Your book is in large part about the importance of the individuals who managed—or mismanaged—the global economic crisis that arose after 1914 and that led to the Great Depression. How did the managers of our economy err this time around?
The central theme of my book is that a group of people had ideological blinkers. The question is did they, this time around, have a different set of ideological blinkers that prevented them from seeing what was happening. Secondly, more importantly this time than last time, is the element of hubris. They were so successful weathering storm after storm, including the storm after the dot-com crash. So, I do think the people who ran economic policy, Alan Greenspan, people who had been in the Clinton administration, people who have come afterward, really thought they knew how to keep the car on the road. And they didn’t.
The economy responded to things as predicted. For example, let's take the Asian crisis. They went in and came up with a policy, they threw a lot of money at the problem, a lot of people told them it would be a disaster, and lo and behold a year later Asia was recovering. They sort of patted themselves on the back. Then, the same story with the dot-com bubble.
“Profits will probably fall by half and I would be surprised if the bear market lasted more than two or three years. And we’re 16, 17 months into it.”
Tell me about that.
Alan Greenspan has become associated with the view that it's too hard to prick a bubble, but you can know what to do when the bubble bursts. And lo and behold they did what they said they would do, which was to cut interest rates very quickly and within two years the economy was back on track. There were some bankruptcies, and people lost money, but the whole system didn't fall apart.
So, it had the stability of a bicycle. They occasionally hit a bump, but they knew how to keep the thing going. But when they hit a really big bump, they collapsed.
What is striking is what a house of cards they were dealing with. Last year, even the most pessimistic forecasters did not imagine that the whole Western system would fall in on itself.
Were the mistakes in your view, a function of denial that itself was a product of the fact that everybody seemed to be doing so well, and economic incentives embedded in the system? How much do you think was a function of the fact that the world had become so increasingly complex so quickly that it was impossible to know what was really happening?
That's an interesting question. Certainly there was an opaqueness about things, in part fostered by policy. That people were allowed to have all these off-balance sheets was like having a second set of books. Why they allowed that, I don't know. So obviously no one quite had a picture of the system. If you asked them to draw a map of the system and tell what the amounts were, I don't think anyone could have. The opaqueness was one element.
On the other hand, there were people who were saying this can't go on. But they were all fuddy-duddies. They started saying "it all can't go on" ten years too early.
And who were the fuddy-duddies?
People like Paul Volcker and Henry Kaufman. All the old dinosaurs, who were astounded by the numbers involved. It was basically old Wall Street hands who were saying this is ridiculous, this is crazy.
There was another group of people who were saying "there is a crisis brewing" and it was a crisis that never came, that the dollar would collapse. And you have a surprising thing last year was the dog that didn't bark. Everyone was looking right and the crisis came from left.
I assume that you believe that what has backed up the financial system globally is the collapse of the shadow banking system. Who should have been monitoring the shadow banks?
Yeah, the shadow banking. First and foremost it is whoever are the two principal people at the Fed. So, the chairman and the head of the New York Fed. They are supposed to provide a window. They are supposed to be the eyes of government on the financial system. You could argue the SEC, but I really do think the responsibility lies with the Fed.
Does that make Tim Geithner a stunning choice to be one of the principle architects of the recovery?
Yes and no. Roosevelt's banking program to save the banks was put together by Ogden Mills, who was the secretary of Treasury in the last year of the Hoover administration. So there is an argument that he knows where the bodies lie. That he's been dealing with it. [Geithner's] learned his lesson and I think he is. But, he's probably the right person, although I have to say I've been shaken in the last ten days by what a poor unveiling they had of the banking bailout package. So, you could make a case that there are people who are in charge who know the system, and as they have watched it crumble are probably in the best place to try and rebuild it.
If you were President Obama, who would want to be talking to all the time and who would you want reporting to you?
I have great admiration for Larry Summers. I think he is supersmart and he brings the same—not that he's always right—but that he brings an analytical ability and ability to think about the issue in a dispassionate way. He's not captured by Wall Street. The big risk and the big argument is that the Fed and the Treasury are victims of what is sometimes called regulatory capture. They're supposed to oversee Wall Street and banks and they allowed themselves to become the tool of them rather than take charge of them. I think he's someone who can say "I've tried that." But I don't know him. I only know what I read in the papers.
Turning back to the importance of personality. An observation sometimes made about Summers is that he is lacking in people skills. If true, is that an issue?
Not so much. This is an issue of analyzing—we’re in uncharted territory and what you want is an open mind and an ability to analyze options in as a dispassionate a way as possible without getting hung up. Without having an agenda. Without pushing one side or the other. I think he's like that. But, I could be proven wrong.
Why are we in uncharted territory? Is it simply the magnitude? We have a crisis in liquidity in the financial system. We have negative growth. We're concerned about the impact of all the money we're printing. It's an extraordinary case, to be sure, but it’s not like a disease we've never seen before. It's not like a new strain of the Asian bird flu, is it?
Well, it is. We did see it in one form in the Great Depression but we haven't seen it since. It does have to do with the magnitude involved. Then the magnitudes were bad and we subjected the system to the wrong medicine. We killed the patient because the disease was bad and we gave it the wrong injection.
Your book really does feel like you're reading about doctors treating patients with primitive techniques.
Yeah, like bleeding the patient. Whereas this time we think we know what to do. I have two things that keep me up at night. One is whether the financial system so large that we've created this Frankenstein that has gone out of control, and from a global perspective it’s too big to save. We know there are individual countries, like the Icelandic banking system, which is too big for Iceland to save.
I was astounded by all the repercussions once Lehman Brothers went over. Lehman was a medium-size investment bank which had a $100 billion hole in its balance sheet. Very few derivatives holders lost money because they had been marking it to market and exchanging margin. The secured creditors—$700 billion of secure creditors got paid. So it was the shareholders and $70 or $80 billion of unsecured creditors that lost their shirt. Why that should cause the Western financial system to completely seize up I don't think we completely understand.
The world has become so complex that it is virtually impossible for institutions to understand their risk profile.
Yes. One of the goals will be to sort of simplify everything. We need a banking system that is clear and we know where the weak spots are.
What else keeps you awake at night?
The other thing that gives me sleepless nights is the point in the book where I say that the Great Depression was caused by a failure of intellectual will. This time around they know what to do but I am a little worried that we may cause the problem out of a failure of political will.
Take the bank bailout. Kim Rogoff from Harvard and everyone has been writing that lots of countries have been through this and it cost somewhere between 10 and 20 percent of GNP to bail out a banking system that got into trouble. In that case, that is somewhere between $1.5 and $3 trillion in our case. The government will at some point have to ask for a check from the taxpayers between $1.5 and $2 trillion. I think we just don't have the nerve. The taxpayers just aren't ready to write a check $1.5 and $3 trillion in addition to the $750 billion we already gave.
Talk more about the possible failure of political will.
There is a second element to the political thing which is the global dimension. The last six months, what has been shocking has been one, East Asia falling off a cliff; second, the European subprime problem, which is not a subprime like ours, it's Eastern Europe. They've all been borrowing francs and borrowed too much and now are about to default and the amounts involved are the same as subprime. Which is somewhere between $1 and $2 trillion. There you have the added problem that you have to get the Germans to bailout the Poles. At the moment, we can get the Texans to bail out the Californians, but that's because they're all part of the same country.
Who do you think is in charge in Washington?
On economic policy, Larry Summers. By sheer force of intellect and personality, he has dominated the agenda. Before he came on the scene, they were not talking about a stimulus package that even came close to being adequate. But he came on and gave his intellectual credibility. No doubt he is the driving force.
Did you think that bill was adequate?
I don't know. Everyone says it was not. They probably reached the limits of political capital. Frankly, I believe they can come back and do more. A bill that is 6 percent of GNP seems to me to be a very good start. There are some people who are saying we needed 8 percent of GNP, 4 percent for two years. This is four short. They're right. But I would give them good marks on that. What really astounded me was that Hoover economics—that “do nothing, balance the budget"—still has a following. It's mind-boggling that people say what we really need to do is balance the budget or let this whole system revive itself, if the government doesn't get in the way.
I have another question about Larry Summers. He seems uncharacteristically quiet when a strong voice might be useful to restore confidence.
I suspect that they got a little worried because he had too high a profile. They sort of pulled him back. It seemed kind of odd that the Treasury secretary, at that point when he had tax trouble, was absent and Larry was doing all the talking. I think they tried to turn the pendulum the other direction so at least Geithner got some profile. He didn't do a very good job. I'm probably the wrong person to figure that out. I don't know if about how the White House works and how it works with Treasury.
Structurally, does Geithner have the right job and Summers the right job?
No. If Larry didn't have the baggage that he had, he would have been Treasury secretary. From what I can gather, Obama was enormously impressed with him when he came on board and advised after Obama won the nomination. There would be these frequent meetings where Larry would summarize what was happening in the economy and he did a phenomenal job.
Going back to your regulatory capture idea, is Treasury too full of Wall Street people?
Oh yeah. In part, this sort of absurd dancing around nationalization is a reflection of that.
What do you mean by that?
They have done almost everything they can to avoid a situation where the government assumes control of one of the big banks. But I just don't see how you can get the government and the taxpayer to put that much money into the banking system—and it’s the only source of money—and not have it assume ownership control. I think they're not giving the taxpayers a good deal. I've been asking myself why? And I can only assume that the country is just hung up that it is going to be attacked for nationalizing banks. But even Lindsey Graham says that is fine with him.
You're suggesting there is some kind of regulatory capture issue, that the people from finance in Treasury are less interested in representing the taxpayer than they are temperamentally disposed to being sympathetic with the private sector.
Exactly right. Again, like Roosevelt, he kept a lot of the Hoover people on in Treasury to help him because they knew what they were doing. This team has done the same thing. You asked the question about whether Geithner was the right guy. Maybe that is a problem. That you needed someone who could look at things with more of a fresh eye.
When you have government spokespeople saying we will begin to see growth in 2010, does that just strike you as happy talk?
They are in a position where what they say influences the outcome. So you should never take what anybody in government says as a forecast. They chose to be cheerleaders, somewhat. I have no confidence in this forecast. But the great thing about bear markets is they’re short. I’m more confident in saying when it’s going to end than saying: ‘The Dow will make its low at 4000 or 5000 or 7000.' The great thing about bear markets is we get it over and done with.
What’s your view of the market?
I buy the idea that the market’s gone from overpricing risk to underpricing risk—and there are great values. Someone called me and said things were going to get bad, and I said, ‘The more you fear that, the better, because that means they’ve all sold.’
The bear market in the Great Depression lasted 30-something months. Profits of US corporations went from $9 billion (9 percent of GDP) to 0. I don’t think we’re going to have the same fall. Profits will probably fall by half and I would be surprised if the bear market lasted more than two or three years. We started in Oct ‘07, so we’re 16, 17 months into it. It’s got further to go, but the low is probably going to be this year, not next year.
Jeffrey Leeds is president and co-founder of Leeds Equity Partners, a private-equity firm based in New York. He is a director of Education Management Corp., RealPage, and SeatonCorp, and a trustee on the United Federation of Teachers' Charter School Board in New York.