You describe the U.S. government response to the financial crisis as the Great Repression. What does that mean?
My point is that we have the potential for a Great Depression, which is to say a very large number of banks to fail and a huge credit contraction. But we are desperately trying to stop it happening by pouring money from the Federal Reserve and the U.S. Treasury into the financial system. It’s more a form of denial than a solution. I don’t have any doubt that a big recession is coming the way of the United States, maybe worse.
People are starting to use the D-word. But in 1929, the Federal Reserve was in its infancy and there was not a global savings glut in Asia. So don’t we have good reason to believe that history won’t repeat itself?
Of course, there were savings in 1929 too. It’s not as if the world ever runs out of savings, it’s just that they’re in the wrong place in a crisis. The Federal Reserve system was very powerful in 1929, but as Milton Friedman and Anna Schwartz pointed out in their monetary history of the United States, they did all the wrong things. They systematically tightened monetary policy when there was already a credit crunch. And one of the key points that Friedman made was that if the Fed had been much more openhanded, then the Depression might have been less severe. Well, we’re putting that to the test at the moment. You could say that Ben Bernanke is running a real-time experiment with Friedman’s hypothesis.
Are you at all optimistic that the Fed can do it?
We’ll see. My sense at the moment is that the momentum of de-leveraging is so powerful that neither the monetary authorities nor the fiscal authorities can stop it. The stupid thing is that it was clear a year ago that a very large number of financial institutions were in trouble. Future historians will look back and say the time to address the banking problem was 2007, not in 2008. What on earth were they doing for twelve months?
What effect do you see this having on New York’s standing as a global financial capital?
I’m in Venice now, which used to be a financial center and is now a tourist center. And the nightmare is that a crisis of this magnitude will turn New York from a financial center into a tourist center. The good news is that London seems to be handling this crisis slightly worse than New York. My sense is that the great financial crisis we’re living through will fundamentally tilt the balance of the world from West to East. Sovereign-wealth funds will matter much, much more because they’ve got the money and we haven’t. New York isn’t quite Venice yet, but I certainly am quite relieved that I don’t own a large block of real estate in Manhattan right now.
What would you say has been revealed about human behavior in the last two weeks, based on what’s happened in the market?
For 20 or 30 years, people have been trying to turn finance into a branch of applied mathematics. They’ve been trying to reduce decisions about credit and debt to equations. And what we’ve realized, belatedly, as a result of this crisis is the human factor is dominant in financial crises. That investors behave rather in the way that cattle do when the herd stampedes. The greed that made them chomp the grass suddenly turns into the fear that makes them charge for the gate. And that’s something that the mathematical models never took sufficient account of. The markets magnify the human tendency to swing wildly from euphoria to despondency. It’s not surprising really that behavioral economics is gradually taking over from mathematical finance. It perfectly matches the shift in the real world.
Where are you putting your own money?
Well, I have been debating today whether gold bars really are the answer. They probably aren’t. The good rule of thumb in a crisis like this is to be diversified and not to have too much debt. I actually went and withdrew the money that I had in Washington Mutual three weeks ago.
You did? You were worried that depositors would be wiped out?
I didn’t want to try out federal deposit insurance for myself, especially since I had reason to think that the whole FDIC system could itself go bust because of the magnitude of the crisis. That’s the key. At some point we stop believing not just in the banksówe stop believing in the government.
Interview by Hugo Lindgren