(Encounter Books, 2009)
Q. Why did you write After The Fall: Saving Capitalism From Wall Streetand Washington?
A. I wrote After The Fall to illustrate that the financial crisis was not a failure of free-market capitalism but the result of the government's failure, over two and a half decades, to understand its proper role in the financial industry. That role includes creating the conditions for fair, free competition, including enforcing consistent regulations that make the economy better able to withstand orderly financial-industry failure. Without such rules, the financial industry enjoys immunity from predictable market discipline, as we've seen. Getting financial regulation right matters, because inadequately regulated financial markets don't bolster free-market capitalism. Instead, they culminate in bailouts and the wholesale nationalization of risk, as government must heavily intervene in the marketplace to protect the economy from disorderly financial-industry failure
Q. Do you think that the financial crisis was a failure of capitalism?
A. No. It was a failure of the government to regulate capitalism properly, using principles and rules that have worked well in the past and that can work well again in the future.
Do you think the crisis was caused by greed or stupidity?
A. No. Nothing about human nature changed to cause this crisis. Instead, the financial industry gradually escaped all consistent rules and market discipline, leading to a disaster.
Q. Don't we have enough regulation?
A. It's not a matter of too much regulation or not enough regulationit is the matter of the correct rules, applied consistently, not arbitrarily, and properly enforced.
Q. Which regulations are keys to preventing similar crises in the future?
A. Most important, we need a return to market discipline. Big or complex financial institutions must operate under the credible threat of failure, with lenders to those firms taking their losses in a consistent, predictable manner, not arbitrarily. Such discipline has been missing for 25 years, since we started bailing out "too-big-to-fail" banks. To make the economy better able to withstand financial-industry, we need reasonable, consistent limits on borrowing, both for financial instruments and financial firms, and we need better requirements for the disclosure of facts and risks behind new financial instruments, such as credit derivatives, that have escaped such requirements.
Q. But why should we trust the government to regulate anything properly?
A. History shows which kind of financial regulations work, and which ones don't. Regulations that allow for innovation within clear, uniform, consistent limits are much better than regulations that call for government micromanagement, for example. The same philosophy holds here as it does in other places where the government necessarily has a role: policing, for example, to create the conditions for a healthy free-market economy. The answer to ineffective policing was not to get rid of policing; it was to improve it.
Q. How can the government know when we're in a financial bubble or not?
A. It can't. But consistent regulations on borrowing for financial firms and financial instruments can help keep burst bubbles from turning into an economic disaster. If, during the housing boom, for example, we had had a requirement for homebuyers to put down a cash payment, just as they must do to buy stocks, the bubble never would have reached its ultimate manic levels, and the bubbles bursting would have been less disastrous, because it would not have left so much unpaid debt behind. If the government had not decreed that AAA-rated mortgage-backed securities were perfectly safe, and that financial institutions could thus escape all but token borrowing limits on such securities, the economy would not have been as vulnerable to a systemic disaster. Markets should assess risk from the bottom up; government should not decree what is safe and what is not from the top down. When market participants make many different mistakes, the market can correct them; when the government makes one mistake, the market melts down.
Q. But isn't the financial industry "different" from other industries in that it's OK to bail it out, because it only supports the rest of the economy and isnt really part of the economy?
A. No. It is "different" in that some financial firms can't undergo failure through the normal bankruptcy process, but all that means is that we need specific rules to govern financial-industry failure, just as we do with the FDIC for commercial banks. If we bail out financial firms instead of making their investors take their losses, investors in the future will know to direct their resources toward financial firms rather than to other worthy endeavors in the economy, thus harming economic growth.
Q. Can't we solve this problem instead by sending financial criminals and fraudsters to jail?
A. No. The crisis was a systemic failure of civil financial regulations and their enforcements. While crimes and fraud were a part of the crisis, the crisis was not caused by crimes or fraud.
Q. What if President Bush and Congress had just refused to bail out financial firms? Wouldnt that have solved this whole problem, by letting the market work?
A. No. We would likely have had a Depression. By 2008, the economy was simply not safe for financial-industry failure. The task now is to make it more robust to such inevitable failure. Otherwise, in a few years time, well be right back where we were: bailing out big firms, while vowing not to do it again.
Q. Most banks have given back their TARP money. The government is out of finance, then. So isnt the crisis over?
A. No. Even after financial firms have repaid their TARP money, investors will assume that the government will bail out these firms in the future if necessary, allowing them to take heedless risks without regard to the consequences, and keeping the economy in grave peril.
Q. Why are you so against Wall Street innovations?
A. I am not against financial innovation. Creativity in finance has a real role in the economy. But innovation must come within limits, and financial products must not be designed for the sole purpose of avoiding consistent rules and market discipline. If anything, our "too-big-to-fail" policy has harmed financial innovation, since it's impossible to tell today which innovations can stand on their own merits and which only exist because of government support.