Examining the crisis

Harold Cole, economist
Photo credit: Candace diCarlo

Harold Cole looks at America’s worsening economic crisis a bit differently than the rest of us.

He’s an economist, after all.

So he’s less prone to panic than the average American and less prone to overheated rhetoric than the mainstream media.

What Cole is really looking for right now is the truth: The truth about what got America in this economic mess, the truth about how we can get out of it and, maybe most crucially, the truth about just how bad it really is. On that last question, at least, Cole isn’t quite sure how to answer.

It’s just too early, he says.

“It’s very unclear to me just how long this is going to last,” says Cole, a Penn professor of economics. “I could actually imagine it being quite short, in which case we might say, ‘Well, why did we waste so much money? Why did we have to bail out those banks? Could we have let Bear Stearns go bankrupt?’ It’s very ambiguous as to just how big this crisis really is. And I think you can argue that [government action] got excessive, that the government overreacted. Which is not to say that they shouldn’t have acted. But the question is, really, how big of a crisis is this?”

Cole doesn’t mean to imply that the crisis is in any way a small one, of course.

By the time the Current sat down with him earlier this month, unemployment was approaching 8 percent, the Dow Jones was spiraling toward 7,000 and housing prices were down more than 25 percent from their peak. Cole understands that people are suffering. He understands their frustration. And he understands why President Obama and Congress were moving forward with a massive plan to try and get the economy back on track.

But he says he also has reservations about the idea that government can spend its way out of a recession. He wonders if bailing out the Big Three automakers and Wall Street banks really makes sense. He finds it curious that some of the same people that got America into this mess are now among those influencing how we aim to get out of it.

And, finally, he says he simply cannot agree with those who would compare the current situation to the Great Depression. By no measure, he says, is this crisis on par with that economic disaster.

At least not yet.

Q. Let’s start with the basics. How do you think we ended up here?
What’s interesting from my point of view is that it’s a combination—a wide variety of things that got us here. It’s also interesting how widespread the blame is, as you start to sort through these things. There are some events that set the stage for the current crisis. In 1995, you have the Community Reinvestment Act, and what that allows you to do is package together mortgages. You had been allowed to package conforming mortgages, but now you’re able to do it for subprime mortgages. That starts in 1995. Then in 1996, Fannie Mae and Freddie Mac are directed to allocate 42 percent of their mortgage financings to below-median income households, and then that was expanded to 50 percent. So I think one of the questions we have to ask is: Really, should everyone own their own home? That’s a big financial commitment. I’m someone who bought my first house pretty late in life. I was well into my 40s before I bought a house, and in a lot of ways, my situation is more secure as a tenured faculty than a lot of people. So again the question is, is it really a good idea to push people into home ownership? That’s something we should be thinking about in the background.

Q. What other factors were at the root of this?
You also saw very low interest rates, especially long-term interest rates, so then the U.S. becomes a big net borrower. There’s a big flow of financial funds into the U.S. that sort of fuels big borrowing by the U.S. And so what you eventually see [according to the Case-Shiller Home Price Indices] is a peak in housing prices in 2006. They’ve since come back down from that peak. So where are we? We’re basically back to where we were in 2002. Housing prices have rolled all the way back to 2002 levels. But I think another question that should be in the back of our minds is: Why is that such a big deal? I understand there was a bubble in the market and that it’s come down, but why has this translated into such a severe crisis? Isn’t it kind of funny for our system to be so fragile that that kind of price rundown leads to this?

Q. So what’s your explanation?
I think a couple of things happened here. Credit agencies gave these mortgage-backed securities very good ratings. So the risk premium attached to them was very low. Then there’s something else that happens: In 2004, the five big investment banks went to the SEC and asked to have the leverage limits on their brokerage units relaxed. And from that point on, leverage explodes in those banks. ... [But] to what extent were their models able to do a good job assessing the risk they were in and making sure it was under control [given the new loans out there]? I think one of the things that happened there was that you had changed the entire home-buying setup. And suddenly all of these people could buy homes who were much more speculative buyers than we had seen before. Let’s think about a buyer doing a pure-interest or no-money-down loan. If the situation goes bad, you turn in the keys and you walk away. You haven’t really lost anything. You haven’t put down much of a down payment. It’s pretty much like paying rent. You’re basically in a situation where if housing prices go up, you win. If they go down, you walk away. I’m sure they’ll put on CNN the people who were taken advantage of. But I think the majority of the people understood the bet. It was a pretty good bet. It was not a bad bet to take. We had set up a situation where we were encouraging people to buy these houses with much more speculation than in the past. So now you’ve got a bunch of people buying houses on a fairly speculative basis. They’re much more price-sensitive than homebuyers of the past. They’re much closer in terms of [what they can afford]. And so anything that pushes on that line, you’re going to see a substantial increase in defaults.

Q. And that’s what we’ve seen?
Yes, today, you can see that overall delinquency has come up. But at some level it’s surprising that the delquincy rate was not was not that bad. But what happened was that a lot of these banks loaded up on these [mortgage-backed] securities. They offloaded the safer stuff but even the stuff they offloaded through these credit default swaps, they agreed to take on the bankruptcy risk. You actually saw that with AIG. … There was a nice article in the Washington Post about what happened at AIG. They started to take on the risk of credit default swaps and mortgage securities. They couldn’t offload that risk and they didin’t. And we also see where [financial institutions] go from leverage rates of 10 to 1 or 11 to 1 to 20 to 1 or 30 to 1.
Now we’ve got a combination of different things going on. We’ve got mortgages out to a lot more risky people. We had done a bunch of things to make home buying cheap, which tends to generate a price boom, and then these others factors come along. They don’t end nicely. So we get a collapse back. But the problem with this particular collapse was that we also had all of these financial institutions going in the tank [because of it]. You got the liquidity crisis. And what [the financial institutions] were doing was borrowing very short-term loans, sometimes overnight. You have this very short-term debt, which you’re rolling over in order to fund all of these assets that you’ve acquired that would be very hard to liquidate immediately. What happens is, suddenly, you’re not able to roll over the debt, and you have to sell all these assets in a fire sale to pay the debt coming due. We’ve seen that mechanism create disaster in the past. So Lehman, AIG—all of those places start to melt down. The government passes the bailout in October. Now I’m sitting here in January and the S&P 500 is down about 46 percent. That’s a big number. And real estate prices are down about 28 percent from what I gather from Shiller’s data.

Q. We’re also seeing pretty huge unemployment numbers. People are starting to talk in terms of the Great Depression.
Well, if you double the population, a given downturn of a given size will put twice as many people out of work as before.
One of the things that bothers me about the situation is the way in which stats are being presented, as if they were designed to make you panic. I don’t know if the people who write these articles are ill-numbered or they just want to sell papers or if they don’t care. I think it’s some combination of both. What you can get out of this downturn is that in terms of employment, it’s worrying looking at the steep decline and wondering if it will keep going. But the actual level is not that extreme. We’re getting high unemployment numbers, but that’s a tricky number. We’re trying to measure a state of mind—do you not have a job and want to have one? What do we mean by ‘want?’ That’s why I like to look at things in terms of employment, which is a much less ambiguous number. … And if we look at employment, it’s not that bad, yet. But the trend line is bad. So the question now is what that trend line will ultimately look like. That’s ambiguous right now. But if we look at the output side, the picture is actually kind of surprising. [Last year], output rises for the first two quarters, and actually rises quite a bit, then dips slightly in the third quarter and goes down quite a bit in the fourth quarter. … During really bad downturns, if you think about output, there are two factors—output per worker and number of workers. In bad downturns, both numbers drop. In this downturn, output per worker goes up and then goes flat. So one of the factors that would exacerbate a bad downturn has not happened yet. All we’re doing is losing employment. This is potentially a different kind of recession. It’s financially driven, and we don’t normally see those. Does this mean labor productivity is going to hold up better than we expect? If so, it may signal this may be easier to recover from.

Q. So this isn’t the Great Depression?
The Great Depression was catastrophic through an entire decade. When people talk about and allude to the Depression … [they don’t understand], it’s an event of such horrendous magnitude. It’s nothing like we’ve seen so far.

Q. It seems that you’re not quite convinced this current situation is all that terrible, at least not yet.
A. What I’ve tried to argue is that the cost on the real economy is not really clear yet. It’s negative, yes, but the question is how negative. How big a deal is it? That’s still pretty ambiguous.
Obviously I think the financial meltdown is a huge negative for households. They have woken up and found their houses are worth a lot less. Their stock portfolios are worth a lot less than they thought. Especially for households nearing or in retirement, that’s a pretty big disaster. Imagine you were in retirement and just woke up and discovered your portfolio is down 50 or 30 percent? What exactly do you do? For many, they can’t go back to work. And also for those households nearing retirement, this has been a huge negative hit. For anyone even thinking about retirement, it’s obviously pretty tough. So what most people are going to end up doing is, households will switch what they’re doing with their money from consumption to savings. That will be one big effect we get. The other thing is that we see a lot of uncertainty about the composition of consumption. What kind of car should I buy? Are gas prices going to boom back up? Do you want a low-gas mileage SUV? I think there’s a lot of uncertainty in households, which will make them very conservative with the composition of their spending. We already saw that around Christmas time. We’re switching away from certain types of spending. We don’t want SUVs anymore. A Hummer? You can’t even mention it. You had all of these ridiculous expenditures. McBathrooms. McMansions. Now we’re pretty down on them. But that’s going to generate a lot of disruption. There were people working in those industries and, somehow, over a period of time, you’ll be moving them to another kind of industry. That doesn’t come for free or without a lot of dislocation.

Q. As of this writing, it seemed the government was preparing a stimulus package in the range of $800 billion. What do you think? Can this work?
I don’t want to pretend that I have any good feel as to what the details of the plan are. We don’t know and I haven’t read through the bill and I’m not planning to. But we’re going to be moving forward with this huge stimulus spending activity. To put this in perspective, it’s like 7 percent of the 2008 GDP. We’ve got a $14 trillion economy. So that’s like 1/14th of the economy. But compared to federal spending, it’s 87 percent—87 percent of government spending on goods and services. It’s a massive increase. So there’s a bunch of questions that immediately come up. Can you really suddenly bring online high value-added projects and spend the money wisely and frugally and get it done? I think there’s enormously good reason to be somewhat skeptical of that. Certainly the last administration has made us nervous about spending programs that they undertook. I think there’s a lot of concern about that. If you go and spend this money and you have to borrow to do it, and you’re left with a higher level of debt, and if you don’t spend on infrastructure and spending that is productive, to what extent have we wasted our money?
What we’re asking here is: What happens if you just blip up government spending? We want to know ... the direct impact of government spending. That leads some people to point at wartime spending experiences [such as World War II], because you can say that kind of spending is sudden and big and you can try and figure it out. But it’s not so clear if that wartime spending experience really translates to this situation. During wartime you’re building a bunch of bombs, guns, etc. So it becomes pretty ambiguous as to how much growth it actually promotes.

Q. You seem skeptical that spending—even really big spending on really big projects—can make a big differenc.
I just think one of the things you need to be thinking about is whether this is really the most efficient way to help people. It seems to me a natural alternative would be to put in place more aggressive unemployment insurance, especially the kind that might be targeted at someone in an industry where people are going under. Another aspect you want to think about is to what extent you want to prop up the Big Three in Detroit. That’s a tricky issue. You’ve got the northern auto industry and the southern auto industry. There’s a lot of cars being built in the South, it’s just that they’re not being built by Ford, GM and Chrysler. To the extent you prop these guys up, you’re hurting the South.
One of the things I’m surprised at is that we can’t let the bankruptcy courts operate for both the auto industry and the banks. These companies [in bankruptcy] are not shut down. … If you want to try and restructure these companies, do you really think the government is going to do a good job of doing that? The government is responding to political forces. Does the government really want to be in charge of laying off people in Detroit? I think that’s a tough call for them. Does the government really want to tell the bondholders at Citibank that they’re going to take a massive haircut? I think what we’re doing there is asking the government to do something it doesn’t do very well.

Q. Looking ahead, when do you think the downturn might end?
I think it’s really unclear. I’m not in the forecasting business. But I think it looks right now like a very different downturn than we’re used to seeing. In the credit crisis of 1980-81, what you saw was a pretty steep drop and then it came back. I think, especially if labor productivity holds up, then you might think the overall functioning of the economy will be maintained quite well and we might see a good rebound, maybe with things turning up by the end of this coming year. It’s just that right now we’re losing jobs at such a fast rate.

Q. This must be an interesting time to be an economist.
It’s bad to answer to yes—to say that, yes, this is an interesting time. The standard curse is, ‘May you live in interesting times.’ And I don’t want to sound insensitive to the fact that these are very hard times for people. I’ve done a lot of work on the Depression, and we can read about what life was like. At an intellectual level, yes, you don’t get very many of these kinds of experiments—trying to figure out what happens. But I must say again, I find it all very surprising that this kind of shock [the housing bubble] could generate so much of a reaction. We’ve blown up all of our investment banks. And these are banks that have been around through the Great Depression. These banks have been here for a long period of time and now they’re all gone. That’s really an amazing statement.
A lot of people took big losses here. And a lot of the smart money got killed. There were some big Bear Stearns people who got killed. When Bear was falling from $100 a share down to $10 or $11, there was a guy there who just put in a bunch of money, thinking he was buying at a steal. These people really were surprised by the events. They were not sitting there thinking they had put themselves at risk. And that ended up being a big part of the story. I find that interesting. But it also explains why the government failed regulatory-wise. They thought they could rely on these guys to handle their own risk. And what’s the ultimate goal for regulators? The goal is to avoid the Katrinas. We built those levees for the severe events. As a regulator you have to be thinking about getting financial institutions through the severe events. I think that perspective clearly wasn’t there.And so it’s also amazing to me that so many of the current actors had their hands in making this mess. Henry Paulson, Barney Frank. On both sides of the aisle, the distribution of blame is all across all the actors and all the main finance guys and the extent to which everyone was involved is really amazing.

Originally published Feb. 19, 2009