The last year and a half has proven a tumultuous time for the United States economy. From the start of the subprime crisis in early 2007, to the more recent government bailout of Wall Street, economics has dominated the headlines in a manner not experienced in modern memory. Yet, despite its commonplace in mainstream media, the complexities of the economic crisis have meant confusion on the part of many casual observers. To help our readers understand the general structure of the crisis and the effect of the Wall Street bailout bill signed last Friday, the Daily Bruin sat down with professors Roger Farmer and Lee Ohanian, experts of macroeconomic theory, late last week. In a break from regular Bruin format, included herein is an excerpt of our conversation:
Daily Bruin: These days, you can’t go anywhere without hearing the current financial crisis being referred to in the same sentence as the Great Depression. Is this a fair comparison?
Lee Ohanian: I don’t think there’s a good comparison to 1929 and one reason is because there were no banking panics or crisis until the end of the Great Depression. So the start of the Great Depression was not about banking panics or banking crisis; the credit market drying up.
Roger Farmer: This is where Lee and I are probably on board.
LO: So you see that in the media. A lot of people are saying we have to do this because it’ll be like the Great Depression. But they don’t have their facts right. The genesis of the banking crisis wasn’t banking panics, the depth of the Great Depression wasn’t banking panics, when banking panics were resolved by deposit insurance, that didn’t bring about recovery. The Great Depression was a totally different animal.
RF: That’s where we agree.
DB: Then with this bailout package that just passed, what’s the problem we are trying to solve here exactly?
LO: So, the perceived problem is that subprime mortgage obligations, a subprime mortgage obligation is one in which the borrower doesn’t meet the standard criteria typically for a mortgage, so it’s not a prime borrower, it’s a subprime borrower. So this would typically be smaller down payment, credit score lower than what you typically see, asset income history being typically what you would see. So the argument was made by the Treasury and the Federal Reserve that institutions that were (set) in losses because of subprime mortgages, those problems were sufficiently large that it posed a very probable systemic threat. So a systemic threat is that you’ve got a capital market, essentially all the borrowers and lenders in the economy, and even though these problems might be concentrated among a very small number of institutions, the Treasury and Fed argued that these institutions are so important that the entire credit market, the sky could crumble on them, and then we’ll have an enormous problem. In the absence of a systemic problem, I suspect the government wouldn’t have stepped in. So it’s only the perceived threat of having a broader problem is what they argued for. In terms of the evidence for that, I didn’t see it at all.
DB: So, did we need a $700 billion government bailout of Wall Street?
LO: I think (Treasury Secretary Henry) Paulson and (Federal Reserve Chairman Ben) Bernanke, I don’t think they intended to do this, but they were kind of crying fire in a theater. They are claiming bad, bad things are going to happen. I was one of 200 economists to send an open letter to Congress saying this plan is not useful, certainly not in its current state. Today, even with the plan being amended, that I think they were useful amendments, you still have some of the best economists in the country saying we should not be doing this, and the reason is because they’re looking at credit markets saying borrowing is up, interest rates aren’t, show me the data that tells me this is really needed.
RF: I am also skeptical about the bailout plan, although not as skeptical as Lee because I do see one possibility in which it could work. It isn’t the plan that I would be suggesting, but I do see a way that it might work. And everything here for me depends on whether confidence is restored in the economy and whether that leads to assets trading at higher prices. … Whether the bailout plan that was proposed by both Paulson and Bernanke is the right way to do that is an entirely different question.
DB: This $700 billion bailout package, of which both of you are skeptical, was the largest in American history. But, for Fiscal Year 2009 budget, the government requested $644 billion for Social Security, $515.4 billion for Defense (for peacetime operations), and $59.2 billion for Education (for discretionary operations). So why are more dollars going to Wall Street than to Defense and Education combined?
RF: So I think it’s a mistake to think about the proposed money in the same way you’re thinking about defense or education spending because the government is not proposing to spend $700 billion on a vacation in Hawaii. Its proposing to swap government liabilities, government debt for private liabilities in the form of mortgage backed securities. So, on the one hand we’re borrowing, but on the other we’re buying an asset. It’s the same way as if you go out and spend money on education or you spend money on infrastructure or something that potentially has a return as opposed to spending money on beer and a pizza.
LO: On some level, this is a fantastic investment opportunity in the sense that when you’re the only buyer, you can buy low. You can buy really low. Unless they really screw up, they should make money on the deal. So, the term bailout is not the right term. That’s the one the media uses all the time, but it should be more like $700 billion asset acquisition.
DB: Do you agree with that?
RF: Yeah, absolutely.
DB: But say the government doesn’t make the money back, it will be my generation paying back the debt for years down the road.
LO: The way to think about it, in the event it costs us, the positive spin is the cost we had to pay would be less than the cost if we hadn’t done it. So, kinda like the sky is falling hypothesis. As I mentioned it before, I personally don’t subscribe to that, but that’s the way to think about this. If you want to have a positive spin on this, the positive spin is there’s a chance the economy could’ve gone down and the cost of that would’ve been greater than the cost of the difference between the $700 billion and what we get back after we take over of these obligations.
DB: Taking a step back then for a moment, how did we get into this mess in the first place?
LO: One issue that I think people aren’t seeing is that it sounds like this is a super complicated, complex, crazy convoluted story, but from just a standpoint of basic economics it is not at all surprising how we got here, or why it happened. A lot of people don’t understand that, but it actually is pretty straightforward.
My opinion: This is the worst case of government in a long, long time. … The basic genesis is that a lot of people bought houses who shouldn’t have bought houses. They were people who didn’t have the necessary income or earning power to support the payments to own a house. There have been signs for years. And there have been people advising Congress that this was going to happen.
So there’s a lot of fingers to point. You can point fingers at Congress. People aren’t doing that nearly as much as I think is warranted. A lot of people are just pointing fingers at the so-called greedy investment banks. You know, they were operating the way they should operate. There were incentives in front of them. Banking regulation gave them incentives to move items off their balance sheets, which are much more regulated than off-balance sheet items. So the incentive was there that it was bad regulation, but they did exactly as the incentives would suggest they should.
The sad thing is there’s a lot of steps that could have been taken along the way, any one or two of which I think would’ve nipped this thing in the bud. (For example) reform of Fannie Mae and Freddie Mac would’ve made a huge difference. There’s a lot of places where doing a little bit would’ve made a big difference. So you’ve sort of got a perfect storm of bad regulation, bad incentives, and its not so surprising what happened, given those things were in place.
DB: Then how do you explain the volatility in the stock markets that has occurred in recent days, weeks and months?
RF: I remember this old quote, it’s an old quote from (John) Keynes, who said you should think about the stock market as a beauty contest and it’s a beauty contest where the judges are not judging how beautiful the contestants are, but how beautiful the other judges think the contestant is. The way to think about that analogy is what you’d like people to be doing is to be investing in stocks for the long haul, but typically what they are doing, we saw day traders in the 90s, are stepping in trying to figure out what other people think is going to go up so they can make a quick buck and pull out and its that kind of speculation that I’d like to see damped.
LO: We don’t really understand this, we can’t do much about it and it’s interesting, from our professional perspective, its very interesting.
RF: I’ll just say one thing in addition to that. These wild dilations, as long as they don’t persist very long don’t have influence on demand and on the economy. But at times like the 1920s when this thing went down and stayed down, it does, and the reason’s simple. Because if stocks go down one day and go up the next, it’s not going to affect you very much. If you lose your job and you get it back three weeks later, it doesn’t make much difference. But when wealth persists and stays down for a long period of time, it does influence what you are doing, and it does influence the economy.
DB: How closely is our financial crisis connected to that happening around the world?
RF: The world economy is a lot more integrated than it was 10, 15, 20 years ago. A lot of the things that’ve been happening with the mortgage-backed security crisis is that these things were packaged and sold all over the world so it’s not just U.S. financial institutions that don’t know what these assets are worth, it’s also banks in Europe, Japan, and other major financial centers that don’t know. So yeah, we’re a connected, interdependent system. Americans own foreign assets, and foreigners own American assets. It’s a world economic system.
LO: : In Britain and Ireland, they’re having housing prices way down, they’re having mortgage issues as well, so it’s not just here, it’s just more publicized here.
DB: Even with the passage of the bailout package, are we headed for a recession, or are we out of the woods, so to speak?
RF: Yes. Even with the bailout package, the economy’s like a slow moving ship. You look at the numbers, unemployment’s been going up for the last three months. It looks to me at least that we’re headed to the kind of downturn that we saw in 1991 (later corrected himself to mean 2001), that was the last recession, and I sincerely hope Lee’s right, and I’m glad something was passed, although I don’t like all the aspects of it. Let’s hope that it’s just a mild recession.
LO: If we have a recession, it’ll largely be a government engineered recession. Engineered by the horrible way this program was put forward, was argued, was handled, because it scared the crap out of people. People weren’t that scared before. The basics of subprime mortgages today aren’t any different than they were six weeks ago, but people are really scared now, because these guys are crying fire in a cinema house. So if we have more than a modest recession, those are the guys to blame in my opinion.
DB: So would it be fair to say you don’t think we are necessarily headed for a recession?
LO: I think it’ll be more like the 2000-2001 downturn which is like after the tech stocks came down. If it’s worse than that, I think we can trace it to what’s happened in the last month.
DB: So where do we go from here? How do we weather this impending recession?
LO: Look, most of these banks are very sound. Bank of America, JP Morgan. Bank of America bought Merrill Lynch, JP Morgan bought Bear Stearns. What people aren’t talking about at all is that now you’ve got a much more concentrated financial system. In economics we’d like to think there’s lots of firms out there, you and I compete against each other, there’s like 20 of us, 50 of us, 1000 of us competing against each other that way we can’t game the system to much we can’t charge too high a price. Now we’re down to basically three major banks, Citi, Morgan, and Bank of America. Is that enough competition? Its not obvious that it is. Nobody’s talked about that yet, but that in my mind, that’s the most significant negative effect of all that’s come out of here. But I suspect the banking system will go right back to where it was a month or two ago when a lot of loans were being made at reasonable interest rates.
RF: So here’s the difference between me and Lee. Lee believes I think, leave the economy to itself as much as possible its going to work pretty well. The problems are mainly caused by government interference and regulation. My view, somewhere between that view and a complete control view, most of the time you want to leave free markets to do what they do, but sometimes they go very wrong and you need institutions to help correct that. I think that the reason the economy “˜s worked pretty smoothly for the last 25 years is precisely because we developed the political institutions in the form of the Fed, and in the form of fiscal and monetary policy and we’ve kept that kind of thing under control. I think we need to rethink those institutions for the next millennia, and I think that involves thinking a lot more about why it is these crises of confidence are going back and hitting Main Street.
LO: Just to clarify, this problem was brought about by the wrong kind of regulation. So if you’re insuring banks, as the government does, you must regulate them. In this case, they regulated them very very poorly, both in terms of Fannie Mae and Freddie Mac and the extent to which they let all this off-balance sheet stuff go on.
DB: But with the economy going sour, as someone entering the job market within the next few years, how worried should I be about the state of the U.S. economy?
LO: Two years from now, you shouldn’t be worried at all. If you’re looking for a job in the next couple of months, there’ll be an issue. However, its much less important for young people than some guy who was a 58-year-old middle manager in some financial institution. They’re going to have a really hard time finding a good job at anything close to their previous salary. Near college grads, they’re much more flexible in terms of the human capital, they have much longer horizon, so I don’t think it’ll be a big deal.
RF: I just have one word to add to that: if you were planning on being a finance major and getting a job on Wall Street, you might want to rethink your career direction.