Market may swing but guru still sees gloom ahead: Interview with Martin Feldstein
Globe and Mail
September 20, 2008
The turmoil on Wall Street has spread fear and desperation throughout the global financial system.
The crisis that began 13 months ago has entered a new and far more serious phase, as hopes that the damage could be contained have evaporated.
The past two weeks have seen the government bailout of private-public mortgage holders Fannie Mae and Freddie Mac; the failure of Lehman Brothers.; and a virtual government takeover of American International Group (AIG), the world’s largest insurance company.
Finally, on Thursday and Friday, came a broad U.S. rescue plan to buy up bad assets and regulate other trade.
Martin Feldstein, one of the world’s leading economists, was an adviser to U.S. president Ronald Reagan in the early 1980s. He is now a Harvard professor and an economic adviser to Republican presidential candidate John McCain.
In 2005, he was a leading candidate to succeed Alan Greenspan as the chairman of the U.S. Federal Reserve, although the position ultimately went to Ben Bernanke.
Mr. Feldstein, who will appear at the exclusive Grano Speakers Series in Toronto on Wednesday, spoke to me last week about the state of the U.S. economy. He couldn’t discuss the AIG takeover because he is on the company’s board, although according to The Wall Street Journal, he believes it is not the government’s role to buy private companies.
We spoke again late this week to catch up with events.
What’s the scope of this financial crisis?
It’s very big and very deep.
Are the U.S. Federal Reserve and the U.S. government on the right track?
In a certain sense, they are doing the right thing. They are providing liquidity to the system. But the specific ways in which they are handling these transactions raise some serious questions.
Have they really got control of this? It seems as if they’re in reactive mode.
[They are] simply reacting to the financial crises that are brought to them.
They are an emergency room, not a preventive medicine department.
Is it the end of Wall Street as we know it?
Certainly the world of investment banking has been dramatically changed. With Lehman Brothers and Bear Stearns gone and Merrill Lynch acquired, there’s very little left.
Are there more shoes to drop?
There certainly could be. The more general problem of the commercial banks and the credit markets has not been solved. Certainly dozens of small and medium-sized banks will fail. And the sharp decline in house prices has not been significantly affected.
How long might that take?
We don’t know. The sad fact is that in order for this credit crisis to come to an end, house prices have to stop falling. The financial institutions that hold mortgages - or that hold these more complicated derivatives based on mortgages - will not know how much they’re worth as long as house prices are still falling and the rate of foreclosures is rising.
Mortgage contracts are very different in the U.S. than they are in most other countries. As a general rule, they are so-called non-recourse loans, which means that if an individual stops making payments, the creditor can take the house - but if selling the house doesn’t provide enough money to pay off the mortgage, the creditor cannot go after other assets or the income of that individual.
That’s very different from Canada or virtually any other part of the world. It gives homeowners who have negative equity [i.e., mortgage debt bigger than the value of their house] an incentive to default because they’ll lose less. They’ll be able to walk away, rent and wait for prices to come down, and they will have escaped the full cost of the mortgage. Until that process stops, the crisis will not end.
So how bad could it get?
Right now, our best guess is that about 20 per cent of homeowners with mortgages have negative equity. That could easily rise over the next year or so to 40 per cent. More foreclosures mean that more houses are put in the market, and that depresses prices, and that means there’s more incentive for more people to walk away. It’s a vicious circle.
We don’t have those mortgage problems here. Why should we be worried?
Because of trade between Canada and the U.S. Even if Canadian banks don’t hold paper, the decline in consumer wealth, and in credit, and the slowdown of the U.S. economy means that we will import less from Canada.
A lot of people used to think that former Fed chairman Alan Greenspan could do no wrong. You disagree. Why?
The problem was that in the early part of the decade he brought interest rates very low - about 1 per cent - and promised to keep them very low. They did it because they were worried about deflation. What they didn’t take into account was that this could contribute to the kind of house-price bubble we have seen.
I think he should have foreseen that possibility - although I can’t say the rest of us did either. Back in 2002, the impact on house prices was not at all apparent. But as they began to rise very sharply, he didn’t do anything about it.
Was the takeover of Fannie and Freddie inevitable?
Yes. It’s amazing that the U.S. Congress and the administration allowed Fannie and Freddie to go on expanding their capital as they did.
So, where were the regulators for all those years?
The supervisors should have been looking at the capital and the asset quality of the banks. They figured these banks had enough capital - and we don’t count the so-called SIV [structured investment vehicles], which are off-balance-sheet items. They were authorized to take that view by the Basel rules. The international banking community and other wise men got that wrong. They were judging the asset quality by what the rating agencies were saying. They thought, “Well, these are Triple-A bonds, so we don’t have to worry about them.”
It seems that there’s been quite a lot of financial recklessness around. We also have George W. Bush to thank for pointing the U.S. toward a trillion-dollar deficit.
The most recent number is $400-billion, and that’s enough. That will be significantly increased by the slowdown in the economy, which will bring a slowdown in tax receipts. We’re looking at a federal deficit of 3 per cent of GDP.
But the real problem is that social security and medicare costs are going to explode in the next decade. So far, the political process has not been willing to deal with that.
Why haven’t America’s political leaders come clean with the public about the looming entitlements crisis?
Both [Bill] Clinton and Bush kept telling the public: Bush proposed a solution in the form of a mixed system of social security that keeps the automatic payment but adds a universal-investment component. But the Democrats wouldn’t even sit down and negotiate. It looks as if we are going to get closer to the crisis point before the political process can act.
You’re an economic adviser to John McCain. What are you telling him is the single biggest economic challenge facing the U.S. today?
I haven’t put it to him in those terms, although we’ve talked about all these issues. Personally, I think the housing issue is the most important short-run problem. We’ve also talked about the size of the federal deficit and the trade deficit. All those issues are important.
John McCain has admitted that the economy is not his strong suit. Critics say his economic strategy looks a lot like Bush’s. Why should we think he’s the best guy to steer the U.S. out of this mess?
He has emphasized the problem of excess spending. He’s talked about it throughout his career in the Senate and he’s been willing to vote against popular spending programs. He went to Iowa and told folks there he’s against the ethanol subsidy. He is willing to square with people - that popular programs have to be cut back. He’s also said that social security can’t continue in its current form. And he wants to negotiate changes in a bipartisan way.
How about Barack Obama’s economic platform?
That’s a tough one. It keeps changing, so it’s hard to summarize. If you’d asked me two months ago, I would have said he’s a man who’s committed to very high tax rates in order to finance spending programs and tax cuts for some targeted groups. Then he decided that wasn’t such a good idea. … He’s trying to pull in middle-class voters [by] saying that only a few rich people will pay higher taxes and 95 per cent of us will get tax cuts.
But he will discover if he becomes president that the math doesn’t work. You can’t get all this money just by pushing up the tax rates on high-income people.
No matter who’s elected, you think the dollar will inevitably keep on falling. Why?
Because of the very large trade deficit. The dollar coming down over the last several years has made us more competitive internationally. It’s given a tremendous boost to our exports, and it’s our exports that are keeping the economy as a whole in “plus” territory.
Are you worried the world might stop buying U.S. debt?
The opposite seems to be happening, at least at this point. People who are nervous realize that you can’t do better than U.S. government bonds.
Is the U.S. facing a longer and deeper-than-normal recession?
It’s been a very peculiar decline since the beginning of the year. Employment has been falling, industrial productivity is down, construction is down terribly, incomes are down, retail sales are down. So if you didn’t look at GDP, which is heavily influenced by the export numbers, you’d say this economy is in recession. The Fed has not been able to turn it around as in previous recessions.
The last two recessions were short - eight months from peak to trough. This time is different because the origin is different. First, there’s the collapse of the house-price bubble. Second is the general mispricing of risk in financial securities. So we have a financial and a housing crisis at the same time. That’s just totally different from before.
I’ll be very surprised if in the end we don’t have a formal declaration of a recession.
Could it be more prolonged and more serious than usual?
Absolutely.
In August, you said you were “much more pessimistic” than you were a year ago about the outlook. So how do you feel now?
It’s gotten worse.
Thank you, Mr. Feldstein. I think I will go hide under my bed now.
Margaret Wente is a columnist for The Globe and Mail.