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Wednesday, January 06, 2010

Report from AEA meeting, Part IV

In 2010 we will know who is the winner of the debate over V-shaped vs. U-or-W-shaped recovery; as for investors, we will know more about whether the market we are having now is a small bull in a long secular bear market (or the so-called New Normal) vs. the more optimistic prediction that this is the beginning of a brand new bull market, which I strongly doubt.

Here is my final report of the series (source: WSJ) on how economists at the AEA meeting think about the issue:

ATLANTA -- Wall Street investors may be breathing a sigh of relief as the financial crisis fades, but academic economists gathered here for the annual meeting of the American Economic Association say we're nowhere close to making sure it won't happen again.

Over the past few days, economists here highlighted the many ways in which the lessons of the crisis have yet to sink in. Few think the U.S. and other governments have made needed repairs to the financial regulatory system. And some suggest governments' response has increased the chances of a repeat, making the banking system more crisis-prone, putting new strains on institutions such as the Federal Reserve and stretching government finances closer to the breaking point.

[Unsolved Problems]

"Our response has made us more vulnerable to a bigger crisis," said Tom Sargent, a New York University economist. "It's distressing."

Banks present the most immediate worry. By providing massive bailouts to commercial banks and securities firms, the logic goes, governments have given bank executives a sort of catastrophe insurance -- and an incentive to take even greater risks than they did before the crisis. But it could take years for policy makers to impose the controls, such as tougher capital requirements, that would prevent the pain from spreading to taxpayers and the broader economy next time the banks get into trouble.

"If the banks really feel that they are insured, then we have a dangerous situation," said Stanford University's Robert Hall, the association's president. "The incentives are to take a very risky position. They get to pocket it if they win and it's the federal government's problem if they lose."

Policy makers find themselves in a tough position. They can't impose controls immediately, for fear they would curb the lending crucial to a sustainable economic recovery. But as the banks regain strength, the political opportunity to create a new financial architecture could slip away.

"You have only a small window in which you can really change things," said Markus Brunnermeier, of Princeton University. "It's closing already."

The crisis isn't over for banks. The worst-case scenarios in last year's stress tests, which restored the market's confidence in U.S. banks, included only two years' worth of losses. But banks are likely to face losses for many years to come as foreclosures mount and the commercial real-estate market sours.

"If the U.S. government could credibly say [to banks]: We'll never bail you out again, it [the banking system] would collapse," said Kenneth Rogoff, of Harvard University.

To quicken the banks' return to health, Princeton's Mr. Brunnermeier believes governments should place much harsher limits on cash dividend and bonus payouts, which deplete the capital banks need to absorb the losses and keep lending.

"I don't think there's enough forcefulness from the administration on this," he said. "If Goldman Sachs is paying these huge bonuses, the other banks are forced to do so as well."

Others fretted about the lack of a game plan for Fannie Mae and Freddie Mac, the money-losing mortgage giants -- known as government-sponsored enterprises -- that are now absorbing huge sums of taxpayer money as part of the U.S. government's efforts to keep the mortgage market functioning. When long-term interest rates rise, as they inevitably will, said Anthony Sanders, of George Mason University, "We're going to see tremendous losses taken on the bank balance sheets and [those of the GSEs]."

"The GSE structure must be ended because it creates inevitable failure based on the incentives," said Dwight Jaffee, of the University of California at Berkeley. But he and his peers differed on the best solution. Mr. Jaffee called for the government to buy mortgages and package them into securities, as Fannie and Freddie do, but only temporarily; eventually, that task should be turned over to the private sector.

A pair of Federal Reserve economists, Diana Hancock and Wayne Passmore, emphasizing that they weren't expressing the Fed's official view, suggested the government should explicitly guarantee not only mortgages but other financial instruments against a catastrophe with a new insurance fund, financed by premiums similar to the one used to insure bank deposits.

Economists also expressed concern about the extent to which the unprecedented measures taken by the government and Fed could weaken them as a backstop in the future. The Fed's massive interventions have exposed it to greater financial and political risk, both of which could lessen its ability to step in and calm markets. And the huge costs of financial and economic bailouts have put added burdens on the finances of advanced-economy governments around the world.

In the next few years, for example, the gross government debt of both the U.S. and the U.K. will exceed 90% of their annual economic output, an event that could both spook investors and seriously impair economic growth.

When advanced countries cross the 90% threshold, their annual growth tends to be about one percentage point lower, said Mr. Rogoff and Carmen Reinhart of the University of Maryland.

"This is very troubling for the U.S. and other advanced economies," said Ms. Reinhart.