Tv Charles Steven analyzed the Banking System to the United States, the united kingdom, canada, mexico and brazil going back several decades to find out what makes the Banking System is unstable. This is about one hour and 15 minutes. Diana ross roberts at Stanford University institute. Welcome to this special edition of econ talk in front of a large audience at the Hoover Institutions washington office. Econ talk is part of the economics and liberty a weekly podcast on economics, philosophy, history, psychology whatever im interested in actually. Sometimes daily life. On itunes we are econ. Org. Today is february 5, 2014 and my guests are Charles Calomiris and his pac nine. Charles is a professor at a Financial Institution at Columbia University graduate school of business and he directed for institutions regulation and Little Research initiative. Stephen haber is the aa gene welch wallet and professor at the school of humanities and science at Stanford University and a senior fellow at the hoover institution. Their book is fragile by designing the political origins of thinkin banking crisis and se credit for just our topic for todays episode. Welcome to todays econ talk. The clai claim of the book you t the idea to think crises are bad wall or a perfect storm. Rather you argue that the banking crisis into systems are by design. What did you mean by that and what is the justification . The basic idea is Banking Systems are fragile by design because it is impossible to take politics of Bank Regulation and its impossible to do so because there are complicated interests between the systems such that the governments need banks and banks need governance. The conflicts of interest boy will down to three teachers. First, the government simultaneously regulate the banks and borrow from the banks. Second, the government used the Police Powers in order to enforce them on behalf of the banks. But people who are being forced out of their houses because they default on mortgage when the banking crisis occur the government have reasons not to enforce those. So, the governments are in charge of liquidating the failed banks. But the Biggest Group of creditors and the bank is liquidated our voters and so governments have incentives to change the rules governing deposit insurance for political ends. They will often extends beyond the statutory of limits. Because of those basic inherent conflicts of interest, its extremely difficult to remove politics from banking. Governments have an inherent reason for wanting to use the Banking System for their own end and at the same time that thinkers need the government in order to do things like enforce contracts. In financing the war. A lot of your book is a remarkable history of banking into the Banking Industry in five Different Countries and incredible work of scholarship in economic history combine with the political economy that we are talking about. I want to talk about the game of the Bank Bargains which is a central concept in the book. Tell us where that is and how you apply it. The game of the Bank Bargains is 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 the always involved parties of the government and some other parties that align together and form an alliance with the government to determine the rules of the game so the plaintiffs in the game of the Bank Bargains there is going to be a group of people who are in charge and they are going to be a group of people often left out. And it wont be a big surprise that the people who are in charge will use their power in the game to take advantage of people who are left out. Of course they are not a monolithic group. They are fighting for that share. This is one insight that i think is important in the book. Its different from the way some political scientists think about political struggles where they tend to think of struggles between political parties. One of the points we make in the book is the coalitions that have been involved in u. S. History to design the rule of the banking have often been bipartisan. In fact they have structured themselves to be fairly immune to electoral partisan outcomes and so just as you would expect if you wanted to have a longlived and invaluable coalition you would want it to be robust outcomes and so sometimes you get a very unlikely partnership. People who ideologically or culturally socioeconomically dont really see eye to eye but find a convenience in being allies in a particular arrangement. The way that i think if it is the democrats and republicans are the same they like to give money to their friends they just have different friends that they have one in common which is the Financial Sector and they are both sent to scratch that sectors back and get scratched back in return. But i would go even further to say that sometimes they may pretend to have different friends more than they really do. Do you want to give an example . Im sure we are going to talk about the current u. S. Crisis eventually led one of the things that is interesting is one of the contributors to the crisis was mortgage subsidy policies in the u. S. Encouragement to the Home Ownership precisely in a particular way by creating subsidies for taking risk in the Mortgage Market. If you can encourage it in a lot of ways but what is interesting is when we look at the last say 15 years or so of that policy, what we see is george h. W. Bush followed by bill clinton, followed by barack obama. He and even though you might think of them as very different ideologically committee actually were part of a continuous thread from the standpoint of some of the issues we are talking about. In terms of the Unlikely Coalition in these agreements we have activist groups aligned to the bankers that were in the process of creating megabanks through the movement. So the point about the mergers activists would show up and testify on behalf of a bank of america merging with nationsba nationsbank. So this isnt the usual role that you would imagine an activist group taking through a bank merger. So you have unlikely partnerships precisely because they struggle to the partisan lines and were extremely durable and it made it very hard for any party to deviate from the agreement. An interesting coalition because as you point out there are a lot of voters in the discussion. They are clearly a lot of those but in general, the democracies some groups get treated particularly well. So i see it as my somewhat cynical perhaps prolific take is that there were vehicles to give cover giving money to these smaller politically powerful groups, the realtors, the Home Builders to finance them through the political incentives inherent in the system. Because everybody that was a part of that Winning Coalition in the game of the bank bargaining did quite well. So the total amount of subsidized credit that was contract shall be agreed as a quid pro quo for those activist groups to show up at the hearings which is an understatement of the amount they actually received was almost 870 billion over the period of 19922007. So thats not chump change. I think that we ought to do a little bit of clarifying. Youre talking about Community Investment act where im going to push back a little bit when we get into more detail but we should mention a lot of people that blame the Community Reinvestment act for playing a role in the crisis and get challenged but that is what passed in 1997. But a piece of the law took place in the 1990s when it became the determinant of whether the bank would merge or not and thats when it started to have an impact. I just wanted to get that right. Lets go back in the history of little bit and we will start with i wish we had a five or six hour podcast and i know the authors do too but we dont. And i know you dont like to stay for that. We arent going to be a book to cover all of the aspects of the book but lets start with the u. S. And go back into the history of the United States. You talk about a 19th century as a particular era of banking in the United States. Tell us why the u. S. Was prone to crisis. When people look back they say my gosh it was crisis after failure. Why was the u. S. Unstable in that area . I am appalled that we dont have five hours. I was counting on that. Second, they inserted a more specific question for the u. S. In the 19th century has a Banking Structure with any other country on the planet. It has thousands of banks tens of thousands rightclick tens of thousands, which are in most states unable to open branches so every bank is what you would think of as a bank of two itself. That means that in the event they run it is hard to move funds from one to another. It means you cant spread risk among the regions. If you are tied to the local economy is meant banks couldnt capture the economies of the administration so they are inefficient. All of those seem pretty obvious, right clicks they are stuck in the local economy. Why there is a political deal. Just like we were talking about the coalition between the populace and the bankers in the 1990s and early 2,000, is a coalition between the small bankers and farmers in the 19th century. And what they are concerned is to give credit to Small Farmers and Small Farmers are also opposed to big city people especially bankers. So you get an alliance of the bankers and farmers and most particularly and famously as the unraveling of the bank in the United States. First in 1811 and in 2,000 the government realizes that it needs a bank to prosecute and then it gets unraveled again during the second bank of the United States. And so, in order to make sure they wouldnt have to face competition in their markets in the Bank Regulation in most states what happened is they made it illegal for the bank to branch into the state meaning from rhode island you couldnt branch into massachusetts. They also made it illegal for a link to open a branch in so those two states had laws that precluded branch banking. The quote that we make in the book is that this was im sure somebody could write down an economic model that just makes sense but this is clearly a political arrangement. There is no efficiency or stability by which he would do this. It did happen to work well for the local bankers because they ran local monopolies. And it worked well for the relatively prosperous farmers in a particular community because they knew that bank have to lend to them and nobody else because the cost of gathering information at a distance were deep enough until the 1990s most bank lending in the United States was local so that created this arrangement could in the te north and midwest for the bankers and bad for anybody else who wanted access to credit him for the system as a whole because every decade or is a crisis so its hard to remember in the world we live where agriculture is 2 of employment in the United States and in 1940 so its an important sector to the more important decisionmakers who will be powerful in the region that as we go forward through the 20th century starting at the end of the 19th at the culture becomes less and less important as an economic factor. Why did in that coalition unravel sooner . Its a nice story after the fact. Explain why he did it unravel yl and why did it not unravel sooner. It lasted about 150 years. There were lots of shocking things going on in the u. S. Two world wars. A Great Depression. A lot of thinking crisis. Even the savings loan crisis in the 1980s which contributed towards its the demise but over turmoil and inefficiency has persisted federalism in the u. S. Because starting from the very beginning, the state had authority over deciding what the roles of the game for engagement were going to be in their states and also they hav had the authoy to restrict outofstate banks from participating so that meant if you were in kansas or illinois or other states if the agricultural interests wanted to maintain the banking they just had to win the battle of the state level so it was easier for those agricultural interests to win at the 50 state levels than it would have been if they had to fight the battle on a centralized basis and we make that argument at length why that is in contras and contrast in pr one of the things that explains why they had a hard time getting a nationwide system going was the decisionmaking about the law then in the 1860s we create the national Banking System that sounds like something the federal government can do that could have been like the bank of the United States but what happens is the comptroller of the currency and the congress probably would have not let them decide differently but they decided that National Banks had to be unit of banks. Meaning one bank basically. So they were in the middle of nowhere and that was it. What was national about it . The charters were the same. They operated under the same rules and the same Charter Authority and at the same Supervisory Authority but they were using chalk because one was in the city and one was in the country and they have particular risks. So they were practically making fun of us. Canada especially was looking at the United States saying what a ridiculous Banking System but it persisted because it was pretty challenging to create a nationwide movement in the environment of political decisionmaking. One of the reasons it doesnt unravel immediately or earlier is the establishment of the Federal Reserve which a lot of people think of it as a sort of well people get greedy and they get out of control then you need someone to clean up the mess neglecting the fact that it was sort of baked in as you use the phrase that there was a unit Banking System so politically it was a way to mitigate some of the worst effects of the system and keep it going longer than it would have. Is that correct . Cynic in the panic of 1907 and 1908 there is a National Monetary commission created to look into how to fix the Banking System. They studied others including mexico which had branches of the largest banks so they studied canada, mexico, germany. They were quite aware of what the other models were and then they rejected them in favor of retaining unit banking but propping it up by creating 12 regional fed banks that essentially went to the unit of banks by increasing liquidity in times of crisis. The same thing happens in a Great Depression where im sure everybody remembers their high School Textbook which talks about how it saved the system by creating deposit insurance. But they dont remember is i helped my daughter study. It was in their. Did you do very well on the exam . I did not. When my daughter took it i panicked. I thought im going to hurt her chances. I usually did bad at english classes. My daughter decided my father doesnt know how to write. In any case in the Great Depression not only did my forebears also get these any glitch, but the response was to prop up the system. The system is incredibly messed up. They said lets use this in order to present the consolidation of banks which is what would have happened in the absence of the deposit insurance which made it illegal to pay interest on checking accounts and capped the Interest Rate on the saving accounts. This was all done to discourage them from competing with one another and to discourage people from having their savings from one bank to another. And what i want to drive across is coming back to something charlie said, the coalition of the populists and the bankers is what drives the decision. Fdr was against deposit insurance. When he was running for president in 1932 he said deposit insurance would make the banks risky because they would take excessive risks. We call that the moral hazard problem when you ensure someone against us they tend to take more risks. So as steve continued he was definitely against it as was the Federal Reserve by the way as was the Treasury Department and carter who had been one of the architects originally and was the architect of banking reform. But someone was in favor of it and so someone is a congressman from alabama who is chairing the committee and is determined to protect the bankers and he runs it through at the last minute and whats interesting about it is its put in place as a temporary measure that was only supposed to affects small deposits and was made more expensive. Do we know anything about his personal life why was he a champion of unit banking . There were politicians going back. We will call them be a greater and populist politicians. They were politicians in the 30s that were cut from the same. Of their constituents work and especially the most important supporters, landowners and the environments that have a small banks that were shaky safe you have only small deposits that means that you are going to have a very good protection for small banks located in alabama. But the new york city banks almost none of them were protected because the protection was only on the small deposits so you might be able to understand why they liked federal deposit insurance from the citibanks too small country banks. If you are in alabama politician, it looks pretty good. There were 150 attempts from 1884 until ultimately 93 to bring the legislation forward and they were all done by similar people under similar circumstances. They never got out of committee until finally in the 1930s. Why did the populace a very english and fall apart ultimately . Theres a couple pieces we can go back and forth. One of them was inconsistent with the changes occurring in the Banking Industry. You will remember, you are too young but i remember the introduction the people in the audience we often grew up they were famous both for discovery and the invention of the network and whats interesting in the network atm into the Computer Technology that goes with it about for two things. First, Computer Technology allowed them to access the borrowers at a distance and they were sealed into the local unit of bank but it also meant that they could skirt the law as the governing branching by simply opening up in atm anywhere that they could. Like a very small branch. In fact, the unit banks took the big banks to court for this claiming that the opening of the network atm violated the law. Of those lawsuits went all the way to the Supreme Court which in 1985 ruled that it was not a branch. The second piece of this have to do with the fact that a system in which there are regulations governing the Interest Rates that banks can pay only works at the time that inflation is very low. And so, certainly in the 1950s intand the early 1960s, the u. S. Has a quite low inflation. Getting into the 1960s especially into the 1970s, the government is running the starting to run big deficits to simultaneously prosecute the war on poverty into vietnam. As inflation claims that come Interest Rates paid on the Bank Deposits become strongly negative. Even postmodern 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 the deposits leaving the Banking System is a mess. Of a thirdparty which put the banks in difficulty because now they didnt have the funds to pay off the promises they made. This is something charlie has written a lot about which is the deathknell of the unit banks. We think of the crisis as being about savings and loan institutions but its also about lots of small banks that are heavily invested in real estate and both of the technological changes and the pressures put on the banks by the virtue of the fact they are competing in a difficult environment and is now having to take big risks it precipitates. There is also a number of shocks that precipitate the crisis and its not until the resolution of the crisis that does state governments and the federal government began to seriously reconsider the wisdom of the unit Banking System. Its interesting to compare and contrac contract the crisist with the effect of the 1920s and 1930s which were also times when the banks were. Whats interesting is i think if they havent convened which was seen in the 1920s, almost 20 states from the 1920s until 1939 had relaxed Banking Research and trade we saw the same thing happening at the state level from 1979 until the early 90s. When the banks get weekend and that the states start seeing them of failing you think maybe allowing them to come in from another state might be worth doing and they say that makes sense because we could reduce the cost of having to support the failed bank. It got pushed back by the 1980s and the 19 90s it did work. Part of the story is demographics. One other important was the u. S. Banks at this point internationally were getting globalization is beginning the globalization of the financing of the banks are losing market share in the 80s even within the United States as we are starting to see major injury. You may not renovate this happened but japanese banks and german banks and british banks are entering the u. S. And its starting to look like we are going to become a big player. Now of course it is irreversib irreversible. You tip the genie back in the bottle. Lets go to canada. Tell us how different the experience is for the United States and why that is the case. First, the most important thing to say about canada is what didnt happen. Canada is a very boring place. First we slammed the english professor and he partly knows how to invest except less in desperate strengths. Sometimes boring is good. Canada never has a banking crisis ever. So come in a team 37 and 1839 some of the problems in the u. S. Banking crisis that were sweeping the country here created a couple of weeks of minor disruption in canada but no failures in the problems of canada never had a banking crisis. The turmoil didnt cause a crisis in canada. The 1830s you said it didnt cause a crisis its not just the Banking Industry weathered the Great Depression better than ours. They had virtually no failures . Of any significance the banks did fail in canada occasionally. But mismanagement parks yes. Another interesting thing is not only did they have no bank failures, but the total amount of credit relative to gdp is either comparable to or better than the u. S. During this history despite the fact that they have lesser density populations and other things that might make you expect a very different outcome. So they had more abundant credit and stable credit and by the way to the analysis of how competitive the Banking System is also showed that it was more competitive. So it is quite a remarkable difference. And i should mention also let me point Something Else out. Canada didnt even create a central bank until 1935. So it wasnt that it was a particular sort of wise central banking policy that explains it either. They didnt have deposit insurance until in the u. S. So it is a story about a particular set of rules for engagement in canada. Part of that, myself included in the past. People looked at this and said thats because canada had a nationwide bank branch. It was much more efficient, much greater diversification of risk. Although things are true. But as we just learned in our own crisis it doesnt always. Said that is why we spend a lot of time in the book asking those questions. 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. One of the fundamental differences when you look at the basic institution structure strn canada and the United States is that the United States was found as independent companies. Of the debate is how strong the Central Government will be. All of the 13 colonies the United States faced in this keyboard so anyone of them could trade directly with england. In canada, the best agricultural lines are in the central. And in order to get out of the sea you have to pass along the st. Lawrence river. We tend to forget that today but at the time of the french pushed the english pushed the french out of canada, canada is over 90 frenchspeaking. That creates a very difficult problem for the british colonists and government which is trying to create a viable colony out of canada so that it doesnt need the same fat meet s the british colonies and the United States met. Its got to give to the right of suffrage to the population, and at the same time its got to limit the numerical power of the french who occupy the key geographic position along the st. Lawrence river because right in front of the city of montreal to show you how to build a canal. But if the french want to hold the british to develop the needs here in the country, all they have to do is block of the canal and then back to the british merchants and people complained about this repeatedly. That means a long most talking about his basic geography drives institutions independent Banking System. That drives the centralization of the authority in canada into the Central Government. It drives the 1860s when canada is given sovereignty. It also drives the decision in canada that all just lesion, all authority not specifically given to the provinces goes to the Central Government. Exactly the opposite of the United States. All power is invested in the Central Government by the ball of the state. Also at the time of the act it 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 u. S. In large part and they then create a set of institutions that are designed to make sure that the french cannot block canadas development. If in chile, they disenfranchise the french population. And the way that they do this is in the senate which is an unelected upper house. Initially senators in canada serve speed to about enough for government. Unlike the british house of lords they have a veto power over legislation and if you look at the view tha the canadian bag there are key moments where the legislation that would have, for example, created a step towards the deposit insurance are blocked in the senate and key moments where there is an impetus towards the unit to banking and they are getting blocked in the senate. Every one of the sort of populist waves happening in the u. S. Where the banking issues are being brought to the floor they are happening in parallel in canada. The difference is that those groups lose in canada he cause they cant cobble together enough Political Support within that centralized and sort of blocked political arrangement. But they win in the u. S. And that is what is so interesting. This is the key insights to the book and this whole approach that economists i think have a tendency to see finances. They see many things. It is a mathematical problem, engineering. You have to find the right incentives. They tend to ignore the political side. If you are thinking of the United States has all these crises, canada has a fabulous round of Great Success well now we know what to do. Just be like canada. But those in place and a lot of times economists make that mistake. They say we know what the right solution is. We are going to advocate for that and its not just that it is impractical or its too theoretical. They are missing what is fundamentally going on that you highlight in the book that is explain why it is that we dont everybody wants a stable Banking System so i would just go to canada and say okay we will do that there. As i explained to one person that askeasked me that questiond you feel about the idea that we would have our senators appointed by the queen of england. That was inconceivable. And the reason its inconceivable is that this is a country that was born from troublemakers. It is the farmers armed to the teeth from the very beginning who created a revolution and were not 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. It created institutions that specifically made it the quintessential Classical Liberal democracy meaning that it created all of these barriers to various kinds of special interest or even majoritarian tyranny. And in fact as steve said, it is ironic that the uk which gives up voting power over the legislation of the house of lords in 1911, canadas senate was modeled on that, but canada persists. The house of lords is pretty much emasculated. So what is interesting is the history of canada is a history of people preventing certain bad things from happening. We have to get the british to migrate to canada and gave enough democracy but they arent going to ask the french are blocking everything so we had to create a democracy that isnt going to be a french ernie. Also, we wanted to get people to migrate from the United States to canada. They had loyalists leading into canada, so it is a 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. That is a positive story. Let me give a negative story. Any reform in the system that takes large sums of money away from people who are getting those isnt likely to be successful barring a radical change. Do you agree . Spinnaker theres always been a temptation certainly since the 1970s in the United States to look to the Banking System as a vehicle for the Income Redistribution off the balance sheets. Thats temptation has been large for the governments regardless of their ideological stripe. For the parties regarded india theologies. That makes a basic problem that no party wants to give up on this. Theres parts of the party that say they do and i believe them but its not as if it is a Winning Coalition. The fundamental problem today of the stable system in banking in the United States is that the bank rules are arcane, hard for the public to understand. Coalitions can get created and defined a two channel to share the credit or channel the credit to particular groups. Those are going to apply to everybody. We are in a democracy after all and that is going to distort everybodys incentives borrowers and thinkers. The result is that the u. S. Is set up because of its long tradition of populism set up to become crisis prone and i think it is a paradox in the United States. One of the things i admire the most of the history of the country is the history of troublemakers. These were willing to go toe to toe with the british army. That took a lot of guts. That didnt happen in canada. One morning people woke up and said we are independent. What does that mean . Circum independence wouldnt have occurred without something of a snore. They said about the fact that they beat us in the war of 1812, not their independence from england. That means that in the u. S. Because we have a paradoxical history of populism that we simultaneously admire which generates this sort of use of the Banking System for these purposes that creates this urge by the politicians to redistribute rather than using the system, using the Banking System and because it occurs off the budget that is hard for a person to understand and it is not you dont have to pay until the crisis occurs and Everybody Needs a bailout so there is a strong temptation to do this. One of the interesting things about the u. S. Is all of these checks and balances that we are trained in grade school that u. S. Is in a liberal democracy because we have checks and balances but the checks and balances often do work to address things like fiscal inequality but theres still be everybody to do things off the balance sheet. The use of the governmentsponsored enterprises or the commercial regulation. Most people dont understand the aspects of the Bank Regulation to understand whatever and was it transfers are involved in that regulation so that means that if you are an ideologically republican representative who wouldnt want to be associated in the transfer you are safe and then you can do your deal in a hidden way. Ironically a lot of people that put faith in the checks and balances are missing the fact in the area of banking regulation which is important that an area we have addressed problems. We have addressed them in this way of using subsidy through the Financial System that tends to destabilize the system as a way to do it even if you are looking at the housing policy, australia that is a unicameral legislation is a country that has been very stable in terms of its Financial System but australia in many ways is a populist country and addresses issues directly through fiscal policy. So whats Affordable Housing policy . Its giving down payment assistance to firsttime home owners. Thats why the weekly heat stability because it subsidizes more down payment which tends to stabilize the Housing Market. What we do redo the only thing g we can which is to subsidize instability by subsidizing leverage. So the point is there are some flaws i would say. I dont want to be too judgmental but there are some flaws that push us in the direction of using this head and stuff and its always coming through the financial arrangements. I find it remarkable how little we have learned from the financial crisis in terms of the hidden subsidies. Of the left has pushed back against any attempt to stop subsidize mortgages and right now we have the Federal Reserve financing the Mortgage Market in the United States. This isnt what the founders had in mind that its politically very attractive to do that, and its not it seems to me. But lets 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 in the committee reinvestment act and the governmentsponsored enterprises. They certainly were part of the problem, but you dont talk much about the large private investment banks that issued the securities which were and enormously large part of the runup in the early 2,000. And to me without that, we would have had maybe an unpleasant system. They may have gone broke. A lot of the loans that were made were not made by the committee reinvestment act. It seems to me it is a moral hazard problem and a bigger problem that there is a cause and to meet the Housing Market is a place that just used out into. Who wants to go first . I will start. I think its important to get the chronology of the factor straight. As you mentioned the investor in the early 2,000. They see a Market Opportunity that freddie and fannie made for them going back to the act that has several curious features one of which was told fannie and freddie that they had to repurchase loans from banks that match the Affordable Housing standard criteria. Dave a lot of money to poor people. Until 1992, the total landings at 18. 8 billion. A lot of agreement between activist groups and banks but very little wending. Beginning in 92, and incidentally this is legislation that is crafted under the first bush administration. This is not a democrat and republican issue. The basic problem they have is they want to get more access through the organizations and constituents quite reasonably. The banks want to merge and in order to get the approval i think from the Vantage Point today we do not have a sense of how rapid these are. Bank of america is a sensually the amalgamation of 37 different banks in the 1990s. So in order to get approvals they have to go before the Federal Reserve board. Community activists show up at the hearings and say that they can block them and in fact if they even write handbooks on how to block the merger you can download them. They partnered with the Community Groups and agreed to channel credits through them but they dont want to hold them if they dont have to. They told the Community Groups and activist groups there is a limit to what we are going to do. In particular acorn and also the Neighborhood Assistance Corporation of america go to congress and the push. So this is a whole decade before the investment banks get an end to this is a story people like to tell they followed private banks in the sense that they are dragged in the kicking and screaming. Kicking and screaming. They dont want to buy these bones the banks are making into the activists are pushing the congress to basically make them do it. They have two crucial features. First they are going to be subject to regulation by a unit of urban development. It sounds bad but syndicates actually worse than it is. Good for them and bad for us. They are Given Capital requirements that are about 40 below those who are commercial banks. That means they can get into the following business. You are a commercial bank that sells me a loan and had to put 4 of capital behind the loan. I as fannie or freddie only have to put 1. 60 in the capital behind the capital because i have a different capital standard. If i create a mortgagebacked security out of these loans that you and charlie and others have sold me and guarantee which i have to charge 45 cents per 100 i can now have the mortgagebacked securities. The banks only lead to any and freddie into the extent that is in their interest to fannie and freddie because they extract the concession. Once the mortgage standards have been written into the basic game has been organized. The fact is there is a lot of it sitting inside privately run not subject to the Community Reinvestment act privately invested in and highly leveraged in the investment banks. They didnt stay on the side. They also depend as much. They were a little more cautious but hundreds of billions of dollars of the mortgagebacked securities were packaged and they all had their own wendin lg and have their own originators. So how do you explain, and let me ask in a different way. They could have gone broke because they made loans after the political pressure. And it would have been a expensive. But to get a collapse in the shadow Banking System took Something Else it seems to me. There are two different issues here. The first question was was there a lot of private players using their own money for these investment banks and citigroup. The key thing to recognize is if fannie mae and freddie mac were the 800pound gorilla in the Mortgage Market as a pretty good put option in other words they were the secondary market where the mortgagebacked securities are mortgages could be dealt. If you talk to people 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 the wink and a nod what the rules were because you knew you could securities. The thing people didnt really know is the total ever get amount of crappy stuff that was being originated and the reason they didnt know it is because there was no correct aggregation going on that you could really turn to and figure it out. Only after we started seeing the default experiences and some of the categories of mortgages did wthatwe realized they were effectively subprime quality and the reason was because starting in 2004, the rise of the socalled all day and we didnt really know how severe those risks were until we saw it starting in 2007. And the option would have been good if there had only been half a trillion of these mortgages. As we know from the sec settlement with fannie and freddie they were holding 2 trillion of those mortgages. And so that put option having bailed them out was no longer good. So a lot of the explanation for why the private parties were willing to engage didnt realize it was going to disappear. The second explanation and we do get into this in the book you are partly right there was other stuff going on. But we think that is the dominant sort of thrust of the story. We wouldnt have had the two requirements to have a banking crisis which are extreme risky assets the banks are holding into the cover for extreme leverage of the banks if there hadnt been that a deal. Expectations of credit or bailout which i think is a hugely important which incentivize the banks and the gop and everybody to be imprudent with the money they were able to borrow which otherwise we would have been able to borrow. We tried to fix a little bit. Most economists think our attempts have been a failure, standing on the edge of another crisis, things are not good. Where does that leave us . A cynic would say you just have to just the way if it is, we will go to crisis to crisis, we seem to be accelerated world wide. Give me a reason for optimism or give any hope for why a different set of political incentives because the theme of your book is it is the way is. You might wish it were otherwise, you might have a better idea but the political set are going to do it so it doesnt matter. That could lead to too a bleak view of the future but that is not your view. Talk to was about this. I am more pessimistic than charlie. I want to be clear. The difference between optimism and pessimism is i say things that are pessimistic and charlie says things that are pessimistic but he smiles. One reason we wrote this book was not just because we wanted to understand how things work, we wanted the public to understand how things work. To come away from reading this book with curious ticks for detecting when the Financial System is heading off a cliff and they should start to become wary. Not just the public in general but financial journalists. I would end here by saying if there is a lesson, there are two lessons that public can extract from this book. 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 any time politician tells you he found a way to create a free lunch and there is going to be a marvelous subsidy and nobody is going to pay for it, reach for your wallet. Especially when that subsidy is coming through the Banking System because what is going to happen, this happened in the years up to 2008, the committee reinvestment act was a bad idea, the logic of the Community Reinvestment act coupled to the megamerger 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 were literally too good to be true. Anytime we wrote this book to make it clear to the public any time a politician says i have a deal that is too good to be true or what bill clinton calls the third way, it is time to get very nervous and think about voting for somebody else. The push in the 1990s for republican and democratic administrations to raise Home Ownership, it wont cost us anything, slightly overly optimistic. Finish this up. Was i would try to say to end on an optimistic note is it is true that we cant just throw away institutions and history and constitutions and pretend we are canada because that wont work but what we can do is learn. Democracies do actually learn, even populists democracies. We mentioned in the u. K. Became effectively unicameral legislature, no separation between executive and legislature so we would say in that sense very populist particularly after world war ii. They have extremely high tax rates but that created some pressures on the economy and in 1970s, 1980s with the high inflation, low growth and guess what, it was unpopular. The rise of Margaret Thatcher was not just about Margaret Thatchers leadership but the fact that the median voter in that populist country was sick of it. An interesting testament that the changes raja under Margaret Thatcher have persisted and are part of the mainstream status quo endorsed by miller band and others. We are optimistic in the sense we are spending a lot of effort hoping that the education of people eventually leads to some sort of positive response. It is hard in finance because it is very arcane. It is too easy for politicians to give you the flimflam. Lets be optimistic. Why not . More educated readers your read your book, will be less susceptible. They have been, thank you for being here. Charles calomiris. We are going to open up to q a and then have volatile food and drink. When you are called on, identify yourself by name if you could. In the front . Use the microphone if you could. Trying to figure what makes canadas bank stable. The thing that comes to mind is charter value. You only have five of them and they are profitable and so they dont want to lose their charter and maybe that stabilizes things. And secondly, if you do, what are forces that keep that from happening in the u. S. You mention the popular sentiment, people dont want banks to be profitable. The government willing to use banks for redistribution purposes. Is there a way, should we be trying to head toward a system where banks have valuable charters and if so, how could we head that way . First of all i want to be very clear here. Thanks have a charter value because for two reasons, one was because they run a business very well and the other is because they are endow with some monopoly, noncompetitive 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. There were thousands of banks in canada but only five that ive very big. 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 limited in the charter and in canada and that is the exclusion of the yankees. That is a very important part of the political bargaining. We are not the first to point this out because the canadian banking act is remade every five years and the banks charters expire every five years. Banks are on a short leash in canada. Also, part of the banking law excludes u. S. Banks and other foreign banks from competing on equal footing with the canadian banks so we think it is conducive to the banks also behaving well in the eyes of the regulator and so long as regulators act in the Public Interest which it has presumably in canada is also helping things so i actually think the exclusion, charter exclusion that matters in canada is not creating a monopoly rounds within the domestic system but one that is creating a vested interest of canadian banks in not messing up their deal to exclude the americans. Any way to create charter value in the u. S. . A recent paper on looking at charter values of u. S. Banks. Most of its is dictated by with if they know how to run certain businesses better than other banks. Theres not a lot of monopoly rent to be allocated. It is really about being able to do your business relatively in certain areas better than other banks. So my question, financial questions can be optimal and dozens that the cost of stopping them destroys, prevents real projects from being funded. One thing that was not in the discussion from the last hour is basically what is any price in terms of the allocation of capital, discounted pay for the decision in the Industrial Organization industry . It creates a set of technical problems because you have to model what canada would look like if you had more extensive banking policies and therefore had more volatility and credit. We can observe that the canada does exist and always struck me about canada, and exaggeration. It hasnt always struck me. About canada from the time it was a separate country. What struck me about canada was this was a country that with a very small swamp of land that you can grow anything on, you get 100 miles north of the border, and it is too cold to grow anything there are pockets of Natural Resources separated by vast differences. Nevertheless canada is a country with a tremendously high gdp by world standards and has accomplished that even though it is mostly of primary product producer which means it is subject to big fluctuations in terms of trade. Part of this is due to the stability of the canadian Financial System. I would be hard pressed to make and im human that canada could have done better had it had the u. S. Financial system which would have created much more volatility. They have done remarkably well given the resources they have. 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. It is really remarkable what they have done given the constraints they have. This raises an important point i want to get to which we didnt get to earlier which we had this obsession with never having any kind of crisis and the right analogy is the forest fire analogy. Forest fires are unpleasant, awful, you can be killed, there is forest fires when you do that other stuff, undergrowth builds up, when a fire eventually becomes a fire you cant put out. It is so much worse than having a lot of little fires with that happened with the Financial System. We publicly say trying to find the perfect way from there being any crises or distress. It works really well and then we have the yellowstone fire which is an unbearable, and pleasant, highcost situation. We should have a system we can cope with rather than one that never breaks. We have this ideal that will happen. Any other questions . Patrick kennedy. One of the themes from the earlier part of the book is that federalism is not always a check and balance the way we think of it and prevent bad policies but enables other types of bad policies. My question is do you think that is unique to finance or as the country is debating National Government versus states rights types of the issues and health care and everything else, you need to finance or you think this is of more generalized issued . It is a great question. I think that it is not unique to finance but it may be somewhat related, the issues in a particular area. It is interesting to meet that one thing we also discovered was Monetary Policy in canada has also been better than the United States. In terms of the inflation of the 1916s and 70s, and its volatility, canada managed to have a better experience. In trade policy you can also point to superior outcomes relative to the u. S. I am not sure, i do think there are at the general kinds of issues applied to other policy areas. I think that you framed a question for political scientists to address. I dont think theres a consensus answer to that question because the question has never been framed quite the way you put it. In most literature about federalism, federalism is always good. There is this flip side of it that has been underresearch. Graduate students thinking of a dissertation project would be a marvelous area to jump into. Last question, one more question . When might european friends and interlocutors say this matches the fall of the United States of america, what is the short answer to that . They have their own method. That is a short answer. Short and true. The view that came out of this, that everything is traceable to the u. S. Some prime crisis is obviously wrong. European problems have been borrowing on their own for quite some time. The u. S. Has done more than its share to destabilize global finances over the last couple decades. On that cheerful note we will adjourn. [applause] there are books available out in the hall. Help yourself to one and say hi to the others. It is the great opportunity. Whether it is