Guest lecturers discuss recession

“The Great Recession: Two Perspectives”

October 7, 2009

You’ve heard the words “housing bubble,” “rate of unemployment,” and “economic recession” in the news, but what does it all mean? William Longbrake and John T. Lawler ’88 gave a presentation and lecture custom made for Knox College called “The Great Recession: Two Perspectives.”

Longbrake, retired vice-chair of Washington Mutual and former CFO for the Federal Deposit Insurance Corporation, discussed the causes of the recession, the current economy, and its recovery. Lawler, Controller, Marketing and Sales of Ford Motor Company, discussed the business side of the recession.

What is a recession? A recession is “a period of significant decline in total output, income, and employment, usually lasting from 6 months to a year and marked by widespread contractions in many sectors of the economy.” Both the U.S. and countries around the world have been noticeably experiencing recessions since last year.

Longbrake said, “The cause of the problem actually developed over a very long time. You hear comments about ‘Well, it’s subprime lending or bankers gone wild.’ Yes, those things did happen, but those were the final crescendo-type of events.”

Causes of the Recession

#1—Overconsumption enabled by “easy credit” and” too much leverage.” For the past 30 years, consumers have been taking on more debt as consumption and spending rose faster than people’s income; in correlation, the rate of saving decreased. There was easy access to credit with people using their increasing housing and stock market wealth to borrow money to finance their excessive spending.

From 1960, the percentage of debt to income for Americans ran between 60 and 70 percent but from the beginning of the 1980s, it dramatically increased. After the “tech” or “dot.com” bubble in the beginning of this decade, when stock from the Internet sector rapidly increased in perceived value (but not in actual value) with the expectations of stock only increasing from there, debt rose from 90 to 130 percent.

As an economy goes in a downward spiral, people tend to restrict their spending because they view money as insurance for the uncertain and unknown future. As there are fewer sales, production for goods and services halt, companies have to lay off workers due to less consumer demand of their products, etc. This general chain of events causes the economy to contract and a recession to result.

#2—Financial innovations and abuses of the financial system. Longbrake said, “Financial innovation is a good thing by definition, but if it occurs in an uncontrolled fashion, it can be a bad thing and that’s exactly what happened.”

Financial innovations like Credit Default Swaps (CDS), insurance against unpaid bonds or loans, lead to “uncontrolled abuses.” The insurance company AIG (American International Group), recently in the headlines for their $165 million in bonuses paid to the heads of the failed company, engaged in CDS. AIG, more interested in the fees and premiums, did not pay much attention to their risk and that weakness was exposed during the financial collapse. As the years passed, financial institute debt shot upward.

#3—Speculation and bubbles. Economic bubbles occur when the values of things rapidly increase and are perceived to be worth more than their real values, encouraging people to spend and speculate that the value of things will only go up. “Bubbles are behavioral effects of things. They’re where people get emotional…Bubbles can become pervasive throughout in the entire economy. ‘Hey, home prices are going up forever, this is a quick way to make a buck.’ When bubbles occur, speculative euphoria just becomes the centerpiece of the action,” said Longbrake. Due to low interest rates, the attainment of easy credit, and the speculation that housing prices were only going to go up, people bought houses as an investment they ultimately could not pay for.

4) Globalization. With China starting to emerge as an economic global power in the early 1990s, along with India, the former Soviet Union Republics including Russia, and South America, there was a spike in global growth. As there is globalization in an open economy, resources shift to where costs are lowest. China and India supply a huge amount of labor at low costs. A typical strategy for a developing country to attain rapid economic growth is to export manufactured goods that can be produced cheaply.

5) Market governance failures. The policy of the Bush Administration tended toward a free market with little to no government intervention. Companies were not as regulated as they could have been which enabled the financial abuses that followed. The financial abuses lead to financial collapse and an investment bank failed, like Lehman Brothers, the first bank to fall. As people could not pay their mortgages or loans, it could not pay back the money it owed to other banks, causing a domino effect.

Surviving the Economy

John Lawler ’88 followed Longbrake, giving a presentation on what Ford Motor Company has done to survive in the economic downturn and become the only U.S.-based automotive company out of “The Big Three” (the other two being GM and Chrysler) that did not take government bailout money. President Roger Taylor remarked that the big difference was Ford had a Knox graduate.

As competition was intensifying and Ford had a reputation for poor quality vehicles, it had to face reality and began to restructure. Before the recession, Ford secured a $23 billion loan. Ford recovered by reducing costs, strengthening its product, improving quality and brand reputation, and following the trends and strategies of other motor companies like Japan’s Toyota Motor Corporation.

Recovery of the Economy

According to Longbrake, recovery is “not going to be quick and easy.” He later continued, “The real question is going to come…how will it feel? Very lethargic growth, I think. Barely keeping up growth of the population. And lots of parts of the county, lots of different industries are gonna feel like, ‘Where the recovery everyone is talking about? We don’t see it.’”

The unemployment rate is currently at 9.8 percent and total hours worked have been down about six percent. Longbrake forecasts that the rate of unemployment will correct itself because it can’t go down forever. Unemployment is still getting worse but things are not getting worse quite as rapidly. Beginning since 1990, the U.S. trade deficit (a gap between exports and imports) has been decreasing but in the last 12 months there has been a reversal as world trade came to a halt.

Real consumer spending has not been negative as long. And like unemployment, it can’t go down forever. Recovery is very slow in all likelihood because people are concentrating on saving and the savings rate has recently turned up. In terms of the housing market, as there are far too many apartments—two million above normal inventory. This will continue to have downward pressure on building and home prices.

Structural Solutions

Solutions to prevent another similar recession include systemic risk regulation, supervision and regulation to prevent market governance failures with consumer protection, and supervision of financial markets to oversee credit default swaps, speculative activity, and bubbles.

In the question and answer portion of the presentations, President Taylor asked, “Some of the pundits said all of this mess could have been prevented if the government had not let Lehman Brothers go down, that’s obviously contrary to your thoughtful presentation. Do you have a reply to the pundits?”

Longbrake responded, “It’s an over simplification. The Lehman Brothers failure was the catalyst to unleash the firestorm….When you have a structure that’s very fragile, which is where we got to in the U.S. economy, anything could trigger the collapse…What the Lehman brothers did point out, if you break the chain of trust…[Lehman Brothers was] the counter-party in a multitude of financial transactions. On the day they were announced to be bankrupt, it put into doubt every single one of those transactions and everyone ran for cover.”

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