#80 - Andrew Metrick: Master Class in Financial Crises & Bank Runs

29:28So they could have a big effect on that. But the market, I think, would correctly infer that the inflation fighting has come to an end. And if inflation fighting has come to an end, the expectations of inflation would go up. Long-term rates are the long-term real rate of interest plus some inflation expectation. So you can easily see a case where if the Federal Reserve or any central bank looked like they weren't really serious about inflation, they could make short rates go down, long rates could go up at the same time. So the Fed, there are a couple steps removed from being able to exercise control over the long end of the curve.

30:10They've done what they can in a world of zero interest rates in the short term. They've done what they could over the past 10 years to try to affect long-term interest rates through quantitative easing, which is a form of monetary policy. But that really is something that in principle is only going to be effective when short-term rates are zero. When short-term rates are higher, your ability to have some kind of deep control over the long rates is going to be much more attached to why those short-term rates are high and what inflation expectations are in the long run. Let's transition into financial crises.

30:49How do bank runs typically occur and what lessons would you say have emerged from historical safeguards like the FDIC? What we observed, the observable evidence of a bank run in the old days was you look out your window and you note a lot of people lined up outside the bank to take their money out. You don't want to be the last one. And other people who seem to be running to get in line, which is perhaps where the term bank run comes from. Now, that would appear to be, at first glance, a liquidity problem, as in the bank might be totally sound and completely solvent with the value of its assets way more than the value of its liabilities.

31:38But because the assets are long-term and tied up in things like houses and businesses, they're unable to access them quickly. And so when a lot of people show up and ask for their money, the bank is unable to do it, which makes more people nervous they don't have the money and more people show up to do it. In practice, that's not why bank runs happen. They're not random events where suddenly show up. People all coming at the same time to ask for their money is typically going to be due to some underlying economic factor. And these days, with central banks able to provide lending to banks, a solvent bank, Actually, I prefer the word viable to solvent.

32:24Solvent is kind of an accounting term. A viable bank, a bank where when the government looks at it, they say, oh, this bank can survive. No problem. A viable bank can always bring collateral to a central bank and get a loan and pay the people back if they randomly showed up. Those runs only tend to accelerate when banks have an actual viability problem, where there's a concern by depositors this bank is not going to survive, usually because some measure of its assets are getting pretty close to some measure of its liabilities. In that world, I don't want to be the last to go into the bank to ask for my money.

33:04In history, bank runs are almost 100 % of the time related to fundamental problems at a bank. The bank is running with too thin of an equity layer, and even the smallest amount of a shock makes people justifiably nervous about that bank. Let's take, for example, the famous case we've had in the last couple of years of Silicon Valley Bank. Silicon Valley Bank published their filings and their SEC filings in the third quarter of 2022. They publicly told everybody, if you mark to market all of our assets and you just take our liabilities at face value, our liabilities are more than our assets. That was public information at the end of the third quarter of 2022.

33:56So people getting nervous that Silicon Valley Bank perhaps wouldn't be able to pay them back wasn't just a rational thing. It was a plain letter in black and white on filings they had made to the SEC. It's not as though someone spread a rumor on Twitter that this bank was in trouble and we had no fundamental evidence at all to support that. And suddenly everyone took their money out and they failed. That may be what we observed as the last step in the chain, but well before that was fundamental problems. It is important, and I think a main misunderstanding of banking crises is even if you talk to professionals who have been involved in banking crises and you ask them, what would you do?

34:39A lot of times the conversation will be about, well, am I looking at a liquidity problem or a solvency problem? When the answer is they are always intertwined. Liquidity problems in the total absence of solvency concerns are actually not problems. Central banks can handle those really easily just by lending. You can't lend your way, though, out of a solvency viability type of crisis. Lending doesn't fix that. If I'm underwater on my mortgage, the bank giving me more money is not making me less underwater. So would you talk about how certain triggers like uninsured deposits or interest rate mismatches could start that avalanche?

35:22Let's start with deposit insurance. In the days before deposit insurance, where nobody was insured at all, banks would hold a much higher fraction of their capital structure in the form of equity, because they needed to. The only way they could convince somebody to lend the money, because again, that's what a deposit is, with the promise that they would be able to get it back, was to say, look at our accounts. Look how much cushion we have. While banks got better and better at managing that over the course of the 19th century, it's still the case that they had to have significantly more capital than they have to have today.

36:06That's because every depositor out there would worry all the time and go to the bank if they got nervous about the bank solvency. So they needed much more of a cushion. With the introduction of deposit insurance, the amount of cushion that a bank needed really, instead of being constrained by the market, became constrained by government regulation. So now the government got involved. Now, if it were the case that you had 100 % insured deposits, you would be very tempted as a bank to run on the very smallest equity layer you could. Because boy, it's wonderful to have deposits and very little equity since I pay nothing on my deposits.

36:46They're almost nothing. And so the government, since they're the insurer here, had an interest in coming in and saying, no, no, no, no, you have to hold a certain amount of it. We don't want to be left carrying the bank. So it is certainly the case that deposit insurance lowered the amount of capital that banks would rationally need to hold in order to convince people that they were safe. I'm leaving aside uninsured for the moment to stick with the insured bank. Some people look at that as the original sin and say, gee, if we just didn't have bank insurance, then the banks would have to be safer.

37:19That's really refuted by the fact that we didn't have insurance for centuries and we have bank failures all the time. It changes the line. It's also the case that bank runs are an extremely inefficient form of managerial discipline. Good managerial discipline is you tell me what you did. I look at the performance. We have conversations. If we don't like the direction of the company, we fire people. We bring in new management. It's not like I get scared. I don't think about your business at all. As soon as I get scared, I come and take my money out and destroy the business. It's a very inefficient form of discipline.

37:57Deposit insurance, I think, was a fantastic innovation to get rid of that inefficient form of discipline where lots of things would get destroyed every time people got nervous. It does create this moral hazard problem, and the way to deal with that is through regulation, and that's what's currently done. In the United States, almost half of the deposits in the banking system in dollar terms are above the threshold that is insured. The uninsured deposit system is a very complicated one, complicated enough that even at the moment that Silicon Valley Bank, which had more than 90 % of their deposits uninsured because they were very wealthy clients who were using it to make payroll and things like that, those clients, those depositors didn't really know which of our money is sitting in the bank account and uninsured, which of it has been swept into money market mutual funds at the end of the day, which while not insured are effectively collateralized because they own things, people were just unsure about that.

38:58And because of that uncertainty, treated it as though it was completely unsafe. And we've learned that our system wasn't really robust to having this high a level of uninsured deposits. Isn't part of that what you described earlier in terms of you don't have a crisis for a while and people become complacent and just feel the system's safer? Some of it is certainly that. If you were an uninsured depositor in Silicon Valley Bank and you asked someone who was an expert on the banking system, how safe is my money? They would accurately have told you the total amount of losses by uninsured depositors over the last 30 years is less than a billion dollars in the entire bank.

39:41Because generally, the government will come in and protect you after the fact anyway, or figure out a way for someone to buy you. A lot of times, uninsured depositors at a bank are great customers. So someone else will buy the business. That's what happened with First Republic, which is a valuable business. So J.B. Morgan Chase bought it. The government didn't have to bail them out. J.B. Morgan Chase effectively did it because they said, we want these clients. They're great. They're really wealthy. They did a lot of other things at the bank. So you would have been correct in assuming that your uninsured deposits were safe.

40:13And in fact, in Silicon Valley Bank's case, the government came in directly to protect them. We have created a system where the government is explicitly behind certain things and implicitly behind others. That system is imperfect. It is, however, in my opinion, better than the next best feasible alternative. because we would like to think a feasible alternative is to say, nope, you guys are on your own. We're going to teach you a lesson. And the next time we have a failure, we are going to not bail anybody out. Nobody is going to get help from the government unless they've been paying into an insurance fund for years.

40:59Even if it comes as a surprise to us, we didn't realize this thing was even happening, but we're not going to do it. And you do that to encourage responsible behavior. Yes. And so the idea, the basic tension always is between moral hazard, what we call moral hazard concerns, which is effectively that the example always given is if you provide some form of insurance to someone, they will take more risks than if they didn't have the insurance. It is always correct to say that that is the tendency. If somebody gives me insurance for whatever it is, and now at least a little less of the risk falls on me, I am going to be a little more risk-taking at least.

41:45That is certainly true. that does not imply that the world would be better if the insurance product was not available. In a world where home insurance for my house burning down was unavailable. So suppose you said, look, this is a terrible thing that we have this home insurance because now people are very not careful around their house with fire. Is it the case that if I couldn't get fire insurance for my house, would I be even more careful than I am about not having a fire in my house? Probably. I don't know on the margin what that would mean. Maybe I'd have someone come and inspect every few months instead of how often they come and inspect things, something like that.

42:32But the notion that somehow once I have home insurance for fires, I'm willy-nilly-ing lighting matches around my house and tossing them with no concern towards my house burning down, That's kind of crazy. So somehow we think just because moral hazard is introduced by insurance, that must mean that insurance is bad. I think it's a tradeoff, something that we have to accept. And so I do believe that we can do better at designing these things, but we're going to have to have some kind of safety net. Second, the after the fact coming in to help stuff out sometimes that we see the implicit stuff, the governments in general intervening.

43:14This is the other big picture moral hazard thing. If only the government would stay out of financial crises and not help. Deposit insurance is one thing. It's a contract that's in place beforehand. We all know about it. What about this after the fact coming in and intervening stuff? Why are they doing that? They should just stop. Stop doing that. So you have a variety of problems with that. One is that it's really hard for governments to commit. Think about a country like the United States. Suppose the current administration makes a commitment. We will never, ever, ever intervene. We won't do it no matter what.

43:49And we're going to write some really powerful law saying no one can ever intervene. That's not unfortunate. the next administration can come in and change it. What you're hoping to get, which is a behavior change, because you promised to everybody that the government is going to behave a certain way forever. The government has a commitment problem. That's the first problem that you have. The second problem is you don't really want to tie your hands that way. Even if you were a dictator who knew you were going to have a thousand year reign running this country, you actually would like sometimes they use the flexibility that you have as the dictator because sometimes you say, oh my God, if we don't intervene, the world will collapse.

44:27And you'd like to be able to do that. That makes it harder for you to make that commitment in advance because everybody knows about that. This debate is a pointless debate. Governments do. They always intervene, whether they are conservative governments, liberal governments. Conservative governments sometimes don't do it for a little while. They hold off a little longer. But just as they say, there are no atheists and foxholes. There are no market fundamentalists in government when a crisis gets really bad, because when it does, you will either as the government try to help or you'll get thrown at odds.

45:02And that's what history tells us for someone who will. The closest we came to the United States was Herbert Hoover in 1932, whose entire government thought that we should stay out of stuff and he was resoundingly thrown out of office. But by the end of his term, he was willing to intervene. Even Hoover was surrounded by market fundamentalists. It's just really, really difficult piece of political economy. That leads to a fundamental proposition that guides a lot of our research at the Yale program on financial stability, which is, it's silly to think that we can prevent all crises because if you prevent them long enough, as you said earlier, people will get complacent enough that they will happen.

45:43So that's proposition one, assumption one, axiom one. The second is, if you think that the best way to handle a crisis will be to commit to never doing anything, you're crazy. Because you can't make such a commitment. You're actually unable to make it in a credible way. And when push comes to shove, you're either going to intervene in some form or you're going to get thrown out of office. So with those two things, we conclude crises will happen and governments will intervene. And thus, we should figure out the right way to do it. We shouldn't be afraid to have the conversation, which says, when someone shows up in the emergency room, we're going to treat them.

46:18That's what it's going to be. So we're not going to get people to stop smoking by saying, if you come into the emergency room coughing, we're going to refuse to treat you if you're a smoker. A polite society can't get away with that. So we might as well figure out the best way to do it. That's what we study here at the Yale Program on Financial Stability. And that's what I think does not get enough attention from the official sector. Because in the official sector, it's a little bit of don't mention the war. If the Federal Reserve starts talking about how they're planning of what to do in the next crisis, then everybody gets in trouble.

46:52And they feel like, oh, they're just gonna make things worse. So they don't wanna do it. Official sector can't really do it. So that's a place for the unofficial sector. to come in and try to be helpful. So I guess one way to think about it is you have the two extremes. You have, we'll backstop everything and we will backstop nothing. And somewhere in the middle is probably the right balance where you allow for some efficiency to occur and you don't overstep. And there's probably a pendulum that swings between the extremes based on the outcomes and occurrences that happen through time. That's absolutely right.

47:29And it was very important to point out that until the global financial crisis, there were people who would say the right thing to do in a crisis is just backstop everything. And then people will stop panicking and we'll go back to normal. That was based on a misunderstanding of this liquidity or solvency issue. And we got an example of a country, a rich country trying that and failing. So let me just tell that for a moment because it's an important endpoint. When the financial crisis hit in 2008, Ireland was swept up in it. Ireland at this time was a very healthy economy, running a primary budget surplus, very healthy government as well.

48:16And their view was, this has nothing to do with Ireland. Our banks are fine. This is just people panicking. This is just about liquidity and people running on banks. If we just tell everyone to calm down, we won't have to do anything at all. And they came out and effectively guaranteed all the liabilities of their largest bank. It turned out a year later, Ireland had its own solvency crisis. Because even though they were a wealthy country whose economy was doing well and was running budget surpluses, it was too much for them to take on the liabilities of the whole banking system. That is a warning that that extreme doesn't work.

48:58It's also a warning for anybody who thinks we can have a narrow banking system where the government liabilities are providing the sole backstop for everything that people consider to be deposited. Even wealthy countries can find that this exceeds their ability to remain solid. And I suppose that can happen to the world's reserve currency as well, the U.S. dollar and the U.S. government. We're playing with fire if we assume that it cannot. We do have enormous benefits in the dollar-based system that enable us to go much further down this curve than even a rich country like Ireland. But eventually, that runs out too.

49:43We can reach a point where certainly we can't have 100 quadrillion of debt. At some point, it's going to run out, and we don't know exactly where that line is. That's why people so carefully watch bond markets. The key point of what you just said is there is a line. You can't pretend there isn't, and it's a reflexive system. So we know there's a line, and it's way down there, and we're not going to stay too far back. We're going to figure out where that line is. Well, it seems like we're on the path to figuring out where it is. But we don't know exactly. But we do know that the markets started to cough up U.S.

50:22debt not that long ago, maybe for the first time. The other times we've had problems in treasury markets, they were really plumbing issues more than anything else. They weren't really about the full faith and credit of the U.S. government. This time seems different. You were talking about Silicon Valley Bank. The other big issue there is related to the asset and liability mismatch. They take on deposits, they pay very little, and then all of a sudden interest rates went up a lot and they have these long-term investments. So would you talk about that connection and what caused that problem? That is banking.

50:57What's remarkable about this, a lot of commentary around the Times-Fillic and Valley Bank was almost as though some parts of the journalism profession had discovered the fact that banks have short-term borrowing and long-term lending and thought, well, this is crazy, but that's banking. And as it happens, the deposit franchise of banks, the business of, I lend you money at as low a rate as I can afford to lend you money, the lowest rate you're willing to accept, turns out that that side of the business tends to do really well when interest rates go up. So leave aside the issue about solvency or viability of Silicon Valley Bank.

51:43Think just about them as a well-capitalized bank with a mismatched assets and liabilities, as you said. If you had asked them beforehand, and people do ask them, because banks take this very seriously, to say, what will happen if interest rates go up? Shouldn't you be better hedged. Most banks will tell you we are really well hedged already. We are hedged by our deposit franchise. Because what typically happens is interest rates go up by a bunch, but we do not have to raise our deposit rates by nearly as much. So if you were creating something, call it the goodwill of your deposit customer base.

52:27The value of that goodwill would go up when interest rates go up. When interest rates are zero, if a bank is paying me zero, it's not worth that much to them. When interest rates are 4%, if the bank is paying me 1%, that's a wonderful business for the banks to be in. Historically, the deposit side of the business has been a remarkable hedge for the long-term investment asset side of the business, which is why when we observe something and think on its face, it looks crazy to borrow short and lend long, we're not taking into account the reality, the effective duration of deposits, which banks track very carefully.

53:11So a bank would correctly say to its supervisor, if the supervisor said, why don't you go out and hedge and get a whole lot of interest rate swaps to protect yourself, the bank would say, we'd be over hedging. Our deposit franchise is a natural hedge. Absent people concerned about the viability or solvency of a bank, that is true. Let's do the tale of two different banking systems. In Europe, the bank regulations and the supervisors enforcing those regulations take very seriously the the straight calculation level of interest rate risk on the asset side of the balance sheet of banks and insist that it be hedged.

53:58They say to banks, we won't let you have this level of mismatch. And thus, note that in 2023, they did not have as much mismatch. When interest rates went up by a lot, their banks did not have as much failure. There was a famous case of Credit Swiss, but that's somehow embedded in a different story. That wasn't about the interest rates. The Europeans in the regulatory side look at what we do in the United States and think that we're nuts to not force that on banks. And our regulators do not. We have taken a different approach in the United States. We've decided interest rate risk exists somewhere in the economy.

54:40Somebody is hanging on to these assets or has liabilities that have floating rate interest and has to absorb the risk of interest rates changing. In the United States, we have effectively decided that risk will sit on the balance sheets of banks and we will watch it very carefully. When interest rates go up by a lot, our banking system has some trouble and we get some bank failures. Note, however, what happens in Europe. If you don't let banks have this risk, you have much more of the borrowing done on a floating rate basis. Therefore, the interest rate risk is sitting with the borrowers. Instead of enjoying a natural hedge that comes through the banking system, it's sitting with the businesses and the people who have floating rate loans with the banks.

55:28That's going to affect the real economy and spending instead of bank balance sheets. You're just shifting the risk to another part of the economy. You're just shifting the risk. And note that while we had banking troubles, we did not have a recession. Europe has had very slow growth since the interest rates have gone up. There's not a free lunch here. I don't think that we really had the conversation about it explicitly using these terms until after Silicon Valley Bank, where there's been a lot of research, a lot of discussion around it in this way. But given that deposits are like a natural solvent here.

56:04Why not use them as a way to cushion some of this instead of forcing it all onto the backs of consumer loans and business loans? It's not obvious to me that an elevated risk of a financial crisis is too big a price to pay for cushioning the business cycle in that way. That's a place where I think we're not necessarily having the conversation the right way in all places. and I still can't convince my European friend. Because you need to have a holistic picture of the entire system because it's easy to focus on the headline of the day and say, oh, there's a problem here, not recognizing that it's a capitalist system.

56:44And if you constrain it in one area, it's like a balloon. You push it on one end, it'll blow up on the other end. And so it's a matter of just where do we take risk most efficiently? And there will be issues occasionally and what's the way we minimize that and maximize efficiency. And that is exactly right. What capitalism does and what the financial system does inside of capitalism is while it's moving savings into investment, it is distributing the risk to the people who are most willing to bear it. Why does it go to them? Because who's willing to accept the lowest return on any kind of risk?

57:17Whoever's most willing to bear it. But it is the case overall that imagine the simple world where all we are as farmers and all we consume is food and weather, global weather patterns change the amount of food that we can grow every year. And in years where we don't grow as much, we'd call that a recession. And flat out, someone needs to eat less in those years. They simply need to. There's not as much food to go around. So what happens? Who will take that risk? Well, probably the people who own the biggest farms, the Warren Buffetts of that world, will say, all right, I already have a lot of food.

57:52I'll have a little less food in those years and I'll absorb that risk. But it has to sit somewhere. And it would be a mistake if we looked out at the world and said, well, look, these people in this year where there was a drought and there's less food, they're going hungry. Well, someone's got to go hungry. We're hungrier. So you'd be worried if in that year and there was a drought, it was the very poorest people who were going hungry and were starving to death. That would indicate a system that had distributed its risk poorly. But has a system distributed its risk poorly? If really, really wealthy investors lose money when the world loses money, that might be an efficient place for that risk to be.

58:30You're just observing that the drought happened. And so the really rich people ate a little less. But until we can eliminate all business cycles, it will be the case that sometimes somebody needs to consume less in bad times. And so in the United States, we've kind of shifted that risk in a certain place. Seems to me Silicon Valley Bank failing and having a blow up that the government is able to control is maybe better than having the entire economy grow half a percentage point slower. Let's transition to the global financial crisis. What caused that and how did its complexity, its global reach, and even the government response to it compare to prior crises like the Great Depression, the SNL crisis, or other international events?

59:14I know that's a big question. The global financial crisis at a very deep level was at least rhyming in its similarity to all other financial crises that we've had in the past. Unfortunately, the explanations that are most satisfying for why the crisis happened are very incomplete and unsatisfying intellectually and holistically, while satisfying emotionally. What do I mean by satisfying? One satisfying explanation is the type that you get, say, from the movie Inside Job, which is kind of like a vast conspiracy. Bankers knew they could just take lots of risk and make a lot of money and then in the end rely on their cronies in government to bail them out.

1:00:02And the only people who would get hurt are homeowners and things like that. It's just the great greed of the system. So that's a satisfying explanation if you're of a certain political persuasion. If you're of exact opposite political persuasion, the satisfying explanation is, well, this was just dumb government policy. but started with the government being dumb and encouraging people to be homeowners who should never own homes and subsidizing that. And then it added to its dumbness when the government came in and rescued the people who caused the problems, thus giving everyone the idea that they should always want to be rescued.

1:00:38This is sort of government malfeasance. That's satisfying if you think government is the problem. They're unsatisfying overall because at best they can explain only a part of what happened. And they also don't help us to understand why crises happen in general. So for example, if you think that this was caused by inside job and greed and stuff like that, well, greed always exists. That's not going to go away. We can't legislate around it. And certainly greed existed in the 1990s. Why didn't we have a financial crisis then? It existed in the 1980s. We didn't have anything like the GFC then. We always have greed.

1:01:14We always have that. And that's always there. Why did it blow up at this particular time is a harder thing than to answer in that world. And then in terms of the government, this crisis happened all around the world. Governments did all kinds of different things in the lead up and during the crisis. So it tends to be a very American angle on things to see a global event and give American specific explanation for it. really to come to grips with the global financial crisis or any other. All those events that people on both the left and the right talk about, they all existed and none of them helped to make things better.

1:01:51But ultimately, it's the very unsatisfying macro forces that were the biggest drivers. The macro forces that were extant at the time really track back to the 1990s. If you remember, you seem younger than me, Alex, so maybe you don't. But in the 1990s, we had the peace dividend and we were actually running, it's hard to believe when you tell it to young people, budget surpluses in the United States. And we were having conversations, believe it or not, what will we do to anchor interest rates when the United States government has retired its debt? What are we going to do? We're actually in a world where the amount of government debt outstanding, which we talked about earlier as maybe being the base for the whole banking system in some cases, banks could just invest in that, that it's a very, very safe way to underlie the collateral system.

1:02:49There was much less of it relative to the demand. And at the same time that was happening, there was a global demand for that stuff that was getting very large from countries like China and the oil producing countries. What Ben Bernanke called in his pre-Fed share days, the global savings glut. The global savings glut collided with there not being as much supply, natural supply of US government securities, and gave an enormous incentive to the private sector to manufacture substitutes for government securities, to find a way to package and to repackage different forms of collateral to give people things that could be used as a substitute for government funds.

1:03:35And that's what they did. There's no better business in the world than you will give me money and I give you virtually nothing in return. If what I'm giving you is the ability to transact and the convenience of something that looks like money, then I can give it to you and pay a very low interest rate. And a lot of the things that were manufactured through the system, they weren't manufactured because bankers suddenly got greedy. We're all greedy all the time. But the opportunity to put that greed to work was because of these enormous macro forces that aren't usually there. You can throw some people in jail.

1:04:10You can make certain things against the law. When somebody can make that many basis points on that many trillions of dollars, it's going to happen somewhere in the financial system. So we ended up with a banking system that wasn't inside the regulated banks. Effectively, we disintermediated a lot of what banks had previously done into a whole chain of acronyms and interventions that at one end was taking savings and at the other end was throwing out investment. But nowhere along the chain was anything that looked exactly like a traditional bank. But like traditional banks, they're subject to runs and they're subject to solvency, viability concerns.

1:04:54And when those popped, the panic was a very inefficient way to discipline that system. I have a whole course where I teach this. And when the course is over, to demonstrate how effectively I teach it, a lot of my students say, can you sum this up really in a couple of paragraphs? And unfortunately, it's hard because it's not nearly as satisfying or as theatrical as what you can do in the big short or inside job documentary. And a lot, I think, of the hardest problems to solve in the world are complicated that way. As humans, we really prefer narratives where there's people to blame and not systems.

1:05:36I give a quick analogy here, which is if you have a massive tidal wave that hits a city, a lot of buildings will collapse. If you go and look in those buildings afterwards, the buildings that collapsed probably were not as well constructed as the buildings that didn't collapse. Does that mean if we had all higher standards, super high standards, no buildings would have collapsed? No, I don't think so. Basically, it was the tidal waves fault. There were going to be buildings that collapsed. We're going to find problems. If you think about the fires that we had near your home last year, you can blame the fire department.

1:06:19You can blame all sorts of things. But if you look at a map, there were a bunch of fires that happened at the same time. So any kind of local explanation, while maybe true that in this particular place we didn't inspect, the real problem is the conditions are really susceptible. Ultimately, there's some form of globalized problem that underlies all of this. And when you see it pop up in 10 different places at once, localized explanations really should be less satisfying and it's going to be something more systematic. I think the GFC was like that. I think most financial crises are. But it's pretty hard to compete with a movie like The Big Short, which does this much more entertaining way than I can ever do.

1:07:08to figure out how to accurately fight these things and to keep the world from spinning into Great Depression 3.0, I think will remain an uphill battle as long as the most comforting narratives out there reinforce people's political beliefs and give them someone to blame. How do you think about this concept of collateral damage in terms of government stepping in? So you have Silicon Valley Bank fail. If it didn't do anything, then you could have this contagion to innocent banks that were acting responsibly and you kind of go far beyond its normal scope. How do you think about that tension? You're absolutely right.

1:07:49And that's the general argument that governments are talking about. When these things are happening, we know that contagion can be quite a rational response. It doesn't mean people are behaving irrationally. If you observe that Silicon Valley Bank failed and their uninsured depositors didn't get helped, you're an uninsured depositor at another bank, your threshold for being concerned has moved much higher. The threshold higher meaning you need to see a much safer bank before you're concerned and before you run. And as I discussed earlier, runs are really destructive, inefficient ways to discipline management.

1:08:29That's what the government worries about. We're just going to create a wave of destruction the same way if I'm bad in my house about not worrying about fires and I set a fire and my house is close to other houses, then those people who maybe were really careful, their houses catch fire. That seems like a bad thing. You can get much the same thing happening through a lot of the same analogous dynamics, which is it's a bank that is similar in the businesses that it's investing in. And so people get worried about it, even maybe if they've had higher standards. So the government needs to avoid that.

1:09:03And that's usually the motivation for stepping in. The concern about stepping in is it will create moral hazard for future crises. As I stated earlier, though, that shouldn't be the end of the story. The discussion will go, well, we should intervene. And someone will say, well, won't that create moral hazard? And somehow that shuts down the argument and the debate about whether we should intervene. Yes, of course it will create some moral hazard. But how much? And how does it compare to what you call correctly the collateral debt? Curious what you think would have happened if the government didn't step in at the depths of the global financial crisis.

1:09:38At some level, this is very much a hypothetical because if they didn't step in when they did, they would have been forced to step in a little while later. We can run, though, in our minds, what if we had dictators all around the world and the dictators absolutely believed and could not be thrown out of power that the government should never intervene? In that world, it would have been Depression 2.0 for certain. The contagion would have spread all throughout the financial system. A lot of destruction of the financial system would have occurred. And the effects of that can last for decades. A lot of collateral damage.

1:10:21A lot of collateral damage. There already was. It was very, very slow recovery. There's very strong evidence that a lot of researchers, I'm a consumer, not a producer of this research, but a lot of excellent researchers have produced work showing the devastating long-term impacts on the real economy of financial crises. Not just on the real economy, but on trust in society and fracturing of the political system. It is not just a coincidence that the worst war in our history books from a global perspective occurred after the worst economic crisis directly after. That is almost certainly not a coincidence.

1:11:05And again, there is evidence that doesn't even include that particular event that shows that relationship. I don't think that the government would have never intervened. For example, the Bush administration, we had not yet had an election in the United States in 2008 when it happened. It was before the election that the Bush administration made a decision to intervene, a correct decision. I am sure that had they not made that decision, things would have gotten worse and for sure Barack Obama would have been elected. And for sure, when Barack Obama came in, he would have done something different.

1:11:41That's generally the dynamic that happens. And if the crisis had happened in 2006 and the Bush administration had refused to do anything for two years, they absolutely would have been voted out in 2008. And the next group that came in would have done something. So that's kind of the way history has taught us it works. So I don't think the hypothetical of never doing anything is a feasible one, a sustainable one. It does mean that we get caught up in this conversation about how can we never do this again? Let's refuse to ever intervene again, which I think is just not realistic. The other conversation that surfaces when you go through experiences like that is what are the long-term consequences of the GFC bailouts?

1:12:25Did they improve stability or did they just simply postpone problems? What are your views? Let's go back to the fire analogy. If I explain it just with the GFC crisis, you'll go, well, it doesn't really, I don't know, it could go either way. Let's just do it with fires and see what you think. So say we got a whole lot of houses and the houses are really close to each other. One house catches fire. Now we say, look, this person should have been more careful. We're not going to help them because if we help them, then people aren't going to be careful in the future. And someone says, but other people's houses will catch fire.

1:12:56You say, well, you know what? Those people, these were their neighbors. They should have told them to be more careful. And now that'll make neighbors tell them to be more careful. And the whole neighborhood burns down. And we've taught that lesson. In a world where every fire was due to someone's negligence, we might lower the probability of fires by a lot. In a world where some fires are happening outside of the control of individual people, for lightning strikes a house, whatever, in that world, those fires will still happen and entire neighborhoods will burn down when they don't have to. We put out the fire.

1:13:32Now people go, okay, the government comes and put out fire so we can be a little less careful. That is absolutely true. They're a little less careful. Quantitatively, how many extra fires do you think that will cause? Percentage-wise. Do you think that if we made everyone super responsible, we would cut all fires down to zero? Because then I would say, let's do it. But even if you cut half the fires, if half the time, suppose I would get one fire a year if everyone's being super careful and two fires a year if people are not being careful. Then in a world where I don't intervene, every year the whole neighborhood burns.

1:14:11And in a world where I do intervene, we get mad at people for being sloppy and the neighborhood never burns down. I want to live in that second world, even though there's moral hazard. I think it is correct to say that if you are a banker, you think that if things get really, really awful and the economy is about to collapse and you are at an innocent bank, you'll get bailed out. By the way, the non-innocent banks, go ask the people at Lehman Brothers how nicely their stock in Lehman Brothers did. Equity oftentimes does not get bailed out. But again, when it comes to debt holders, in some form, right away, the belief was that they were just going to get pennies on the dollar, which is part of the reason that the crisis spread in the first place.

1:14:54They ended up doing a lot better than that. But some bondholders end up getting bailed out. Those are usually the ones at the very top of the capital structure. And they just make for very bad money. But again, I am willing to stipulate absolutely it makes people take more risk than they otherwise would. But the quantity of this matters. If the house fires went from a thousand a year when people weren't being careful down to one a year when they were, it still might be worth it to put out the fires. if the consequences of not putting them out or the whole neighborhood burns down. And it just means I have to pay for a fire department and we have to go and put out fires and people get injured in those fires.

1:15:36And it's not great, but it's probably still better than the alternative. So we need to have a better sense of those magnitudes. I don't pretend to know exactly what they are, but I do think that the consequences of not putting out the fire are massive. You can imagine two worlds, one with policy A and one with policy B. And you look at those two worlds and say, which one is better. And then there's obviously a lot of degrees in between. That's exactly right. And unfortunately, my grant application to run a parallel universe and test these things has not yet been accepted. But like many economists, I really wish they would give me that opportunity.

1:16:11So based on your study of historical crises, is your sense that financial crises are generally foreseeable in terms of their likelihood, even if their exact timing cannot be predicted? History has taught us that there are certain types of things that look like crises. It appears in history you can grow out of. So for example, Reinhardt and Rogoff, there's these famous authors around this who looked at the great history of these things, said you can graduate from having sovereign debt crises. At least up to now, you can find countries that go a century or two without having a sovereign debt crisis.

1:16:49And it looks like they're not going to have them. For a variety of dynamical reasons, that can happen. You do not see evidence of countries that graduate from banking crisis. Part of the reason for that is you become a financial center in the world because people think you are the most trustworthy place. What happens is you become safe, you become trustworthy, people throw more and more trust into you, you run a bigger and bigger financial system. That's where we put the risk of the world. So when the drought happens, that part of the world then has to eat less. I think that dynamic is always there.

1:17:24Money centers are places where the crises are most intense. And that's because that is probably the natural place to put the risk. What are the biggest risks in today's financial system? By far, the biggest risk that we have right now is to the sustainability of the fiscal path in the United States. and thus the role of treasury securities and the dollar at the core of the global financial system. That's a major, major first order concern that dwarfs anything else. And I want to say that this is something people should be concerned about no matter what their politics are, no matter who they voted for.

1:18:03Both political parties in the United States have plenty of blame for the situation that we are in now. There has not been a party of fiscal responsibility in the United States for a really long time. Party that said they were a fiscal responsibility wasn't. And a party that denied that fiscal responsibility was necessary has gotten even more aggressive at it. Neither the Democrats nor the Republicans have covered themselves in glory. And there is not one president or one administration that one can pin the blame on for this place that we're in now. But it does appear since the United States became the global financial center.

1:18:42Bond markets for the first time showed reticence to hold as much US government debt under the fiscal path that we had set out. They showed their first time reticence for that. And I've got to think that part of what happened in the spring would have led, and this is something, Alex, that you would have better insight into than I would have. And I always ask investors, I asked our friend Andrew Houtman, and his colleagues this question. But don't you think that investment committees around the world in April and May would have had conversations along the lines of, we got 20 % of our portfolio in the United States government securities right now.

1:19:25Let's see if there's a way to move that down to 15%. We're not talking wholesale, massive, huge things. But that might've been the first time that conversation reached an investment committee, actual asset allocation level at a critical mass of places. And that's a meaningful step. And probably not the opposite. Maybe this is the time we should be increasing. Yes. I don't think people had that conversation in April and May. And again, there were very specific things that happened in April, but there's a long history of this in the United States. It's not as though one president, one administration made a decision and caused all of this.

1:20:07We have been building this house of cards for a long time, wondering at what point there would be instability noticed by markets. And it appears to have happened. We've been given that warning. The UK received that warning when they had their mini budget and their guilt crisis. We received it in a less extreme form, but we're a bigger place in April. The largest risk to the system is that the connection between markets and fiscal decisions that we make will be sufficiently strained. I think that what we've done so far, there's a part of it that's irreversible. That decision to go from 20 % to 15 % or whatever is not something that people will immediately say, all right, the problem's done.

1:20:52I think the U.S., no matter what we do in the next five years, I don't see people saying, I'm sure the U.S. will be fine for the next 50 years. There's nothing we can do to get back what maybe we had 30 years ago when people thought we might not have debt anymore, or I should say 25 years ago. I think that we've done some harm to that position of U.S. Treasuries and the dollar, some harm that's not coming back. The biggest risk is, will we do more? It sounds like we're getting closer to that line, and it seems that some underlying fragility has surfaced as we've had some policy uncertainty and bond market reactions.

1:21:28I agree. The markets have certainly sent a warning flare to us that has not been sent before in our time of hegemony of the global financial system. And we would be wise to heed that and to proceed with some caution in terms of what we're telling the world about our fiscal path and our seriousness as economic stewards of this privilege that we have in this dollar system. And again, this is a bipartisan issue. It's happening now under one administration, but it's not a new process. It is inherited from the last administration, which inherited from the last, which inherited from the one before that.

1:22:08So could a crisis worse than the GFC occur, or do you envision that as the worst case? A crisis where at its core is a loss of confidence in U.S. government securities is a conflagration beyond anything that we have experienced in the modern capitalist economy. It's beyond the Great Depression. There is not a currently available substitute to base the global financial system off, which is why those investment committees couldn't go from 20 percent holdings down to zero. But if suddenly there's real lack of confidence, the bond markets add a risk premium onto U.S. government securities that is large and permanent, there's not really a reaction to that.

1:22:57Government's ability to intervene in financial crises is totally predicated on their ability to manufacture safe assets to replace the unsafe ones circulating out in the system. You can't do that if you're the source of that problem. And in the past, there were wealthy countries that could help the less wealthy countries when it happened to them. There's nobody with the capacity to help the United States if that happens. And there's nobody with the capacity to step up and fill whatever vacuum is left if we're not playing that role. So that is the largest concern. And as I said, it dwarfs all the other stuff.

1:23:35It dwarfs crypto and cyber risk and any of the other private credit, any of the other stuff that is changing and could be a problem. But those are normal types of problems and slow growing sectors that aren't going to bring the whole global financial system down with them. But the base of that system is the dollar and U.S. treasuries. And it's reasonable for people to be worrying about that. If you could redesign the financial system from scratch, is there anything major that you would change? Nobody designs the financial system. So you can do your best on regulating what exists. but the incentive system to do finance and the functions of finance way dwarfs the power of any government and has lasted longer and been around longer than governments.

1:24:28So I don't think there's anything that you can design. You can do your best to regulate. You don't have infinite power. You can move risk around much more than you can lower it or increase it. The main thing that I would do is I would try to focus my regulatory attention on things that have similar functions, getting some form of congruent regulation to them. So if you're in the business of manufacturing money and safe asset creation, I shouldn't really care whether you call yourself a bank or an insurance company or a hedge fund or a CDO. I should try to figure out a way to get the regulatory system to treat you not identically, but with the notion that you're in the same business.

1:25:16That would help, I think, give us a more flexible way to deal with the types of regulatory arbitrage that move risk around always into the places where we're at least able to see it and to deal with it. Well, Andrew, this has been a fascinating conversation. I felt like I just sat through one of your courses. So I appreciate you taking the time and educating us and sharing your insights. Really appreciate it. Well, my apologies for that, Alex, but it's been my pleasure. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast.

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