Middlebury

Middlebury faculty economists scrutinize the U.S. financial crisis [video]

October 2, 2008

MIDDLEBURY, Vt.-About 200 students jammed into Dana Auditorium on Wednesday, October 1, along with scores of faculty, staff, and townspeople, to hear what four faculty economists had to say about the country's current financial crisis.

Middlebury economists, from left, Peter Matthews, David Colander, Scott Pardee, and Bob Prasch.


Scott Pardee, the Alan R. Holmes Visiting Professor of Monetary Economics, opened the discussion titled "The Financial Crisis: What is Going On?" by taking listeners step-by-step through the crisis.

Pardee views the nation's current economic condition "in terms of three human emotions: greed, fear, and confidence." Greed got us into this situation, he said, fear has fueled the problems, and now the nation is looking at government to restore confidence in the economy.

Sub prime mortgages, which Pardee defined as "mortgages extended to people who, in the past, would not have gotten mortgages," spawned a movement in the industry in which secure mortgages and risky mortgages were packaged together and sold on the open market. Unfortunately, Pardee added, "scams and fraud in sub prime lending" combined with "greed and the misuse of models" caused a "contagion in the market" in which "no one wanted to buy the packages."

Factor in over $45 trillion in credit default swaps, or CDS, in which the major investors in mortgage-backed securities took out insurance against default, and "then you have a house of cards," Prof. Pardee noted. "A liquidity crisis developed in which banks wouldn't lend to each other, followed by a solvency crisis as prices plummeted, and that's when firms like Lehman Brothers went out of business," he said.

Inspection goods

Associate Professor of Economics Robert Prasch asked members of the audience, many of whom were perched on the edge of their seats hoping for clarity, to consider the core quality of items such as lemonade or chocolate chip cookies.

"In economics terms," Prasch said, "these are called inspection goods because you can always taste the lemonade or the cookies, quickly determine whether they are good, and know right away what they are worth."

"The difference is that finance is not like inspection goods. With finance, we don't find out the true value of an investment until a later date." Prasch said the same was true with mortgage-backed securities. "No one really knew what they were worth ... but greed drove people to buy them, even though they were not inspection goods."

Prasch also discussed housing prices and said the price of houses generally kept pace with the rate of inflation, with few notable exceptions, from 1905 through 1995. "Then, for the next 10 years, housing prices soared considerably faster than both the rate of inflation and median income. Home prices went up 44 percent nationally between 1995 and 2005," and so it was predictable that housing prices would eventually plummet.

"Now that it's ended with a five to eight trillion dollar bubble in the housing market-money that just disappeared-the country could go into recession."

Professor Peter Matthews spoke next and recounted that the last "Big Five" financial crises in the industrialized world-Spain in 1977, Norway in 1987, Finland and Sweden in 1991, and Japan in 1992-"were all precipitated by a sharp run up in housing prices," just like in the U.S., and he noted other similarities such as increased borrowing from other countries and increases in the ratios of public and private debt to income.

Matthews, the James B. Jermain Professor of Political Economy, was not optimistic about the country pulling out of the crisis anytime soon. "The next administration [in Washington] will inherit an economy much weaker in both the short and long term or structural senses," he said, and nearly every economic indicator of current and expected future economic activity is down.

"The economic case against the Paulsen plan is ironclad," Matthews also remarked. "It transfers resources from, in effect, the public to the owners and shareholders of banks, insuring them against the consequences of their own decisions ... for the economists who support it, it is support born out of despair."

The fourth panelist, David Colander, the Christian A. Johnson Distinguished Professor of Economics, solicited questions from the floor, and the first questioner tried to find an upside to the crisis: "What fiscal stimuli would be most appropriate in this situation?"

Peter Matthews took the question and advocated for rebuilding America's infrastructure-bridges, roads, public buildings, etc.-to stimulate spending and create jobs. Congress's proposed "collection of small tax cuts" in the buyout legislation won't go far enough, he contended.

Robert Prasch said the last thing the country should do "is give a lot of money to banks and rich people, and the reason is that banks and rich people won't spend it. But if you give a couple of thousand dollars to students or poor people, they will spend it." Then, with the "multiplier effect," those dollars will start circulating in the economy.

He also argued against cutting the tax on capital gains because "the capital gains on most assets are at or close to zero, so cutting the capital gains tax rate is pointless." Government could give the money to the middle or lower classes in America or spend it on bridges. Either way it will help, he said.

Engine overhaul needed

That's when Professor Colander, who is often quoted on the economy in the New York Times and other publications, joined the discussion and used the analogy of driving a car with the engine oil warning light on.

"If you continue to drive when that light comes on, the engine will seize up. And if you just add oil to your engine, the car will run but you will still have to overhaul the engine." That's why Colander thinks that "bailout" is a terrible term to use: the word suggests an overhaul to the engine when, in reality, Congress's plan is more like adding oil to a motor that needs to be re-built.

"I suggest that they [Congress and the president] create a voucher plan that can only be used to buy houses or pay mortgages, to try and hold up prices. ... Housing prices are still way too high and somehow they have to come down. The bailout will not solve that. The bailout simply is not a fiscal stimulus; it is just a way to stop the engine from falling apart."

Prasch does not object to the term "bailout," but for a different reason. "The bailout will create political space and show that deregulation doesn't work. ... It says that these guys [bankers and financial managers] can't do it on their own and so it is now evident that they are wards of the state." He called for a plan more like the bailout of the Chrysler Corporation in 1979 in which the government took an equity position that it could cash out after five years and in which the firm's senior executives were almost entirely compensated in stock that they could not sell for several years.

Additionally, he suggested that the terms of any bailout should state: "Any bank that gets propped up now should be prohibited from lobbying the government so as to get easier terms later. ... [M]oreover, the data and the models used to evaluate these mortgage-backed securities should go to the Treasury with a copy to the FBI."

Scott Pardee brought the discussion back to Vermont. He had kind words to say about the state's strict banking regulatory system, as compared with other states. "The credit crunch will still affect us here," he said, but the cost of housing never skyrocketed in Vermont like it did elsewhere.

"Nevertheless, we in Vermont are not immune from a recession or depression in the U.S. economy," Pardee said.

The possibility of recession was not something that the panelists would rule out, but Matthews did address the subject as the 90-minute discussion drew to a close.

When asked whether this was a moment to embrace less consumerist lifestyles, he remarked: "I am not sympathetic to the notion of recession as an exercise in voluntary simplicity. The troubling thing to me is that the burden of a recession is not shared equally. Furthermore, it falls the hardest on the people least able to handle it."