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Tepper Economists Weigh In

Together, these international advisors weigh in and offer a combined perspective like none other: why the U.S. is, indeed, not headed for another Depression; how more regulation could hinder, rather than help, the market’s efforts to recover; whether the government can credibly commit itself to stop intervening; and when the current crisis is likely to end.

Tepper Magazine: Dr. Meltzer, the current crisis has been compared to the Great Depression of the 1930s. Is this a useful comparison? 
Meltzer: The current situation is very different from the Great Depression. First of all, we don’t have a fixed exchange rate, which was a serious limiting factor in the Depression. We’re doing very different things, like much more expansive policy – there was very little expansive policy from 1929 to 1933. Second, the depth of the crisis is nowhere near what we went through in the 1930s. The unemployment rate went to 25 percent. There was no underlying support system. People lost their jobs, they went back to the farms, because we were still very much an agricultural nation at that time. They didn’t have a welfare system. Today, we have an unemployment rate that is below the post-war average: About 50 percent of the people who lose their job find a new one within eight weeks. So those are very different circumstances. One of the things that people say very often is housing defaults are the worst since the Great Depression. Well, what does that mean? Now they’re six percent. [editor’s note: interview took place April 22, 2008] At their peak in the Great Depression, they were 50 percent. Seems to me that’s a world of difference, and it makes the comparison simply not very meaningful. 
TM: Dr. Goodfriend, as in the 1930s, the crisis today is fueling calls for more regulation. Have we gone too far down the road of deregulation through the ’80s and ’90s, and is more regulation perhaps a cure for current ills?
Goodfriend: I would draw an analogy to life expectancy. Medical science increased life expectancy by curing diseases that used to kill people at age 50 and earlier. Now, we’re living to 80 and beyond. Likewise, we’ve learned to extend the length of the average expansion of the business cycle. Inflation used to bring an end to business expansions years before they end today. Now, we’re seeing events in business expansions rarely seen before – for instance, “extreme asset price fluctuations.” It’s premature to suggest that we need more regulation to deal with these asset price movements and their consequences. What we need is long business expansions with inflation under control so that markets learn to price assets, and how to manage asset price increases in these long expansions. We need to allow markets to learn to discipline themselves.
TM: Are we in danger of regulation overreach that could put us  back into a more socialistic framework?
Meltzer: We’re dealing with a problem that is age old. Financial institutions lend long and borrow short. And so periodically there’s going to be problem. They won’t be able to renew their short-term loans fast enough to service their long-term assets. So there’s a limit to what we can do, and the best thing that regulators can do is to try to think about the incentives they create when they write regulations.

On the prevalence and the relevance of “moral hazards” in today’s financial markets:
TM: 
How does the concept of “moral hazard” play out in the current situation, including the Fed’s involvement with Bear Stearns?
Goodfriend: By moral hazard, I think you mean the idea that if something is insured, there’s an incentive for people to take less care of the thing that’s being insured knowing that they can get compensated if something happens. The counterparties with Bear Stearns were made whole. And so there is an element of moral hazard associated in what was done with Bear. If I do business with a big investment bank, I have more confidence that if something goes wrong, the investment bank might fail, but my counterparty position would be made whole.
Meltzer: It’s pretty hard to avoid moral hazard, and it isn’t clear that you should. There are some cases in which that’s the price you pay for something that you really need: You don’t want the financial system to collapse. Politically, practically, they’re under the gun. The attitude of the regulators was, “We have to have an agreement before the Japanese market opens at 7:45 our time on Sunday evening.” By doing that, they actually said to J.P. Morgan Chase: “You tell us the terms.”
TM: Should the Fed be denied the authority to engineer this kind of transaction? Would banks be more prudent about their balance sheets otherwise?
Meltzer: Go back 70 years, during the Great Depression – we had a system in which the government rarely wanted to intervene. You had a problem – it was your problem, not a public problem. I don’t believe the 21st century is going to get a government that will keep its hands off in the midst of a crisis. The public will be screaming: “Our deposits are becoming worthless. What are you going to do about it?” Long before you get to that point, the government will be there. That’s the modern way.
TM: What role might the consumer play in providing incentives for financial markets to become more transparent? 
Goodfriend: Companies structure their products based on what their customers demand, or what their customers are willing to accept. The great success of the U.S. economy is that the customer has been demanding, and has been free to choose which firms to buy from. And so the customer, understanding the products, with a free choice about who to buy from, has disciplined our firms to produce great products, the best products in the world. One of the markets in which customers are less  demanding is finance. Finance is a complicated thing. People need to be more demanding in financial markets as borrowers, lenders and investors. If a firm is producing something you can’t understand, the customer should say, “I can’t understand that. Give me a product I can understand, and I’ll buy it.” Americans are sheepish in financial matters compared to their decisiveness in other markets. I believe that will change. People have not been happy with outcomes in financial markets of late. As people become more demanding, firms will respond. We should not give people the impression that they can count on regulation alone to provide product protection.

An insider’s view of Federal Reserve communication styles:
TM: When Ben Bernanke became Fed Chairman, he set out to communicate policy in a manner different from his predecessor, Alan Greenspan, who was noted for statements that were hard to understand. Has Bernanke achieved the goal he set for himself?
Meltzer: Not fully. He set some very high standards. He was going to make the Federal Reserve more collegial – that is, give greater importance to the other members of the Open Market Committee. He hasn’t really been able to do that. The press, the public and Congress expect him to speak for the Federal Reserve, and that goes with the role of Chairman. So I think he’s been perhaps better than Greenspan, but he could be much better than he is. There’s never going to be complete and perfect information. The market people, who live in a regime of great uncertainty, would like to know more than anybody can tell them. My father used to say, “They’d like to read tomorrow’s newspaper.” They can’t get that, so they’re never going to be satisfied. But they could be told more that would reduce uncertainty, and that should be the standard the Fed sets for itself, because that uncertainty is a cost to the people in the market, and it’s also a cost to the rest of us.
TM: When one works inside the Fed, as you did, Dr. Goodfriend, how is communication crafted? What goes into developing a policy and communicating it?
Goodfriend: I attended the Federal Open Market Committee meetings for 13 years. After the policy discussion, the committee must come together and describe what it decided in four hours within a policy statement that is a few paragraphs long. It’s always difficult to summarize the nuances in the debate and the crosscurrents of ideas. Committee members all have expert points of view, and this is subtle business.

On how Fed Chairman Ben Bernanke’s performance compares with that of his predecessors:
TM: There has been great pressure from Wall Street and Washington to “do something.” Is Federal Reserve Chairman Ben Bernanke on track? 
Meltzer: He’s been very active, imaginative and creative in finding new ways to help the financial system. His monetary policy I don’t favor. I believe he’s putting much too much weight on the possibility of a recession – which may very well come – and too little attention to the prospect that later we’ll have inflation.
TM: How does the Fed manage pressure from Congress and the public?
Goodfriend: Under Former Chairman Paul Volcker, the Fed took responsibility for the inflation rate and brought it down. Before that, people blamed inflation on all kinds of things other than the Fed. Now the public holds the Fed responsible for inflation. That disciplines the Fed to stabilize inflation better today than it did before Volcker, regardless of any external pressure.
TM: If you had a wish to bestow on central bankers in the U.S. and around the world, what might it be as we continue to navigate through this time of turmoil?
Meltzer: As far as policy is concerned, I would like to see central banks adopt the Taylor Rule. It’s not perfect, but it’s about as good as we have. It says we are going to look over two to three years, and we’re going to try to concern ourselves about both inflation and unemployment. I think short-term policymaking, trying to head off unemployment now, head off inflation later, hasn’t worked very well. We did very well during the Volcker-Greenspan years, when we looked a little bit farther ahead and
aimed at both targets. The Europeans, the Canadians, Australians, many others have adopted what they call inflation targeting. For example, they might say, “Three years from now this is what we want the inflation rate to be, and we’re going to try to aim our policy now.” That puts a discipline into the system, and makes them work longer-term.

On preventing another credit crisis:
TM: Should the banks have been allowed to invest and leverage themselves in these securities that perhaps were the catalyst for the credit crisis?
Meltzer: The Fed isn’t going to be able to regulate that market in the way in which people talk about it. You have to ask yourself: Why are the graduates of major business schools – the best business schools in the world – why are they buying and selling pieces of paper that everybody has to know are not worth much? The answer is because they are being richly rewarded for doing it. And, as long as that’s true, that’s going to be a problem. Pay them on the average of their performance over five
years, not quarter by quarter. There are other ways of doing that, but we have to change their incentives, otherwise we are going to have these problems. Second, I believe that some regulators are beginning to recognize that they entered into a flawed agreement that said that if a bank holds risky assets, it has to hold more capital. Well, what did the banks do? They didn’t hold the risky assets, they invented all sorts of instruments off their balance sheet. That’s another case where the lawyers make a
regulation, and the market figures out how to circumvent it. Instead of having these risky loans on the balance sheet of banks where at least regulators could observe them, no one knows where they are now. It is not a good system, and one that we have to change. So this is a case where regulation helped to bring on this crisis, because it helped to create all these off–balance sheet instruments. We won’t go through that again right away because the people who have taken huge losses will have learned something. But don’t count on the fact that it will go away forever. There are several things that have to happen before this crisis is going to end. One is the banks have to be recapitalized. Two steps there – they have to get more capital, and they have to recognize their losses and write them off. What has to happen to get the market straightened out won’t happen until people have a good idea how far housing prices are going to fall. As long as they don’t know where housing prices are going to settle, they don’t know how to value the mortgages that are tied to those housing prices.

On the American Century:
Meltzer: For many reasons, we are seeing the end of what one might call the American Century, where the United States had a dominant influence on what happened in the world. It still has an important  influence, it’s still a major country, but many international institutions that we established at the end of World War II are not working very well. So we are at the end of that era. What will take its place? Who
knows? We’ve been through a period of the greatest growth affecting more people and more countries than any period in the history of mankind. We’ve recently seen enormous progress. In the last 20 years we’ve had three of the longest expansions in American economic history punctuated by short recessions.
Goodfriend: Inevitably, the share of world output produced by less developed countries like China and India will rise. That’s all to the good. One problem is that the effectiveness of policy institutions in many less developed countries lags far behind that of their counterparts in the United States and the developed world.

Why economics is not a dry practice and how it helps us all to better understand the world in which we live:
Goodfriend: Economists are trained to identify fundamental forces that govern markets. Economics is a valuable tool for understanding the world. For example, the rising prices of food and fuel are inevitable consequences of the rise of China and India. The first things people buy when they rise above subsistence are better food and more fuel. For the first and last time in the history of Planet Earth, half the world’s population, or thereabouts, is moving out of subsistence to join the modern market economy. Our planet is going through the most severe economic stresses imaginable. We can do this best if food and fuel are traded freely in world markets at flexible prices, so that demand and supply fully reflect their growing scarcity.

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