Jay Rosengard on the U.S. Financial Crisis

October 1, 2008

The current U.S. financial crisis is being labeled the worst since the Great Depression by economists and policymakers alike. Jay Rosengard, lecturer in public policy and director of the Mossavar-Rahmani Center for Business and Government's Financial Sector Program, offers context and perspective regarding the current crisis and analyzes the future global economic outlook.

Q: What are the dynamics at play in the current U.S. economic crisis?

Rosengard: What you have, basically, is a loss of confidence in our financial system. We have a bit of a contagion effect in which one crisis leads to another crisis and threatens systemic collapse.

Q: How do you envision that the financial markets will look when this crisis is all over?

Rosengard: We have this negative synergy right now between the financial sector and the real economy and that’s aggravated by asset price deflation, so the situation keeps feeding on itself. Over the long run, I think you’re going to see a very different landscape for the financial sector; it will probably be much more consolidated due to a lot of mergers, acquisitions, takeovers and liquidations.

This is unhealthy because it basically concentrates the risk. One of the decision rules for government to intervene is when an institution is considered “too big to fail.” So if at the end of the day, those institutions left standing are all too big to fail then you’re shifting a lot of the risk and a lot of the burden to taxpayers through government intervention.

Q: Your specialty is microfinance. Please discuss some of the implications of this economic crisis on microfinance institutions, small businesses, and consumers.

Rosengard: Well, if you look at microfinance in the US – this is finance for low-income households and family businesses – most of this is done through personal lines of credit, unlike how it operates overseas. And so, with a credit crunch a lot of small businesses are losing access to working capital which will constrain their business opportunities. And that works its way through the real economy.

Overseas, when you have a financial crisis, microfinance tends to be counter-cyclical as people start to buy local products instead of imports; they start to go to local markets rather than supermarkets. The types of things that these informal businesses sell tend to become in some ways even more popular. So I think the impact overseas will be somewhat different than it would be in the US.

Q: So this is a global situation now?

Rosengard: Yes, this is a global situation. For example, many of the securities issued by Fannie May and Freddie Mac are owned by foreign institutions, foreign central banks. Also AIG, which is a worldwide institution. And so you have reverberations being felt around the world. And it is affecting the capital markets, the real estate markets. It’s affecting general economic stability in several countries.

So, on a macro-scale this is a global crisis, but in terms of microfinance that tends to be a bit counter-cyclical. As your banks and main street commercial lending come under stress, these informal channels tend to become very healthy outlets.

Q: What are some of the longer-term answers? How can and should the government respond to this situation?

Rosengard: What we’re really looking for is smart regulation but the worry is that the government will overreact and kill all incentives to take risks. A little bit of greed in the financial markets is good – that spurs innovation – but you want to know whose money is being played with and you want a proper alignment of risk and rewards. In smart regulation you want to get some kind of balance back in the system and a lot of emphasis on reporting and disclosure. We really don’t know the magnitude of a lot of these problems because of lack of disclosure and I think under the new regulations you’re going to see a big emphasis on just making a lot more information publicly available.

The financial sector around the world is one of the most regulated because it has a lot of characteristics of market failures and to protect consumers and financial institutions you’ll have things like deposit insurance. You’ll also have enforceability of contracts, property rights and so on and you want to make sure that operating financial institutions that take money from the public are sound. And this is really the role of government – to make sure that public funds are being prudently used.

Q: You’ve co-authored a paper that discusses the mortgage market and how specifically government could be stepping in to help save troubled home owners under these current economic conditions. What arguments do you make and could that still play out?

Rosengard: The basic argument is that a lot of mortgages right now are upside down – the value of the loan is greater than the value of the property. That’s because people put very little down or the down-payment now is smaller than the decrease in housing prices. And what we’re recommending is a fast-track, easy way to restructure the loans and to share the cost. So you want banks basically to take the losses to write down the loans, but banks will save money in not going through foreclosure procedures. With restructured loans, with a fixed interest rate people could get back on schedule and stay in their homes and so it seems like a win-win situation for both homeowners and financial institutions. The government’s role would be if the loans are restructured and written down to market value, then they could be government insured which would provide a little bit of comfort for the financial institutions.

Q: As a final question, you have spoken about how this current situation differs in many respects from the 1930s and the Great Depression. What are some of the significant ways in which these two different eras differ?

Rosengard: I would say one of the biggest differences is the role of government. The government during the Great Depression was largely blamed for a lot of the magnitude of the problems in so far as increasing interest rates and then not lowering them quickly enough and creating a real liquidity squeeze. In this case, the Fed has been much more proactive. They have lowered interest rates; they’ve loosened requirements to have access to liquidity. And we have federal deposit insurance that we didn’t have – the FDIC didn’t exist before. So the government as a regulator and stabilizer – despite failures in regulation – is much more significant than it was in the Great Depression and I think that will cushion the impact on the real economy. The financial sector is going to continue to take a big hit, but unlike the Great Depression, where the economy in nominal terms went down 50 percent, I don’t think you’ll see anything of that magnitude and I don’t think you’ll see anything approaching the unemployment rates during the Great Depression.

I would just add that the crisis is still playing out. My guess is that property prices have not yet bottomed out so we really don’t know yet the true magnitude of the problem and whether the government’s interventions in the end have been the correct ones.

Interviewed by Doug Gavel on September 18, 2008.

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