American Enterprise Institute

April 28, 2008

[Edited transcript from audio tapes]

1:45 p.m.	Registration
2:00	Introduction:	Peter J. Wallison, AEI
2:15	Panelists:	Charles W. Calomiris, AEI and Columbia University
		Kevin A. Hassett, AEI
		Desmond Lachman, AEI
		John H. Makin, AEI
		Allan H. Meltzer, AEI and Carnegie Mellon University
		Vincent R. Reinhart, AEI
	Moderator:	Peter J. Wallison, AEI
4:30	Adjournment

Proceedings:

Peter Wallison:  Okay, I think we will get started.  Everyone take his or her seat.  I want to welcome you all on a pretty rainy and nasty day.  I am delighted that all of you came out.  This should be one of the more interesting conferences of the year and I can understand why you are all here.  This is the second conference on exactly the same subject. 

The last time these esteemed AEI economists got together to discuss the future of the credit crunch and the U.S. economy was in December of 2007.  At that conference, there was sharp disagreement about whether the U.S., as a result of the housing meltdown, the credit crunch and other factors, was headed for a deep recession, a shallow recession or merely a slowdown for a quarter or two.  The data presented at that conference showed a serious breakdown in trading in the credit markets and major losses in housing values. 

 Now these factors would suggest a serious recession, but at that point there was no clear evidence of a recession during the fourth quarter of 2007, at least.  The Dow, which opened at 13,339 that morning was down from its high of 14,000, but certainly was not signaling a serious recession.  All of the participants in the December conference thought that their predictions would be proved correct when several months of additional data was available, so we scheduled this conference to see whether, in fact, their positions have changed and whether things have become any clearer to our AEI economists.

 From the perspective of the non-economist, I must say that things still look pretty cloudy.  The Dow Jones is about 500 points lower than it was in December, but it has risen recently.  It's up again marginally today when I last looked.  Friday's Wall Street Journal noted this with the headline “Dow rises 85.73 as some investors shed fear.”  Since most of the buying was of financial stocks, banks and brokers, the fear that investors shed was probably that the credit crunch would deepen.

 If in fact the credit markets are returning to normal, that would be one reason for taking a deep recession off the table.  In this connection, it is useful to note that the three month Libor is 40 percent down from its 52 week high.  This first chart shows that the spread of mortgage backed securities over the ten year Treasury has declined substantially since the Feds moved in conjunction with the bailout of Bears Stearns in March.  But it is still 50 percent higher than it was last April and 10 percent higher than it was at the time of our December meeting.  And the very high jumbo mortgage rates haven't come down at all since December. 

 Nevertheless, it does look as though we are beginning to deal with the credit market fallout from the sub-prime meltdown.  Attached is Table Two or at least right here is Table Two.  It is a very interesting chart that shows recapitalization that has been going on among the banks.  This indicates, it seems to me, that we are not headed for what we have or what various people have called a Japan problem. 

 What you see there is that the banks in the last few months, since January, have recapitalized by raising about $212 billion in new money against about $308 billion in written down losses.  The recapitalizations will enable banks to begin lending faster without concern that their loans will further reduce their regulatory capital.  Sustained bank lending will shorten and reduce the severity of any recession. 

 In your materials is an article that I wrote a couple of months ago arguing that the real question of the sub-prime meltdown was whether the taxpayers or the shareholders would bear the losses.  At the moment, it looks very much as though it is the shareholders, and that is the way it should be.  The issue, as I saw it, was whether the banks would recapitalize, diluting their shareholders, or hold back in the hope that the government would pick up the losses. 

 The bank recapitalizations, which are probably forced by regulatory jawboning, seems to be answering that question.  Nevertheless, there are indications that some banks will not be able to recapitalize and will fail.  That will produce a market shock that could send the market reeling again because things are really quite fragile.  At the same time, the votes last week in the House Financial Services Committee significantly narrowed the number of sub-prime or other borrowers who are likely to be eligible for bailouts. 

 What this means, I think, is that the decline in home prices will be sharper, but will end sooner.  You can take your choice about whether this is good or bad.  The important thing in my view is that the losses are recognized by the financial institutions and appropriate actions are taken, and that appears to be happening.  Finally, a few weeks ago the Business Roundtable published a summary of the views of the CEO members at the Roundtable about the future.  And the best summary of this summary is a slightly better economy, in their view, in the months to come. 

 As you can see, that first sector at the top on the left, how do you expect your company's sales to change in the next six months, 70 percent of them believe there will be an increase in sales.  So overall, there is a modest improvement, but the key issues, how far will home prices fall and whether there will be failures among the banks and other intermediaries, these are still major unknowns and this is just right for commentary by our economists.  We will go in alphabetical order, as it turns out – it's probably the best way to get these people to talk anyway given what their positions are likely to be.  And so we will start with Charles Calomiris. 

 I'm not going to introduce them at any length because I think that all of you know them, either by watching television or reading the stuff that they write, so I will just say a sentence or two about what they are doing now.  Charlie is a Visiting Scholar at AEI and he's co-director of AEI's program on financial market deregulation.  He is the Henry Kaufman Professor of Financial Institutions at Columbia Business School and a Research Associate at the National Bureau of Economic Research.  Charlie?

 Charlie Calomiris:  Thanks Peter and welcome everybody.  It's a pleasure to be here.  What I've done for the presentation today is use exactly the same slides that I used before, except I updated the data and I don't think I changed ten words in the slides.  I guess what that is meant to indicate is that I think that probably I was right before, although I want to emphasize that I agree with Peter.  I learned a saying as a young man, “Today's peacock, tomorrow's feather duster.”  And so I don't want to be too effusive in my self-praise, except to say that I do think that it was forecastable. 

 Of course, there is uncertainty in the economy, but I do think that there were elements of this turmoil from the very beginning that gave us reason for optimism and it set it apart from the experience in 1989 to 1992 and, of course, very far apart from the 1930s.  I am not going to discuss it, I've already discussed it.  I will highlight a few of those issues, because I only have 15 minutes. 

 What I want to do though is say that I very much underline my view last time was explicitly the forecast that banks would be raising capital and not just that the regulators would try to get them to.  Remember, regulators don't actually regulate capital, they regulate capital ratios.  Regulators really pretty much can't make banks raise capital.  What they can do is make banks either raise capital or shrink assets.  And when banks are faced with severe problems of asymmetric information in markets that make it very difficult for them to raise capital, they choose to shrink.  That is what happened in the '30s, that's what happened in '89 to '92. 

 What I was forecasting, which I think has turned out to be true is, that despite much of the confusion in the markets, that the banks were in sufficiently good position and that there would be sufficient ability to resolve that confusion that they would be able to significantly access capital markets.  That was the real prediction, the real uncertainty, the biggest uncertainty, in my mind.  And as you saw from Peter's slide, all of that capital was raised since December.  So that is the sense in which there really has been a significant piece of news and that is what is very gratifying for me, since I stuck my neck out and predicted that it would happen. 

 I'm not going to review this slide except just to point you towards it.  This was exactly the same slide that I used last time, except I added a line here which I think was missing before just to explain how we got where we are.  I am going to skip over that.  Remind you of how abrupt the financial innovations of the last five years had been in terms of CDO issuance, mortgage backed securities, making use of sub-prime.  I spent a lot of time talking last time about how inappropriate the risk measurement was and how it had been inappropriate ex ante. 

 And many of us had criticized it and saw it, particularly the ratings agencies, confusing use of triple B or double A or single A to mean completely different things when they were looking at structured products and at normal corporate securities as one of the key contributing problems.  And also the way the ratings agencies had failed to do appropriate stress testing of the sub-prime. 

 One of the things we pointed out last time was that the crisis has been very localized.  It hasn't affected everyone.  Even financial commercial paper issuers have been – that is, the ones that aren't directly related to sub-prime – were not really very hard hit by it and non-financial commercial paper issuers weren't affected at all. 

 But we had about half a trillion dollars of runoff in that first stage of the crisis coming from sub-prime related problems and working capital management by the large banks in the form of SIVs or asset backed commercial paper conduits that had to run off a lot of commercial paper.  That was the first part and I think I correctly forecast last time that we wouldn't have a return of that and we haven't.  That was a one time shot. 

 Why this happened?  One of the things that I want to emphasize for those of you who weren't here last time is part of the problem here was that the financial system learned the wrong lesson in 2001 and 2002.  Actually, it may surprise you that, just look at this graph, you can't see it very well, but the top line here shows you that the peak foreclosure experience in the sub-prime mortgage market was in 2001, 2002.  We still haven't gotten back up there.  And that is going to be a surprise if you haven't heard that before. 

 Of course it was a much smaller market, but it experienced very high foreclosure rates.  But since the housing market was booming, the loss given default in sub-prime in that experience was only 6 percent.  That's how you got liar mortgages, no docs mortgages from a perception that it didn't matter what people's credit worthiness was, because housing prices can't fall.  Sounds a lot like Japan in the 1980s, right?  Real estate prices never go down.  That was the mentality then in Japan and it was very much the mentality here about sub-prime.  And that was built into the ratings agencies assumptions; it was known to be wrong. 

 The other thing built into them was grade inflation; it was very self-conscious.  A triple B CDO, as of 2005, a triple B debt coming off of a CDO as of 2005 had a five-year default probability of 20 percent.  A triple B CDO corporate bond had a five-year default rate of 2 percent.  Obviously, triple B did not have a meaning that was common to all securities.  From last time again, what are the likely macroeconomic consequences, and I stress two likely transmission mechanisms of adverse consequences. 

 One, credit supply contraction; the other, housing price decline.  And I argued and remain with those arguments that the credit supply wouldn't be severe because banks would be able to raise capital, that they had continuing profit sources, they were much better diversified and that the losses would not undermine their ability to grow.  And that they would be bringing capital from outside and growing their loan portfolio rapidly. 

 And of course, in fact, the last four months have been among the fastest growth period in U.S. bank lending in post-war history, as I will show you in just a minute.  What about housing prices?  I argued that the Case-Schiller Index is a flawed index, that the Median Home Sales Index is a flawed index.  And that, in fact, there are reasons from a macro perspective to prefer the OFHEO Index, which gives us a much brighter picture. 

 And I talked a little bit about some of the problems in the construction in some of these indices.  I still believe that, and I also believe that the wealth effects are overestimated by most macroeconomists when they think about the effects of housing price decline and that they are probably more like half the size that most people estimate.  That led me to the conclusion that this is not going to be 1989 to 1991 for both of those reasons and one additional reason, and this is something again that needs to be emphasized. 

 The Bush 2003 dividend tax cuts had an effect that was exactly what they intended, which was to reduce leverage, excessive leverage that was there to try to take advantage of tax advantages of debt.  And leverage, corporate leverage has fallen since 2003 like a rock.  This is very important to bear in mind as we go forward.  What it means is the debt positions of U.S. corporations are back to where they were prior to the 1980s, giving huge debt capacity to those corporations and we are seeing a lot of debt being raised right now.  And that again takes the pressure off of the banking system for large corporate borrowers.  That is another very important fact to bear in mind.

 These are pictures of the growth of bank lending, whether you looked at the large weekly reporting commercial banks or the overall banking system, and you can see huge growth that has been made possible by that continuing growth in profits and also outside capital raising.  This gives you the jumbo and the conventional mortgage rates. 

 The key point here I would make is yes, it's true that the jumbo rate has edged up, but let me take you down to Latin America when a financial crisis causes interest rates to go up a little bit more.  What has really been happening here, of course, is the bottom line shows the Fed has been targeting this mortgage rate effectively and just reducing interest rates as need be to keep that mortgage rate from going off into the sky.  That is one way to look at this graph.  The money market rates have come way down; we are currently at I think too low a Fed funds rate at two and a quarter percent. 

 I will skip this in the interest of time, but the point here is how interesting some of the new patterns in money market spreads have been in this crisis.  Maybe during the question and answer, we can come back to that, what is the meaning of some of these very unusual spread movements that we've seen.  Some of these unusual movements have been persistent.  They are the part of this crisis that has surprised me, that they haven't corrected themselves more, particularly the overnight Libor relative to overnight Fed funds, which I will point to in just a minute. 

 How accommodative is monetary policy right now?  When you look at real Fed funds rate, we are in a position that we've only seen about five times in the post World War II period in terms of the real Fed funds rate.  And in my view, actually, that is – it's even worse, because my expectations of inflation are higher than the market consensus.  So I think we are in an extremely accommodative position in monetary policy. 

 My view is that the Fed has done the right thing on the discount window consistently and I praise them for it.  I think they have overdone it on the Fed funds rate and that, by the way, I noticed was the theme that came out of today's Wall Street Journal lead editorial.  This is the graph of the spread between the overnight Libor and Fed funds reflecting the fact that large banks and lending to each other still are not lending at very low rates. 

 That reflects a combination of counterparty risk perceptions among the large borrowers, because the Libor is a big bank to big bank market, as well as just a general hoarding going on by large banks still to get back to their equilibrium liquidity position.  So we are still seeing a stubborn persistence of high Libor rates that makes us think that we are really not done with the money market part of the adjustment, the liquidity part of the adjustment of this.  Credit spreads, which is the bottom graph here, have risen and that is good news.  They were way too low; they are back to about normal. 

 I will predict that that triple B spread will fall to below 3 percent, let's say within six months, but shouldn't fall much more than that.  The good news is the stock market has kept itself fairly high.  Credit spreads, you can sort of see the turmoil as happening in three waves and I have two spreads here.  One of them is the credit default costs as indicated by the CDS spread, credit default swapped costs.  And you can see the three waves there.  We are now in a position that is much lower than it has been during any of the three waves.  The orange graph, though, is Fannie and Freddie spreads over Treasury and you can see those have actually gone up recently.  And the reason for that is that we've expanded Fannie and Freddie's roles since this point and expanded their riskiness. 

 And so this is a concern.  It's not a concern about the crisis so much as it is a concern about how long-term policy towards Fannie and Freddie has now given us a new long-term risk because we've given up on capital regulation and portfolio restrictions that we shouldn't have given up on.  This is the point I was making about how much post-2003.  Corporate leverage has fallen like a rock and those of you who are thinking it's a good idea to repeal the Bush tax cuts, take a good close look at this graph and think how much worse off we would be if we hadn't gotten all of that excess debt capacity since 2003.

 Housing prices, I will just be very brief and say that I think the last two months have given us a brighter picture of housing prices in the data, but it doesn't surprise me.  I think that – I'd like to talk a lot more about housing prices.  I have another paper, which I'd like to present here actually at some point, maybe in a month, on the relationship between foreclosures and housing prices going forward. 

 And I will stay with the prediction I made last time, which was according to the OFHEO combined resale and refinance index, that peak to trough, we won't see a nationwide decline in excess of 10 percent, and I will stay with my 5 to 10 percent range.  Nothing like the very irresponsible and really almost crazy statements by some economists, none of them are on this panel, by the way.  No, and I mean that sincerely – by people like Nouriel Roubini or Bob Schiller, who I think Bob Schiller I think said that housing prices might fall by 50 percent in the U.S. – just ridiculous, and nothing like that. 

 And actually last time, even though we differed in our interpretation, many of us I thought, I think John and I specifically said we thought about a 10 percent decline was about what we would expect.  Maybe John will revise that view, but that is still my view.  Case Schiller is a very untrustworthy index.  Regionally it is not constructed in a way that gives us the kind of indications that we want for the whole economy or for the segment of the population that is most subject to wealth effects coming from house price declines.  So I won't say any more about it, except just to say that I am not a big fan of that index. 

 There is real concern about the connection between foreclosures and house price declines, and that is what my next paper is all about.  There is going to be a continuing pressure on house prices to decline because of foreclosures, but there is a good news story, too, which is that housing starts have been in decline for a very long time prior to this crisis and so the pipeline has not been increasing for over a year. 

 What we are going to see is I would say that by September, we will be back to a more or less an equilibrium in terms of inventory and I think that this is the reason for that.  So the good news is that the housing price slump – I'm sorry, that the housing slump in housing starts long predated the crisis and that's helping us a lot looking forward and what we are going to end up with, with housing prices.  So severe recession risk is minimal for all of the reasons I've said before and I think that this has, so far, been true. 

 I've already talked about Fed policy.  Foreclosure relief, I've said before, I think, and I will stay with it, I think we should be doing more.  I think it's a waste of money.  We've spent $160 billion on this completely useless fiscal relief package.  It's all politics.  We should have spent $20 billion on encouraging efficient foreclosure avoidance.  We could have done it, we still may do it and I will leave that for the questions and answers. 

 Bank regulatory response – of course, I wish I had spent all of my time on this topic because this is one of my favorites.  I think it has taught us how bad the Basel II standards really are and it has taught us a lot of other things.  We need to increase capital substantially phased in over time for U.S. banks, I think, among other things.  Reforming the GSEs, this is one of the tragic aspects of this crisis is how far we've gone from the right direction on that policy.  Inflation is really worrying me here. 

 You can see I'm a fan of the discount window, I'm not a fan of the Fed funds rate reduction.  Look at commodity price acceleration, industrial commodity prices have been booming.  Look at the spread between the Fed ten year tips and nominal Treasury showing you inflation expectations are rising substantially.  And if you look at, it's not just the U.S. that is experiencing this, especially countries that have tied themselves to a dollar exchange rate, but more generally all of the world is seeing much higher inflation.

 So for this sample of countries, Panama, Saudi Arabia, Hong Kong and China, inflation now approaching more than 8 percent.  So I think that we do have some corrective policies to do and hope the Fed doesn't keep expanding the mistake, which I would put at about 75 basis points too much expansion so far.  Thanks.

 Peter Wallison:  Very good Charlie, thank you.  Kevin – let me first say a few words about Kevin.  He is the Director of Economic Policy Studies here and a Resident Scholar at AEI.  He is also a weekly columnist for Bloomberg.  And for Kevin and everybody else, there is quite a lot of biographical material in your kits.  Kevin?

 Kevin Hassett:  Thanks a lot, Peter.  If we go back through the wayback machine to the last conference, then my humble contribution was to discuss an article I had just written in The New York Times which was the real time output of a book that is now in editing here at AEI that I have been writing with Jim Hamilton of the University of California at San Diego and Marcelle Chauvet at Cal Riverside. 

 And what we've been doing is developing, especially Marcelle going all the way back to her dissertation was working on this area, developing real time models that help you call when you are in a recession or not.  And the basic idea is that the National Bureau of Economic Research is the official arbiter of whether we're in a recession and they very often tell you you're in a recession on average, I guess it's about seven to eleven months after the recession begins.  And since a recession lasts, on average, about eleven months, then you can sometimes find out you are in a recession after the recession is over. 

 And when we were meeting late last fall or early in the winter, I guess – I forget which side of the solstice it was – but it seemed to me at the time that everyone had made up their mind that we were in a recession.  And this model that Marcelle and I drew up on our New York Times piece is a very effective model of a recession that takes the data and then reproduces calls that the National Bureau of Economic Research would make, although many months later.  In fact, the model had called every recession correctly, reasonably precisely down to the month in post-war history without ever giving a false signal. 

 The message, as of last December, but then we were really talking about hard data through October, as I recall at that point, was that there was no recession as of October.  I had about half of the data for November and I said it doesn't look like November, either. 

 And so the conclusion of my talk was that I am not nearly as able as my colleagues to do it for a living to think about what the future might hold, but I'm pretty good at forecasting the past in this case and that I was reasonably comfortable saying that we weren't in recession at the time.  And if a recession was going to begin, then it would have to be in December – I think that was the punchline. 

 Well subsequently, we've had, some time has passed and we've drifted down the river and we've had a few more months of data.  I now have complete data for December and January or we do, Marcelle ran the numbers last week.  And there was absolutely not a recession in December, absolutely not a recession unless we kind of change the definition in January. 

 In February, the data took a marked turn for the worse and we're at that point now that is most frustrating for econometricians, the point that is most, I guess annoying to be at, which is that the model says that the probability of recession for February is about .5.  So the last time I talked – how have things changed? 

 The last time I talked I said I don't know if we're going to have one next year or not.  I think that some of the things that the folks over here to the left of me are going to say are pretty disturbing and may give you pause, but on the other hand Charlie was kind of pumping me up and I wasn't sure.  But I was really sure that we weren't in a recession yet. 

 And so I've changed quite a bit because I've gone from being really sure we weren't in a recession yet to now suspecting that when I end up having my complete data for February, that it will show that a recession began in February.  But the second New York Times piece hasn't been written yet because we don't have, February is not a complete story and it's right at a point that is frustrating.  So if it finishes February at point five, then we will have to wait for March to see. 

 So again, though, note that this is a remarkably different place to be than it seems like the popular culture has taken us to where in if we call a recession the same kind of thing that happened before when we called it a recession, then it's not obvious that we are in one yet despite all of the awful things that have happened.  And that is to me actually pretty remarkable. 

 Now looking forward, I think that we have to think about where we are going to go from here.  I think that there are a number of new factors as the tax policy person that one needs to point out.  Let's assume that the model does end up convincing us that the recession starts in February, so then that means that well, if it's typical then it will probably last through until about the end of the year, so we will have a bad year.  It will be a really opportune time for the next president to arrive, because if you arrive right at the trough, then every growth comparison to anyone else will always be favorable.  So we are looking like something that could run towards the end of the year, but then the question is what has policy done to make it so that it will be shorter or longer? 

 And in that regard, I will leave the discussion of monetary policy to people who are far more able than me to discuss that, but it looks like there has been a heck of a lot of stimulus since our last meeting.  And if we are basically riding about flat last year, not quite in recession and riding about flat as near as we can tell right now, I asked some economist friends of mine who do this for a living, what first quarter GDP was.  The high estimate I got was about 1.3 and the low estimate was about zero. 

 So first quarter GDP, it could end up negative, but it is a little bit positive.  It is not really negative, which is one of those things that you're looking for, for a recession.  And so we're running about flat and then we've thrown all of this stimulus in and so what's the risk going forward?  Well, it could be that finally the bad things we've been fearing happen or it could be that inflation gets really out of control and certainly commodity markets are fearing the latter. 

 What has policy done outside of monetary policy?  Well, the stimulus package is going to have probably a small effect.  If we use back of the envelope approaches to think about how much – so the stimulus package is probably worth maybe half a percent, a percent of GDP the second half of the year, and that is if you're optimistic about people consuming from a temporary tax cut. 

 The literature on that I think is mixed.  People inaccurately have cited a paper by Jonathan Parker, which looked at the last tax cut and found that people consumed it and then concluded that the stimulus would be large.  The comparison is weak because the last time we did this we gave people a permanent tax cut and so even Milton Freedman would concede that they would consume a lot of it – at least permanent as long as the bird rule applies or you get your ten years of Bush tax cuts.  But this time it is really explicitly temporary, so you might expect to see a very, very small effect. 

 The last policy thing that I think we have to start thinking about in terms of what is going to happen to this recession if we do kick in in February is that there are a heck of a lot of policy variables on the table, both for the next president and also I guess to be discussed during the campaign.  And those policy variables, I guess there are two main ones.  One is the deficit and the other is the marginal tax rates. 

 If you crank the numbers for Senator Obama, assuming he is the nominee – I guess nobody really knows for sure – then the top marginal tax rate on labor income for Mr. Obama is, after you account for interactions of things, about 52 percent.  It goes from the current rate to about 52 percent.  He gets that high rate on labor income because he removes the cap on the payroll tax.  The top marginal tax rate on non-labor income for wealthy people is about ten points below that, so it's a lot higher than where we are, but not nearly the big marginal tax hike up to 52. 

 That difference, however, is exacerbated, like the gap between where we are and where we might be under Mr. Obama, is exacerbated by the fact that he is going to argue for an increase in the capital gains tax rate and it seems a repeal of the dividend tax cut, although I find the positions at times murky on these things.  But if the dividend tax were to go back up to, say, a top rate of 42 percent or something, then we would be talking about a kind of change that would have really a pretty dramatic effect, I believe, on equity markets. 

 I think that if we go back and look at the dividend tax cut before, then you can sort of back out that maybe a 7 or 8 percent celebration occurred in equity markets because of the dividend tax reduction.  In this case, we might be more than reversing it.  And with a 50 percent probability, if you think that it's a coin flip election.  And so that means that as we head into the fall, there is a significant amount of tax policy uncertainty that you might really begin to see in financial markets. 

 Now the last time around, I had a paper in the American Economic where we looked at the behavior of the futures markets, options markets in response to presidential futures and teased out that there are really bit and significant effects of tax policy on equity markets around the election basically with higher taxes being more likely when Kerry's future was very positively traded. 

 And so what that means is that as we think about how we get through this recession, the policy thing that I want to add is that we're about to enter a fall where there are going to be some pretty big policy stakes potentially that might really move markets around as markets change their priors about how Mr. Obama is doing.  I guess I have to – full revelation, I'm not speaking in any way for a campaign at the moment, but I do advise informally Mr. McCain from time to time. 

 But I think that this policy uncertainty has the potential to be really big in financial markets, and not just that, but another area where you might see it would be in municipal bonds markets.  Because if marginal tax rates are going up a lot, then that has a big impact on the relative price of muni bonds and it is something else to look for.  And so then to summarize, I think that last time I was sure that we weren't in a recession yet, this time it's close. 

 I guess if you are a betting person, you might argue that getting all the way up to 50 means that with a little bit more data revision, we will be over the top and it will look like February will be the start of the recession.  I think that policy, on the one hand, might give us a little half a percent or so from a not so bad level over the rest of the year, but that uncertainty about future policy, which would be of a much larger scale, might have an effect in the opposite direction.  And so for me, the way I'm feeling right now, is a little bit worse than the flatness that we've been riding and maybe lasting a little bit longer than we might have thought.

 Peter Wallison:  Thank you very much, Kevin.  We are having a little bit of difficulty with the computer, so you all should have in your packages Des's slides.  Des, I think you are going to be talking from slides, is that right?  In any event, let me just talk about Des a moment while we’re waiting for something to happen.  Des joined AEI as a Resident Fellow after serving as the Managing Director and Chief Emerging Market Economic Strategist at Solomon Smith Barney.  He was previously the Deputy Director in the International Monetary Fund's Policy and Review Department and was active in the staff formulation of IMF policies towards emerging markets. 

 Desmond Lachman:  I was quite prepared for this.  I have worked in New York for awhile at Solomon Brothers, and the first thing that I was told at Solomon Brothers was you didn't have to worry about anybody stabbing you in the back; at Solomon Brothers, they would stab you right up front.  So that is how I am feeling right now.  Thank you very much, Peter and thank you very much for arranging this seminar. 

 As I said at the last seminar, I hope to do this in six months time, but I hope that we don't have reconstructionist versions of what we said at the time.  My recollection is that I was very clear that we were headed for a recession, that there would be a lot of problems in the financial system.  And my recollection is also that I didn't get much support at this table for those views.  So let me be quite clear about what I am thinking right now. 

 I think that I take quite a different view from the previous speakers in that I think that the outlook is not very bright, to use a euphemism.  I think that what we've got here is a recession that is going to be very much longer than the normal recession and what we are going to get is we're going to get a recurrence of problems in credit markets.  This time around, what is going to be occurring is that the weakness in the economy is going to be feeding back into the credit market.

 Just to begin with my slide presentation, I thought it would be useful just to take stock of how things have changed since we were here in December and in particular, to take note of a couple of people who seemed to be coming around to my point of view.  Let me start with Alan Greenspan, who is perhaps the architect of the mess we are in, who is now describing the situation as the most wrenching credit crisis in the post-war years. 

 Wanting to outdo him, we've got Paul Volker describing the present crisis as the mother of all crises.  Ben Bernanke has recently acknowledged that output in the first half of 2008 could have contracted in the United States, but more importantly what he's done is he's led the Fed to adopt measures that they haven't resorted to since the Great Depression. 

 Just to round this out, we've got Marty Felstein who has some influence on the National Bureau of Economic Research who dates these recessions and will tell us how long it is, who is talking about this being very likely to be a severe recession.  And then finally there is the minor issue of the data, we've lost 230,000 jobs in the first quarter of the year and consumer sentiment now is at its lowest level in the past 25 years. 

 What I did in December was, the reason that I had a pessimistic view of the outlook, was I thought that there were a confluence of three factors that were impacting the economy.  When I asked myself where are we going now, I asked myself are those three factors still in play, have some of those factors perhaps got worse and my answer is indeed, those three factors are in play and a number of them have certainly got worse. 

 What I am referring to, of course, is the housing bust.  I just refer you to a chart, which shows that house prices now in real terms have fallen by something like 14 or 15 percent the past year.  And that when we look at the rate at which they are falling, this is from the much maligned Case-Schiller Index, that the last quarter we've got house prices now falling at 20 percent. 

 So in terms of the housing market, I would suggest that not only have we got a bad situation, which I'm wanting to talk about a little bit more, but it is accelerating.  The pace, if you like, the second derivative is positive, which is problematic.  We've seen that also, you know, just in terms of mortgage equity withdrawal, which was a big support of consumption.  That is now just evaporating.  So that is the first part of the crisis that bothers me. 

 The second is the credit crunch and some of the slides that have been shown before which suggest that despite the Fed cutting interest rates by 300 basis points, borrowing rates are, for the most part, above where they were in August last year.  So I'm not sure how stimulative the monetary policy is, I'm not sure why one would look at the Federal funds rate adjusted for inflation when what we are getting is we're getting the long end of the curve not coming down so much and spreads widening so that the borrowing rates are high. 

 In addition, what we are getting is we're getting contraction of balance sheets and once again, I wouldn't look at the banking sector, simply at the banking sector.  I would be looking at the whole financial system.  Banks today only intermediate something like 30 percent of overall credit as opposed to something like 50 percent fifteen years ago. 

 The third shock that I would suggest has got a lot worse than when we were here last time is international oil prices.  My recollection is in December, they were at $85 a barrel.  Today that is about $120 a barrel.  So when I take those three shocks together and see that they are still in play, still some of them getting worse, I am not sure that I see what the case is for thinking that this is going to be a short, shallow recession. 

 I would add that what we've had is we've had stock prices declining, we've had debt prices declining, which is a further drain on wealth.  And a point that I will come back to, which I think is rather important, is that we are now getting very clear signs that the commercial real estate market, which was booming last year, is now entering into a bust.  So there are very many reasons, I think, to be concerned. 

 Let me just go through the housing market rather quickly, the reason why I'm concerned.  And the reason that I'm doing this is twofold.  I am suggesting that if we don't get stabilization in the housing market, that could be very important for consumption, which after all is 70 percent of aggregate demand.  And the reason it could be important for consumption is that housing is the largest asset, largest component of wealth in private portfolios. 

 And secondly, it makes it difficult for people to borrow against their homes, which is the way in which they were financing their consumption.  The second reason I think one wants to focus on the housing market is that the bigger the bust that you get in the housing market, if it's true as I would suggest that housing prices are probably going to decline another 20 percent before this is all over, what we get is we get an amplification of the losses that we're going to be getting in the financial system. 

 Those losses, incidentally, are already estimated fairly widely at something like a trillion dollars, of which only something like $250 billion has been recognized by the financial system.  So I'm not sure that I see that we're at the end of the tunnel. 

 Let me now just run through quickly the part of my reasoning why we are going to get housing prices declining by 20 percent.  This chart is just showing you, using the OFHEO index, how much we got away from equilibrium during the boom, that you can see that there is a trend line, that that looks like it's something like 30 or 40 percent above what the trend is.  If I do this in relation, if I scale it as I correctly should in relation to income, if I look at a house to income ratio, I come to the same conclusion that that ratio rose from something like 3.2 to 4.5.  So that alone would tell you that coming back to equilibrium would require a rather big package.  But I would rather focus on what are the facts on the ground. 

 If I look at the housing market inventories of unsold homes are now something like a million units above what is a normal level of inventories.  Or if you want to look at it in terms of ratio to sales, we've got the ratio to sales housing to sales at something like ten or eleven months supply, which is the largest that it's been the last 30 years.  So we've got a situation where we've got excess supply on the market and what I would suggest is that is only going to get worse for at least three reasons. 

 The first is just in terms of the financing of the house markets.  If you look at what occurred in 2001 and 2006, in 2006 something like 40 percent of the financing was coming from sub-prime lending and alt-A lending.  You fast forward to the fourth quarter of 2007, what we've got is 90 percent of the lending is coming from the GSEs and that the amount of lending has contracted from a rate, an annual rate of $3 trillion in 2006 to $1.8 trillion in the fourth quarter of 2007.  So the financing side is going to make less demand for houses. 

 You see it also, if you just look at the lending condition index, the survey that the Fed does, that is really just going through the roof.  That is back in January.  I would expect the next quarter to be even worse than this, so we're going to get less demand.  We are going to get also a question of resets.  That might not be as serious as it was when I was talking in December because we've had some interest rates coming down, but nonetheless, it's going to come into play on the reset. 

 What I am really concerned about is the story on the foreclosures.  Foreclosure procedures that have already been initiated in 2007 are literally going off the chart.  That what we're getting is we're getting something like double the rate.  Instead of at 900,000 units a year, which was the story in 2006, we are now at something like 1.8 million units in 2007.  And there is a lag of something like 12 months, 18 months before those houses hit.  So we've got a real problem on the foreclosure side.  Foreclosures are going to come on to a saturated market. 

 Another way of looking at it, which I find rather scary, is that the equity in people's homes has now dropped.  The average household has only got 47 percent equity in his home.  It is the lowest it has been in the post war period.  And the chart that I have constructed is that if house prices fall by 10 percent in 2008, this histogram just shows that you're going to have a third of households having negative equity in their homes and this great land of ours with non-recourse loans, people have got every incentive to walk away from their houses.  So I am not sure that we stop a foreclosure problem, even if we have the Frank Dodd bullet in place.  If you don't want to take my word for it, just take a look at the forward market. 

 In the Case-Schiller Index, just looking around major cities in the U.S., something like Los Angeles, over 30 percent decline the next two years in house prices.  Just eyeballing that, it doesn't seem to me unreasonable to expect house prices to fall this year by something like 10 to 15 percent and probably fall by a similar amount next year.  As I mentioned, I am not only concerned about the housing sector, I am concerned about the non-residential construction sector. 

 What you've got in 2007 was that as housing was busting, you were getting a boom in commercial real estate.  All of the indications are telling you that that has turned.  The last three months have been pretty negative for commercial real estate and looking forward, when you see what is happening with lending conditions on commercial real estate, the expectation is that that is going to be busting further, which I think just compounds the story on the credit crunch. 

 Let me just briefly say a word or two about the credit crunch.  As I've mentioned, my read of the credit crunch is because of the credit crunch, we've had spreads widening.  This has been going on since August of last year, borrowing rates are no different than they were August of last year, so we've really got a situation that I would not describe as accommodative.  And the second point that I would make is that balance sheets are being shrunk, not simply on the banking side, but outside of the banks we are already getting a process of de-leveraging occurring--that my expectation is that that continues.  I just thought I would put up one or two more slides. 

 This slide just suggests that if the line in black is the way in which credit conditions have tightened as measured by the Federal Reserve survey for the banks.  And what it does is it just pushes it forward by four to six quarters, which is the lag.  One doesn't expect as credit conditions tighten in the banks, one doesn't expect bank credit to fall immediately because what happens is people either draw their lines or if they can't be borrowing, if they can't be placing their bonds in the market with a high degree of securitization, they go to the banks.  But what occurs four to six quarters later is what we are going to be getting, is we are going to be getting, at least in my view, a contraction of credit.  Some of these other charts have been before just in terms of interest rates not being very different than before. 

 This is the chart that I just think needs some attention paid to.  It is really just looking at the amount of intermediation through banks and through the securities markets.  And what you see the last 25 years is that basically the action is ready in the security markets rather than in the banks.  So that if you've got problems, if you've got shrinking of balance sheets on Wall Street, I think you've got a problem for the economy.  So where I am is that the recession is going to be longer, deeper than before. 

 I think that it's not too early to be thinking of additional stimulus measures and I think that we might have to resort to the non-orthodox measures that have been talked about to put a floor under the housing market if we're not going to get a really deep recession. 

 Peter Wallison:  Thanks.  Does anyone wonder why he says all of that with a smile?  The sedatives are in the back, incidentally.  Our next presenter is our colleague John Makin.  John is a visiting scholar at AEI and he is also a principal at Caxton Associates.  He has been an advisor to numerous U.S. government agencies and Federal Reserve system and the Bank of Japan.  John?

 John Makin:  Thank you, Peter.  I don't have slides because Desmond's are so good – I don't really need to go through them again.  But the title of the Outlook that is in the package that you have is called, “Denial, Hope and Panic.”  And we certainly have heard some denial up here today, not from Desmond, but from my colleague Charles Calomiris, who I often wonder what planet you are living on.  But let me try to make that case.

 Peter Wallison:  We don't get personal here, do we?

 John Makin:  Well, your numbers, I don't know where those came from, because I have data from the bank credit analysts on capital infusions and they are somewhat below yours.  But anyway, look, I am concerned here because we have an audience in front of us that is probably trying to figure out where the economy is going.  And when they get through listening to this panel, I expect they will probably be very confused because they are hearing very different interpretations of what are supposed to be a set of facts. 

 So what I am going to try to do is suggest a very basic theme that economists have looked at over at least a century, two centuries really.  That you have two things going on; you have the financial sector and you have the real economy.  And in this particular episode that the United States is in, you have a crisis in the financial sector that is being driven by a rapid drop in housing prices and you are having a crisis in the financial sector because it is chock full of securities that were written conditional on the assumption that house prices don't go down. 

 And the value of those securities is very difficult to ascertain and they have a huge bearing on the financial well-being of many of the institutions that we're looking at, the commercial banks and the investment banks.  The reason that I am a little bit surprised to hear the idea that everything really is okay and we never had a problem or bad things might happen – bad things did happen in March. 

 Let me tell you that if the Fed had not stepped in, if the Fed had not stepped in on Sunday, March 16th to – I don't know how to put this, did they rescue Bears Stearns?  No, actually they rescued the investment banks.  The Fed essentially stepped in in order to stop a run on the investment banks from their counter parties.  The counter parties to investment banks are analogous to the depositors in commercial banks. 

 I know that most institutions in the financial sector on Sunday, March 16th, were sitting around their conference tables watching the screens waiting to see what the Fed was going to do.  And if the Fed had elected to do nothing, Bears Sterns would have failed and a list of investment banks that I will not name would also have failed.  And so the Fed really had no choice but to take the extraordinary measure really to do two things.  They opened the discount window to investment banks, which is almost unprecedented. 

 And secondly, they took $30 billion of toxic crap from Bears Sterns' balance sheet on to their balance sheet and then turned it over to Black Rock to manage for them.  Of course, the head of fixed income at Black Rock is none other than Peter Fisher, the former manager of the desk at the New York Fed.  I suppose, I mean my own nervousness about financial market is probably driven somewhat by my intimate involvement in this and the days I spent in early March moving funds out of Citibank and into Treasury bills while Treasury bill yields reached as low as 60 basis points. 

 So if nothing was really happening in the credit sector, I wonder why there was such a run into absolutely safe assets if the yield on Treasury bills went to 60 basis points.  If everyone was sitting around saying – hey, it's going to be fine, no problem, there would not have been a virtual panic run out of banks and into Treasury bills. 

 But part of what happened on March 16th is very important.  The Fed took away the downside, that is the Fed took away the incipient run and collapse of the investment banking system by opening the discount window to those institutions.  And I think the analogy is, you know, when someone is beating you over the head with a two by four, which is you have an incipient collapse of the investment banking system, when they stop beating you over the head, you feel better. 

 So one of the things that happened was that the Fed, I would argue the Fed never should have been putting itself in the position they were in on March 16th.  And had they not been so casual about how bad the economy was and had they not been too slow to move on remedying those problems, had they not been so complacent, they wouldn't have been in that position.  But given that they were, they had no choice but to try to stop a run on the investment banking system, and they succeeded. 

 And so when you say that well, people are now raising capital, they are.  Lehman Brothers and other investment banks are raising capital because the Fed’s essentially put the safety net under these otherwise aggressive institutions so that they can raise capital.  In effect, they are diluting common shareholders by doing so, but they are raising capital. 

 I would point out, however, and this is in the Bank Credit Analyst last week, that level three capital, which is basically the junk bin that banks and investment banks use to put assets that they choose not to value into is still running about $568 billion out of a trillion dollars of total equity capital in the banking system.  Equity three capital is basically stuff that they don't want to value and so it suggests to me that some of the incipient risks that Desmond is talking about are still there. 

 So I think that one of the reasons, and I'm trying to account for my own different view here, one of the metrics for being concerned about a financial system in the economy is probably how close you are to it.  Maybe I'm too close, but in my view, we were too close to where I didn't want to go, which was to which Bear and a bunch of other investment banks go under.  By the way, the rules were pretty well followed with Bear.  The rule is let the shareholders go and protect the depositors.  The depositors, in this case, were the counter-parties who were protected. 

 Most counter-parties had already abandoned Bear and were preparing to abandon all of the other investment banks in the Fed essentially came in and said don't worry, you will be okay.  That was a very important step.  The shareholders at Bear were probably treated a little too well and I think maybe JP Morgan had a little too much leverage at the time because they were well aware of the need, literally, for an announcement to be made by whatever it was, 7 pm on that evening, 7:45, give or take.  I was too busy sweating to watch the clock, but there it was.  So we had a near meltdown in the credit sector, which was averted by aggressive Fed action and that took some of the wide tails off of some of these financial markets and some of the instruments have improved considerably. 

 In other words, if you're not having to price credit derivative swaps for the possible meltdown of the financial system, you can be a good deal more aggressive in buying those things.  And we have seen a nice comeback in the credit markets.  So my shorthand is and I think it may help to bridge some of the gaps here, not all, and we're not going to agree on everything is that credit, we had a credit near panic averted; that is good. 

 Now we have the real economy, which is slowing rapidly and I kind of agree that the numbers starting in February would, if you look at all of the numbers, and I'm very plodding, I look at the number and I say – ooh, what happened in the last six recessions and how does consumer confidence look and how does employment look.  It is probably what your computer does very systematically.  How does housing look, how do all of these things look and everything looks like we went into a recession in the first quarter.  And by the way, fourth quarter growth was 0.6, which is not exactly a rip-roaring economy. 

 And so probably your model was starting to wonder and we'll get a report on the first quarter numbers probably on Thursday.  We are probably going to see a number around zero to .5 headline, but the domestic final sales, which is really the demand growth part, I think the important, I would argue the important part of the number is probably going to be negative.  And the difference will be, we will have an inventory accumulation and the inventory accumulation, in an environment where growth is slowing, is not a good sign going forward, it is a sign that momentum is being lost. 

 So one of the things that concerns me as I talk to people about the economic outlook is yes, I know it feels good that we're not going to have a collapse of the five major investment banks, I am really happy about that and you should be, too.  However, that doesn't mean that the real economy is going to do wonders and this month I tried to look at that in kind of a long-run sense.  And the de-leveraging, we are going to see de-leveraging in the financial sector and we have begun to see that. 

 Many of those who thought that they had home equity lines of credit with the major banks have discovered that they don't because the boss at the bank says we don't want any more exposure to households.  So if they haven't used their home equity line, cancel it.  And if they have used it, we are stuck because home equity lines are second liens and banks find that people walk away from those lines and say come and get me, but you will have to foreclose on my mortgage first, which may have something to do with the rise in foreclosure rates we are having. 

 The housing sector – again, I hate to argue about numbers, but I mean, the Case-Schiller Futures Index is a market.  People buy and sell those contracts, it's not the biggest invest market in the world, but it is numbers people are willing to bet on.  And house prices are falling and they are falling at an accelerating rate.  OFHEO – again, we had this discussion in December, we will have it again.  OFHEO is conforming mortgages only, it excludes the most vulnerable part of the housing market. 

 Be that as it may, real estate markets everywhere are weakening rapidly and not only that, but the rates which haven't come down much, don't fully tell the story.  I invite you to go to your bank and ask for a loan – be it a regular loan or a jumbo loan, and see how much the down payment requirement is relative to what it was a year ago.  It will be substantially larger, 20 to 30 percent. 

 So you have rates at the same level with higher down payments and so credit conditions are more difficult for perspective homebuyers.  And will probably continue to get more difficult because banks are de-leveraging.  They don't want exposure to households because they are trying to de-leverage while they raise capital and they have been, in effect, asked by the authorities, various authorities, to do so.  So what about the longer run? 

 Well, I went back and looked at the Fed's data on household wealth, because I am trying to get a sense of how much do households have to de-leverage.  And what I discovered was that in the 1990s, from 1990 to 2000, household real net worth, which is kind of the bottom line of the flow of funds data, rose at an annual rate, compounded at an annual rate of over 5.4 percent.  So households, at the same time the household saving rate, which excludes, the mirror image of this, was that the household saving rate went from about 8 percent to 2 percent. 

 So households were developing the notion, at least the way the broad numbers looked, that I don't need to save out of measured income, I simply will be able to save by virtue of wealth accumulation.  In the current decade, wealth accumulation, that is household real net worth, has compounded at about a 2.3 percent annual rate through 2000, that is from 2000 to 2007. 

 But as we look at household balance sheets now, we see that equity prices are down – not too much, maybe 10 or 11 percent from the highs, but they are not going up any more.  And house prices are down, and we can argue about how much, but house prices are certainly down from their highs and the availability of credit that has been tied to the rise in house prices has sharply curtailed. 

 So probably as households face sharply higher energy prices, de-leveraging by the financial sector, their own need to de-leverage, the data on state tax collections show that real incomes are dropping, have to be dropping unless people are avoiding tax.  We're going to have a sharp slowdown in consumption, which has already started, it's in the data.  Beyond that, we've also seen investment spending start to slow.

 One of the things that we suggested back in December was that that would be what you would expect to see as we get closer to a recession, and that is what we've seen.  So again, it seems to me it is playing out exactly as – the big wrinkle was the crisis in March, which none of us actually envisioned. 

 Charles Calomiris:  You and I did; I will remind you of that.

 John Makin:  Okay, I didn't envision something quite that intense, but we had it, we got through it, it's a good thing.  The Fed performed their job.  But now I think the problem is we have this underlying de-leveraging in the financial sector and the household sector that is going to slow consumption growth and probably pretty rapidly.  We throw in a little bit of a curve ball here because as everyone has mentioned, the Treasury will be sending out checks that total up to about $100 billion over the next several months.  It's very hard to figure out how much are people going to spend. 

 I do know that if you annualize the increase in energy costs over the past month, it's $60 billion, simply because gasoline and other energy prices have gone up so rapidly.  That may go away, it may not.  But it's not a plus for households' disposable income.  So where do I come down on this?  The financial sector is better than it was six weeks ago and we dodged a very serious bullet and that feels good and it has given financial markets a nice lift. 

 By the way, this is the thirteenth 5 percent balance in the stock market we've seen since last summer.  As I checked, Alan Ableson [phonetic] pointed it out over the weekend and sure enough, we've had a lot of – and actually, I'm surprised it's not a little bit better given that again, they've stopped hitting us over the head with this two by four called an incipient credit crisis.  But the underlying picture in the real economy, which is tied to a persistent and accelerating drop in home values, which is the major balance sheet item of most households, continues. 

 And I suspect, again, I suspect that if we gather again in six months we will say gee, consumption slipped quite rapidly, investment slipped rapidly and the second quarter growth rate was somewhere around zero because we got a boost from the stimulus checks.  But when the stimulus checks go away, the second half of the year actually could be more difficult.  So it's not as dramatic as the onset of a credit crisis, but it is kind of a steady grind down, which I think probably adds up to a fairly lengthy recession.  I will stop there.

 Peter Wallison:  Thank you very much, John.  There isn't actually any pattern to these presentations except alphabetical order.  So if you think that it's been arranged in some way, it hasn't been.  Okay, our next speaker is someone who was not here for the one in December, for our meeting in December, so he's an entirely new participant, and that is our esteemed colleague Allan Meltzer. 

 Allan is the Visiting Scholar at AEI and he's also the Allan H. Meltzer University Professor of Political Economy at Carnegie Melon University.  He was a member of the President's Economic Policy Advisory Board during the Reagan Administration and he has been an acting member of the President's Council of Economic Advisors and a consultant to the Treasury and the Fed.  I should mention that he received the first annual Irving Crystal award and delivered the Irving Crystal lecture at AEI's annual dinner in February, 2003.  Volume Two of his History of the Federal Reserve is forthcoming from the University of Chicago.  Allan?

 Allan Meltzer:  Thank you.  Having watched the sessions over something like a 50 year career, I must say that one of the things that strikes me most about this one is the enormous exaggeration that characterized the comments that were being made.  People were talking about – people as smart as Larry Summers were talking about depression and how we are on the verge of depression. 

 The media was just full of talk about how the 6 percent, at the time, 6 percent default rate on housing was the worst since the Great Depression.  Well, on the Great Depression, it was 50 percent and if you can't see the difference between 6 percent and 50 percent, you have to be as blind as many of the people who write the newspapers.  Another example is the hand wringing over the decline in house prices.  House prices have to fall.  The problem won't end until house prices fall.  We have to see house prices fall.  A quick fall will be hard, but it will also get it over somewhat faster. 

 Sure, they may overshoot, but what will signal for me and many other people the end of this problem, the housing problem, the beginning of the end of the housing problem will be when the expectation in the market of the housing price stabilizes.  When they know what the housing price or think they know what the housing price is going to be, they will be able to value the securities in their portfolio.  They will be able to raise more capital.  People will have more confidence in what their assets are. 

 If you look at the market now, you see that people, banks are willing to lend to each other, money market people are willing to lend to each other for one night or two nights.  But they are not willing to lend for 30 days, because they don't know what kind of junk is in the portfolio of other people.  And that junk is characterized by the fact that we don't know what the value of the underlying assets are and we can't know that until the expected housing price settles.  So that has to happen and that will be a signal of the fact that we are approaching the end of this financial crisis. 

 I share with you that this slowdown – it's not yet a recession, it may be a recession, but it's not yet a recession – that the slowdown in the economy will be prolonged, not so much because of the housing price problem, although that certainly contributes, but more important for consumers is the fact that gasoline and energy prices are way up and they are really pressing on individual family budgets. 

 I mean, take a person at the median income of around $40,000 a year.  Every week when he fills up his SUV to go to work and he needs to fill the SUV to get to work, he spends $80, approximately for gasoline.  It's a big slug out of his weekly income, monthly income, annual income.  It only amounts to maybe an additional $500 or $600 a year, but that is a big bite in cost and food costs add to that problem.  So the reason I think that that is affecting more people is because I don't inhabit Wall Street. 

 I can see what I think is plain from the data, that is that this is a crisis, which is very localized.  The worst of it is in Southern California, Southern Nevada, Arizona, Southern Florida and for very different reasons, in the area around Detroit.  The rest of the country, housing prices may be falling, but most of the people who own those houses are not going to move and many of them are not going to default.  They know that housing prices can go up, they believe that prices can go up or down and they live through the uncertainty that that creates. 

 Now a friend of mine who is the chairman, the CEO of a very large bank says to me that I should read the number on foreclosures with a certain amount of skepticism.  Why?  He said that because my customers default on their loans, they give back the house, they don't pay their mortgage.  They go across the street and buy the exact same house at a lower price.  So the defaults are going to be overstated for that reason.  How important that is, he can't tell me.  He tells me it's important for his bank, whether it's universally important or not, we'll find out eventually. 

 Second, let me talk about – so I think that there is a great deal of exaggeration about the disaster in the housing market.  I believe that people on Wall Street saw disaster because their positions and mortgages were under water.  And so what they saw was something – if they have anything in Wall Street, they have hubris and they believe if things are bad for me, they have got to be bad for everybody, but that isn't true.  They were talking their position. 

 I agree with those who say that the Fed, one of the Fed's responsibilities is to act as lender of last resort.  I have believed for, maybe forever, that the Fed is the lender of last resort to the financial system, not to the banking system, not to the member banks.  And I have nothing, I have mostly praise for what they did in their lender of last resort role.  They said we have an obligation to protect the payment and settlement system.  We can't allow the settlement system to fail. 

 What we did for Bear Stearns was essentially what the Congress instructed us to do for banks when it passed fiduciary.  It said get rid of the management, wipe out the stockholders and keep the institution running because we don't want to eliminate what economists called network externalities.  The fact that people were trading with each other and depend on each other to trade, that they get hurt when one of their trading partners goes down. 

 Sure, they can find somebody else, but there is going to be a bad period wile they search around, so keep them operating, but wipe out the equity and wipe out and eliminate the management.  And basically, that is what the Fed did.  Now in order to do that under the gun or waiting for the Japanese market or wanting to get it done before the Japanese market was open.  They said we have to have a deal by 7:45 on Sunday evening.  That's the same as telling a shrewd operator like Jamie Diamond you name the terms, and he did.  Maybe there was no other way to do it.  In any case, that's what they did. 

 So I have nothing to criticize about the bulk of their policy of maintaining the payment and settlement system.  It has been, for the most part, successful.  The biggest problem that seems to remain shows up in the rate, the London and the bank borrowing rate, the Libor rate.  No one, as far as I know, knows quite why that rate doesn't come down. 

 My own conjecture is that it has much more to do with Europe than it does with the United States.  That is, that it has to do with the fact, rumors that the Landesbanken [phonetic], the German Landesbanken, or at least some of them, are deeply troubled by the bad loans that they haven't yet announced in their portfolios and this affects the European credit markets more than the United States. 

 Now there may be other reasons, I don't think anyone knows for sure.  But the Fed's policy seems to me to have worked reasonably well.  I disagree with my colleague Desmond on many things, but especially on the fact that he uses nominal rates to point that they haven't brought them down.  But the inflation rate is now the expected inflation rate looking forward is about 4.8 percent for the year ahead and I'm going to say a few things about that. 

 The part of the Fed policy that I don't like is the inflationary policy, which has led to a severe devaluation of the dollar, to an increase in the desire for protection, to bring back a lot of the problems that we have had and make them worse.  In your folder, you will see two pieces of paper that I sent to you from the website of the Federal Reserve Bank of St. Louis.  One shows the extraordinary, and it is extraordinary, growth of M2.  It has really taken off since the Fed began its severe [indiscernible] in January.  You can see that if you look in your packet. 

 The other is a statement which, if you look at from the same source, if you look at bank credit, all banks, large banks, C&I loans, commercial and industrial loans.  You will see that there is hardly a break in the rate of increase.  I mean, despite all of the talk that you hear over and over again on radio and TV about the credit crunch and how you can't borrow and no one can borrow, just look at what is happening and you will see that people are borrowing.  And that while there has been a slight decline in the last couple of weeks, that the rate of growth of loans and leases, of bank credit and especially all banks, banks outside of New York. 

 Now why do we get this news?  Well, because New York plays an important role in the financial system and the Fed, throughout its history, has always been very sensitive to the attitudes and fearings of the New York bankers.  They are an important part of the economy.  Not quite as important as they think, but important. 

 Second, I would add to the discussion of the possible recession the fact that if we look at the unemployment rate, it has risen and it will probably rise more, but it is still below the long-term average of the post war period.  So people are working.  Not in New York perhaps, but they are working.  And a measure, which is more contemporaneous than the unemployment rate, which is a lag indicator, is how long it takes a person on the average who loses his job to find another job.  Currently the median for that is eight weeks.  A year ago, it was ten and a half weeks. 

 So it has improved.  Now it will get worse, but how I would describe the situation is, as I said, I think there is a real problem for households and consumers because of the increase in gas and energy prices and food.  There is the possibility of all sorts of shocks that could happen.  The German Landesbanken may fail, the Bundesbank may not bail them out.  Very unlikely, but possible.  There are all sorts of things that can go wrong.  If you want to look for a list of things that can go wrong, talk to Desmond. 

 Desmond Lachman:  Have gone wrong.

 Allan Meltzer:  No, might go wrong.  The Fed's policy, what I dislike about the Fed's policy, is it strikes me as a return to the mistakes of the 1970s.  In the 1970s, the members of the Open Market Committee were not stupid.  They knew that they were producing inflation.  What they told themselves and each other over and over and over again was: we will stop the inflation before it gets bigger, before it gets worse.  And then the time came and they did it and the unemployment rate ticked up and that was the end of the anti-inflation policy. 

 So fine tuning, stop and go policies failed and they are going to fail again.  That is my biggest concern.  We have seen in the Europe markets M3 growth, which is what the Europe Central Bank watches, is up 12 percent.  You can look at the chart of M2 growth for the United States and you will see that it has really ballooned.  And as I said, the expected rate of inflation one year ahead is now 4.8 percent.  That is getting up there. 

 The Fed, when you listen to Bernanke, others from the Fed, Don Kohn, talk about the problem of inflation, they say essentially without using the words, say we're relying on a Phillips Curve.  That is a weak read on which to lean.  It failed them, Othenatios Orfenedes [phonetic] wrote a number of very good papers pointing out how that policy failed in the 1970s.  It failed because, he said, he pointed out, because we don't know what the expected rate of growth is going to be. 

 We can only guess at that and we usually, often guess wrong.  It moves around more than the Phillips Curve, which assumes it is constant, would like us to believe.  We see in forward looking markets traded good prices up, depreciation of a dollar up, lots of signs that the market is anticipating continued inflation and at a higher rate.  The Fed thinks and says that when the economy slows, the inflation rate will come down.  Maybe.  That is a weak bet on the Phillips Curve or a strong bet on the weak Phillips Curve. 

 The lesson that I draw from reading, writing The History of the Fed is that most of the time, the Fed is not independent.  Rarely is it independent.  It is whipped around by the Congress and that is what is happening now and Mr. Bernanke is not standing up to the Congress, at least negotiating with them, but in a sense giving into them.  They also are very much under the gun from Wall Street.  People who hold bonds and mortgages that are under water would like to see interest rates lower in the hope that those bond prices and their losses were smaller. 

 And although I don't know this for certain, I would be surprised if Mr. Bernanke's telephone doesn't ring with phone calls from the Administration as well.  So I sympathize with him.  I mean, he is under pressure all of the time.  He has yielded to that pressure and he has gone back to doing, to making the mistakes that got us into trouble in the '70s.  I hope I am wrong, we will see what happens. 

 At least we begin to see that expectations on the market that a few weeks ago called for a 1.5 percent federal funds rate by June have now come back up.  So the Fed may stop cutting, but I don't want to see them stop cutting.  I believe the policy that they have to pursue is one that says we cannot run the economy from quarter to quarter.  Our influence, we know for a long time that what monetary policy does, it does over a period of uncertain length, but at least nine months or more on average. 

 So we should run the monetary policy as if that were a fact, as if what we can influence is the average at which the economy moves.  The Fed's best policy was the policy, the best policy over its history, was the period from 1985 to about 2004.  It essentially followed, not deliberately, but it followed in effect John Taylor's rule.  And that policy worked very well on average.  He kept down unemployment, he kept down inflation.  It deviated from that policy now and it ought to get back to it.  It ought to pursue a policy, which aims at the middle course. 

 I want to close with one last comment, which is why did we get into this mess and what do we have to do to prevent future messes of this kind?  I believe there are two reasons which very few people talk about, but which need to be discussed more.  One is the bad regulation, Charlie Calomiris mentioned Basel.  The Basel Agreement said to banks: if you hold more risky assets, you had better hold more reserves. 

 So we got what is the usual thing.  Lawyers make the rules, the market figures out how to circumvent them.  The incentives were all wrong.  The incentives were take it off the balance sheet and put it in these strange instruments that we invented and then we don't have to hold more reserves, and we didn't.  That was a silly, foolish policy.  Regulation, if there was to be regulation, has to worry about what are the incentives that are being created?  It isn't easy, but if you're going to have regulation, you had better worry about what are the regulators going to do when they see the regulation. 

 Second and last, the incentives in the market are geared to making short-term profits.  You have to ask yourself why would the MBAs, my former students, students from all of the best business schools in the world, why were they buying and selling pieces of paper that they had to know were worth not much?  The answer is because if they didn't do it in most firms, they lost their jobs.  If they did do it, they got big bonuses.  That is not a very good system.  That is how we got the dot com problem and that's how we got the housing problem. 

 So what we need to do is change those incentives, and an easy way to do it would be to average their returns over five years, do something other than what we now do.  If we don't do that, we are dealing with a market in which people borrow short and lend long, so we are always going to be subject to some kinds of ups and downs.  They are unavoidable, but we can make them much more avoidable if we change the incentives, both the regulatory incentives and the incentives on the participants.

 Peter Wallison:  Thank you very much, Allan.  Okay, our last speaker is Vince Reinhart.  He is the newest member of this team, he is a Resident Scholar at AEI and a former director of the Federal Reserve Board's Division of Monetary Affairs.  He has spent more than two decades working on domestic and international aspects of U.S. monetary policy.  Vincent?

 Vincent Reinhart:  Thank you, Peter.  Peter, those thanks, of course, are tinged with regret that you couldn't see past the tyranny of the alphabet, so I have to speak sixth after so many disparate views were expressed.  And actually, it reminded me of something that F. Scott Fitzgerald wrote, which was the test of a first-rate mind is an ability to hold opposing ideas at the same time while retaining the ability to function.  Perhaps it could also be said about a panel, although I note that it was in a book called The Crackup. 

 I am going to talk about three things in terms of what lies beyond the credit crunch.  The current state of the U.S. economy, that is the current conjuncture.  The outlooks for the U.S. economy, and what I am going to argue is that there really are two distinct possibilities.  And then the financial world after March 14th.  I date the changing not at 7:45 on the 16th, but 8:15 on the 14th. 

 First, in terms of the current conjuncture, the ongoing housing price, housing correction is posing three drags on U.S. economic activity.  The first, there is the direct inventory correction as builders cope with excess stocks.  And I would point out, like Des, they are chasing a moving target in that they are cutting back production, even as sales fall even faster and we see inventory sales ratio rise. 

 The good news is that sector is getting arithmetically smaller and smaller so the contribution to the drag should lessen over time.  But in addition, reductions in house prices are reducing wealth, slowing the growth of consumption.  There you have the two favored house price indices on on the right of our panelists, either the OFHEO Index, the solid line that Charlie prefers, or the thin line of the Case Schiller. 

 But the main point being that households have about $23 trillion worth of housing wealth on their balance sheet are feeling less wealthy and will have less wherewithal to support consumption.  You might argue that's not a bad thing given the saving rate being so low, that adjustment needed to happen.  The question is if it happens in too narrow a window, you will slow total aggregate demand. 

 And then third, deterioration of the balance sheets of large, complex financial institutions has made credit more expensive and difficult to get.  The left panel is the new net standards on C&I lending, which moved up sharply, but nowhere near as sharply as the right panel, which is net standards on mortgage loans that just took off in the last survey in January.  I look forward to seeing what the results of this survey are next week if presumably there is one in the field.  The obvious question is, is this a recession?  It's not an obvious answer for I think the reasons that Kevin talked about. 

 What I've plotted there is my favorite contemporaneous indicator of recession, and that is the contribution to the unemployment rate of short to intermediate spells of joblessness.  That is, the unemployment rate for people who have been unemployed under 26 weeks.  What you note about that indicator is it moves very asymmetrically between recessions and expansions.  In recessions, the yellow area, it goes up about three-tenths of a percentage point a month.  In expansions, it mostly moves sideways.  Actually, it declines on average like a tenth every six months. 

 We have had a weak job market.  We've had a string of declines in employment, but that indicator, as most indicators of the labor market, haven't moved sharply in the manner that we would normally associate with recessions.  Hence you get the ambiguous conclusion that we are either in or about to enter a recession or we're probably in the third quarter of real GDP growth averaging something like a half percent.  In either case, it feels pretty badly. 

 And I think in some case, it's a consequence of the great moderation in economic growth.  If you look in the upper left panel that plots real GDP growth since 1930 and quite clearly, from around 1983 onwards, something happened.  And that is the growth of real magnitude, nominal magnitudes as well, became much less volatile.  Economists call that the great moderation.  What has accompanied it is what I would call the great whining in which public sensitivity to a slowing economy has increased.

 In some sense, the total amount of news is about unchanged, you just need a bigger response to each basis point of slowing associated with the moderation in economic activity.  And one place you can see that is if you look at, go to Google Labs and look at Google trends.  That just looks at the number of hits and the number of newspaper articles in the bottom panel using the word “recession.” 

 What is striking and you can actually extract it from Google is they do that for longer periods of news articles alone.  And you see that the increase in references to the word recession this year is about, it made up about two-thirds of the increase in 2000 and 2001 and even more now than was the case in 1990 and 1991.  I think what all of that is supposed to mean is you should filter what we hear commensurate with the reduced volatility in macro aggregates. 

 Now what I like to do next is – so, in terms of the current conjecture, you've got your choice.  We are either in the third quarter of growth averaging something like half percent or after the fact, a few of those numbers will be revised down and we will be technically in a recession.  Going forward, I would like now to talk about the economic outlooks, and that is actually not a typo. 

 Much of financial market behavior depends on expectations.  Markets with an important role for expectations have really interesting theoretical properties, like you observe herd behavior where people follow the first movers.  You have the possibility of self-fulfilling prophesies where just the thought of something going wrong makes something go wrong.  You also have the possibility of multiple equilibriums. 

 That chart on the right is something out of a Brookings paper that I wrote with Brian Sack.  It gives us a little example of, consider a market where agent A's participation in market trading depends on the participation of agent B and similarly, agent B's participation in market activity depends on the participation, expected participation of A. 

 What you get in that particular case are two outcomes, potential outcomes, a high trade equilibrium and a low trade equilibrium.  If everybody goes to the restaurant with long lines, one could imagine that if not enough people show up, you crash.  A lot of people show up, you will succeed with the long lines.  The same thing in market participation.  If it is expected that a lot of people will participate in market activity, then you will participate in market activity and you get a high trade outcome. 

 If, however, you fear that not much of your competitors will participate in market activity, you wind up with a low trade outcome.  Why am I talking about that?  Because financial markets do pose right now a quite distinct set of risks.  We are seeing, back when macroeconomics were fun, people would talk about fallacies of composition and that is, individual behaviors don't necessarily aggregate up to good behavior at the macro level. 

 What we're seeing now is the paradox of de-leveraging.  It is in the individual interest of every large complex financial institution to shrink their balance sheet so they have balance sheet ratios more commensurate with the lower capital they have after they have realized the losses on their mortgage portfolio.  And it is in each one's interest to do so, but if everybody does it at once, you wind up potentially in the low trade equilibrium where there is no market clearing because everybody is trying to sell at once. 

 So I take that to mean in the high trade outcome, the large complex financial institutions come to grips with that problem by getting more capital.  That would allow financial markets to improve, financial conditions would improve, allowing the substantial easing of monetary policy, that is the reduction in short rates in the upper right panel, to show through and support economic activity. 

 At the same time, there will be additional impetus associated with the tax rebates and not inconsequential, the dollar depreciation, which has encouraged net exports, as you see the dollar depreciation in the middle panel and the net contribution of real net exports of goods and services in the right panel.  So in the high trade outcome, it works because trading firms get more capital that supports better market functioning and the considerable policy ease by the Federal Reserve will show through.  Let me go on record as saying the glass is one-third full.  In that high trade outcome, in fact, the Federal Reserve's problem will be to remove excess accommodation as quickly as possible. 

 You see in the upper right panel a solid line, core PC inflation is in the neighborhood of three and a half percent, rather total PC inflation is in the neighborhood of three and a half percent.  And the core PC inflation, the dash line, is hovering at 2 percent.  And we know from the central tendency forecast published in the minutes, both in October and March, that the committee's implicit inflation goal is an outcome for that index somewhat less than 2 percent.  So if they want to satisfy their own internal goal, they've got a problem with inflation. 

 And it is a problem with inflation that could be more serious, given as you see in the bottom two panels; the considerable increases in commodity and oil prices.  So in the high trade outcome, the Federal Reserve is going to have to show that its policy in this new post-gradualist world is symmetric.  That is, it's got to be willing to tighten policy as quickly as it eased policy.  That might not be as hard as you think, because if in fact in that high trade outcome financial markets improve, that is spreads narrow, it would be a natural thing to remove the policy accommodation put in place because of the unusual circumstances in markets once those unusual circumstances lift.  And they would be able to show that they learned the lesson of 1998 and 1999, they learned the lesson of 2004. 

 So in that high trade outcome, what we're witnessing is a price discovery process.  The people who have capital are holding out for a better price.  Some have already moved, some more will move and will get recapitalization in the banking system.  But there is a low trade outcome, too.  You can align your balance sheet ratios to what is desired either by getting more capital or with your depleted capital, shrink the asset side of your balance sheet sufficiently. 

 So the alternative in the low trade outcome is that capital doesn't come in from the private sector.  Large complex financial institutions have to shrink their balance sheets in order to bring them in better alignment with their depleted capital.  Financial conditions do not improve.  Now they don't get worse, because the Federal Reserve has established on market functioning with the primary dealer credit facility.  If no primary dealer is allowed to fail, then there is no reason to have runs on primary dealers and market functioning doesn't get worse. 

 But in that environment, there is no financial stimulus to show through the economy because spreads are still high and you have to worry about other parts of spending, including non-residential construction and the willingness of households to continue to spend in an environment in which there is obvious turmoil.  And so the economy moves sideways or weakens if in the end the way large complex financial institutions deal with their balance sheet problems is by continuing to shrink their balance sheets. 

 Now we have talked about the primary dealer credit facilities as establishing a floor on market functioning.  I would like you to consider just a little bit the world after March 14th.  I would agree with the other panelists that the Federal Reserve is to be commended for using both the size and its composition of its balance sheet to affect the economy.  It's the size of the balance sheet that determines the federal funds rate, which has been used aggressively to offset weakness.  It's the composition of the balance sheet that influences market functioning. 

 Essentially the Federal Reserve has been swapping with the private sector for illiquid assets, their mortgage-related securities, for which there is no effective market in return for either reserves through long-term RPs or the term auction facility, or for Treasury securities through the term securities lending facilities.  And that is an imaginative way to use, to expose the Federal Reserve's balance sheet to credit risk, to stem the deterioration in market functioning, to buy time until that capital comes.  And recognize, however, your central bank doesn't provide capital; your capital bank provides temporary credit and they are buying time for that capital to come. 

 I would argue that the decision to lend to Bear Stearns and extending lending to all primary dealers through the primary dealer credit facility really was the worst policy mistake in a generation.  I think it will be comparable with longer-term consequences to the great contraction and the great inflation.  And part of the reason we don't see this is we tend to jump over the range of possibilities. 

 And that is, if you give me the choice between Bear Stearns' failing setting off a cascading multiple failures of other financial institutions or the Federal Reserve providing them funds.  I can understand the argument for the Federal Reserve providing funds.  The problem with that is the excluded middle, the possibilities that we don't really, that we haven't talked about, like would it be possible to a tougher line with JP Morgan?  Were there other suitors that could have been pursued?  Was it possible to lift out the troublesome part of the Bear Stearns portfolio?  Would it have been possible to do an on-the-spot term securities lending facility? 

 All of those things, short of lending to the dealer, could have been possible, but weren't obviously pursued and we're going to live with the consequences.  What are those consequences?  I think it eliminated forever the possibility that the Federal Reserve could serve as an honest broker.  What's that mean? 

 Well, think back to September of 1998 when seventeen large firms were brought together in the director's room of the Federal Reserve Bank in New York and told you've got a problem, find the capital to solve it.  I think that after March 14th, the reasonable question that any one of those people in the room would now ask is, and how much will you contribute to that solution?  And I think that has changed what we think of our central bank. 

 It has also tilted the political playing field toward direct mortgage relief.  Why?  Well, most households either own their home outright or are meeting their mortgage payments or renting.  And when asked the question do you want to help the people down the block who got overextended, as really a statement of fairness say no. 

 However, if you re-frame the question and say now that the government has helped an investment bank, do you also think it's appropriate to help t