0:33 Intro. [Recording date: February 5, 2014.] Russ: Welcome to this special edition of EconTalk, recorded in front of a live audience here at the Hoover Institution's Washington office.... Their book is Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, which is our topic for today's episode.... I want to start with the fundamental claim of the book: you reject the idea that bank crises or bad luck or a perfect storm of random events. Rather, you argue that banking crises and systems are fragile by design. Steve, what do you mean by that claim and what's the justification for it? GuestH: So the basic idea of the book is that banking systems are fragile by design because it is impossible to take politics out of bank regulation. And it's impossible to do so because there are inherent conflicts of interest between government and banking systems such that banks need governments and governments need banks. Those conflicts of interest basically boil down to three features. First, governments simultaneously regulate banks and borrow from banks. Second, governments simultaneously use their police power in order to enforce debt contracts on behalf of banks; but people who are being, let's say, forced out of their houses because they've defaulted on a mortgage are voters, and so when banking crises occur governments often have reasons to not enforce those debt contracts. Third, governments are in charge of liquidating failed banks. But the biggest group of creditors to a bank when a bank is liquidated are its depositors--who are voters. And so governments have incentives to change the rules of government deposit insurance for political ends--so often extend deposit insurance beyond its statutory limits. Because of those three basic inherent conflicts of interest, it's extremely difficult to remove politics from banking. Governments have, or parties inside the government have inherent reasons for wanting to use the banking system for their own ends, and at the same time, bankers need the government in order to do things like enforce debt contracts. There's no getting politics out. Russ: And financing wars--the book is a remarkable history of banking and the banking industry in 5 different countries and a credible work of scholarship and history combined with the political economy that we're talking about. Now, Charles, I want to talk about the game of bank bargains, which is a central concept in the book. Tell us what that is and how do you apply it? GuestC: The 'game of bank bargains', a phrase that we invented to describe the fact that the outcome of the rules of the game of banking reflects political alliances that are formed, between always involving the parties that are in charge of the government, and some other parties that ally together and form an alliance with the government to determine the rules of the game. The point is that in the game of bank bargains there is going to be a group of people who are in charge. And there are going to be a group of people often who are left out. And it won't be a big surprise to you that the people who are in charge will use their power in this game to take advantage of the people who are left out. Russ: Of course, they are not a monolithic group. They are fighting among themselves for their share. GuestC: In fact the key, and this is one insight that I think is important in the book--it is a little different from the way some political scientists think about some political struggles, where they tend to think it's struggles between political parties. One of the points that we make in the book is that the coalitions that have evolved, let's say in the U.S. history, to design the rules of the game of banking have often been bi-partisan. In fact, they purposely have structured themselves to be fairly immune to electoral partisan outcomes. And so it's just as you would expect. If you wanted to have a long-lived and valuable coalition, you would want it to be fairly robust to electoral outcomes. And so sometimes you get a very unlikely partnership, people who ideologically or culturally, sociologically, don't really see eye-to-eye at all, but find a convenience in being allies in a particular arrangement. Russ: Yeah. The way I think of it is: The Democrats and the Republicans are the same; they both like to give money to their friends. They just have different friends. But they have one friend in common, which is the financial sector. And they both tend to scratch that sector's back and get scratched back in return. Which is another way of-- GuestC: I agree with you, but I would go even farther to say that sometimes they might pretend to have different friends more than they really do. Russ: You want to give us an example? GuestC: Well, you know, we're going to I'm sure talk about the current U.S. crisis eventually. But one of the things I think is really interesting is that one of the contributors to the crisis was mortgage-subsidization policies in the United States. Russ: Encouragement to home ownership in all kinds of dimensions. GuestC: But encouraging home ownership precisely in a particular way, by creating subsidies for taking risk in a mortgage market. You can encourage home ownership in a lot of ways. Russ: Correct. GuestC: What's interesting is when we look at the last, let's say, 15 years or so of that policy, what we see is George H. W. Bush, followed by Bill Clinton, followed by George W. Bush, followed by Barack Obama. And even though you might think of it as people very different ideologically, they actually were part of a continuous thread of very similar kinds of policies from the standpoint of some of the issues that we're talking about. I would add to that, that [?] the unlikely coalition members that sort of sit underneath these bi-partisan agreements. In the case of the United States we had activist groups allied to bankers that were in the process of creating mega-banks, through the 1990s merger movement [?]. To the point that at Federal Reserve Board hearings about mergers, activists would show up--for example, from ACORN (Association of Community Organizations for Reform Now) and testify on behalf of the Bank of America merging with NationsBank. This is not the usual role that you would imagine an activist group taking vis-a-vis a bank merger. So you get these very unlikely partnerships which precisely because they straddle partisan lines were extremely durable and made it very hard for any party to deviate from the agreement. Russ: It's an interesting coalition because as you point out, there are a lot of voters in the discussion. Those are the homeowners, who are clearly a lot of those. But in general in democracies, large groups don't get treated particularly well. So I see it is--my somewhat cynical, perhaps realistic take, is that they were a vehicle to give cover to giving money to these much smaller and politically powerful groups--the realtors, the home-builders, and the banks who financed them through the political incentives that were inherent in the system. GuestC: Well, they got everybody who was part of that winning coalition in the game of bank bargains did quite well, thank you. So the total amount of subsidized credit that was contractually agreed as a quid pro quo for those activist groups to show up at the merger hearings, which is an understatement of the amount they actually received, was almost $870 billion over the period 1992-2007. So that's not chump change. Russ: We've gotten into the weeds here a little bit and I think we ought to do a little bit of clarifying. You are talking about the Community Reinvestment Act, which--I'm going to push back a little bit when we get to it in more detail, but we should just mention here that a lot of people who blame the Community Reinvestment Act for playing a role in the 2008 financial crisis get challenged by saying: Well, but that law was passed in 1977. But the teeth of the law really only took place in the early 1990s when it became the determinant of whether a bank could merge or not. And that's when it started to have an impact. How big that impact is, we'll talk about. But I just wanted to get that straight.

10:11 Russ: Let's go back in the history a little bit. And we'll start with the United States. I wish we had a 5 or 6 hour podcast; I know the audience do, too; but we don't. And I know you'd all like to stay for that. But we are going to not be able to cover all the aspects of the book. But let's start with the United States and going back into the history of the United States. You talk about the 19th century as a particular era of banking in the United States. Steve, tell us why the United States was so prone to crises. A lot of people, when they look back at the 19th century, they see it was bank run after crisis after failure. Why was the United States so unstable in that era. GuestH: So first let me say I'm appalled and shocked that we don't have 5 hours. I'd been counting on it. Second, to answer your more specific question, the United States in the 19th century has a banking structure unlike any other country on the planet. It has thousands of banks-- Russ: Thousands? GuestH: Thousands of banks. Russ: Tens of thousands, right? GuestH: By the early 20th century, tens of thousands. Which are, in most states, unable to open branches. So every bank--every bank which you would think of as a branch is a bank unto itself. That means that in the event of a bank run it's very hard to move funds from one branch to another because there aren't branches. It means you can't spread risk across regions--that you are tied to the local economy. And it meant that banks couldn't capture scale economies in administration, so the banks are very inefficient. Russ: All those things seem pretty obvious. Right? That they were inefficient, they are stuck with the local economy. Why-- GuestH: So, there's a political deal that's underneath this. And essentially, just like we were talking about the coalition between populists and bankers and mega-bankers in the 1990s and early 2000s, there's a coalition between small bankers and farmers in the 19th century. And what their concern is, is to get credit to small farmers. And small farmers are also opposed to big city people--that is, big city aristocrats. Especially bankers. And so you get an alliance of small bankers and farmers against big bankers. Most particularly and famously is the unraveling of the Bank of the United States--first in 1911, and then it gets re-founded because Central Government realizes that it needs a bank to prosecute wars. And then it gets unraveled again during the Jacksonian period--the Second Bank of the United States. And so, in order to make sure then that banks would not have to face competition in their markets, [?] years of bank regulation in most states, what happened in most states is they made it illegal for a foreign bank to branch into your state. Meaning a bank from Rhode Island couldn't branch into Massachusetts. They also made it illegal for a bank to open a branch. And so most states had laws, except themselves[?], that precluded branch banking. The point we make in the book, the takeaway is--I'm sure someone could write down an economic model in which this made sense. You can write down lots of models. That was a joke. But this is clearly a political arrangement. There is no efficiency or stability criterion by which you would do this. It did however work quite well for local unit bankers because they had captive local markets. Essentially they had local monopolies. And it worked well for relatively prosperous farmers in a particular community because they knew that that bank had to lend to them and nobody else, because the cost of gathering information at a distance in the 19th century--even up until the 1990s, most bank lending in the United States is local. Really until the computer revolution. So that created this sort of cozy arrangement, good for the local farmers, good for, in the North and in the Mid-west, good for unit bankers. Bad for anybody else who wanted access to credit, and bad for the system as a whole. Because about every decade there is a banking crisis. Russ: So it's hard to remember, in the world that we live in where agriculture is 2% of employment in the United States. In 1900 it's about 40%. So it's an important sector. The people who are the more important decision-makers in that sector are going to be politically powerful in their region. But as we go forward from the 19th century, really continually through the 20th century and starting at the end of the 19th, agriculture becomes less and less important as an economic factor. Why didn't that coalition unravel sooner? We have branch banking--came around I think 1970 or so. So Charles--it's a nice story, ex post, right? It's easy to tell a story after the fact. Why did it unravel and why did it not unravel sooner? GuestC: Well, I think first I want to emphasize how striking it is that it lasted for about 150 years. So, many things--there were lots of shocking things going on in the United States. The Civil War. Two World Wars. A Great Depression. A lot of banking crises during the late 19th and the early 20th century. Even the Savings and Loan Crisis in the 1980s, which finally contributed toward it's demise. But what's interesting is that over 150 years of turmoil and inefficiency, it persisted. Now part of the story is Federalism in the United States, because, starting from the very beginning, the states have authority over deciding what the rules of the game of engagement for banking were going to be within their states; and also they had the authority to restrict out-of-state banks from participating. So that meant that if you were in, let's say, Kansas or Illinois or many other such states, if the agricultural interests there wanted to maintain unit banking, they just had to win the battle at the state level. And so it was a lot easier for those agricultural interests to win the battle at the 50 state levels than it would have been if they had had to fight that battle on a centralized basis. And we make that argument sort of at length in the book, why that is, and contrast in particular one of the things that explains why the United States had such a hard time getting a nationwide branch banking system going was the decision-making about the law was at the level of the individual banks. So then, in the 1860s, we create the National Banking System. It sounds like something if Federal Government is going to do this, could have been a nationwide banking system, like the Second Bank of the United States were. But what happens is the culture[?] of the currency and Congress probably would have not let the Comptroller decide differently. If the Comptroller decided that national banks had to be unit banks-- Russ: A unit bank, meaning one building, basically. GuestC: Right. So national banks were the National Bank Out In The Middle of Nowhere. And that was it. Russ: What was national about it? GuestC: The charters were the same. They were operating under the same rules, under the same chartering authority, under the same supervisory authority. But they were cheese and chalk in terms of the business that they did because one is in a city, one is in the country. And they had, as Steve pointed out earlier, very particular risks, too. They couldn't diversify across regions. So the United States was--as everyone understood and was practically making fun of us. Canada especially, 'look at the ridiculous banking system these people have.' But it persisted because it was actually pretty challenging to create a nationwide branch banking movement in an environment of political decision-making that was so fragmented.

18:31 Russ: So, one of the reasons it doesn't unravel immediately, or earlier--and I'll let you take this, Steve--is the establishment of the Federal Reserve, which was--I think a lot of people think of the Fed, the Central Bank of the United States, as sort of the--well, bankers, they get greedy; people get greedy; they get out of control; they run amok; and then you need somebody to clean up the mess. Neglecting the fact that the mess was sort of baked in--I think you use that phrase--and the fact that there was this unit banking system. So the Fed politically was a way to mitigate some of the worst effects of this system and keep it going longer than it would have. Is that correct, Steve? GuestH: That is correct. What's interesting about the Fed is it has to be understood as a reaction to the Panic of 1907-1908, and there's a national monetary commission that is created to look into how to fix the banking system. One option they had--in fact they studied the banking system in other countries, including Mexico, which had branches of two of the largest banks who were allowed to branch nationwide. So they studied Canada, they studied Mexico, Germany. They were quite aware of what the other models were. And then they rejected all those models in favor of retaining unit banking, but propping it up by creating 12 Regional Fed Banks that could essentially lend to unit banks by increasing liquidity in times of crisis. Russ: Essentially a safety net for them. GuestH: Essentially a safety net for unit banking. And I'd point out: The same thing happens in the Great Depression, where I'm sure everybody remembers their high school textbook which talks about how the 'New Deal saved the banking system by creating deposit insurance and creating the Glass-Steagall Act. Russ: It's not in the textbook. GuestH: I helped my daughter study for the AP-United States history test. Russ: Did you do well on that exam, by the way? GuestH: I got a 4. Russ: I did not. When my daughter took the AP history exam, I panicked, because I thought, 'I'm getting a 2 here, and I'm going to hurt her chances.' I had a different perspective. GuestH: I usually did bad in English classes so if I helped my daughter write a paper for an English course she'd get a B-. So my daughter decided, 'My father doesn't know how to write.' Probably right. In any case, in the Great Depression, not only did my sort of forebears also get Bs in English, but the response was again to prop up the unit banking system. Russ: Realistically; history could have turned out very differently. They could have said this system is incredibly messed up. We had thousands of banks fail; we need a different system. And instead they said, let's choose this lever. GuestH: And in order to prevent the consolidation of banks, which is what would have happened in the absence of, for example deposit insurance and Regulation Q, which made it illegal to pay interest on checking accounts and kept interest to be paid on savings accounts. It's all done to discourage banks from competing with one another. Done to discourage people from moving their savings from one bank to another. And what I want to drive across here: again it was a, to come back to something Charlie said, there's the coalition of agrarian populists and unit bankers is what drives that decision. FDR (Franklin Delano Roosevelt) was against deposit insurance. Russ: When he was Governor of New York-- GuestH: And when he was running for President-- Russ: Explain why he was against it. It's very important to understand that. GuestH: Go ahead, Charlie. GuestC: When he was running for President in 1932 he said deposit insurance would make banks riskier because protected[?] banks would take excessive risks. Russ: He was onto something there. [?] GuestC: Well, of course. In insurance [?] we call that the moral hazard problem. When you insure someone against risk, they tend to take more risk. So he was--let Steve continue--he was definitely against it, as was the Federal Reserve, by the way. As was the Treasury Department. As was Carter Glass, who had been one of the architects of the Fed originally and was the architect of banking reform, some of the banking reforms, during the 1930s. But someone was in favor of it. GuestH: And so the someone is, Henry Steagall, who is a Congressman from Alabama and is chairing the House Banking Committee, and he is determined to protect the unit bankers. And he rams deposit insurance through at the last minute. And what's interesting about it is it's put in place as a temporary measure that was only supposed to affect very small deposits. And then a few years later it's logrolled and made far more expansive. Russ: Do we know anything about his personal life? Why was he a champion of unit banking? Why was he their friend? Do we know? GuestC: Well, there were some politicians going back--we'll call them the agrarian populist politicians. William Jennings Bryan, going back to the 19th century. Henry Steagall was--and Huey Long--were the politicians in the 1930s cut from that same cloth. Their constituents were--especially their most important supporters--landowners in environments that had small unit banks that were particularly shaky. So the thing, as Steve pointed out--if you have only small deposits protected that means you are going to have very big protection for small banks located in Alabama. But New York City banks--almost none of their deposits were protected. Because the protection was only on small deposits. So now you may be able to understand better why Henry Steagall liked Federal Deposit Insurance. Russ: He had a few friends, too. GuestC: But it was clearly a transferring mechanism from city banks to small country banks. So if you are an Alabama politician it looks pretty good. There were 150 attempts from 1884 until ultimately 1933 to bring the Federal deposit legislation forward, and they were all done by similar people under similar circumstances. They never got out of committee until finally in the 1930s.

25:00 Russ: So, why did this populist, agrarian coalition fall apart ultimately? GuestH: Well, there are a couple of pieces that I think we can bounce back and forth about this. One of them is it was inconsistent with technological changes that were occurring in the banking industry. You guys are too young--I remember the introduction of the first-- Russ: Which one of us? GuestH: No, the people out there in the audience. We're all the same--we all grew up in the days of disco. And you remember that the 1970s were famous both for disco and the invention of the networked ATM (Automated Teller Machine). So the networked ATM and the computer technology that goes with it allowed for two things. First, computer technology allowed bankers to assess borrowers at a distance. They weren't sealed into a local unit bank. But it also meant that banks could skirt the laws governing branching by simply opening up an ATM anywhere they could rent 6 square feet of space. Russ: A very small branch. GuestH: Yes. In fact, the unit banks took the big banks to court over this, claiming that the opening of a networked ATM violated the law. Those lawsuits went all the way to the Supreme Court, which finally in 1985 ruled that an ATM was not a branch bank. Second piece of this had to do with the fact that a system in which there are regulations governing the interest rates that banks can pay, Regulation Q--only works at a time when inflation is very low. And so, certainly in the 1950s and the early 1960s, the United States is characterized by very low inflation. Beginning in the later 1960s, especially through the 1970s, the government is starting to run big deficits to simultaneously prosecute the War on Poverty and the War in Vietnam. As inflation climbs up, interest rates paid on bank deposits become strongly negative; even Post-Modern English professors understand that under those circumstances, you should take your money out of a bank and move it into another vehicle. And so you see deposits leaving the banking system en masse, going into money market mutual funds and the like. Russ: Which put banks in great difficulty because they now didn't have the flow of funds they needed to pay off the promises they'd already made. GuestH: Right. This precipitates something that Charlie's written quite a lot about, which is the Savings and Loan Crisis of the 1980s, which is the death knell of the unit bank. We think of the S&L Crisis as being about Savings and Loans institutions, but it's also about lots of small banks which are heavily invested in real estate. And both the technological changes and the pressures that are put on banks by virtue of the fact that they are competing in a very difficult environment and now having to take big risks, precipitates--there's also a number of shocks--the S&L Crisis. And it's not until the resolution of the S&L Crisis that both state governments and the Federal government begins to seriously reconsider the wisdom of the unit banking system. Russ: [?] GuestC: It's interesting to compare and contrast the S&L Crisis's effect with the effect of the 1920s and 1930s which were also times when lots of banks were failing. And what's interesting is that I think if Henry Steagall and those people hadn't intervened, we'd already seen in the 1920s almost 20 states from 1920 until 1929 had relaxed their branch banking restrictions. And we saw exactly the same thing happening at the state level, from 1979 until the early 1990s. When banks get weakened and states start seeing a lot of banks failing, they start thinking, Well, maybe allowing a NationsBank to come in from another state might be worth doing. And then the FDIC (Federal Deposit Insurance Corporation) says, Well, that makes sense to us, too, because that could reduce our costs of having to support that failed bank. And so what's interesting is that didn't work in the 1920s and the 1930s. It got pushed back by Steagall. But in the 1980s and 1990s it did work. Part of the story is demographics--that there weren't as many people who were part of that agrarian coalition any more. Part of the story Steve mentioned is the ATMs and that Supreme Court decision. I think we can go into a lot of other elements. But one very important element was: the U.S. banks at this point, internationally, were getting globalization of finance beginning. And the U.S. banks are losing market share in the 1980s, not just outside the United States in international banking, but even within the United States. We're starting to see major entry. You may not remember this, that happened, but in the early 1980s, Japanese banks, German banks, British banks are entering the United States. It's starting to look like we're really going to become a bit player in the global drama of banking. And Alan Greenspan articulates this problem; and I think that many people are realizing that the United States, if it wants to continue being a global player [?] has to get serious about creating an efficient banking system. All these pieces are kind of coming together at the same time. And finally pushing us to a different outcome, which now of course is irreversible, because Federal law, in 1994 and branch banking, once it happens, you can't put the genie back in the bottle.

31:03 Russ: Let's move north and let's go to Canada. Tell us how different Canada's experience is from the United States. Charles, why don't you continue? What happened in Canada? GuestC: Well, first the most important thing to say about Canada is what didn't happen. Canada is a very boring place. Thank God. From a banking standpoint. Russ: First we slam the Post-Modern English professor who hardly knows how to invest unless we're in desperate straits, and now you are making fun of our-- GuestC: No, no, I'm not making fun. Sometimes boring is good. So, Canada never has a banking crisis. Russ: Ever. GuestC: Ever. In 1837 and 1839, some of the problems in the U.S. banking crises that were sweeping the whole country here created a couple of weeks of minor disruption in Canada. But no bank failures and no problems. So Canada has never had a banking crisis. This recent sub-prime turmoil didn't cause a crisis in Canada. The Great Depression didn't. The 1830s didn't. Russ: When you say it didn't cause a crisis--that's just that their banking industry weathered the Great Depression better than ours. They had virtually no failures? GuestC: No failures from any bank of any significance. And banks did fail. Small banks failed in Canada occasionally. Russ: Mismanagement. GuestC: Right. Another interesting thing is not only did they have no bank failures, but their total amount of credit relative to GDP (Gross Domestic Product) was either comparable to or better than the United States's during this history, despite the fact that they had lesser density of population and other things that might make you expect a very different outcome. So they had more abundant credit, more stable credit. And, by the way, analyses of how competitive the banking system is also show that it was more competitive. So it's really quite a remarkable difference. And I should mention also, probably-- Russ: [?] GuestC: Well, let me point something else out. Canada didn't even create a Central Bank, like a Federal Reserve System, until 1935. So it wasn't that it was a particular sort of wise central banking policy that explains it, either. They didn't have deposit insurance until much more recently than the United States. So it's really a story about a particular set of rules for engagement in Canada. Now, part of that, myself included, in the past people looked at this and said: Well, that's because Canada had nationwide branch banking; and of course that made it-- Russ: And hockey. GuestC: And hockey. But nationwide branch banking was much more efficient; much greater diversification of risk. All those things are true. But you know, as we've just learned in our own crisis, nationwide branch banking doesn't always give you stability. And so that's why we spend a lot of time in the book asking the question: What was it about Canada that made the political rules of the game in banking so successful? And when we dug deeply into that we found that there was a lot to be uncovered in the political history. Russ: [?] GuestC: I think that one of fundamental differences when you look at the basic Constitutional structure of Canada and the United States, is that the United States was founded as 13 independent colonies. Nobody imagines anything other than 13 sovereign states would be brought together in some kind of a union; and the debate in the 18th and 19th century is how strong the central government will be. In Canada, there is a basic geographical difference. All 13 colonies in the United States faced the seaboard, and so any one of them could trade directly with England. In Canada, the best agricultural lands and the timber resources are in the center of the country, in present-day Ontario. In order to get out to the sea you have to pass along the St. Lawrence river [sic--Seaway--Econlib Ed.], which goes through Quebec. We tend to forget it today, but at the time that the English pushed the French out of Canada, Canada is over 90% French-speaking. That creates a very difficult problem for the British colonists and for the British government, which is trying to create a viable colony out of Canada so that it doesn't meet the same fate the British colonies in the United States met. It's got to give sort of rights of suffrage to the population and at the same time it's got to limit the numerical power of the French in Quebec, who occupy a key geographic position along the St. Lawrence river, because right in front of the city of Montreal are the Lachine Rapids, which meant you had to build a canal around the rapids. But if the French wanted to hold up British commerce and development in the interior country, all they had to do is block canal development. And in fact, the British merchants in the interior of the country complained about this repeatedly. That means the long and the short of it--we spend a lot of time in the book talking about this, how basic geography drives institutions and those basic institutions then drive the banking system. That drives a centralization of bank chartering in Canada in the central government. This is in the 1860s when Canada is given sovereignty. It also drives a decision in Canada that all legislation, all authority not specifically given to the Provinces goes to the Central Government. Exactly the opposite of the United States, where all power is not vested in the central government by default of the states. It also at the time of the Dominion Act gives explicit rules that state that the central government will be in charge of banking policy. So right from the very beginning they go down a very different route from the United States. They go down that different route in large part for some geographic or geo-political reasons internal to Canada. And they then create a set of institutions that are designed to make sure that the French cannot block Canada's development. They essentially disenfranchise the French population. And the way they do this is in the Senate, which is an unelected--and is still an unelected--upper House. Initially Senators in Canada served for life. They now only serve till age 75. Russ: That's enough for government work. GuestC: And they still actually, unlike the British House of Lords, have veto power over legislation. And if you look at [?] of Canadian banking, there are key moments where legislation that would have for example created a step toward deposit insurance are blocked in the Senate. And key moments where there is sort of an impetus towards unit banking, and they are getting blocked in the Senate. In fact sort of every one of the populist waves that's happening in the United States, where banking issues are being brought to the fore, they are happening in parallel in Canada. The difference is that those groups lose in Canada because they can't cobble together enough political support within that centralized and sort of blocked political arrangement. But they win in the United States. And that to me is what is so interesting.

38:53 Russ: But this to me is one of the key insights of this book, and this whole approach. Economists have, I think, a tendency to see finance as--they see many things. Essentially it's just a mathematical problem, it's an engineering problem; we just have to figure out what the right incentives are. We just have to fix it. And they tend to ignore the political side. So, if you heard this story, you are thinking about it: Well, the United States has all these crises--bank runs, failures, disasters. Canada has this fabulous run of great success. Well, now we know what to do. Just be like Canada. Just give me your statutes and we'll just put those in place. And I think a lot of times economists make that mistake. They say, well, we know what the right solution is; we're going to advocate for that. And it's not just that it's "impractical" or it's too theoretical. They are missing what is fundamentally going on, and which you highlight in the book. So, Charles, explain why it is that we don't--you know, everybody wants a stable banking system, right? So why don't we just go to Canada and say, Okay, we'll just use theirs? Why doesn't that happen? GuestC: Well, as I was explaining to one person who asked me that, I said: How would you feel about the idea that we would have our Senators appointed by the Queen of England? Russ: That's a negative. GuestC: And that was inconceivable. And the reason it's inconceivable is, this is a country that was born from troublemakers, right? The yeoman farmers, armed to the teeth, from the very beginning who created a Revolution and weren't about to not be vested with authority in a particular way. But Canada is a country that was designed by people to avoid a Revolution. That created institutions that specifically made it the quintessential classical liberal democracy. Meaning, that it created all of these barriers to various kinds of special interests or even majoritarian tyranny. In fact, as Steve said, it's ironic that the United Kingdom, which gives up voting power over legislation in the House of Lords in 1911--Canada's Senate was modeled on that. But Canada's Senate persists! The House of Lords is pretty much emasculated in 1911. Russ: In England. GuestC: Yes. So what's so interesting is the whole history of Canada is a history of people trying to prevent certain bad things from happening: We've got to get Brits to migrate to Canada, so we have to give them enough democracy. But they are not going to migrate to Canada if the French are blocking everything, so we have to create democracy that is not going to be a French tyranny. Also, there are lots of--we want to get people to migrate from the United States to Canada; they had quite a few royalists leaving in the early 19th century to Canada. So it's an environment of people who are trying to find a way to have a democracy, to have freedom, but to still be within the British Empire.

41:58 Russ: That's a positive way to tell the story. Let me give the negative story. So, any reform of the U.S. financial system that takes large sums of money away from people who are already getting those large sums is not likely to be successful, barring some radical change in the political incentives. Do you agree, Steve? GuestH: I think there's always been a temptation, certainly since the 1970s in the United States, to look to the banking system as a vehicle for income redistribution off balance sheet. Russ: Yeah. [?] GuestH: Exactly. So rather than-- Russ: In the U.S. government. GuestH: Yeah. That temptation has been large for governments regardless of their ideological strife, and for parties regardless of their stated ideologies. That makes the--it's that basic problem, that no party really wants to give up on this. There are parts of the Republican Party that do. Russ: That say they do. GuestH: And I believe them. Okay? But that's not a winning coalition. The fundamental problem facing sort of you know facing the creation today a stable system of banking in the United States is that bank rules are arcane; hard for the public to understand. Coalitions can get created, designed to channel, to share the credit or to channel credit to particular groups--those rules are going to apply to everybody, because we're in a democracy, after all. And that's going to distort everybody's incentives--borrowers and bankers. The result is that the United States is set up, because of its long tradition of populism, set up to be crisis-prone. And it's I think a paradox in the United States. One of the things I admire most about the history of our country is the [?] history of troublemakers. Right? These were farmers who were willing to go toe-to-toe with the British army. That took a lot of guts. That didn't happen in Canada. One morning people woke up and they said, Oh, we're independent. What does that mean? Well, we will still have tea. So--independence when it occurred in Canada was something of a snore. They celebrate that they beat us in the War of 1812, not their independence from England. Right? That means that in the United States, precisely because we have this paradoxical history of populism which we simultaneously admire, but which generates this sort of use of the banking system for redistributive purposes--that creates this sort of urge by politicians to redistribute, rather than using the fiscal system, using the banking system. And because it occurs off the budget and because it occurs in a way that is very hard for the average person to understand, and because it is not--you don't have to pay for the bill until the banking crisis occurs and everyone needs a bailout, it's not seen. And so there's a very strong temptation to do this. GuestC: If I can just build on that briefly--one of the interesting things about the United States is that all of these checks and balances that we are all trained in, in grade school--what are we taught? Well, the United States is a liberal democracy, because we have all these checks and balances. But those checks and balances often do work to thwart fiscal policy to address issues like inequality. But then there is still a lot of freedom to do things in a hidden way. Off balance sheet. The support of the GSEs (Government-Sponsored Enterprises). Russ: Fannie Mae and Freddie Mac. GuestC: Right. Or the creation of regulation. Most people don't understand the arcane aspects of bank regulation, to understand what implicit transfers and taxes are involved in that regulation. So that means that if you are ideologically Republican representative who wouldn't want to be associated with a particular transfer, you are safe-- Russ: Because nobody knows it's happening. GuestC: Because nobody knows. And then you can do your deal in a hidden way. So, ironically, I think a lot of people that put faith in the checks and balances in the U.S. system are missing the fact that, particularly in the area of banking regulation, which is very big and very important, that that's an area where we have sort of addressed problems, especially inequality problems--instead of addressing them head on, we've addressed them in this very destructive way of using subsidies through the financial system, which tend to destabilize the system, as the way to do it. Even if you are looking at housing policy, Australia, which is unicameral legislature, is a country that has also been very stable in terms of its financial system. But Australia is in many ways a populist country. And Australia addresses issues of inequality directly, through fiscal policy. For example, what's affordable housing policy in Australia? It's giving down payments assistance to first-time homeowners. That, by the way, creates stability because it subsidizes more down payment. Which tends to stabilize the housing market. What we do is, because we have to do it through the back door, we do the only thing that we can do, which is subsidize instability, by subsidizing leverage. Russ: Yeah. GuestC: So, the point is, there are some flaws, I would say--I don't want to be too judgmental here, but there are some flaws in the way we address certain problems that kind of push us, as Steve was pointing out, in the direction of using this hidden stuff; and it's always coming through the financial arrangement. Russ: Just to echo that back: I find it remarkable how little we've learned from the Financial Crisis in terms of these back door, hidden subsidies. The Left has pushed back against any attempt to stop subsidizing mortgages; basically right now we have the Federal Reserve financing the mortgage market of the United States. This is not exactly what the founders of the Federal Reserve had in mind; it's not what most people would say is good economic policy. But it's politically very attractive to do that. And it's nuts--it seems to me.

48:38 Russ: But let's talk about the Crisis. Because I want to let you put your explanation on the table and then I do want to push back a little bit. You put a lot of stock, to my surprise, in the Community Reinvestment Act (CRA) and the Government-Sponsored Enterprises Fannie Mae and Freddie Mac. They certainly were part of the problem. But you don't talk much about the large private investment banks that issued private mortgage-backed securities (MBS), which were enormously a large part of the run-up in the early 2000s. And to me, without that we would have maybe an unpleasant system; we might have had Fannie Mae go broke. But a lot of the loans that were made were not made by loans that were under the Community Reinvestment Act. And it seems to me the moral hazard problem is a bigger problem as a cause. And to me the housing market is just the place it oozed out into. But it was something else. Defend yourself. Who wants to go first? GuestH: I'll start and Charlie will finish. I think it's important to get the chronology of the facts straight. As you mentioned, the private investment banks get in, in the early 2000s, into the MBS market. Russ: With two feet. GuestH: Oh, yeah. They see a market opportunity that Fannie and Freddie blazed for them going back to the 1992 GSE Act. That Act has several curious features. One of which was it told Fannie and Freddie that they had to repurchase loans from banks that met Affordable Housing standard criteria. Russ: They had to lend a lot of money to poor people, in bad neighborhoods that weren't getting-- GuestH: Up until 1992, total CRA lending is only $8.8 billion. A lot of agreements between activist groups and banks, but very little lending. Beginning in 1992--and incidentally this is legislation which is crafted under the first Bush Administration--be clear here; there is not a Democrat/Republican issue. The basic problem that the community groups have is they want to get access to more credit, channeled through their organizations to their constituents. Quite reasonably. That's their stated job. Russ: That's what they are trying to do. GuestH: Banks want to merge. In order to get approval for mergers. I think from the vantage point of today we don't have a sense of how rapid fire and dramatic these mergers are. Bank of America is essentially the amalgamation of 37 different banks in the 1990s. So in order to get approval for these mergers, they have to go before the Federal Reserve Board. Community activists show up at those merger hearings, and said that they can block them. And in fact community groups even write handbooks on how to block a merger. You can download them off the web. Banks backward induct, and they partner with the community groups and agree to channel credit through them. But they don't want to hold those loans if they don't have to. And they tell the community groups, the activist groups: There's a limit to what we are going to do. The activists, particularly ACORN but also the Neighborhood Assistance Corporation of America, go to Congress and they push. Particularly ACORN. And there are Senate hearings in 1991. So this is a full decade before the investment banks get in. This is a story that people like to tell, which is Fannie and Freddie followed private banks. Well, they followed in the sense that they are dragged in kicking and screaming into this deal. They don't want to buy these CRA loans that banks are making. The activists push in Congress to basically make them do it. And the thing that Fannie and Freddie extract in return is two crucial features. First, they are going to be subject to regulation not by the Fed; they are going to be subject to regulation by a unit of Housing and Urban Development (HUD). Russ: Their own regulator. GuestH: Their own regulator. Russ: It sounds bad. It's actually-- GuestH: worse than it is. It sounds bad and it's worse. Russ: Good [?] for them; bad for us. GuestH: Second, they are given capital requirements that are about 60% of--about 40% below those of--commercial banks. Russ: They are allowed to be highly leveraged. GuestH: Right. That means that Fannie and Freddie can get into the following business. You are a commercial bank; you sell me a loan. You had to put $4 in capital behind that loan while you held it, as a prudential reserve. I, as Fannie or Freddie, only have to $1.60 [?] in capital behind that same loan, because I have a different capital standard. If I now create a more mortgage-backed security out of a bunch of these loans that you sold me, that Charlie sold me and others have sold me, and put a guarantee on it--which I have to charge $.45 per $100 for--I can now create a mortgage-backed security essentially now being back by $1.60 in capital against the mortgage-backed security plus the $.45 for $2.05. And then sell it back to you. This creates tremendous incentive for me as a government GSE to be in the business of buying your bad loans and selling it back-- Russ: I understand-- GuestH: The banks only lead Fannie and Freddie in the extent that it's in their interest that Fannie and Freddie get into this business. Fannie and Freddie extract concessions. Later on, once this process is well underway, and once mortgage standards have been written, once this sort of basic game has been organized, that's when the investment banks get into the game. It is no accident that when the Crisis occurred, well over half and perhaps as much as two-thirds of all the toxic assets are sitting inside Fannie and Freddie. Russ: I don't know if that number is true. I know there is some controversy about it. The fact is, though, a lot of it is sitting inside privately-run, not-subject to the CRA, privately invested in highly leveraged investment banks like Bear Stearns and Lehman Brothers were, and some of it is even held by J.P. Morgan and Goldman--people treated it like [?] they stood aside; they didn't stay aside. They also were doing it. They didn't do it as much. They were a little more cautious. But hundreds of billions of dollars of mortgage-backed securities were packaged. They all had their own lending arms, originators. So, Charles, how do you explain their--let me ask it a different way: Okay, so Fannie and Freddie could have gone broke because they made a lot of bad loans under this political pressure we were talking about--which I think is true. And it would have been expensive. But to get a collapse of the shadow banking system to something else, it seems to me. GuestC: There are really two different issues here. Your first question was: Weren't there a lot of private players using their own money, these investment banks and Citigroup? Russ: Well, not their own money. GuestC: Well, their stockholders' money. Russ: Yeah. Kind of. GuestC: And the taxpayers' money. Both. Russ: Yeah, implicitly. GuestC: Weren't they also making some decisions here? So that's one question; I want to turn to that. Then there's a second question. The key thing to recognize is, if Fannie May and Freddie Mac were the 800 pound gorilla in the mortgage market and they were giving effectively what people regarded as a pretty good put option--in other words, they were the secondary market where mortgage-backed securities and mortgages could be dumped--this was especially important if you talked to people in the industry for explaining why there were so many violations of the various limitations on the portfolios that were being structured. Because as long as Fannie and Freddie were willing to give it a wink and a nod, it really didn't matter what the rules were because you knew you could sell these securities. The thing that people[?] didn't really know was the total amount of crappy stuff that was being originated. And the reason that they didn't know it was because there was no correct aggregation going on that you could turn to and figure it out. Only after we started seeing the default experiences in some of the categories of mortgages did we realize that they were effectively sub-prime quality. And the reason was, starting in 2004, the rise of the so-called Alt-A, non-documented mortgages. And we didn't really know how severe those risks were until we saw it starting in 2007. So people were actually very convinced; and that put option would have been good if there had only been half a trillion of these crappy mortgages. In fact, though, as we know from the SEC's (Security and Exchange Commission) settlement with Fannie and Freddie, they were holding $2 trillion of those mortgages. So that put option, as we know from having bailed them out was no longer good. So I think a lot of the explanation for why private parties were willing to engage in this so much was they didn't realize that that put option was going to disappear. The second explanation, of course, and we do get into this in the book, is that actually you are probably right. That is, there was other stuff going on. It wasn't all the story that we're telling. But we think that that's the dominant thrust of the story. There are other narratives out there having to do with monetary policy which we think also contributed. But we think that we wouldn't have had the two requirements to have a banking crisis, which are: Extreme risky assets that banks are holding, and tolerance for extreme leverage of the banks and the GSEs--if there hadn't been that political deal that underlay it all. And just one final sentence about this: the key thing is, Fannie and Freddie, when they relaxed their underwriting standards, they didn't relax it just in the affordable housing area. They relaxed them for everyone. Because they said: if we just relax them in this area, they couldn't have defended it. They had to pretend that they were not doing something imprudent. And that's what opened the floodgates for everyone.

59:14 Russ: I wish we could talk more about this, but we are almost out of time. So I want to try to sum up a little bit. Which is that--2008 was a really bad experience, for the United States and lots of countries. How much of that was due to bad social policy, expectations of creditor bailout--which I think was hugely important, which incentivized the investment banks and the GSEs and everybody to be imprudent with the money they were able to borrow, which they otherwise wouldn't have been able to borrow. We tried to fix it a little bit. Most economists think that our attempts to fix it have been a failure; that we are standing on the edge of another crisis in the next x years--we don't know what x is but things are not good. Where does that leave us? A cynic would say: Well, that's just the way it is; we just have to go from crisis to crisis. They seem to be accelerating, actually, worldwide. You have any reason for optimism? Or, do you have any hope for a different set of political incentives? Part of the theme of your book is: This is the way it is, folks; you may wish it were otherwise; you might have a better idea, but the political incentives don't let you do it. So it doesn't really matter. So that could lead to a very unrosy view of the future. But I don't think that's your view. So, one of you is an optimist and one of you is a pessimist. Which one's the pessimist? GuestH: I'm more pessimistic than Charlie. Russ: Okay, you go first, because I want to end on an optimistic note. GuestH: I want to be clear, however, the difference between optimism and pessimism is I say things that are pessimistic and Charlie says things that are pessimistic, but he smiles more while he says it. So, one of the reasons why we wrote this book is not just because we wanted to understand how things work. We wanted the public to understand how things work. And to be able to come away from reading this book with some heuristics for detecting when the financial system is heading off a cliff and they should start to become worried. Not just the public in general, but also financial journalists. And I would end here by saying if there's a lesson--there's two lessons the public could extract from this book. First, if you are counting on your elected representatives to be watching out for your financial interests as an average taxpayer, think again. The second is that any time a politician tells you that he's found a way to create a free lunch and that there's going to be this marvelous subsidy, and nobody is going to pay for it, reach for your wallet. Especially when that subsidy is coming through the banking [?]. Because what's going to happen is what happened in the years leading up to 2008. It's not that I think the CRA was a bad idea. It's that the logic of the CRA coupled to the mega-merger movement gave rise to incentives for Fannie and Freddie to lower their underwriting standards. And once that happened, they had to lower them for everybody. The whole society could pile into deals that literally were too good to be true. One of the reasons we wrote this book is to make it clear to the public: Any time a politician says, I have a deal that's too good to be true, or what Bill Clinton called 'the third way', it's time to get very nervous and think about voting for somebody else. Russ: And I would just add to that, that the push in the 1990s through both Republican and Democratic Administrations to raise the homeownership rate--[?]--'and it won't cost us anything.' Slightly overly optimistic. Russ: Charles, finish this off. GuestC: Well, I guess I would say, to try to end on an optimistic note, is: It is true we can't just throw away our institutions and history and constitutions and pretend that we are Canada, because that's not going to work. But what we can do is learn. And democracies do actually learn. Even very populist democracies. So, we've already mentioned, the United Kingdom for example became effectively a unicameral legislature, no separation between executive and the legislature, so we would say in some sense very populist. And particularly after WWII. And they nationalized all their industry[?] and they had extremely high tax rates. But that created some pressures on the economy. And in the 1970s and 1980s we saw extremely high inflation, very low growth; and guess what? It was unpopular. The rise of Margaret Thatcher was not just about Thatcher's leadership. It was about the fact that the median voter in that populist country was sick of it. And it's an interesting testament that the changes that were wrought under Thatcher were persistent and now are part of the mainstream status quo being endorsed by Edward Miliband and others. So I think the key thing is we're optimistic in the sense that we are spending a lot of effort hoping that the education of the people eventually leads to some sort of positive response. It's very hard in finance because it's very arcane. It's all too easy for politicians to give you the flim-flam. But let's be optimistic. Why not? Russ: More educated readers, who read your book, will be less susceptible to the flimflam.

1:05:05 Russ: Okay, we are going to open it to Q and A. And then we are going to have a little food and drink. Please when you are called on, identify yourself by name if you could. And use the microphone if you could. Audience1: I'm Arnold Kling. I'm trying to figure sort of what makes Canada's banks stable, and the thing that comes to mind is charter value, that the--you only have 5 of them, and they are profitable, and so they don't want to lose their charter, and so maybe that stabilizes things. First, I wonder if you agree with that. And secondly, if you do, what are the forces that keep that from happening in the United States? I think you mentioned the populist sentiment--people don't want banks to be profitable. The government wanted to use banks for redistribution purposes. Should we be trying to head toward a system where banks have valuable charters and if so, how could we head that way? GuestC: Okay, I'll take a first stab at it. So, first of all, I want to be very clear here. Banks have charter value for two reasons. One is because they run a business very well; and the other is because they are endowed with some monopoly, non-competitive rights. In the case of Canada, there is a lot of evidence that the second is not true, and has not been true. Despite the small number of large banks. By the way, of course there are thousands of banks in Canada, but there are only 5 that are very big. But the literature on competition among the banks has uniformly found that the banks are extremely competitive. But there is an element of importance to what is being limited in the chartering in Canada, and that is the exclusion of the Yankees. That is a very important part, we believe, of the bargain; and we aren't the first ones to point this out. Because, look at it this way. First, the Canadian Banking Act is re-made every 5 years. And the banks' charters expire every 5 years. Banks are on a fairly short leash in Canada in that sense. Also, part of the banking law effectively excludes U.S. banks and other foreign banks from competing on equal footing with the Canadian banks. So, we think that that is a system that's very conducive to the banks' also behaving well in the eyes of the regulator. And so long as the regulators act in the public interest, which it has consistently in Canada, that's also helping things. So, I actually think that the charter exclusion that actually matters in Canada is not one that is creating monopoly rents within the domestic system, but one that is creating a vested interest in the Canadian banks in not messing up their deal to exclude the American banks. Audience1: [?] a way to create some kind of charter value in the United States, or you don't think that's what you would? GuestC: I have a recent paper on looking at charter values of U.S. banks. And most of it is dictated by whether they know how to run certain businesses better than other banks. There's not really a lot of monopoly rent to be allocated. It's really about being able to do your business relatively, in certain areas, better than other banks.

1:08:54 Russ: Another question? Yeah. Audience2: Hi. Benjamin Kaye [?]. So, my question is: so, financial crises can be optimal in the sense that perhaps the cost of stopping them prevents real projects from being funded, positive NPD[? Maybe NDP, National Domestic Product?-- Econlib Ed.] projects from being funded. And so one thing that was not in the discussion from the last hour was basically what if any price in terms of the efficient allocation of capital does Canada pay for the decisions that they make in the industrial organization of their banking industry? Russ: Good question. GuestH: So, it's an interesting question and it creates a sort of technical problem because you would have to be able to model what Canada would look like if it had more expansive banking policies and therefore had sort of more volatility in credit. We can't observe that Canada. We can observe the Canada that does exist. And what has always struck me about Canada--that's an exaggeration; it hasn't always struck me about Canada; it struck me about Canada from the time I realized as a New Yorker that it was a separate country. What has struck me about Canada is the fact that this is a country with a very small swath of land that you can actually grow anything. You get 100 miles north of the border and it's too cold to actually grow anything. There are pockets of natural resources. Russ: Except hockey players. GuestH: Except hockey players. Right. Pockets of natural resources sprinkled here and there separated by vast distances. Nevertheless, Canada is a country with a tremendously high GDP (Gross Domestic Product), by world standards. And in fact has accomplished that even though it's mostly a primary-product producer, which means it's subject to big fluctuations in its terms of trade. A lot of that I think is due to the stability of the Canadian financial system. So I would be hard-pressed to make an argument that Canada could have done better had it had the U.S. financial system, which would have created much more volatility. They've done remarkably well given the resource base that they have. Just to give you a sense of this: the state of Iowa has more farmland suitable for growing corn and wheat than the entire country of Canada. So it's really remarkable what they've done, given the constraints they have. Russ: I want to just follow up on that question though, because I think it raises an important point that I wanted us to get to, which we didn't get to earlier. Which is: we have this obsession with never having any kind of crisis. And I think the right analogy is the forest fire analogy. So, forest fires are unpleasant. They are awful. Things die. It's not good. Your house can burn down. You can be killed. So there's a natural tendency to say forest fires are bad; we won't have any. When you do that what happens is that the kindling and tinder and other stuff, undergrowth, builds up to such an extent, because there's never a forest fire, that there eventually comes a fire that you can't put out. And it's so much work compared to having a lot of little fires. And that's what has happened with our financial system. We publicly say we are trying to find the perfect way to keep there from being any crises or distress. And as a result, it works really well--until it doesn't. And then we have the Yellowstone fire, which is unbearable, unpleasant, high-cost situation. And I think--Arnold Kling asked a good question, asked it the right way; I can't say it as well as Arnold, but we should have a system that, when it breaks we can cope with it rather than one that never breaks. [?] breaks can't happen, but we have this ideal that it can't happen, and it's a mistake.

1:12:57 Russ: Any other questions? Yeah. Audience3: Drew[?] Kennedy. So, one of the themes, I take it, from the earlier part of the book is that Federalism has not always functioned as a check and balance the way we think of it in that it prevents bad policies, but that sometimes it enables just other types of bad policies. And my question is: Do you think that's unique to finance, or as the country is continually debating national government versus states' rights types of issues, and health care and everything else--is that unique to finance or do you think this is a more generalizable issue? GuestC: It's a great question. I think that it's not unique to finance. But I think it may be somewhat related to how complex the issues are in the particular area. So, it's interesting to me that one thing that we also discovered was that monetary policy in Canada has also been better than in the United States. In terms of the inflation of the 1960s and 1970s, its level and its volatility, Canada also managed to have a better experience there. I think in trade policy you could also point to superior outcomes in Canada relative to the United States. So I'm not sure. I do think that there are these general kinds of issues that apply to other policy areas. But I want to take them one at a time. GuestH: I would add to that: I think that you bring question for political scientists to address. I don't think that there is a consensus answer to that question because the question has never been framed quite the way you put it. In most of the literature about Federalism it's all about market-preserving Federalism. Federalism is always good. There is this flip side of it, and I think it's been under-researched. So I think graduate students thinking about a dissertation project, this should be sort of a marvelous area to jump into.