Crisis 101 | Economist Charlie Colgan, chair of the Maine Consensus Economic Forecasting Commission, on what caused the global meltdown and how it will affect Maine

[An abridged version of this Q&A appeared in the Nov. 17, 2008, issue of Mainebiz.]

Mainebiz: How would you characterize the global financial crisis at this point? What's the latest?

Charlie Colgan: I don't think there's any question that the global financial crisis is a repeat of a periodic set of events in the financial system that has occurred regularly, well back into the 16th and 17th century. It's not anything new. We've done this before in many different guises. The current crisis is distinguished by the speed with which it has unfolded and the complexity of the relationships that have manifested. But fundamentally, we've done this before.

Meaning we've had recessions before?
Well, let's distinguish the difference between a financial crisis and a recession. There are a number of financial crises that have occurred without a recession. There were several -- for example, the 1987 stock market collapse, the collapse of what was called Long-term Capital Management, a hedge fund, in the late 1990s -- there have been several financial crises that have not resulted in or been associated with recessions, mostly because, for the most part, we've learned how to deal with financial crises when they occur and they are of a relatively small scale. The difference now is that the financial crisis is on an epic scale and it occurs right at the time when the economy is also undergoing several other significant vulnerabilities, not the least of which was run-up in oil prices. And the period since the last recession in 2001 has been one of extremely slow growth in terms of the employment sector. This is true in Maine and nationally, so the economy has had a lot of weaknesses. It's largely been built on debt.

You're talking about the last recession in 2001?
Yes, the economy since then has largely been built on debt and leverage in ways that are unusual and left the economy unusually vulnerable to financial crisis.

Because people and organizations don't have the capital cushions that they need?
Well, it means that too much of the economy -- the U.S. economy and, to a large extent, the Maine economy -- too much of the economy was built on consumers taking on debt either for the purposes of consumption, just day-to-day consumption, or for the purposes of buying houses. And so you have all this debt accumulating in the consumer sector -- primarily in the consumer sector, not so much in the corporate sector -- to finance the expansion in consumption, and that's what's really driven the economy since 2001. And when that whole edifice started to collapse, when the whole financing system started to collapse, that debt structure started to collapse, which is essentially what all of the events from Bear Stearns to Fannie Mae and Freddy Mac are about. This time the financial crisis collided with the real economy and produced the recession.

Are subprime mortgages to blame?
They are an important part of the story but not the only part of the story. Subprime mortgages did a number of things. First, they created a lot of what some people have called "dodgy debt," which is people who really shouldn't have been borrowing started borrowing very large amounts of money.

They started being allowed to borrow...
Right, being allowed to borrow very large amounts of money. That, plus the normal housing cycle and several other factors that had to do with the way in which the U.S. economy, the way in which certain regions of the U.S., [has] grown. This is especially true in California, Nevada, Florida, Arizona. They were the fast-growth areas. Essentially, a lot of this debt was fueling housing growth in ways that were just crazy. I mean, Clark County, Nevada, where Las Vegas is, was the fastest growing county economy through almost all of this decade, but Clark County is in the middle of a desert. The only industry there is gambling. It is an entirely artificial regional economy and yet huge, you know, billions of dollars went into growing that economy and housing in it in a really unsustainable way. So subprime mortgages not only created a lot of dodgy debt, they also fueled the run-up in home prices and the illusion that home prices, which had never declined since the depression, would keep going up. It was that illusion that lay behind much of what was going on and that illusion was not simply a function of subprime mortgages, it was also a function of people's expectations about housing, their desire to move to get into housing, and frankly a lack of historical perspective about how these cycles really work.

What percentage of mortgages are subprime?
Well, it depends on what you mean by subprime so there are several categories of subprime mortgages. Subprime mortgage is by definition a mortgage that would not meet the credit standards of Fannie Mae or Freddy Mac for resale. That's the definition of a subprime mortgage, and there are several variations on that depending on down-payment requirements, interest-rate resettlements, resetting of policies. There are also things called jumbo mortgages, which are mortgages on houses above $425,000 which is the upper limits of what Fannie Mae and Freddy Mac would guarantee.

So if you look at the subprimes as a percentage of the total mortgages outstanding, it's probably 10% or so. If you look at subprimes as a proportion of new mortgages written in this decade, it's 30 to 40%, depending on how you do the estimate.

How do we go from defaulting subprime mortgages, which you say account for about 10% of the mortgages in the country, to a global financial crisis?
The simple answer is leverage. There's no easy way to explain this...well, let me try. A bank takes in deposits, lends out money and has to keep a certain amount of the deposits on hand in what's called the bank's capital. In other words, that's the money available to repay lenders, to repay its own loans and to pay depositors on a given day. That's the simple model of a bank. In this decade, that model was broken up. First, mostly by what's called securitization, by taking the subprime mortgages that a bank really would never touch, by slicing those up and selling them [to banks] as securities rather than as mortgages, those securities which got rated AA looks like low-risk debt rather high-risk debt. So high-risk debt got transferred into low-risk debt so banks and other companies could take it on. Secondly, most of the lending took place outside of the commercial banking system where capital standards are fairly set. In fact, that was the whole point -- in order to avoid having to save a certain amount of money as capital, you went outside the system and created this entire shadow lending system that worked around the globe. It was entirely to avoid the regulations.

How would you go outside the system?
If you were a mortgage lender in Maine, you'd write a bunch of mortgages. You'd take those mortgages and you'd sell them to a consolidator, which might be an investment bank. And the investment bank is not subject to the same rules as the commercial bank. The investment bank then consolidates those with a whole bunch of other mortgages and sells them into as bonds to Europeans or Chinese or Japanese or back into the U.S. They sell them to investment houses, to insurance companies, to governments.

And this is within the last decade or so?
Well, securitization has been going on for about 20 years. What this decade has been about was the idea of taking high-risk debt and transforming it into the appearance of low-risk debt and then spreading it around so that nobody really noticed that they were holding a bunch of really high-risk debt; they thought they were holding low-risk debt and so then they kept accumulating it. This is what happened with AIG [American International Group, based in New York City]. They bought up a whole bunch of this debt thinking they were going to make money on it, because they were going to get paid every month and so on, but they didn't have the capital base if housing prices collapsed and it became no longer possible for people to repay the [mortgage-backed] bonds. AIG and the investment banks did not have the capital, because they were not commercial banks, to sustain the losses.
That's exactly why there are no more investment banks in the country. Two of them got sold, one of them went bankrupt and the other two got transformed into commercial banks.

So even though defaulting subprimes, this toxic credit, accounted for a minority of the mortgage base, because they were divvied up in investments they contaminated everything?
Because it was divvied up among institutions that really, because they did not have an adequate capital base, could not sustain themselves when the debt started to go bad.

I heard that the reason that this subprime market started a decade ago is because the Fed had kept the bond interest rate at 1% so it was no long appealing to invest in bonds. So world investors started to look at mortgages, and once prime mortgages were spoken for, they began investing in riskier and riskier mortgages.
Yes, this is the argument that the Fed, after the 2001 recession, kept interest rates too low, which did two things. First, it increased the money supply circulating in the U.S., and thus the money supply in the world, so there were more dollars chasing investment opportunities. Second, it created rate differentials which made these kinds of derivative investment instruments look attractive. And so the two things together, you had both supply and demand occurring at the same time, and that really pushed it ahead. Now, the derivatives market, the subprime market, securitization all of that stuff, existed before this decade. It was the combination of ingredients that happened after the 2001 recession and after the tech-boom that brought all of this about.

And do you think there's still a lot more to shake out?
So much is hidden in these derivative instruments, where the underlining values arise from something else and now you've got second and third-order derivatives where your bond is depending on a derivative of another bond and so on down the line. Who knows what the underlining value is? The biggest challenge that the federal government has now is trying to figure out what does it own. What's the value of it?

Of what the government owns?
Yeah. Or I should say, what we own.

Meaning the $700 billion bailout package?
Yep.

That sounds pretty scary. Should I be scared?
I guess I'd put it this way: It is a system that everybody has an interest now in fixing. Before, everybody had an interest in keeping the system going even though it was likely to break. Now that it is broken, everybody has a reasonable interest in getting it fixed. And so both the public sector and the private sector, though they may disagree on details, recognize now that in fact they have fallen off the cliff and that they are on the way down and unless somebody does something, it's going be very painful. In that sense, I think that the conditions are in place to fix the problem. But two things hang out there. One is no one still knows how big the problem really is and with each week that passes, some new wrinkle in the complex interrelationship among the country and the financing systems pops up. The last two weeks, for example, there's been a huge amount of worry about the flight to the dollar and the fact the dollar has strengthened hugely which is not good news because it means that the U.S. is not able to rebound and balance the payments. Basically we've been importing far more than we've been exporting.

Do you think that we're looking at a situation like the 1970's, or are we looking at something like the 30's, or something else?
Well, I don't think it's going to be like the 1970's in the sense of stagflation, because the 1970's had two major problems creating the inflationary pressures. One was significant wage/price upwards pressure. Prices went up so wages went up, wages went up so prices went up. That's not happening in this economy. Wages are extremely weak. In fact, wages are so weak, wage growth is so weak, that it's contributing to recession not inflation. The other problem was the oil crisis of 1973 and 1979. We've had a huge run-up in oil prices this year but we've also shown that within six weeks the price at $147 and even $100 a barrel is not sustainable. And so the oil price in the 1970's -- the oil price tripled in 1973 in the Yam Kippur war, it quadrupled in 1979 after the Iranian Revolution. The oil price break did not come until 1980, late 1985. So it took 12 years for the oil price break to occur. In 2008 it happened in less than four weeks.

I don't think you're looking at the same kind of problem.

And the 30s?
The 30's is a replay of the three. Clearly, this is a financial crisis on the order of what happened in 1931 and 32. Here the differences however are significant in that we're not seeing a shutdown of the commercial banking system. For the most part, there's no run on the banks. There have been a couple of very dodgy events -- IndyMac bank out in California, there was a mini-run on that bank -- but largely that's all been brought under control. And of course, the government has moved with much greater speed and force [than the Depression-era government] so I don't think you can say that we're on the edge of another Great Depression. Unless the financial system really does collapse and there's another seize-up of credit like we saw in late August into September [where] essentially people stopped lending money, period. The government's toolbox is pretty empty. There's not much more. I mean, we're buying the banks, we're taking the dodgy debt off their books, if they decide to freak out and not do anything [and] the financial sector seizes up again, there are not many tools left in the toolbox. However, I'm not sure if that that will happen.

So what does it mean for Maine?
Maine's come through generally better than the U.S. as a whole. Our labor market has held up better. Our growth has not been too bad through the first part of the year. We've been slow but we've been slow all decade. We haven't hit above 1% employment growth in a year since 2004. It's just been painfully slow, which is reflective of the national economy, by the way.

It's not just us?
It's not our fault. The labor market in the U.S. has essentially downshifted into first. There are two paths, I think --- Maine gets away the way we did in 2001, things are not too bad. The other is we really do tank over the next four quarters with much bigger job losses than we're expecting.

How bad could it be?
Well, in the current forecast we're looking about 7,000 jobs lost. And my alternative, more pessimistic, scenario is 17,000. It's a decline of 2.1%. It would push the unemployment rate to about 7.5%. The most vulnerable sectors in Maine will continue to be construction and retail.

If that happened do you know how that would rank Maine? How vulnerable is Maine compared to other state?
We will be better off than the rest of New England.

Even if that happens?
Yes. We'll probably be a little worse than New Hampshire. We'll probably be a little better than Vermont but we'll be much better off than anybody in southern New England. Rhode Island is already at eight and a half [percent unemployment] and they haven't even hit the worst of it yet.

Does this have to do with the banks too? We have a lot of credit unions and local banks.
It does have to do with part of the fact that we do not have a lot of employment in the most vulnerable sectors, because this is a consumer led recession. Look at the auto sales which took an unbelievable tank of 30% drop in one month over the previous year. Well, I guarantee nobody is rushing to the auto dealers in Maine either. Now, the big risk is in retail. We dodged a bullet this week. I thought that Circuit City is one of the national chains that have been rumored to be on the verge of bankruptcy, shutting down. They did wind up just announcing that they were shutting, I don't know, something on the order of 70 or 80 stores, but none in New England. So we dodged a bullet on that one.

So you think we're in a recession right now.
Yeah, no question.

Nationally and locally?
Yes.

And how long do you think it will last?
In the optimistic scenario, two more quarters. In the pessimistic scenario, four more quarters.

Are you optimistic or pessimistic?
I change hour by hour.

Is that normal or is this really a unique situation?
No, it's just huge. It's just so hugely unique. I mean, at the moment I'm cautiously optimistic that we can get through the optimistic scenario. We can basically have a hard time but not as hard as the U.S. or the region as a whole. But everything right now depends on, quite frankly, the government getting a stimulus package in place and the consumer coming back with at least a little bit of [spending].

Now, the problem with the government is they're already spending money hand over fist to do the bailout so I think in the long run they're just going to say, ‘Damn the torpedoes, full deficit ahead.'

The consumer's a bigger problem -- because wage growth has been meager, most of the expansion and retail growth in this decade has been sustained by housing price growth and credit cards. But there's no more big gains in home equity loans. The other problem is on the credit card side, where a lot of credit cards are going to get pulled back. Standards are going to go way up and there will be an overshoot -- just as there was an overshoot in terms of giving out debt, there'll be an overshoot of pulling it back until things even out, probably in 2011.

Maine has one big problem and one big potential opportunity during this period. The problem is Brunswick. [The Brunswick Naval Air Station is] going to close, most of the people from Brunswick will be gone by the end of next year, but most of the effect of Brunswick's closing is going to happen at the worst time in terms of the recession. The opposite, good news, is the potential for the wind power and transmission lines construction projects coming online just as the economy is coming out of recession and substantially boosting our upward trajectory when the time comes.

So it's not an entirely bleak picture. We do have some advantages. But the hardest year is definitely going to be 2009.

You said another stimulus package might be really critical to getting out of this, but is it wise policy to encourage consumers to keep spending? Is that kind of teaching us more bad habits?
Well, so there's sort of two levels of spending. The first problem is I think people are dramatically pulling back from consumption. In other words, they're not even consuming at the level that their income, that their regular income, would suggest they could spend. They're scared, they're stuffing the money in the mattress or the equivalent thereof and they're just holding off on decisions on any kind of consumption and this is apart from consumption of things with what I would consider to be within reason, within their income level.

Then there's the consumption that comes from getting three or four credit cards and running those up. Those are two different propositions. I would suggest that right now the consumer has pulled back so far that they could come back to a level of consumption consistent with income and not do any damage to their balance sheets and help out the economy some. But we're not going to see the big spurt in consumer spending that was sustained by the flood of cheap credit coming out in the credit cards and the home equity loans. When you cross that line you are in fact getting into problems. But we've pulled back so far, at least from the evidence of September and October [consumer spending data], that there's room for the consumer to come back without incurring a lot of extra debt.

What would you advise business owners to watch during the tail end of this year? What's a good economic gauge for them to keep an eye on?
Well, the numbers that I'm looking at are initial unemployment claims, those have been going up steadily in the U.S. but they've just begun to go up in Maine. That's the leading edge of the unemployment problem. If we see an explosion in Maine on initial unemployment claims, similar to what's happened in the U.S., that's going to be a real trouble sign. If our initial unemployment claims go up only moderately, that will suggest that our labor markets will suffer some but not as seriously. That's the major indicator I'm looking at in terms of the Maine labor market. That's very good leading indicator. It tells you where the unemployment rate is going to be trending, one to three months ahead.

The other thing that I've been following is what's called a "TED spread," which is the Treasury-Eurodollar interest rate spread and represents the interest rate on short-term lending between financial institutions. It hit a very high point in September and it's been coming down ever since. It represents an approximate measure of equity and volume of transactions in the financial market. If that comes back down towards 1% by the end of the year, it will mean the financial markets have probably stabilized back into some sort of normalcy. So it will take a year to sort out all of the details, but the end result will probably be OK.

I guess the third thing I'm watching is oil prices. I do not see oil prices doing what they did in 2008 again in 2009, but nobody saw 2008 coming either. The major problem with oil prices will almost certainly come from some supply stop. So that would be the other big vulnerability.

Interview by Sara Donnelly