The New Economics of Debt and Financial Fragility

Transcript

Rob Johnson:

(singing) Welcome to Economics & Beyond. I’m Rob Johnson, President of the Institute for New Economic Thinking. (singing) I’m here today with Moritz Schularick who’s been a grantee at INET, a senior fellow. He’s a professor both at University of Bonn and Science Po in France. He is guided a very, very interesting project, which is now in the aftermath of a very exciting conference among the new generation of young financial and financial macroeconomists. He’s brought together in University of Chicago a press book that we released in November called Leveraged. Moritz, thanks for joining me here today.

Moritz Schularick:

Thanks for having me, Rob.

Rob Johnson:

So, at the outset, I guess I’m curious, going back to the pre-conference as you and Richard Vague who’s on the INET board and has written the brief history of doom and about debt jubilees and everything else, what were you envisioning? What was the problem that you wanted to address that inspired this entire line of work resulting in this book?

Moritz Schularick:

Well, we thought that since the 2008, 2009 global financial crisis, there had been a new generation of macrofinancial economists who thought differently about the sources of endemic financial instability in our economies, in our society. We wanted to give voice to that new generation, bring them together in a conference that INET had organized. It coincided with roughly the 10th anniversary of the global financial crisis. We wanted to take stock.

The problem that we said at the outs and our participants and speakers and contributors were given is, how do we explain that this drive towards financial liberalization, deeper and more integrated financial markets that had started in the 1970s, 1980s, how do we explain that … It’s all undeniably, finance is much bigger. Markets are more integrated. Markets are, in a way, more complete than they’ve ever been before. How do we explain that this idea and this process of financial integration had produced the opposite of what its cheerleaders in this liberalization drive envisaged? Namely, more stability, more completeness of markets, more opportunity, and ultimately, more growth. The starting point for this conference was that it seems that market deepening in the area of finance has not produced what Arrow, Debreu would call more complete markets that are self-stabilizing but an endemic financial stability problem.

Rob Johnson:

So, at the level of, what you might call, seeing what might be called false projections of optimism in light of experience, do you then explore, in essence, the nature of the public policy regulating finance, or are you exploring things like the spillovers between the financial sector and other sectors or all of the above? What are the deep dives that you find in this book that, what you might call, unmask some of the false consciousness of that Orthodox era and also what kind of things to do to understand it better and to manage it better in the future?

Moritz Schularick:

That’s an excellent question, Rob. So, I think we started out with the idea of a diagnosis and the diagnosis was financial liberalization. The deepening and expansion of financial markets has not made the world a safer place. It has not led to more stability, and it has not necessarily led to more growth. Instead, a lot of what that financial sector that we have right now does is quite far away from what we traditionally would call as the savings investment intermediation that is at the heart of finance, so that was the diagnosis.

Then, we said when we invited a number of really excellent outstanding scholars and gave them questions, gave them relatively precise curated questions that we asked them to address and reply. I’ll give you a question. An example would be, do the risk and costs of credit booms outweigh the costs? Is the price of risk in periods leading up to financial crisis, is it mispriced? Do we understand why these over-optimistic periods … Another question we gave, do these periods of excessive risk taking that ended in financial crisis happen because people have wrong incentives or people have wrong beliefs?

So, we curated a set of question that we thought was central to understanding that phenomenon of really instability that is with us as a feature of this financial system that we’ve created and asked our contributors, asked our authors to address them in a very concentrated way. I think if I can add that, Rob, one starting point for this project is one that has proven through repeatedly also in recent, in the past two or three years in the pandemic and after, namely the feeling that whenever something bad hits our economies, and unfortunately, we have had quite a few bad hits recently, the financial system only survives that with an awful lot of government support. Government support, I mean, also central bank liquidity support, so remember when COVID struck. Central banks reacted very quickly and flooded markets with liquidity, created facilities for corporate debt markets, for high-yield junk bond markets. All of a sudden, we discovered that we had to protect hedge funds, private equity funds and other very risky players in the market because they had become systemically relevant.

So, the question how we ended up in a world where essentially, we’ve built this very large and enormously big financial sector that seems to be only able to survive with a government central bank backstop that’s very … The invisible hand doesn’t do it. It needs a really visible hand of central banks to keep that market together. So, something seems to be very fragile, endemically fragile, and that’s a central theme that we talk about in the book.

Rob Johnson:

No, I gather from my reading through the chapters that there is a great deal of concern at one level just within the market dynamics about what you might call side effects and unintended consequences. There’s some concern that if you create, what you might call an amplifying feedback, boom, it only leads to a bust and slower long-term growth, but on the other side, I sensed the dilemma that sometimes, if you don’t allow what you call enthusiasm and vitality to bootstrap and jumpstart technological innovation, you’re almost confining the economy to be in a less, what you might call dynamic and evolving way. So, I sense these dilemmas going back and forth in the different chapters, but I also sensed, and you’ve said it very nicely implicitly in your last comment here, it’s not so much about the interactions between different things in the private sector. It’s about that creature, which I might call the mother of all moral hazards.

If you see these things, these as you said, hedge funds, big financial institutions, et cetera, as being too big to fail, and then they understand that they will be bailed out without any kind of system of prior restraint, we are, what you might call, fomenting excess, then the taxpayer who supports the bailout with the funding is subsidizing aggressive risk-taking in the financial sector. That did obviously, after the Dodd-Frank and TARP legislation and so forth appeared to demoralize a lot of people because as Joe Stiglitz said, the polluters got bailed out, and the polluters got paid, and the rest of us, how do you say, bore the burden of the downturn.

So, I see, what I really like about this book is that a lot of these dilemmas are consciously addressed. There’s no hiding thinking from powerful sectors in the economy that this young group of people, seeing how profound that crisis was in terms of not only economic activity but the credibility of expertise and the belief in governance, this becomes a very, very important environment to explore vigorously.

Moritz Schularick:

Right. There is also a thread running through that book, and I think it connects very nicely to what you just said, which is there is this one side when thinking about financial stability that has to do with the incentives of financial agents and financial actors. As you mentioned, the repeated policy of going back to bad debts and even longer … that central banks are the lender of last resort to financial institutions in trouble, that is something that we probably all just, as deposit insurance, we subscribe to these safety nets.

We think they’re tested and proven, and we need those, but we’ve also ended up in a world where it seems like central banks assuming that role have to run ever faster just to stand still in the sense that there is this interaction that you talked about between what the financial sector does, how it thinks about how price is risked and how it anticipates a risk and how central banks then, when things go wrong, if you will, come in as the re-insurer of last resort for finance in the name of protecting the economy and protecting society from the fallout of that.

I think central banks, they have a very good argument. They say like, why would I help the economy hostage for the speculations or the deeds of some people on Wall Street? On the other hand, with that very justified protective instinct of central banks, you will not get into a situation where these players on Wall Street ever take the responsibility for what they’re doing is in a way, it’s only when they fail and when they’re in trouble that you actually have the power to regulate them because the moment you’ve stabilized everything, they’re quite healthy again, and they influence the political process in their interest.

So, that again, the political economy of finance where it looks like the players that often caused the crisis or did the most risky things beforehand get rewarded by getting even bigger after the fact, that is another very fundamental question about the financial sector in our modern economy that we haven’t solved. I mean the first one I mentioned was, how is it possible that more complete markets that we … Growing up as economists, you think that more complete markets are great. That means people can ensure more, there’s more choice. There’s all kinds of mechanisms that make sure that if there’s a large and deeper choice of options to choose from, then things should be more stable and better. How did they fail so spectacularly in the case of finances where more complete markets have presumingly brought us more instability and not more and not more stability? The other question is, how do we ever leave these cycles of, these political economy cycles of risk taking, bailouts and lobby power that prevents fundamental change in financial regulation?

Rob Johnson:

Yeah, yeah. I thought one of the more innovative chapters was created by Rudiger Fahlenbrach, where because of what you might call the ex-post demonization of financial executives, I never met a financial executive that was at the top of one of these institutions at the time of the great financial crisis that was happy about it. So, understanding, how would I say, we’re in charge is different than saying they could feel deeply, heads, eye, wind, tails, you lose. While that may seep in, Fahlenbrach really went through the compensation structures and the incentive schemes and so forth and essentially said what it looks like because a lot of these people had a lot of skin in the game and lost a lot of money personally.

So, perhaps the question once again is more about how the taxpayer pays for what you might call it, securing the creditors, keeping the cost of funding down and all kinds of things, but when the crisis occurs, the executives are not, how would I say, on the sideline, having protected themselves while the ship goes down. They are seemingly from this paper. People who didn’t see it coming perhaps were caught up in the enthusiasm of the boom and didn’t see the turning point and themselves also paid a price, which is I think an interesting contribution to the debate, to the yin and yang, and good and evil that you’re exploring here.

Moritz Schularick:

I’m very glad you bring this up, Rob, because I wanted to also give an example where this new cohort of economists that we brought together for this project is, I think, in a very good way, undogmatic, willing to entertain new hypothesis, willing to step outside of the orthodoxy even if that is something that we might all consider something that’s a truism. The truism being that, oh these CEOs on Wall Street, they didn’t have enough skin in the game, and things would’ve gone otherwise if, I don’t know, they folded. Lehman Brothers had more skin in the game.

What Rudiger Fahlenbrach does in these chapters is to expose very nicely that many of these people had a lot of skin in the game and lost a lot of their own money, which doesn’t mean didn’t potentially still did things that were irresponsible. Presumably some of them really did, but it tells us that we need to look deeper than the easy explanations for why financial crises happen. In this case, if you boil it down to the question, do crises happen because people have bad incentives or people have bad beliefs? Rudiger Fahlenbrach makes the point that likely now, Samuel Hanson, in his wonderful discussion that’s in the book, makes the point that it’s probably a combination of both. Just assuming that all these CEOs on Wall Street knew it was a big housing bubble and everything would go to hell in a hand basket also doesn’t do justice to the complexity of crises.

We’ve learned in the past, if you will, past 15, 20 years, almost the most interesting research that has come out of financial economics has been behavioral finance. We’ve learned so much now about the deviations from rational expectations, the herding, the biases that can lead to mispricing and risk-taking, and we set up almost in … We almost say this would be a great book for graduate course in financial instability to use as a textbook because you’d go through these individual chapters week by week, and you address really each week one of the fundamentally important and much debated issues. What’s the role of incentives versus the role of beliefs or bad expectations? What’s the role of, for example, swinging the game and preventing risk taking?

There’s a chapter on that making the point that we had very high capital ratios in the 1920s, and it didn’t prevent the Depression, and it didn’t prevent all the risk-taking that took place because the potential for disciplining risk-taking at the banks through skin in the game might that actually be quite limited. There’s no way around tighter regulation, also on the looking closely at what banks do on the asset side and not just regulating the liability side.

Rob Johnson:

How would I say? When I look at the good and evil, this paper that is about the bankers suffering is distinct from the question of what banks and their lobbyists do to create a, what you call a system that’s perhaps unduly supportive of their desires. So, the question of, who gets appointed to the Fed regulators, how often do you have examination, how tight is the supervision? These are things that in a world that depends on money and politics that can very clearly be influenced by deep-pocketed lobbyists. So, there isn’t, what you might call a declaration of innocence vis-a-vis the structural form of finance, but that one dimension, which is somehow these people are cynical and have abandoned ship and preserved themselves while we all suffer, is it’s in itself wrong.

Like you were saying, when you think about the INET young scholars or whatever making a course out of this book, you can see how, you might say you as a team, you did not blink at exploring any of these avenues, but you didn’t because of the wave of emotion, which was particularly early on anti-finance. You didn’t neglect exploring whether certain aspects of the accusation are without basis.

So, I can see in the themes of the book these questions of what creates a vital medium-term economy. I can see concerns about the incentives of executives, some concerns about political economy, and it would be interesting, I think, to hear from a collection of writers in what you might call a follow-up what … If you said the next course was how do we design what to have in light of what we learned, I think it would be fascinating because many of the authors were quite refreshing in saying, “I don’t really know what to do here,” particularly the first section of the book, which was talking about the trade-offs between, what you might call it restraining credit allocation and the capacity for innovation and dynamism versus what you might call not getting reckless and having booms and busts. Is a boom-bust economy in the medium term actually more dynamic than one that is tightly constrained and never really develops the momentum that may spur great innovation? I think that dilemma is fascinating.

Moritz Schularick:

Exactly. That’s a fascinating chapter that Emil Verner who is an assistant professor at MIT wrote, and then there is an equally, I think, intellectually forceful discussion of that paper by Holden, Miller that’s from NYU.

Rob Johnson:

Yep, that’s right.

Moritz Schularick:

That’s exactly that point. Well, how do we know that a financial system that avoids these boom and busts cycle, there’s ultimately more, ultimately in the interest of society or the economy, we might think it is. I think we all have our priors here, what would be the financial stability. Also, if you think about the political consequences that it has is extremely desirable, but as you say, it’s far from clear that restraining, making sure that no booms and no busts ever happen is in our long term interest and increases welfare of citizens because … You cut down on some dynamism, and that’s an old question, I think, that the book addresses. Just says, if I can highlight this, another very fascinating chapter by Atif Mian from Princeton who looks at the link between inequality and financial instability and what finance does.

The argument there is that in a way, you can’t separate the two because if you have changes in the distribution of income, all of these financial flows and income flows are ultimately handled by the financial system. So, that translates into savings behavior. More rich people at the top of the income distribution get more income, the bigger share of the pie, if you will. Then, more savings will pile up at the top because savings propensities are higher. That means that there’s a lot of savings in the economy that are looking for a home and financial engineers come and find instruments to place these savings and turn them into investments and to borrowing of other people and companies.

So, in there, I would say we learned something very deeply about the interconnectedness of societal trends such as inequality and the risk that poses for financial stability. It all brings us back to this point that I think is for me a very fascinating intellectual starting point, is we started 30, 40 years ago in unfettering finance and letting it go and grow in the today with same, the naive assumption that this would make up for more stable, more complete, better functioning, pro-growth financial system. We now stand in front of this. If you look at the quantitative indicators as you mentioned, Alan Taylor, Oscar Jorda and I are able to develop in the long run as part of our INET grants and INET projects, you look at these charts, and they all look like hockey sticks where something, the last 40 years, all these financial indicators, credit volumes, leverage, house prices, whatever you look at have accelerated and have exploded in some cases.

We realize today in 2022 that we have very, very bad idea about how does world actually … What are the deep parameters of this financial sector? As you say, what’s the role of incentive?, what’s the role of expectations of beliefs? What’s the role of regulators in pushing these booms? What’s the role of CEOs? So, it feels like we’ve created this enormous, enormous financial sector. What we know is that our premises, our priors that we had 30, 40 years ago were wrong but there’s a big void in saying, so what is it actually? How do we think about this leveraged wealth that we’ve created? Maybe it was good, maybe better than counterfactual, but to be honest, we don’t know. I think that’s the strength of the book to really clearly point to these dilemma that are out there.

Rob Johnson:

I do think there are some, what you might call very long-term echoes that, if you will, reenter the stage. What I’m thinking about is Keynes treatise on probability and ontological uncertainty, Frank Knight, Kindleberger-Minsky, others saying this, what I’ll call engineering-like, and I was trained as an engineer as an undergraduate. Engineering-like mechanical financial economics is not the right vision when there are unknown and unknowable unknowns in the future. We’re not doing backward induction. This isn’t just, what you might call smart guys with software and arbitrage who adhere to an equilibrium and maximize everything. That fundamental radical uncertainty, which George Soros wrote about in Alchemy of Finance, is the context in which all of this is embedded and acknowledging, what you might call that humility that even, for instance, I’m speaking on the horizon now. When you look at climate change, the statistical distributions you’d have, whether asset prices or actuarial tables, really don’t mean very much when a profound new structural challenge emerges. You just don’t have stability of the distributions that you can count on and work in that kind of algorithmic or mathematical way.

I see lots of people in the ESG world and in the insurance business and so forth is quite daunted now by the challenge of not knowing what the structure, which implies survival of the human race, will have to look like. It’s not like we know when we’re corrupt. It’s really that there may be resistance that might be called damaging to the future of humankind, people with vested interest. I’m not denying that, but there is a daunting uncertainty, and a financial system that doesn’t acknowledge that as the context, I think, is a misspecification.

Moritz Schularick:

I think that’s an excellent point. I think the point that we make in the book that’s related is the idea that people typically, households and businesses typically take on debt and leverage up in situation where they think the future is a place they can envisage in a way. They have some stable parameter about how the world works. That’s the situation when people feel comfortable to go deep into debt. It doesn’t necessarily mean that they expect that the future will be puppies and rainbows but situations in which they think there’s little downside are situations when people … and this is all the Minsky and Kindleberger in a way. When things are stable, this is when people become willing to take bets on that stability. By taking these bets on future stability, they actually dig their own hole because the increasing leverage means that any shock in the future will have much more, much bigger consequences than what they thought it would have. They also miss that everyone else is kind of doing the same.

So, I think your climate change example speaks to that, the idea that, coming back to what I said earlier, that we live in this now leveraged world, hence, Leveraged, the title of the book. So, we’ve woken up to the fact we live in this highly leveraged world, and the future doesn’t look quite as safe anymore as it maybe looked in the 1990s when there was the end of history. No. Now’s the end of the end history. The world is not such a safe place anymore, but we still settle with these large amounts of debt.

Then, I can understand why probably if we were running the Fed, Rob, you and me would do the same. Whenever there is a shock, we would do whatever we can, whatever it takes as Mario Draghi said, to stabilize the situation but people … This is the irony, and then the forward-looking nature of things. People understand that we will always do that, and they will take this into account and take on even bigger risks.

So, we are in a really difficult position and especially, which I subscribe to, we are in this world where we, actually, we can’t put probability on the future of history, so we might end up in a situation where a lot of this debt that was taken out in the expectation of stability of income, stability of interest rates, I think that’s a big question right now. How far can the Fed even go with interest rates before reaching some financial stability up abound, if you will? These are certainly, there are a lot of people who’ve made plans in the last 10 years and not assuming that mortgage rates would go up to 7% again.

Rob Johnson:

Well, I always remembered when I was an undergraduate and flirting with the idea of becoming an economist. I took a course with Charles Kindleberger where he was working on his book, Manias, Panics and Crashes. One day, one of the students, a very dynamic young guy, later worked with Long-Term Capital, he said to Kindleberger, “When were things most dangerous?” Kindleberger said, “When people get optimistic, and they think past this prologue is when they’re putting their neck in a noose.” It’s that notion that you don’t know but you get, how would I say, calmed and less on guard, and then you start with the optimism, extending yourself, putting yourself at risk for when things deteriorate.

Moritz Schularick:

Exactly.

Rob Johnson:

The other thing that I remember not from Charlie but from others like William Greider who wrote a famous book, Secrets of the Temple on the Federal Reserve, was people talk about the importance of the independence of central banks. In your book, there are a number of passages which talk about, what you might call electoral cycle. Boom busts where extending credit to help people, incumbents get reelected and what have you, but the idea, once we got to these large scale bailouts like the great financial crisis was when they said the Fed has to be independent, it was like they had to be independent from the electoral cycle manipulation, but now, the question is, who do they have to be independent from?

When they’ll do the bailouts, I never blame a central banker once we’re going over the cliff. If you’ve got a choice between crashing over the cliff or having a safety net and getting everybody back from falling off the side, you go for the safety because the unnecessary losses are enormous, but the question is ex ante. Can you create a system that’s resilient enough that you don’t have to exercise that bailout emergency very often? That’s where the lobbying and other things come back in.

I’m curious. There’s a number of people that have worked with INET, Michael Greenberger in particular, who at this juncture is quite concerned about the number or scale, I should say, of derivatives that are not reported so that there can be, what you might call, whether it’s offshore or whatever, it’s involved, it’s woven into the bank holding companies and investment bank holding companies in ways where we don’t know how risky things are at the institutions that we have to protect for systemic stability. Some people who have suggested to me, Greenberger did a lot of this research after he left the CFTC for INET, some have suggested to me that this relates to the competition around the world between financial centers. Less disclosure, less scrutiny means that the financial firms will migrate to the equivalent of exchanges in the locations, whether it be London or Frankfurt or Shanghai or Hong Kong or what have you. They’ll go to the places where the regulatory requirements are minimal, and then we get into a competition among financial centers to attract market share by making the system actually more dangerous vis-a-vis bailouts and taxpayers.

Moritz Schularick:

I mean, I think there’s a strong element of this in what we’ve seen in the crypto space in recent years. I mean, speaking of it, and it’s not that we … There is a chapter in the book that Juliane Begenau wrote. She’s an assistant professor at Stanford and Nina Boyarchenko from the New York Fed also has a wonderful discussion on this, but she exactly talks about the question of, how do we actually understand the risk exposure of banks, and how can we think about this in a way that does justice to the complexity of the balance sheets to the arbitrage opportunities that are exploited across jurisdictions, across platforms? How do you integrate that? She has very interesting ideas in how you can essentially use techniques from valuing financial instruments and you apply those to apply those to banking portfolios as well.

I think it prepares us, and that’s the interesting back door there. I see that as a policy discussion coming up in various places to think about banking regulation and financial regulation not just as regulating the liabilities of the banking system, which as you know, is about deposits and how liquid can they be, and do we need to ensure them? Is there deposit insurance? It’s about capital, how much capital it should be, but to also look, as you say, on the asset side, on the derivative exposure. We need to really better understand what banks do on their asset side and maybe get up to speed there with regulation as well in ways that we haven’t been particularly successful in the past.

Rob Johnson:

Which in a kind of meta sense, we deploy the private sector people to go into energy, and they have solar or they have wind or they have fossil fuels or whatever and what we call externalities of carbon burning, upper atmosphere deterioration becomes, what you might call, the public good, meaning embedded in all these activities are side effects. Some can be positive. Some can reduce carbon, but in the financial sector, we’ve treated these entities like they are private entities in a market-based society, more freedom, more discretion to use their expertise where they do, but these systems, the credibility of the systems, the fear of collapse, the need to invoke the public treasury are all testament that there is an element of systemic design and maintenance that is about the public good. It’s not just a private entity, and the scale and the power, the penetrating power of finance has turned it into, what I’ll call a public system whose integrity affects us all even if we don’t play day-to-day inside of the financial sector.

I think it’s an amazingly powerful dilemma over for, we might call, architects of future social design and how we … When you mentioned crypto, I watched a number of videos at a conference in Miami a few months ago. People were acting as though freedom of crypto, even on very large scale, was about personal freedom as though there were no systemic side effects from what you might call massive default propagation that would affect the banking system and other things. I found it fascinating how, what you might say, with the history of currencies, medium of exchange, unit of accounts, store of value, too big to fail, all of these other things, how these people could even be having that discussion without considering the systemic side effects.

Moritz Schularick:

Right. I mean, Leveraged as a book title implies already. I mean, what you’re talking about are the externalities that my debt, your debt, our debt imposes on everyone. Somehow, that leverage isn’t … That’s the externality, the risks that we individually take that ultimately … Well, big banks or the other side, the borrowers that ultimately are too big for us to … they’re not priced correctly, I guess. That’s the easy way to think about it.

So, having this enormous amount of debt out there and all this leverage that’s been created over the last 30 years has created massive externalities for the economy, and we will … I mean, it’s a different way of saying, of telling the same story, thinking about what I do, my decision to buy a house with a loan-to-value ratio of 90-10 affects the stability of the system as a whole. I might not see the externalities that I create when things go badly, but they’re clearly there. These collective decisions might have brought us to a place, and I guess that’s in between the lines of the book, that is the thesis there, that had we known how finances operates and what the deeper parameters in the instabilities, behavioral issues, the regulatory issues, the incentive issues are, we wouldn’t have grown a financial sector as big as we have it now.

Rob Johnson:

One of the things that I found fascinating just about this whole endeavor, and I’m taking it back even before this conference, is codified in Richard Vague’s book on the Brief History of Doom because he shows that … Let me just contrast it. The chapter on the bankers with their incentives also taking a hit, it’s fascinating, in contrast to Richard’s work, which says you can see these things coming. Central banks can look at certain ratios and debt and maybe first and second derivatives and so forth and identify, ex ante, the we might call it zones in which things become dangerous.

His Brief History of Doom is about 40-some financial crises that have common measures that can be seen ahead of time. So, it’s a bit fascinating that he can find that, and perhaps central banks or particularly, people with so much at stake like CEOs of big banks and investment banks haven’t assimilated that framework to protect themselves or to manage their portfolio or to manage their society. Richard who’s on the INET board and was the primary supporter of the project that led to this conference in his book, I think his work perhaps in the next chapter might be fascinating to integrate in … How would I say? I’m a doctor’s son, so when I heard you early on talking about diagnosis, I say, “Okay, when the diagnosis is as interesting as this, now what are the remedies?” It might be interesting to have a follow-on event with the diagnosis, and what do we diagnose that’s not there that should be there like Richard’s insights, and then what kind of remedies and preventive medicine can we envision?

Moritz Schularick:

Absolutely. I think the historical evidence that Richard in his book and the academic studies that have shown us, that Richard uses in his book to show that crises are not black swan events. There’s some indicators. There’s some things we can look at in a regular way, in a systematic way that show us that the risk of a financial instability event is rising. Credit growth comes to mind, the combination of credit growth and asset price growth. Clearly accentuated. The single best indicator is probably just the amount of credit and its change in relationship to GDP. So, there’s much more credit created than real economy growth or produces in additional goods and services. Some people are taking bets on a future that might not come true.

The fascinating thought then is, if that is true, to what extent can central banks act on this information? I think they’ve taken this lesson on boards with things such as macroprudential policies where they say, okay, credit is growing very fast, we can decrease loan-to-value ratios or modify debt-to-income requirements, et cetera, but it also raises the question, if this is to some extent predictable, why does it still happen?

Then, we’re back to square one where we’re saying, okay, there must be or likely, there is either an incentive that brings people or bankers and maybe even households because it always takes two to tango, so someone else has to borrow, to ignore the risks and do it maybe knowing that this is kind of a risky, little bit too risky actually, but I’ll do it anyways because, guess what, if things go wrong, interest rates are going to fall, the central banks are going to do something about it, or I guess also, what we’ve seen a little bit in crypto. I mean, people tell themselves stories about this time is different and why the logic of boom and bust and previous evidence on credit growth can be dangerous, can lead to crisis. Why doesn’t it apply in this case?

I had this conversation recently, if you look at the collapse of these big exchanges, these crypto exchanges and the collapse of the value of some of these coins, you think, with hindsight, it looks like just taken out of Kindleberger’s book. It’s such a predictable event, but if you’d argued that two years ago or a year ago when non-fungible tokens and whatever were the latest hottest thing in town, people would’ve had all these arguments why this is not a tulip mania, why this is different. With hindsight, it just looks like a good old, old financial bubble.

Rob Johnson:

There’s a humility and a dynamism and a curiosity and an energy that embodied in this book that I find very, very magnetic. When you talk with your colleagues and when you talk with the other authors in the aftermath of that conference, what do you all see as next steps? What’s the next thing you’d like to explore?

Moritz Schularick:

So, that’s very interesting. So, one question that followed directly is one that we have already implemented, and you were there at the beginning of the year when we had a conference on debt restructuring and on debt forgiveness and on ways to deal with, strategies to deal with excessively high leverage in our economies. Some of these with the student debt relieve some of the ideas and discussions from that conference where one way or the other reflected or became reflected in policy and spoke to that recent debate.

I think another big open question where a lot of us are thinking about right now is what Atif Mian describes as this link between inequality and savings gluts in a way that some … What’s the distribution of them? Who are the debtors. and who are the creditors? The ultimate debtors and the ultimate creditors. So, in the end it’s all about households, and it’s households lending to other households and trying to map. If you think about what would happen if we think about debt forgiveness, how does this tie into questions not only of financial stability but also wealth and equality and of broader political stability?

We need to understand how these financial entanglements within societies actually look like. That’s a big gap in our understanding. I mean, there’s great people who’ve started, looking at this, Gabriel Zucman and Emmanuel Saez, Thomas Piketty and others, Atif Mian, Amir Sufi. There’s work on this question, but ultimately, we don’t understand very well. Think of the bank as a little bit just as intermediary, and on the other side of that bank, there are people, households having the deposits in this bank that provide the funds that bank lend out, so you have these financial relations within societies that we actually need to understand if we want to think about the effects of policies. So, that’s one.

I think the other probably even more directly policy related questions is, what does this mean for the business of central banking? I think we’re right now, certainly in Europe but also to some extent, in the U.S., are realizing that that 10-year period of ultra low interest rates has led to some steps taken by central banks, thinking about the balance sheet expansion, the large quantitative easing programs that, all of a sudden, look much more complicated to unwind and much … It was easier to do it than to imagine a world where short-term interest rates would go up to 5%, and you created all these new reserves in the banks. Now, you have to pay the 5% interest on them, and what does that mean for the stability or the financial situation of central banks, but also, what does it mean more broadly for fiscal monetary interactions?

So, I think financial stability policy through the back door has brought us back to very big questions about thinking about the coordination of monitoring fiscal policy. It might well be. I mean, it’s not my prediction, but we could end up saying we’ve saved the financial system but in the process, central bank independence got so compromised that we will reconsider whether how would the relations between the fiscal, the taxpayer, the fiscal authority and central banks are simply because the amounts of fiscal support needed have become so big, and central banks and fiscal authorities are now so intertwined that it becomes really difficult, for example, to raise interest rates beyond a certain level without endangering the economy, fiscal stability or financial stability.

So, there’s a lot of potential for a third follow-up conference maybe with a focus on, so how do we think about policy, central bank interaction going forward? What role does central bank, does monetary policy play in creating? How does low interest rates and risk-taking, how are they linked? We have some ideas, but structurally, we’ve kept these two parts of what central banks do. Monitor policy on the one hand and financial stability are quite separate. If you’re bringing the third, which is monetary fiscal interactions … I mean, I had this discussion with Adam Tooze a while ago, and then we both agreed in the end that the business of central banking in 10 years will look very different from what it is now. Anyone [inaudible 00:55:12] how it’s going to look like but a lot of the preconditions on what we came to think of as normal in the past two decades, including the self-regulating role of finance, by the way, are just not true. We’re waking up to the new reality now.

Rob Johnson:

Yep. I think in addition, to give a little relief to the central bank, about the time that they could have been on their horse, tightening interest rates, we had this global COVID pandemic. Then, everything went down to zero and stayed there for a couple of years because there was a tremendous shock that, I think they, how would I say, stabilized but because it came at the end of that prolonged low interest boon, we saw stocks and asset prices and everything, including hoses going up in the middle of the crisis. Then, they were behind the curve.

Then, finally, I think it’s something, which I learned a lot about when I was an undergraduate at MIT, I worked with an oil economist named Maurice Adelman and with Bob Solow and Charlie Kindleberger. In those days, the question is, is the Phillips curve broken, or is it just shifting because petroleum prices went up? In other words, how does a central bank with aggregate demand stability deal with supply shocks? They’re not as, what you might call … If you have overheating demand, if you have wages and prices et cetera, accelerating because of overheating demand, throttling back is one thing, but when you have a cost push, prices are going up as activity’s going down. Now, do you exacerbate the downturn in order to stabilize prices? If you don’t, do you pay a big price dynamically?

I think this is a much … It’s a re-visitation of what the onset of OPEC created as challenges that, in some ways, was a different time because, say organized labor was stronger, globalization was smaller, but the shocks related to Ukraine, the shocks related to the unraveling of supply chains now, it’s not clear that the central bank has the tools to, what you might call, bring us into the dock peacefully from this storm.

Moritz Schularick:

I do agree, and I think the dilemma here, another dilemma is quite clear, which is by the time monetary policy has its largest effect, the economy might be in a very different place from where it’s now because energy prices, especially in Europe, will have a contractionary effect on the economy anyway, so let’s assume Europe is in a recession next year. That’s then when current interest rate hikes will have their biggest effect, but that’s not when you want them anymore. So, that timing is very tricky.

At the same time, you want to make sure that inflation expectations do not run away and think there’s a point where … Also, with an eye on political stability, there’s this famous word that you debase the currency, you debase a system, that we are, I guess that’s true in the U.S. as well. We are clearly not in a situation where trust in the stability of the democracy and the political system is particularly high, so inflation is something that goes that can tear the social fabric apart even more because there was a point of central banks to make sure here that people at least have the sense that this stays a one-off affair, and it’s not the harbinger of continuous inflationary pressures. That might have some cost. I mean, I wish there was an easy way out.

I mean, speaking of the comparison with the 1970s, I think they’re very clear, on the other hand, that again, this is why I think we didn’t plan this, but I think why Leveraged is such a timely book is the key difference between 1970s and now ism to a large extent, debt that’s out there. So, we now have an economy that’s four, five times more levered than it used to be with interest rate payments being much larger, outstanding amounts of debt being much larger. I guess the sensitivity of whatever consumers and households and businesses do to changes in financial conditions has risen. It’s risen tremendously.

So, I think it’s an open question. Maybe you have a better or a good idea, better idea [inaudible 01:00:17] than I have. After a decade of interest rates near zero, I would be surprised being just a reader of Kindleberger and Minsky that we don’t find out over the next six to 12 months that there were big pockets of the financial sector that were just banking on low interest rates to continue, and that we wake up to the fact that many of these business models, financing models are no longer valid and no longer work when you borrow at 5% instead of at zero.

I mean, crypto’s the most obvious one where we find out that, yeah, I mean at zero interest rates, the opportunity cost of playing around in other worlds is very low. When I can get three, four, 5% of my deposit, I might think differently about investing in asset that has a zero that produces no cash flow.

Rob Johnson:

I think as you alluded to early in that most recent passage, the loss of faith in governance and expertise and the hostility as, say embodied by the January 6th insurrection in the United States, we’re in a place where people are not believing in experts or governance. They’re saying the central bank pumped up everything for the highly concentrated wealth to get even wealthier, and now, they’re bringing the pressure down on all of us. People like Martin Wolf at the FT was writing a book right now that’ll come out just after the turn of the year, are really focused on the sustainability of democratic systems when in even recent polls, a quarter of people in America said things were so out of balance in both parties that they would just like to have somebody come in and operate the place rather than depend on democratic elections.

When people are despairing to the degree that they might acquiesce to authoritarian control, I think we’re in a very dangerous place for our policymakers. In other words, there’s another dimension in play here, which is the resilience of our governance institutions may be increasingly threatened as we saw on January 6th and in other systems, what we might call symptoms of polarity and anxiety. As you said, Atif Mian’s chapter and work on the relationship between distribution and all of these policy dilemmas, I think is another important part in light of the fragileness of our governing institutions in this next chapter.

Moritz Schularick:

I do agree. I worry about that element as well. I think there is a link, and that’s something also to talk about between … especially a link between financial instability and financial crises and the loss of trust in the system because it’s such a clear and visible and undeniable systemic failure, something that wasn’t supposed to happen that politicians and the system told us that’s safe, and all of a sudden, it falls apart. Guess what? No one has a real explanation for why, and all these smart people didn’t see it coming.

Rob Johnson:

Right.

Moritz Schularick:

The queen’s question.

Rob Johnson:

Financial system-

Moritz Schularick:

The queen’s question. That was-

Rob Johnson:

Exactly. The queen’s question. Exactly. So, that’s in a way, that is the recipe for loss of trust in the system. That’s a lot of recipe for populism. In a way, it’s true. If you’re all so smart, and you all told us that financial liberalization is good for us, so how is this possible that this happens? So, might trust you a little less, and we might be a little bit more open to having some maverick voice. Then, by the way, I think that’s what research also shows. The Urbans and the Trumps and the [inaudible 01:04:44] of this world, they don’t solve the problems that bring them into power. They use other means to stay in power, but that’s not a solution. The solution has to come from within the system.

Yeah. Well, Moritz, how would I say? Congratulations on the book, and thank you for all the organizing and insights and everything you brought to bear, and thank you for sharing it with our audience today. Do you have any closing thoughts or anything you’d like to share before we call it a day?

Moritz Schularick:

Well, I mean, I’ll guess I come back to where we started and then give the passes on, a little bit also the baton, to the next generation of young financial or economists, whatever you do, whatever you’re thinking out there. I think there’s been a different generation whose voices are brought together in this book. We produce more questions but slightly better answers to old questions, but new questions as Rob summarized very nicely. I think that that open spirit of scientific inquiry is what keeps us going. So, I hope we will have another book, and it’s no longer going to be us in 10 years that looks back at what we’ve learned over the past decade. The challenges are enormous. I think my hunch would be if you think about central banks, if you think about financial questions, would love to get the answers from you about the open questions that, the dilemmas as Rob called them, that this book still speaks to.

Rob Johnson:

Well, I think, how would I say? I often get a soundtrack in my mind as I’m listening to people like you, and the song that came to my mind today, I’m laughing, was The Moody Blues, and the name of the song is Question. So, I’ll ask our listeners to listen to that and come back to the table perhaps in the comments when we post this and nourish us with their curiosities and enthusiasm, but I think your book is tremendous nourishment for their curiosities as it sits. So, congratulations, and again, thank you for joining me today.

Moritz Schularick:

Thanks for the support from INET obviously.

Rob Johnson:

My pleasure. Check out more from the Institute for New Economic Thinking at ineteconomics.org. (singing)