…The Long-Term Consequences of Debt Region: Well, let’s talk about the U.S. debt and its long-term consequences, in the context of the current economic crisis. The Stabilization Act authorizes $700 billion, some of which will contribute to the growth of national debt. Economists such as NYU Professor Nouriel Roubini suggest $2 trillion …
Rogoff: I have, as well, suggested $1 trillion to $2 trillion.
Region: Yes, I think up to $2 trillion “to fix the system” are your words.
Rogoff: That is because the bailout process is just at the beginning. Look at history. Carmen and I have a paper coming out … looking at the aftermath of banking crises. We argue that it is highly misleading to look at reported ex post fiscal costs because these are subject to a great deal of accounting manipulation and typically do not reflect true economic costs. If, instead, one looks at things that are less manipulable, like the run-up in public debt, it’s clear that the costs of a financial crisis are just staggering.
For example, even though this interview won’t be published for a couple of months, I think it’s safe to say there’ll be a huge stimulus package, some of it surely dissipative. We’ll probably bail out the mortgage holders before this is over, some large class of them. Auto companies, municipalities and so on.
Perhaps the costs will be less. But I doubt it.
Region: And the long-term growth consequences of that additional debt?
Rogoff: Fortunately, adding a trillion dollars in debt is quite manageable for the United States. Of course, it is not a fun way to spend money, bailing out the financial system. We’d rather spend it on health, education, infrastructure or the environment. (That is, if the expenditures are well crafted and packaged with policy changes and structural improvements.) The fact is that for all the railing against the Bush deficits, the United States grew decently until recently, so that our debt/GDP burden is still modest by European or Japanese standards.
The rising debt burden will have some effect on growth. But I’m more concerned about what happens to our financial sector at the end of this, what’s left of it. I just don’t know what’s going to emerge after the political system works it over. I hope that we do not throw out the baby with the bathwater. If we rebuild a very statist and inefficient financial sector—as I fear we will—it’s hard to imagine that growth won’t suffer for years.
Yes, the financial sector needs to shrink. … So some retrenchment is desirable. But I worry we are going to turn back the clock altogether too far. What are needed are (much) greater capital requirements and more transparency, not regulatory strangulation.
Addressing Moral Hazard Region: In a recent Washington Post column titled “No More Cream Puffs,” you praised the government for not bailing out Lehman Brothers. That column made clear the problems of moral hazard and the wisdom of resisting bailouts. Yet it’s also clear that there are issues of systemic risk and spillovers from institutions or banks that may be too big to fail. How would you address that paradox?
Rogoff: I’d first say that the financial system was falling under its own weight, and it had been propped up by the bubble. If you look at the stresses and the LIBOR and credit spreads, they were blowing up at the time of Lehman. If it wasn’t Lehman it would have been Merrill, and if it wasn’t Lehman or Merrill, it would have been someone else. The system was not sustainable. Like any overextended industry, it needed to shrink.
The financial services industry had been taking in 30 percent of corporate profits and 10 percent of wages despite representing only 8 percent of GDP (at its peak, and that is counting insurance). Why should a supposedly efficient financial system be soaking up so much of GDP? It is quite possible that a lot of what has happened to our overbloated financial system needed to happen anyway, albeit one would have expected the process to take five years instead of five days.
To the extent that there was a tactical mistake made, the problem was not casting a very wide deposit insurance net early on.
My strong guess also is that Lehman’s leadership itself bears a heavy responsibility for what transpired. Lehman seemed to consistently be trying to drive a hard bargain, even as support for its equity faded. This dynamic seemed to occur again and again up until the last, last, last minute. Society cannot let itself get blackmailed by the financial system any more than by other large industries that seek side payments and protection.
Region: Without focusing on Lehman in particular, but from a more general policy standpoint, are there steps that can and should be taken to avoid moral hazard while containing spillovers?
Rogoff: Things have moved so far since then. I said then and still feel that the best outcome would have been to let market discipline take effect so that we didn’t have to regulate the system until no grass grows in the financial sector for 20 years. Unfortunately, we didn’t put in strong enough deposit insurance quickly enough after Lehman. The result was a good old-fashioned bank panic in the financial system. Now we have reached a point where we almost have to rebuild the whole thing from the ground up. I think that in a few years even the existing financial institutions, the ones that have been saved, probably won’t look anything like they do now. Do we really want a financial system with a few big universal banks, riddled by internal conflicts and contradictions, and yet too big to fail?
We have to rethink banking. Suppose you were putting your money in a bank, and it’s being insured up to a large amount by the government. Suppose then the bank is taking the money and putting it at the Federal Reserve and getting interest on it. This arrangement begs the question of what the bank exists for. Should the bank just be charging for markup services on checking? If the government is ultimately going to be the one providing liquidity services, should the whole structure be different than it is now?
I don’t know. I’ve taught for years in my class that many types of money funds and asset classes outside the traditional regulatory system are subject to the same kind of runs as the conventional banking system. I have had my classes write papers about whether the government can credibly promise not to bail out money funds, and if it cannot, then should they be subject to more regulation? This is not a simple question, but researchers need to provide better answers. I would venture that the present financial crisis will have an effect on the future research in macro and finance similar to the influence the Great Depression had on several generations of economists.
Macro and finance have been dominated by the perfect markets paradigm because it’s very convenient, and we got a lot of nice results and it’s been constructive. But I think the advocates of that approach have all too often argued, “Well, OK, we know markets aren’t perfect, but it’s hard to do better than this in a constructive way. Besides, whatever we’re missing maybe isn’t so important.”
But for many policy issues and especially for monetary policy, one cannot work only with models featuring perfect financial markets. Consider the fact that a lot of the inflation targeting literature employs models with perfect financial markets. So it’s not exactly amazing that scholars wedded to this approach find that there is never a good case for looking at housing prices, above and beyond their effects on output and inflation. Yet empirical researchers have long argued that there is considerable danger whenever asset price inflations are accompanied by sharp rises in indebtedness. The doctrinaire inflation targeters dismissed this perspective, but hopefully they are rethinking things now. This is another reason why optimal inflation targeting models are simply too fragile.
No doubt, young economists will figure out better models for monetary policy. Of course, we already have models embodying financial market imperfections. For example, we have a lot of such models in international finance, including especially the literature on sovereign debt and default. Unfortunately, they can be very tough to work with practically and do not lend themselves to the same kind of flexible empirical analysis as the standard New Keynesian models (with perfect financial markets) now widely in use.
Fortunately, the financial crisis is going to stimulate a lot of further research seeking better practical monetary policy models. Happily, at the same time as the financial crisis has confronted us with fascinating new problems, it will encourage a lot of talented young students to go into economics research instead of the investment banking sector, where they might have gone until recently [laughter].
Region: Thank you very much.
Originally published at the Economist’s View reproduced here with the author’s permission.