Excerpt of an interview with Harvard professor & America's most influential economist, Martin Feldstein. The entire transcript is available in the April-May 2008 issue of 'Mutual Fund Insight'. To subscribe for this magazine, please click here.
How different is this U.S. recession in origin and character to the earlier downturns?
The recessions that began in 1991 and 2001 lasted only 8 months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.
Previous recessions were basically caused by the Federal Reserve tightening in order to overcome excessive inflation. So the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back towards price stability. It then reversed course, reduced interest rates and brought the recession to an end.
The causes of this recession are much more fundamental. It was not a tightening of monetary policy but the bursting of the house-price bubble after 6 years of exceptionally rapid house-price increases.
Do you think it will be longer and deeper and more painful than the previous ones?
Yes, I think it will be deeper.
House prices have been going up for some time, but suddenly there was an inflection in the year 2000 and they moved up very sharply, something like 60%. So they inevitably had to come down. It was a super dot com bubble. I say super because housing wealth is much greater than the dot com wealth. Homes are worth about $20 trillion in the U.S. So a 20% fall on that is a major loss on household wealth and consumption. Unfortunately it was combined with a very high loan-to-value ratio that created the kind of situation we are in.
Traditionally, people's mortgages were around 70-80%. But with house prices rapidly moving up, people wanted to buy quickly. So people who did not have much money would put just 5% or 10% down. And the banks foolishly agreed. They would lend 90% of the value of the home since house prices were going up so fast that they figured within two years it would be 75%. Many of the loans made from 2005 onwards have turned out to be negative loan-to-value ratio.
There is an unprecedented level of negative equity in U.S. homes - 13% of homes at the end of 2007 had negative equity. That is about a trillion dollars of mortgages.
What is your take on decoupling with the U.S. in a recession?
I don't think we can have complete decoupling. There are too many links - trade links, intra market links. But I think the impact on India and China will be relatively small. Exports to U.S. form a small part of India's trade and GDP. China's net exports (when you net through how much it imports in order to re-export) are not so much a driving force in their economy. If their exports slow down, they will shift toward more domestic spending.
The Europeans and Canadians are much more closely linked. Since the dollar is going to keep coming down, the U.S. trade deficit is going to shrink. Not just for six months or a year but over a longer term. It's a wake up call to other countries to stimulate domestic demand to take the place of exports.
Do you think the dollar is going to keep coming down?
When you compare the real trade weighted value of the dollar last year with 20 years earlier, it has come down by 7% - less than half-a-percent a year. So it has basically not changed very much at all. The dollar has to keep coming down in order to decrease the large trade deficit. Our trade deficit peaked in 2006 and fell last year. So a weaker dollar is helping. We still have a trade deficit that is 5% of GDP. I don't have much doubt that over the longer term the dollar will keep coming down.
How scary is the situation on Wall Street?
Very scary. Citigroup's shares were around $70 year ago. When its capital was in danger, it came out with convertible preferred securities at little more than $30. The stock is now at around $20. These firms were running asset-capital ratios of 25 to 30. You don't need much of a loss in the value of your assets to wipe out your capital. Just look at what happened to Bear Stearns, an old and respected institution. There is a lot of nervousness out there on Wall Street. And I guess the Fed did not want to take the chance of letting Bear Stearns go under.
How different is this U.S. recession in origin and character to the earlier downturns?
The recessions that began in 1991 and 2001 lasted only 8 months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.
Previous recessions were basically caused by the Federal Reserve tightening in order to overcome excessive inflation. So the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back towards price stability. It then reversed course, reduced interest rates and brought the recession to an end.
The causes of this recession are much more fundamental. It was not a tightening of monetary policy but the bursting of the house-price bubble after 6 years of exceptionally rapid house-price increases.
Do you think it will be longer and deeper and more painful than the previous ones?
Yes, I think it will be deeper.
House prices have been going up for some time, but suddenly there was an inflection in the year 2000 and they moved up very sharply, something like 60%. So they inevitably had to come down. It was a super dot com bubble. I say super because housing wealth is much greater than the dot com wealth. Homes are worth about $20 trillion in the U.S. So a 20% fall on that is a major loss on household wealth and consumption. Unfortunately it was combined with a very high loan-to-value ratio that created the kind of situation we are in.
Traditionally, people's mortgages were around 70-80%. But with house prices rapidly moving up, people wanted to buy quickly. So people who did not have much money would put just 5% or 10% down. And the banks foolishly agreed. They would lend 90% of the value of the home since house prices were going up so fast that they figured within two years it would be 75%. Many of the loans made from 2005 onwards have turned out to be negative loan-to-value ratio.
There is an unprecedented level of negative equity in U.S. homes - 13% of homes at the end of 2007 had negative equity. That is about a trillion dollars of mortgages.
What is your take on decoupling with the U.S. in a recession?
I don't think we can have complete decoupling. There are too many links - trade links, intra market links. But I think the impact on India and China will be relatively small. Exports to U.S. form a small part of India's trade and GDP. China's net exports (when you net through how much it imports in order to re-export) are not so much a driving force in their economy. If their exports slow down, they will shift toward more domestic spending.
The Europeans and Canadians are much more closely linked. Since the dollar is going to keep coming down, the U.S. trade deficit is going to shrink. Not just for six months or a year but over a longer term. It's a wake up call to other countries to stimulate domestic demand to take the place of exports.
Do you think the dollar is going to keep coming down?
When you compare the real trade weighted value of the dollar last year with 20 years earlier, it has come down by 7% - less than half-a-percent a year. So it has basically not changed very much at all. The dollar has to keep coming down in order to decrease the large trade deficit. Our trade deficit peaked in 2006 and fell last year. So a weaker dollar is helping. We still have a trade deficit that is 5% of GDP. I don't have much doubt that over the longer term the dollar will keep coming down.
How scary is the situation on Wall Street?
Very scary. Citigroup's shares were around $70 year ago. When its capital was in danger, it came out with convertible preferred securities at little more than $30. The stock is now at around $20. These firms were running asset-capital ratios of 25 to 30. You don't need much of a loss in the value of your assets to wipe out your capital. Just look at what happened to Bear Stearns, an old and respected institution. There is a lot of nervousness out there on Wall Street. And I guess the Fed did not want to take the chance of letting Bear Stearns go under.
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