As in Japan, an underlying driver of the U.S. credit crisis was a housing price bubble, Wharton finance professor Franklin Allen tells Knowledge at Wharton in this interview. But Japan’s bubble was “much bigger than what we have had in the U.S.,” he says. “When it burst in 1991, property prices [in Japan] fell for about 15 years in a row. And they went down about 75% or thereabouts.”
An edited transcript of the conversation follows.
Knowledge at Wharton: You have studied financial crises around the world over time. Everybody who is living through a financial crisis thinks it’s the worst thing that could possibly happen. I’m just wondering how this one ranks and compares to others that you have looked at.
Allen: The situation is similar in that one of the fundamental problems in Japan was [that] property prices got out of line. There was a huge bubble. In Japan, they fell 70%, 75% over 15 years and that wreaked havoc on the financial system. In particular, the banks had enormous problems and that spilled over into the real economy and their growth rate went from being one of the highest in the world up until that time, to being one of the lowest. They are still, in some ways, not out of it.
Now [in] the U.S., I think the basic problem that caused this was that property prices got too high. We had a bubble again. It is an interesting question as to how big that bubble was. Some people say it’s around 25% because property prices for the U.S. as a whole at the peak were about 25% higher than the long-run trend growth line.
Knowledge at Wharton: And if that is the case, are we sort of midway through the pullback in prices?
Allen: Yeah, they are down about 12%, 13% at the moment. So if that was the correct diagnosis, there would be about another 12% to go. But the interesting question is whether we will have feedback effects on the real economy — unemployment will go up and those kinds of things — and that will cause them to go down below their trend rate. So they may go down significantly further than that.
Knowledge at Wharton: And over what period do you think that might happen, if it does?
Allen: If you look at people who are experts in the real estate market, they typically are tending to say one or two more years, or maybe a little bit longer than that. But again, it depends on the feedback effects because as one thing collapses, that causes other things which feed back into property prices and so on.
Knowledge at Wharton: When financial experts talk about transparency, what do they mean?
Allen: Transparency means: Do you know what is going on in an institution such as a bank or a mutual fund? Do you know what they are actually doing? What are the assets they hold and so forth? In many cases it is very difficult to figure out from the information in accounting statements exactly what the assets are that they’re holding. In those cases, we say there is opacity or opaqueness. If we know what is going on, well then we say there is a lot of transparency.
Knowledge at Wharton: So you need transparency to assess the amount of risk and the value of things?
Allen: It certainly helps to assess risk if there is transparency about what the assets being held are, yes.
Knowledge at Wharton: There has been a lot of talk in the subprime crisis about systemic risk. What does that term mean?
Allen: Systemic risk is talking about risk to the financial system and this gets to the notion of contagion or domino effects. So the problem is if one bank or one financial institution goes bankrupt, then is that going to spill over and cause another institution, which has claims through the interbank market on it. Is that going to cause the second institution to go bankrupt? And so on, in a whole chain, in a sequence – people often call it the domino effect.
Knowledge at Wharton: Some people are concerned that remedies for the credit crunch will involve moral hazard. What does that term mean?
Allen: I think what we need to do is to get rid of moral hazard to solve the problem. What moral hazard means is that people take risks for their own advantage, which are damaging to the rest of the financial system. So the classic example is if you are a debt-financed institution, then you can go out and take a lot of risk. If it is successful, and if the projects or assets in which you are investing are successful, you make an enormous amount of money.
If they are not, then the people who pay are the debt holders, or in the case of banks, the Federal Deposit Insurance Corporation or some other entity like that. It’s this problem of risk taking with debt that moral hazard is about. It’s a very significant problem in the financial services sector. It’s something about which we need to worry a great deal about.
Knowledge at Wharton: And the concern when we hear in reference to bailouts is that if you create a safety net every time something goes wrong then people will just take more risk.
Allen: Exactly. So if you look at some of these institutions like Bear Stearns or Merrill Lynch, which started taking big risks –they wanted to develop risk-taking cultures — then in the good times they made inordinate amounts of money. In the bad times, it’s other people who are picking up the bills. That is the problem. What we need to do is to have systems of rewards, which make moral hazard much less of a problem.
The interesting example here is Goldman Sachs. Goldman Sachs has a very long run of incentive systems. They managed to figure out that there was a subprime crisis coming and [they] got out. Most of the other banks — which are basing their compensation on annual payouts, annual profits and so on — they didn’t.
I think it’s too soon to say exactly where it will rank when it is finally over. But it is certainly a significant one.
Knowledge at Wharton: Now, are there others that would serve as a model that evolved in this way or is this one unique?
Allen: It has a lot of unique features. But I think it has a lot of parallels with what happened in Japan in the 1990s.
Knowledge at Wharton: Can you describe that?
Allen: I think the main parallel is that [the] underlying driver is property prices. So in Japan they had a huge property bubble, much bigger than what we have had in the US. When it burst in 1991, property prices fell for about 15 years in a row. And they went down about 75% or thereabouts.
In the U.S., it is probably a much smaller bubble, maybe about 25% to 30%. We have already had prices go down about 12%, 13%. [There] may be another 10% or 15% to go unless there are big feedback effects. So it’s much smaller. But what happened was that the fall in property prices hurt the banking system and that hurt the economy. And what we have to see is how much that process is repeated in the U.S.
Knowledge at Wharton: That was my next question, which is how is it that a problem that begins with housing — and really began with just a sub-sector of U.S. housing — has mushroomed to involve the entire housing market, the securities markets, apparently affecting the real economy and affecting other countries as well. How could that be?
Allen: Banks use contracts which are fixed in terms of what you repay. The problem with those contracts is that if asset prices fall significantly, … they aren’t able to make good on their fixed promises to depositors or bondholders or whoever. So they have a cushion, which is their capital. Typically that would be around 10%, maybe 15%. If … the assets they are holding fall by more than that, then the banks get into serious trouble. That’s what causes the difficulties in the real economy.
So, if asset prices fall by 20% or 30% on average, then the banking system goes under and that has enormous disruption for people’s savings and so on and then for the real economy. Now that hasn’t happened in the U.S. yet. But it has happened in many economies in the past 20 years. Hopefully we won’t get to that but that’s the basic reason for the problem.
Knowledge at Wharton: We are certainly seeing a kind of contagion that is spreading. At first it was fairly easy to understand why investors would be nervous about securities backed by subprime mortgages. But we have also seen a freezing of debt markets for securities on which there really haven’t been large defaults. Yet people are having a hard time pricing them and a very hard time selling them. What has caused that?
Allen: I think there is a great deal of uncertainty about what is going to happen going forward. We don’t really know what the feedback effects are going to be and we have very little idea of — if there is contagion — how serious that is going to be. We don’t really understand how the Federal Reserve will intervene.
Knowledge at Wharton: So it’s kind of a fear factor that just prevents people from doing anything that they think might be risky?
Allen: I think that that’s a large part of it. There’s great uncertainty.
Knowledge at Wharton: Now, looking around the world there are various economies that are showing some signs of stress these days. Is it true that some of that is ripple effects from these problems in the U.S. or are these just other economic factors taking over if you look at other parts of the world?
Allen: I think it depends exactly where in the world one is looking. Japan is clearly having big problems. I think that is somewhat related to this, but it’s more related to exchange rate issues. Europe is also having problems. Some of that is direct, but again, I think a lot of that, particularly going forward, will be exchange rate issues.
So, one of the problems here is that the Central Bankers don’t agree on what’s going on and they have had different responses. The European Central Bank has kept interest rates fixed and the Fed has cut them dramatically. That has led to a big difference, which has caused the Euro to go to record levels. That is going to hurt the European exporters in a big way, going forward, I think.
Knowledge at Wharton: So the Fed’s response to the problem here has had a ripple effect in Europe with the skyrocketing Euro?
Allen: It has, but it’s been amplified by the fact that the ECB has taken a very different position.
Knowledge at Wharton: You mentioned also that there has been a certain amount of ripple effect from the U.S. to Japan. How has that worked?
Allen: Again, there is an exchange rate factor. They can’t really change their interest rate and the Yen is strengthened against the dollar, not by as much as the Euro. But that is also causing them problems. But they have longer seeded problems, which we talked about a few minutes ago. And they really still haven’t recovered from those problems back in the early 1990s.
Knowledge at Wharton: Now, the dollar of course has been in the news a lot for having fallen so much although it has recovered a little bit, just recently. But is the falling dollar related in part to the Fed rate cuts that are a response to the economic slowdown here?
Allen: I think that’s a large part of it. But there is also a longer-term problem, which is, we still have these big global imbalances that people have been talking about for many years. We still run a huge deficit with the rest of the world. I think a part of the response is to that long-term problem. But, it is definitely accentuated by the interest rate differences.
Knowledge at Wharton: Now, there has been a lot of talk in recent years about the booming economies in China and India and this changing the nature of the international economy. How do you see that evolving and is that affected at all by these events in the U.S.?
Allen: I think that is a very important factor in what’s happening in the global economy, in terms of higher commodity prices and higher oil prices. So it is certainly playing into the inflation, which we have not talked about yet. But it is an important contributing factor to what is going on.
Knowledge at Wharton: And what is the mechanism – the falling dollar again?
Allen: That’s part of it, but basically there is a greater global demand for oil, commodities and for food. That has driven up the prices of all these things. China and India are a large part of that extra demand now. Their economies are continuing to do well. Their stock markets have actually dropped a fair bit, more than most of the developed countries. But their economies are actually much stronger and they are likely to remain strong in my view. A lot of what is happening in China is still demand for building infrastructure and so on. That is likely to continue.
Knowledge at Wharton: Now demand is very high in those two countries, China and India for commodities. We have seen commodity prices go up quite a bit. Oil and gasoline are certainly of real concern to Americans. Some of this I take, is due to a falling dollar, in addition to the demand issue.
Allen: Yes, I think it’s both those factors.
Knowledge at Wharton: I see. And the falling dollar, part of that can be traced to this subprime crisis?
Allen: Yes… this difference in interest rates that we’ve talked about.
Knowledge at Wharton: I see. Now, you mentioned inflation. Of course commodities as we just mentioned are a factor in inflation, but what has been driving the uptick in inflation in the U.S. recently?
Allen: Commodities and oil have had a big impact on the headline number, which is the total. The problem I think is that traditionally the Fed has not worried too much about the headline number. They have looked at core inflation. But it has been so big — the rise in commodity prices and oil prices — that it is now having a big impact, and it is not clear that these things will be temporary. I think some analysts are predicting oil will go to $200 a barrel from its current level [at around $138]. That may well happen.
So these things can get worse rather than what usually happens, which is that they are just quite volatile and go up and down. But, because of the long-run situation of increased demand, they may stay up.
Knowledge at Wharton: Now the Federal Reserve is always in a balancing act with interest rates. They can reduce the interest rates to stimulate the economy, but cutting them too much stimulates inflation. So, it has cut rates in recent months. How do you assess its response in the rate cutting area?
Allen: I think they are engaged in a very interesting experiment. I think we are in [a] territory [in] which we have very little idea of how things are going to play out going forward. So they’ve cut rates to try and save the real economy and stop us [from] going into [a] recession and stopping what happened in Japan, which is often discussed as the rationale. But as I say, no one has really tried this … in this way. It may well be it works out, in which case in maybe a year or two years from now, things will be fine and everything will be back to normal.
But it may also be that things get worse and they are being exacerbated by this cutting of rates when inflation is at levels that we haven’t seen for some time. The problem is if it gets embedded into people’s expectations, then it may start to take off again like it did in the 1970s.
Knowledge at Wharton: Well, the 1970s were a period of horrific inflation. Mortgages were double digits during some of that period. Do you really think we are in for something like that?
Allen: I certainly hope not, but it is already up to over 4%. In China it is running at 8%. So that is the sense in which I think we are into the unknown. If you look [at] Europe, it is also running high. There, I think there is a lot of evidence that it is beginning to be built into the wage expectations and so on. The problem is once it gets into a spiral, it’s difficult to deal with, particularly if the Fed is cutting interest rates at the same time.
Knowledge at Wharton: You mentioned that the Central Banks and Europe have not responded with the same kinds of rate cuts that we have seen with the Federal Reserve. Why not?
Allen: Part of it is that they are in a different situation so they don’t perceive the risk of recession as being the same as here. But also I think part of it is very much a difference in beliefs about what’s important and what is going on. So the European Central Bank, … they have one mandate, which is to fight inflation. That is the result of a long historical process from the 1923 inflation in Germany. So they are even talking about raising rates in the Euro zone. So, I think it’s a combination of different situations, but also [a] different philosophy. The U.K. is a little bit mixed so they have done some cuts, but nothing like what the U.S. has done.
Knowledge at Wharton: Now one of the things you said surprised me. We think back to some changes in Germany and there were certainly changes in Britain in the Thatcher era. But you mentioned that the expectation of wage increases is embedded or is that re-embedded? Wasn’t that the problem in Europe?
Allen: Yes, that used to be the problem. But the problem is that they’re also running around at these high levels around 4%, 3.5% — those kinds of numbers.
They are much more unionized in many countries than we are here. So for example, [during] recent trips to Germany, one of the things one has to start worrying about is [whether] the trains going to be on strike. Who is going to be on strike? Those are things that hadn’t been that prevalent in Europe. But they have begun to happen again because of this inflation and demand for higher wages.
Knowledge at Wharton: Now coming back to the Federal Reserve, another of the things it did in response to the credit crunch — we don’t know what term to use properly because bailout seems to be not approved of — was to do something to help Bear Stearns or to ease that problem of the transition, the purchase of J.P. Morgan. What was your feeling about that maneuver?
Allen: I think there are two issues here. [The first] is, did they deal with the shareholders of Bear Stearns in a correct way? The second one is the more general one. Should they have done the intervention at all? So, the reason they did the intervention was to prevent contagion of Bear Stearns important counterpart in many transactions. So I think one can debate that. But probably they did the right thing there.
I think where I would disagree with what they did is in providing a guarantee, and at least as I understand it, not charging for it. That allowed the shareholders to walk away with substantial amounts of money –not large compared to what they would have had a year ago, but nevertheless, the head of Bear Stearns had sold his stake for $61 million. If they had charged for the guarantee in the way that the Bank of England had talked about charging for the guarantee that Northern Rock got, then it’s not clear that they would have got very much at all, if anything.
Knowledge at Wharton: Well we hear the term moral hazard in this context. Do you think they have created a moral hazard?
Allen: I think they have. As I said, I think if the employees held large portions of the shares of Bear Stearns, going forward we get into similar situations if people think that they are going to be able to walk away with some money as opposed to nothing. That will make a big difference [in] the way they behave. So Mr. Kane may have behaved very differently if he thought that he would get zero with certainty if there were problems, as opposed to walking away with $60 million, which for most people is a fairly comfortable retirement. So I think it will change, and hopefully [the] next time, they will charge for the guarantee if they provide one.
Knowledge at Wharton: In addition to that, the Federal Reserve has done some things like: in order to improve liquidity, lending out treasury bonds and taking on mortgage obligations that are much riskier as collateral, and other types of things to make sure that there is money available to financial institutions. Have these been good strategies?
Allen: I think again we are in the unknown. We haven’t done this before. On the face of it, it looks as though it helps the markets. But I think that we have to wait and see. I think there are some aspects of it, which are unfortunate. So, one of the things that financial institutions such as mutual funds have to do is they have to report their holdings at the end of quarter. What they try and do is to get as high-quality securities on their books as possible.
By the Fed providing treasuries in exchange for low-quality securities, what they are doing is essentially helping financial institutions to make their books look better than they in fact are. So they hold high-quality securities provided by the Fed for a day or two. Then the rest of the time they are holding lower quality securities. Investors don’t know about that because the Fed is helping this lack of transparency.
Knowledge at Wharton: This is what is called window dressing, I think.
Allen: Exactly, yes.
Knowledge at Wharton: I think it’s because the financial reports are just a snapshot of that day.
Allen: Exactly.
Knowledge at Wharton: And so you may not have owned it the day before. You may get rid of it the day after. But your investors think you loaded up on all this healthy stuff and they won’t know the difference for six months.
Allen: Exactly, and that’s a problem. What they should do instead is change it so that it is a random day sometime in the quarter so people can’t plan, as you describe.
Knowledge at Wharton: Well it is going to be fascinating to see how it all unfolds. Thank you very much.
