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Economics panel predicts U.S. recession, not depression

by Cindy Weiss - October 6, 2008

The Great Depression was “great” because of what happened after the initial financial crisis, a scenario that probably won’t be repeated in the current financial meltdown, said several economics faculty members at a forum on campus Sept. 30.

Several of them predicted possible recession, but nothing on the scale of the 1930s.

After the stock market crashed in 1929, banks failed over several years. Unlike now, the Federal Reserve withdrew money, leaving banks with no liquidity, said Christian Zimmermann, associate professor of economics.

Over-regulation of banks, labor issues, and protectionism in the 1930s contributed to the problems, he said. “This is not the environment we have now.”

What we do have now is a solvency problem, according to Stephen Ross, associate professor of economics.

“We have put hundreds of billions of dollars of liquidity into the system,” he commented after the forum, referring to the Fed’s open market window loans and its loan guarantees to Wall Street banks. “I don’t believe that anyone thinks these firms are not liquid enough to loan. Rather, the problem is that they are insolvent,” he said.

“We have to do something to change the incentives they face concerning making loans. The hope is that more solvent firms will take more risks and make more loans,” he added.

Zimmermann said the issue of solvency – having the assets to back up claims – should not result in bank runs today. At this point, people are still working, factories are open, and the non-financial sector is still in good shape, he noted. But over time, if little credit is available and investment is reduced, the impact of the financial market’s problems could spread.

“I’m reasonably optimistic there are solutions out there,” he said.

Arthur Wright, professor emeritus of economics and a specialist in regulatory policy, said a large part of the current crisis has regulatory roots.

“The regulatory system has not kept up with the rate of innovations,” he said, especially with what he called “stealth banks,” financial institutions that have behaved like banks but have not been subject to regulatory scrutiny.

Wright expects a recession.

The period of “the great moderation,” from the Clinton years on, when the economy was characterized by growth, low interest rates, and moderate inflation, “may have led regulators to get lazy,” he said.

Stephen Ross, associate professor of economics, discusses the country’s financial crisis during a panel Sept. 30.
Stephen Ross, associate professor of economics, discusses the country’s financial crisis during a panel Sept. 30. Photo by Jessica Tommaselli

This is a problem that won’t be solved before the presidential election, he said. After the election, Wright favors strengthening the Federal Reserve, perhaps consolidating regulatory power that now is scattered across agencies.

Steven Lanza, editor of The Connecticut Economy, a quarterly publication of the economics department, said the government has responded remarkably quickly to the crisis. By contrast, in the 1930s, it took years to buy up assets of companies and banks that failed and to prop up the housing market, where values dropped by half.

In some places now, property values have dropped as much as 20 percent, Lanza said. But Connecticut never experienced the speculation in housing prices that was seen in some other states – “a silver lining of the dark cloud of zero population growth in Connecticut.”

The state depends more on the financial services industry than other states, however; 45 percent of the state income tax comes from Fairfield County, where many people are employed on Wall Street and in the financial sector.

“We’re not going to see the six and seven and eight-figure salaries we did before,” he predicted. “The state is going to face some very serious budget problems.”

The economists at the forum generally favored exploring alternatives to the $700 billion buy-up of toxic assets recommended by Treasury Secretary Henry Paulson.

The Swedish solution, in which the government bought equity in firms that it propped up, was one of several models suggested.

Lyle Scruggs, associate professor of political science, pointed out, however, that a “partial nationalization of these banks” would be hard to sell politically in a capitalist society.

Ross worried that “the U.S. is no longer seen as a safe place to put your capital” by foreign investors who have financed much of this country’s deficit spending.

Ross also commented that student loans will see the effects of the financial crisis. Nine months ago, people stopped buying securities based on student loans, he said: “Clearly this is something to be worried about.”

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