State of the economy: a primer

Mark Ostow

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Y: An alumnus, Robert Petrie '74, sent us a question for you. In your last baccalaureate address, you said the debate over financial sector reform "has been replete with misunderstanding about what actually went wrong and a misplaced desire for revenge." He wrote, "I would like to know economist Levin's view of what went wrong and appropriate financial sector reforms." It's anot that these are inherently bad, but the prices of these instruments got totally out of line with the true risks. Credit was so easy that people were willing to take bigger risks for a very modest amount of reward. even more interesting question now, considering that you came close to getting the top economics jobs at the White House.

L: I was honored to be considered, but I think it came out just fine for the nation, for Yale, and for me. Leaving Yale on very short notice would have been a wrenching experience. And the president chose a strong team.

The underlying cause of what went wrong with the financial sector was easy monetary policy for too long. Very low interest rates persisted even as the economy was growing robustly. Normally, it makes sense to ease credit when the economy weakens and tighten credit when the economy is growing rapidly, to prevent excessive expansion and the creation of a bubble in asset prices.

Easy credit encouraged the creation of derivative financial instruments that entailed a huge amount of risk. Derivatives based on mortgage securities and derivatives based on the probability of the bankruptcy of companies—credit default swaps—were the most prominent examples. Not that these are inherently bad, but the prices of these instruments got totally out of line with the true risks. Credit was so easy that people were willing to take bigger risks for a very modest amount of reward.

I think both Greenspan and Bernanke bear some blame. But, in fairness, the prevention of asset bubbles wasn't clearly part of the statutory mandate of the Fed. The mandate in the past has been for monetary policy to maintain full employment and prevent inflation. One of the key elements of financial sector reform is to make explicit that the Fed's mandate includes monitoring systemic financial risk.

Y: It's part of the Dodd-Frank Act?

L: Yes. Before Dodd-Frank, it was unclear what the federal government's powers were to intervene in a crisis. During 2008, the Fed and the Treasury were very uncertain about what authority they had to intervene. They managed to avoid severe repercussions from the collapse of Bear Stearns by finding a buyer—they were essentially intermediaries in creating a takeover transaction. But in the case of Lehman, they couldn't find a buyer. They tried just about every supposedly solvent bank, because they knew the collapse would be a disaster. But they didn't think they had the authority to seize Lehman Brothers in the way they had the authority to seize a chartered bank. The new bill gives the Fed the power to take over any systemically important financial institution.

Y: So those are, in your view, the two crucial components?

L: Yes. The government now has clear responsibility to monitor systemic risk, and the Fed has emergency powers to put any systemically important institution under federal control. The way the law's written now, you could do this with a large investment bank or a large insurance company—any systemically important financial institution. These improvements should make it easier to manage the next crisis.

Y: What about the repeal of the Glass-Steagall Act, which allowed banks to take on these huge investment risks?

L: The repeal of Glass-Steagall per se was not what caused the recent crisis. With low interest rates, there wasn't enough money to be made in safe instruments, so banks kept searching for greater margins and taking more risk. Reinstating Glass-Steagall won't solve our problems. Regulating the leverage of commercial banks is much more to the point.

Y: What's more important now—creating jobs or reducing the deficit?

L: Both are essential, as President Obama has made clear. We need to focus on job creation in the long run—through enhanced investment in R&D, education, and infrastructure, which creates the framework for innovation and growth in the years ahead—and, at the same time, we need to address the fiscal deficit. It doesn't have to be cured in a year. In fact, acting too quickly would slow the recovery.

We cannot eliminate the deficit by cutting discretionary spending. There's not enough discretionary spending to cut. Part of the deficit will disappear through recovery and growth, but the rest—four or five percent of GDP—can only be eliminated by reducing spending on Social Security, health care, and defense, or by reforming taxes. That's where the dollars are. Every action will be painful, but the problem is soluble.

Y: When we discussed economic policy two years ago, I asked for your forecast. You said, "I'm not a forecaster, but all my instincts tell me that unemployment will … persist at high levels through 2010." You said that before employment recovers, asset values would start to rise, and "that could come sometime in 2010." You were right. What do you think today?

L: Again, I'm not a forecaster. But, despite the spurt we saw in the first six weeks of 2011, I don't think we'll see as much growth in stock market values this year as we saw last year. And despite the gains in January, I suspect that unemployment will still hover around 8 percent at the end of the year. But I'm moderately optimistic about GDP growth.