Submitted by Caroline J. Hanna

Marjan Hajibandeh ’09E talks about downturns, gas prices and bubble phenomena, among other things, with economics department chair Geoffrey Woglom, the Richard S. Volpert ’56 Professor of Economics, for our new “Who Knows” series. Feel free to log and add comments.

MH:  What is a recession? Are we in one now?

GW: A recession is a generalized downturn in economic activity. The National Bureau of Economic Research are the official recession callers. You frequently hear that there is a rule of thumb of two consecutive quarters of negative real GDP growth, but that’s just a rule of thumb. The NBER decides when the economy is in a recession. Typically they don’t decide on that until well after the recession has started. The most recent measures of real GDP growth have still been positive. Clearly, we’re in a downturn; it could be a very significant downturn. One of the frustrating things about being a macroeconomist is that you don’t know until well after the fact exactly how severe a problem’s going to be.

MH:  What started the domino effect of the current downturn?

GW:  A recession happens when, for one reason or another, one sector of the economy slows down its spending. It can be business spending on investment, or it can be households in terms of consumption. That slowdown in spending leads to firms having more inventories on hand then they planned. So then they lay off workers to reduce their inventories, which leads to further reductions to consumer spending and a generalized slowdown in the economy.

MH: What is the relationship between the current economic downturn and the sub-prime mortgage crisis?

GW: You can think about two kinds of recessions. One is this sort of plain vanilla slowing down of economic activity in a relatively short period of slow or negative economic growth. The current one has the potential for being more severe because there has been a disruption in credit markets. That disruption came about when households started to default on sub-prime mortgages. There were lots of investment banks and hedge funds that had invested in sub-prime mortgages. Their balances sheets became impaired, and as a result, a lot of lending stopped happening. So when you have financial institutions and financial markets, in general, that are stressed at the same time the economy is doing badly, you can have cascading defaults. Bear Stearns in one of them. Avoiding the cascade effect is what the Federal Reserve is trying to do.

MH: In general, because sub-prime loans are a greater risk, they would be expected to default at a higher frequency. And in that case, wouldn’t this whole crisis have been predictable?

GW: Bubble phenomena are eminently predictable after they’ve burst. They are much less easy to predict beforehand. I can remember lecturing to the introductory course in, I think, the fall of 1995 and saying the stock market was grossly overvalued. And the bubble didn’t burst until 2000. So, it’s a little bit hard to predict these things.

You shouldn’t think of all of these sub-prime mortgages as risky speculation. In fact, many people were able to buy homes who, in the past, would otherwise not have been able to buy homes, and they are going to keep their homes, which is not to say that there hasn’t been a lot of damage for a lot of people.

MH: Americans used be savers and are now borrowers. What accounts for the shift?

GW: A conjunction of things have led to very low levels of personal savings. The stock market went way up in the 1990s; when that burst, the housing market went up. Households are concerned with saving for retirement. They’re concerned with how much wealth or net worth they have. Many economists have argued that the capital gains [Americans] were enjoying on their pension funds and on their homes was substituting for saving. Clearly, that was not a very good bargain: now homes are not worth as much, and the stock market is not as buoyant as it was. People are going to have to save more. Now we’re getting into the realm of psychology. I almost feel as if people got it into their minds: I can consume all of my income because my home’s going up. They haven’t broken out of that pattern yet. And we’re all going to have to. But that’s down the road, I guess.

MH:  Are lenders offering more credit than they used to, and is that why borrowers have been borrowing more?

GW:  Thirty years ago, banks—savings banks and, to a lesser extent, commercial banks—lent money to homeowners to buy a house and then held on to that mortgage on their balances sheet. Today, banks originate the loans but then package the loans together and sell them on capital markets to investors. This lowers interest rates to borrowers, and in general, I think this is a good thing.

But credit markets have a tendency to take good things and go a little bit too far. These financial institutions are going to try to find the next new thing that they think will provide them with good returns. I think it’s probably fair to say that we overdid it with regard to sub-prime mortgages. These things were riskier than they were perceived.

 MH: People are saving less than they were a generation ago. Could this be because they have lower real incomes (rather than because their consumption patterns have changed)? 

GW: Absolutely, but I don’t think that those personal circumstances are responsible, in general, for low levels of aggregate household savings. You hear a lot about people who get into credit card debt. Many people aren’t being irresponsible; they just have had some tough breaks. Some people, in trying to avoid foreclosures, have been running up their credit cards. That’s just postponing the inevitable—and with tragic consequences. But I don’t think that’s the general explanation as to why, over the past 10 years, personal savings rates have been so low.

MH: What are the similarities and differences between the increase in oil prices in this decade and that during the 1970s?

GW: [The increase in oil prices is] having much less of an effect on inflation [today] than it did during that time period. But that is not to say that there aren’t as many real effects; I filled up my car, and I paid $4.01 per gallon for gasoline. That’s a pretty dramatic effect. At some level, Americans are going to have get used to living at a relatively lower standard of living. In the past, we’ve grown accustomed to being able to run tremendous trade deficits and consuming cheap energy. Those days, I think, are coming to a close. 

MH: Will changes in car designs and in transportation habits be long-term or short-term trends?

GW: We need to confront a whole bunch of long-term economic challenges, and energy certainly is one of them. We’re going to have to make some very hard choices that we’ve been reluctant to face in the past. I don’t believe that bio-fuels are going to be all of the answer. We may have to take a hard look at nuclear power again. And, by the way, this is politics as much as it is economics.

MH: I noticed you drive a Prius.

GW: Yes.

MH: There is the saying that, “When the United States sneezes, the rest of the world catches pneumonia.” Is this statement as accurate today as it was years ago?

GW: It’s probably less true today, but the United States economy is still very important for the world economy. There foreign banks that have been exposed to problems from the sub-prime mortgage market in the United States. So they are feeling some of the pain.

The United States is currently running a trade deficit of something like 6 percent of GDP. We should be running a trade surplus, given our aging population. How we get from running a trade deficit to running a trade surplus is going to be a very difficult process, particularly because our trade deficit has been buoying demand for foreign countries’ goods and services. We have to coordinate our activities so that we get our own house in order without causing European economies to collapse.

MH: Would more federally backed insurance be an answer to the mortgage crisis?

GW: Many economists would argue—and I think there is some merit in this argument—that the problem is not the explicit FDIC insurance. The problem is the implicit insurance that the Fed will not allow large institutions to fail. It’s not that Bear Stearns’ shareholders got—I think—$10 per share when the stock had been trading at $60 per share. Believe me, the Bear Stearns shareholders, employees and managers have paid a cost. The problem is the people who lent to Bear Stearns: they got repaid in full. As a consequence, many economists are concerned that, essentially, you don’t have to worry about lending to large financial institutions; if they do something stupid and go bankrupt, the Fed is going to come in and make sure you’re okay. As a consequence, not enough people are paying enough attention to what institutions like Bear Stearns are doing and are, in fact, allowing them to take on much riskier positions than they should.

You don’t want the financial markets to collapse. If you allow Bear Stearns just to go its merry way and declare bankruptcy you might, in fact, have multiple bankruptcies. On the other hand, you’re trying not to provide signals like: “Don’t worry about it, lenders; we’ll bail you out.” It’s a delicate balance. I think that some regulation of financial institutions can help, but there is a real tension.

MH: What do you think needs to happen for the United States to eliminate its trade deficit?

GW: We as a country have to save more, and one of the things that we could do directly to save more is to reduce the government budget deficit. I’m afraid that will have to come with some increase in taxes. The problem is that in the short run, if we were to raise taxes, that would lower demand even further and raise the risk of recession. So somehow we have to get our economy back near full employment and growing, and then work on a much more sustainable budget policy than we’ve been running in the last eight years.