By Miriam Hill
Professors Franklin Allen, Mike Useem, Jeremy Siegel, and Stephen Hoch on the state of the economy now and in the year to come.
Unemployment is up. Retail sales are grim. Global markets are pitching up and down, and the fate of U.S. automakers is uncertain. In the middle of December 2008, Wharton Alumni Magazine checked in with four Wharton professors who shared their thoughts about what’s been happening and how it’s likely to play out in the year ahead.
Nippon Life Professor of Finance; Professor of Economics
Q. A lot has happened since we last spoke. Where do you think we stand? Are we still in crisis, or have we turned the corner?
A. We’re still on the way down, in my view. I think we’re going to be in a global recession. Pretty much everywhere is slowing down now. It used to be that China and India looked as if they would have less of a slowdown, and that’s looking less and less likely. We’re slowing down. Europe is slowing down.
Q. What changed the outlook for foreign countries?
A. I think the world is a little more interconnected. Exchange rates are moving in quite unexpected ways. The Euro was at 1.60, if I remember correctly, and now it’s around 1.25. The yen has strengthened considerably, which has come as somewhat of a surprise.
Q. Why are currencies strengthening in weaker countries, such as the United States?
A. I think the reason the United States has become a safe haven is because we don’t have huge amounts of debt and we still have taxing capacity. We’re in a better state than many countries in Europe that way. If we go into a recession, the individual states will bear a lot of the unemployment costs, so the federal government will be affected but not as much. I think Japanese banks are still in relatively good shape.
Q. But what about the bailout and the costs of the war? Haven’t those expenditures ramped up U.S. debt considerably?
A. It could well become a problem. It’s a question of how everything plays out. We may well have a debt problem going forward, but the starting point is reasonable. It could be a lot worse. The other thing that is helpful is to the extent they keep interest rates low, it will not be that costly to fund, particularly at the short end.
Q. Does keeping rates low risk inflation?
A. It’s not a great thing to do in terms of risking inflation, but since the whole world is pretty much going into recession, it’s less of a worry.
Q. What has the U.S. government done correctly? What have they done wrong? Is the situation at all under their control?
A. They’ve tried a lot, and I think it hasn’t really affected things that much. You could say the details were wrong. I think the original plan [by Treasury Secretary Hank Paulson] was quite sensible, and people were very critical of it. But once the House rejected it, that set us on to a very different dynamic. The original purpose of the bailout plan was to spend $700 billion on problem assets to try to restore confidence to the markets. Now, basically, the $700 billion is going to be used for many things including handouts, it seems, which is unfortunate. It doesn’t really seem that all the banks really want this extra money. The idea is that banks aren’t lending because they are undercapitalized, but they may not be lending because the economy is weak, and they’re just too afraid. They’ve been talking about handouts for the auto companies. If they get that, everybody will be there asking for help, including possibly the airlines.
Q. How was the original plan not a handout?
A. The question was, “Is it a pricing problem, or are these really bad securities?” Not that long ago, the view, and not just at the Federal Reserve, was that these assets were underpriced. In fact some of these assets were selling at 22 cents on the dollar, and even in the worst-case scenario, they had to be worth more than that. I think the view was that the government will just act as a buyer of last resort and correct the market.
Q. What would you have done?
A. I would have tried to have a politician promote the point of view that these mortgage-backed securities were terrible, and that the prices they were selling at were just wrong. They were undervalued. Of course, it’s not clear that anyone could have done that, but the president would have been one candidate.
Q. Why do you believe that the problem may have been one of pricing, meaning the assets, some of them selling as you noted for 22 cents on the dollar, were undervalued?
A. These are tranched securities, which means that if there are defaults, the senior credits get paid off first, while the most junior ones get paid last, if there is anything left over from the stream of mortgage payments. To explain 20 cents on the dollar, that’s roughly speaking, an 80 percent loss rate. To get that, you would have to have something like 80 percent of the mortgages default with zero recovery. House prices are down on average about 20 or 25 percent. These are incredibly low prices for these securities.
Q. Why do you think the government’s direct investments in banks are unlikely to ease any credit crunch holding back the economy?
A. I’m not sure the banks want to lend. Also, it’s not clear to me how many people want to borrow at the moment. If we do go into deflationary times, this debt is going to be a millstone around people’s necks. There’s not much the government can do about that. I think it’s still unlikely that we’ll go into anything like the Great Depression when unemployment was 25 percent. On the other hand, it may be the modern equivalent, which would be something like 10 percent unemployment. I’m not sure history is much guide because it’s been a long time since we’ve had this kind of situation.
Q. Some critics have said the Federal Reserve and the government are fighting the last war — injecting huge amounts of liquidity into the system because the failure to do so led to the Great Depression — when the problem this time is lack of confidence in the markets. What do you think?
A. I don’t think they had much of a choice there. Whether it’s done much good I think is questionable, but it wasn’t worth taking the risk of not doing it.
The William and Jacalyn Egan
Professor; Professor of Management
Mike Useem is a student of how leaders make decisions under pressure. The Wharton management professor has drawn leadership lessons from the battlefield at Gettysburg and from the Dalai Lama. One of the students who absorbed those lessons was Neel Kashkari, the 2002 Wharton graduate overseeing the Treasury Department’s bailout plan. History has yet to render a verdict on Kashkari’s actions, but Useem sees some lessons emerging already from the actions of industry and government.
Q. From a leadership perspective, what caused this economic turmoil? And how well do you think U.S. leaders are handling it?
A. The question I have asked myself a dozen times over is, “Why is it that very smart and highly experienced people didn’t see the economic turmoil coming, or at least didn’t take steps early enough to avert the turmoil once the warning signs became evident?” I believe one obvious answer is that we suffered from a momentary myopia or even euphoria of cashing-in on short-term gains without adequate regard for systemic risks.
Now we all have to hope that those in leadership positions in business and government who are making the fateful decisions on how to overcome the turmoil are applying great care and intelligence in reaching their decisions — and that they have become far more mindful of the systemic risks that have insidiously accumulated in recent years. The impact of their decisions could well be historic, defining our nation’s future the same way that critical decisions by President Roosevelt helped America end the Great Depression. Today’s decisions, made right, could reverse the turmoil; made wrong, they will only deepen it.
So far, in my opinion, the jury is still out on those decisions. The U.S. Treasury at times exhibited a halting and uneven approach, and even more so did Congress. Consider Treasury’s decision to help save Bear Stearns but not Lehman Brothers, and Congress’s decision to rescue the mortgage lenders but not the automakers. The patchy decision-making reflected in part the terra incognita that we had stumbled onto without quite realizing where we had ventured. We are now all coming to realize that this is a unique and unfamiliar crisis, and that its enormity exceeds anything that we have experienced in recent decades. With this recognition, the Administration, Congress, and Federal Reserve have fortunately shifted into high gear. When anxiety and fear runs deep, panic and paralysis can interfere with good and timely decision making, but the powers that be have managed to stay focused and engaged, swiftly acting to avert the worst.
Q. Former Citigroup chief executive Charles O. Prince used the phrase, “As long as the music is playing, you’ve got to get up and dance,” to explain why he felt he couldn’t get out of the subprime market, even when problems started to become clear. What do you make of this logic — that executives simply have no choice but to join in when so much money is being made?
A. When everybody is dancing to the same tune, that is exactly the moment that a company leader who has been entrusted with other people’s assets should be making a hardheaded independent assessment of what will best grow and protect those assets, regardless of how the competitors are dancing. To do otherwise is to abdicate a defining responsibility of leadership, which is to help others to achieve their common goals by protecting them from risks they do not see but the leader should.
Consider an odd analog, that of fighting raging fires in urban and wilderness settings. Incident commanders are given the authority to place firefighters in harm’s way. The leaders of firefighting teams — sometimes numbering in the thousands when forest and brush fires threaten urban areas such as San Diego or Los Angeles — are charged with not only suppressing the fires, but also, above all, protecting the lives of the frontline firefighters who do not necessarily see a roaring blaze behind a nearby hill that threatens to overtake them. The same on Wall Street: bank executives must not only ensure prudent growth in their assets and returns, the equivalent of defeating the fire, but also ensure that customer assets, investor shares, and employee jobs are not placed at fatal risk.
Q. What did you think when former Federal Reserve Chairman Alan Greenspan went before Congress and said he was surprised that free markets did not work as he expected?
A. Alan Greenspan stated in his testimony that our financial crisis is a once-in-a-century event, and that intuitively sounds about right. But that’s exactly what people in high station are charged to think about ahead of time. Academic research confirms that if left to our own devices, our minds often turn a low probability event into one we think has no probability. But a leader’s obligation is to self-consciously work to overcome such natural biases that lead to sub-optimal decision making, and to be ready for very unlikely but high-consequence events, ranging from terrorist attacks to financial meltdowns.
Connecting the ominous dots that are not normally seen to connect is one way to be more prepared. The near-loss of Long-Term Capital Management in 1998, the collapse of the Internet bubble in 2001, and the explosive growth of subprime mortgages in recent years were among the dots that, with the benefit of hindsight, might have been better connected. Making those dots more transparent and more readily connected — and at the same time mastering the art of avoiding false signals — is one of the reform tasks ahead.
Q. Members of the U.S. government seem to waver in their opinions and don’t seem to speak with one voice. Treasury Secretary Hank Paulson first wanted to use the bailout money to buy troubled assets and then said he would not use it for that. Then, the FDIC came out with its own plan to help homeowners. Is it good to have a variety of viewpoints, or does it just confuse people?
A. The proposed restructuring of General Motors was instructive. When it proposed a bailout strategy to Congress and the White House this December, we expected a single plan from the company, not a host of competing proposals. CEO Rick Wagoner and his lieutenants no doubt debated the best options for the plan behind their closed doors, but he then set forward a single proposal. Whether the plan was good or less than good, and it drew ample criticism from Congress, the credibility of the company would have been even less if it had spoken with several voices. By the same token, if key U.S. decision makers can speak with common voice on the most important ways for overcoming our financial turmoil, everybody from domestic consumers to foreign investors will have greater confidence that our national leadership has found a good way forward.
JEREMY J. SIEGEL
Russell E. Palmer Professor of Finance
In the last six months, Jeremy Siegel has shifted from thinking recession was a relatively slim possibility to believing the country is in one. But he also thinks the United States — and the world — will not only survive but thrive enough to give stock investors solid returns over the long run.
Q. When we talked in the spring, you weren’t sure whether the country would enter a recession. What do you think now?
A. We are certainly in a recession, and it is going to be more severe than what we had in 1991 or 2001, although I do not think it will be as severe as in the 1970s and 1980s. I do not believe unemployment will rise over 8 percent.
Q. How well do you think the Fed has handled the credit crisis?
A. In retrospect, the government should probably not have let Lehman Brothers go under since it caused unprecedented chaos in the money markets. Overall, the Fed has been doing an excellent job of adding liquidity and preserving the integrity of deposits and our payments system.
Q. You have been telling investors to put money in foreign markets because they are growing so quickly. Where do you think global markets stand now, after this broad downturn?
A. Foreign markets have declined more than U.S. markets, and are down from 40 percent to 75 percent or more. I believe they will bounce back. Almost all equity markets are now priced at levels that will give investors generous returns going forward.
Q. You’ve said that if you were grading the Treasury plan, you would give it a B+ but would give an F, or worse, for how it was marketed. Where do you think the government failed in marketing?
A. They explained the plan very poorly to Congress and didn’t know how to conduct an auction of these troubled assets. Also, they didn’t counter the word “bailout” that was used by so many and failed to indicate that the government could make a profit on these purchases.
Q. Japan took well over a decade to work its way out of an asset bubble similar to the one we’re experiencing now. Investors in the Japanese stock market have done poorly. What makes you think a downturn that extensive won’t happen in the United States?
A. First, Japan had a much worse bubble in both stock and real estate. Also Japan didn’t lower interest rates quickly and never had a plan to recapitalize the banks.
Q. Do you think the government should bail out the auto industry?
A. No, it isn’t a good idea at all. There is no comparison between the financial industry and the auto industry. If General Motors went bankrupt, GM stock and bonds would be little affected since that possibility is already built into the asset prices. Also, the job losses would not be anywhere as high as the industry says as bankruptcy will allow them to continue to operate.
STEPHEN J. HOCH
Patty and Jay H. Baker Professor Professor of Marketing
Stephen Hoch knew the outlook for retail was poor when we talked to him last spring. But it’s turned out even worse than he thought. Bellwether department store Macy’s lost $44 million in the third quarter of 2008 and said the thenupcoming holiday season would be a “nail biter.” Retailer Wal-mart, which boosted its earnings by 10 percent in the third quarter of fiscal 2008, lowered its forecast for the year, citing a weakening economy and a stronger dollar. Hoch doesn’t expect improvement for a long time.
Q. Have recent events in the economy — the drop in the stock market, the bailout plan — changed your outlook?
A. I wasn’t expecting it to be that great because of softening, but this is beyond anybody’s expectations. My guess is that it’s going to be a lousy end of year for retail, but it’s going to be a lousy end of year for a lot of things. Obviously, if unemployment keeps going up, it’s going to be tough for retail.
I think there’s a trend toward a very quiet Christmas. People are going to change their focus to their families and friends. Even if they can afford it, they are looking around and seeing that there’s a lot of pain out there for other people, so there is not a lot of interest in going out and buying. Normally, by this time of year, I’ve had like 10 calls on “Christmas creep,” the phenomenon where holiday decorations and items seem to appear in stores earlier and earlier every year. This year, I haven’t had a single one.
Q. Will any sectors of retail do better than others?
A. This is almost trivial given the pain, but high-end retail is also going to be feeling it. One of the things propping up the high end was the cheap dollar. Europeans were just propping up that end of the market. A bunch of New York retailers like Tiffany’s and Saks Fifth Avenue benefited from the weak dollar and people flying over to shop. You can see a similar phenomenon related to gas prices. You don’t see people going around buying Escalades anymore. Can you imagine how embarrassing it would be to go in and buy one of those things now? All of it really happened fast. The auto business has just stopped. As an accounting friend of mine said, “You can’t get a loan, can’t get a lease at all. If you want to buy a car, you have to put down $50,000.”
We’ll see the same trend with food. Humans have to eat protein, but it doesn’t have to be meat. It doesn’t have to be expensive meat. People are going to shift their consumption. They’ll go to Target rather than Macy’s, and to the Dollar Store rather than Wal-mart.
Even before this complete cratering in retail, I’ve been thinking that the low-cost providers are generally in a better position. Just as Dell was the low-cost provider in computers, and decided to grab market share from Hewlett-Packard, you may see similar attempts with retailers in this downturn. The low-cost guys are better positioned to grab market share, and the higher-priced competitors are not. For example, you can go to Costco and get jeans for $12.95 or go someplace and spend $200. My kids make fun of them, but what the heck. I’m 56 years old, so I wear jeans for maybe other reasons than other people.
Q. How much do you think retail spending will fall?
A. Well, there’s no inflation, or not that much. The population is still growing a bit. My guess is that excluding gas and cars, I wouldn’t say it’s going to be down much more than 1 percent or 2 percent. There’s a big chunk of retail that’s totally non-discretionary. It’s clear the home-improvement guys are just kind of waiting it out, and I would think that people before who might have been interested in getting a 52-inch television are probably satisfied to go with the 42- inch TV they’ve already got.
Q. What are some of the other reasons you don’t see a larger retail downturn?
A. For a lot of people Christmas is non-discretionary, but the amount is discretionary. The thought of having a holiday is part of western, or U.S., traditions. It could be larger if unemployment goes crazy and goes up to 8 percent or 10 percent. I can’t imagine that happening by the end of the year, but it could happen by the end of the first quarter. There’s population growth. There are increases in disposable income. There’s inflation. I just don’t see it being the end of the world.
Writer Miriam Hill is a business reporter for the Philadelphia Inquirer.