KUDLOW: What happened? Some--there's got to be some rational explanation to get from the middle of those seven into the autumn of '08.
Mr. PAULSON: Well, what you need to understand is what had happened before even the middle of '07, which is you'd had these excesses had been building up for some times. You'd had a--we had been overstimulating housing. So if you look at the combined weight of all of our policies in the US government...
KUDLOW: Wait. It's HUD-backed, unaffordable mortgage loans, Fannie and Freddie?
Mr. PAULSON: What you have--yeah, yeah, Fannie and Freddie, the FHA,various state programs.
KUDLOW: Community Reinvestment Act.
Mr. PAULSON: You know, mortgage interest deduction. I'm not saying of them were...
KUDLOW: Zero capital gains tax on home sales.
Mr. PAULSON: That's right. And so you had--so you had all of this going on, and then you had even more basic than this, you had these big global economic imbalances, structural imbalances, which stem from the fact that we, as a country, save not enough, both as a government and individually. Overreliant on debt. And so this--so you had these big structural imbalances. We have a tax system that penalizes savings and it really rewards consumption.
KUDLOW: Right.
Mr. PAULSON: And so you had these huge capital flows, global capital flows raining down through the banks. And so it was something--economists would talk about this, and they would talk about it, and I remember someone even using this term that was, you know, "stable disequalibrium," you know...
KUDLOW: Yeah.
Mr. PAULSON: ...the oxymoron, almost. But--so you had these excesses and then you have, in 2007...
KUDLOW: Right. Before we get to those, though, I want to say...
Mr. PAULSON: Yeah.
KUDLOW: ...Hank, you were effusive in your praise of Ben Bernanke.
Mr. PAULSON: That's right.
KUDLOW: Effusive.
Mr. PAULSON: Right.
KUDLOW: In a number of pages. You call him the most brilliant guy, he's a nice man.
Mr. PAULSON: Yeah.
KUDLOW: He shows up on time for meetings. As I recall, you like that, too. But so many of us believe that the Fed's ultra-easy money, with Greenspan running the Fed in the early part of the decade, and Bernanke as intellectual co-pilot, ultra-easy money, ultra-low interest rates, negative real interest rates helped the housing bubble, the commodity bubble. And you know, as a former Wall Street veteran, you throw negative real interest rates at Wall Street traders looking for yield to please customers and whatever, that's like throwing blood into the water for sharks. And so they just took those—and then I want to ask you, that it comes around--what goes around, comes around.
After the Fed finally figures out that they were too easy and the inflation rate started rising to 5 or 6 percent, then they tightened the screws from pillar to post. And if you look at a chart, real interest rates were 4 or 5, 6 percent by the time we got to '07, '08. So they pumped the money in, they bubbled out the asset prices, then they clamped down on them with a huge liquidity squeeze. Why aren't you more critical of the rock 'n' roll monetary policy?
Mr. PAULSON: Because what I looked at, and this was--this was my view of the world, my view of the world was inflation was very low globally, there was--the world was awash in excess liquidity, and you saw--so, in this world, investors were reaching for risk and mispricing it. But to get to your basic question...
KUDLOW: How easy to misprice when the Fed has mispriced its own monetary policy?
Mr. PAULSON: Well, when the world's lost--but if you--but to get to your basic question, because--which I think is critical when you say why did you get this chain of bank failures suddenly, you had--remember, the crisis hit in the late July-August period of 2007. So before we got to Bear Stearns, this had been going on for some time. And the--it was taking its toll. And I think that given some of that accounting conventions and so on, the losses weren't realized.
KUDLOW: Something happened, Hank. Here's the thing that I'm--I don't want to dwell on this. I mean, your book, your narrative is...
Mr. PAULSON: Yeah.
KUDLOW: ...this was financial Armageddon, peering into the abyss.
Mr. PAULSON: Right.
KUDLOW: And you know what, I don't--I don't disagree. I think you're right. I'm not sure we need to talk about why the rest of the public today doesn't understand that. But I'll come back to that. But it seems like when these big banks, brokers, mortgage lenders, let's not forget Countrywide went down...
Mr. PAULSON: Yeah.
KUDLOW: ...something happened between Bear Stearns and, I don't know, Merrill Lynch, something happened so the system turned off. What was the event that happened?
Mr. PAULSON: Well, I would say that, but first of all...
KUDLOW: Turned a downturn into a catastrophe?
Mr. PAULSON: Well, first of all, again, this had been building up for a long time. These institutions were--there was a--I think they didn't adequately understand the need for liquidity cushions. There was a lot of focus on capital, which is important, but I think they didn't have adequate liquidity. I think it was a complexity of products. But again, they were--I was aware from August of 2007 right up through that period, how severe the problem was.
KUDLOW: Well, I'm not blaming you.
Mr. PAULSON: No, no.
KUDLOW: There's no perfect foresight in this game. I'm not blaming you.
Mr. PAULSON: No. But I was just saying...
KUDLOW: Nobody blames you.
Mr. PAULSON: No, I wasn't...
KUDLOW: The question is, though, in terms of how this thing hit...
Mr. PAULSON: No, I was--I was saying...
KUDLOW: ...what was it? We wake up in the fall of '08, Hank, and it's a total catastrophe.
Mr. PAULSON: See, I was--well, here's the point, I think.
KUDLOW: Something must have happened.
Mr. PAULSON: But here's the point I'm trying to make, which is I think--see, I saw it hitting in August of 2007, and it was beneath the surface. So it was building and building and the system was becoming more and more fragile.
KUDLOW: And you're still going to defend the Fed during this period?
Mr. PAULSON: And it was hard. We were working, yeah, with the Fed, during that period, we were working jointly with the Fed trying to get institutions to raise capital and trying to get them to raise capital while they still could raise some. And I was calling up bankers and saying, I don't know of a single CEO of a major bank or any bank who's ever got in trouble by having too much capital, raising capital. But they viewed it as a sign of weakness.
KUDLOW: All right. We're going to take a break here.
Mr. PAULSON: Yeah.
KUDLOW: I understand that. And I agree with, by the way, the capital issue, and I think that's a key part of this solution. All I'll say is this: Wouldn't it be nice to have a steadier monetary policy that didn't go on, let's take real interest rates. I mean, the inflation rate went to 5 percent for awhile, then it went back down, then it went to 6 percent for awhile in 2006 to 2008. They blew their targets. Wouldn't it be nice to have a central bank and policy that didn't fluctuate from a negative 4 percent real rate to a positive 4 or 5 percent real rate? Because I submit that that was an ocean that drowned--first it created the waters and then took the water out. This was a liquidity squeeze of the first magnitude. First, they pumped it up, then they deflated it. That's got to be part of the issue here.
Mr. PAULSON: Well, I have looked--I'm not trying to debate it. I just looked at, from my perspective and from a banker's perspective, I saw huge complexity, much of it unwarranted. I saw--and I saw big capital flows stemming from imbalances, and with the world awash in that kind of liquidity from the capital flows, and low inflation around the world. So that was, you got it from me, not an economist, not a monetary economist but a banker. And when we were working to put out the fire, you know, I could not have had better partners.
KUDLOW: Well, we'll get to the putting out the fire part. We're going to take a full break. We have Mr. Paulson here for the entire hour.
We're going to talk about mark to market accounting, where he's totally going to disagree with me. We're going to talk about the role of the dollar. We're going to talk about Lehman, we're going to talk about AIG. We're going to ask the former secretary whether he, in fact, put a gun to Ken Lewis' head to buy Merrill Lynch.