In '99, you and [Ben] Bernanke write a paper. What is it about?

We were commissioned by the Federal Reserve Board to write a paper about how they should respond to asset bubbles. So what we did was use the earlier research we had done on financial crisis and how it affects the economy and included asset bubbles and explore different policy responses.

The conclusion we came to was that the best response to an asset bubble was regulatory; that is, set up a regulatory system where the financial institutions would be protected against the fallout. What we found is that if the central bank tries to directly attack the bubble by raising interest rates, that could have a destabilizing effect. So the best thing the Fed could do with interest rate policy would be to stabilize the economy, and it should use regulatory policy ahead of time to try and insulate the economy against the effects of asset bubbles.

And in fact, what we found is highly consistent with history. In the Great Depression, when the Fed tried to target the asset bubble in the late 1920s, it helped lead to disaster. When the Bank of Japan did something similar at the peak of the Nikkei, it led to disaster.

Now, many people ask about the experience in early 2003-2004, in the wake of the recession in the U.S. economy. The labor market was weak; inflation was low, bordering on deflation. There was a deep fear about turning into a Japan-type stagnation. So what the Fed did was keep short-term rates low in the wake of an increasing housing bubble.

Some people argue that that's the cause of the housing bubble. I don't agree with that for a variety of reasons. If the Fed had raised short-term interest rates, say 25, 50 basis points, 75 basis points at that time, it wouldn't have arrested the housing bubble. If it would have done enough to curb the housing bubble, which would have required several hundred basis points, it would have creamed the economy.

So that's why we argued in those types of situations that it's really much better to have the regulatory system right. And when you look at the current crisis, the regulatory system is way out of whack.

Go back to '99 for just a minute. What's the state of play in the American economy at that time?

The state of play was the tremendous appreciation of equity prices, and there was concern about the fallout. The question was whether or not they should increase interest rates to fight the equity bubble.

The difficulty is to know exactly when you have a bubble. In 1996, for example, asset prices shot way up. That was a period of irrational exuberance. But at the time, the fundamentals justified the increase in equity prices. And in fact the U.S. economy had roughly a five-year period of high growth. Had the Fed tried to kill the asset boom then, it would have affected this boom period in the '90s, which we think of as the best period we've had in recent memory. ...

The tech boom.

That was the tech boom. In that period, we did have an unraveling of equity prices, but the economy weathered it. Now, in that situation, the regulatory system was not out of whack the way it would be subsequently out of whack. For example, commercial banks were well capitalized. There weren't a lot of highly leveraged financial institutions outside the banking system the way there were in the current crisis.

What is a bubble?

It's an appreciation of asset prices that cannot be justified by fundamentals. The great difficulty is, it's hard to know when you're in the midst of a bubble whether they're justified by fundamentals or not, because they depend upon investors' expectations of future dividends flow, their beliefs about how they should discount asset prices. So in the midst of a bubble it's very, very difficult to identify one. Even ex post, there can be some debate, because it's possible that investors had some reasonable expectations at the time, and then had good reason to change their minds. So it's a very, very difficult business. ...

What had [Alan] Greenspan been doing [as Fed chair]?

I think they had been nervously worrying about bubbles, but staying focused on keeping the economy stable. Again, you have to look at the context. Asset prices rose in '95-96 just as the economy entered a long boom, at least a boom for five years, so the difficult judgment call was whether or not to try and kill the boom or let it go. And that's not an easy call to make.

It killed itself.

It killed itself, yeah. I think eventually investors realized that this was not sustainable, and there was a relatively mild recession.

Now, to be clear, the Fed can't eliminate recessions. There's a normal boom-bust cycle built in to the economy. The Fed's job is to moderate these cycles, and if you look at the period since 1984, the Fed had done a pretty good job in moderating the cycles.

In my view, where things got out of hand is there was a failure to adjust the regulatory system. You could go along the way and say, look, if we had not permitted subprime lending, if we had not permitted these financial institutions that weren't banks to basically adopt portfolios like banks, holding mortgages and issuing short-term liabilities, we would not be in the mess we are today.

How did the regulators miss the regulation?

Unfortunately, I think it always takes a crisis to get change. In the late 1980s, we had a banking crisis. ... The commercial banks went into risky commercial real estate lending and took losses. The crisis generated support for regulatory reform, and we had the Basel capital requirements phased in, and these banks were required to hold more capital, and in fact they did raise their capital base. So there's a case where crisis leads to reform. Reform, at least for a while, sets you on the right track.

But then, as happens throughout history, financial institutions [learn] how to game the system. So banks, instead of initiating and holding mortgages, which would require them to have capital against these mortgages, would initiate them and sell them. The securitization market had been growing, so here was a new type of loan. You could securitize mortgages.

Also, along the way, there was a growing belief that everybody should have access to home ownership. That was politically appealing to both Republicans and Democrats. So there was an easing of standards, and these subprime loans were securitized. There were people who did ring warning bells about this, but again, when the economy is going well, it's difficult to get change.

And I would add one more factor to the brew. Since 1984, the U.S. economy had performed reasonably well -- the two recessions, but both very mild, relative price stability. There wasn't the sense of urgency to bring change, even though some people did see that the regulatory system wasn't right.

[What was Fed policy between 1984 and 2004?]

Paul Volcker, [Fed chairman from 1979 to 1987], started it off by reining in inflation, which needed to be done. Greenspan did a good job of managing interest rate policy, looking back. It's hard to improve on it. He also handled a number of financial crises: the 1987 stock market crash, LTCM [Long-Term Capital Management]. So I think you can give that to them. I think what he missed, and others at the time, was the necessary regulatory adjustment.

They thought that the best government is no government: You leave it alone, it will kind of regulate itself?

To first approximation, yeah. The crises weren't happening on a large scale. That led to a sense of complacency.

But the tech bubble goes down. Greenspan's response is, "Let's let the housing bubble grow; let's keep interest rates where they are."

You have to go back at the context. The 2001 recession ended in November, but the labor market kept deteriorating. ... The actual level of employment growth stagnated through the middle of 2004. The stock market had crashed. ... Inflation was falling through most of 2003. There was deep concern about falling into a Japan-type deflation trap. ... So the focus of Fed policy was to avoid exactly the kind of crisis we are facing today, and that meant keeping short-term interest rates low.

Now, did that fuel the housing bubble? I think it had a modest effect, but not the main effect. There were two factors that were far more important. First of all, long-term interest rates were low. The central bank has only modest control over long-term interest rates. ... Why were long-term rates low? Well, tremendous growth in China and India, tremendous saving. The saving needed a place to go. Stagnation in Europe. Investment demand was low in Europe. So where did the funds pour in? They poured into the U.S., and this had the effect of lowering long-term interest rates. That's the first factor.

The second factor was a general relaxation of standards for subprime borrowers. What you saw is the mortgage spread for subprime borrowers relative to long-term interest rates narrowed. And those two factors were far more important than the short-term interest rate policy that the Fed undertook. ...

How did you and Bernanke come together? And how are you similar, and how are you different?

We crossed paths. I was leaving graduate school; I was at Stanford. I was going to a job at Cornell at the time. He was a Ph.D. student from MIT coming to Stanford, and we had a mutual friend who hooked us up because he thought we would have common interests. ... We did what all new Ph.D.s do: We talked about economics and sports. We had a common passion for baseball statistics. ...

In terms of differences, I think early on, he would think big in a way that the typical graduate student didn't do. Most of us would take the technical training that we learned in graduate school and extend it to some problem we were interested in. He decided to study the Great Depression and try and figure out what the cause of the Great Depression is. ...

Do you know why?

I once asked him that, and his response was, "If you want to understand geography, study earthquakes." He wanted to understand the economy as well as he could, so he wanted to study the moment of greatest crisis.

Was '99 the first paper you wrote together?

No, not at all. ... Our first work was in the ... early 1980s. Ben had identified the breakdown of the financial system as a key factor in the depth and duration of the Great Depression. We were interested in modeling how those kinds of phenomena could come about; how financial distress could lead to weakening of the real economy, and then there could be feedback, and the whole thing gets magnified. And that's really what our early work was about.

We first did a paper on banking. This was a startup paper, where we studied how declines in bank capital could affect the economy. It could affect borrowing and investing.

And that worked us up to develop a more general model that we call the financial accelerator model that really formalizes how you could have this feedback between the condition of balance sheets and the overall performance of the economy. ... And we developed that further to talk about the implications for monetary policy in these types of situations -- the role of government policy, how things like equity injections might be necessary -- and then also how to incorporate this type of phenomenon into a conventional forecasting model.

... What are you doing? Are you heading toward proving a theory of the world or following your noses?

I'll credit Ben on this. He was always interested in doing something relevant. I don't think he had in mind at the time becoming Fed chairman. In fact, I know he didn't have that in mind. But he did have in mind doing something that's important, that is not just modeling, but really trying to understand what's going on in the macro economy. Of course it's nice to make it in your field, but ultimately we were interested in doing something that we thought was relevant.

And his academic trajectory was?

He was considered a star coming out of graduate school. He had performed so well at MIT, and his reputation preceded him. In fact, I had heard about him before I met him. And then with his Depression paper, he really validated all of the praise that he had received coming out of graduate school. ...

What is his theory espoused in the Great Depression paper?

That it really was a breakdown of the financial system that was key. [Milton] Friedman and [Anna Jacobson] Schwartz had really pioneered the approach. They had gone back carefully and looked at all of the money and financial data, and Friedman and Schwartz argued that a key aspect was the Fed's failure to act when the economy was sinking in '29-30. '29-30 was a recession which was normal for the time. We would consider it a deep recession. GDP contracted about 10 percent. But in 1930 the Fed was at a crossroads, and it was just paralyzed.

That was an important first step. But the details needed to be filled out about why the Fed inaction led to such a great contraction. And one thing it did was it permitted the banking system to fail. It permitted prices to fall. The deflation ... basically led to a breakdown of the financial system. And really what Bernanke did was come in and really focus on this and get it out of the data and show that this was a very plausible candidate for the severity of the contraction. ...

What is Bernanke's personality?

He is pretty shy and unassuming. ... He was at first ill at ease in public, but that's no longer the case. And that's something that just evolved over time with the different roles that he has. He's a genuinely nice person, has enormous integrity, pretty good sense of humor.

Why the Fed?

His research. He has spent his academic life working on problems related to the Fed on financial crises, on inflation targeting, and I think after he finished being chairman at Princeton, he was looking for something new, ... and this opportunity to become a governor came up. To him, that seemed like the best of both worlds, because he could get in on the policy-making side, but a Fed governor is the kind of job where you still have a chance to think about things. It's not bureaucratic, administrative work. You're involved in policy-making, but part of your role is to sit back and think. Of course, not these days. They don't have time to. ...

What does the Fed do?

The Fed manages short-term interest rates. ... Its mandate is to set interest rates to keep the economy stable, to maintain price stability and output at full capacity.

Now, a related mandate is financial stability. So when there's financial turmoil, it's supposed to go in and use whatever means necessary and legal to maintain the functioning of financial markets. ...

How does the Fed decide when and when not to act?

Every six weeks, the Federal Open Market Committee meets to decide the level of overnight borrowing rates. They set the target rate, and then at the Federal Reserve of New York, they buy and sell bank reserves to keep the short-term interest rate at a particular target rate. The trade-off is the following: If the Fed sets the target rate too low, there might be too much borrowing and spending, and the economy might overheat, and we get inflation. If the [Fed] sets it too high, the reverse could happen: stagnation and deflation. So, once every six weeks, they perform this balancing act.

If there are problems in between meetings, for example, as occurred in August 2007, when we had the beginning of the subprime meltdown and the commercial paper market started to go haywire, the Fed might have to intervene with nonstandard measures to cool down the crisis. In fact, that's what they've been doing for the last almost year and a half -- both setting the funds rate every six weeks and intervening directly in credit markets, lending directly, to try and keep the credit markets performing.

So what's the difference between somebody like [former Treasury Secretary] Hank Paulson and somebody like Ben Bernanke? ...

In this crisis, the distinctions have narrowed. ... If credit markets are disrupted, [the Fed is] the one institution that can quickly move in and intervene.

Now, historically, it's been considered desirable to not have the Fed involved in the allocation of private credit, because there's a strong political dimension to that. ... In normal times, what the Fed does is buy and sell government bonds. Now it's buying and selling private securities. ... When there's a crisis going on, the Fed has to be there. But when things have calmed down, it's a political decision. It's really the Treasury that should get in, because it's a political entity.

So in this case, in effect, is Paulson the caboose on the train being driven by [the Fed]?

What happened is by September 2008, the Fed had exhausted all of its tools. It had lowered short-term interest rates. It had intervened to lend funds directly to financial institutions that weren't banks. It had done as much lending as it could, but financial institutions were still in trouble. There was a shortage of capital in the market. This required the political system to get involved, because the Fed couldn't unilaterally say, "We need $700 billion to help out the banks." At that stage, the Treasury had to get involved.

They couldn't just print $700 billion more?

No. And this is an important point, which I think was completely lost in a lot of the discussion. ... By law, the Fed can only lend against "good collateral," and also with an institution over which it would have recourse.

In the case of Bear Stearns, which was the first instance of the government coming in and helping an institution, the Fed lent against securities that were considered sufficiently good collateral. That was the $30 billion loan. Plus, they had [JPMorgan] as an acquiring entity, and they had recourse against [JPMorgan].

When Lehman came along in September, neither of those criteria held. Lehman did not have collateral to lend against, and there was no acquiring entity. The Fed could not do it alone, and at that point, it was necessary to bring the Treasury in, actually. Technically, it was necessary once it was clear AIG was in trouble as well.

So it's not the case that the Fed was just acting randomly. They were dealing with institutions over which they had no regulatory control. They had control over commercial banks. Neither of these institutions were commercial banks, and they were also limited by law in what they could do.

I would also add the situation was something that had never been faced before. To say, "Aha, we want to determine [a] predictable strategy in this type of situation," of course we all do, but good luck doing it.

Do you think, given Ben Bernanke's expertise, looking at Bear Stearns in March '08, thinking about implications, it was an "Oh, my God, the real thing is happening right before my eyes," or is that too much to say too early in March?

Oh, no, certainly. I think even going back to August 2007, it was clear that this had to be contained. It was no doubt in his mind. The question is, what measures could you take?

Now, don't forget, at the same time -- and I think we all tend to forget this -- oil and commodity prices were beginning an upward trend. They would double in over a year, so he had to contain the financial crisis, because he, more than anybody else, appreciated what would happen if it got out of control. And he also had to balance this against inflationary pressures. But by the time Bear came around, I think they were pretty aware of the potential consequences. ...

It's amazing: Here's you and a guy who studied the Depression. ... Suddenly, this crisis unfolds. We all know you can't fight the last war, but at the same time, there's an awful lot of it that must feel similar.

No, I think he had a sense of how things could play out in the worst-case scenario. It's complicated by the fact that you have to try policies that have never been tried before in the U.S. without a completely clear idea about how they're going to work out. For example, the equity injections, asset purchases -- these are things that have been thought out in theory in the U.S., but really haven't been tried on a large scale under these circumstances.

So in fairly quick order, you have to make a decision about what to do, and that's tough. And then you have almost half of the economic and business community screaming at you, telling you there's not really a crisis. If you recall after the TARP [Troubled Asset Relief Program] was proposed, there were lots of people rolled out on television who said: "Look, there's no crisis. We don't need to do anything." So, not an easy circumstance.

So then summer of '08 comes along.

Things calm down for a while.

Did you think they were calmed down?

It was very unpredictable, because things calm down a bit on the financial front. They've introduced these new lending facilities. They were lending directly to non-bank financial institutions, but oil and commodity prices were continuing their upward trend, and they would peak in July. So there was a lot of pressure on the Fed not to lower interest rates, even though the financial situation was highly fragile. ...

I think both Alan Greenspan and Paul Volcker have conceded that this was the most difficult situation that any central banker has faced in the postwar, the twin threats of inflation and financial crisis -- and financial crisis in a world that was completely new. We had all these new financial products, all these new financial institutions, and all pretty much outside the regulatory framework, so you had to operate in a world you really couldn't see. ...

[What happened with Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Mortgage Corp.)?]

That was the Treasury that took the lead in taking over Fannie and Freddie. Most of these problems we know now were buried in the mortgage market really beneath the surface, and everybody missed it. The rating agencies missed it, everybody. ...

And it goes back to the Great Depression that in a financial crisis, one thing you do is the government takes control of the mortgage market. That's what happened in the Great Depression. It happened much later on than in this crisis. So that seemed like a natural step to do, and I think there was hope that that would do it. ... The difference now is the financial instruments look quite a bit different.

Like what?

Securitized mortgages.

What's a securitized mortgage?

In the past, financial institutions like a bank would initiate a mortgage and hold it on its balance sheet. In the securitized world, an institution will initiate a mortgage and then package it with other securities, and sell it off so any other financial institution can hold it.

And maybe the biggest problem underlying this crisis is, standards were lowered on the type of mortgages that could be initiated. They were sold off and securitized. They were given the stamp of approval by the credit rating agencies, who, along with everybody else, grossly underestimated the risk. They underestimated the default risk, I think in part because there were lots of shady practices in subprime lending, so you could get people who met the official characteristics to qualify [for] the loan, but if you had dug deeper, they really weren't qualified.

Also -- and looking back, this is the most numbing aspect -- there were no provisions to renegotiate these loans if the borrower got in trouble. In other words, if the borrower is dealing with a bank, the borrower is in trouble, you renegotiate. With a securitized mortgage, the way they were set up, this was not possible.

So what that meant is that the only option was foreclosure. Foreclosure meant the home was put on the market. All these homes on the market from foreclosure drove down housing prices, making the problem worse. And we're still stuck in that situation today. We can't figure out a way to deal with these foreclosures just because of the way the institutions were set up. And I don't know of anybody who saw this. There were people who predicted crises; I don't know of many people who saw this coming. ...

[What happened with Lehman?]

... There were two things going on. One is the Fed, again, they were limited in what they could do. Two, there were lots of people saying, "Don't do anything." The Bear experience didn't work very well. And three, there was planning the best they could. They had been going through contingency planning just in this event, and there was a period of about 24 to 48 hours where it looked like it might work. The markets didn't react all that badly at first.

But then came AIG. And to me, AIG was the low point of this crisis, and the reason is that this was a huge insurance company that had a very good credit rating that was outside the Fed's regulatory framework. The Fed doesn't regulate insurance companies. But lo and behold, it had been using its good credit rating to acquire these mortgage-backed securities.

That, to me, was the most demoralizing moment of this crisis. To me, this signaled everything that this crisis was about: You have a regulatory framework that's just out of whack with the financial system. You have financial institutions that are gaming the system. AIG is a big entity. This causes chaos in the market. And personally, people say, "Oh, you should have seen the crisis." I don't see how anybody could have seen this, certainly, anybody policy-making. The Fed has regulatory responsibilities, but AIG was not within the Fed's regulatory net. ...

Do you think Ben and the others, Paulson, knew [the effect Lehman's failure would have on the commercial paper market]? Is that AIG, or is that Lehman?

I think that it's both. They knew that this was going to be tough. I don't have access to the inner workings of the Fed. ...

Now, people at the Fed who I've talked to say that yes, the derivatives were a problem -- not the biggest problem. The biggest problem was all of these mortgage-backed securities out there, that nobody really fully appreciated the risks.

And also, let me just add to the story. There's one other dimension that was not forecasted, and that is that the commercial banks in many cases had implicit arrangements to take this stuff back that they sold. ... This ultimately helps get the banks into trouble. Now, if the crisis had been walled off from the banks, it would not have reached the scale it did today, because the banks are central in everything, and once the banks get into trouble, then it's the whole financial system that's in trouble. ...

The banks started the crisis in good shape because they had been operating under Basel. So they had pretty healthy capital at the beginning. They had initiated these loans and sold them off.

The beginning is when, '07?

Yeah, '07. Yeah, before that, they'd been initiating and selling off. But then the banks start taking this stuff back, making them vulnerable. And I think it's the wake of Lehman, I think Ben sees that the Fed cannot handle this alone. They need to call the Treasury in, and that's the beginning of the TARP rollout. And I think -- and here I'm guessing; I don't know firsthand -- I think the shell shock was AIG, and this led to this moment where they really had to scramble to get political support.

You have to understand, this whole crisis in some ways is about the fact that you can't do anything unless you show the public that there's a crisis. In fact, if there could have been the regulatory readjustments early on -- this could have been done in the late '90s and 2000 -- we wouldn't be here. But there was no crisis to get people moving. You couldn't go to the Congress and ask for $700 billion in March. There was just not the evidence. And even in September, when they went, there were lots of people saying, "This isn't necessary." And in fact, the bill went down. Now when it was rolled out, it wasn't articulated very well. ...

Was it a kind of contagion of fear or distrust, or lack of confidence that also caused in some way a run on Bear Stearns and a run on Lehman?

Another way of saying that -- and that gets back to my point -- is this crisis is about the regulatory system not being right, because essentially, you had institutions operating as banks that weren't regulated as banks. … They had short-term liabilities and illiquid assets. Historically, those are the kinds of institutions that are within the regulatory safety net.

And these are not fly-by-night mom-and-pop banks in Kansas. These are the big five.

No, and it wouldn't have been a problem if it was mom-and-pop banks, but it was a problem.

AIG needs a big infusion of what, $85 billion?

Yeah, that was a collateralized loan. A little bit different. Again, the AIG model was close to the Bear model; that is, it's lending against collateral.

The next stage is, OK, the commercial banks are now infected. This is like a disease spreading. The commercial banks have too little capital relative to their assets. This is leading to an outflow of deposits. This means they can't raise money to lend, so that was the reason the TARP came about, was to address this problem. ...

When you say commercial banks, is that like Bank of America, Wells Fargo, those kind of things?

Yeah. These are the institutions that are within the regulatory control of the Federal Reserve. They obtain funds mostly by deposits from households. They also issue bonds and equity, and they make loans to businesses, mortgages -- generally, what we call information-intensive loans. They require monitoring borrowers, evaluating borrowers, often loans that can't be securitized because there's just not enough information about them.

Historically, these kinds of institutions have been subject to runs because they have liquid liabilities and illiquid assets. So they're regulated. They have deposit insurance on their deposit base, and they're required to hold capital.

These institutions are important in just about all forms of credit in the U.S. They're very important in the money market because firms that are able to borrow in the capital markets and the money markets, they often secure their loans with backup lines of credit at banks. So banks are the most vital entity in the capital market. And once the crisis spread to the banks, that's the point at which the system was truly threatened.

When you say truly threatened, what do you mean?

A cutoff of credit that could affect most of the economy. In other words, we're no longer just talking about mortgages; we're talking about car loans, loans to small businesses, commercial paper borrowing by large banks. The key arteries of credit could be frozen. And basically that's what happened in September-October.

So Ben, who studied the Depression, who knows about central banks, says that government's role is to help those banks.

Well, he needs the equity injections from the Treasury. They're also doing other things that they can do. There's new lending facilities that are cropping up, the commercial paper lending facility. Now they're going to get involved in mortgage-backed securities, newly issued ones.

I should say one thing he has boasted thus far is the Fed has not lost any money on its balance sheet. They're taking seriously the idea that this stuff has to be of a particular quality level for them to be allowed to [become involved in] it.

He calls Paulson. ... Are there hints of camps, of arguments, of strife, of something between these two guys in any way that you pick up?

No. The only thing I know personally is they're good friends. I don't know Paulson at all. I know that Ben has a lot of respect for Paulson. ...

I think there were differences of opinion between the Treasury staff and the Fed staff on how to proceed. ... The Fed wanted a combination -- that is, they would go in and do equity injections like was done with Sweden, and also some asset purchases. The rationale by the Fed was, a key problem was that there were no market prices for these assets. And so the idea is if the government got in there, it could possibly try to get a market going. The Treasury, my understanding is, initially favored more emphasis on asset purchases. ...

When they go up to Congress, what do they ask for?

Initially Treasury asked for $700 billion and the freedom to allocate it as they pleased, and this just generated an outrage.

You mean a blank check?

Basically a blank check. I think also, the PR department at Treasury might have been asleep. This wasn't passing out $700 billion to the banks. This was taking $700 billion and acquiring assets [in] one form or another. So the cost to the taxpayer was the difference between the $700 billion laid out and the value of the assets left over. This was never made clear in the beginning. So the PR dimension of this is horrible.

And everybody's panicked.

Everybody's panicked. We know we're officially in a recession now, but at the time, there was dispute about that. So you also had many people arguing that the situation was not that bad. ...

It was a period of enormous stress, because what was key was to restore confidence to the market. They didn't have to have the plan in action that day, but they had to convey to the market that they were proceeding; this was going to be done. The market is very forward-looking. But then again, you had lots of people saying, "This really doesn't need to be done."

And it's [in] the midst of a presidential election, by the way.

Oh, it was a carnival-like atmosphere. Totally. One thought I had throughout this was that it became increasingly like The Bonfire of the Vanities, just in terms of the extreme, extreme craziness and all the people going before the camera to pontificate. I mean, it was an insane environment to operate under.

[And then the House voted against the bill.]

That's another example of the political process getting in the way of doing the right thing. We started the beginning of this conversation -- you asked me why there wasn't regulatory reform before this crisis. It would have been impossible to get it through Congress without a crisis. Here you have a crisis, and nobody is really that persuaded.

Now, admittedly, the PR aspects of the Treasury plan were horrible. But that day showed to me -- I kept thinking, the one way we're going to have a Great Depression is if the political process gets in the way. If we can get people together to calmly figure out the right course of action, we will eventually work our way out of this. But the political process might kill it. ...

[When the bill was rewritten, the idea of capital injection] was in there, but people didn't know, right?

Oh, you're absolutely right. Again, that's another dimension of the poor PR, where there's people [who] were complaining that it didn't allow for equity injections, when in fact if you read the fine print, it did. That's another example.

In retrospect, if he could have come back and asked for what they ultimately did anyhow, [the response] would have been much better: Ask for equity injections and to hold some money in reserve as the crisis unfolds. That's pretty much what they did. It would have been better if they had announced it right away.

So another example, I suppose, of how the world has turned occurs on Oct. 19, when nine banks are called into Henry Paulson's conference room, seated in alphabetical order, and told what?

I believe that [they have] to accept this equity; that we have a serious problem. There's a lack of confidence in the financial system. It's pretty clear that banking system has a capital shortage. We're going to become your partners.

Your friend Ben is in the room. ... What do you think is going on in his head at exactly that moment?

In this kind of situation, he'll be analytical. He wants to get the job done. If he can't get the job done, he'll worry. But the goal of the moment is to put together this package, and that's what he's focused on. So I would imagine he was probably more like a doctor giving a diagnosis to a patient, and that was his demeanor.

And the diagnosis would be?

That if we don't fix the banking system, this crisis will magnify and persist, and we risk the likelihood of a situation like Japan, where there is a decade-long stagnation. ...

Was it a hard pill for these guys to swallow? I know Wells Fargo said, "I don't need it; I don't want it."

There's an externality here. ... If one institution gets [into] trouble and has to sell its assets, it drives down the prices of the assets at the other institutions. So even if an institution is above water, in this case, there's room for another cushion just to make sure it doesn't happen, or to reduce the likelihood. ...

What will be the reaction to all this? Will it be more regulation, tighter controls, less easy credit?

Hopefully there will be smarter regulation, and we won't go overboard. The people who Obama has surrounded himself with are very capable, and I think they understand that; [they] don't want to go overboard. You can't let this kind of situation, where institutions that are effectively banks but not regulated, crop up. We can't be in a situation where we deal with an institution that's too big to fail that has completely misbehaved. Something has to be done with it; otherwise we'll just continue to go through this circumstance. ...

What has to be done now is to figure out the smartest way to do it that solves the problem and doesn't go overboard. As [economist and New York Times columnist Paul] Krugman has emphasized, it's critical to do it as soon as possible, because if you lose the moment, it might not get done. ...

When Greenspan goes up on the Hill when he's leaving and everybody applauds and calls him "maestro," did he deserve all of that?

I think he prevailed over an economy from 1987 to 2005 that, most of the time, performed extremely well. I personally think he did a brilliant job managing interest rates. I think looking back, hard to do any better. The one thing he missed was regulatory adjustment -- maybe a little bit too optimistic about [how] the private market ... would behave left to its own devices.

But that's as hard as you'd be on him?

Well, I do think that's what really laid the seeds of this crisis, was the regulatory system being out of whack.

Can I also say one other thing? It wasn't just Greenspan who missed it. Some people saw it coming, but lots of people didn't. But if you think about it, in [retrospect], throughout history, the reason we've had crises is because the regulatory system has been out of whack, and financial institutions have taken advantage of that. ...

What could have been done to regulate derivatives?

Certainly making them more transparent. One problem with this crisis is that when it hit, nobody could clearly see where the risks are, because this was a market that didn't require transparency. So any new regulatory resolution is going to have to involve transparency.

There's also an issue about the design of the securities. These securities were not designed in a way to handle a systemic fallout. You could offer credit default insurance, and you could pay it off to a company that defaulted in normal times, but when everybody defaults, it's tough to pay off. So I think the financial institutions have to think about the design of securities a little better to handle these situations. ...