Good morning, I’d like to thank the University of Chicago for inviting me to speak today, and thank you Austan for that kind introduction. Being back here reminds me, Austan, of soon after we first met. You were working out of a cramped office with books and papers piled sky high. Since then, your office moved to a pretty fancy address in Washington. But now that you’re back in Chicago, the real question is, what does your office look like now?
In all seriousness, I met Austan when he was a valued advisor to then senator and candidate Barack Obama. At the time, I was working on Hillary’s campaign. And when his candidate became the Democratic nominee, Austan was exceedingly gracious in welcoming the other candidates’ advisors into the fold. It turns out, we were better teammates than rivals. It’s great to see you back in Chicago, Austan.
Lessons of 2008
Three years ago, the financial system failed, and the financial regulatory system failed as well. We are still feeling the aftershocks of these twin failures.
There are many lessons to be learned from the crisis. Foremost, when financial institutions fail, real people’s lives are affected. More than eight million jobs were lost, and the unemployment rate remains stubbornly high. Millions of Americans lost their homes. Millions more live in homes that are worth less than their mortgages. And millions of Americans continue struggling to make ends meet.
Second, it is only with the backing of the government and taxpayers that many financial institutions survived the 2008 crisis. We are seeing this situation all over again with the current debt crisis in Europe.
A perverse outcome of these crises may be that people in the markets believe that a handful of large financial firms will – if in trouble – have the backing of taxpayers. We can never ensure that all financial institutions will be safe from failure. Surely, some will fail in the future because that is the nature of markets and risk. When these challenges arise though, it is critical that taxpayers are not forced to pick up the bill – financial institutions must have the freedom to fail.
Third, high levels of debt – and particularly short-term funding at financial institutions – was at the core of the 2008 crisis. When market uncertainty grows, firms quickly find that their challenges in refunding debt, so called problems of “liquidity,” threaten their solvency.
Fourth, the financial system is very interconnected – both here at home and abroad. Sober evidence from 2008 was AIG’s swaps affiliate, AIG Financial Products, which had its major operations in London. When it failed, U.S. taxpayers paid the price. Further evidence is the risk posed to the U.S. economy from the ongoing debt crisis in Europe.
Lastly, while the 2008 crisis had many causes, it is evident that swaps played a central role.
Swaps added leverage to the financial system with more risk being backed by less capital. They contributed, particularly through credit default swaps, to the bubble in the housing market. They contributed to a system where large financial institutions were considered not only too big to fail, but too interconnected to fail. Swaps – developed to help manage and lower risk for end-users – also concentrated and heightened risk in the financial system and to the public.