This Tuesday, on a day when the federal government announced it will pump a quarter-trillion dollars into our nation’s banks, four of Minnesota’s most prominent economists were by turns caustic and cautionary in their criticism of the federal response to changing financial markets and to the economic crisis that has spread across the globe over the past few weeks. (The 90-minute program, sponsored by the Hubert H. Humphrey Institute of Public Affairs, can be seen in its entirety here, and there’s a live-blog account of the event too.)
After an interminably long-winded introduction by Humphrey Institute faculty member Robert Kudrle and a rather benign history of how and why the Federal Reserve Bank was created from Arthur Rolnick, the director of research for the Fed’s Minneapolis branch, the program sharpened considerably when U. of M. professor V.V. Chari spoke. Calling the bailout legislation passed by Congress and signed by President Bush a week ago “remarkable, and in my judgment remarkably unwise,” Chari, who is also a consultant to the Federal Reserve Bank of Minneapolis, sarcastically noted that the bill authorizes the Treasury Secretary Hank Paulson “to purchase essentially any kind of paper that the Treasury Secretary deems necessary to save the world. As far as the Fed is concerned,” Chari continued, “the Fed is now lending to anybody who meets one of two conditions: Either you are breathing and alive, or you are not breathing and dead.
“Are we doing the right thing?” Chari asked rhetorically. “That’s impossible to answer. We have done so many things over the course of the last month or so in particular, that I am convinced some of the things have got to be right—the law of large numbers dictates it. [But] the vast bulk of things we have done…will lead to either a substantial increase in the amount of risk that financial institutions will take in the future, or to extreme and punitive regulations that will prevent them from undertaking any reasonable commercial activities.”
Chari then acknowledged that he probably “would have done exactly the same things they have done” because the prevailing narrative is that the capitalist economy “rests on a thin skein of confidence, and if you break that confidence, everything comes crashingly to an end.” He said such a premise is “highly questionable” and leaves onlookers to assume that the Fed knows things it isn’t telling the general public. But that led to another biting commentary about the lack of transparency in the bailout process. “Our policymakers are treating us like children who can’t be told all the bad things that might happen. ‘Just do what we say and everything will be fine. If you don’t, then the end of Western Civilization is nigh,’” he said.
Chari pointed out that some of the Fed’s claims are demonstrably alarmist. For example, a central theme has been that credit is so tight that banks have stopped lending to viable commercial entities, or even to each other. But when he delved into the Fed’s own database, he said, he found that in the week ending October 1, “bank lending — for commercial-industrial loans, securities, mortgages — are all up. Most surprisingly, intrabank lending rose at its fastest rate in three or four years.” He concedes that the cost of such borrowing has skyrocketed and that “prices are an important indicator of where we are going. But quantity [of borrowing] is also important.
“It is entirely possible that policymakers are seeing things that the rest of us poor children are not seeing or don’t have access to,” Chari concluded. “My one plea is, tell us what you are seeing that worries you so much.” Otherwise, it may be that “policymakers are panicking for no good reason.” Either way, Chari says, “If I was in the market, I’d be panicking too.”
In an effort to mitigate Chari’s extraordinary statements, which seemed to debunk the magnitude of the crisis, program moderator Jay Kiedrowski (the former finance commissioner under Gov. Rudy Perpich) said his former colleagues at Wells Fargo told him the markets were so rattled that they weren’t receiving premiums on three-month Treasury notes — indeed, they had to pay more than the guaranteed return. And Minnesota state economist Tom Stinson noted that the market for municipal general obligation bonds has almost completely dried up, with the largest sales offerings being relatively puny issues of $40 million in North Carolina and $35 million in Kansas. The previous week, Stinson said, Kentucky had been forced to pay 6 percent interest on tax-exempt bonds. In other words, credit is indeed tight.
At this point, Kiedrowski turned to Tim Kehoe, who, like Chari, is a U. of M. professor and adviser to the Fed in Minneapolis, and asked him to explain the roots of the crisis. Kehoe cited a lack of adequate safeguards, saying that if various financial institutions were deemed “too big to fail,” then they should have better regulated. He also said that the bond rating agencies were conferring Triple-A ratings “on assets that were fundamentally bets that the housing market could do nothing but go up.” They were rated so highly, he continued, “because they had insurance against them from AIG. We didn’t understand that if something happened to the housing market, AIG would go down…that the bonds being rated Triple-A in effect were riskier than Argentinian government bonds in the 1990s.” This sucked cautious investors who backed only the highest-rated bonds into the crisis.
Kehoe then sought to put the crisis into perspective. He said that in October 1987, the stock market plunged 34 percent in two weeks, considerably more than the 24 percent the market had dropped in the past two weeks before Monday’s 900-point gain. “You all remember the Great Depression of 1987? No you don’t, because we didn’t have one. The stock market was back to where it was [before] in three years.” He said he wouldn’t be surprised if the present market rebounded in a period of three to five years. But he mentioned “one big caveat” that might prevent that from happening — “what the overreaction we are seeing in Washington [now] is going to do in the future.
“In a well-functioning financial system, we should get paid for taking risks” in bailing out these questionable mortgages and securities, Kehoe continued. “It is not clear to me that the people designing the bailout are making sure that the taxpayers are going to get paid for taking this risk.” Furthermore, bailing out these financial institutions creates a horrible precedent. “If somebody tells you to go down to the casino in Shakopee and bet, and if you win take the money home, and if you lose, don’t worry, I’ll cover it — well, then you’re going to do some pretty crazy betting,” he said. “That’s what the government is telling financial institutions in this country.”
To dramatize how much this way of thinking has already cost taxpayers, Kehoe ran through a financial calculation to determine the actual losses due to bad mortgages in the financial system. He arrived at a figure of $320 billion. “Why are we talking about these huge amounts then?” he asked, such as Rolnick’s earlier estimate that the government had poured close to $3 trillion into the system over the past six months. “We are going to not just bail out the bad mortgages. We are going to bail out lots of the bets on the bad mortgages, which are far bigger,” he emphasized. “The incentives that that gives the financial system to do things wrong in the future are overwhelming.”
Kehoe then held up a book, the result of a project he and a colleague had run for the Federal Reserve Bank of Minneapolis, joining with 24 other economists to take a look at all the economic depressions that had taken place around the world in the past century. “We find that the causes of these Great Depressions are not financial shocks. Instead they are [caused by] misguided overreactions on the part of government.” He compared the current crisis to what happened in Mexico in 1982 and Japan in 1991. He said that the government reactions guaranteed that Mexico’s finances would not grow over the next 13 years and that Japan would have no significant growth since 1991. “I don’t agree with Chari yet — I don’t think we’ve destroyed this economy to keep the sky from falling down. But the danger is that we might,” Kehoe concluded.
Kiedrowski turned the conversation to Stinson, asking Minnesota’s state economist what the implications of this federal crisis were for Minnesota. Stinson said the short answer is he doesn’t know — too much has happened in terms of the crisis and the federal response to permit reliable conclusions. But he did allow that they look at a number of different forecasting mechanisms, and “uncomfortably they are all very similar. The best guess we have is that the policy actions are unlikely to keep us from a recession.” This is hardly news, as — much to Governor Tim Pawlenty’s chagrin — Stinson claimed a statewide recession was underway months ago. He acknowledged this, held out hope that the bailout measures “may cause the recession to be less deep,” then delivered some very sobering news.
“The quarter we just finished was probably negative… In Minnesota, our sales tax receipts fell from a year ago. It is very likely we are going to have a negative outcome for the fourth quarter and it is also quite likely that we are going to have a negative quarter for the first quarter of 2009.”
However, Stinson said, “The recession is not expected to be particularly deep.” He added that high fuel prices had undercut the federal stimulus package this summer, but that falling fuel prices conversely should mitigate the recession over the next two quarters. Then, more bad news: “Housing is really a disaster. The construction industry is really a disaster. This year we will have had less housing starts than [any year] since World War II. And the forecasts now, looking on out, is that we will have even less housing starts in 2009 than in 2008.”
Finally, unemployment is a huge concern across the U.S.: “Private sector employment started declining last December, total employment started declining in January. It has gone down and down and has a long ways to go probably further. Everybody now is expecting to see unemployment rates in excess of 7 percent, which is a substantial jump from where they are right now.”
The final half hour was taken up with audience questions. This recap is long enough already, so I’ll bullet-point a few highlights and let you go to the videotape for more.
• Kehoe said he thinks Wells Fargo bought out Wachovia because he knew the federal government would bail out Wachovia. “I am going to interpret that what Wells Fargo did is just betting on a government bailout. They are betting that me as a taxpayer is going to pay.”
• Talking about how the political situation of an unpopular President and a looming election plays a role, Chari likened the Bush Administrations behavior on the bailout to what it did with the buildup to the Iraq war. “The consistent message is: ‘We are grownups, we understand the real problems, you don’t.’ What we found out about Iraq was, they did not have the information. In this particular instance, I hope they do have the information. All I am asking is that they disclose it. But there is this nagging feeling: Maybe they are overreacting to weird feelings in their own heads.” Stinson countered that the financial crisis is more tangible and credible than the supposed threat in Iraq. “This isn’t Mr. Chalabi reporting visions of mobile bio-weapons labs running around the streets in Baghdad…We are in a difficult situation with the President and a lot of other political leaders who had never little credibility. But I do believe the threat was credible in this situation.
• There was a general consensus that developing nations are going to be penalized by this global crisis more than economically established countries. “The Mexican peso has depreciated 30 percent. The biggest movement it has had in the last 13 years happened in the last two weeks,” Kehoe said. “It is a phenomenon we call ‘flight to quality.’ The financial problem originated in the United States,” he continued, but when the crisis hit, “when it spread throughout the whole world and makes people nervous, what do they do? Invest in the United States.” Rolnick sees a longer term problem of countries who had pinned their hopes on globalization being cut out of the mix as countries become less confident in the stability of global markets.
• How will we know when the crisis is lessening? Rolnick said it will be when housing prices begin to stabilize. Kehoe fancifully replied that it will be when “Secretary Bernanke and Chairman Paulson stop running around like chickens with their heads cut off, pulling every lever they can get their hands on.”
• Which aspect of the financial system is most in need of re-regulation? Rolnick says all investors have to take a hit whenever a bailout is enacted. Kehoe says it should be Fannie Mae and Freddie Mac since they are the institutions most regarded as being safeguarded by government resources. Chari and Stinson agree that it should be the regulation of “credit default swaps,” markets that regulate against bond defaulting. Chari believes it is used by banks and others as a dodge against capital requirements.