Recession or Depression? Part 2

 

“The Great Depression was a worldwide economic downturn starting in most places in 1929 and ending at different times in the 1930s or early 1940s for different countries. It was the largest and most important economic depression in modern history, and is used in the 21st century as a benchmark on how far the world’s economy can fall.” – Wikipedia.

From the PBS’s Nightly Business Report, October 9th here is Allan Sloan, Senior Editor-At-Large at Fortune magazine:

Everything has been so gloomy lately, I thought I’d play against type, and find something reassuring to say. The problem, though, is that it looks like things will keep getting worse for a while, as the economy and the banking system inflict more and more pain on more and more people.

The one cheerful thing I have to say is that this isn’t going to turn into another Great Depression. That’s the comparison you keep hearing. And it’s wrong. The Great Depression had 25 percent unemployment. It had millions of people losing their life savings when their banks failed and took their money down with them.

Old people had no income and no health insurance. Neither did unemployed people.

Now we have federal insurance on bank deposits. We have Social Security and health care for old people. We have unemployment insurance and other safety nets.

What’s going on now isn’t any fun. It’s not fun to see your retirement accounts get hammered. It’s not fun to have your mortgage foreclosed or lose your job. And it’s not fun if you can’t borrow money except at rates that would make a loan shark blush.

But trust me, no matter how bad this gets, it won’t be a second Great Depression. And remember that sooner or later, this mess will work itself out. Just as booms don’t last forever, neither do busts. And in this case, that’s a good thing.

I’m Allan Sloan.

photo credit: Eoghan OLionnain

Criticism of the U.S. Bailout Plan, Part 4

Economics Unplugged: A conversation with Professors Allan Meltzer and Marvin Goodfriend is a just released 60 minute interview which took place on April 22, 2008. Meltzer and Goodfreind, two professors of Economics at Carnegie Mellon, discuss the current financial crisis and how we got here.

As free market economists, they continue to be very skeptical that increased federal regulation and oversight will be enough to avert future problems. In their opinion, increased regulation will not work, because although lawyers write regulations and accountants enforce them, the management of banks and investment banks will always find a way to circumvent them (regulations).

Bank management has an incentive to take big risks to earn large rewards, and the rewards are incorrectly based on short term results. Meltzer thinks bank executives should be paid “on the average of their performance over five years, not quarter by quarter. There are other ways of doing that, but we have to change their incentives, otherwise we are going to have these problems.”

If you believe that better regulation is the solution to the financial crisis, you might find a different viewpoint interesting.

Their key points are:

• The main problem is that financial institutions lend on a long term basis, but borrow on a short term one. Periodically, there is going to be a problem.
• Regulation has a limited role to play in disciplining markets.
• Think about incentives when writing regulations.

Other observations are:

• The current situation is very different from the Great Depression.
• Banks have to recognize their losses and raise more capital.
• We will not know how bad the economy will get, until we see how far housing prices will fall.
• We are seeing the end of the American Century, where the United States had a dominant influence on what happened in the rest of the world.

Although this interview is almost 6 months old, Professor Meltzer recently expressed similar conclusions. On September 23rd on a PBS News Hour program, he was asked whether he thought the bailout plan was a good idea. His response, “It’s a terrible idea. It’s undemocratic. It’s bad economic policy, and it’s bad social policy. And it has a very little chance of solving the problem in a meaningful way.”

photo credit: Matti Mattila

Recession or Depression? Part 1

 

“Unlike during the Great Depression the government is now a huge part of the economy. And officials have moved quickly, if clumsily, to contain the crisis.” – Robert J. Samuelson.

In the October 13th Newsweek, Robert J. Samuelson asks a provocative question – Is This a Replay of 1929?  The short answer is No. There are many differences.

Watching the slipping economy and Congress’s epic debate over the Treasury’s unprecedented $700 billion financial bailout, it is impossible not to wonder whether this is 1929 all over again. Even sophisticated observers invoke the comparison. Martin Wolf, the chief economic commentator for the Financial Times, began a recent column: “It is just over three score years and ten since [the end of] the Great Depression.” What’s frightening is not any one event but the prospect that things are slipping out of control. Panic—political as well as economic—is the enemy.

There are parallels between then and now, but there are also big differences. Now, as then, Americans borrowed heavily before the crisis—in the 1920s, for cars, radios and appliances; in the past decade, for homes or against inflated home values. Now, as then, the crisis caught people by surprise and is global in scope. But unlike then, the federal government is now a huge part of the economy (20 percent vs. 3 percent in 1929) and its spending—for Social Security, defense, roads—provides greater stabilization. Unlike then, government officials have moved quickly, if clumsily, to contain the crisis.

Unlike postwar recessions, the Depression submitted neither to self-correcting market mechanisms nor government policies. Why?

Capitalism’s inherent instabilities were blamed—fairly, up to a point. Over borrowing, overinvestment and speculation chronically govern business cycles. Herbert Hoover was also blamed for being too timid—less fairly. In fact, Hoover initially expanded public works to combat the slump. The real culprit was the Federal Reserve. Depression scholarship changed forever in 1963 when economists Milton Friedman and Anna Schwartz argued, in a highly detailed account, that the Fed had unwittingly transformed an ordinary, if harsh, recession into a calamity by permitting a banking collapse and a disastrous drop in the money supply.

The Great Depression resulted from the perverse mix of a weak economy and government policies that magnified the weakness and that were only partially neutralized by the New Deal. If we can avoid a comparable blunder, the great drama of these recent weeks may prove blessedly misleading.

photo credit: jillclardy

Stabilize House Prices, Part 2

“The features that Congress added to the initial Treasury plan do nothing to achieve sustained confidence in the financial institutions….They do not address falling home prices.

We need a firewall to break the downward spiral of house prices. ” – Martin Feldstein.

In an October 4th Wall Street Journal editorial, The Problem Is Still Falling House Prices, Martin Feldstein outlines his very direct plan for solving the current financial crisis. Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard University, and a member of The Wall Street Journal’s board of contributors.

A successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities.

The recently enacted financial rescue plan does nothing to stop this spiral. Credit will not flow and liquidity will not return to the banking system until financial institutions have confidence in the solvency and liquidity of other banks.

Because of the 20% fall in the price of homes since the bursting of the house-price bubble, there are now some 10 million homes with mortgages that exceed the value of the house. Residential mortgages are generally “no recourse” loans, meaning that if the homeowner stops making payments, the creditor can take the property but cannot take other assets or attach income. Individuals with loan-to-value ratios greater than 100% therefore have an incentive to default even if they can afford their monthly payments, and to rent an apartment or other house until house prices stop declining. When individuals default and creditors foreclose, the property is added to the stock of unsold homes. That depresses prices further, increasing the number and magnitude of negative equity houses.

The prospect of a downward spiral of house prices depresses the value of mortgage-backed securities and therefore the capital and liquidity of financial institutions.

Briefly, Feldstein proposes a plan that would stop the downward spiral in house prices by reducing incentives that allow homeowners to merely walk away from home ownership. His plan is for the government to make mortgage replacement loans. These replacement loans would be at a reduced interest rate, but with full recourse. The homeowner would save on mortgage expenses but would no longer be able to walk away, from at least a portion of the mortgage.

Here’s how it might work. The federal government would offer any homeowner with a mortgage an opportunity to replace 20% of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. This would be available to new buyers as well as those with mortgages. The interest on that loan would reflect the government’s cost of funds and could be as low as 2%. The loan would not be secured by the house but would be a loan with full recourse, allowing the government to take other property or income in the unlikely event that the individual does not pay. It would by law be senior to other unsecured debt and not eligible for relief in bankruptcy.

Although the total size of the mortgage-loan program might be as much as $1 trillion, this would not be comparable to other government spending or to a swap of government bonds for impaired assets. The government would instead have a fully offsetting claim on individuals who could be counted on to repay their low-interest government loans. The cash that the banks and other creditors would receive from the government to replace the existing mortgages would be available to finance new loans.

So, Martin Feldstein, who has impeccable, conservative credentials, is proposing a $1 trillion government program. I find this quite remarkable. It will be interesting to see whether or not Professor Feldstein’s plan or the one proposed by R. Glenn Hubbard and Chris Mayer gets any traction.

Incidentally, Professor Feldstein was recently a guest panelist on the September 30th episode of the Charlie Rose Show. 

 

photo credit: respres

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