Former Fed chief: Credit crunch not going away soon

5/2/2008 - Returning to the Kellogg School for the second time this year, Michael Moskow, former head of the Federal Reserve Bank of Chicago, offered students his observations on where the U.S. economy is headed in 2008. No one cheered.

“You can expect a protracted period of slow growth and slower consumer spending for some time,” said Moskow during a 90-minute lecture and discussion in the Donald P. Jacobs Center on April 30. He visited Kellogg as part of the school’s Executive Leader in Residence Series, which is designed to augment classroom study with real-world insights from top practitioners.

If after the lecture few felt more financially secure, the audience did gain a richer understanding of the forces that have created a slowdown in the American economy. The former Kellogg professor detailed the reasons for the downturn, focusing on the current credit crunch. He singled out failures related to subprime lending, including financial engineering practices such as securitization — chopping up and selling off risky loans to investors as mortgage-backed securities and collateralized debt obligations — calling it a “major change” in banking and a relatively recent phenomenon dating back only two decades. While subprime lending is not a new development, by 2007 some 13 percent of all U.S. mortgages fell into that category, and about 20 percent of these are now in default, Moskow indicated.

He also blamed the credit ratings agencies that blessed these riskier transactions by giving them investment-grade status. The underlying risk became apparent, however, once homeowners began defaulting on these loans in late 2006.

Investors, meanwhile, lost faith in the very agencies that had served as financial arbiters, further increasing market volatility. Banks, which had made the original loans and then moved them off their balance sheets, were forced to take massive write-downs and absorb the losses, a situation that constrained the ability of these institutions to make new loans and resulted in them seeking additional capital from the markets, including from foreign investors. The crunch also has made it harder for all creditors to borrow, even those with good track records.

“People knew there was a [housing] bubble, but few anticipated the chain of events that today affects all markets,” Moskow said, adding that the size of the housing sector — it is about 5 percent of U.S. GDP — has amplified the seriousness of the problem and spurred debate about how long the slowdown will last. “Is this the beginning of the end, or the end of the beginning?” asked Moskow, before aligning himself with the latter camp and stating that he believes 2008 will be a declared a recession once all the economic data is examined and revised in coming months.

“Consumers are pulling money out of mutual funds,” he said. “That means you are losing the confidence of mainstreet investors.” Historically, such a move is correlated with an overall decrease in consumer spending. “You’re going to see more people saving, not spending.”

He pointed out that residential construction declined nearly 27 percent in the first quarter this year, while inventories of unsold homes remains high, giving credence to his view that the crisis “has a long way to go” before resolving. In addition, housing prices have declined significantly and continue to fall. As a result, homeowners feel poorer, spend less and may suffer foreclosure, perpetuating the unhappy cycle and helping spread the contagion across a wide swath in the broader economy, affecting credit cards, commercial real estate, student loans and auction rate securities. In addition, as entities like the Financial Accounting Standards Board (FASB) exert pressure on banks to absorb more of the toxic off-balance-sheet transactions, the credit crunch will likely continue.

The federal government is providing some modest mitigation. The Bush Administration’s fiscal stimulus plan should offer some relief, but only temporarily, Moskow said. The government checks, which will increase consumer liquidity by providing $600 a person and up to $1,200 for a married couple (the amounts are contingent upon adjusted gross income), arrive starting this month. Moskow predicts the stimulus will boost second quarter growth about 1 percent and third quarter growth by 0.5 percent, but that the final quarter of 2008 will see flat growth. “It’s a short-term boost,” he said of the stimulus. “The question is, how do we go into next year?”

Moskow also addressed the implications of a weaker U.S. dollar, saying it brought both good and bad news for the economy. One benefit of the dollar’s decline against other currencies is that it drives up U.S. exports and reduces the country’s current account deficit, he said. Unfortunately, the weak dollar also may be pushing up commodity prices, like oil, and be contributing to inflationary pressures, one of the key challenges facing the Federal Reserve as it fights to achieve both maximum economic growth and price stability.

“You’re going to see increasing concern about inflation from the Fed,” Moskow said, noting that, so far in the current crisis, the government primarily has focused on spurring growth by lowering interest rates, a practice that can lead to a rise in overall prices.

What will help the economy move back toward solid footing is a reduction in housing inventory and an associated clarity surrounding home prices, Moskow said. But this process will take time. He said his “biggest concern” is the risk of overreacting to the crisis through excessive regulation. While admitting that there were “clear abuses by lenders and some borrowers,” efforts to punish these individuals should not be so draconian that the overall economy suffers.

Moskow, who also spoke at Kellogg in January, served as president and CEO of the Federal Reserve Bank of Chicago from 1994 until 2007, leading a staff of 1,500 and helping supervise and regulate more than 2,700 depository institutions across five states. He is currently vice chairman and senior fellow on the global economy at the Chicago Council on Global Affairs. A former English major, Moskow changed his academic focus to economics, earning a doctorate in that field from the University of Pennsylvania in 1965. He is a member of the Kellogg Dean’s Advisory Board and a former professor at the school.

After his lecture, Moskow met with a small group of students to continue the discussion and field questions about leadership and professional life.

Said Michelle Buck, director of leadership initiatives and clinical associate professor of management and organizations: “Michael Moskow’s visit is part of the rich intellectual depth offered by the Kellogg experience. The Executive Leader in Residence program enables our students to meet and interact with professionals who bring extensive experience and expertise, offering a unique opportunity to learn how theory intersects with practice.”