Sergio Rebelo, professor of finance, gave his perspective on the Great Recession at a lunchtime seminar Tuesday. His talk was a thorough yet accessible explanation of an economic crisis that has been difficult to describe at best and nearly beyond comprehension at worst. Rebelo believes the recession is easing, but does not believe that the recovery will be swift and decisive.
Our economy has experienced nine discreet recessions since World War II alone, not including the current one. Each time, the U.S. economy managed to turn around relatively quickly. “A lot of prosperity in the United States comes from the ability to always go back to where we were,” Rebelo said, “even after the Great Depression and the Second World War. It’s as if nothing had happened. The U.S. economy got right back to its trend.” Yet he argued that the current recession resembles the pre-World War II downturns, contractions that coincided with liquidity crises and credit crunches.
“One very clear pattern is the difference between business cycles before the Second World War and business cycles after the Second World War,” Rebelo said. “Take a look at the pre-war period. Business cycles are very severe… But also recessions were very long lasting. The average recession in the United States in the post-war period is about one year. That’s a short amount of time… But in the pre-war period, recessions were much, much more severe and lasted as long as five years.”
And a credit crunch, of course, is at the heart of the current downturn. Rebelo traced the chronology of the financial crisis from its roots. The Federal Reserve during Alan Greenspan’s tenure set low short-term interest rates to counter the dot-com bust in the early part of this decade, but then held them low in response to lingering unemployment. At the same time, foreign investors increased their appetite for long-term government bonds, creating a decline in long-term interest rates. Cheap credit also helped fuel a boom in the housing industry, while low interest rates led investors to search for safe assets with better yields that those offered by government bonds. Bankers responded by securitize mortgage pools and sell them off in tranches, a creative solution that allowed them to create AAA-rated securities with relatively high rates of return.
“Two words that should never go together are creativity and banking,” Rebelo said. But the creativity didn’t stop there. Investment banks then resecuritized the BBB-rated tranches (which Rebelo joked stands for “bad-bad-bad”), selling the first tranche of the new security as AAA. Some bankers became nervous with this second securitization, Rebelo said, and that’s when companies like AIG stepped in with insurance for squeamish investors. Many viewed the BBB-backed securities as safe as long as long as loan delinquencies—the proverbial canary in the coalmine, Rebelo called them—remained low. Banks planned to pull out the minute delinquencies rose. But delinquencies not only remained low, they dropped. “Not only is the canary in the coalmine fine,” Rebelo said, “it starts singing!”
Meanwhile, the banks were accumulating toxic debt at a growing rate. The AAA-rated tranches were flying out the door, but the toxic waste portions sat on the shelf. Eventually, the gig was up and the federal government had to throw the banking system a lifeline.
More than a year past the start of the credit crunch, the economy is showing both signs of life and continued sickness. While certain indicators are improving, unemployment still dogs the system. Rebelo believes the turnaround will not be as quick or steep as some would hope. Mortgage delinquencies continue to rise, he pointed out, and many of those will soon turn into foreclosures. Zarnowitz rule—the larger the recession, the faster the recovery—may not apply this time around.
Still, there are things businesses can do to make the most of these trying times, Rebelo said. Consumers are prone to buy smaller sizes of the same product in a recession, for example. Adept managers should adjust their product lines to suit such tendencies, he said. Promotions are also more effective than in normal times, he noted, and may be a way to build customer loyalty that can pay dividends when the economy finally recovers.