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World Economic Update [Rush Transcript; Federal News Service]

Speakers: Robert Shiller, Professor of Economics, Yale University, Peter Hooper, Managing Director and Chief Economist, Deutsche Bank Securities, and Stephen S. Roach, Chief Economist and Managing Director, Morgan Stanley
Moderator: Daniel K. Tarullo, Professor of Law, Georgetown University Law Center
September 9, 2007
Council on Foreign Relations


September 11, 2007

DANIEL K. TARULLO: We want to get ourselves started here, so we can get you out on time.

Welcome to -- we've styled this quick-hit edition of the world economic update. Quick hit because we're being hit right now.

A couple of introductory remarks which you've heard before. You know that this meeting is on the record. I hope you've already turned off or at least silenced your cell phones, pagers, BlackBerrys and any other electronic devices. And you know, I think, that council members around the country and the world are participating in this event through -- I'm told it's a password-protected -- teleconference.

We're very pleased to have with us this morning for the first time, sitting to my immediately left, Professor Robert Shiller of Yale University whom, as you know, literally wrote the book on irrational exuberance. Rejoining us -- for I'm not sure how many times Peter has been here -- Peter Hooper from Deutsche Bank. And someone who couldn't resist coming back halfway around the world -- (laughter) -- as things turn bad as had been predicted in his new avatar as chairman of Morgan Stanley Asia, Steve Roach.

Well, as you know, usually in one of these sessions, we have two or three different questions which take a little while to elaborate. I think the questions this morning are pretty simple, and there are three of them. What's happened and why? What happens next? And what should be done? (Laughter.) So we're going to take those in turn, and let's start with the what has happened.

Now, in purely factual terms, we know some of what's happened. There has been a re-pricing of risk across a pretty broad range of asset classes. Anyone who had been watching the Case-Shiller index knew that housing prices had already been falling before the events of the last six weeks or so. We've seen subprime problems for at least a year in terms of increased delinquencies and defaults. But something different, obviously, did happen last month. The unexpected development, I think, at least no one I've spoke with has said they expected it, was the freezing up of the commercial paper markets. The asset-backed, commercial-paper interest rate in mid July was around 5.3 percent. Today, it's around 6.2 percent. The amount of all forms of commercial paper that have been on the market has plummeted, contracting at a rate of about $60 billion a week for the last few weeks. This is a new development and something which is, obviously, creating a new set of problems.

So, Bob, maybe we can start with you just to give a bit of perspective on exactly what has been happening in the markets and why it happened now.

ROBERT J. SHILLER: Well, I've written a whole book on this. How much do you want me to expand? (Laughter.)

TARULLO: Chapter one.

SHILLER: Okay, first of all, I'm an academic. So I'd just say in general terms we're seeing -- this is very general at first -- the result of feedback. The economic system is very interdependent and that psychological feedback operates. And also we've been seeing the results of innovation -- financial innovation -- which is something I heartily applaud but understand that when things change institutionally, there are errors that are made. And that's part of what we're seeing. So there are so many different perspectives. The fundamental thing is that we have seen the biggest real estate bubble in world history. It has never been this pervasive. We've seen local real estate bubbles going back over 100 years.

But a fundamental change in our thinking has happened where we tend to view housing as (a spectacularly less ?) -- well, we did recently. And this has somehow claimed the imagination of people all over the world, and it's caused a huge increase in housing asset values. But whenever you have a boom, there's also -- we look down our guard on financial -- well, our lending standards decline, new institutions are developed that are experimental, and we don't know what their outcome will be.

But anyway, (then I ?) -- (inaudible). We have passed the peak in terms of rate of increase of home prices a couple of years ago in 2005. So we've been heading down for two years now. The recent event which I think is prompting this is kind of a bank run that often occurs at the end of a speculative boom. But I guess Paul McCulley at PIMCO calls it a run on the shadow banking system. The shadow banking system being the issuers of asset-backed commercial paper.

We somehow escaped -- with all this financial innovation and change, they never really got under the regulatory arm of the Federal Reserve and other agencies, so they're kind of like a 19th-century banking crisis that we're seeing repeat. And it's happening again, because these things are natural. They naturally follow on a speculative boom. And we just didn't get our regulation and our monetary authorities in charge of these people. So it's unwinding as has happened many times in history.


Peter, what, if anything, would you add or qualify in what Bob has said?

PETER HOOPER: Maybe to get a little more specific on aspects, I agree fully with the overview Bob has given here that we tend to have these cycles. They follow one another. This one followed as central banks, particularly the Fed, lowered rates to very low levels to deal with the last bubble or the bursting of the previous bubble, the stock market and investment bubble of the last '90s. That very low level of interest rates had its traction primarily or most importantly through the housing market stimulating that sector, keeping the economy to a very mild recession. An extremely deep recession in business spending, but consumers never turned down, and the housing market boomed along.

And as Bob suggested, as these booms come, you tend to get excesses, and certainly we had some severe lending excesses in 2005, 2006 in subprime. And we're now paying the price there.

The thing that caught us by surprise -- we had been thinking that the subprime mortgage loss which we were sharpening our pencils and trying to get a handle on what the total value of this loss was -- 100 (billion dollars), 150 (billion dollars), 200 billion (dollars) -- seemed manageable against the background of what total assets of lending institutions were. And it seemed also manageable in the sense that nobody knew exactly where these losses lay. The feeling was they were widely distributed; therefore, it would be more manageable than during crises in the past when you had them very concentrated in particular financial institutions.

Well, what caught us, I think, by surprise is the reaction that you did have -- the bank-run type of reaction. It was as these losses became evident that the securities in which the subprime mortgages were being held were themselves at risk, people, investors withdrew. And there was a very sudden and sharp withdrawal, not just from the mortgage-backed securities but more broadly any securitized asset that was at risk of holding the securities directly or indirectly. That's how it spread over to the commercial paper market. You've had an investor strike. Investors are just not buying what used to be thought of as very high quality, very low risk paper. So you have a banking system which is generally viewed to be in very good shape, well capitalized, but large banks are just not lending to one another. I mean, there's just a sudden freeze, if you will, in the plumbing here. And it's, I think, a dangerous freeze, one that will have to be dealt with.

TARULLO: Now, Peter, just to clarify one point here. Is the freeze and is the run on the bank to which Bob alluded principally, in your view, because no one really knows what to make of the values of the assets that are backing either the commercial paper or any other collateralized loans or anything else? Is this, at root, a transparency problem?

HOOPER: There is a transparency problem. There's an uncertainty where these losses lie, certainly on how to value but more so exactly where they lie, who is at risk here. I mean, to solve this problem, we will need to have disclosure of who holds what and how to value the assets that they hold. That's going to take time. But I think as a result of this uncertainty, investors have withdrawn from risk. You've gone from a situation where you had a tremendous appetite for risk -- I think bubbles tend to inflate gradually and then to deflate very quickly -- to just the opposite, a complete withdrawal from risk. And that's a bad situation. You want to have risk-taking. That's part of what makes the economy function. But we've gone from one extreme to another here, and that's what's given us this current problem.

TARULLO: Steve, I remember -- boy, I can't remember how many years ago, but I know it's in years -- that you were talking about the asset bubbles which you saw developing and bemoaning the fact that in your view, the Fed wasn't paying enough attention to the inflating of asset bubbles. In retrospect, how big a role do you think monetary policy played in promoting the development of the bubble which is now bursting around us?

STEPHEN S. ROACH: Well, first of all, thank you for having me back. I told you I would keep coming back until I was right -- (laughter) -- and then you said well, that may be a little bit too long to wait.

I think central banks, especially the Federal Reserve, have tremendous responsibility in creating an environment that has allowed the United States, the world's greatest economy in the last seven years, to go from equity bubble, to property bubble, to credit bubble, you know, you name it. We have just gone from bubble to bubble to bubble. And they have a view that was articulated by my old friend Rick Mishkin in Jackson Hole 10 days ago, and first postulated by the great maestro -- who I'm sure you're going to all run out and buy his book next week -- and again, by Ben Bernanke that the central bank should not be in the business of worrying about asset markets. It has the ability and the fire power to come in and clean up the mess after the bubble bursts.

I completely reject that. I think that's an unconscionable way to run modern monetary policy in an increasingly modern era -- which Bob Shiller correctly indicated because he's on the leading edge of it, that is driven by innovation, very complex securities and a lot of non-bank intermediation, and it's increasingly connected globally.

The idea that all of these problems can be fixed by adhering to a narrow CPI target, whether it's core or headline, is absolutely ludicrous. And so what Greenspan did incorrectly -- well, I mean, go back, I mean, we have two people here who were actually present at a Fed meeting in -- when was it?

HOOPER: 1996

ROACH: It was 1996 -- Bob was there, and my great friend Byron Wein was there -- maybe a few weeks before the irrational exuberance -- two days, two days before, okay -- and Greenspan had it right then. He said the stock market was irrationally exuberant. And then he actually delivered on that in March of the following year with a 25 basis point tightening aimed at going after the asset bubble, and was, you know, criticized, changed his mind and then became a cheerleader for the bubble, which I think was a huge mistake that he made.

The bubble popped and then he did what he had to do, which was ease aggressively, setting us up for bubble after bubble after bubble. So now we're in this -- on this treadmill where the Fed's just saying to you, you know, we know we have a problem and there may be bubbles but, you know, we'll always be there to clean up the mess afterwards. I mean, it's moral hazard, it's a -- it's a dysfunctional monetary policy. You want to know how I really feel about it? (Laughter.)

TARULLO: Bob, what is your view on both the specific matter, of whether Fed monetary policy over the -- the degree to which Fed policy over the last five or six or seven years has exacerbated the bubble and thus the aftermath, and, more generally, on the degree to which the Feds should take asset values into account in setting its own monetary policy?

SHILLER: Well, the Fed cut rates -- funds rate such that the real funds rate was negative for 31 months, from 2002 to 2005. The only other time that they have exceeded that was 1974 to '77 under Arthur Burns, they cut rates -- they had negative fund rates for 37 months that time.

The outcome of the Arthur Burns negative real rates was catastrophic because inflation built to record levels. After Bill Miller we had Paul Volcker who came in and had to clean up the mess created by Arthur Burns -- pushed interest rates up to record highs, caused the biggest recession in the post-war period, and got us back on track. But that was the other experience.

So we have seen a long period of negative rates, and you kind of wonder why. Apparently, it was because of the sense that, already, that the Fed is watching out for inflation and not asset values. And inflation didn't seem to be picking up. Greenspan was getting accolades for having -- not having choked off growth prematurely, and so he kept doing that. But as a result, asset prices have gone up.

Now I don't think that it's just that. I think it's -- the whole system is more complicated. We can't blame a worldwide real estate boom just on Alan Greenspan. (Laughter.) But what should they have done? At the Jackson Hole conference, I was frustrated that there was so much talk about what we should have done and Mishkin saying we shouldn't have done anything differently. But there are a lot of disputes, but very little talk about what we're going to do. I guess the future is harder to talk about than the past. (Laughter.)

And so, since nobody else can talk eloquently on that, maybe I won't be able to either. But it seems to me that some interest rate cuts will probably be necessary. And also I think we have to increase our regulatory scopes and vigilance. We have to unite the different agencies that regulate mortgages. That's more for the next time. But the immediate thing is we do have a potential -- this crisis is not necessarily over -- the credit market crisis.

TARULLO: I do want to say what -- I want to turn to the question of what happens next, but just before we leave that, maybe we can go back, as a factual and explanatory matter, to the way in which the commercial paper -- the freezing of the commercial paper market is having negative feedback effects.

So one way is clearly that the enterprises, which have been relying on short-term commercial paper in order to raise money, are now not able to get that money. And they, in turn, are looking at the banks that have provided them contingent credit lines, and are saying we're now going to draw down on those credit lines. And the banks, in turn, are saying, well, now we may have these obligations so we better hold back from other lending. What else is going on, Peter, that's creating this problem?

HOOPER: Well --

TARULLO: We mentioned transparency, we mentioned the contingent obligations of the banks. Is there anything else we should have on the table?

HOOPER: I'm not sure of your question. The commercial paper market problem is a combination of, well, banks being unwilling to lend to one another -- banks not being able to raise term financing. Money markets that -- usually buy money market funds, that usually buy commercial paper, are -- (audio break) -- (hoarding ?) treasuries, are being more cautious. And as a result, banks are just having to pay higher -- significantly, very high rates by historical standards for -- (audio break) -- (term?) or 30, 60, 90-day loans.

That is raising the cost of credit at the very center of this plumbing system that runs our financial system overall. If it continues, it will result in higher rates, interest rates to households, to businesses, and that's going to be a depressing factor. The thing we can't really quantify is that it's not just a price effect, but there's benefit a cut in the quantity of credit available, at any price, just about. I mean, there's very little term lending going on to banks at these high prices.

The mortgage market -- the last year, 60 percent, nearly, of mortgage financing was -- (audio break) -- subprime, so-called "Alt-A" and "jumbo," and that's just about disappeared. So mortgage credit is, right now, very difficult to come by. That quantity effect is something we're not sure exactly what the effects will be. If it lasts much longer, you will begin to see some, I think, significantly negative effects on the economy.

TARULLO: I also wanted to give you a chance to weigh in -- although Bob is quite right; we can dwell too much on the past. I want to give you a chance to weigh in on the question of the Fed policies over the last several years, because I recall your view a year or a couple of years ago, I think, was, as you put it, the jury was still out. But I think you were trying to put yourself in the positions of the people then on the board who were worried that a tightening could have arrested the economic growth that was occurring three or four years ago. Did the jury come back in now?

HOOPER: It's always easy to criticize an institution that's at the center of this when the problem comes along. I think what you ought to consider is, what are the alternatives? What if, during the '90s boom -- and when you have a boom, there's a lot of momentum behind it. I mean, for the Fed to step in and stop a boom midway, it would have had to raise rates, I think, a great deal. And that would have precipitated a potentially very deep recession.

I mean, so we could -- we're here criticizing the Fed for managing things. Yes, it's been a rocky road and we're paying for their efforts to keep the economy out of deflation, which would have been -- if we'd been allowed to go into deflation, if we hadn't cut interest rates sharply, that would have put us in, I think, a much worse position than where we are right now.

If we had killed the boom in the late '90s with a very steep run-up on interest rates, we might -- who knows where our GDP per capita would be, but I maintain it'd be perhaps significantly below where it is now. I mean, home ownership -- yes, we've had excesses. Home ownership is way up. There are some benefits to what's been going on here.

I'm of the school that let's manage this as best we can. I think there are always going to be bubbles. If the Fed succeeds in achieving its goal of price stability and trend growth with great success, that is going to reduce economic volatility. That's going to reduce risk. That's going to encourage more investment. That's what we've seen. And that's a natural response for the financial sector, for investors, to take advantage of. I'm of the school that you're not going to avoid having bubbles no matter what you do. And perhaps having some of these bubbles is a sign of the success the policy has had in minimizing economic volatility.

TARULLO: David, do you want to come back on that, or should we move on?

SHILLER: Can I just comment?

TARULLO: Yeah, Bob.

SHILLER: I was impressed. Alan Greenspan gave a talk at Brookings last week, and I was impressed that he said almost exactly what -- he said that the bubble --

TARULLO: That may not be entirely coincidence.

SHILLER: Bubbles -- this is Greenspan; I don't remember the exact words -- but bubbles are essential to -- they're big and we can't avoid them. And then he, of course, absolved himself by saying there's not much we can do about them except maybe pick up the pieces afterwards.

I was surprised to hear them say that they're so central to the way economies work.

HOOPER: Well, because that's sort of what's defined his career. (Laughter.)

TARULLO: That's true. After the fact he's noticing that.

HOOPER: But let me just pick up on one thing before we move on to what's going to happen, Dan. And Peter alluded to this in his opening comments. You know, this freezing up of liquidity is as much expectational, driven by fear, as opposed to something traceable just to the narrow subset of mortgage-backed securities that clearly is in trouble.

And the reason the fear is there is because of the opaque nature of these structured products that contain subprime and these Alt A type securities. No one knows where they are. And the regulators, the central banks, are the last to know. And I've had discussions with them for a long time. They know very little about the distribution of counterparty risk in terms of who holds structured products.

And so the fear is that, you know, as we move into the mark-to-market process where holders have to sort of stand up and the bodies float to the surface, that there are going to be more and more of these accidents that then continue to have feedback effects, as Bob said, throughout the system into other types of investors, institutions and securities.

And so this is the dark side of financial engineering in the so-called distribution of risk, the automatic cushioning mechanism that we were told in good times would stabilize the system. The problem with that, while it's good in theory, to the extent the stabilizers really rest on these very opaque securities that no one understands, let alone the holders of it, that's a big, big risk. And I think that continues to undermine this key expectational dimension of liquidity.

And so, you know, the Fed does, you know, discount window operation, what have you. People come to work each day saying, "Oh, the worst is over." And yet rest assured that in this mark-to-market sort of accountability process that we're now about to go through, you could argue that there's plenty more that will be floating to the surface.

TARULLO: Well, one of the problems (might be ?) that people have been marking to model and not marking to market over the last several years, and only now are they beginning, actually, to mark to market.

Steve, let's pick up right there where you left off with asking what happens next. There are three sets of things maybe we could worry about: One, the intensification of the problems we've already seen in mortgage markets. I mean, there's -- the resets of adjustable rate mortgages are actually only now beginning to rise to their peak, and over the next year there are going to be more resets than there have been to date, so you've got the potential for more people having difficulty servicing their mortgages.

Second, as you suggested, there might be kind of contagion effect with the opaqueness of the whole system of complicated financial assets. And credit derivatives are the thing people have been whispering about -- "What's going on with credit derivatives?"

And third, and probably most importantly -- well, definitely most importantly -- what about the real economy? We're already seeing everybody adjusting their odds of a recession. Depending on where they started, they're jumping up a bit. But you hear anything now between 20 and 50 percent chance of a recession over the next 12 months.

Which -- any or all of those of particular concern to you? Where do you think -- I know how hard this is, given the opaqueness of it all, but where do you think we're going now?

ROACH: No, I think -- I just focus on the real economy linkage, Dan, because I think that's what we haven't talked about yet. And I think that's ultimately going to be critical.

Again, Peter said when the dot-com bubble burst -- and, by the way, there was huge denial this would have any impact on either the rest of the market or the real economy; that turned out to be wrong, of course. But the transmission -- the real economy took place through capital spending, as Peter said.

And I think at the end of '99, business capital spending was at a peak of about 14 percent of U.S. GDP and it collapsed. And that really drove the economy into this shallow but prolonged post-bubble recession.

This time it's the consumer. And this is really a fascinating issue. But I think the consumer's at risk. The consumer right now is at a record 72 percent of U.S. GDP. We've never seen a number like this in the history of the United States. It's five times the share the bubble-sensitive Cap X sector was seven years ago.

And consumers are hugely overextended in terms of income-based savings rates, debt ratios, lack of solid support from wage earnings. They're asset-dependent, and they've extracted a lot of equity from overvalued property. And as Bob has articulated very well for quite some time, the property bubble is over. And now what subprime does is it inhibits the refi, the ability to lever up the asset.

So lacking in income support, lacking in asset support, I don't think there's any way the consumer can hold at 72 percent of the GDP.

And it's just a question of sort of the descent of the consumer towards a more sustainable norm that has huge consequences for the U.S. and for the global economy -- you know, the big debate about, oh, the world is in great shape -- it's decoupled. You know, I now live in Asia, believe it or not, and the Asians say, "Oh, this can't hurt us. I mean, you know, what is subprime?" And if the U.S. consumer goes, Asia is going to figure out very quickly how decoupled it is from the U.S. And I think there's a lot of -- I mean, I know there's a lot of denial out there right now.

The consumer is the place to look. I could be wrong on that, but I have a pretty simple model. If consumers aren't driven by income, if they aren't driven by wealth, what are they driven by?

TARULLO: Bob? And the role of housing prices feeding into that?

SHILLER: The thing that I would stress -- and I agree with what you said, but what I would stress in addition is that home prices have increased -- real inflation directed home prices have increased about 85 percent over the last 10 years, and they have gone up almost as much as that relative to construction costs. So they're very highly valued. There's something uneven when they're way ahead of construction costs. That means the supply will eventually increase. That suggests to me that there could be a protracted decline in home prices continuing over years to come. And this shouldn't be a big surprise that from 1989 to 1994 there was an 8 percent fall. Since that was a five-year period, that amounts in real terms to more than a 20 percent fall in real home prices over that five years. So something like that is entirely plausible. What that will do to the consumer over these years is probably incline them, if that happens, to weaken their consumption spending.

One thing that's been happening is the saving rate, personal saving rate in the U.S., has just about hit zero. And one reason for that is that people see -- they almost think it's futile to save of your paycheck when your home price is doing 10 times better than you would likely -- you know, people make 10 (thousand dollars) or $20,000 a year -- it's all in their home. So they have this sense of security from the increasing home market. But if we see years of decline, that security will disappear.

TARULLO: Before I turn to Peter for his perspective on the world economy, Steve, let me just go back to you for a moment. Why, given what you said -- and what you said is hardly heterodox, now -- I mean, a lot of people are talking about these same sets of issues -- why have the equity markets to this point remained relatively unscathed? I mean, yeah, equity markets have dropped, but nowhere near what you would -- not even really a correction, much less an indication of a recession.

ROACH: Well, it depends on which day you pick. But, you're right, in general equity markets have really viewed the future, Dan, very differently than fixed-income markets. I mean, fixed-income markets are looking for fairly aggressive Fed easing between now and year end, and then going into '08, pretty much framing the view on the basis of an economy that, if it doesn't go into recession, it's pretty darn close to it. Then they've given up any fear of accelerating inflation. Equity markets, you know, just then you get caught up with maybe looking over the valley talking about booming growth at home and abroad, and ongoing earnings' vigor. The disparity between the two markets is about as wide as I've seen in a long time.

So, you know, one of these two markets is wrong. Stocks or bonds. And, you know, I definitely side with the bond market here. I think the equity market is far too overly optimistic at this point and is very vulnerable to what could easily turn into a consumer-led recession.

TARULLO: Peter, you were quoted in the paper, either yesterday or maybe on Friday, as saying you thought it was a bit too early to make a judgment as to whether we were starting to purely slide in the real economy. What's the story for how the reversals in financial markets and perhaps the problems to come don't push us into a serious economic slowdown or a recession?

HOOPER: At this point, I think the story is the decisive action by the Fed. I think that's critical. If we don't get it, then you do, I think, significantly increase the risk of sliding into recession.

TARULLO: Excuse me, and what's decisive action by the Fed right now?

HOOPER: Oh, I would say a 50 basis point cut at the meeting next week, followed up by more if needed, and a clear indication that more would be coming if needed. I think they have done a very good job of letting the market know they are aware of the problem. Maybe they don't fully understand all the aspects or exactly how best to deal with it. But --

TARULLO: Can I stop you? Do you think that they've done a good job of indicating that they're aware of it? I mean, their reaction -- the reactions of a number of governors early in August suggested a relatively low level of concern. Right? They didn't -- initially their reaction was only to change the discount rate, not the federal funds rate. Are they -- there's at least a case to be made for the proposition that the Fed has been a bit behind the curve either in their own analysis or in communicating to the public what their analysis is.

HOOPER: Well, relative to -- I mean, the Fed is an institution with many decision makers, and relative to their performance in the past I think they're about on track in the face of a financial crisis.

I was impressed on August 17 when they both did the discount rate -- which was a modification of monetary policy in an easing direction; they also stated that at that time they recognized that the risks have decidedly shifted to the downside, that now there was no longer a concern about inflation -- it was now a concern about the downside risk to the economy. They recognized their problems. I thought the speech that Ben Bernanke gave at Jackson Hole laid out a pretty good description of the problem they face in more detail than many were expecting.

And while you've gotten a number of different speeches from a number of different folks, there are some that I tend to focus a little bit more carefully on. I thought Jane Yolen gave a very nice speech yesterday detailing the problems that we face and a pretty clear understanding. I think the Fed has a lot of different contacts. They're talking to a lot of people. They're not ignorant about what's going on by any means. And it's gotten close enough to the next meeting that I think the decision to hold off and let's take the action at the next meeting. But the time is coming now for some decisive action -- not that monetary policy, not that a cut in interest rates is going to address the immediate problem that's causing this blockage of plumbing. I mean, that's going to have to be cleared eventually by the markets, by a disclosure of where the problem assets lie and what the valuations of these things are. That's going to take some time.

But what we need from the Fed is to avoid things getting a lot worse from here, for one thing, to maybe give the system a little more oxygen to help this process of writing off these loans. I think we're past the point now of moral hazard being an impediment. There are going to be losses -- there are going to be very large losses on Wall Street by holders of these assets. I think people will have learned the lesson we don't want to drag the whole economy down to ensure that every last investor pays fully for his or her transgressions on this.

But the reason for Fed action at this point is to help to bolster confidence. I mean, we are at a point now where the margin for error in the money markets is thin enough that any big negative surprises could really cause things to snowball downhill. We do need this confidence builder. I'll say that I agree fully that one reason the equity market is doing okay is the strong expectation that the Fed is going to do what it takes. And if it fails to do so, then if you add a down trend in the equity market to this down trend in home prices that is certainly upon us, I agree fully that with lending standards and the mortgage market having tightened substantially, with mortgage credit not available, demand for housing is going to be down.

There's going to be a lot of foreclosures coming, so supply is going up. And we're already facing a huge overhang excess supply of housing that's putting downward pressure on prices.

So these price declines that Bob's telling us about are certainly not implausible, and that is a critical variable for where the consumer goes going forward.

The economists are marking down their forecasts, I think. We're not yet in recession territory. My own view is we're somewhere in the -- I've been edging it up. A year ago I was 20 percent and now I'm somewhere between 30 and 40 percent. I'm not quite to the 50 percent camp, because I do have faith that the Fed --

ROACH: Peter, can I just ask you a question, though? This is -- I find, fascinating. And just some numbers: housing starts are down right now about 40 percent from their peak, and yet the employment in the residential construction sector is down only 5 percent. To me that is an extraordinary development because it says there's either a collapse in construction productivity or there's a huge decline that's about to begin in residential construction employment that is going to undermine income generation and again really tighten the noose on the consumer.

So what's going on here, in terms of the construction sector? I mean, I guess they're finishing up projects and they have these workers still on the job, but there's nothing in the pipeline. And doesn't that suggest there's going to be a huge layoff in residential construction with big macro consequences for the economy?

HOOPER: We've been waiting for this lag story to come through for some time now. I mean, I think actually, Steve, we're well past the normal lags and we're wondering if it's ever going to come now. And there are other potential explanations. We did see, on the way up, hiring lagged well behind the increase in construction. You didn't hire anywhere near as many people as you might have expected during the up cycle and now we're seeing the opposite on the down cycle.

One theory that does have some empirical support through other sources of data is that there's a lot of unreported hiring going on here. There are a lot of illegal immigrants. I mean, Latin American construction workers are prevalent in the U.S. construction industry. You've seen a very sharp decline in remittances of Latin American workers to their home countries -- Bank of Mexico reports a sharp drop.

So I think there are -- there are other --

TARULLO: So you're saying that there have been layoffs, but they're layoffs of illegal immigrants?

HOOPER: There are layoffs that are not being recorded. So I think we are seeing an adjustment and it's -- it can explain a significant part of the puzzle you're pointing to, Steve.

TARULLO: So Bob, do you agree that fairly aggressive easing by the Fed is indicated right now? And even if they ease fairly aggressively, will that be enough to cushion the economy from the effects of what I think you anticipate to be a short to medium-term housing decline no matter -- decline in prices no matter what people do?

SHILLER: Well, I think some easing is probably necessary after the next meeting. But I think the fundamental problem is going to be difficult to solve. Home prices have only fallen 3.2 percent since their peak in the second quarter of 2006 -- according to our indexes. That means that we're still very close to the peak. The problems come when home prices have fallen a lot from the peak and that puts more and more people underwater in their mortgages.

When people contemplate defaulting on their mortgage the first thought is: if I can't make these payments, look, I'll just sell the house and I'll get out of it cleanly and I'll have some money. Forget all these problems with foreclosure. When they're underwater they have a different opinion. They're much more likely to walk away and that means that the problem may be only just beginning. And the Fed can cut rates, but it doesn't change this fundamental imbalance in the housing market.

TARULLO: Steve, do you agree that fairly aggressive rate cuts are indicated?

ROACH: Yes, I do. But I think the Fed is a very incremental institution. And I think only rarely have they moved beyond, in recent years, this 25-basis point move per meeting. And again, I agree with what Bob Shiller just said. Whatever they elect to do next week is not going to alter this profound imbalance that's built up in the supply-and-demand forces in the property market, in the transmission of this wealth destruction into the consumer.

But the Fed, from the standpoint of its financial management responsibility in dealing with distressed markets will most assuredly ease. I wish they would do what Peter says. I'm not convinced they will, but if they do -- if they did 50 basis points -- I think that would be greeted with a very euphoric response in financial markets. And maybe that's what they want. Maybe the Fed is so conditioned by market response after all these years that they're playing for the markets and that's a risk.

TARULLO: I was just going to ask you: How much do you worry that if the Fed does what Peter suggested, and you just endorsed, that we've moved from a Greenspan put to a Bernanke put?

ROACH: Well, I think we sort of simplify and sort of personalize these things. But you know, I think the Fed in its studies of the lessons of Japan correctly came to the conclusion that in post-asset bubble economies, if a lot of risk builds, you want to be ahead of the curve and you want to be aggressive.

Where I am critical of the Fed is not in responding aggressively on the downside of these cycles, but in staying easy for much too long -- as Bob Shiller indicated in his description of the negative real federal funds rate for such a long period of time. If you're going to break this daisy chain, you've got to break it in the upturn, not in a downturn. The Fed's, you know, dealing with a downturn down. But it's got to, at some point, come to grips with this accession of bubbles.

TARULLO: Okay. So you're suggesting, I think, that it's not a moral hazard issue. That Peter's point that there's a lot of pain is a valid one, so it's not so much a matter of telling people, oh, that's okay. We'll take care of it, even if you have to --

ROACH: No. I wouldn't go -- you know, look -- no. I think it is a moral hazard issue, because if every time we have a bubble, and you know, the bubble brigade comes in and says, oh, it's time to clean it up again -- if that's not a moral hazard, I don't know what it is! So they're trying to, quote --

TARULLO: Well, but -- wait a second --

ROACH: They got us into this thing.

TARULLO: No. I understand that, but I'm saying they're two related but separate issues. One, the degree to which the moral hazard effects come ex-post because the Fed comes in and immediately props up asset prices by lowering interest rates. If there's a lot of real economic loss then you may have some moral hazard, but you don't have unabated moral hazard, right? People are still sustaining losses.

ROACH: Well, we can sort of split hairs on who's moral and who's immoral. (Laughter.)

TARULLO: All right. All right.


HOOPER: Well, let's look at where Fed funds are right now. They're at 5.25 percent -- by many estimates inside the Fed now at neutral and something below that -- maybe 4.5. That's been slightly above neutral, because financial market conditions had been so accommodative. Well now, those financial market conditions are no longer accommodative. They're something decidedly restrictive right now. So it's appropriate for the Fed to be thinking about cutting rates anyway.

On top of that, you have everyone marketing down their forecast for growth. We're probably sub-2 percent over the next several quarters with unemployment likely rising fairly significantly. I think the Fed's going to be forward-looking.

They're not going to pay much attention to data coming in right now that don't reflect the effects of the financial crisis we're in the middle of yet.

So I think there's a very reasonable point that can be made in favor of cutting rates solely because of where the macroeconomic outlook has moved, where financial markets and financial conditions have moved solely -- totally independently of doing something to make life easier for these -- the money market at this point in time. I think it would make good sense to try to do something -- to do that, anyway. I'm not -- I think -- as the money markets begin to become a significant risk to the macroeconomy, you have to begin to focus on that and less on the next moral hazard problem.

TARULLO: Bob, little that -- a little while ago when you tried to turn the conversation to looking forward, you mentioned Fed policy. But you also talked at the beginning -- talked about regulation. As you survey both the past and the present of asset bubbles and irrational exuberance, is -- are there regulatory steps that we ought to think about to -- which themselves could be a bit of a drag upon asset bubbles in the future? Or do that -- did those risk causing more harm than good?

SHILLER: I think a good part of what's happened is the regulatory failure. The mortgage industry is not regulated by any single federal agency. There's five different federal agencies and even they don't cover them all. I think that low-income mortgages used to be managed by the FHA and the VA and RHF, and these were -- I think they had more uniform standards of integrity, and people thought that this was the way things are done here. And then we started moving toward subprime -- private subprime mortgage lenders who were not always regulated and who did not always have the highest standards of integrity. So people were -- in many cases were encouraged to take out mortgages for which they were unsuitable. And that is a problem, and it's a -- I think it's a fundamental problem that we have to confront because the success of our economy is -- depends on a sense of fair dealing and the reason so many people invest in the U.S. is they trust our markets and our regulators and our standards.

So something wrong has been done and I think that we have to do something about that. And this wrong may be amplified with more foreclosures -- more people being turned out of their houses, and I just don't see that Congress should ever even think of standing by and just watching that happen. The last time we had a huge housing crisis in 1933, Congress sent up -- set up the Home Owners' Loan Corporation and it made a million loans to homeowners in distress. Now that was the Roosevelt time, but I think that we're -- we may be in another -- maybe not quite as bad as that, but we have to do something like that.

TARULLO: Let me -- and the kind of regulation you're talking about -- is it -- are you essentially saying we ought to extend lending -- the kind of lending standards that the Federal Bank regulatory agencies impose on ensured depository institutions to the uninsured institutions like mortgage companies, or is it more like consumer protection legislation that you're talking about?

SHILLER: Well, I like the proposal that Elizabeth Warren at the Hubbard Law School has. She says we should have a consumer product safety commission for mortgages, and that would be -- right now the various regulators are not -- their announced mission is not consumer protection.

TARULLO: (Inaudible.)

SHILLER: Yeah, and that -- we also need -- I suppose we also need NAR and other industry groups to take it upon themselves to strengthen suitability requirements, and so that it becomes more clear that you as a mortgage lender are responsible that the borrower is really going to be able to manage this mortgage.

TARULLO: Before we turn to the audience for questions, does either of you want to get in on the regulatory question? Because one of the -- we keep talking about the opaqueness of the markets and all these instruments. Is -- should anything be done at a regulatory level about opaqueness or should we just count on counterparties in the future asking --

ROACH: I'm not -- I would just -- you know, the only thing I would add to what Bob said -- and I agree with everything he said was again, you can't minimize the role of the Federal Reserve in sending a message about the suitability or unsuitability of what turns out to have been in retrospect really inappropriate lending practices. You had a central bank chairman who extolled the virtues of subprime lending, as well as the president of expanding home ownership into areas of society that might not otherwise not have access to shelter. It's a noble cause, but it again sent a very clear message that this is a practice that was condoned and encouraged by the guardians of our financial system, and I think that's an inappropriate -- in retrospect very inappropriate stance for the former chairman of the Federal Reserve to have taken.


HOOPER: I guess the excesses that occurred in the mortgage market were largely outside the purview of bank regulators. It was in the mortgage --

TARULLO: Well, the Fed can exercise jurisdiction.

HOOPER: It can, and I think -- well, the Fed did not have enforcement authorization over the mortgage brokerage associate -- not the mortgage brokers. But that, I think is changing and the Fed is working with other federal agencies and trying to coordinate with states to at least make sure that existing laws are enforced and there is some -- if you will -- policing of the regulations place. So I think that -- I guess if I can add a bit of a note of caution here, there -- you have had a tremendous shift in lending standards, which is part of what's depressing the housing market and potentially the economy right now. I think we need to tread a little cautiously in how much more heavily we step on this is in regulatory -- (background noise) -- markets.

TARULLO: Oh, right now. You don't mean in the future.

HOOPER: Well, I mean, in this process of bubbles, you set rules, and it's the job of markets and risk takers to find ways around them. And you're inevitably always going to find this challenge, and you'll have a collapse, and you'll have to deal with it. And part of the dealing with it is finding a better way to maybe try to regulate without killing risk in the whole system.

TARULLO: Okay. So let's take some questions now. And when I recognize you, please stand, wait for the mike, then identify yourself, and ask your question.

Okay, have we got a question? Yes, right -- Nancy.

QUESTIONER: Hi, Nancy Jacklin. You talked a little bit about the freeze-up in the credit market and the need for the system to work through it. And I wonder if you can tell us a little bit of your understanding of what the trade associations are doing to try to move that process forward and how you foresee this problem in fact unfreezing over time.

TARULLO: What trade associations, Nancy?

QUESTIONER: News reports yesterday said that the securities trade associations -- I assume it is the -- you know, the --


QUESTIONER: -- the SIA, bond market are meeting today with counterparties, I thought, to try to talk about how you get more transparency. And I didn't know if you had any information on how that's going to proceed.

HOOPER: Well, I think the way this will evolve is -- right now, you've had sort of a blanket withdrawal of investors. And there are a lot of good profit-making opportunities going languishing right now, because there's a total lack of willingness to take risk. I think over time you'll begin to see some tiering, the better-quality stuff starting to move. That process will be accelerated, will be helped along the more institutions themselves begin to talk about what their exposures are. Our chairman at Deutsche Bank came out last week and laid out pretty clearly what our exposures are, and it seemed to help a little bit on our side of things.

The more other institutions do this and the more, I guess, trade associations get involved to encourage this, it can only help.

TARULLO: Anyone else? No, okay.

Other questions? Yeah, right here.

QUESTIONER: Guy Erb from LECG. There have been some reports that in the housing market the first wave of foreclosures was due to the loss of suburb by-speculators, those who are frequently buying houses that they never intended to live in but just expecting the prices to go up. If that's the case, has that wrung out the moral hazard part of the housing market at least? And are we really ready now for the kind of homeowners, loan corporation that Dr. Shiller mentioned?


SHILLER: Well, I was saying that I think that this has a long way to go. As home prices continue to fall, it will affect more of the first homebuyers in the future. So yeah, I guess there's less of a moral issue when you're talking about someone who owns three houses and was trying to make a lot of money. But I think it's going to go beyond that.

HOOPER: I think the culpability here is not just investor speculators but, I mean, certainly the mortgage brokerage side of the business. Many of them are going out of business, so they're pacing. But that probably has further to go. And then what's still coming is the homeowners who bought that in many cases did qualify as they should have, either because the system was misleading them or, in some cases, they were misleading the system. I mean, a lot of that's still to come, I think.

TARULLO: Yeah, this chart is scary, the adjustable rate mortgage resets. Essentially, it -- one, two, three -- the factor of resets increases three and a half times from fourth quarter of '06 to fourth quarter of '07 and then goes up another 30 percent into '08. So all of that is left to come still in addition to anything else that might be going on up there.

Yes, sir, right there.

QUESTIONER: Kim Davis from St. Charles Bank Capital. To what extent do you think the rating agencies are culpable for having perhaps mis-rated some of these structured vehicles that were created to hold these subprime mortgages when all of us in this room knew two or three years ago that there was an impending housing bubble?

TARULLO: Rating agencies in this?

ROACH: Well, it's like every era has its poster child. And you just answered the question. We all knew several years ago that the ratings put out by the rating agencies weren't worth the paper they were printed on. It's sort of like the buy recommendations that came out of Wall Street at the end of the dot-com boom. Nobody took them seriously except Eliot Spitzer. (Laughter.)

TARULLO: Well, but wait a second, Steve. But they have legal effect, though, in allowing certain kinds of institutions to invest in those instruments.

ROACH: I understand, but I'm just saying that, you know, the rating agencies certainly are guilty of malfeasance at best.

SHILLER: Sure. In a sense, it was guilt of a lack of courage -- intellectual courage -- to confront the possibility of an unprecedented crisis. It's correlated risk. They were looking at all these assets and comparing with the defaults they'd seen in the past. They had to think forward that yes, we're in a big housing boom, and yes this could correct down badly. They didn't take that intellectual leap. In a sense, they -- it is sort of a moral issue, but it's also a failure of -- it just -- when you haven't seen something happen yet, it's hard to down-rate a security based on the possibility that we could be in some unprecedented --

TARULLO: But did they fully understand the securities that they were rating, too?

SHILLER: Well, that's another problem. They may not have allocated enough resources. They should have put more of their top people in charge of figuring this whole mess out and telling them to do it right. But in fact, it was business as usual, and you know how it happens, you know. You just never really confront the problem.

HOOPER: Yeah, no doubt the agency -- I mean, this is going to be an issue with us for some time to come. There's some fundamental issues to wrestle with there. I mean, they're given an official imprimatur by the regulatory system. They have a role in finding bank capital --

TARULLO: They will as Basel II goes into effect.

HOOPER: They will as Basel II goes -- yes. They have an important function there. They're not really accountable in the sense of being a culpable pursuit. And they are viewed, I guess, as being beholden more to the borrower than the lender in terms of who pays them. Now, there's no easy solution to all this. And I'll say that, in their defense, that there have been some spectacular failures, but there's been very good performance generally speaking. I think there's got to be a little more regulatory oversight of the agencies in some form and perhaps finding some way to reduce the appearance, at least, that they're beholden more to the borrowing side than the lending side in the market.

TARULLO: Okay. Yes, right in the middle, sir.

QUESTIONER: Thank you. I'm Harrison Golden. I wonder whether the panelists would be willing to comment a little more on the central question relating to the correlation between even aggressive lowering of rates over the short or intermediate term and the unclogging of the plumbing, the willingness to take risk, the unfreezing of illiquidity in the credit markets.

TARULLO: Peter, you've touched on that before. Why don't you start?

HOOPER: I guess my recommendation for a decisive 50-basis-point move, followed by indications -- more would come if needed -- is justified by where, I think, the economy is likely to be headed. It's justified by what's been happening in broad financial divisions. It's not in itself going to unclog the plumbing. That's going to be a function of further information, allowing -- (inaudible) -- to make decisions. But it will, I think, improve the overall climate.

There's a feeling we're headed downward from here. That's going to make it even more difficult for this problem to be resolved. But I think -- call it giving the system a little broad oxygen -- making risk-taking a little bit more attractive because of the feeling that the overall economy is going to be doing a bit better because the Fed's acting decisively here, I think, is going to help.

TARULLO: Steve, let me ask you, as someone who studied Japan carefully during their travails of the last decade and to now, one of the many lessons from Japan's experience was if you try to kind of hold the bad stuff in the back room and think you're going to slide by, you may just perpetuate your problems rather than avoid them, and everybody is kind of frozen because they think that there's bad debt there but nobody really knows.

In the case of Japan, we all knew what could have been done. The Japanese bank regulators could have just gone in and insisted that the banks confront their bad debt, as they eventually did.

What can we do here, given that much of this debt is not held by banks, to try to unclog the process and avoid that extended period of uncertainty that Japan had?

ROACH: Well, I think we've touched on it, Dan. I think -- and Peter just said it again -- you know, there's the Roto Rooter approach, which is really sort of cleaning out the pipes here. But that doesn't really deal with the expectational piece of this liquidity crisis if you're fearful that there's more to come.

So the only way to deal with that is really to get aggressive on disclosure. I mean --

TARULLO: And in practical terms, what does that mean?

ROACH: For people to stand up, whether they're investors or intermediaries who are warehousing the stuff, and say, "This is what I've got."

TARULLO: What's the incentive for someone to stand up and do that first?

ROACH: It probably needs to be something that's imposed upon the holders by a regulatory authority. I think Peter's institution thus far is a notable exception in the broad scheme of -- I mean, you've got somebody from the Bank of China a couple of weeks ago saying, "Yeah, we have $10 billion," or whatever. But it's been very fragmented.

But again, Dan, the idea that we're in a crisis and it's a central bank thing that can be fixed by injecting liquidity and then getting the holders to disclose positions, I don't want you to -- you know, and Bob Shiller said this a number of times -- this may not fix the fundamental problem. The fundamental problem is what's going on in the property market and its ripple effects into the financial system and the real economy.

And so you can get a band-aid or a short-term fix where markets have rallied and everybody feels good, but, you know, the supply-demand imbalance -- if he's right and home prices are going down for the next three to five years at a protracted rate, it's going to be very difficult to really solve that with an aggressive disclosure, central bank easing problem.

TARULLO: Last word, Bob.

SHILLER: Since you bring up Japan, their urban land prices peaked in 1991 and then went on 15 consecutive years of decline, leading to a 65 percent real decline in home prices. That's how Japan reacted to their bubble of the 1980s. And that's part of the Japanese story.

TARULLO: So with that cheery last thought -- (laughter) -- I want to thank everybody very much because we promised to get you out of here on time. We'll be back in a couple of months. (Applause.)

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World Economic Update

Speakers: Peter Hooper, Stephen S. Roach, and Robert J. Shiller
Presider: Daniel K. Tarullo

Watch experts discuss recent turmoil in the markets and the steps that can be taken to address it.