The University of Arizona Alumnus / Spring 2009
Stay Liquid / Econ. 101
The Meltdownby Ford Burkhart
Nothing else is likely to educate University of Arizona students so profoundly about economics as the meltdown of 2008 and the longing for recovery in 2009. Here’s a mini-seminar by five UA faculty members who teach about such things in almost every class. They were selected via Alumnus magazine’s usual nonscientific method — asking around for who’s really good on the economy. We came up with UA experts on financial markets (Chris Lamoureux), corporate governance and finance (Thomas Bates), the national economy (Gerald Swanson), forecasting (Marshall Vest), and the historical view (Price Fishback).
To meet our deadline, our brave experts spoke in early spring. By May, the whole economy could be creeping up or spiraling down. You will know the latest, but we hope these insights will help you endure the ride.
Go ahead and send answers to your essay questions to alumninews@al.arizona.edu or sbeaudry@al.arizona.edu. We will post them online at www.arizonaalumni.com/Alumnus/Econ/.
Chris Lamoureux: Improvising in Uncharted Waters
In every class, we have talked about the financial meltdown. We are still in the flight-to-quality mode, where people run away from any kind of risk. In February, no one wanted to hold any type of risky assets, stocks, or houses — so prices fell. People wanted Treasury securities. The U.S. dollar appreciated and the yield was low on Treasury securities. It was like that rush after someone shouts “Fire!” in a crowded theater. Everybody went after the highest-quality assets and that disrupted the financial markets. After the ridiculously low levels at the start of the year, things seemed to move back a little toward normalcy.
In the frenzy at the end of 2008, my fixed-income class looked at the Federal Reserve’s response. If you went to the Fed’s page a year ago, you saw three tools to implement monetary policy. Now you see 12 tools — brand new things — with new ones added every week. It makes you understand that we are in uncharted waters, and there are no charts to help navigate our way through the danger. The Fed should get high marks for designing new tools as they go. They don’t want to overlook a single source of problems in the economy. They don’t want to let this situation get out of hand. Yes, the public complains: Why aren’t we better off? But if not for the Fed, we’d be much worse off today.
Recommended reading: Avoid the press — The New York Times, The Wall Street Journal. Most journalists have a specific agenda and aren’t good at dispassionate assessments. Read what Federal Reserve Chair Ben Bernanke has to say at federalreserve.gov.
Essay question: Summarize the financial meltdown that occurred in 2008, and explain how the Federal Reserve adapted to this environment.
The crib sheet: By final exam time, even if things don’t seem better, the stimulus may still have worked. The Fed did a nice job of stanching the bleeding in the financial markets.
Thomas Bates: Stay Liquid. Good Periods Do Follow the Bad.
I make sure my students understand what risk is when they make an investment. Even older students can forget their losses from the deflation of the dot-com bubble in 2000. In general, investors tend to over weight more recent experience (good and bad) when evaluating risk rather than taking a more objective perspective. Students need to realize that risk means both a chance for good outcomes and, as we are seeing in the economy today, a chance for some very bad outcomes. Many practitioners also seem to have underestimated their exposure to these very bad outcomes. We have just been reintroduced to what risky outcomes actually look like and it dwarfs the worst outcomes that most of us have experienced in our lifetimes.
On the positive side, I believe that we are going to have a whole generation of people who make more prudent investments going forward. Now more people know that you have to do “due diligence” to understand the contracts you enter into and the risks you are taking, rather than focusing solely on returns.
In the area of financial contracting, this banking failure provides us with a significant lesson concerning counterparty risk. That’s the risk that the other person insuring you against default might themselves default. If Citibank or AIG defaulted, a massive array of their counterparties would also then default and you’d have systemic failure. In underestimating default risk, investors underestimated the joint effect of counterparty risk. We are all going to become more conscientious investors.
If we use history to guide us, bad periods are followed by good periods. Stay liquid. Weather this downturn. Maintain diligence. Be consistent in your investment plan and be diversified. Finally, don’t look at the business section of the newspaper every day. There is a lot of bad news in there that is going to ruin your daily outlook, but since that news is already incorporated into security prices it isn’t going to do much to inform your investment decisions.
Recommended reading: Against the Gods: the Remarkable Story of Risk, Peter L. Bernstein (John Wiley & Sons, 1996, 1998). From gamblers in ancient Greece to chaos theory, risk underlies everything.
Essay question: Should the Fed have allowed a bank like Lehman Brothers to fail while Citibank was being propped up? What was the rationale? Was this a mistake by the Fed?
The crib sheet: There’s no consensus yet. Strict market adherence says, “If they made mistakes, Let them fail.” Others cite counter-party risk (effects on the rest of the banking system), saying a failure of a major bank has contract tentacles across the international economy.
Gerald Swanson: A View from the Classroom
College seniors are very worried. They know that by May they will face one of the worst job markets ever, and for many of them graduate school is simply the most respected form of unemployment. By the end of May, I expect things will be worse. Some say a downturn of two years is a depression. This downturn started in December 2007, and by May it would have lasted for 17 months, so do the math. We may see more government layoffs and furloughs. More people may have to work a 30-hour week. There are tools to help stop inflation — taking money out of the economy, tightening interest rates — but there are no tools to make people spend money and no way to lift low wages.
The difference with this cycle is its breadth. All the world’s economies are going down in sync, and no sector is being spared, even healthcare. The last cycle anything like this was in the early 1980s — today’s students grew up in 30 years of no downturn that really mattered. But I tell the students that it will fix itself. The stimulus plan was needed to stop the meltdown from feeding upon itself in a vicious cycle. We were in a crisis of confidence — in government, in the financial system, in the economy as a whole. But we need time to regain confidence and a bill being passed won’t do that.
Recommended reading: The Great Inflation and Its Aftermath: The Past and Future of American Affluence, Robert J. Samuelson (Random House, 2008). Samuelson views the economy as a social, political, and psychological process, explaining how the Great Inflation from the late 1970s left Americans feeling hopeless about their institutions until the Reagan era.
Essay question: What were the primary causes of the housing market collapse and the global financial meltdown?
The crib sheet: Think moral hazard.
Marshall J. Vest: What’s Next — a Rocket or a Roller Coaster?
Over history, financial crises, dating back to the 1600s, are always preceded by an asset bubble, fueled by a huge expansion of credit. This time, it happened when the people issuing the funding for mortgages didn’t have to hold the risk. We had a time of easy money. Now we are three years past the peak of the bubble, and the slide is a very painful process, as we all know.
Investment (Wall Street) banks became insolvent, merged with commercial banks, and those investment banks are part of history. Now, the Fed and the Treasury are doing what the textbooks tell them they should do. They are applying liquidity. Money is no longer flowing freely. The Fed and the Treasury are going into the frozen credit markets, trying to thaw them out, and close to $10 trillion has been committed to the rescue. To put that in perspective, the entire economy, the Gross Domestic Product (GDP), in a year is about $14 trillion. Wow. There’s a tremendous amount of liquidity that’s being applied, and that’s what will eventually turn this economy around. The economy could come back a lot faster than what’s forecast. It could bottom out as early as midyear, or the end of the year.
In the meantime, solvency is the key. The state should try to spread out the damage, push it into the future, borrow, sell, use whatever gimmicks there are, and utilize federal aid to states and raise taxes to avoid simply cutting and laying off workers. If the liquidity is not drained when the growth begins, the economy could take off like a rocket. But if there’s another bubble of high inflation and high interest rates, we could be on a roller coaster.
Field work: Be sure you have adequate savings to pay your bills. Control your costs. These cycles don’t last forever. By the end of year, this cycle should be in the books as one of the most severe since the Great Depression.
Recommended reading: Manias, Panics, and Crashes: A History of Financial Crises, Charles P. Kindleberger (Wiley, 2005, 5th edition). The 1978 classic on financial crashes in a new edition after the dot-com bubble.
Essay question: With so much liquidity being pumped into the system, the economy could take off like a rocket. Where will the next bubble materialize? Stocks? Bonds? Commodities? Farm land? Real estate? Gold?
The crib sheet: When you discover the answer, let us know.
Price V. Fishback: Staving Off Disaster
The government gets a B for avoiding earlier mistakes and an Incomplete on staving off disaster. In any case, it’s not the Great Depression, and it’s not the next one either. By May, the ship may still be sinking a bit, but the rest of the world is taking more damage than we are. The meltdown of 2008 was spectacular and the fallout will continue, but the seeds of recovery are appearing. Businesses are reorganizing and worker productivity will be up as workers are asked to do more. In a normal year, you’ll see 8.5 million new jobs, and 7.5 million jobs lost. Think about that. If you read the newspaper, how many job-creation stories will you see? Dribs and drabs.
In December 2007, unemployment was 4.9 percent. Since then, we have seen the stock market down 50 percent, the elimination of Wall Street investment banks, and a focus on toxic assets. The unemployment rate has risen more than 8 percent. In the Depression, the rate went from 2.9 percent in 1929 to 11 percent in 1930 to 16 percent in 1931, and then to more than 20 percent in the next four years. We are a long way from that.
Compared to 1929, the ’32 and ’33 gross domestic product (GDP) fell as if everything west of the Mississippi had been shut down. That’s what the Depression looked like. Compare the role of government. It didn’t do much until three years after the big bank failures started. The GDP was 74 percent of its 1929 level when the Fed stepped in. The response was far too small — Hoover and Roosevelt had almost balanced budgets. What we are doing now is unprecedented. President Obama talks about a budget deficit of 10 percent, something not seen since World War II. Now the big worry is inflation. But it’s not going to be as bad as some people think it’s going to be. There’s a lot of fear out there, and I see why people are worried, but my long-term view is optimistic. People have written many best sellers predicting the next Great Depression, and every one of them is wrong.
Recommended reading: Government and the American Economy: a New History (University of Chicago Press, 2007). Price V. Fishback was the lead author, adding the work of 15 others, writing for undergraduates and general audiences on what insiders know and everybody needs to.
Essay question: Is this the next Great Depression? Compare and contrast with the 1930s.
The crib sheet: We’re nowhere close to it. The government’s response has been extraordinary, while in the past it was too little, too late. (Tip: Cite Fishback.)
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