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although the subprime crisis seems to be
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showing some signs of easing debate over
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what caused it whether it could have
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been prevented and how long it might
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last will continue for some time to come
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knowledge at Wharton asked Wharton
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Finance Professor Franklin Allen for his
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perspective on the latest economic
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developments welcome Professor Allen
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you've studied financial crisis all over
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the world and uh Through Time how does
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this one in the US stack up compar to
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the others I think it's too soon to tell
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at the moment we're not through it yet
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and it it it may end fairly soon but it
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may get worse if there are significant
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feedback effects in the real
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economy I think though that the one that
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has the closest parallels is the crisis
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that Japan went through in the 199s and
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in the early part of this Century so so
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how was the situation in Japan similar
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to that
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here the situation is similar in
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that one of the fundamental problems in
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Japan was was that property prices got
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out of line there was a huge
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bubble in
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Japan they fell 70 75% over 15 years and
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that wreak havoc on the financial system
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in particular the banks had enormous
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problems and that spilled over into the
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real economy and their growth rate went
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from being one of the highest in the
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world up until that time to being one of
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the lowest and they're still in some
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ways not out of it now the US I think
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the basic problem that caused this was
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that property prices got too high we had
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a bubble
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again it's an interesting question as to
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how big that bubble is some people say
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it's around 25% because property prices
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at the peak were about for the us as a
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whole about 25% higher than the long run
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Trend growth line and and if that's the
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case we what sort of Midway through the
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uh uh the pullback in prices yeah so
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they're down about uh 12 13% at the
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moment so if that was the correct
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diagnosis then it would be about another
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12% to go but the interesting question
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is whether we will have feedback effects
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on the real economy unemployment will go
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up and those kinds of things and that
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will cause them to go down below their
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Trend rate so they may go down
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significantly further than that and over
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what period do you think that might
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happen if it does if you look at the
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people who are experts in the real
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estate market they they typically
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tending to say one two two more years or
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maybe a little bit longer than that but
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again it depends on the feedback effects
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because as one thing collapses that
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causes other things which feed back into
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property prices and so on we're
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certainly seeing a kind of contagion
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that's spreading I mean at first it was
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fairly easy to understand why investors
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would be nervous about Securities backed
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by subprime mortgages but we've also
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seen a kind of freezing of of debt
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markets for Securities on which there
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really haven't been large defaults uh
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and yet people are having a hard time
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pricing them and a very hard time
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selling them now what's caused that I
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think there's a great deal of
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uncertainty about what's going to happen
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going forward we don't really know what
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the feedback effects are going to be
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and we have very little idea of if if
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there is Contagion how serious that's
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going to be we don't really understand
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how the Federal Reserve will intervene
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so it's kind of a fear factor that just
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prevents people from doing anything that
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they think might be risky I think that's
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a large part of it that that there's
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great uncertainty now uh looking around
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the world there are there are various
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economies that are showing some signs of
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stress these days uh is it true that
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some of that is has Ripple effects from
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these problems in the US or are these
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just other economic factors uh taking
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over if you look at different parts of
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the world so I think it depends exactly
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where in the world one is looking at so
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um Japan is clearly having big problems
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I think that's somewhat related to this
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but it's more related to exchange rate
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issues Europe is also having problems uh
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some of that is direct but again I think
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a of that particularly going forward
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will be exchange rate issues so one of
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one of
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the problems here is that the central
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Bankers don't agree on what's going on
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and they've had different responses so
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the European Central Bank has kept
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interest rates fixed and the FED has cut
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them dramatically and that's led to a
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big difference which has caused the euro
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to go to record levels and that's going
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to hurt European exporters in a big way
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going forward I think so the fed's
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response to the problem here has had a
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ripple effect then in Europe with the it
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has skyrocketing Euro it it has it's
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been Amplified by the fact that the ECB
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has taken a very different position and
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you mentioned also that there there's
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been a certain amount of uh ripple
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effect from the US to Japan how how has
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that worked so again there's an exchange
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rate Factor so they they can't really
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change their exch their interest rate um
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and the yen is strengthened against the
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dollar not by as much as the Euro but
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that is also causing them problems but
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they have
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longer seated problems which we talked
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about a few minutes ago and they really
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still haven't recovered from those
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problems back in the early '90s
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now uh the dollar of course has been in
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the news a lot for for having fallen so
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much Al it's recovered a little bit just
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recently uh but is the is the the
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falling dollar is related in part to the
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Fed rate cuts that are response to the
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economic slowdown here so I think that's
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a large part of it but there's also a
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longer term problem which is we still
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have these big imbalances Global
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imbalances that people have been talking
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about for many years now we still run a
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huge deficit with the rest of the world
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and I think part of the response is is
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to that long long-term problem but it's
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definitely accentuated by the interest
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rate differences now there's uh been a
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lot of talk in recent years about the
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the booming economies in China and India
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and uh this changing the nature of of
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the international economy uh how do you
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see that evolving and and is that
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affected At All by these events in the
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US so I think that's a very important
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factor in what's happening in in the
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global economy in terms of higher
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commodity prices and higher oil oil
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prices so it's certainly playing into
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the inflation which we haven't talked
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about yet but is an important
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contributing factor to what's going on
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and and that and what is the mechanism
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the falling dollar again or so that's
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part of it but it basically there's a a
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greater Global demand for oil
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Commodities and for for food and that's
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driven up the prices of all these things
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and China and India are a large part of
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that that extra demand now their
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economies are continuing to do well uh
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the stock markets have actually dropped
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a fair bit more than most of the
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developed countries but their economies
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are actually much stronger and they're
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likely to remain strong in my view a lot
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of what's happening in China is is still
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demand for building infrastructure and
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so on and that's likely to continue now
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demand is is very high in those two
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countries China and India for
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Commodities and we've seen commodity
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prices
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uh go up quite a bit oil is and gasoline
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are certainly a of real concern to
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Americans and and some of that this I
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take it is due to the falling dollar and
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and and uh in addition to the demand
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issue yes I think it's both those
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factors I see and the falling dollar
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part of that can be traced to this
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subprime yes crisis as and so these
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different in interest rates that we
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talked about now uh you mentioned
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inflation you know how is inflation uh
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of course Commodities as as we just
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mentioned
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are a factor in inflation but uh what
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has been driving the uptick in inflation
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in the US
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recently so Commodities and oil have had
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a big impact on the headline number
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which is the total and the problem I
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think is that traditionally the the FED
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has not worried too much about the
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headline number they've looked at core
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inflation but it's been so big the rise
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in commodity prices and oil prices that
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it's now having a big impact and it's
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not clear that these things will be
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temporary I think some analysts are
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predicting oil will go to $200 a bar
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Barrel from its current level of around
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120 and that may well happen and so
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these things can get worse rather than
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what usually happens which is that
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they're just quite volatile and go up
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and down but because of this long run
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situation of increased demand they may
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stay up now the Federal Reserve is
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always an a balancing act uh with
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interest rates if it it can reduce
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interest rates to stimulate the economy
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but cutting them too much stimulates
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inflation so it it has cut rates uh in
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recent months uh how do you assess its
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response in the in the rate cutting
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area I think they're engaged in a very
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interesting experiment I I I think we're
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in territory which we have very little
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idea of how things are going to play out
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going forward
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so they've cut rates to try and save the
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real economy and stop us going into
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recession and stopping what happened in
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Japan that that's often uh discussed as
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the
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rationale but as I say no one's really
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tried this in this way and it may well
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be it works out in which case maybe a
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year two years from now things will be
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fine everything will be back to normal
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but it may also be that things get worse
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and they being exacerbated by this
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cutting rates when inflation is at
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levels that we haven't seen for some
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time and the problem is if it gets
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embedded into people's expectations then
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it may start to take off again like it
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did in the
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1970s well the 1970s were a period of
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horrific inflation as I recall being
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right out of college at the time and
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double digits mortgages were double
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digits during some of that period do you
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really think we're in for something like
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that I certainly hope not but uh you
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know it's already up to to over 4% in
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China it's running at
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8% so I that's the sense in which I
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think we're into the unknown uh if you
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look in Europe it's also running high
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and there I think there is a a lot of
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evidence that is beginning to be built
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into the wage expectations and so on and
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the problem is once it gets into a
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spiral it's difficult to deal with
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particularly if the FED is cutting
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interest rates at the same time and you
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mentioned that the central banks in
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Europe have not responded with the same
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kinds of rate cuts that we've seen with
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the Federal Reserve why
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not part of is it is it that it they're
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in a different situation so they they
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don't perceive the risk of recession as
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being the same as here but also I think
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part of it is very much a difference in
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beliefs
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about what's important and what's going
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on so the European Central Bank they
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have one mandate which is to fight
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inflation and that's the result of long
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historical process from the 1923
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inflation in in in Germany and so they
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even talking about raising rates in in
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in the Euro Zone and uh so I think it's
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a combination of different situation but
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also different philosophy the UK is a
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little bit mixed so they've done some
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Cuts but nothing like what the US has
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done now one of the things you said kind
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of surprised me because we we think back
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to
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uh there have been some changes in
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Germany and there were certainly changes
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in uh uh in Britain in the in the
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Thatcher era that but but you mentioned
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that the expectations of wage increases
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you think is is embedded or is that
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re-embedded uh didn't that used to be
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the problem they used to be the problem
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but the problem is that they're also
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running around you know these high
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levels around 4% three and a half% those
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kinds of numbers
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and there that's much more unionized in
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in many countries than we are here and
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so for example in recent trips to
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Germany one of the things one has to
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start worrying about is are the trains
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going to be on strike who's going to be
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on strike those those are things that
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haven't been that prevalent in Europe
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but they they've begun to happen again
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because of this inflation and demand for
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higher higher wages now coming back to
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the Federal Reserve another of the
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things it did uh in in response to the
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credit crunch was
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uh we don't know what term to use
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properly because bailout seems to be uh
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uh not approved of but they did
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something to help be Sterns or to ease
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that problem uh the transition to the
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purchase of JP Morgan what what was your
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feeling about that that
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maneuver so I think there are two issues
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here one
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is did they deal with the shareholders
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of be STS in the correct way and the
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second one is the more General one is
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should they have done uh the
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intervention at all so the reason they
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did the intervention was to prevent
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contag best ear's important counterparty
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in many transactions so I think one can
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debate that but probably they did the
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right thing there I think where they I
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would disagree with what they did is in
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providing a guarantee and at least as I
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understanding understand it not charging
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for it and that allowed the shareholders
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to walk walk away with substantial
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amounts of money not not large compared
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to what they would have had a year ago
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but nevertheless you know the the head
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of bur STS had sold his stake for $61
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million and if they charged for the
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guarantee in the way that uh the bank of
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England had talked about charging for
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the guarantee that Northern Rock got
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then it's not clear that they would have
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got very much at all if anything well we
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hear the term moral hazard in this
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context do you think that they've
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created a moral hazard I think they have
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I think as I said I think if if uh you
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know the the employees held large
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portions of the shares of best earns I
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think if going forward we get into
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similar situations if people think that
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they're going to be able to walk away
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with some money as opposed to nothing
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then that will make a big difference to
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the way they behave so Mr Kay may have
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behaved very differently if he thought
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that he would get zero with
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certainty if there were problems as
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opposed to walking away with 60 million
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which for most people is a a fairly
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comfortable retirement so I think it
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will change and hopefully next time
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they'll charge for the guarantee if they
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provide one and in addition to that the
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federal has the Federal Reserve has done
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some things like um in order to to
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improve liquidity uh like lending out
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treasury uh bonds and taking mortgage
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obligations that are much riskier as
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collateral and other types of things
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that that is done to make sure that
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there is money available to financial
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institutions uh have these been a good
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strategy so I think we're gaining we're
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in the unknown we don't we haven't done
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this before uh on the face of it it
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looks as though it helps the markets but
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I think we have to wait and see I think
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there are some aspects of it which are
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unfortunate so one of the things that
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financial institutions such as mutual
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funds have to do is to report their
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Holdings at end of quarter what they try
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and do is to get as high quality
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Securities on their books as
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possible
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and by the FED providing treasuries in
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exchange for Le low low quality
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Securities what they're doing is
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essentially helping financial
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institutions to make their books look
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better than they are in fact are so they
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hold high quality Securities provided by
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the FED for a day or two and then the
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rest of the time they're holding lower
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quality Securities and investors don't
00:17:44
know about that because the FED is
00:17:45
helping this lack of transparency this
00:17:49
is what's called window dressing I think
00:17:51
and it's because the financial reports
00:17:53
are just a snapshot of that day exactly
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so you may not have owned it the day
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before you may get rid of it the day
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after but your investors think you
00:18:01
loaded up on all this healthy stuff and
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they won't know the difference for 6
00:18:05
months exactly and that's that's a
00:18:08
problem and what they should do instead
00:18:09
is change it so that it's a random day
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sometime in the qu so people can't plan
00:18:15
as you described all unfolds thank you
00:18:18
very much thank you
