 Welcome to the Mercatus Center. We have today a book panel, Greg Ips, Foolproof, Why Safety Can Make Us Dangerous and How Danger Makes Us Safe. One of the very best books of the year, not only in economics, but one of the very best books, period. I'll introduce the commentators before they go. There's a lot I could say about Greg. He's the chief economics commentator at the Wall Street Journal. He has been the U.S. economics editor for the economist for I think six years. I think of Greg as the person I know who actually understands best how the Federal Reserve works, other than the people I know who've been on the, you know, the Fed Board of Governance itself. So Greg has a fantastic background. He has another book called How the Economy Works in the Real World. The title is Little Book of Economics, but with that I'll turn it over to Greg. And again, Foolproof is the book I highly recommend it. Greg? Thanks. It's an honor to be here. And Tyler, thank you very much for hosting me. I've been an admirer of yours and an admirer of the Mercatus Center. One of the many institutions in this work that I rely on for really thoughtful and trenching analysis. So it is really a pleasure to be here. So I wrote this book partly as a mea culpa because I was one of those people who thought that we weren't going to have another big financial crisis. I'd watch the Federal Reserve for 25 years and I thought these guys have really got it figured out. You know, the great change of moderation is all in. We're not going to have bad crises again. And then it came along and we had this crisis and it wasn't supposed to happen. And I've spent the last seven years trying to figure out why that is the case. Why did it happen? I was pretty sure that I wasn't like suckered in, you know, or in anybody's I wasn't fooled or bribed into thinking the wrong thing. I knew I was trying all that time to figure out why what was going on in the economy. And I wanted to find it interesting that I'm not the only person who's still seven years later trying to figure out what happened. I've been watching the presidential debates as well. And it's fascinating to see that they're still fighting over what caused the crisis and what we should do about it. So this book ended up being an exploration of how the United States and the world in general found itself sliding into a very severe economic chaotic event. And as I investigated this question I concluded actually that it wasn't just in the financial world that we have this problem of our inability to see catastrophe coming. But I've seen the same thing happen in the environment and just in things as simple as automobile accidents. And I wanted to figure out what was going on. What is it in our mental and our social makeup that breeds this inability to see catastrophe until it happens. And this book is the result. Now even though these stories have a very contemporary ring, my story actually came quite a long time ago in the progressive era in the early 1900s. Now as you may know the Federal Reserve was created as a reaction to a violent panic on Wall Street in 1907. That wasn't stopped until James J.P. Morgan himself gathered New York's bankers in his library and they came up with a plan to bail out most of Wall Street. But the United States still suffered a very severe recession as a result. And there had been discussion for many years about creating a central bank in the United States. There had actually been two central banks, but they'd both been allowed to expire because Americans were very suspicious of centralized power and centralized financial power in particular. Robert Latham Owen was a senator though. He had seen his father's he was born the son of a very wealthy Virginia industrialist but his father was wiped out in the panic of 1873. Owen's mother was Partcherichy and she moved their family back to Indian territory where he started his own bank. And that bank was almost wiped out in the panic of 1891. So he went around the world. He went to places like Britain and France and Germany and he became convinced that that's what the United States needed. That after the panic of 1907 he said it's a duty of the United States to provide a means by which these periodic panics shall be stopped. And so he became co-sponsor of the Federal Reserve Act with Carter Glass of Virginia and in 1913 Woodrow Wilson signed the Federal Reserve Act. Now this was a progressive era. It wasn't just about taking the jungle of the economy and bringing it under the guidance of the government. It was also about doing the same with the environment. In 1910 the United States suffered its worst forest fires in its history at that point. Now up until that point fires were just allowed to burn. Settlers actually used it for clearing land just as the Indians had done years before the Europeans had come. But this fire burned 5,000 square miles and killed 85 people, destroyed many small towns, been the subject of many excellent books. And the Forest Service which was only 5 years old at the time found in this event its mission, its purpose in life which was to suppress fires. It's interesting because Theodore Roosevelt who was president at the time, he wanted to create national parks and he was always at loggerheads with the lumber companies who just wanted to like harvest the wood. But this thing they agreed on is that whether you wanted them for wood or for wood, they had to put fires out. And so the USFS became dedicated to fire suppression. In the 1930s they actually formalized this mission with what they called the 10 a.m. policy. By 10 a.m. the next day all fires must be under control. So let's these posters I think both of which appear in my book I like because they capture in a very graphical form the overall I think tenor of how the agreement saw its mission. On the left you'll see a poster that the young Federal Reserve distributed to its member banks and it displays a fed as a gigantic dam holding back this reservoir of funds to save the economy when it's threatened by a financial panic or crisis. On the right you'll see one of the early posters from the Smoky Bear campaign. Smoky Bear was dreamed up in the late 1930s and the early 1940s as a way to sensitize the public to the importance of extinguishing wildfires. And in fact there are many wonderful posters that show the threat of Japanese invaders for example putting setting fire to American forests and why you had to be aware of that thing. And what I find interesting about Smoky Bear posters is nowadays they're portrayed normally as a good environmental stewardship. But at the time it was very much framed as your economic and civic duty because forest fire would create an economic waste which was bad for economic growth and it was bad for the war effort. Was it successful? Well it's an interesting question. I mean did we manage to put an end to financial crisis? We did for a while and as I was saying I myself was one of those who believed that we had solved the problem of severe financial crisis until 2007-2009 came along. The Forest Service probably thought for a while that it had done the same with fires. But in the last decade monster wildfires are back. The fires it's been one of the worst decades in recent memory for fire. This year actually may be the worst year in Western United States history for wildfire in the west. And I say this isn't because of the failure of these organizations. It is actually as the unintended consequence of their success. In 1989 I tell the story about an interesting conference that takes place almost two years to the day after the 1987 stock market crash. This is a conference sponsored by the National Bureau of Economic Research perhaps the pre-eminent research organization and economics in this country. And at the time just a few days before there had been what became known as the mini-crash on Wall Street. And those of us who were actually alive at the time would remember but almost nobody else remembers it because it was gone. It came and went in a weekend partly because the Fed said that they would step in and do what was necessary to protect the economy. And a couple of people said well you know every time the Fed does this they're just encouraging people to take more risk because they're convinced they'll be protected. One of those people was Hyman Minsky. Most people have now heard of Hyman Minsky but until the crisis came along very few people had. That was the one we'll hear from who actually knew Hyman personally. One of the reasons people hadn't heard about him was almost impossible to understand anything he said. If you actually read his articles in his papers they're very turgid. He's not the world's most clairvoyant speaker at all. But the essence of his theory was that stability was destabilizing that everything we did to make the economy protect the economy from recessions and crises would encourage risk taking and it would encourage financial innovation. And this risk taking and innovation would combine to bring about a larger crisis. Paul Volcker who had been Fed chairman from 1979 to 1987 independently came to the same conclusion. And this is great quote where he stands up in front of these people and he says you know I just kind of worry that every time that the FDIC or the Fed or the federal government steps in and saves us we just encourage the behavior that makes the next accident even more pervasive. And he says when I was president of the New York Fed I often said to myself what this country needs to shake us up and give us a little discipline is a good bank failure. But please God not in my district. And I love that it's the perfect Federal Reserve expression of the Augustine Augustines like please Lord make me chase but not yet sort of thing. The inability to actually resist like diving in and saving the system when it's staring you in the face. I mean the great irony I think of Volcker's comments was that he had just finished eight years where he did nothing but save the system over and over again. So this is 79 is when Volcker becomes chairman. As you can see we have two recessions and quick succession and this one until the latest was the worst of the post war period because he's got double digit inflation he's got like all our banks have led massive amounts of money to Latin America and Mexico is about to default. And so it was a pretty terrifying time and he has to like you know basically pull the United States out of all those crises the Latin America debt crisis the fact that the banks are insolvent and the fact that we have double digit inflation. And in those dark days it was hard to tell but he actually succeeded. So the Volcker disinflation kicks off the 80s boom and after bailing out the banks in 1984 once again he has to do when Continental Illinois is failing and he actually puts pressure on the Treasury and the Federal Deposit, Federal Deposit and Insurance Corporation to like bail out and then take over Continental Illinois because he's afraid that if Continental Illinois fails the panic will spread to a lot of other banks and a congressman who's grilling Volcker on this says we now have a new class of banks in this country too big to fail banks. That is the first recorded instance of that expression. Paul Volcker is the father of too big to fail. He doesn't like to admit to the fact but it is true. But the point is is that we actually had a pretty good economy as a result. For 25 years we had pretty stable growth, steadily declining unemployment, steadily declining inflation and this became known as the great moderation and it fooled people like himself into believing we had licked the problem of crises and recessions. It wasn't just about defeating inflation. It was also about regulating the banks. So one of the narratives of the crisis oh we let the banks you know like get away with murder we deregulated them but that's not quite right because if you look at what Volcker and then Greenspan did they were aware of the problems the banking system had in the early 1980s when they became too exposed to things like real estate and to Latin America debt. So they forced them to get more debt and the banks fought them out of the way. If you think the banks are fighting the regulations today you should have seen the kind of stuff that Volcker and Greenspan, the Greenspan's credit had to put up with as they were being accused of causing credit crunches and all sorts of things and putting American banking at disadvantage and it worked. Banks by the time of the crisis actually had more capital than they ever had and you're a capitalist right basically if you're a bank you make loans and you pay for them with deposits but some of those loans go bad you don't want your depositors to lose their money so you need a layer of shareholders equity but if the loans go bad it's your shareholders who lose the money, the capital, not your depositors and that essentially is the cushion that they were forced to build up. But here's the thing as banking became safer became less profitable and so risk began to migrate and the profitable lending opportunities began to migrate elsewhere into what today we call the shadow banks, investment banks like Lehman Brothers and Bear Stearns, Fannie Mae and Freddie Mac, money market mutual funds. You know if you own a money market mutual fund you help cause a financial crisis because your request for safety in a money market mutual fund enabled a money market mutual fund to buy all the commercial paper that those mortgage backed securities investors were issuing. Gary Gordon has come up with what I consider perhaps the best theory of financial crisis. I'm sorry this is a terrible chart and I'm going to like beat up Gary about this because he really needs to do a better job with the chart but essentially he has a theory about essentially what causes financial panics. The financial system wants to make loans so that businesses can invest and people can buy homes and fund those loans by gathering up some kind of liabilities of their own. Traditionally bank deposits very safe but as our financial system migrated away from banks these other shadow banks came up with other types of so-called safe assets to fund the lending. They became known as repo loans asset backed commercial paper and yes money market mutual funds shares again I'm sorry but if you own a money market mutual fund you contributed to that problem and so by the time of the crisis we had seen that bank deposits were a fraction of the supply of lending in the economy that they were back in the 50s and 60s and most of it had been taken over by these other versions of safe assets. The problem was that while deposits really are safe because the federal government guarantees them all this other stuff only seemed to be safe because it was structured to seem safe until some of the assets like mortgage backed securities began to fail and then a panic began which as it turns out is exactly what used to happen in the 1800s before we had deposit insurance in the Federal Reserve. So as the financial system the classical banking system became safer the quest for more risk and more lending caused lending to migrate to places that looked almost as safe but really weren't. Going back to my forest fire analogy for a moment this is a chart that was made over the last 2000 years and I spent a lot of time learning a lot about the history of fire here. Now one of the things that we do know in the last century is that the climate has gotten a lot warmer and a lot drier. A lot of that is attributable to man-made burning of fossil fuels in the build up of green house gases. So what Jennifer Marlin, a scientist at Yale University has done is she and her colleagues have put together a history of forest fire in the western United States. It's very clever the way they do this. They basically when the forest burns it throws up all this charcoal into the air. It settles on the bottom of lakes and if you actually dig deep into the sediment of the lakes you can pull out like a core sample and it's like a time capsule and tells you thousands of years of history of fire. So she has used this stuff to basically figure out when the west's forest burned more intensely than when they did not. Now separately other scientists, the dotted line is the climate and so she has taken other estimates of climate and done a prediction and aligned it to what? This is how much forest burned and this is how much this is the state of the climate. So she did a correlation between the two and given how hot and dry the climate has got this is how much forest we should have seen burned. But this is how much actually burned. Why? Because we were suppressing them. For a century we've suppressed those forest fires and it's created what they call a fire deficit. It's almost like the forest wants to burn and we haven't been letting it happen. So it's a little bit like our financial system that allowed a lot of risk and leverage to build up but it was just waiting for an opportunity to emulate the same things happen to our forests. So it's not so much, it's not, it is a climate a warming climate is playing a role but the natural combustibility that allowed to accompany that was held back until the last decade when the density of the forests, which is occurred because of the repeated fire suppression, now creates more intensive and destructive fires than ever. In the 1970s so in trying to frame what it is that does this, I looked at a lot of things, you know you could call this moral hazard which is essentially if you protect people from the risks they take they will take more of those risks but it's much more complicated picture. In the 70s Sam Peltzman who's an economist at the University of Chicago came up with what later was named after him, the Peltzman effect. He did a study looking at how drivers at the incidence of accidents after the introduction of seat belts and he concluded that while driver deaths had gone down pedestrian accidents or deaths had gone up and therefore this was evidence that people when they wore seat belts were driving faster and actually it was not making people collectively more safe. And this actually started like decades worth of controversy and research and people have found evidence of things like the Peltzman effect and things like NASCAR racing and hockey. But it turns out that people have studied this very carefully now believe that the Peltzman effect actually does not occur in safety belts. When they've studied the introduction of safety belts in state by state incidences they do not find that the incidence of pedestrian deaths go up. But they have found it in other things like anti-lock brakes which were at the time thought to be the greatest safety innovation since safety belts and study after study discovered no reduction in accidents due to anti-lock brakes. Why was that? Well it turns out that with safety belts a lot of people actually eventually forget they're even wearing them. So if you don't know you're wearing a seat belt you don't drive differently it doesn't affect your behavior. But anti-lock brakes apparently did give people the sense that they could handle their cars better. So they would drive faster, they would drive differently, they would brake harder, they might have fewer front-end collisions but more rear-end collisions. So the presence of a device or a technology that gives you the sense that you have more control over your environment that's when it changes your behavior. Now I draw the analogy to financial derivatives for example. Financial derivatives enable banks to take risks that they otherwise wouldn't because they can now make loans or types of loans that are now protected because they've hedged it using a derivative. And that is the point. The point of a derivative is to let you take a risk that you couldn't before. And for each individual bank it might be rational but it might mean that sometimes the risk management will fail as it did for example with J.P. Morgan in the so-called London Whale trading accident. And it can collectively cause a problem because if every bank buys a derivative from another bank in the belief it makes them safer there's kind of a fallacy of composition here. You can't all be safer if you're all buying insurance from each other. In the insurance business they say the bigger the disaster your insurance the more you have the problem that you're buying insurance on that Titanic from somebody who's on the Titanic. Another example of this is antibiotics. So if you have children, small children, then you know what it's like to have your child sick and you just go to the doctor and you just want something, anything to make them better. And a lot of us will say, please give my son antibiotic. I think he's got strep throat or something like that. And the doctor if you really want to make feel better will prescribe the antibiotic even though only one in ten sort of cases are actually caused by bacteria. The others are caused by viruses and they don't respond to antibiotics. Similarly we're all going around slathering this antibacterial soap on our hands when in fact studies show that it has almost no effect on reducing infection but it does actually inculcate resistance among bacteria. And as a result we have beasts like MRSA which kills tens of thousands of people a year and sickens 80,000 all because what we think makes us healthier makes everybody less healthy. This is a famous chart a little bit jazzed up by my former colleagues at The Economist which shows that as along this axis antibiotic usage along this axis incidence of resistant bacteria and you can see a pretty good R squared there, much stronger you can see in most microeconomic studies. So the more antibiotics we use, the more susceptible we will come to the bugs that do not respond. When I explain my thesis to a lot of people they sort of say well that's a bummer. What are we supposed to do? Just take it? Well no, in fact I spent a lot of my time working on the book trying to come up with what I thought were good solutions to some of the problems that we faced. The first is to try and exploit the fact that if safety can be dangerous then how can we allow danger to make us safe? And one of the greatest, one of the most fun I had was studying aviation. Now those of us in journalism are used to the plane companies complaining that you guys always write about the planes that crash and never write about the ones that land safely. So I decided to study why so many planes landed safely and I became convinced that because plane crashes attract so much publicity that they galvanize response by the public, by the airlines, by the plane manufacturers and the regulators to do everything they can to make flying safe. It's what's really astonishing is how much safer it has gotten over the last 40 or 50 years. In the 1960s Don Draper, if he was going from New York to Chicago and he was worried about dying, he should have driven because he was more likely to get there alive if he drove than if he flew. Today he should fly because you're more likely to get there alive if you drive, but fly instead of if you drive. In fact, flying is now so safe compared to driving that if you fly from Boston to Chicago you will not only save eight hours of time, you will add 15 minutes to your expected lifespan. So there's actually a little agency, there's actually a little agency that operated by NASA and what they do is they actually encourage pilots and air traffic controls to anonymously report near misses and then they share that information with the entire industry and if you are constantly being reminded of how somebody else killed a plane full of passengers, it turns out that this can have a very positive effect on your own taking a lot of trouble not until the same thing happened to you. So this is an industry that I say has sort of, in aviation, that it helps to be a little bit scared and that's one of the reasons why flying is so safe because it's so scary. What about space? So one of the things I found, one of the universal constants I found is that space makes us safer is that because it is so difficult to predict the threat that's coming at you and that's going to bring down your economy or your car or anything, is that the best thing to do is put as much space between you and the eventual source of the threat as possible. When I was driving in France on my honeymoon, I remember seeing a sign on the screen where that said, if I translate correctly, speed makes everything worse. Essentially it was telling me that when you're driving faster, you use up the space between you and the car ahead of you much more quickly and when you collide, the force of the accident is much greater so I slowed down and I think about that all the time. So if you want to know the best way to protect yourself in an accident leave a little more space between you and the next car. This is my prediction that once Google's driverless cars take over, we're going to have a lot more accidents because drivers will be driving a lot more close together. I don't know if on Net we will have more accidents than we used to but I do predict that we will have more fun in and rear-end collisions as a result. In fact it's already happening. There's actually reports that these Google cars keep getting rear-ended because they stopped too abruptly. In the world of flooding, I mean the Dutch have, the Dutch who've used levees and dykes a lot, they have a saying, there's only two types of levees, those that have failed and those that will fail. So they have tried to move away from the levees only policy of trying to protect us by building walls against the water and actually tearing down the dykes and allowing the flood, the water to flood the floodplain and by doing that they actually protect the rivers, the cities that are downstream. The entire town I think of Grand Forks was moved away from the upper reaches of the Missouri River to protect it from repeated flooding because space is more safer than a levee. And in the financial world I talk about equity because basically essentially what equity is, it introduces space between the bank's loans and its deposits, or its debts. And the more space it has there, more protective equity there, the less likely it is to fail. One banker I heard said the best, what we should have had after the crisis was more capital and less of everything else. By which he meant that when a bank is trying to protect itself it can do risk management, it can hedge itself with derivatives, it can have its little internal policemen constantly looking over the shoulder of its traders, making sure they aren't taking chances, but somewhere something is going to fail. It always happens. But if you have a lot of capital it almost doesn't matter. When J.P. Morgan lost $6 billion on that trade, if you had actually looked at the trading of their bonds you would have seen nothing happen. And the reason why is they were so jam-packed with capital that there was almost no way that that loss could have brought the bank down. But the final lesson I want to say here is, oh by the way, but there are risks and I just want to bring this up in the context because of the presidential election, which is that one thing we know from the 80s is that if you make the bank safe or is that risk will migrate elsewhere, and that's already happening, or actually can see that as bank lending has dropped, mutual funds are now starting to take up some of the slack. Is that safer or is it less safe? Complicated question. But I do know that risk is migrating elsewhere just as it did two decades ago. Over here we can see that emerging market bond funds are now major sources of lending to emerging markets because banks are pulling out of that space. And over here in the mortgage area, because banks for their own reasons or for regulatory reasons are more reluctant to make many sorts of mortgages, we're seeing shadow banks and finance companies take that space. So that's just one thing to keep in mind is that the story of risk is that when you clamp down on one area it comes back to another place. But the final point I want to make and I don't want to spend too much time is that our goal should not be to get rid of all crises because crises result from risk-taking and a lot of risk-taking makes us wealthier. You should not want an economy with no crises because an economy with no crisis is an economy with no risk-taking. And I say that fully aware of the pain and the consequences of the last crisis we had. But I want to show you this chart which I think is a very nice little example of what I'm trying to say here. Compare Thailand and India. So Thailand was very open to foreign investment and had a very liberalized financial system and as a consequence in 98 they had a devastating financial crisis and that kicked off the entire Asian emerging markets crisis. India had a very repressed financial system and it was very hostile to foreign investment and they've never had a financial crisis and remotely like that. But as you can see India also grew more slowly. Thailand ended up richer as a result. So I think that's kind of a lesson I want. It was that disaster and crisis happens partly because we take risks. Partly because we want people to feel safer. It's a civilizing impulse. We want to get rid of stability and disaster. And in the process we are in the long the line going to sometimes create complacency. But Gordon actually connected to George Mason? Yeah, yeah. So in that case you probably all know this story. But I'm just going to finish this story. He said if you really want to like eliminate car accidents put a dagger in the steering wheel aimed right at your heart and guarantee that there will be no car accidents. But you know what? Nobody would drive very much either. So that's what I want to sort of the last thought I want to leave you with which is that do not aim for a world without risk because it's not a fun world to live in.