Wednesday, October 28, 2009

Is the Financial Crisis Over or Just Beginning?

This is the text of a speech I gave today at the South Dakota Chamber of Commerce's Third Annual conference on the economic outlook in Sioux Falls, SD.

Let me answer that question in three words: I don’t know. Unlike my erstwhile colleague Bruce Bueno de Mesquita, I do not try to predict the future. I do have something to say about the question, however, much more, in fact, than I could possibly say in the time allotted. Although I rarely teach history courses per se, I am an historian by training so my approach to the future is to look to history for analogous situations and then outline the paths that the economy may take while assigning rough probabilities to each.

The first path or scenario I call The Fairy Tale because the gist of it is that they all lived happily ever after. In other words, the economy is going to rebound robustly and we won’t experience another major financial panic during our lifetimes. To be perfectly blunt, I think the Fairy Tale scenario is about as likely as a scullery maid getting to wear glass slippers in a coach and four created from a pumpkin and four rats. Or, if you prefer, about as likely as an adolescent girl with 40 feet of hair capable of bearing the weight of a full grown prince. The U.S. financial system suffered major crises in the 1760s, 80s, and 90s, the 1810s, 30s, 50s, 60s, 70s, 80s, and 90s, the 19 aughts, teens, 20s, 30s, 70s, 80s, and the two thousand aughts. There is absolutely no reason to believe that we have reached the end of financial history and one very big reason to suspect that another crisis will hit us again, sooner or later: to date, none of the causes of the most recent financial crisis have been mitigated, much less rectified.

I have a book coming out next year called Fubarnomics that discusses the causes of economic sectors that are FUBAR – which is an acronym that stands for fouled up beyond all recognition, at least in polite circles. You know, hyper-dysfunctional sectors where costs consistently outstrip inflation such as construction, retirement savings, healthcare and insurance, higher education, and the like. Such monstrously messed up sectors all result, I conclude, from hybrid failures, or complex combinations of market failures like asymmetric information, externalities, market power, and public goods, AND government failures such as inappropriate and ineffective regulation and highly distortionary taxation. Despite partisan narratives from the Left that focus exclusively on market failures and from the Right that concentrate on government failures, the financial disruptions of 2007 and 8 were actually caused by eleven hybrid failures, not one of which has yet been adequately addressed. First,

1) The housing bubble. It’s pretty clear that in 2005 and 2006 many Americans paid waaaaaaaay too much for houses, especially in the New York City metro area, parts of Florida, Vegas, Southern California, and other hotspots. Nevertheless, many economists still believe that asset bubbles are impossible, that prices always reflect so-called fundamentals like interest rates and expectations of future prices. Following their lead, the Federal Reserve does not try to identify bubbles ex ante, which is to say before they burst and cause trouble. No other part of the government does much of anything to prevent or deflate bubbles either. That might not be such a big deal if it were not for:

2) Numero Dos -- rampant financial illiteracy. The U.S. economy works despite the fact that very few Americans understand economics. We’re sort of like the dog that manages to consistently catch a thrown Frisbee in its mouth. The dog can’t describe the physics involved but it doesn’t need to in order to get what it wants, the approbation of its owner and a Scooby snack. American consumers know that it is better to buy low than to buy high, and to sell high rather than to sell low, and that is enough to ensure reasonably efficient markets for most physical goods, professional and semi-professional services, and labor. But finance is different. It is more like rocket science. Just as the dog will never get a Frisbee into orbit, America will never have a stable financial system until most citizens thoroughly understand at least the bare basics of investing. At present, they clearly don’t. Many confess to dumb mistakes like putting all of their savings into a single investment such as Enron, staying invested in stocks as their retirement looms, and, like Buzz Lightyear, extrapolating trendy trends to infinity and beyond. They are so daft that they believe that traditional stockbrokers provide sound investment advice. Many institutions, including the Museum of American Finance, with which I am associated in various ways, are trying to increase financial literacy but the going is tough. Because it controls most education K through 12 and even much of the college market, the government could work wonders here, but it hasn’t. Most people never take a course in finance, a subject that is so little understood that most people who learn that I teach financial history and political economy are dumbfounded at the very notion that such disparate concepts as finance and history or political and economy can be combined into a course of study. Which leads me to:

3) Macro-incentives. Although many Americans are ignorant enough of finance to be easily suckered into fueling asset bubbles, be they tech stocks or spec houses, they are not stupid. They can be taught and they do follow their self-interests when the rational path is unambiguous. When the government basically told them via the IRS code to borrow to the hilt on their houses in order to invest in the stock market, they did so. I refer, of course, to the combination of the mortgage interest deduction and the ability to make pre-tax contributions into 401ks, 403bs, and other retirement accounts. No longer rewarded for striving to own their homes outright as they once were, Americans in the final quarter of the last century increasingly rented – for lack of a better term -- their homes from mortgage lenders and bought equity shares in corporations over which they had no control. The ability to put little or nothing down and to easily tap accrued equity through lines of credit of course fueled the real estate bubble and made the resulting downturn in the housing and stock markets much more traumatic than they traditionally would have been. Those tax distortions have not been addressed and are unlikely to be anytime soon. Moreover, many other potentially destabilizing distortions undoubtedly lurk in our massive tax code, awaiting only the right circumstances to sally forth and bite the economy in the posterior. I don’t know whether to laugh or cry when people claim that the recent crisis shows that free markets don’t work. They were far from unfettered. In addition to distorting macro-incentives there was also the problem of:

4) Macroeconomic (mis)management. Low interest rates provided yet another macro-incentive impetus for the bubble. From 2001 until 2005, the Federal Reserve and world trade patterns kept interest rates extremely low, which is just another way of saying rewarding people and firms for borrowing. Recently hurt by the bursting of the tech stock bubble, many investors used the opportunity afforded by the low rates to speculate in housing, a tangible asset that could not possibly lose value, or so many believed. By raising interest rates in 2005 and 2006, the Fed effectively punished new borrowers and those who had borrowed short-term via adjustable-rate mortgages. That of course decreased demand for houses and increased defaults, both of which led to the price collapse. Overnight interest rates are now near zero and the Fed shows no signs of increasing them anytime soon. So once again the government is encouraging investors to borrow to the hilt in the apparent hope of ending the ill effects of one bubble with yet another. It isn’t yet clear which assets will puff in price, but gold and the so-called rare earth elements are currently hot, hot, hot and insurance-linked securities, like catastrophe and death bonds, bear resemblance – or should I say resemble bull resemblance? -- to the securitized mortgage products that Wall Street banks and their apologists were all agog about just a few years ago. I should note here, again, that I see all of these causes as hybrid failures, not pure market or pure government failures but rather failures of both. Nowhere is that clearer than in:

5) Government Sponsored Enterprises or GSEs. Colloquially known as Fannie Mae and Freddie Mac, the GSEs were privately owned but publicly backed and as such were abominations of nature that should never have been countenanced, much less nurtured for decades. In his veto of the Second Bank of the United States, America’s second major GSE, President Andrew Jackson noted that QUOTE the powers, privileges, and favors bestowed upon it in the original charter, by increasing the value of the stock far above its par value, operated as a gratuity of many millions to the stockholders. UNQUOTE Such a subsidy, he argued, was an unwarranted redistribution of wealth from taxpayers to stockholders. Moreover, the bank was unconstitutional because it was neither necessary nor proper. The same argument can, and in fact has, been made against Fannie and Freddie. The GSEs did provide an important service, securitization, or the bundling of individual mortgages into bonds for resale to institutional investors worldwide. It is not at all clear, however, why the market for such securities needed to be duopolistic and subsidized with the full faith of the U.S. government, or in other words with taxpayers’ wallets. The original Fannie Mae was a government agency and should have remained as such. Or, conversely, securitization should have been opened up to free entry and no government guarantees granted to Fannie, Freddie, or any other mortgage securitizer. The government again nationalized the GSEs after their failure in 2008. Their future, however, remains murky. Fannie was spun off in 1968 to get it off the government’s books, which were under a bit of pressure due to LBJ’s Great Society programs and the Vietnam War. With the government’s financial position again rather tenuous – have you seen the budget deficit and the size of the national debt recently? -- there will be tremendous pressure to spin the GSEs off again and no guarantee that it will be done properly this time. Another prime example of the mixed or hybrid nature of the financial crisis is:

6) Government protected credit rating agencies. Of the many institutions responsible for the financial crisis of 2007-8, the big U.S. credit rating agencies (Standard & Poor’s, Fitch, and Moody’s) rank among the most odious because they appear unworthy of the trust many investors reposed in them. The agencies profited by giving high ratings to securities that ultimately proved toxic, or in other words nearly worthless and practically impossible to resell. An overabundance of such assets ultimately killed Bear Stearns, Lehman Brothers, AIG, and other major financial services firms and touched off a financial panic the likes of which had not been witnessed since the darkest days of the Great Depression. In addition to injuring investors, who lost trillions, the agencies’ errors also harmed many innocent bystanders who lost their jobs in the sharp worldwide recession caused by the financial system’s woes. The entire melancholy episode raises several important questions: Why do rating agencies exist? How did they come to have such power? What should be done about them? Financial securities are as old as the nation itself. During the Revolutionary War, government bonds lost most of their value because the rebel state and federal governments could not borrow or tax enough to make scheduled interest payments. The bonds traded only occasionally and at pennies on the dollar until after passage of the Constitution, when Treasury Secretary Alexander Hamilton took them in exchange for new bonds solidly backed by tariff revenues. The new bonds soon rose to par and traded frequently in the nation’s nascent securities markets in Philadelphia, New York, Boston, Baltimore, and Charleston, S.C. They were soon joined by the equities of scores, then hundreds, then thousands of business corporations, including banks, insurers, manufacturers of numerous stripes, mining companies, utilities (water and later telegraph and gas), and transportation companies like canals, turnpikes, and, eventually, steamship lines and railroads. Many of the last mentioned group also issued prodigious quantities of bonds. By the Civil War, over 20,000 corporations had formed and most of them issued at least one type of security. The markets for most early corporate securities were local or regional, however, so investors usually dealt directly with issuers. Before the Civil War, most companies sold securities themselves through a direct public offering or DPO rather than through an investment bank-intermediated initial public offering or IPO. Investors could assess the risk posed by securities without outside help because they often knew company organizers personally, understood the issuer’s business plan, and/or thoroughly knew its market. As companies, particularly manufacturers and railroads, grew larger and more complex in the second half of the nineteenth century, however, investors increasingly relied on third parties. Investment banks sprang up to intermediate offerings and information sources -- including industry journals and investment manuals -- proliferated. The best of them quickly grew more comprehensive and sophisticated. In the 1860s, for example, railroad journal editor Henry Varnum Poor and his son Henry William began the annual publication of the financial statistics of almost all U.S. railroads. In 1909, John Moody went a step further and began to rate bonds, or in other words to evaluate their risk of default. In 1916, the Poor Company also made the leap from information provider to securities evaluator. In 1941, it merged with Standard Statistics to form Standard & Poor’s, which McGraw-Hill acquired in 1966. The ratings business thrived because collecting and assessing financial information was costly and difficult. It therefore made economic sense for specialized firms to do it and to sell the results to investors. The original business model closely aligned the incentives of the rating agencies and investors. If the ratings were generally accurate, investors would continue to subscribe. If they were not, investors would switch to another, more accurate rating agency. Due to those incentives and that competition, ratings were as reliable as market prices and other performance indicators. Through the first three quarters of the twentieth century, the rating agency business was pretty sleepy. The rating agencies weren’t blamed for the Great Depression and shouldn’t have been. They completed their analyses, published their increasingly mammoth ratings books, and collected their subscriptions, increasingly from institutional investors like insurers, savings banks, and pension and mutual funds. But then two disasters struck. The advent of cheap photocopying made it easy for illicit entrepreneurs to make a fast buck by selling photocopies of ratings for a fraction of the price they cost the rating agencies to produce. That cut into revenues and profits, which sent the rating agencies scurrying for a new business model. Unfortunately, the one they hit upon – charging issuers -- was highly problematic to say the least. No sensible person or business bites the hand that feeds them. The new model therefore transformed rating agencies from pro-investor watchdogs into pro-issuer lapdogs. Before that happened, however, the government aided the then-struggling rating agencies by designating five of them -- the aforementioned big three and niche players A.M. Best and Dominion Bond – as Nationally Recognized Statistical Rating Organizations or NRSROs. The government also effectively perpetuated that cartel by barring new entry and forcing institutional and public investors, like public pension funds, to rely on the NRSROs’ ratings when making investment decisions. Even large, well-known issuers like General Electric had to pay for their securities to be rated or face loss of the institutional market. With such strong government support and an almost complete lack of market competition, rating agencies waxed complacent while the financial instruments they ostensibly graded grew ever more complex. The agencies even began to bill companies for unsolicited ratings! Since the late 1990s, a number of observers, including law professor and former investment banker Frank Partnoy, financial historian Richard Sylla, and hedge fund manager David Einhorn have argued that the new institutional arrangements dulled rating agencies’ incentive and ability to accurately assess the risk of issuer default. Ratings downgrades almost always occurred only after adverse news caused large price declines, many noted. Critics’ views gained credence when the rating agencies grossly overrated the securities of Enron, Worldcom, and other companies headed for bankruptcy early in the Third Millennium. On 29 September 2006, the government responded by passing the Credit Rating Agency Reform Act. The legislation, which quickly and easily sailed through Congress, facilitated new entry and abolished NRSRO-status. It did nothing, however, to change the perverse incentives at the heart of the system. The Reform Act of 2006 was a good start but in retrospect was too little, too late. The ideal regulation would support competition, freedom of choice and action, and transparency. Anyone who wants to rate corporate securities should be allowed to. Anyone who wants to use those ratings should also be allowed to, provided they properly disclose that fact to their investors. Nobody should be forced to use the ratings of any particular agency or agencies or indeed any ratings at all, again provided they disclose their practices if applicable. In addition, rating agencies should be free to sell their services to issuers, investors, or both but they should have to disclose the sources of their income. They should also be able to choose if, when, and how to guarantee their ratings. Agencies should not be forced to disclose their methodologies but book authors, journalists, bloggers, brokers, and others should be allowed to freely discuss the information the rating agencies disclose -- or don’t as the case may be -- and the pros and cons of their business models. An open approach like that just advocated would make the money and capital markets freer and hence less distorted, more like the svelte models of financial economists and less like binge and purge realities of the last three decades. It would also give rating agencies incentives to find less corruptible business models and perhaps even return to their original, investor-based model. Photocopies are cheaper than ever but encrypted databases are difficult to crack and nearly impossible to monetize. They can also be infinitely partitioned, from full, unlimited access for a big hedge fund to a single query on a single security by an individual investor. As soon as investors, especially institutional ones, make clear that they will no longer invest based on ratings that issuers have paid for, change will come rapidly and will be more efficient than reforms mandated from on high. The government is unlikely to follow the path just described, however, because rating agencies have large incentives to prevent it. Businesses generally dislike competition and typically expend much money and effort to avoid it – when it comes to themselves and not their suppliers or distributors, of course. Collectively, investors would benefit from fighting such special interests but a collective action or free-rider problem will likely prevent them from doing so effectively. It is possible, however, that a few large institutional investors could pull together and encourage more competition. The scope and nature of any new legislation or other policy changes are therefore difficult to predict but history suggests that the odds of marked improvement are low. The same could be said of:

7) Pathetic corporate governance. Far be it for me, or anyone else for that matter, to dictate how much a corporation pays for its talent. Unless, that is, I’m a stockholder. Then it seems like I should have some say. A lot of say in fact. But I don’t, and neither do other stockholders, unless they are controlling ones or the government. In fact, common stockholders these days have very little say in the management of the corporations they own. That was not always the case. Before the Civil War, stockholders reigned supreme. Small stockholders were protected from large ones by so-called prudent mean voting schemes, where the number of votes any one stockholder could cast was capped or where it took 5 or 10 more shares to get another vote in director and other corporate elections. Back then, directors consulted stockholders about everything important, including their wages. Stockholders could and frequently did call special meetings and conduct thorough investigations of the doings of managers and Board members. The situation changed in the second half of the nineteenth century, however, so that by the Great Depression Adolph Berle and Gardiner Means could complain, and rightly so, about the separation of ownership and control. At the same time, government regulations purposely stripped institutional investors of their governance rights due to some overblown fears about J. P. Morgan and his crew. As a result, we have a system of weak owners and strong managers. It is not surprising that those strong managers rigged the game in their favor with big bonuses, golden parachutes, and perks galore, like $35,000 dollar commodes. And what has the government done about this deplorable situation? Exactly nothing. Instead of making it easier and cheaper for stockholders and institutional investors to look after their own property themselves, it threatens to limit executive pay, at least at the companies that imbibed deeply of the government’s largesse last year. Of course all that it may end up doing is inducing those companies to return the government’s money ASAP, even if it threatens those companies’ recoveries. As for more general limits on executive pay, I hope that the government will never have the temerity to go there. But don’t get me wrong -- that doesn’t mean that some governmental oversight of compensation isn’t need to combat:

8) Distorted executive compensation systems. The structure of executive compensation, as opposed to the amount of compensation, I take to be a matter of public interest because of its clear connection to financial system stability. If their compensation structure rewards them for making short-term profits but doesn’t punish them for making long-term losses, managers will take big, short-sighted risks, thus greatly exacerbating systemic fragility. The proper policy here is fairly simple. Managers should not receive bonuses on the basis of alleged accounting profits. Such a system is too easy to game, either by manipulating the accounting assumptions or by deliberately backing projects that are short-term winners but long-term losers like -- oh I don’t know – subprime mortgages, CMOs, and other risky crapola. That’s not a technical term by the way. Deferred compensation, clawback, bonus-malus -- call it what you will – they all mean no more big paydays today on the basis of loans or other contracts with 15, 30, or more years to run. Stockholders liberated from the straitjackets I just described would push for more incentive-compatible contracts but while they rebuild their management monitoring skills the government should step in and force compensation deferment. And it should get other governments to sign on too, lest we lose some of our most innovative financiers and most important financial companies to London, Zurich, or Shanghai. And please do note that I refer here only to publicly-traded financial services companies, not to closely-held family firms or partnerships, which can take care of themselves as the big investment banks did from their formation in the nineteenth century until the 1980s and 90s, when they switched to the joint-stock form without, apparently, giving any thought to the implications for management incentives. Here again, the government has not even begun to move us in the right direction. Even if it does, there is still the problem of:

9) Static regulatory cling. Regulators are problematic for many reasons but primarily because they breed complacency. Why most investors believe that salaried government bureaucrats care more about their money than the investors themselves do is a difficult question to answer. I suspect that many people reason that because the U.S. government has the capability of putting a man on the moon, destroying the planet 100 times over, and so forth, it can surely stop financial fraud. Of course such reasoning is a tragic non sequitur. Regulators are not rewarded for stopping fraud or crises so they don’t do it. They are rewarded for upholding the letter, rather than the spirit, of the law, so that is what they do. As currently constituted, the government can no more stop financial fraud than it can catch Osama bin Laden. Like generals, regulators are prone to prepare to fight the previous war rather than the forthcoming one. With that analogy in mind, Sarbanes-Oxley was the Maginot Line of the 2008 financial panic. In the 1990s, companies incentivized managers with stock options. Some managers responded as hoped and increased the efficiency of their firms by lowering costs, expanding into new markets, gaining market power in established markets, and so forth. Others, however, found that to be too much work and instead increased stock prices with shady accounting practices. Sarbox stopped that from happening again, just as the Maginot Line prevented the Nazis from invading France directly. But it didn’t stop the other major way of getting stock prices up, by undertaking risky projects. Just as the Germans swept through the Ardennes and the Low Countries and from there moved into France, U.S. financiers simply outflanked the regulators sitting complacently behind Sarbox. Meanwhile, some observers complained that if only the government hadn’t repealed Glass Steagall, the New Deal legislation that separated investment from commercial banking, the crises of 2007 and 2008 would have been averted. That is a little like saying that if only French soldiers had stood in a line and fired their muskets in a volley at the German tanks and airplanes Paris would not have suffered the indignity of four years of German occupation. The Fed had already rendered Glass Steagall a dead letter by the early 1990s. Besides, the real culprit in the most recent crisis was not the large size and complexity of financial services firms per se but rather:

10) Too Big To Fail policy. There is a notion, not necessarily a bad one, that the government should prevent the financial system from freezing, exploding, or otherwise causing negative externalities for economies foreign and domestic. The Federal Reserve was created, in part, to serve as a so-called lender of last resort, as a safety net for the financial system. As part of that mission, the Fed announced in the mid-1980s that it would allow small banks to fail but in times of trouble it would step in to save the 11 largest banks on the grounds that their failure would threaten the stability of the entire financial system. The problem with the policy -- which is not only still in effect but has apparently metastasized into investment banking, hedge funds, and insurance – is two-fold. First, because the government offered its guarantee free of charge those institutions that are clearly “too big to fail” can pursue risks with reckless abandon, safe in the knowledge that ole Uncle Sam has their back. Second, those institutions that think that they are close to being considered “too big to fail” have major incentives to grow bigger so that they too can reap the rewards of taking on more risk – free of cost and, ironically enough, free of risk! The government thinks that it can offer the Too Big to Fail guarantee because of:

11) The Hubris of Planners. The government thought that it could raise homeownership rates by implementing a number of policies, including the tax breaks and GSEs formerly alluded to. Via policies like the Community Reinvestment Act, it also encouraged lenders to make loans to weaker borrowers when it should have instead eased entry requirements for credit unions and community banks. It also allowed the doctrine of secret liens to erode, thus enabling the growth of “silent second” and “piggyback” mortgages, or loans for down payments. When you let a borrower borrow the down payment you don’t really have a down payment, which was traditionally the number one defense against default because it served as a sort of life jacket that kept the borrower above water or with positive equity. Finally, the government allowed the development and proliferation of non-recourse loans. Essentially, it gave borrowers a free put option on their homes by allowing them to walk away when they are under water or in the bucket -- or in other words have negative equity – and to do so without serious adverse consequences. Such largesse certainly did increase homeownership rates, however temporarily, but did not increase the total amount of equity in homes. The put options, the silent seconds, and the Community Reinvestment Act all remain more or less intact.
Clearly, then, there is no Fairy Tale in our future. In fact, we should count ourselves lucky if our story ends they all lived rather than they all lived happily ever after.

At long last we come to the second scenario, which I call “Turning Japanese.” In this scenario, the financial system achieves stability but the economy remains stagnant, with an extended period of low or no growth, much like the Japanese economy has experienced for about two decades now. That is a sobering prospect but I believe that the probability of the U.S. economy turning Japanese, while greater than the “Fairy Tale” scenario, is nevertheless low. The people who most fear this scenario are macroeconomists fond of talking about liquidity traps, the inability to push on strings, and similarly inscrutable concepts. I think Helicopter Ben Bernanke of all people knows that he can lower real borrowing costs by increasing inflation expectations and the actual price level in a variety of ways even if overnight lending interest rates are near zero, something the Japanese could never quite bring themselves to do.

Moreover, I believe the stagnation of the Japanese economy runs much deeper than monetary policy. For starters, I think the Japanese economy simply outran its educational system, which focused far too much on rote memorization at the expense of creative or integrative thinking. America’s educational system, from K to Ph.D., is far from perfect but it does a much better job of nurturing creative genius. The United States also enjoys much more flexible labor markets and a superior system of entrepreneurship. It also traditionally did a better job of preventing the government from meddling too much in the economy, generally avoiding the trap of thinking that the economy needs the guidance of a Ministry of International Trade and Industry. If the U.S. economy does stagnate, it will be due to the ossification of overzealous bailout initiatives like that ridiculous [insert the name of your least favorite bailout here].

The third scenario I call “Louisville, 1839.” In 1837, the United States had been rocked by a financial panic so severe that many people, like O. D. Battle of Kentucky, could not even afford postage. By early 1839, the economy appeared poised to rebound so merchants in Louisville and elsewhere began to stock up in expectation of a strong recovery in 1840. You might think that their optimism was self-fulfilling, that their orders put factory and dock hands, clerks, and others back to work, and that those workers, paychecks in hand, increased employment for barbers, waiters, lawyers, and so forth in a virtuous and self-reinforcing cycle. ‘Twas not to be. Another round of financial troubles struck later in 1839 and quickly squelched all hope of quick recovery.

By 1840 things were so bad again that when Dr. Thomas C. Mercer of Louisville begged Norvin Green, who would later create Western Union, for a $25 loan, Green replied on the same sheet of paper that QUOTE so impoverishingly pinching are the Van Buren times that neither am I able to comply with your very urgent wishes, or to furnish a sheet on which to reply UNQUOTE and then he beseeched Mercer QUOTE pray don’t reply til fall when I shall probably be better able to pay the postage UNQUOTE. As one observer later recalled, early optimism actually delayed recovery because it meant that merchant shops bulged with goods purchased on credit that customers would not or could not buy. The streets of Louisville remained nearly deserted and real estate prices remained on the decline for several years after. As late as 1842 every day looked like Sunday in the streets of Louisville and other market towns as nominal per capita incomes fell from $97 in 1837 to $83 in 1843.

My fear, of course, is that another round of financial troubles will strike while the economy is still recuperating from the events of last autumn. The 1890s, 1930s, and 1980s also witnessed multiple financial crises spaced a few years apart and so-called double-dip recessions, long recessions with a period of slight growth in the middle. The most important questions we face, I believe, are: When will the next crisis occur, where will it strike, and how severe will it be? Again, I don’t make predictions but I am reminded of an old song by Merle Haggard called If We Make It Through December. <> Unfortunately, I don’t know which December will signal the all clear. Certainly not this one, but maybe next. Of course that will not mean that we’ve landed in the Never, Never Land of the “Fairy Tale” scenario, merely that we’ve avoided “Louisville, 1839” and probably also “Turning Japanese.”

That leads me to the final scenario, which I call “Return to Normality.” In this scenario, the economy is not subject to any major shocks -- financial, swinish, or otherwise -- and slowly returns, with some relatively minor ups and downs, to full employment right about the time the Mayans – the Hollywood version anyway -- say we are all going to be dead anyway. Of course I don’t really believe the Hollywood Mayans are right because if I did I would be surrounded by fishing poles, guns, beer, and women right now. In any event, employment is a lagging indicator so if and when the unemployment rate gets back to around 5 percent we can close this unhappy chapter in our economic history and look forward to the next unhappy chapter.
The only other scenario that I can think of is that a major war might break out and quickly drive the economy to full employment, much as World War II did. I sure hope that doesn’t happen as it is better to suffer from high unemployment and remain at peace than to suffer the deaths and dangers of full scale conflict, especially in this nuclear age. Placing a probability on large-scale war is notoriously difficult. On the eve of World War I many people argued that a major power war was impossible because globalization rendered it too costly. Boy were they wrong.

In conclusion, obviously I am not in the Obama administration. But if I were, I would strive to achieve the “Return to Normality” scenario. That would basically entail allowing the recession to run its course while simultaneously trying to foresee and prevent or at least mitigate potential shocks. To date, the government appears to have done a good job combating the swine flu and restoring some confidence in the financial system. The administration’s ill-conceived healthcare agenda, however, has created uncertainty and distracted attention from the desperately needed financial reforms that I discussed earlier. Cap and trade has the potential to do likewise. I conclude, therefore, that businesses should prepare for both the “Louisville, 1839” and “Return to Normality” scenarios. We could well muddle through this one without further incident but we might also face another large financial crisis and concomitant recession.

On that note, thank you for your time and attention and have a wonderful afternoon.

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