The U.S. Economy: What Happened & What’s Next?

Published: November 13, 2008 in Knowledge@Emory

The stock market closed up 144 points the final Friday of October, putting an end to one of Wall Street’s most brutal months. The Dow Jones Industrial Average fell 1670 points in October, taking trillions of dollars in equity value with it. In an effort to woo voters, the presidential candidates scrambled to present solutions, but a panel of professors at Emory University’s Goizueta Business School who gathered on October 30 to discuss the current state of the U.S. economy wasn’t tempted by their offerings. According to the professors, years of short-sighted decisions dug the hole the U.S. economy finds itself in, and it will take long-term leadership to climb out of that hole.

Moderated by Susan Gilbert, associate dean and director of Goizueta Business School’s Evening MBA Program and an associate professor in the practice of finance, the panel discussion, “The Economy: What Happened and What’s Next?” touched on the makings of the mortgage meltdown, its effect on the credit and stock markets as well as what it will take for the economy to regain its footing.

Before the discussion began, a short video showcased faculty from Emory University and its Goizueta Business School speaking to various news outlets, such as CNN, in an effort to explain the unraveling of the economy. They expressed concern, offered reasons, and, in the case of Tom Smith, assistant professor in the practice of finance at Goizueta, a tell-it-like-it-is attitude: “You can’t give loans to people who can’t make their payments,” he told a news anchor. “Now [the housing market] is settling and when things settle, there’s a lot of dust.” After the video ended, those in the room (and likely those who watched the discussion via webcast) reflected for a bit on its sobering content before Gilbert approached the microphone and began the discussion.

Years of easy money moved financial institutions to extend loans to individuals and businesses that were credit risks. The result? “Excessive leverage caused by overconfidence in new asset securitization investment products,” notes Jim Grissett, adjunct professor of real estate and founding partner of The Parthenon Group. The combination of record low interest rates and loose lending standards allowed millions of formerly non-qualified homebuyers to buy real estate. Demand pushed prices higher and builders got busy. Those who already owned homes refinanced, and others opened home equity lines of credit.

Back on Wall Street, financial institutions bought and packaged (and repackaged) risky debt, borrowed more money, and designed new financial products laced with subprime and adjustable rate mortgages (ARMs). These institutions used legal but less than transparent bookkeeping methods to ensure their AAA, or excellent, credit ratings—even though they had risky debt on their books. Such ratings allowed entities like commercial banks and pension funds to invest in these nascent financial products.

But in 2007, the real estate market cooled and interest rates rose slightly, triggering ARMs to reset at higher rates. Borrowers began to default and foreclosures to rise. As a result, mortgage lenders found themselves without a secondary market for their bundled loans, and they couldn’t raise capital. When government sponsored enterprises like the Federal National Mortgage Association, better known as Fannie Mae, and the Federal Home Loan Mortgage Corporation, better known as Freddie Mac, lost more than 2% of their collateral, it wasn’t good news, but it was “not the end of the world,” explains Grissett. But, he adds, when those loans are leveraged at a 40 to one ratio (which they were), it’s another story.

According to the panel, financial institutions had help getting into this mess. Public policy over the last two decades encouraged excessive leverage. In the mid-1990s, then President Clinton attempted to increase home ownership by pushing his National Homeownership Strategy. President Bush signed into law the American Dream Downpayment Act of 2003 and offered tax credits in an effort to increase minority homeownership.

Back on Wall Street, government regulations couldn’t keep up with (or reign in) the financial innovation and engineering on Wall Street. The roots of that innovation gap can be traced to 1987 and the reinterpretation of the Glass-Steagall Act, a move that then Federal Reserve Chairman Paul Volcker opposed. (Glass-Steagall was enacted in 1933 and not only established the FDIC, but included banking reforms designed to control speculation.) It was further altered in 1999 during the Clinton administration. While members of one party attempt to place blame for the meltdown on the opposing party, Greg Waymire, a chaired professor of accounting at Goizueta, calls the market’s downfall a “bi-partisan scandal.”

Adding fuel to the fire is “fair value accounting,” explains Waymire. “It’s making a bad situation worse,” he says, noting that as the market falls, an asset’s “fair value” falls. These losses are reflected on corporate balance sheets, causing a further downward pull on a company’s stock.

“This is not your typical financial market meltdown,” explains Lawrence Benveniste, dean, Goizueta Business School and a chaired professor of finance. Benveniste is equally, if not more, troubled by the larger implications of the market collapse. He believes the challenge facing the country and its politicians is more fundamental than a market correction. “This is about the bigger picture and the excesses of our country,” he says.

The U.S. far outspends what it earns (In 2007, the U.S. Trade Deficit was $708 billion) and other countries finance that deficit. The U.S. gross National Debt topped $10 trillion this year and, going forward, the government sector still faces huge spends in terms of social security and Medicare.

U.S. individuals don’t fare much better than their government. As of June 2008, consumer debt (which does not include debt secured by real estate) stood at $2.6 trillion dollars, more than $8500 for every man, woman and child who lives in the U.S.

According to the panel, consumer saving is the wise choice for the long run, but consumer spending makes up nearly three quarters of the U.S. economy. When consumers save, they don’t spend as much, and the market contracts. “When consumers drop their spending, it leads to a drop in GDP and is a signal that the economy is in trouble,” says Smith. The classical economic approach would be to let the contraction occur and the market adjust, but for several decades, the government “protected” financial markets by keeping interest rates low. “If we continue to do that, we’re putting off worse pain,” adds Benveniste.

As it is, the pain is bad enough. Unemployment hit 6.1% in September 2008, and October’s number climbed to 6.5%. By next spring, unemployment is forecast to top 7%. “It doesn’t bode well for the economy as a whole,” says Smith. “It’s something to be frightened about.” He adds that the biggest blows will befall construction, manufacturing and retail.

The global economy is taking a hit as well. U.S. consumer spending accounts for about 25% of the world economy. As U.S. consumers spend less, the global economy slips. Over the last year or so, the weak dollar has resulted in export growth robust enough to offset the weakening housing market. There is a danger that the recent boost in the dollar’s value could reverse that trend and be another drag on the economy. But, notes Ray Hill, assistant professor in the practice of finance, exchange rate changes typically take a year or more to affect trade flows, and should not affect the economy much in the short run. There is some good news, though. India and China will see their economies slow somewhat, but not much. According to Hill, economists are expecting China’s growth rate to fall from just under 10% to closer to 8% growth. “They’re still a good aggregate source for demand,” says Hill.

Hill’s optimism doesn’t make Benveniste any less jittery about the economy. He’s concerned that the quality of U.S. debt—considered the highest in the world—will fall in line with the credit status of European governments, making it harder for the U.S. to refinance the debt it already has. “People borrowed money to pay for things rather than save to pay for them. Now we have to pay back those excesses,” says Benveniste.       “We have to start living within our means—as consumers and as a government.”

Waymire shares Benveniste’s concern. “If we have a long term accounting scandal in this country it’s our government’s accounting,” he says. “We’ve built up massive liabilities that have the potential to bankrupt our children.” Don’t think it can happen? Grissett points to the recent troubles in Iceland, a country that accumulated a reported $10 in debt for every dollar of GDP before effectively going bankrupt in October.  The United States, notes Grissett, “has actual and potential liabilities of between $7 to $8 for every dollar of GDP if we add future entitlement obligations, such as Social Security and Medicare, to our existing debt and loan/pension guarantees,” Grissett says. “Policy actions now can reduce those future obligations."

Goizueta’s Hill goes further. “The government needs to be a better steward and save more,” he says, not hand out new loans and tax rebates in an effort to encourage spending.

As President-elect Barack Obama prepares to take office and tackle issues such as the U.S.’s troubled economy, the panelists encourage him to resist the urge to “quick fix” the situation via manipulation of interest rates. “My hope is that at the beginning of his term, he will put things in place for the long term not the short term,” says Gilbert.

 

Photo: Dean Lawrence Benveniste, left, with Jim Grissett, and Ray Hill.

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