Neil Fligstein is the Class of 1939 Chancellor’s Professor and Co-Chair of the Network for a New Political Economy. He is especially interested in the fields of economic sociology, organizational theory, and political economy. He is also the author of the new book The Banks Did It, a history of the Great Recession. We spoke recently about the Great Recession, the state of macroeconomics, the Federal Reserve, and financial regulation.
AAYUSH SINGH – APRIL 25TH, 2023
In your book you quote Janet Yellen questioning if the “creative financing” later proven to lead to the Great Recession was driving the housing bubble. To what extent was that statement representative of the views of top macroeconomists at the time?
That’s a good question, I don’t know that I know enough about what everybody in macroeconomics thought. The Federal Reserve sees its job as to manage this macroeconomy, and what they’re interested in is things that would threaten the whole thing. So for example, this whole cryptocurrency thing: so far, they don’t really care. And one of the reasons they don’t really care is that they don’t see how it impacts the financial system. And it doesn’t really have a big impact on the way the economy works. It doesn’t have a big impact in any macroeconomic model. So the fact that a bunch of people who are essentially gambling on things like bitcoin doesn’t matter to them. And it would only matter to them if it did start to have an impact on the rest of the economy or the money supply or inflation or whether or not we were going to go into a recession or whether we were going to bring down the banking system. So the thing they would care about is if the banks are into this up until their elbows. And if you come back around to what was going on during the early part of the century between 2001 and the Financial Crisis, I think they saw that there was this run-up in house prices, they saw that there was this subprime market which came into existence but they didn’t see it as being fundamentally a threat to the larger economy. Ben Bernanke said something, which I know he must regret to this day, and the only reason he doesn’t really regret it is no one remembers it and he doesn’t matter anymore. In May of 2007 he said you know this subprime thing is not a good thing and yeah a bunch of people are getting their houses foreclosed on but at worst it’s going to be a 200 billion dollar hit to the economy; in a 20 trillion dollar economy, it’s not a big deal. And that’s kind of how they saw it.
So I wanted to zero in on that. Why did they think it was so siloed? Why did they take a view of finance as so separate from the rest of the macroeconomy?
Well I think that’s where you get to macroeconomics. And in macroeconomic theory, finance is generally viewed as – as someone put it to me who works at the Federal Reserve – “plumbing.” So if you go to look at macroeconomic models, macroeconomic models don’t include in their system of equations, an equation about the financial sector. And the only way that finance can affect the real world from their perspective is if the whole thing collapses I guess. They don’t see it as consequential for the real economy. They have something called the DGSE model, which is a dynamic general system equilibrium model – the model they use to estimate the impact of changes in the economy. And in that model, it’s more about employment, consumption, wages, inflation, government expenditures; when it’s sectoral, it’s about things like construction, manufacturing, services, things like that. So, for example, the way they saw the housing market, a downturn in the housing market would mean a downturn in construction and a downturn in consumption of consumer durables, that was kind of how they saw it. But they didn’t see the fact that the banks were the cause of that. It’s not that the bad banks were loaning money to people to buy houses or to get home equity loans; that wasn’t really the driving force of the home market in the overall economy to them. So the model itself doesn’t conceptualize finance that way. One of the things that’s happened is that people have tried to tweak the model in the last 10 years to try to put banks into it. And I haven’t pursued that. It’s got to be a really technical question of how exactly do you write equations and put them into this general model and what are their general impacts. I’m sure someone has done some really good technical work. But I haven’t personally tried to run it down. But they generally have this view of the economy as this pretty big boat and it takes a while to turn it. Like right now, this conversation they’ve been having about inflation and about raising interest rates. They don’t have a lot of levers and the interest rate is the big lever they have. And they also have a kind of bully pulpit where they get up and say what they’re going to do, in which case financial markets freak out and prices go up or down on the basis of what they say. But they see the way the economy works as much more about the real part of it and much less about the financial part of it. Another way of thinking about it is if you think about the economy as an input-output table. So what happens if construction goes down? Well all of a sudden, people stop buying lumber, people stop buying big machines that move things around, all of a sudden people don’t hire people to build houses, plumbers are out of work, and that has knock-on effects on things like consumer durables, refrigerators being sold, and it can have big impacts if particular communities are heavily dependent on construction. They never saw that the housing market was connected across the country. The way they see the economy is a bunch of regional economies which are connected in different kinds of ways in a sort of input-output table. So high prices in the Bay Area would be met with prices that were unchanging in Chicago, and that’s what you would expect because those prices are local. And so, when the market was going up, when the average price of housing was going up, they weren’t seeing it as a systemic thing, they were seeing it as: California it’s really hard to build, people are making a lot of money, they’re building up a lot of money, but it’s California’s problem. It doesn’t matter for the real economy.
It’s interesting that they didn’t see finance as part of the model especially in the context of the growing importance of finance in the macroeconomy. What do you think of the financialization of the American economy in the past half-century?
I don’t think economics is where people have been studying that process except for the last couple of years. And the reason is that it doesn’t easily fit into economic theory: shareholder-value capitalism and the financialization it came out of don’t easily fit into macroeconomic theory. And they also don’t fit easily into industrial organization economics; so the two kinds of economics that might have been put to this question were never put to it. And since finance was seen as being about taking money from people who didn’t need it and financial intermediaries, there was a theory of finance but it wasn’t a theory that was connected to this larger understanding of the way the economy operated. So if you go study financial economics – there’s different branches of that too – but that’s not connected to the macroeconomy in any way. So you have this financial economics which is going on and macroeconomics which is worrying about unemployment and inflation and GDP and then industrial organization economics which is not doing very much of anything in this period because they’ve all decided that all markets are contestable so we don’t need to worry about monopolies anymore. And so they kind of missed the whole thing – it doesn’t actually figure into the economics and that’s very much a result of economic theory. What’s happened in the last ten years since the Financial Crisis is that economists have become much more open to understanding all of this, and the empirical facts have given them some pause and I think they have at least – academic economists have – become more open to thinking about these things. But I don’t see it at the Federal Reserve as much as I see it in the kind of things economists are interested in more generally. So for example we’ve had this new interest in has the concentration and centralization of the American economy caused it to grow slower because there’s monopolies? That conversation wasn’t going on until the last ten years, and that conversation isn’t going on at the Fed, it’s being pushed by lawyers – they want to see if it’s against the law. There’s some economists who have kind of come on board with that but mostly it’s been lawyers. So Tim Wu, who’s a lawyer, and Lina Khan, who’s also a lawyer – they have a different take on all of this, and there’s sociologists who’ve had takes on this. Shareholder capitalism – I just wrote a review paper – and there’s some economists who’ve kind of come around to seeing it. I think a lot of the economists interested in inequality have realized the massive increases that have occurred in inequality, particularly the inequality amongst the 1% is a result of shareholder-value capitalism – they’ll even use that term sometimes.
We read Professor Steve Vogel’s book in a class recently. I guess he’s not an economist per se, but from the lens of political economy, that conversation also seems to be happening.
Yeah, I think that in our economics department we have a few people like that: Emmanuel Saez and Gabriel Zucman, who work with Piketty. Piketty at this point is a sociologist, he’s pretty much said that. Raj Chetty is pretty much a sociologist. I think Gabriel is a little more keeping his economist credentials in order. I think a lot of what economists have done though is they’ve understood these issues aren’t very easy to deal with. Power in particular isn’t very easy to deal with from an economic perspective. As soon as you move there you have to tread very lightly from the point of view of the profession. There’s more than there used to be certainly. Neoliberalism is still pretty much there, but they recognize that the world doesn’t exactly work that way. Now the weight at the top of the profession is to do something really hard with data. And that means you’re gonna start doing stuff that isn’t going to fit the models. Now all of a sudden does it really make sense that 1% of the population owns 40% of everything? Is that right? Is that necessary? Is that the only way we can have society work?
I wanted to ask about the response to the Financial Crisis from the Federal Reserve. With Ben Bernanke and Janet Yellen, they pursued low interest rates, did quantitative easing, and pumped more money into the economy. What do you make of that response?
I think we were really lucky that Bernanke and Yellen were sitting there when it happened. Bernanke in particular had written about the Great Depression. He recognized that we were in an extinction event and that the entire banking system was collapsing. He didn’t exactly know why, but they realized that they needed to prevent that from happening, and so I think at the beginning they were trying out a bunch of different things, and I think they finally realized that putting liquidity into the banks was the most important thing. They tried that in the Fall of 2008 – didn’t work out very well because a lot of the banks – the financial instruments they held, the CDOs – were not worth very much and nobody knew what they were worth, and so it was really impossible to make those banks liquid. And so the first thing they did was put all those banks out of business. But then what they did was they bought back all of the mortgage backed securities that were based on conventional mortgages and they forced companies to borrow money and they made sure that they weren’t going to go out of business – the ones that were stable – and that saved the financial system. And the same thing happened under Powell two years ago during COVID. The markets started to freeze up in March and April of 2020, and the Federal Reserve recognized that it was the same thing, that all of these banks were now experiencing a liquidity crisis. Powell went out one day and said publicly that everybody out there is going to have more money than they can do anything with. Then the next day the stock market took off. So I think they learned quite a bit from this. I think they learned that keeping the system going was their main job and that making sure there was enough liquidity in the system was what they should be doing. And I think those lessons are kind of where they’re at now. I wouldn’t expect in a subsequent crisis for them to behave any differently. Though if there was high inflation, it would be very interesting. If a banking collapse occurred in the face of high inflation, then they’d have a much more difficult time figuring out what to do because they might need some new tactics. To dump a trillion dollars into the economy in the space of a couple of months if there was massive inflation, it’d be interesting what would happen.
From the point of view of Congress – in 2010, they passed Dodd-Frank. Do you think that was enough? You mention Glass-Steagall in your book: should we reinstate it? Should we break up the big banks?
At this point, there’s an old thing that people say: “you can’t shut the door on the barn after the horse has gotten out.” I think that’s where we’re at right now. At this point, it would be very difficult to go back to Glass-Steagall. I just don’t see how you can do it now that we’ve got the conglomerate banking that exists, and now that eight banks control 60-70% of all the assets, and I think the concentration of financial assets means that it’d be really difficult at this point for anybody to figure out how to break it up. I do think that the one thing about Dodd-Frank I feel really positive about are the stress tests. I feel like it makes it a lot harder for the banks to hide and I do think it’s had an impact on their risk profiles. What the stress test does is it says what happens if housing prices drop 25%? What happens to your bundle of assets? Does that put you into a liquidity crisis? Do you have enough money on hand to deal with that? And I think banks have had to readjust their portfolios based on these stress tests at the moment – though of course Trump tried to get rid of them (but they are in place still). I think it’s kind of changed the habits of a lot of the banks. These big, giant conglomerate banks – they’re not doing any of that anymore. They’re doing other things to make money. That’s a credit to the Fed and Dodd-Frank. There was an attempt to create a reinstatement of Glass-Steagall, but it was going to be really hard to do. I personally don’t think that’s a viable strategy. I think it’s hard to go back to the way things were. It’s a little bit like breaking a glass; it’s really hard to put it back together, it’s much easier to buy a new glass. We’re living in a new world now. They’re not doing the same things. They’re not involved in all of this stuff they were before. All of these things they were doing that put them at risk are kind of not there. That doesn’t mean a new thing couldn’t come up. That’s the real question: can the Fed recognize a new financial threat – not a bubble but a threat – a threat to the stability of the system? And I think that the bubble language isn’t the right language anymore. The right language is what threats to stability and peace banks pose. Everybody borrows a lot of money, and there’s a lot of short-term borrowing going on. One of the things that caused the Recession in 2008 was that lots of companies borrow money in the short run to fund a lot of their activities. What a company does is sell stuff, but it’s 60 to 90 days before they’re getting paid back. They have to have working capital, and often, they’re borrowing money to meet their payrolls and there are these short-term markets where they can go in and say look I have these accounts, I want to borrow money for 60 days. What happened was that it was impossible for them to borrow that money, and all they could do was fire people because they couldn’t meet payroll. So there was this unintended consequence of how everything was working. But I think that the Fed is much more aware of the connectedness of finance to the real economy, and the fact that the stability of finance does have a big impact on everything else. When COVID hit, it looked like we were going to have a repeat event of what happened in the Fall of 2008. And they just went in there and flooded the markets with money. It was amazing, it was impressive actually.
Let’s talk about another banking crisis: the Wells Fargo scandal. In 2016, the Fed seemed to act more swiftly in punishing the bank. Do you have any thoughts on the Wells Fargo crisis?
So I think banks verge on being criminogenic organizations. For example, I don’t know why anyone would do business with Goldman Sachs. I don’t understand why anyone gives money – they are pirates and they are going to rip you off and they are going to stab a knife in your back. So why would you do business with someone who’s going to cut off your ear? Because of the way banks make money – because they depend on people not understanding what they’re doing – I think it’s a slippery slope to them doing things that are illegal, and I think Wells Fargo was a criminogenic organization. I think that they actually got off easy. They were making up accounts for people. I just think finance is one of those places because you depend on people not getting it. The average person deals mostly with the kind of fees banks charge you when you have overdrafts. They want you to have an overdraft. That’s free money. A long time ago, they figured out we can make a lot of money off of overdraft fees. It’s a really good business. And if you think about it, it’s completely predatory. Minimum balances in accounts is totally a predatory business. It’s a way for them to keep money. I know I’m a cynic. All large corporations are being sued all the time. Banks are particularly under lawsuits. It’s really hard to uncover a lot of it – you’ve got to really understand what happened. During the Financial Crisis, there were all kinds of untoward things happening, but it was really hard to uncover. It was hard to uncover mortgage fraud. It was easier to uncover securities fraud because they knew the mortgages they originated were bad, and they knew they helped people lie when they filled out their credit forms. It was hard to get a handle on it and prove it. And particularly when the FBI is actually the organization that was in charge of that and they were looking for scammers – for individuals who were doing it. Nobody even thought it could be systemic. After people went back and tried to figure out how many mortgages were gotten that broke the law, the numbers estimated were 25-50%. That’s a big number. 25-50% is a huge range. I think banks were kind of on that slippery slope.
I think the dichotomy you pointed to between economics and other fields comes up here again: a number of people in the finance and economics world saw the response to Wells Fargo as really strong.
Economists tend to see that these things are efficient. They generally want to think that people are honest. In their theory, they think that reputation matters and that people worry about their reputations and that keeps them from doing bad things, so why are we blaming banks? I was an expert witness on a lawsuit against Bear Stearns – the remnants of Bear Stearns – and I got to see the email trail. I can tell you that they knew what they were doing, and all these banks knew what they were doing when they were putting pressure on originators to find mortgages that were getting worse and worse. They knew what they were doing. There was no doing a good thing for the customer. Washington Mutual was another one that was a really evil bank. They were so desperate that they just had to do anything they could. And once you’re thinking that way: you have a pulse, you get a loan. There’s a way in which they were just trying to keep their business models going. But their business models were problematic and so they couldn’t get out of it.
This discussion is pretty insightful in light of the debate over the renomination of Jerome Powell. Senator Elizabeth Warren came out and labeled him a “dangerous man” because of his, in her view, lax financial regulation. How do you view Powell’s term in office?
I think Powell has been great. He was the best appointment Donald Trump made – maybe the only good appointment he made. Maybe because he made so many bad ones it makes Powell look better. I don’t think he had a clue when someone said let’s nominate Powell. If you go back in the records, Powell was one of the few who was concerned about what was going on in Wall Street and if it was going to spill over into Main Street. He was one of the ones who was worried about it. I have a lot of respect for him. I think Elizabeth Warren was wrong about him.
Do you see a problem with the Fed being both the institution that undertakes monetary policy and the one in charge of financial regulation?
I do see an institutional problem, but that was in the original organizational design when they did this a hundred years ago. And as we’ve discovered in the United States, it’s really hard to change these institutions. They’re really arcane. In England, they separated the two positions – the bank regulator from the central bank. Has it been better? I don’t know. The regulatory side stays away from the policymaking side. The Federal Open Market Committee (FOMC) isn’t really part of the regulation process. Because they’re really two different forms of regulations.
There is a separate position of Vice Chair of Financial Supervision that Dodd-Frank established under the Fed.
Yeah, that’s part of it. They have different points of expertise. Because someone doing financial regulation is worried about the stability of the banks and their balance sheets and how much they’re taking on. They’re not thinking about whether the interest rate should go up a quarter of a percent or not. The FOMC is worried if there’s unemployment or inflation or if the economy is roaring along too fast. Those are really different kinds of things. I guess in some ideal world you’d want to break that off. I haven’t seen anyone make a good compelling argument for why one impacts the other. The big complaint about what happened in 2008 is that they were too nice to the big banks, and not nice enough to the people who were losing their houses. But that’s because they didn’t have any power over those people; they did have power over the banks, they had regulatory power. It wasn’t their job to rescue the ten million people that lost their homes. Their job was to make sure that the financial system operated and it was an argument that they made in January 2009. If you went after these banks too hard and just loaned them a bunch of money and they go belly-up you’re going to lose that money. They gave up on prosecution at the beginning. One of the reasons all those cases settled in the second term of Obama was that they felt like the banks were more stable. That’s when they started going after the securities fraud. They wanted to create stability first. It’s an expert’s game. And it doesn’t have much oversight from Congress. But you can certainly argue that getting the financial system stable and taking out the bad apples was probably the right way to think about the problem.
I think that’s all the time we have together. Thank you so much for the discussion! Any closing thoughts?
To kind of wrap it up, the problem is that economic theory has been built up to manage all these things, but we don’t have an alternative. But I think they know they were wrong. They’re aware of that. In any situation where something really bad looks like it was happening, they will intervene in an extreme way and that’ll be the way it’s going to be for the next twenty years until the next crisis. The theory will be damned. They’re more worried about stability then they will be about the fish in the sea. That’s what I think. You don’t know what’s efficient but you sure know what’s stable.
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