Swat Professors Express Views on Financial Crisis

1. What was the most important factor contributing to the financial crisis?

Professor Mark Kuperberg

Professor Mark Kuperburg, Economics:

Markets are robust institutions. For financial markets to meltdown as they have requires the confluence of many factors, like a perfect storm. And like a perfect storm, the meltdown could have been avoided if any one of the following factors were missing. So,

1) The housing bubble set the stage for the meltdown by encouraging people to buy homes they could not afford, encouraging lenders to make loans they should not have made, and encouraging investment banks to package bundles of mortgages and price them at unrealistic values.

2) Too loose monetary policy kept interest rates artificially low and encouraged excessive borrowing throughout the economy.

3) Lack of regulation of mortgage lenders resulted in lax and predatory lending.

4) Securitization enabled lenders to package their mortgages and sell them to someone else, so the original lenders (who were the only people who knew anything about the actual borrowers) did not have to worry about whether the loans would be paid back.

Still, if the entire problem had been limited to the housing industry, we would not see the meltdown that we have. Compounding this is:

5) Financial engineering by Wall Street firms which created incredibly complex financial derivatives that amounted to nothing more than bets on what would happen in the housing industry. These bets compounded the effects of defaults on the underlying mortgages many times over.

6) Excessive and reckless rates of borrowing by financial institutions (ie excessive leverage) who used these borrowed funds to place their bets in these derivative markets.

Professor Steve O’Conell

Professor Steve O’Connell – Economics

I suspect that oil prices had a bigger effect than is suggested by conventional measures (like GDP growth). To put this in perspective, a barrel of oil cost around $25 in Feb 2003 before the invasion of Iraq.

But the main problem, I think, is a regulatory failure that tends to happen in financial markets when they are in a boom. The job of regulators is to protect the public from fraud and from excessive risk-taking by financial managers with limited liability. This is both difficult and important when markets are booming: difficult because it’s hard to tell well-managed from poorly-managed firms (everyone is doing well) and important because all managers are under pressure to show sparkling results and ignore the down side. The Bush administration accelerated this process because (a) it is ideologically opposed to regulation; (b) it views markets as inherently fair and so has no problem with huge CEO salaries and corporate incomes; and (c) it has promoted a culture of financial irresponsibility, in which one’s own ambitions are always someone else’s financial obligation (the federal debt doubled under Bush).

Professor Ayse Kaya – Political Science

I agree that subprime mortgage is at the heart of the crisis – in that it is one of the most significant examples of the consequences of financial innovation outpacing regulation. The rapid proliferation of securitization of asset-backed debt (which included subprime, of course) especially in the last decade has largely gone unregulated and seems to have been insufficiently transparent, allowing an over-valuation of these assets. To give an example of poor regulation, there has been a blatant conflict of interest in how these securities were rated by the rating agencies because banks were the ones that hired the agencies. Some other factors that provided a fertile ground for the crisis to flourish can also be highlighted. One such factor is the low real interest rates maintained by the Fed that fueled the bubble. One other important factor is the net savers of dollars in the emerging world, particularly China. The point here is not at all to suggest that the crisis is the responsibility of countries that saved, but rather to emphasize that as these countries put their savings into buying American debt, they also enabled over-borrowing in the US economy. Overall, though, the complex interaction of a number of trends seems to have escaped the scrutinizing eye of governments and key spectators, as virtually no one would have predicted the downfall of Lehman a year ago.

Identifying exogenous factors that worsened the crisis is not an easy task. In some respects, we are in uncharted territory. One of the factors that exacerbated the crisis seems to be lack of a global coordinated effort until recently, and ultimately most fiscal initiatives remain national or regional in character. To give an example, while Prime Minister Gordon Brown outlined a clear plan to re-capitalize the UK banks, with much of Europe following suit, the US response appears to have vacillated between recapitalizing its banks and outright purchasing of “troubled” assets, such as subprime debt.

2. How do you think the Fed is handling the situation?

Professor Mark Wallace

Mark Wallace

The bailout is a short-term, quick-fix response to a larger problem. Tragically, it continues business as usual. Our economic system has one focus: maximizing the financial returns of shareholders. Instead, it should focus on the flourishing of all members of society – children, the poor, many middle-class families – by balancing economic returns with social well-being. The business of business is not business; rather, the business of business should be maximal growth for all citizens. The response of a bailout, while understandable, misses the wider ideal of rebuilding our economy’s much needed focus on jobs, schools, infrastructure, alternative energy, and health care.

Kuperberg: The Fed is doing fine now. Ben Bernanke is the one guy on the planet who you would want in this position right now; but the Fed is closing the barn door after the horses have escaped. Bernanke and Alan Greenspan can be faulted for taking the view that it was not the Fed’s job to try to keep the housing bubble from getting out of control. Greenspan, but not Bernanke, can also be faulted for resisting all regulation of the financial markets.

O’Connell: Gov Bernanke is a leading scholar of the Great Depression and is determined not to repeat the mistake of intervening too little an too late (also in Japan early 1990s). I fully support the aggressive innovations he has implemented in the past month or more, in an attempt to prevent a crisis from becoming a long-lasting disaster for the economy. If he fails I think the verdict will not be that there
were mistakes but that events overtook a capable and clear-eyed Fed.

As a thought experiment: what if this crisis had happened at the end of Bush’s first term? The White House would then be demanding control of the situation; the Treasury secretary would have no autonomy; Congress would be cowered; and Bernanke (Greenspan actually) would be relegated to acting alone. We are lucky that the White House has been completely marginalized. If this process had happened 4 years ago we’d already be in a disaster.

There are some similarities to the Asian crisis of 1997/98; in both cases financial liberalization with lax regulation created systemic risks in the financial sector, and then a sharp reassessment of asset values brought a sudden and self-reinforcing stop to credit, bringing asset prices crashing down (in the Asian case it was external creditors and the exchange rate was one of the key asset prices).

The magnitude of economic suffering, so far, has been much milder in the USA than in the Asian crisis countries. But very difficult stresses are hitting the middle class and lower-income households, and things can get a lot worse.

3. Can you compare the events of this crisis to what happened in Asia and Latin America previously?

Kuperberg: This crisis is very different from what happened in Asia (excluding Japan) and Latin America because these countries got in trouble by borrowing from foreigners in dollars (which they cannot print). We also borrow from foreigners in dollars, but we print the dollars so it is not a problem.

O’Connell: One big difference between our situation and the Asian crisis is that the Asian macroeconomic fundamentals were generally pretty strong. Ours are weak — very large government budget deficits and trade deficits, and tremendous political difficulties in raising tax revenue. We look more like Latin America in the early 1980s, or Argentina in the late 1990s, in that respect.

4. What do you think is the short term and long-term impact of these events? How long do you think it will take to start restoring order?

Kuperberg: In the short run we will certainly go into a recession (which technically we are still not yet in). It will take at least 5 years to sort out this mess – it could take as long as 10. The scary analogy for the US economy is not Asia or Latin America but Japan in the 1990’s. Our situation now is very similar to theirs when their housing and stock market bubbles burst.

O’Connell: Short-term I think the crisis will help get the Obama team elected, for 2 main reasons. First, when McCain and Palin use the word ‘maverick’ they mean ‘straight-taking, independently-minded Washington outsider.’ But the word can also convey ‘impulsive, risk-taking, and bull-headed’ (e.g., a ‘maverick trader’ in financial markets). These are not qualities people value in the middle of a financial crisis. The economic risks of a McCain/Palin ticket are extraordinary and I think people understand that. Second, the crisis has given greed a bad name, and that plays against McCain in the regulatory and tax arenas where he has consistently favored the wealthy.

In terms of economic impact I think we are in for a serious recession in the USA for the next 18 months or so, regardless of how well things work out with the rescue. If the rescue succeeds, I think markets may bottom out as early as the first quarter of next year — but there’s no guarantee.

In terms of good that can come: first, I support the Obama/Biden ticket and so the boost the crisis gives to that ticket is of potentially huge consequence from my perspective, not just for economic issues but for a whole range of challenges facing the USA. I also think that the necessity of heavy government involvement may stimulate some positive reassessment of the social contract in this country, in part by reviving public support for the government’s legitimate role as regulator and promoter of economic fairness.

Kaya: This is a global crisis, not just an American one, so inevitably any efforts to fix it and minimize its recurrence have to be global in nature. In the face of a global market and a global financial system, the world cannot afford to lack a global financial structure. Calls for a 21st century Bretton Woods summit are thus appropriate. What seems necessary is the creation of new global standards of financial regulation through careful coordination among major players, who are no longer confined to the heavyweights at Bretton Woods.

Furthermore, the crisis has provided the world with yet another opportunity to contemplate the role of international financial institutions. Some commentators have criticized the international financial institutions, especially the International Monetary Fund, for being passive spectators, leaving the role of leadership and problem-fixing to national governments. The IMF can dispense advice and provide bail-out packages to governments in the developing world, but beyond that it has no role to play in the current crisis. In the last few decades, neither the IMF’s voting structure nor its mandate have kept pace with substantial global economic changes that shifted the core of the world economy away from Western economies and Japan. (Obviously, other international organizations can be criticized in the same way, but the current crisis shines the critical light particularly on the IMF.) The point is that the moment of crisis is yet another moment to re-think global expectations from international institutions.

In sum, the crisis illuminates some long-term weaknesses in the governance of financial systems and points to the need for a new global financial structure. Good can come out of this crisis, as governments re-think their regulatory frameworks and the government-market balance. But, when regulatory failures are fixed, there is a danger to provide the wrong fix, or to overshoot. While non-extreme viewpoints concur that there has to be a balance between governments-markets, the exact ingredients of that balance continue to remain elusive.

4. What is the relevance of the crisis to Swarthmore students as college students or prospective workers about to enter the job market?

O’Connell: The job market will be very weak in the financial sector, but it will also be weak across the board as public and private-sector budgets tighten. However, Swarthmore graduates will float to the top in many labor markets (private and public sector) because their skill sets are even more relevant in an environment of complexity and uncertainty. It is critical for students to remember that in the job market, persistence pays off and that the world needs their creativity, motivation, and ‘ethical intelligence’ more than ever.

There will be a general swing towards graduate school among new and recent college grads, so grad school admissions will toughen too; but again Swarthmore grads are superbly well-positioned as graduate schools try to select the best candidates.

The crisis may also open the door politically for a re-commitment of American government to areas of science and technology that will be generating immense professional opportunities a global basis as countries begin to cope seriously with issues of sustainability and climate change. These are areas in which Swarthmore grads can play leading roles, both on the science side and in public policy.

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