THREE IMPORTANT ELEMENTS THAT MAKE THIS ECONOMIC DOWNTURN DIFFERENT AND

MORE DIFFICULT TO DEAL WITH, RELATIVE TO A “TYPICAL”

DOWNTURN

• FEAR

• UNCERTAINTY

• DISTRUST

Applying these three terms to a current event – I almost fell off my

chair!

From the Front Page of the Centre Daily Times, Thursday, March 26,

2009

BACK PEDALING ON BONUSES

• “Lawmakers are softening their stance on denying bonuses to employees of bailed-out financial institutions after President Barack Obama warned them against alienating the industry.”

• Refer to cartoon

AND….

• “Less than a week after pushing through legislation to impose a 90 percent tax on the bonuses, the House Financial Services Committee prepared a considerably milder proposal that would let Treasury Secretary Timothy Geithner and financial regulators decide if employee compensation was “unreasonable” or “excessive”

We need a new major!

A BS degree in determining whether or not compensation is “unreasonable” or “excessive”

!

Think of all the calls you will get!

This is just one of a string of government actions (including the

Federal Reserve) that has (unfortunately and unintentionally) created or has added to a mood of fear, uncertainty, and distrust in the

economy.

• In defense of the Government (and related institutions as the Federal Reserve), we are in uncharted waters and these decisions have been rushed at best and urgent at worst. We live in an extremely complex world that is inter-connected like never before…..

In the past few decades we have experienced major changes in the world of finance including, but not

limited to:

• , the globalization of financial markets (computer technology plays a critical role here – a ‘borderless world”)

• major financial innovations that have created financial instruments that got so complicated, many people who were trading them didn’t even understand what they were trading… many are now “toxic”

• Financial Deregulation – the Greenspan Fed and many others felt that a ‘hands off’ was preferable to a ‘hands on’ policy. This development got ‘us’ into a lot of trouble.

So without a doubt, the world economy is interconnected like never before – think of it as the

inside of a watch – there are many moving parts that need to move in

order for the watch to work.

Observations

• When one wheel stops – they all do.• One of these wheels is AIG as in “too big to fail”• Another way to say it: The failure of AIG poses a

“systemic risk” as in, the whole system may collapse if AIG fails (all wheels stop). Since we can’t afford that, we are not going to let it happen (referred to as ‘risk management’)

• These are tough choices – Bernanke and banging the phone more than once with AIG.

Let’s digress and talk about what got us here, take a look at some

major current economic statistics, and the corresponding reaction by

the policymakers.

What got us here – the “Perfect Storm”

• The bipartisan support for more homeownership - more is better

• Very low long-term real interest rates – Greenspan, China and the glut of savings

• Deregulation and Globalization of Financial Markets – NINJA no doc loans, package into MBS, get a rubber stamped AAA rating, and sell to whoever wants a ‘safe asset with a high return’

• Greed – discuss credit default swaps and how they worked – rumors – easy money?

A look at some economic statisitics – start with the three biggies

Others…

Wealth lost in 2008 = …… add in real estate losses, along with many job losses (get a number) and job

insecurity, along with aforementioned 3 elements of this downturn, fear, uncertainty, and distrust, and we have a mess!

Policy Reaction

Fiscal Policy

• Extremely expansive – will it work?

• Discuss feud with Europe – we want them to expand fiscally (like us) but they disagree (i.e., they believe that fiscal expansion is not necessary and not wise).

• Discuss flexibility (or lack there of).

Monetary Policy

• Extremely Expansive – in a “quantitative easing” mode…. More money is better…..we learned our lesson from the Great Depression

• Will it work?

• Concerns?

Important points moving forward : What Next?

• Regulation – this is a sticky point and is quite controversial – we all agree that we need more regulation but how much is enough and how much is too much? And who is do it? The Government or private firm? Should we have one or many? More questions than answers.

Important points moving forward : What Next?

• Dealing with systemic risk and the institutions that are “too big to fail.” Policymakers are working on this as we speak. The idea is to wind down these ‘zombie’ institutions in a gradual and predictable way. This will help immensely with public discord regarding bailouts.

Important points moving forward : What Next?

• Dealing with strings attached to government aid/finance. We can’t have ‘no strings attached’ but we could imagine “too many strings” being attached as in the Gov and the AIG bonuses (e.g., the resignation of the AIG VP in the NY Times yesterday, the article “Backpedaling”) and banks giving back their money as in “thanks but no thanks” regarding TARP money.

Important points moving forward : What Next?

• The Fed and all the money creation. Do they have a viable exit strategy (to avoid inflation) and has there been a permanent change (loss) in the Fed’s treasured independence? The farther into the private sector the Fed journeys, the higher the risk of losing that independence.

• Closing comments – a silver lining?

• What goes up also goes down – recessions happen.

• Consumers and spending beyond our means. Maybe we will start living within our means and save more. The increase in savings will make us less dependent on financing our previous “reckless” spending with savings from abroad (i.e., a more sustainable trade balance) and instead, will allow the savings to go into productivity enhancing investments that are the key to increasing living standards.

• Regulatory environment: We needed to deal with re-regulation sooner or later – sooner of course is better. There are many very smart people working on this re-regulation and if we get it right, a crisis like this will never happen again.

• Time is on our side. Fiscal policy and Monetary policy work with lags and thus, have not fully ‘kicked’ in yet. In addition, those three elements of fear, uncertainty, and distrust will all subside with time, and those wheels in that watch will all start turning again……. But when???

• My prediction: The economy will begin growing again by the fourth quarter of this year…… but remember, we aren’t very good at forecasting!

• Thank You Very Much, It has been my pleasure!