfills the goal. @31:33
Stitzel: You want that as a customer or as a macro-economist?
Mattson: I want that...
Stitzel: So what’s your goal?
Mattson: I want that as a customer.
Stitzel: Because there's a lot of people in financial systems that that is not the goal. Their goal is…
Mattson: Sure.
Stitzel:…to get rich quick.
Mattson: Exactly.
Stitzel:…their goal is to get as much money as they want.
Mattson: So…
Stitzel: That's the kind of thing…
Mattson:…if…
Stitzel:…that leads into these crises.
Mattson:…if I was more risk loving, then I would want to – well I guess I would go to Vegas-- but no, if I was more risk loving I would want to, yeah.
Stitzel: People draw the connection between what happens in Vegas and the stock market all the time.
Mattson: Sure.
Stitzel: And there's an element of truth there.
Mattson: But then I'm going into a market that I know is not regulated. And that's part of, you know, that this monetary policy issue is that the people who are participating in the shadow banking system knew (or should have known) the rules. There is no explicit bailout. Some people started believing there was an implicit bailout, and then you had people getting into it who maybe should have been getting into it before. But there is -- that should be a spot. And, you know, the Federal Reserve and the FDIC all looked at that as well, as this is gonna be where people want to gamble. This is going to be for corporations, financial firms, [and] hedge funds. They should be on their own. And then the financial innovation that came from that produced so many returns, and looked so stable that you'd have more and more people jumping into it. This grows. This grows. And at some point, you got to get a correction, right? At some point, that's got to come in. So there was the correction. There was the run on the shadow banking system. But there was no effective approach to stemming that run on the shadow banking system.
Stitzel: Where would the come from? Oh from the Fed.
Mattson: Yeah.
Stitzel: O.K. so you're essentially arguing let's let that be Vegas. Everybody knows the rules. You play here, you get burnt. Which is again, if we can circle back around to my idea about incentives, [then] that is a good thing.
Mattson: Hmm mmm.
Stitzel: If you lose, you lose.
Mattson: Right. Right.
Stitzel: If you win, you win.
Mattson: Hmm mmm.
Stitzel: Those are good incentives.
Mattson: Hmm mmm.
Stitzel: If you lose, the public loses. And if you win, you win. Those are bad incentives. So that's what I mean…
Mattson: Right.
Stitzel:…by I sort of perverse incentives. That to me is very clear in the bailout.
Mattson: Hmm mmm.
Stitzel: It's sort of less clear to non-economists how deposit insurance does that. But it's essentially the same mechanism. It's just related to when…
Mattson: Yeah.
Stitzel:…you pull your money out of a bank, and how that disciplines the bank's behavior. But then you're saying the critical key here is what happens in that commercial market is still very real. It still affects the economy…
Mattson: Yes.
Stitzel:…if things go sideways, and we go from…
Mattson: Yeah.
Stitzel:…2 trillion to 1 trillion in that market, [then] it has real effects on the rest of us that didn't want to play.
Mattson: Hmm mmm.
Stitzel: And that's where the Fed should be stepping in.
Mattson: Hmm mmm. Yes.
Stitzel: That's -- I've never heard that story. It's very clear. I shouldn't say I haven't heard that story. I haven't heard it that clearly and concisely.
Mattson: So there's a researcher named Arthur Kennickell -- and forgive me I can't remember if he’s at the FDIC, or no he's the Fed Reserve Board -- and he was working with people at the FDIC. And the problem that Kennickell and his co-authors bring up -- I saw their presentation at a conference three or four years ago -- was that when they went in to untangle Lehman, Lehman didn't get the bailout, right? So Lehman was left to decay as it was. But in their attempts to clean up Lehman, they went in and they found that they could not differentiate between parts of Lehman that looked like an FDIC-insured bank and parts that were not. So…
Stitzel: Wow.
Mattson:…something like a financial firm as large as Lehman Brothers was they had a shadow banking component that they were mixing with their traditional banking component. And that's where
some of these ratings...
Stitzel: So we never got out of that.
Mattson:…were problematic. Because then you'd have -- let's say you have -- within Lehman a corporation called Stitzel & Matson Depositing, and people are leaving money with us. We're saying yes it's FDIC insured and blah blah blah. And then within that, you have Mattson & Stitzel Hedge Fund. And then, you know, you have these two very similar names within it. And you're not sure which one is which at certain times. And then you also find that they're kind of funneling money between each other.
Stitzel: Right.
Mattson: And you can't really take out one from the other. And this became a huge problem with when those/some of those financial firms failed. How do we figure out who got these deposits, or who got insured deposits, and who didn't have insured deposits? And that was, you know, in one way a way to again diversify, right? I mean, Lehman was looking at -- the people working in Lehman were responding to incentives of: people want safety, but they also want return. So we have different parts of our corporation that are doing different things. Some of them are more regulated than others, and it was the mix of that that became, I think, very problematic. So I'm O.K. with if Lehman wants to go to Vegas and drop down, you know, $10 million dollars on roulette. So long as their clients are well aware: hey, your depositing it, so they can go to Vegas and drop $10 million on roulette. I'm less O.K. with it being, you know, if it's a pension fund and they have no idea what Lehman's doing. For the pension fund they're saying: oh hey, we're, you know, we're looking for safe assets. Like oh, we've got these safe assets here, and then they move that. Now the issue with that is that, you know – I’ll say this and I do sound like I'm, you know, accusing the shadow banking system of doing something, you know, wrong here (yes and no) -- but those were the incentives. So the other thing is -- even in a traditional banking sector they're these things called sweeps. So you deposit your money at Amarillo National Bank or Happy State Bank or Bank of America. Let's say Bank of America for now. You deposit your $500 dollars at Bank of America in your checking account. You're not gonna take all that out, right? So what Bank of America can do is [that] they can take maybe $300 of that, and they're gonna put that in my market mutual fund. And they'll get the interest off of that. And maybe you're lucky enough -- you're part of the interest paying checking account at Bank of America. So you get a little bit of that. But Bank of America is making more money by taking what's supposed to be in a safe asset, putting it into a more risky asset [such as] money market mutual funds [and] CDs (maybe not that risky with CDs), and maybe they put in CDs. All banks are doing something to this effect. We used to measure how much they were doing in sweeps. We don't measure it anymore, which is terrible. Federal Reserve used to actually have numbers on how much sweeps were going on. St. Louis Fed was providing those on, and then they stopped. And so again, you've got all the stuff that say Lehman was doing with: hey, this is our unregulated portion, here's our regulated portion, and we'll mix these together. Don't think the Bank of America is not doing the same thing. It's just when they're doing it probably most of the instruments they move into are also FDIC insured. So they have no problem. Or at least they have no potential for crisis and bank run there. We're not measuring aspects of our financial system that that are prone to this. We're not measuring this. And if we do, I think we're gonna find again like much like with, you know, this 2009-2010 what the Divisia aggregates are showing with this contraction in the money supply. We're gonna see that our growth in terms of liquidity and monetary service has not been very stellar. And you see that reflected in the inflation rates. So you look like you have a question.
Stitzel: Yeah. No, I wanted to jump in here. So a couple of things, right? One thing is -- there is a contingent. Most economists, I think, fit very much with you. People were given a set of incentives. Some of those policy incentives were things like deposit insurance and bailouts -- which we think O.K. that's a trade-off that we might want to make in that favor. And the consequence is gonna be incentives -- I would call perverse, but you apparently have a different word for them -- and that's the way that it goes.
Mattson: Yeah.
Stitzel: And a lot of your mainstream economists right I mentioned Arnold Kling. He was an economist…
Mattson: Hmm mmm.
Stitzel:…at Freddie Mac, I think at the time that these things were happening, right? So he's on the inside. There's lots of different people that we would find it [that] they make that kind of analysis.
Mattson: Hmm mmm.
Stitzel: There are important people like Alan Blinder who argue this is fundamentally a greed problem, which as an economist I’m saying we this this shouldn't be an argument that an economist makes. But I think what he's trying to say is there's a misbehavior here.
Mattson: Hmm mmm.
Stitzel: That story you told me about sweeps sounds like it fits there. We're taking money that should be in one place, and we're putting it in another place, right? If you have a system where if I'm right I'm rewarded, and if I'm wrong I'm punished, [then] that's no problem. But when you have the system that socializes the losses, [then] that behavior it seems as though you should have some responsibility to make those kind of choices. But there's no way to enforce that. That's an impossibility. So comment briefly, sort of, on how I think you said you sort of do and don't blame them at the same time. Comment a little bit on this version of the story that I think the casual observer would feel very different from the economist about [how] the behavior of those guys on Wall Street was reprehensible. Comment on that version of the story for them.
Mattson: Well so, I think, you know, you and I both go to church. We know right and wrong. We have certain moral ideas that we stand by that’s reflected in our actions and what we try and do every day. But in an economic context, and defining these incentives, then my question then is what is greed? Someone is supposed to be a utility maximizer, right? He's maximizing his revenues subject to his costs. So if Bank of America can sweep money out of a checking account, [then] put it into a money market mutual fund, and make (I don't know) 1-2 percent, and then they pay, you know, a little bit from that .25 percent -- you still are accessing your money. You know, you can go to the ATM [and] you get it out there. You may be even (if you're lucky enough) you're getting some small amount of interest from it. And Bank of America as a bank is more profitable, and therefore more solid.
Stitzel: Well, see I like that version of the story.
Mattson: That seems like they're acting responsibly.
Stitzel: Yeah.
Mattson: Yeah.
Stitzel: When that works well…
Mattson: Hmm mmm.
Stitzel:…everyone involved is happy.
Mattson: Right.
Stitzel: I'm happy I gained a little money…
Mattson: So…
Stitzel:…in my checking account. They're happy that they increase their profit margins. The person they loan that money to…
Mattson: Hmm mmm.
Stitzel:…wherever that money goes in the sweep, [then] they benefit as well.
Mattson: Right.
Stitzel: Right. So when we have economic activity, self-interest isn't bad.
Mattson: Hmm mmm.
Stitzel: And because one of the things that I principally try to teach my students in every version of every economic class that I have -- is when you have two parties and they engage in economic exchange…
Mattson: Hmm mmm.
Stitzel:…it's mutually beneficial.
Mattson: Right.
Stitzel: Right. And so the simplest version of the story is -- I'm sitting here having lunch [and] I have two apples. You're sitting there having lunch [and] you have two cookies. We both would obviously be happier if we had one apple and one cookie, [so] we trade.
Mattson: Yeah.
Stitzel: Now I didn't get the best of you, right?
Mattson: Yeah.
Stitzel: I benefited.
Mattson: Hmm mmm.
Stitzel: You didn't get the best of me, and yet you benefited. That's the magic of economic exchange. So when that story goes right, it's the exact same thing…
Mattson: Right.
Stitzel:…with Bank of America. The question is (and this is where you're going), so I cheat.
Mattson: Yeah. That’s O.K.
Stitzel: Not to cut you off. What happens when it doesn't go right?
Mattson: Right.
Stitzel: So let's go to that point.
Mattson: So let's think about Lehman then, right? O.K., so we have this regulated portion of our firm that is supposed to be doing things with regulated and insured money. And they're moving it into an unregulated and uninsured shadow banking environment. And for the most part, things go right for 2004, 2005, [and] 2006.
Stitzel: Very right.
Mattson: Very right. I mean people at that point again hey you're moving into the shadow banking system, which by the way, is generating more loans -- which those loans go to local governments mom-and-pop stores. I mean that's it's not just they're, you know, they're not just throwing money into Vegas but…
Stitzel: Economic activity is good.
Mattson: Economic activity. …wages are paid, things are bought, firms expand, and things like that. So it all goes well. And then it doesn't, right? Then you have the unregulated section. They, I mean, they go through these horrendous losses, and that brings down the regulated section. The incentive structure --you know, I find myself in the weird position of defending greed at this point. I'm not arguing like a Gordon Gekko [played by Michael Douglas] “greed is good” [Wall Street (1987)] thing here.
Stitzel: There's nothing…
Mattson: What I'm arguing is the incentive structure that was set up and that everyone was operating under -- they all saw this as well hey, we can play with this money. And, you know, if we go into mortgage-backed securities, for example, home prices always go up, right? I hope.
Stitzel: I remember being told that when I was young.
Mattson: Home prices always go up.
Stitzel: That was an...
Mattson: Yeah.
Stitzel:…axiom that I grew up with. And then thankfully was disabused of that before…
Mattson: Right.
Stitzel: I got to the home buying…
Mattson: Right.
Stitzel:…stage in my life because of this crisis.
Mattson: So then, I got a question for you. Your -- if this isn't too personal here -- your retirement. You're in mutual funds? Or what was is it? Stock indexes? Yeah.
Stitzel: So…
Mattson: Yeah.
Stitzel:…I am a little less risk-averse than you...
Mattson: Yeah.
Stitzel:…I think. And so, you know, I'm a homeowner.
Mattson: Yeah.
Stitzel: Very normal, like well within our budget. But certainly not a small…
Mattson: Hmm mmm.
Stitzel:…part of our income goes to housing. I think that's the normal American experience. On an earlier podcast that I did with Dr. Pjesky, we talked about this. So if you listen to all the podcasts you can…
Mattson: Yeah.
Stitzel:…learn a lot of details about my life here. When I went to -- going for a retirement investment (I'm in this way for a while) is I'm in large cap…
Mattson: Yeah.
Stitzel:…stock…
Mattson: There you go.
Stitzel:…index funds.
Mattson: You buy the S&P.
Stitzel: I buy the S&P, right?
Mattson: You buy the S&P.
Stitzel: Yes a couple of versions of index funds…
Mattson: Yeah.
Stitzel:…that have very low fees. When people hear that I'm an economist -- so like O.K. well, what's the stock market gonna do? Nobody knows that! But definitely…
Mattson: Right.
Stitzel:…an economist doesn't know it. And then they ask me for investment advice, and I tell them…
Mattson: Well, listen
Stitzel:…listen, ride the index funds. Because if the index funds go to zero…
Mattson: Right.
Stitzel:…if index funds go to zero we're all screwed anyways, right?
Mattson: Yeah. Yeah.
Stitzel: And the money isn't gonna matter…
Mattson: Right.
Stitzel:…if as long as it keeps chugging along, [and] everyone does well, [then] you do well.
Mattson: So let me rephrase that in a more optimistic term for you. Stock indexes will always go up, right, I mean over the long run?
Stitzel: Yeah. Correct.
Mattson: So you and -- I'm doing the same thing, by the way. Don't let me scare you too much here.
Stitzel: I thought you were in government bonds which you said some time ago.
Mattson: But well, yeah. And those are always secure, right?
Stitzel: Definitely we would never see a government default on that.
Mattson: Oh definitely not, no of course not. Yeah we've all read Reinhart and Rogoff, right? O.K. So I I've got mine in, yeah, in index funds. Why? Because I've been told throughout most of my life, [that] the stock market overall is gonna go up.
Stitzel: Yep.
Mattson: And nothing has disabused us of this notion.
Stitzel: 100 years of history there.
Mattson: So yeah, even 1929 -- you have, you know, boom -- it goes down and then it comes back up. You have -- and this brings up actually [that] Bernanke, Geithner, and Paulson in their new book have this graph on the severity of the 2008 crisis. The 2008 crisis in terms of the stock market was actually worse than 1929.
Stitzel: That’s amazing.
Mattson: That's their numbers. They had The Great Depression going down 44.9% stock market prices from peak. And [in] 2008 the financial crisis 57.8% down from the peak.
Stitzel: So you're gonna…
Mattson: So…
Stitzel: You’re gonna…
Mattson:…I want to…
Stitzel:…make fun of me for this.
Mattson:…make fun of you and all your listeners..
Stitzel: Yeah.
Mattson:…in the same way…
Stitzel: That’s leaning.
Mattson:…that everyone says housing prices always go up. Sure, if you believe stock prices always go up. But we may want to re-examine that.
Stitzel: Absolutely. Absolutely. And so part of it, right, is I'm leaning on a certain amount of logic that says…
Mattson: Yeah.
Stitzel:…you know, what are you gonna do with your money instead?
Mattson: Hmm mmm.
Stitzel: And if you do it ‘cause you can do other things in-house. You can do other things than index funds. My guess is if something is central as index funds, we ride that thing all the way down. We got a different set of problems.
Mattson: Yes. Yeah.
Stitzel: So that's my logic. That's maybe -- we could carefully construct an argument that just analogizes that to the housing market perfectly. I don't think you can.
Mattson: Mmm no.
Stitzel: But if you have if that comes to you later on we'll make another episode…
Mattson: Yeah.
Stitzel:…or something on why Dr. Stitzel’s investing strategy is wrong.
Mattson: If yours is wrong, mine's wrong too.
Stitzel: Yeah O.K. But that's why our investing strategies are wrong maybe. One of the things that I did --when it came time to really make serious decisions about what my retirement investing was gonna look like -- is I went back and looked at compound annual growth rates of the stock market.
Mattson: Right.
Stitzel: Because I had a -- and I end up forgetting what his title would be like a personal financial advisor…
Mattson: Yeah.
Stitzel:…come in
Mattson: Yeah. Yeah.
Stitzel:…and try to sell me…
Mattson: Hmm mmm.
Stitzel:…and he said words like: oh we have all this downside capture and stuff like this. And I looked at the graph that he was showing me. And at the end of the day, the performance of his mix of all these financial instruments didn't do as well as the stock market. Now the stock market fall…
Mattson: Exactly. Yes.
Stitzel:…was sharper. But, the recovery was sharper as well.
Mattson: Yes.
Stitzel: When you go look at – (I forgot which one) I want to say the Dow -- [but] when you go look at some of these big index funds, go look at what the what the growth rate is in 2009…
Mattson: Hmm mmm.
Stitzel:…and these measures of the stock market -- it's like 33 percent.
Mattson: Right.
Stitzel: Right. You didn't get it all back. And this is rumor. This is compound annual growth rate. So this is not…
Mattson: Yeah. Yeah.
Stitzel:… there's always this problem losing versus gaining, because your…
Mattson: Yeah.
Stitzel:…game comes after your loss [and] you're gaining off of a smaller base. All right. So there's compound annual growth rates, right? We have a 50 percent loss, and then you have a 33 percent gain, right? So I think these kind of dips in the stock market -- they're related to something that has been a thread weaving through this entire podcast…
Mattson: Hmm mmm.
Stitzel:…which is people responding to these things and pulling out in some ways exacerbates the problem, right?
Mattson: Right.
Stitzel: That's a vicious cycle.
Mattson: So O.K., 2009 the recovery in the stock market been great since 2009, right? I mean, it's been going like gangbusters. But think that this way, interest rates are at zero. Where are you gonna get return? You're not gonna get return from government bonds.
Stitzel: Yeah.
Mattson: You're knocking it return from your savings account you will only get that kind of return at this point from the stock market, or you go into the shadow banking system.
Stitzel: Yeah.
Mattson: So going back to this idea of the incentives and Lehman, you know. You -- so you have your financial adviser, and O.K. so you didn't think he was better than the index funds. But you gotta admit, other people are handling your index funds too.
Stitzel: Yeah, of course.
Mattson: And they are moving your money around. And you're O.K. with that. You know, I mean, you're going in. You're aware. Hey, but you still have that expectation. Stock market's always gonna go up. So then are these guys behaving unethically by putting your money into the stock market as they're supposed to do with their job? This is…
Stitzel: Yeah, so…
Mattson: Am I saying what Lehman there was -- no I really don't need to be saying that. But the incentives that they faced back then that was -- that what everyone's telling them to do.
Stitzel: So let's -- so let's do the economist thing and stand in defense of greed for a minute. The person who's handling my money…
Mattson: Gordon Gekko, right O.K., here we go.
Stitzel:…the person who's handling my money -- he's doing it because he or she wants to feed their family.
Mattson: Right.
Stitzel: They want to make their mortgage. They want to travel to wherever they want to travel.
Mattson: Hmm mmm.
Stitzel: They're not doing that so that I can feed my family, so that I can have a nice retirement, so that I can go kick my feet up on a beach after my academic…
Mattson: Yeah.
Stitzel:…career is over.
Mattson: They get a fee and a certain transaction… @53:00
Stitzel: And they get a fee.
Mattson: Yeah.
Stitzel: And so they the incentives align there.
Mattson: Hmm mmm.
Stitzel: they're doing -- they're an agent on my behalf.
Mattson: Hmm mmm.
Stitzel: And they're doing what I want them to do. Now maybe they do it poorly. But then they pay…
Mattson: Well.
Stitzel:…the correct consequence. So my incentive is well aligned with theirs. Now turn to the Bank of America/Lehman Brothers situation that we just described.
Mattson: Yeah.
Stitzel: Right? So I'm gonna come back, and I'm gonna defend my position. Those are perverse incentives.
Mattson: Yeah. O.K.
Stitzel: So that’s…
Mattson: So…
Stitzel: That's where I'm coming at.
Mattson: That's -- yeah. Yeah.
Stitzel: Because if I get…
Mattson: Well.
Stitzel:..my little cut of their sweeps…
Mattson: Hmm mmm.
Stitzel:…and then, you know, Bank of America engages in fewer sweeps, and therefore makes less money, but is less likely to burn…
Mattson: To fill… @53:44
Stitzel:… down the house in the process, [then] you're more risk averse than me. You go with Bank of America. I'm less risk-averse, [so] I go with Lehman Brothers. As long as Lehman Brothers and I pay the appropriate consequence…
Mattson: Hmm mmm.
Stitzel:…that is fine.
Mattson: But then you're saying they weren't paying that consequence.
Stitzel: That’s my argument.
Mattson: So then that kind of leads to one of the things that we talked about, I think pre- this podcast, like this question I had here. Should there have been firms saved through government action?
Stitzel: Oh yeah. This is one of the central questions in the fallout of the axis.
Mattson: Yeah. Yeah. So here is at least what I go with my Money and Banking class. Yes. And that is…
Stitzel: Yeah.
Mattson:…that I can already see on your face there. Here we go. So one of the books that we read for Econ 4312 we did was Laurence Ball’s book The Fed and Lehman Brothers [2016]; where he makes the argument that: not only was the Fed supposed to have behaved as a lender of last resort for a non-insured, non-regulated investment bank…
Stitzel: This is in their mandate?
Mattson: Yeah. This is in their mandate. And they had the ability to do it, which is also the question of how much money do we have to throw at Lehman for it to be rescued. That was a big part of who's gonna/how are we gonna finance, you know, all of this mess. And so what Ball is arguing is that the fallout after Lehman was larger than what the cost would have been of bailing them out. And he likens it back to The Great Depression again, where you know in 1929, 1930, [and] 1931, a lot of these banks were failing, but there wasn't a whole lot of deposit insurance out there. And people were asking the same question [of] why should we bail these people out? And that gets to the interconnectedness problem.
Stitzel: Yeah.
Mattson: Too-Big-To-Fail.
Stitzel: Systemic risk.
Mattson: The shadow banking system provides this wonderful incubator of financial innovation of high return with high risk that should exist. It should not have been linked with the regulated industry. I want to say, really in anyway, but then that's where it was and that's how it was. So then, in my opinion, yes the Federal Reserve had a mandate at that point, because of these linkages that at the time we were ok with and now we're not ok with them. And we've put up a little more barriers between them. But Lehman, Bear Stearns, [and] Countrywide -- these institutions that messed up -- should have gotten a bailout with the Fed, as Friedman even was saying, acting in accordance with the principles of what it was founded for. And that I see also has a failure in how the Federal Reserve responded to this crisis. Now the question that immediately comes up: well then, aren't we just encouraging that moral hazard?
Stitzel: Yeah, I’m going to lay that argument out.
Mattson: I/you can back up and say: wait a minute, no, no, no, no. This guy just said that there's a problem with privatizing games and socializing losses.
Stitzel: Yeah.
Mattson: And yes, exactly, that's where we are.
Stitzel: This question is extremely difficult.
Mattson: Yeah.
Stitzel: Just like deposit insurance is important, because it stops bank runs. But it breaks the linkage between you disciplining your bank by taking your money somewhere else because you don't care. Because it's insured.
Mattson: Yeah.
Stitzel: You know, just like, well this is the fundamental question. Just in the same way that these bailouts in the past set up irresponsible behavior in the future, those are very bad. But systemic risk, interconnectedness, the credit market completely freezing…
Mattson: Yeah.
Stitzel..[and] no liquidity…
Mattson: Yeah.
Stitzel:…are serious and real fundamental problems.
Mattson: Yes.
Stitzel: That said, I disagree with somebody like Laurence Ball, saying the cost of Lehman Brothers going down…
Mattson: Hmm mmm.
Stitzel:…is greater than the cost it would have been to bail them out. Because that is probably -- let's assume it's true, I haven't seen that that individuals work…
Mattson: Hmm mmm.
Stitzel:…does that then take into account the fact that the next time we go into a crisis, the fallout is gonna be even bigger because we've established…
Mattson: Right.
Stitzel:…this pattern of bailouts? I really doubt it. And that's where -- I almost as this would probably be controversial -- I almost liked the way they went about it in terms of: you'd like the mandate to save people to be applied very thoroughly.
Mattson: Hmm mmm.
Stitzel: I would like there to be holes, such that there's doubt in the back of your mind the next time you’re Lehman Brothers going: O.K., are we Goldman Sachs this time, or are we Lehman Brothers this time?
Mattson: [Laughs].
Stitzel: And maybe we're the company that falls through the hole.
Mattson: Yeah.
Stitzel: The dichotomy doesn’t..
Mattson: The dichotomy of getting away with it.
Stitzel: Yeah. Right.
Mattson: Yeah. Yeah.
Stitzel: There are companies that got bailed out in the wake of this.
Mattson Hmm mmm. Yes.
Stitzel: And we would think O.K. well if we let them all go down…
Mattson: Hmm mmm.
Stitzel:…they're gonna take all of us with us.
Mattson: Right.
Stitzel: That is a legitimate concern.
Mattson: Sure.
Stitzel: That’s systemic risk.
Mattson: So that that becomes a marginal question, you know. How many of them do we save? Do we need to save?
Stitzel: I say we have a coin-flipping process.
Mattson: Coin-flipping process?
Stitzel: Yeah.
Mattson: You just..
Stitzel: At the time -- at the time that you want to be bailed out.
Mattson: Yeah.
Stitzel: And of course I'm saying that a little bit tongue-in-cheek.
Mattson: Sure. Sure.
Stitzel: But I think -- I think some one certainty there would be good.
Mattson: Hmm mmm.
Stitzel: Right.
Mattson: O.K.
Stitzel: Because now -- all the economists would say O.K. like rational expectations and they're gonna go through and they're gonna behave that way.
Mattson: Hmm mmm.
Stitzel: And at least takes the edge off it.
Mattson: Yeah.
Stitzel: Right. Of course, there's no probably good way to implement that. Because as soon as you install these kind of rules, they get gamed.
Mattson: Hmm mmm.
Stitzel: That's one of our fundamental lessons of economics. If you've learned one thing from this podcast -- let it be that the incentives matter.
Mattson: Yeah.
Stitzel: This is a hard problem.
Mattson: Hmm mmm.
Stitzel: This is one of those things that I've wrestled with a long time. I don't see an answer to it, right? Now I’m no Bernanke.
Mattson: Well.
Stitzel: I’m no Ryan Mattson.
Mattson: Well.
Stitzel: So...
Mattson: Yeah.
Stitzel:…correct me. I don't see a beautiful answer to this problem, right? I think this is one of those things that it's very difficult decision to make, because we can't let them take us all down with us.
Mattson: Right.
Stitzel: We can't get rid of the financial system.
Mattson: Hmm mmm.
Stitzel: Somebody like Arnold Kling would lay it out and say we need to raise capital requirements.
Mattson: Hmm mmm.
Stitzel: We need to establish boundaries on sort of the size of firms that these banks are allowed to be…
Mattson: Hmm mmm.
Stitzel:…and to have.
Mattson: O.K..
Stitzel: Because the financial industry is fundamentally different from every industry. And that all these things that you and I have talked about, they are inherently unstable in a way. Apple…
Mattson: Well…
Stitzel:…can cruise along for the next hundred years probably…
Mattson: Hmm mmm.
Stitzel:…until somebody comes along and puts them out of business with innovation -- and that's creative destruction. And that's good. The financial industry seems to have this inherent instability where things go…
Mattson: Well…
Stitzel:…up and we all jump in and things get out…
Mattson: Well...
Stitzel:…and when things go down and we all jump out.
Mattson:…the financial industry is so important to that idea of monetary service. We all want a money that we can use, and everyone agrees on because that simplifies things. You know, I don't want to be bartering with people. I don't want to be dealing with three different currencies, or one currency for Walmart, one currency for Target, one currency for buying cars, or whatever. But these financial firms are so important to the creation of liquidity [and] the creation of monetary service. And the shadow banking system has a really important role to play in that. And the financial innovation that they also produce is extremely important. There will always be a role for that. And they'll always exist, because whenever you create a regulation, there's now going to be 12 people employed to get around that regulation, right?
Stitzel: You're saying regulations create jobs?
Mattson: Yeah. Regulation creates jobs.
Stitzel: You really are a Keynesian.
Mattson: I really am a Keynesian. I've never pretend to be anything other than that. So what I would say, you know, one thing that was that was good that came out of the crisis is that we did say, you know, (as you were saying) we increased these capital requirements. We did unfortunately through this, make the banks that survived (the financial firms that survived) much bigger. So there needs to be some way that we can get some newer markets in there. I mean, Lehman Brothers was around for what 130 years?
Stitzel: I've no idea.
Mattson: 113 years?
Stitzel: I mean, it’s one of the oldest financial firms.
Mattson: Oh Yeah. Over a hundred years before it crashed. Well how come there haven't been any new entrants? I mean, you talked about Apple could go for a hundred years in. But Apple is fairly young.
Stitzel: Yeah. Apple is young, and they're not going to, because as soon as somebody invents…
Mattson: Yeah.
Stitzel:…holograms…
Mattson: Yeah.
Stitzel:…or brain implants that [people, but not me, may] want, now decide that Apple is done for.
Mattson: Yeah. We have that. The creative destruction you're referring to. I, you know, at least in terms of looking at the biographies of some of these financial firms we haven't seen, right? I mean…
Stitzel: Recently.
Mattson:…how old is Bank of America? How old is Goldman Sachs?
Stitzel: So, you don't mean recently? You mean historically?
Mattson: I mean historically. Yeah. I mean these firms have been around for a while. And you don't generally see a lot of new competition coming in. So that may be something else they want to look at, but the Fed is tied down. Because with regulation in terms, the Fed and the FDIC can go back and forth about how we're gonna regulate the traditional banking system. With the shadow banking system though, we have the knowledge [that] something needs to be done, but we don't have the tools. So I'm going back to this forest fire where Ben Bernanke shows up with a garden hose in there. Honestly, I don't there was anything he could have done about the shadow banking system. I think there were some symptoms and side effects of the zero lower bound that, you know, in some cases helped, and in some cases hurt. But this is a very large part of our economy that we don't know a lot about. We, I mean, in terms of measurement, it's sometimes called the shadow banking [system]. By the way, for those who don't know it's not/it wasn't named that way because it's unregulated and therefore it’s in the shadows. No, the term shadow actually comes from economic term of shadow price or shadow cost.
Stitzel: Right.
Mattson: You don't directly observe the price. What you observe is the reflection of that price, or the shadow of that price from some other observation. There's nothing nefarious about shadow banking. it's just unregulated. And there should be a role for that. But there should also be a separation, I think.
Stitzel: I'm glad you defend that. Because I think that's something that not everybody would immediately think or agree with that we need to have this unreg[ulated]. We want everything regulated in the financial sector.
Mattson: Hmm mmm.
Stitzel: Let's -- and that's been the response, right? That's Dodd-Frank. That's all these kind of policies that are in response to that. They're all the same thing.
Mattson: Yeah.
Stitzel: Right. We have this problem. Let's just ratchet up the regulation on that.
Mattson: Yeah.
Stitzel: So I'm glad that you took it this direction, sort of, when I asked you about the size of firms. And I think there's -- I haven't wrapped my mind around it -- there's, I think, a feeling of concern with the nature of concentration of industries and the size of firms.
Mattson: Hmm mmm.
Stitzel: I think that could be a little bit overblown. Because that happens largely and in…
Mattson: Hmm mmm.
Stitzel:…these more high-profile areas. And it's probably fine for 90 percent of the markets that we actually interact with on a day-to-day basis. So as we bring this in for landing, I would like you to sort of paint a picture of: what do you think some of the policy recommendations-- the regulations or I suspect you're gonna start with like a comment -- about how the Fed ought to be actually measuring their monetary aggregates?
Mattson: Hmm mmm.
Stitzel: Give us some policy recommendations as we bring this in.
Mattson: Yeah. I mean, I got to say first of all, the Fed really does have to start providing good monetary aggregates. Because if we're gonna have a ten year period of zero lower bound, then we need better measures than M1 and M2. And we certainly better measures than monetary base which just, you know, exploded. And then you have guys like Art Laffer in 2009 saying: we're gonna see inflation skyrocket. Of course didn't happen, because the monetary base has no concept of the shadow banking system which is collapsing. So you have..
Stitzel: Wow. True.
Mattson…a lot of currency.
Stitzel: But if you're taking a blunt approach to it, and explode the monetary base, get inflation is really straight forward.
Mattson: Sure, you’d think it would be.
Stitzel: Some nuance there.
Mattson: Yeah. I mean, you missed some nuance there. You miss pricing. A lot of these different assets by their interest rates, and multiple interest rates, not just a Fed Funds rate not just a deposit rate. But anyway, so that that's the first thing I would do, you know, in terms of getting them measuring money right. And the second thing is, you know, having more of a measure of the shadow banking system. Everything that I've said is, you know, I'm relying on commercial paper and repurchase agreements. And those are the few things we measure about it. We don't know, because it's not a regulated industry. So no one's writing into the Fed and saying: this is how large we are. And O.K. well, that's part of not being regulated. But going back and starting to again ask banks about: O.K., how much sweeps are you guys enacting? And even just going to these firms and saying: O.K., can you give us some idea of what you're doing? That way -- and provide it. Make it available. I realize there's a lot of, you know, private data issues and we don't want our competition knowing about this. But, you know, average interest rates [and] total quantities -- that's not identifying information. Having that available then to the public would allow people to make better decisions. And this is…
Stitzel: Well one of the things that we glossed over a little bit. We said we were busy saying economic activity is good...
Mattson: Hmm mmm.
Stitzel:…and these trades are good.
Mattson: Hmm mmm.
Stitzel: And as long as the incentives are aligned, it's good. That all rests on some level of transparency of the information.
Mattson: Right. Yeah.
Stitzel: I think this gets out that.
Mattson: Right. Hey, you know, if you have transparent information people can look at it [and] make their own decisions. I can say ooh, you know, Lehman Brothers -- I'm not sure like how this looks. I'll go to Bank of America. Fine. Then I've made that decision, and I was equipped with that. We talked about capital requirements. I do think that's an important thing to make sure that banks have the proper capital requirements. In lieu of going to a financial firm and saying you're unregulated but you need to have (or you're uninsured but you have) this amount of capital requirement, [then] at least go through and say here's the suggestion: you hold such and such assets [and] you probably should have this capital requirement. And then again, you know, hey let people make their decision on whether they trust Goldman Sachs or Lehman to do that. Again, we want that innovation from the financial market, and this is the price that we pay for that. But we do need to find some containment, so that when there is a correction. And, you know, 2007-2008 it's a correction. The problem came in 2009, 2010, [and] 2011 when the fire kept burning. And just like with The Great Depression, it wasn't necessarily the stock market crashed -- it was the Federal Reserve contracting the money supply when they knew better. And O.K., now they know better, you know, the measurements they're looking at it wrong. And some of these things, they don't even have the tools for. Shadow banking -- it's unregulated [and] there's going to be a correction. What we can do is at least contain the damage, and then, you know, let the market come back. Let the forest regrow. That kind of thing.
Stitzel: My guest today has been Ryan Mattson. Ryan thank you for joining us on the Econ Buff.
Mattson: Thanks very much.
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