Jim Hartley on the Economy

Questioning Authority recently caught up with Jim Hartley to get his thoughts on the country's struggling economy. Hartley, professor of economics, specializes in macroeconomics, business cycles, and the "great books" of Western civilization. He also teaches a seminar titled Money and Banking.

QA: How do you define “recession,” and are we in one?

JH: A recession is generally defined as two quarters (six months) of negative GDP growth. GDP growth for the fourth quarter of 2007 was a positive 0.6 percent. We don’t know for sure what it will be for the first quarter of 2008, though most estimates are that it will be slightly negative. Guessing what it will be in the second quarter of this year is simply speculative at this point.

That being said, the obsession over whether we can call this a “recession” or not misses the real point. The best guess is that GDP growth this year will be between negative 1 percent and positive 1percent; that is slow growth no matter where the economy ends up in that range. One would think from reading the press that a year of negative 0.2 percent growth, which we can call a “recession,” is somehow qualitatively different from a year of positive 0.2 percent growth, which would not be a “recession,” but the reality is that very few people would notice the difference between those two growth rates.

QA: Is the mortgage foreclosure crisis the sole cause of the sagging economy?

JH: It isn’t really a “foreclosure” crisis, but rather a credit crisis that is the problem. In the last 10 years, the mortgage market boomed. This was due to a combination of two things. First, in the wake of the savings and loan crisis and the LDC debt crisis of the 1980s, there was extensive change in financial markets. One of the results of these changes was the rise of a whole new way of arranging home mortgage loans. The subprime market developed, allowing people who formerly would have never qualified for a home mortgage loan to be able to get loans and buy homes. Home ownership rates in the U.S. went from 64 to 69 percent. Since many of these borrowers would not have qualified for a loan under the old rules, the loans were riskier. Secondly, in the late Greenspan years at the Federal Reserve, an asset price boom began. Housing prices were rising rapidly, and were well above what many housing experts thought were sustainable prices.

The combination of those two things meant that quite a few people were buying homes with loans that they would not have been able to get under old rules with the expectation that the value of the homes would continue to rise at a steep rate; the hope of many of these people was that they would be able to sell their homes for large profits at the point when they could no longer afford the mortgages on them. When housing prices stopped rising, this gamble did not pay off. Similarly, many of the subprime borrowers who would have been unable to buy a home at all under the old mortgage rules were unable to make their mortgage payments. As a result, a large number of these new home mortgage loans went into default. Those who lent money to these borrowers are suffering large losses. Those who bought homes with mortgage loans they cannot afford are losing the homes.

The big question now is whether this credit crisis will have any spillover effects into the rest of the economy. The jury is still out on that.

QA: Could this problem have been averted through increased regulation of the mortgage industry?

JH: It isn’t a matter of “increasing” or “decreasing” regulation, but rather a matter of how to regulate. Financial markets are very difficult to regulate. If you regulate the wrong way, then financial markets will not function effectively. There is increasing evidence that one of the biggest differences between poor and rich countries is that poor countries have undeveloped financial markets. However, it is difficult to know exactly how to regulate developed financial markets. The last 40 years in the United States have seen a regular pattern of crisis, followed by a new set of regulations, followed by a new crisis arising from that new set of regulations, followed by yet another set of regulations, and so on. Many of the things that we are now seeing at the root of the current problems arose to solve problems under previous regulatory rules. For example, in the savings and loan crisis, we learned that to have a set of institutions whose whole portfolio is loans in local mortgage markets was a bad idea. So, the securitization industry developed, allowing home mortgages to be packaged together and sold as bonds to institutional investors. That is a good idea. But, Bear Stearns, for example, invested heavily in this market and when this market went bad, Bear Stearns experienced very large losses. Suddenly, the securitization market is not looking so good after all. But, it isn’t clear how to regulate the market to get all the benefits with none of the costs.

QA: Will the “stimulus package” have any mitigating effect, or is it just window dressing?

JH: It will have a negligible effect on the economy; it will likely do neither any good nor any harm. While we will all enjoy receiving the checks from the “government,” ultimately, of course, the “government” isn’t paying us--we are paying ourselves.

QA: When can we expect to see things turn around?

JH: That really depends on what the Federal Reserve does. In the absence of Federal Reserve mistakes, it looks like the economy will have close to zero growth in 2008, and begin increasing again next year as financial markets settle down. However, the Federal Reserve has been increasing the money supply quite rapidly of late, and the result of that could be much higher inflation next year. If inflation rises, then it will be a long, painful process to get rid of it.

That being said, economic forecasting is an art, not a science. As my old money and banking professor used to say, “There are two things I don’t do: I don’t take drugs and I don’t predict movements in interest rates.”

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