Episode 85 – Shadow Banking with Robert Hockett

Macro N Cheese – Episode 85
Shadow Banking with Robert Hockett

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Robert Hockett [intro/music] (00:03):

[Montage] Every time there’s some sort of financial calamity of the kind that we underwent in 1929 and after, and in 2008 and after, these things always bring out a class of person you can think of as money cranks, right? Money cranks are kind of like gingivitis, right?

If you’re not brushing your teeth and washing your mouth with Listerine regularly, it kind of crops out and money crankery crops out anytime there’s some sort of crisis as well. The RFC in its day was by far the largest financial institution in the entire world. Its balance sheet dwarfed all of the combined balance sheets of the Wall Street institutions. And this institution was a public institution.

Geoff Ginter [intro/music] (00:44):

Now let’s see if we can avoid the apocalypse altogether. Here’s another episode of Macro N Cheese with your host, Steve Grumbine.

Steve Grumbine (01:38):

Hi, everybody this is Steve with Macro N Cheese. For this week’s episode, we went back into our vault to bring you an interview I did at the beginning of 2018 with Robert Hockett on shadow banking and the role of the Federal Reserve. A few years earlier, the movie, The Big Short had been released, based on the book of the same name.

Before the Big Short, most people had never heard of shadow banking and even now there’s very little understanding of it. Since it’s such a pernicious part of the finance industry, we think it’s well worth revisiting. We originally opened the interview with a clip from the film, but since it’s copyright protected, we’re going to skip that part today and jump right into the discussion. The Big Short that movie is an epic depiction of the housing collapse during the great financial crisis and the shadow banking that occurred during that time.

For those of you who followed us during the primaries and Bernie Sanders’ campaign, you saw Hillary and Bernie fight tooth and nail about reinstating Glass-Steagall and her and her smug ‘hahaha’ saying, well, Glass-Steagall, doesn’t touch shadow banking, and so forth. So what I’ve done is, because we typically talk purely about Modern Monetary Theory and we focus largely on enabling a New Deal, we have decided that it was very important to provide some perspective on this phenomenon known as shadow banking, and also to kind of disabuse folks of the fallacious notions about the Federal Reserve.

They do an awful lot of bad things, but they do an awful lot of good things too and they’re a needed piece of this component. So what I’ve done is I brought in Cornell Law’s own Robert Hockett. So Bob, what I want to do is have you just take a moment to explain who you are and what you do, and maybe even talk a little bit about your time in the Occupy movement.

Robert Hockett (03:40):

Sure. Yeah. Well, thanks for asking. I am the Edward Cornell Professor of Law over at Cornell Law School. And there I specialize in finance and financial regulation, as well as the law of money. I got there by a sort of, I suppose, a circuitous route, but that route might offer a little bit of explanation, I suppose, as to why I sort of come at things the way that I do.

So I was doing a doctoral degree in economics way back when, and was sort of troubled, as many people are, by the orthodoxy that seemed to be prevalent in the Academy. So I took some time off to spend a little bit of time figuring out what I wanted to write my dissertation on, exactly, after having finished the coursework. And during that time, I started working under a bridge with a bunch of homeless guys just to sort of figure out why they were homeless.

And a couple of interesting things sort of emerge from that experience. One was that these guys didn’t have any access to banking services. And so although they made a lot of money detailing cars, washing cars, squeegeeing windows and the like, they couldn’t save any. And that got me sort of wondering why it is that we don’t have financial services of any sort for folks who aren’t at the top of the income and wealth distributions.

The other thing was kind of interesting was they had sort of a business in a way, right? They essentially had kind of replicated the idea of a kibbutz under the bridge. And so I started referring to us as a kind of homeless kibbutz and that got me wondering why we don’t have that as one of our business forms. And so basically I started thinking about sort of the nexus, I guess you could say between law, productive activity, and finance, and thought, well, maybe that’s what I should do my doctoral work in ultimately, or maybe that’s what my dissertation should ultimately be on.

So I ended up getting a law degree, then finishing up my doctoral work in finance. And then I did a bit of work over at the IMF and over at the New York Fed, in addition to becoming a legal academic. During the Occupation in the autumn of 2011, I was actually working over at the New York Fed for half of each week. And so I would be working there during the day and then I would camp out over in Zuccotti Park – which is as you know, a couple blocks away – in the evenings.

And that made for some rather interesting conversations, you might say, in the sense that on the one hand I was camping there because I thought the same way that everybody there thought, at least when it comes to sort of the role of finance in our particular economy and in our society. But on the other hand, of course, I also did believe, at the very least, in the potential that the New York Fed in particular, but also the Fed system more generally, has to do good. And so we had a lot of interesting conversations, needless to say, by night, about what the Fed does, what its role is, where it falls short, where it could do better and so forth. So that’s, I guess, how I ended up here on your wonderful program.

Grumbine (06:10):

One of the things that’s amazing to me is the overt smugness, the callous deafness, if you will, of society around them falling apart, as they’re just raking in and vacuuming up money, as the entire system is about to implode. What about the repeal of Glass-Steagall and things like that, if any, did it have to set up this shadow banking world. Maybe better yet, can you define shadow banking for our audience so they understand what it’s all about?

Hockett (06:44):

Right. Yeah. So I think maybe the best way to think about shadow banking is by focusing on one particular aspect of it that renders it reminiscent of banking. And then look at the other feature of it that renders it a shadowy form of banking, if you will. So that which supposedly makes it banking is the fact that you have essentially got a kind of endogenous money creation going on.

You’ve got a sort of endogenous credit expansion going on. And the way that it happens is that you essentially have an infrastructure whereby some people are able to borrow very short and then to quote, unquote “invest,” or to lend, or to speculate long. Right? So basically anytime I’m able to say, get short term credit from you – let’s say you lend me a certain sum of money for a day and then I can use that money to invest in something, some asset or some supposed asset, that doesn’t mature until quite a bit later – we’ve got essentially a so-called maturity mismatch there.

I’m borrowing short in order to lend or invest long. The thing that makes it possible, of course, is that you have to be willing to keep rolling over the debt that I owe to you. Right? If you lent to me for one day, the following day, my debt is due to you, but you say, ‘okay, you can keep it for another day. You’ll just pay me a little bit more in the way of interest,’ or whatever my borrowing cost is. And then you roll it over on the third day and on the fourth day and on the fifth day and so on. You keep rolling it over.

But on any given day you can refrain from, or you can refuse to roll it over and just go ahead and call in the loan, so to speak. And in that sense, your lending to me is not unlike what happens when somebody deposits money in a bank, in the form of a demand deposit. At least that’s the idea. And what that means is that I’m borrowing from you short term in that particular sense. And that means, in turn, that I have to pay you comparatively low borrowing costs, right?

A very low interest rate or very low borrowing costs in whatever form they take. In the meanwhile I’m investing quote unquote in a longer form. And that means, of course, that I can recover more. I can take more in the form of interest, or in the way of borrowing charges, from whomever I’m lending to, or from whomever I’m investing in, or maybe I should say whatever I’m investing in. And that means in turn then that what I’m essentially doing is legging the spread, as they say on Wall Street.

Basically I’m borrowing cheap and I’m lending more expensively. And my entire business model is based on basically capitalizing on or recouping the spread between those two rates. Now that’s the way we typically look at, or the way people typically look at ordinary banking institutions or depository institutions. The idea is, you know, you and I put money in, we deposit the money. And in that sense, we’re lending short term because we can always take the money out.

So if it’s a demand deposit, we can in effect refrain from rolling over the debt that the bank has to us at any given moment, the bank for its part makes longer term investments. And so it basically capitalizes on the same spread. At least that’s the picture that people typically have of banks. And that’s in turn then why so-called shadow banking looks like banking to these people. It’s worth noting as a quick aside that that’s not actually an accurate picture of what banks do as I’m sure many of my friends and colleagues and your friends and colleagues in the MMT movement have made clear.

Banks don’t borrow and lend, but we tend to think of banks as doing that. That’s the sort of popular vision of what banks do. And so whenever some other institution does something that kind of is reminiscent of that picture of banking, but isn’t regulated as a bank, they call it shadow banking. Now that of course takes me to the shadow piece of the story. And that’s a fairly simple piece. That’s actually much easier to get across than the banking piece of this description.

And that is that we call it shadow banking, essentially because it’s not regulated as banking, it’s not policed, or it hasn’t been policed in the way that banking traditionally has been, in particular with a view to its liquidity risk, right? I mean, we don’t want it ever to come to pass that a bank isn’t able to pay out to its depositers. If they all decided to withdraw it at the same time, or if a bunch of them decide to withdraw at the same time, or if a bunch of people are drawing on their accounts and the banks at the same time.

And so we regulate the banks very carefully with a view to their liquidity. And we also of course regulate their portfolios. We tell them what they may and what they may not invest in. And of course we require them to hold capital so-called capital buffers against those asset portfolios as well. The thing that makes shadow banking shadow banking is precisely the fact that we don’t actually do that with those institutions.

And so in effect, they are doing what we tend to think of banks as doing, but without any of the strings attached that are designed to kind of maintain the safety and soundness of the industry. Is that more or less clear?

Grumbine (11:37):

I think the irony for me is that I’ve come into this world through a different angle, right? I didn’t focus as much on the finance side and on the Wall Street portion of this. I really focused on the currency issuer versus currency user, the paradigm of our federal government and it serving our needs. And then you have this, dare I say, casino economy over here that they’re gambling on all of our lives.

I mean, it’s like they’re watching our decisions and laying money on whether we’re gonna live or die, basically. At least that’s kind of what I’m hearing. That’s salacious probably. It’s probably just a little bit more salacious than it need be. But the point is that what I see here is largely a gambling economy that has nothing to do with creating anything of use, nothing useful whatsoever coming from it, other than people creating more and more and more and more money basically from these gambles.

Hockett (12:38):

Yeah. So I think you’re exactly right about that. And actually that’s sort of the thing that comes across to me first, before anything else does when watching that clip that you opened with, is just what a remarkable irony it is that this thing is even possible, right? That the story that’s being told, or that’s being conveyed in that clip, is even possible.

There’s a kind of contradiction in the middle of it. And here’s what I mean: all of that sort of complex synthetic financial instrument building is done, in theory at least, the claim or the justification that’s typically proffered for it, is that you want it to be the case that those who are most able to bear risk will bear that risk. And those who are least able to bear risk will be able to shed that risk. And so you divvy up various pools of securities and cut them up into tranches.

And basically those tranches are indexed by reference to their comparative risk properties, right? So you want the riskiest tranche to be invested in by those who are most able to afford to bear that risk. And of course they demand a higher return on that risk-bearing. And then you want those who have the lowest risk tolerance to be able to buy the lowest risk tranches of those particular pooled securities or pooled assets, whatever they might be, whether they be mortgages or anything else.

And the whole idea, then, the entire premise behind the idea, the entire premise behind the phenomenon of securitization and then synthesis of various kinds of derivative financial instrument is that you have to be able to, again, sort of cater to the differing risk tastes of various investors. But now here’s the kicker. Here’s where this gets ironic. That entire idea – the idea that it’s a compelling need to be able to sort of cater to the different risk tastes of different investors – is predicated on an error.

And the error is that, well, we have a shortage of capital out there, that we live in a world of capital shortage, or money shortage or finance capital shortage, whichever of those terms you want to use. The idea is that credit is somehow scarce. That finance capital is somehow scarce. And so in order to optimize the availability of credit, which we assume private parties are the ones to extend, we create these secondary markets in which people can buy and sell securities that have already been issued, or in which people can buy and sell different kinds of security that bear different kinds of risks in order to optimize or maximize those private capital suppliers participation in the financial markets in the first place.

That’s a long-winded way of saying that we explain, or we try to justify the existence of the secondary markets, including the derivative markets -which I guess you could think of as tertiary or quaternary or whatever, you know, markets – we always try to justify those markets on the theory that they make the primary markets, right, the initial credit extension markets, more liquid. That they bring more credit into the economy that otherwise wouldn’t be there.

But now that is crap, of course, because as we all know, the economy is not an any sense faced with conditions of capital scarcity. There is no such scarcity and it either hasn’t been for ages assuming that there ever was. And in a certain sense, the people in that clip understood this and they knew this as well because shadow banking just is one of the reasons why we don’t have capital scarcity.

The shadow banking markets are in a certain sense proof that there is no such thing as capital scarcity, because they are proof that money or credit-money (maybe we should use that term instead credit dash money) that credit money is endogenous, as the post-Keynesians put it, right, that there is no such shortage. So there’s a contradiction in the middle of that clip in the sense that all of these instruments that they’re talking about are justified by reference to their optimization of the availability of credit in the primary markets where credit actually is useful.

And yet they themselves have to know that there is no such shortage of credit that would justify the need of those particular instruments. Given the fact that they themselves are engaged in shadow banking, meaning that they themselves are living embodiments of the endogeneity of the credit-money supply.

Grumbine (16:51):

You bring up a great point and it’s one that I want to touch on. And this is something that even some of the more experienced MMTers get wrong. And I’m one of them. Can you please explain to our audience the facets of exogenous money creation and endogenous money creation and why it is so vital to understand the difference between the two, because it appears to me that people really do confuse, and I’m really grateful that you broke it out as credit-money versus just net financial assets-based money currency, straight from the government, et cetera. Can you just take a few minutes and explain that?

Hockett (17:30):

Yeah. So I think the easiest way to do this is to think of the endogenous element as the private element and think of the exogenous element as the sovereign element. Okay. So, and here’s what I mean, maybe the best way to explain that, or sort of map this out is by reference to a typical bank lending transaction. And you’ve probably seen this before.

So a bank decides whether or not to make a loan to somebody not by going and checking the vault or making sure that they have enough reserves on hand or whatever, to ensure that they actually have the money to lend out. They basically make the decision on the basis of whether they think that the loan is going to prove profitable. And so a bank is actually in theory, able to make a loan, even if it has no deposits at all.

And if you want a kind of dramatic, I suppose, proof of this, or sort of object lesson in this, note how across most of the English-speaking world outside of the United States, banks don’t even face reserve limits any longer or required reserves – reserve requirements we should say – any longer. And here in the States reserve requirements, don’t kick in until quite late. So what a bank does is it endogenously, as it were, extend credit to things it can make a profit off of lending to.

Then the exogenous element comes in when the sovereign elects either to recognize or not recognize that particular loan. Now recognition here takes various forms, right? One form is simply even to allow it, right? If it’s regulatorily permissible for the institution to make the loan, then of course it’s permissible and it’s quote, unquote “recognized.”

Furthermore, if for example, a bank makes a loan to you simply by opening or crediting an account in your name and you’re able to draw on that account by writing a check or making a payment out of it to somebody, and then whoever you make it to deposits that payment into his or her own account. And then the Fed here in the States or the central bank or monetary authority in some other jurisdiction is prepared to recognize and clear that particular draft to clear that check, then that’s another form of recognition. That’s what we call “accommodation.”

Here in the States, the Fed accommodates bank loans, as long as those loans meet particular criteria. And there are two, there’s a kind of exogenous element, at least relative to the private sector, because the sovereign has the power either to recognize or not recognize or to accommodate or not accommodate that particular extension of credit. Now note that, that means then that in so far as there’s exogeneity here, this is only exogeneity relative to the private sector because there is this public element, there’s this sovereign element, that determines what the limits are.

Note however, by the same token, as far as the sovereign itself is concerned, there’s no exogeneity at all, other than the so called resource constraint that our colleagues in the MMT movement point to, right? In other words, there’s no natural constraint on how much credit the Fed or the federal government were broadly can recognize as being permissible for banks or other lenders to extend or create or generate.

There’s no natural limit to that other than the inflation constraint, which of course, as you know, is derivative off of the resource constraint. But apart from that, there’s not even an exogenous constraint on the sovereign. But in so far as there’s any exogenous constraint, it’s a constraint based by the private sector that is imposed by the sovereign when the sovereign is doing its job, right?

And one way to think of this, you might know this, I mean, I’ve been sort of pushing around for a while or kind of pushing for some years now, a certain metaphor that I think is very helpful when it comes to sort of comprehending what’s going on here. I call the system a sort of ‘franchise system’ where the sovereign is the franchisor, the various private lending institutions or private financial institutions are franchisees.

And what they’re charged with doing is distributing what amounts to a public resource, namely the sovereigns monetized full faith and credit. And in fact, that’s, what’s going on. Anytime the Fed, quote, unquote, “accommodates” or “recognizes a bank loan” or a loan extended by any other institution, anytime it does that, it is effectively turning a private liability into a public liability and doing it in monetized form. And so in that sense, you can think of this as a case where you’ve got a franchise or it’s essentially outsourcing the distribution of its resource to these private institutions.

But if it’s not fully cognizant that it has that role and that that’s what it’s meant to be doing, that it’s meant to be exercising quality control at the same time that it’s allowing this purveying to go on. Then of course, you’re likely to get a defective product out there. And that’s sort of what happened, of course, in the lead up to 2008,

Grumbine (22:13):

That may have been the best explanation I have ever had in my life. And I’ll tell you why, aside from the obvious. We’re riddled, unfortunately, what has happened over the course of time is the libertarian strain of the world has infected the progressive movement and not necessarily in terms of ethos, but in terms of tales from the fire pit and the bar stool that have overcome common sense. And I will give them this much, the explanation prior to your analogy that you just made.

That’s a lot to take in. If you’re not an economically-minded financially-minded educated person that has been through countless books, studies, and tests, and so forth – research – that’s a lot to absorb. But that idea of the sovereign franchising itself out, and distributing but not really understanding its own quality control component, I’m going to hold onto that for dear life because that right there really put a lot in play for me.

It’s very frustrating as you and I spoke offline, it’s extremely frustrating to work with people that are dead set in this concept of, you know, the US is now in chains, and now owned by Jewish banksters. And they’ve got this long laundry list of antisemitic drivel that comes through the door and they talk about the Rothchilds.

And I’m like, what are you going to do? Put a bar of soap in their tub and make them slip on it? You’re going to spike their Earl Grey? What are you going to do? Stop! There’s always going to be rich people. There’s always going to be some power struggle. This is our world. This is where we’re at right now. It would be better to understand how it really is than to makeup tales from the fire pit, do hieroglyphics on caves. It’s better just to learn the truth because the truth is how we win. Telling stories – you can’t act on storytelling. You tell myths and legends, there’s no actionable anything there.

Hockett (24:12):

Yeah, there’s a sort of a really disturbing irony, I think, that comes from the importance of the secondary market in any financial system these days. And I think the importance of the secondary markets is itself, I think, a product of a gross maldistribution of wealth in our society. People at the top of the distribution or the investing class or the rentier class, as Keynes would have called them.

Most of us who aren’t at the top of the distribution are not of that class, all of this extra money that can’t be consumed, all of this extra wealth that can’t possibly be consumed. But there’s a hole that gets invested in the so called secondary markets. And that of course leads to all sorts of complexification of financial instruments, because everybody’s always trying to come up with something new that hasn’t been marketed to these people before, in order to be able to earn higher rents on yet another new financial innovation.

And what that does is it makes finance look much more complex, much more difficult to track, much more intractable to the ordinary Jane or Joe than it needs to be. And what that in turn encourages then is for people, once they realize that something has gone wrong, but they can’t quite put their finger on what it is precisely because of the complexity, they come up with a simplifying conspiracy theory. When in fact there’s a much better conspiracy theory that we could all avail ourselves of.

But one upshot of this, historically, is as you doubtless noted through your own reading of financial history, every time there’s some sort of financial calamity of the kind that we underwent in 1929 and after, and of course in 2008 and after, these things always bring out a class of person you can think of as money cranks, right? Money cranks are kind of like gingivitis, right?

If you’re not brushing your teeth and washing your mouth with Listerine regularly, it kind of crops out. And money crankery crops out anytime there’s some sort of crisis as well. And I think that the money cranks in a certain sense mean well, right? And they recognize that there’s something really ugly going on. And they also recognize that there are people who are very happy for us not to know the details because they know that the less that we know in the way of the details, the less likely they are to be scrutinized or regulated.

But the sort of dark side of that then, is that when people do recognize that there’s something wrong, they come up with these very silly stories to try to explain it like, ‘Oh, it’s all the Rothschilds.’ I’ve heard this from so many well-meaning people. And of course, I actually heard it from a lot of people in Zuccotti Park when I was camping there. And part of my task at the time, I thought, is precisely to say, look you guys, there’s a much better explanation for this.

So things are actually worse than you think. We would be lucky if it were just the Rothschilds, right? Then we would know what to do. It’s not that, right? The problem is actually much more pervasive than people realize. That’s not to say that it’s more complex than people realize, but it’s much more pervasive than people realize, I think.

Intermission (27:07):

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Grumbine (27:57):

So one of the things that has really spoken to me… I’ve been doing this since about 2009. Not this, but like learning MMT and changing from a far right wing nut job, who was one of those cranks, who was a Ron Paul guy, who was a gold bugger, who was an end the Fedder, who was all those things. So I have experienced, and I feel perfectly adept at smacking my brothers and sisters for saying that silly stuff. The Alex Jones community, right?

We get away from the Idiocracy and we start moving towards a more informed perspective that allows us to take action. And I’ve gotten to the point now, and maybe it’s because I’m a parent and I’ve learned to tune out noise. I’ve learned to tune out noise in this process as well, understanding that the single greatest thing that this system fears is an informed citizenry.

And if the citizens can but get rid of all the ‘pedo-gate’ stuff and stop talking about ‘pizzagate’ and stop talking about all the stuff that they really can’t do anything about, pick up a good James Bond novel when they’re bored, to read, and let’s focus on getting the sovereign to spend on the people. If we can take care of the people, then we can do a lot of eradicating of the other noise that comes from a result of not taking care of the people.

And so here we are, as we move forward. And I realize that we do need to reform banking in some way, shape or form, and maybe it is a reinstatement of Glass-Steagall. Maybe it is a modernized Glass-Steagall. Maybe it’s something that includes reining in the shadow banking. But the reality is – and this is what I’m going to drive towards – anytime you put restrictions on things in the realm of which people tend to do, these prohibition type attitudes, what you end up getting is black markets.

And when you get black markets, you end up with a whole different form of problem. You’ve got these Panama Papers and you’ve got all these other things showing what’s happening behind the scenes that we’re not capable of having insight to. And now all of a sudden we have insight to. What does reform look like to you in your perfect world? And I mean, obviously this is a dissertation, so just keep it so that it’s concise here. What would that look like to you? What would be a good reform in your mind to bring about some sanity within banking and, quite frankly, bring our government up to speed on what its role is?

Hockett (30:30):

Great. Yeah. Yeah, sure. So I would think in sort of functional terms – which I guess we all do, right, when we’re sort of thinking clearly – I think the real key separation that I think has to be drawn is that between actual, how should I call, institutions that really do function as finance franchisees on the one hand and all other financial institutions on the other.

And here’s what I mean by that: the dominant understanding of what finance is, out there (and this connects up with this mistaken view of what banks do), is what you can think of as the intermediation view or what I always call the intermediated scarce private capital view. So we have this tendency to think that financial institutions are basically go-betweens. They’re middlemen, as we say, standing between private suppliers of scarce capital on the one hand and then private, and sometimes public, end users of that credit on the other hand.

And so we tend to view financial institutions as not actually generating credit on their own or generating or issuing money on their own, and we just tend to look at them as the go-betweens. And I think they’re actually oftentimes very pleased for us to view them that way.

But in fact, what’s really the case is that some financial institutions, namely those that are accommodated by or backed up by, in any way, the Federal Reserve here in the States or counterpart Central Banks or monetary authorities in other jurisdictions, there are those institutions on the one hand, and those are the ones we can call the franchisee institutions precisely because they can generate new credit that will then be backed up by the public, which means they are actually literally increasing the money supply on the one hand, and then the institutions that don’t actually generate credit or generate new money, but simply do intermediate in the way that the financial intermediation story sort of has things, on the other hand.

The key problem, I think, that we’ve faced historically, particularly over the last century – this was part of what Glass-Steagall was trying to end – is we oftentimes have the same institutions doing both of those things. And that’s very dangerous. And the reason for that is that when an institution that is catering to people who are up at the top of the income distribution, basically the so-called investors (they would be better called speculators) when the same institutions that cater to the speculators and generate credit that they can send their way on the one hand, are also primary creditors to institutions that function in the real economy like manufacturers or small businesses, or what have you, on the other hand – that’s where the danger happens.

Because when those institutions that overextend credit when they’re not adequately monitored by the franchisor, and so the quality control suffers. And so a lot of bad credit gets extended. And then finally the proverbial chickens come home to roost when the bubble bursts, it’s not just the speculators who are affected. It’s all of these firms in the real economy as well. And hence, it’s all of us who rely on them for jobs, or for the provision of services or goods, or so forth, who suffer as well.

So that basically all of these externalities, these massive externalities occur when you have a crash. So I think the key thing to do is completely to separate all institutions that actually extend primary credit in the primary markets – to actual home buyers or to actual small businesses, to actual producers of goods and services – separate them off from the institutions that act as actual intermediaries, that don’t actually generate credit but just intermediate between people at the top of the income distribution and the wealth distribution who have money to invest on the one hand, and the end-users of their investable funds on the other.

So that then, if there’s too much dangerous activity that occurs in that second area, among the intermediaries, and things come a cropper for them and they fail, the rest of us over here in the real economy and the primary markets are just not affected by it in the way that we have been historically. I think that’s ultimately what Glass-Steagall was meant to do.

What Glass-Steagall did, as you know, is it tried to separate the depository institutions (banks in other words) which actually do work in these primary markets, which do lend to people like you and me, when we want to buy homes or what have you, on the one hand, from the high end investment banks, the broker/dealer firms, the Goldman Sachses and so forth, on the other hand. That was the idea.

It’s to separate out the institutions that facilitate speculation in the secondary markets from institutions that facilitate actual economic activity in the primary markets. In the old days, that was the depository institutions on the one hand and the broker/dealer firms on the other. Now it’s not quite that simple, but the functional distinction remains just as simple as it always was.

And it seems to me that the key thing to do then is to work the separation in that way, just to say, ‘okay, no secondary market player is allowed to be also a primary market player and vice versa.’ The easiest way to do this, I think would actually be to start experimenting, at least, with direct public provision of credit in the primary markets. In other words, you might remember, I think it was at the end of chapter 12 of the General Theory Keynes had, there were two sort of, I think, quotable or very memorable lines.

He had a real gift for the one-liner, but one line that Keynes offered was what he called the ‘euthanasia of the rentier.’ And then the other line was the ‘socialization of investment.’ And if we distinguish investment from speculation and just think about investment as a primary market activity, rather than a secondary market activity.

Think in other words of investment as the provision of credit in order to finance actual purchases of physical goods, real goods or real services, or more to the point to finance the actual production of real things that people buy, sell, need, and so forth. Say, ‘okay, why don’t we have the public itself maybe directly supply credit in those areas and then let private credit be extended only in the secondary markets,’ right? Only in this kind of speculative realm.

This would have a couple of effects, first of all, it would keep the speculative actors out of the real economy where they can do harm, where they can do damage, and let them just gamble on their own accounts, so to speak, in the way that people do at Las Vegas, right? And that would keep the rest of us sort of insulated from the kinds of harms that can be done when speculative manias take over in the secondary markets.

And it would also of course, make a little bit more transparent, what is already true, but occluded, which is, again, that basically anytime worthwhile credit is being extended, it is ultimately being extended by the public sector anyway. We just hide that fact by saying, ‘Oh, it’s banks that are doing it,’ but we conveniently ignore the fact that the banks are franchisees purveying, a public resource, namely the monetized full faith and credit of the United States.

So a lot of people don’t know this, but up from about 1938, really arguably 1934, but certainly no later than 1938, on up until the mid 1990s, we had an entirely safe and stable housing market. And we actually moved from being a country which fewer than 40% of households own their own homes to being a country where about 65, 66% of American households own their own homes. All of this was done through the extension of public credit and public guarantees of the extensions of private credit, right?

It started in 1934 with the Federal Housing Act, which gave us FHA the Federal Housing Administration, which offered guarantees of all mortgage loans provided they met certain quality characteristics. So here we have, in a sense, the franchisor exercising quality control. And then of course the picture was sort of completed in 1938 with the creation of or the establishment of Fannie Mae, which was designed to make a sort of secondary market – although that’s a bit of a stretch to call it a market – but basically to be a secondary buyer of mortgage loans.

And so the idea here is that now lots of private banking institutions were willing to extend mortgage credit when they wouldn’t have done it before because the public stood behind the loans and guaranteed the banks against any losses on those loans and even was ready to buy them off of the bank’s books – again, as long as they were so-called qualifying mortgages. This was an [inaudible].

You might think of this as a sort of public option where housing finance is concerned. And it was entirely public and there were no problems in the housing market. Well, of course there were other kinds of problems, but there were no financial problems in the housing market. What happens in the 1990s? Well, some private institutions, private investment banking institutions thought, ‘Hey, what if we can extend credit to a few more people who wouldn’t otherwise have qualified?’

Another way to say this is, ‘What if we can extend loans that are crap loans and then package them in securitized pools? So we can say, Oh, well, we’re pooling the risk. And so things are less risky and then sell securities that amount to claims on the proceeds that those pools enjoy in the form of mortgage payments on those more marginal loans, maybe we can make a killing on that.’

This was all private sector type stuff. None of this was public. None of this was publicly aided, or assisted, or even publicly approved, right? And that was the beginning of the so called private mortgage market or the private securitized mortgage market. And it’s exactly at that point that the housing bubble really began to move, starting in the mid-1990s, okay? None of this was necessary.

And in a certain sense, it was almost by definition, a bad idea, because again, remember there was a reason that there were conditions attached to the insurance, the mortgage insurance, or the guarantee that FHA was willing to extend on mortgage loans. And there were reasons that Fanny limited – essentially attached conditions – before they would buy any particular mortgage loans in the secondary market. That meant that basically by definition any mortgage lending that was done outside of that system was inherently marginal lending.

And it’d be probably exploitative lending, right? Now, that’s problematic obviously in itself, but where it becomes really problematic is when the institutions that do that, the institutions that are sort of outside of the public sector that are doing that also happen to be institutions on which the private sector depends for primary market credit. Right.

In other words, if a banking institution, let’s say, is associated with this private sector, securitized mortgage lending, if it’s associated with this and it ends up getting into trouble by hint of that association, it’s not just the victims of the exploitative lending who are going to be victimized. And it’s not just the investors in the exploitative products who are going to be victimized. It’s the rest of us, too.

If we depend on Chase to issue credit, say, to small businesses or to issue credit to ordinary folk who need to borrow in order to, say, buy a car or to do some kind of an upgrade on their home or what have you. And so that’s where the externality comes in, right? So if we have said, okay, look, if you’re going to do this kind of marginal lending or mortgage lending outside of the public option that we’ve had since the 1930s, if we had said, okay, we might allow that under some circumstances, but under no circumstances, will we allow institutions that the public relies on for primary market credit to be involved in any way with this, then the financial system as a whole, and the real economy as a whole would have been insulated against the aftermath of that bad lending that went on.

But as it is, we didn’t do that insulating. And this is exactly where a kind of Glass-Steagall style of insulation would be called for. Although, again, I sort of hesitate to say this because I don’t want to be too cavalier about saying, well, it’s okay for that exploitative lending to take place as long as it can’t come over and affect the rest of us because the exploitation itself is problematic, needless to say. But what I’m saying is it’s not only exploitative of the immediate victims, it’s exploitative of all of us, when the institutions that do it are not insulated from the ordinary primary market credit lending system.

Grumbine (42:48):

Sir, I tell you, this has been a very informative interview for me. I mean, most of the stuff… I’m going to watch this interview probably five times to learn everything you just said. Very, very eye-opening. What I’d like to do is give you a moment to kind of close out for folks to understand what may be around the corner, what might be an immediate, you know, cause this stuff has already happened. So now let’s take a look forward and get a feel for where we need to go and then we’ll close it out.

Hockett (43:18):

Great. Right. So maybe I’d say a couple of things. The first is it’s probably good for all of us to keep in mind that shadow banking is a relative term, or maybe it’s better to say it’s a functional term rather than a proper name. And what I mean in emphasizing that is to say, what would have been shadow banking 10 years ago need not be shadow banking now.

And what would not have been shadow banking 10 years ago could very well be shadow banking now. Right? So back in the lead up to 2008, there were sort of three primary forms of shadow banking, you might say. One was the repo markets. A second was the money market mutual fund and commercial paper markets. And then finally a third was of course the derivative markets.

And one thing that Dodd-Frank did was to try to bring those three principle elements of the shadow banking sector out of the shadows, so to speak. Essentially, partly commandeer them – have the Fed partly commandeer them, partly turn them into public utilities. And then of course, attach regulatory restrictions to them as a sort of condition of the sort of public guarantee that would be afforded those particular sub-industries of the financial services industry.

So those pieces of the old shadow banking industry are a little bit less shadowy now than they were then. I think we still have to shed a bit more light on them. They’re not fully out of the shadows, but they’re not nearly as important to look at now as they would have been before 2008. But what that means, in turn, is that there are other things we should be on the lookout for.

We should basically be on the lookout for the next forms of shadow banking and the next speculative assets that will become the objects of speculative fads. I think one obvious place to be looking right now is cryptocurrencies, distributive ledger technologies, all of the sort of whole FinTech realm, I think, is probably going to be the realm where the next forms of shadow banking, in the classic pre-2008 sense, emerge. And that’s where the real shadows are right now.

And that’s where the stupid money is going now rather than in mortgage loans. So I hope that the regulators are on the lookout for this. I’m certainly trying to urge that on them. And I think lots of other people are as well, but that’s the first point to make. And I think, you know, Ms. Clinton, I’m glad that she brought up shadow banking, but it was pretty old news when she first brought it up.

That was, as you know, Paul McCulley had pointed out or sort of drew attention to it and actually canonically named the ‘shadow banking’ sector way back in 2007. But the funny thing is that the people who finally informed Mrs. Clinton in 2015, that there used to be this thing called shadow banking were probably thinking of something that was no longer as shadowy by 2015 as it had been before 2008, precisely because, again, Dodd-Frank addresses repo indirectly, at least through Title VIII, addresses derivatives through Title VII, and of course addresses the money market mutual fund and commercial paper industries as well.

So that’s the first point I would sort of close on. The second, I want to leave you with a kind of maybe a provocative example from history that I think nicely illustrates something we were talking about a moment ago, and that is that again, I think the public sector can take a much more overt role in the credit extension system than it has been doing in recent decades. Right?

So again, behind the scenes, it’s our credit anyway, that all of the credit out there in the financial system, insofar as it’s backed up publicly as our full faith and credit, yours and mine, it’s our collective full faith and credit that’s monetized in the form of a national currency, which is itself issued by our own duly constituted, federal government instrumentality known as the Fed. So we might as well make that overt instead of leaving it in the shadows – pardon the use of that word again.

And lest it be thought that that’s hard to do or that that’s somehow crazy or really wacky or out there, I would encourage everybody to Google the name of one very interesting institution that we had in this country for a long time during the ’30s and the 40’s, called the Reconstruction Finance Corporation, or the RFC. The RFC in its day was by far the largest financial institution in the entire world.

Its balance sheet dwarfed all of the combined balance sheets of the Wall Street institutions, all combined. It was by far the largest credit-generating institution, credit-extending institution in the world, and it extended loans as small as $20 or $30 to African American barbershops in certain Los Angeles neighborhoods to giant mega-million or even billion dollar loans for large public infrastructure projects like the Hoover Dam or what have you.

And this institution was a public institution. It was a government institution. And indeed many of its children we still have with us: Fannie Mae was simply a child, a subsidiary of the RFC. The Small Business Administration SBA, which we still have, was a child of RFC. This was again by far the world’s largest financial institution. It was entirely public. It was the ultimate in public options in the financial sector.

I see absolutely no reason why we can’t restore a modern version of that now. And that would make very transparent to everybody that we don’t need Wall Street as a source of credit or as a source of credit extension or credit generation. And that I think would encourage further, then, belief in this basic proposition I’ve tried to get across, which is that Wall Street could be turned into a pure intermediary sort of sector where they only basically intermediate between private holders of capital and those who want to use it, but don’t actually generate public credit, which is backed up by the federal government, which can then of course end up in credit bubbles and the like.

So just if everybody would just Google Reconstruction Finance Corporation or RFC, just to sort of see what a real public option would look like. And then I won’t mention the article and white paper that I had out there. I won’t advertise in detail my own attempt to sort of sketch a modern version of this. Let the old one suffice for now the RFC itself is incredibly inspiring institution and we ought to bring back a modern version of it.

Grumbine (49:33):

Bob, this was one of my favorite interviews ever. Thank you so much. I hope you’ll come back. I really do. I want to be able to do this again and again, because this is so informative. And I think that as long as we provide a service to the people and they continue to find value in it, I think we should continue to do it. This is beautiful.

Hockett (49:54):

Thanks Steve. Happy to do it anytime. And thank you so much for doing this – for running the series. This is one of the greatest things out there on the web. I watch every one of them and thanks so much for doing it and please never stop and I’m happy to help out any time.

Grumbine (50:05):

Oh my God. Thank you so much, sir. I really appreciate it. Have a good day, Bob. With that, I’m going to say goodbye to Bob. Say goodbye to you all. Have a great day everyone.

Announcer [music] (50:20):

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