Will Financial Crisis Take Months Or Years To Escape? U.Va. Experts Weigh In

October 16, 2008 — University of Virginia professors Robert Bruner and Herman Schwartz, during a forum on the current economic crisis Wednesday, agreed that we are not headed for times as bad as the Great Depression, but that this is the worst U.S. financial crisis since then.

But how long will it take to climb out of the economic doldrums?
  
The collective actions of the U.S. Treasury Department, Congress and financial ministers worldwide standing in solidarity may be the crucial factor that brings the current financial turmoil to an end in a matter of months, by the first quarter of 2009, said Bruner, dean of the Darden Graduate School of Business.

Or, the damage may continue to spread due to fundamental weaknesses in the U.S. economy, making for a couple years of hard times, said Schwartz, professor of international relations in the Department of Politics.

Wednesday's forum, presented by U.Va.'s Miller Center of Public Affairs brought together several experts to dissect what has become known as a "meltdown" in the U.S. and world economies.

Bruner, drew on his recent book, "The Panic of 1907," to outline how financial crises throughout American history — including the current one — have several things in common.

All crises follow a boom period that ratchets up financial optimism, leading to an atmosphere of excess — overreaching investments that borrow heavily to purchase overpriced assets, Bruner said.

As one example of how far the excesses had gone leading up to this crisis, forum participant David Leblang, J. Wilson Newman Professor of Governance and Miller Center faculty member, noted that deregulation in 2004 allowed investment banks to invest with fewer limits on their reserve funds, which generated high profits for many investors. The now-bankrupt Lehman Brothers, at one point, was investing with borrowed money worth 33 times its cash reserves. Under such leverage, investment mistakes can quickly wipe out a company.

When such mistakes are made, savings — both personal and institutional cash reserves — act as financial "shock absorbers" that can contain the losses, Bruner said. But with American savings at historically low levels in recent years, trouble in one area of the financial system quickly infected other sectors.

All crises have been preceded by a wave of financial innovation that increases complexity, Bruner noted. The notorious examples in this crisis are subprime loans, securities based on those loans and credit default swaps so complex that even sophisticated financiers and regulators find them difficult to value.

Every crisis features some adverse leadership. In this case, Bruner points a finger at the leaders of mortgage loan origination companies who jumped into "almost predatory lending" to "folks that really had no business borrowing under such terms." The culpability of former Federal Reserve Chairman Alan Greenspan has yet to be sorted out, but he also was "part of the leadership picture" that led to this crisis.

There is always a trigger that sets off a financial crisis, Bruner said. In 1907 it was the San Francisco earthquake that set off a liquidity crunch. This time around it was the "surprising discovery of a dramatically higher default rate on subprime loans than was previously expected."  Since they were a rather new type of loans, they were difficult to value, and there was confusion about how many would default. The higher-than-expected default rates caused quick declines in their value starting in late 2006 and accelerating in 2007.

Based on his study of past crises, Bruner said, how long and severe a crisis will be is determined by whether leaders can generate collective action. In the 1907 crisis, legendary financier J.P. Morgan used his personal fortune and moral suasion over New York's major financial players to prop up certain banks and stem the panic. The major panic subsided in about six weeks, with aftereffects for another couple of months, Bruner explained.

Today, Bruner sees collective action everywhere. Worldwide finance ministers are joining forces to take comprehensive measures in their respective countries, rather than fiddling with bank-by-bank solutions. To implement the Oct. 3 bailout legislation, on Oct. 14 Treasury Secretary Henry Paulson "basically ordered" the CEOs of America's nine largest banks to accept injections of federal money — ranging from $2 billion to $25 billion per bank — to reduce the stigma for other banks who may be aided by similar stock injections.

All financial crises are "very, very complicated," Bruner said. But the current crisis is the most complex ever, and the largest, at least in nominal dollars. It may end up costing $1.5 trillion to $2 trillion, according to various forecasts, Bruner noted. The fact that information and money can travel around the globe in seconds also adds a new wrinkle to this crisis.

Less optimistic than Bruner was Schwartz, who discussed fundamental shifts in the American economy and society since the 1980s that may exacerbate the current crisis.

From roughly the 1950s through the 1970s, Herman said, more than 50 percent of retirees had either a defined benefit pension that guaranteed a steady income based on one's former salary or had paid off their home mortgage, eliminating rent costs and providing significant retirement savings if needed. For the vast majority of American workers, incomes rose steadily, in tandem with productivity gains.

Those factors gave Americans more money, even during market declines, to keep spending and drive a recovery.

But those sources of resiliency have all been eroded in the past 30 years. As 80 percent of Americans have faced stagnant wages over the past 15 years, they have increasingly turned to home equity loans to supplement their incomes, removing that savings cushion.

Fixed pensions have largely been replaced by stock-based individual retirement accounts, which are undercut by market downturns, especially the huge 40 percent loss of recent weeks. This will tend to rein in spending at the exact time that the market most needs consumer spending to turn things around.

These changes will hinder a recovery from the current crisis, said Schwartz, who predicts hard times for the next two years.

Whether the future of this crisis will hinge on the collective actions of leaders — as past crises would indicate — or will expose some fundamental weaknesses in the U.S. economy, only time will tell.

— By Brevy Cannon