Longer pieces: Trust Betrayed

from Forward March-April 2009
Trust Betrayed Seven economists well-known to the metals industry contend current economic systems are so structurally flawed, it’ll take more than money to mend them.
Interviews by Michael Chevy Castranova

The origins of today’s immense financial challenges, and the public’s apparent lack of confidence in our economic systems, lie in deep structural problems that will take time and far more than tax credits and stimulus plans to fix. Forward magazine spoke with seven economists well-known to the metals industry to ask them what went wrong, as well as what they believe will be required to return trust to those severely damaged systems.


PARTICIPATING ECONOMISTS
SCOTT A. ANDERSON, senior economist and vice president, Wells Fargo & Co., Minneapolis, Minnesota
NARIMAN BEHRAVESH, global chief economist, IHS Global Insight, Lexington, Massachusetts
PAUL KASRIEL, senior vice president and director of economic research, Northern Trust Corp., Chicago, Illinois
PETER MORICI, professor, Robert H. Smith School of Business, University of Maryland, College Park, Maryland
JEFFREY ROSENSWEIG, director, Global Perspectives Program, Goizueta Business School, Emory University, Atlanta, Georgia
MATTHEW SLAUGHTER, associate dean, Tuck School of Business, Dartmouth College, Hanover, New Hampshire
WILLIAM STRAUSS, senior economist and economic adviser, Federal Reserve Bank of Chicago

The current recession demonstrates the consequences of permitting various bubbles to simply burst—first the housing bubble, which led to a collapse, among other things, of the commodity price bubble, and a similar collapse of credit markets. What could have been done to avert some of this pain?

Rosensweig: In a mere decade, two massive bubbles popped. Both of these speculative bubbles were fueled by too much liquidity supplied to the economy by the U.S. Federal Reserve, and regulation that was often weak or nonexistent. First, technology stocks formed the dot.com bubble and bust, followed by real estate and commodity prices. Interestingly the legacy of [Federal Reserve Chairman Alan] Greenspan will be forever tarnished by the fact that he presided over the first bubble, did not learn that too much liquidity must be quickly mopped up, and thus repeated the mistake. The Fed should have stepped in once the unemployment rate had fallen to a good level in 2005, rather than keep interest rates low, mortgages virtually unregulated, and allow the housing bubble to get out of control.

Kasriel: A common element in asset price bubbles through history has been cheap credit. The Fed is an important source of cheap credit and should be less active in practicing countercyclical policy and try to be a more neutral element in the economy. Business cycles are an expected and welcome phenomenon due to changing tastes, supply interruptions, etc. If the Fed were to limit the growth in its balance sheet—that is, the amount of money and credit it creates out of thin air—then the economy would not be likely to experience cumulative price increases, price increases of goods/services and assets.

Behravesh: There’s a mistake here in the sense that this is not a crisis that was made in the USA, although there’s a tendency to blame the U.S. This was a global credit bubble. If you look at money-supply growth, not just in the U.S. but in Europe, in China, it was very rapid. Chinese money-supply growth was well into the double digits, as was the money-supply growth in Europe. What this did was fuel not just the housing bubble in the U.S., but also housing bubbles in the U.K., in Spain, Ireland. It fueled bubbles in stock markets in emerging markets, and it fueled the bubbles in the commodity markets.

What economic indicators do you now watch for signs of continued decline or signs of potential improvement?

Kasriel: First and foremost, the behavior of the index of leading economic indicators. When the LEI levels off, a recovery will not be too far off. A reduction in rate differentials between interbank and corporate money market instruments and T-bills will be a sign that the credit markets are thawing and that investors are once again more willing to take on some risk. A pickup in bank lending to the private sector would be a good sign for a recovery.

Anderson: What I think is a good proxy of global demand right now is crude oil prices. Part of the reason why crude is down is because demand has fallen off a cliff. If we saw oil moving back up, that would be a good sign that some of the worst is over. I’m also looking at the credit markets very carefully. I’m looking at things like commercial paper spreads over treasury bonds, LIBOR [London Interbank Offered Rate] spreads for signs of improvement in the money markets. That’s very important for the cost of funds for banks and might make them more willing to lend and restart the credit intermediation process. We’re also looking at credit spreads in the corporate bond market to get some sign that business conditions are improving. A look at leading indicators is good … and certainly a stock market rally wouldn’t hurt, either.

I would also throw in there some of these ISM [Institute for Supply Management] manufacturing and non-manufacturing surveys, which usually move a lot quicker than things like GDP and employment [reports].

You mentioned crude oil prices. When prices start to go up, will things already be better?

Anderson: It would be a coincident-type indicator. But certainly the problem right now is we’re seeing a huge drop in demand, among both consumers and businesses. That’s being reflected very quickly in the oil markets.

Rosensweig: I watch the stock market, as it is a leading indicator. This is better than coincident indicators, such as retail sales. The stock market is the summary of judgments of investors, speculators and analysts all over the world, and they each have the incentive to invest in studying the future potential of the economy and thus of profits.

Morici: When banks are lending to private entities, depending on the nature of the lending and why it’s being lent, but if it’s to businesses to expand activity, certainly that’s a leading indicator.

Employment unfortunately tends to lag expansions. If you see employment going up steadily, you’re well into the expansion because, in the initial stages, most businesses can get along with the same number of employees and make more of whatever it is that they make. Likewise, as they turn down, often productivity falls before they lay workers off because there’s such a high cost in rehiring.

Behravesh: Commodity markets are incredibly sensitive to changes in demand conditions. The fact that they’ve begun to level off suggests maybe we’re approaching bottom. Usually they lead the recovery somewhat, maybe six months or so, and a lot of commodity prices have begun to level off, and a couple of them actually have started to rise. The so-called Baltic Dry Index, which is a measure of trade volumes, has picked up recently.

Strauss: With the bottoming of the housing sector, there is some disagreement about how critical that is. But I think that’s one of the great uncertainties, that there are so many of these assets on the balance sheets of these institutions. They’re having a real difficult time pricing out exactly what these assets are worth. So once the housing sector stabilizes, and, in particular, prices on these homes stop declining, at least they’ll be able to say, OK, it appears that they’re not going to go any lower than what they are right now, and we can start to reassess what our value is of these assets and figure out how much capital they need to back that up.

When the Fed needs to be doing less, that means the rest of the private sector is coming back. And the job numbers—when job cuts soften, that’ll certainly be a good sign.

Some economists believe we can expect the economy to begin to rebound in the second half of this year. Others say it will take several years for all the shocks to work their way through the economy. Who’s right? What has to happen to pull us out of this deep recession?

Kasriel: The economy will mount a recovery in fourth quarter 2009 because of the monetization of [President] Obama’s fiscal stimulus plan. What needs to happen for this recovery to be sustained is that the banking system be recapitalized, house prices and wages need to fall to market clearing levels.

Rosensweig: 2009 will be a very difficult year. I believe, but without much faith, that the bottom will be reached in the fourth quarter. However, the recovery will not be the usual V-shaped one, but rather an L, where the barely-above-horizontal part can last roughly two or three more years.

Anderson: Consumers are in for a long adjustment. This is a structural adjustment … and because of that, we don’t really see growth returning to what we saw in the past, where three and a half percent growth rates were common. We’ll be lucky to see growth rates of 2, 21⁄2% by 2010.

Behravesh: We’ll probably bottom out over the summer or the autumn sometime. But “rebound” is too strong a word. We’ll start to grow slowly by the end of this year, beginning of next year. It really won’t be until 2011 that we get back up to, say, 21⁄2, 3% growth. So it’s going to take a while, but not many, many years—that is overdoing the pessimism.

There are four reasons why I think there will be a recovery of some kind, and we haven’t repealed the laws of economics. Number one, commodity prices have plummeted. The drop in gasoline prices alone is the equivalent of a $250 billion tax cut to U.S. consumers, and they’ve already gotten it.

Number two, the bank rescue packages: They are working, actually. Yes, there are problems with them. But they’ve lowered a lot of the risk premiums, these big risk spreads that occurred right after Lehman Brothers collapsed.

Number three, interest rates are very low right now and will remain low. Mortgage rates have come down, and in the U.S., what we’re beginning to see is a huge wave of refinancings that will not necessarily mean people will take out more debt, but they’ll reduce their monthly mortgage payments.

Number four is these fiscal packages, which are huge for the U.S. and China but much smaller in Europe and Japan.

What else has to occur to pull us out of this recession?

Slaughter: My crystal ball is not clear on this, but it’s plausible to see a scenario playing out where, for some period of time, household consumption isn’t going to grow very much, or it’s going to continue to decline to some extent. And that right there says, boy, 70% of aggregate demand that’s not going to be growing, or [will continue] to contract, that’s going to make it hard for the overall economy to recover.

Then you need to look to what public policy could do to try to stimulate export demand or investment demand by companies—the buying of new property and equipment—or what spending the government could do. Governments buy goods and services, so part of the demand of our overall economy is state, federal and local governments “buying” roads, “buying” bridges, paying teachers for the education that’s provided through the state ….

Part of what the U.S. economy does need to do to have a better balance of output is to move away from relying so much on American household and consumption demand and have more export demand, build more goods and services to sell to the rest of the world, and also have more capital investment by companies, try to incite companies to build up our productive capacity for the future.

But then, you’re thinking about policies like new trade and investment liberalization around the world. If you’re trying to stimulate capital investment by companies, you can do it through things like reducing the corporate tax rate or offering bonus depreciation rules for expensing capex. There are things historically that some countries have tried to pursue, the United States included, to stimulate export growth and stimulate capital investment. It’s fair to say those are policy tools that have not been front and center in a lot of the stimulus discussions.

Morici: We have to fix the trade deficit with China, which means either they revalue their currency or we find some way to offset their currency subsidies and other restrictions on imports from the United States that they have put in place.

With regard to energy, we need to build out a fleet of much more fuel-efficient vehicles, not necessarily electrics or hybrids—because their capacity to fully meet that need is still several years away—but more fuel-efficient internal-combustion-engine driven cars. And we need to provide incentives for consumers to trade in their vehicles and move to much more fuelefficient vehicles—we can build those. We certainly have to take a very hard look at how we assist the Detroit Three. They’re vital to the U.S. economy, but we must insist that their labor agreements and other management practices are as competitive as those of the Japanese companies when they make cars right here in the United States.

Speaking of China, it has played a major role in financing U.S. credit needs, supplying American consumers and using the United States as a marketplace for its own surplus products. Now China is slumping like everyone else. What should our economic policies be toward China in the coming years?

Behravesh: The biggest problem with China is it relies too much on export-led growth. Almost 40% of China’s GDP is exported. We shouldn’t necessarily put pressure on China to revalue the yuan. That’s counterproductive. We should put pressure on China to boost its consumer spending. China needs to become an engine of global growth, rather than reliant on growth in other parts of the world. China’s becoming too big and too important to rely solely on export-led growth. And the way it gets out of that is not through exchange-rate changes, although, yes, that can play a minor role. It’s through policies that boost especially Chinese consumer spending.

Just to put things in perspective, our consumer spending in the U.S. is 70% of the economy. India’s is 60%. China’s is 38%. China needs to boost consumer spending. Period.

Kasriel: We should manage our affairs and let China manage its affairs.

Morici: I think we should make everybody play by the rules, and we should play by the rules, too. In the case of China, the most flagrant rule violation is the notion of currency. It’s possible for a small country, a small developing country, whose impact on trade is very small, to have an undervalued currency for a period of time without notice, but not someone like China.

With regard to other rules, we have not been as rigorous as we should be with regard to China. Certainly the rest of the world is very rigorous with us. We’ve had policies that have been found to be in violation, and we’re constantly defending ourselves in the WTO [World Trade Organization]. That doesn’t mean the United States is a free trade renegade, but rather the WTO rules are very comprehensive. Many of them are very new, and we’re just learning their meaning. The Uruguay Round [of trade negotiations] is going to take several decades to fully understand in terms of its impact on domestic policy.

Anderson: I’d tread very carefully here. As you mentioned, we are very dependent on China right now to finance these deficits we’re projecting going forward. I do think China and the United States both need each other for different reasons. It’ll be necessary for them to work together to get through this crisis intact.

There’s no doubt that China … can’t put all the blame at our doorstep, either. They’ve been willing actors in this symbiotic relationship. Perhaps they have kept their currency too low for too long, and that helped build up the financial bubbles we saw develop in the United States.

Rosensweig:We need China, especially as a buyer of the massive treasury securities we must issue to fund our record-sized federal deficits. They need us as a market. The relationship between us needs to be healthy, now more than ever. There will be pressure on each side to become protectionist, thinking that domestic jobs can be saved by blocking imports from the other nation. Certainly we must be vigilant against China trying to dump its goods—or gain a further currency advantage—into our market.

However, protectionism—the Smoot-Hawley Tariff [Act of 1930, which raised tariffs on more than 20,000 imported goods]—and the inevitable retaliation, is the one clear thing that we know helped cause the Great Depression. We cannot repeat that tragic mistake.

Strauss: As much as we talk about a tough year here in the U.S., I think it’s going to be a very tough year in China.

If you look at the percentage of imports coming in from China, it has surged, as one would expect, over the last 15, 20 years. If you look at the percentage of imports coming in from Asia, including China, it’s flatlined, if not even trending a bit lower. So all the gains we see coming in from China have been offset by declines coming from Japan and [South] Korea and other countries that were previously shipping directly to the U.S. Now they’re having the assembly work done in China, so when we blame China for a lot of this, a lot of that is actually impacting things in other parts of Asia.

The hit that’s going to happen now is going to have less of an impact on the U.S., given this is very much a consumer-led slowdown. But this effect is going to be very hard felt in countries that are producing those consumer goods, that is, China and many other parts of Asia that are supplying the componentry. You see what’s been going on with regard to commodity prices and the slowdown, the GDP numbers that are coming out of China are much reduced from what people believe it needs to have in order to support its growth of population.

There is a lot of anti-Chinese sentiment. I don’t look at the rhetoric, I try to look at the economic data and understand the fact that China is trying to improve its economic conditions for its people. And when you look at where China was 30 years ago, the number of people that have been lifted out of poverty over this period is absolutely spectacular.

Several of you touched on banks earlier. What do we do about banks? Paul Volcker, chairman of President Obama’s Economic Recovery Advisory Board, suggested, among other things, nationalizing some of them, as was done in Sweden. Should there be a cap on how big a bank can get? Is the “bad bank” idea still workable?

Morici: Nationalizing the banks? That’s silly. We have over 8,000 banks in the United States. Even if we just nationalized one or two, the federal government probably would not know how to run them effectively. We don’t have national enterprises, any history of running them effectively, other than utilities of various kinds. Also, in countries where they have nationalized the banks, there are very few banks; they have a very highly centralized banking system. We have a distributed banking system, that’s why we have some 8,000 banks—it goes back to the days when we didn’t allow banks to do business across state lines ….

We need to sweep a good amount of the questionable securities, not just the bad securities, off the books of the banks and create an aggregator bank, similar to the Resolution Trust Corp. The aggregator bank would make money on many of the securities, but it would lose money on others, and in net it probably would make a profit, as did the Resolution Trust and its Depression-era predecessor.

The real problem is not the size of the bank, but rather that banks have been combined with investment banks, securities companies, securities dealers, hedge funds and the like. If we were to separate the banks out again, clear their questionable assets off their books, it would be possible to recapitalize them and effectively regulate them again.

Slaughter: The key fact that needs to be acknowledged is we just have a lot of financial institutions— some banks and some other financial institutions—that are holding on their balance sheets a lot of assets, the value of which has gone down a lot and is probably going to stay down for a long time.

The right policy solution is to try to protect the soundness of the financial system, [but] that doesn’t mean protecting every single bank or financial firm that has experienced a deterioration of their balance sheets. Then the question is, what do you want the government taxpayer dollars to do? Do you want to try to protect individual banks? That carries some political risks. Do you want to try to protect the financial system more generally and the ability of some banks, whether it’s new banks or existing banks or some government-related bank, whether [Obama] calls it a “good” bank or “bad” bank, to try to allocate that capital?

It’s a very complicated set of tradeoffs with where the business environment is right now and where we want our capital markets to be in two years, three years, 10 years. I’d counsel a little caution with, “oh, we definitely should do X.” If there were an obvious playbook that we could all turn to for this, we all would have turned to it by now.

Some have suggested that one of our problems is not our current regulatory arrangements, but the low quality of our regulators themselves. Were there opportunities for alert, motivated regulators to have helped avert much of the current economic pain?

Rosensweig: When historians look back on the current deep crisis, they will marvel at how incompetent the regulators were. The poster child for this incompetence, perhaps even malfeasance, could be [Bernard] Madoff. The SEC was repeatedly warned, many years in advance, that he could be running a Ponzi scheme, and they just swept it under the rug.

Anderson: I think that’s a credible criticism. In retrospect, the regulators should have stepped in sooner and taken the punch bowl away before the party really got rockin’. We had a series of bubbles, and I think we had a mortgage finance bubble before we had a housing bubble, and so there was an opportunity there for some of the regulators to step in. If we’re going to reshape the financial system, there’s a need for more oversight of non-bank finance companies. We forget that’s where this whole crisis started—[with] a lot of these non-bank mortgage lenders, a lot of the risks that were taken and leverage that was taken in the derivatives markets among hedge funds and investment banks. And I wouldn’t leave out the credit ratings agencies that were rating all these things AAA credits. There are a lot of villains to point the finger at.

Morici: Regulation in the United States is too fragmented across many agencies. If it were consolidated, that would help a lot. And banks are heavily regulated, though there are some gaps as to what to do with derivatives and so forth. My feeling is that it has more to do with the organization of banks and the culture that it breeds. By combining banks with investment banks, securities dealers, hedge funds and the like, bankers become compensated according to their models, which is basically a bonus-based system. That encourages reckless betting.

Therefore, you should separate the commercial banks into separate entities, and you should be very careful about activities you let non-banks do, so as to not make it difficult for commercial banks to compete, for example, on deposit-taking activities. The scope of regulation certainly needs to be extended into areas like … new kinds of derivatives and new financial instruments that we didn’t have 20 years ago.

Kasriel: The primary cause of our current problems was the easy credit policies pursued by Greenspan. The most important price in an economy is the price of credit, or the interest rate. The Federal Reserve, along with most central banks, chooses to fix the price of credit. Most rational people would disapprove of some government agency fixing the price of copper. It would be only by accident that this agency would fix the price of copper at the level determined by the interaction of the supply and demand for copper. Yet few object to the concept of the Fed fixing the price of credit. Like copper, it would only be by accident that the Fed would fix the price of credit at its free-market equilibrium level. By keeping the price of credit persistently below its equilibrium level, the Fed has created all kinds of distortions and asset bubbles in the economy.

In addition, if the Fed and the government do not run to the rescue of lenders and borrowers at the first sign of trouble, these economic agents would develop a more healthy respect for risk, and less regulation would be needed.

I do agree that alert regulators might have been able to curb some of the recent excesses. The irony is that even more regulation will be imposed when the amount of past regulation probably would have been enough, had it been exercised.

Do we need to reconsider existing international agreements about fiscal and monetary systems? Who should lead that effort?

Anderson: There’s probably a need to strengthen [the systems], especially when you’re in a global crisis like we’re in today. I would expect the IMF [International Monetary Fund] will take a big lead in the shape of those new international and financial efforts. But there might be a need for a new global regulator to better integrate some of these things. I’m not sure the IMF is a big enough organization to do that. I’d hate to add a lot of bureaucracy to the whole thing.

So are you suggesting there should be a whole new agency to take charge?

Anderson: It’s a little too early to tell. I think we need to start discussions on what’s necessary, recognizing that the present systems have a lot of problems. Part of the reason we’re in this problem is we’ve had this global imbalance in trade for 20 years. So this is the time to bite the bullet and try to figure out a way to keep that from happening again.

Rosensweig: Due to the current global nature of the crisis, there are increasing calls for a new international economic order, or monetary architecture. We have seen such calls before, during various times of crisis in parts of the global economy, for example, East Asia in 1997. However, this time the crisis has spread everywhere, and the potential depth and length of a global contraction has most observers particularly worried.

Thus, some aspects of a new order must be considered. Ultimately this cannot be led by the rich nations, such as the G8, only. There is now so much economic and financial influence stemming from the big emerging markets, such as China, that the lead will have to come from a broader group, such as the G20. Ultimately the multilateral institutions that came out of the Bretton Woods agreement following World War II, the World Bank and the IMF, will be substantially reformed.

Behravesh: I think we have too many agencies as it is, and most of them are totally ineffective. What I would strongly suggest is that we tighten up the G8—basically what you want in there is the U.S., the euro zone as one rather than as four or five different countries, maybe the U.K., Japan and then the BRICs—Brazil, Russia, India, China. Make that, rather than a gabfest each year, an effective sort of policy coordination mechanism. The IMF is too big and too unwieldy for this.

Slaughter: When you look at residential real estate and the related asset markets, they’ve been some of the most heavily regulated parts of our economy for a long time. Fannie Mae and Freddie Mac are these quasigovernmental agencies that have had, in the eyes of markets, an implicit guarantee by the federal government. The policy challenge now is not so much [that] we need more regulation rather than less. We need to have sounder regulation. By that, I mean we need to think about trying to preserve the innovation and a lot of risk-taking activities that capital markets do, while at the same time ensuring the stability of the overall financial system.

Strauss: [The Fed has] been playing a lead role on the monetary standpoint. We had a coordinated action in the fall of last year. There’s constant discussion that takes place among the foreign central banks, and in fact we’ve had a swap agreement to exchange U.S. dollars for a foreign currency to help liquefy markets with dollars in those regions, in Europe in particular.

With regard to the trade agreements, we have continued over time to move toward opening up markets, and that certainly is a good thing. Economists can disagree on a lot of issues, but generally when it comes to protectionist movement, there’s pretty consistent agreement that that would not be a good thing for any economy.

Do you believe any fundamental changes in consumer behavior need to be made to put our economy on a long-term positive course?

Rosensweig: There is a great irony in what is being asked of the U.S. consumer. We need them to save less, and to save more. Right now, we need consumers to spend, to get demand up for products. However, the U.S. has massive debt in both government and household accounts, so ultimately the only answer is to rein in consumer spending and increase our savings rate. More savings leads to more investment, and we must hope a chance to grow our way out of the massive debt we have now will incur.

Behravesh: The answer’s yes, and it comes in a number of ways. One, it will happen automatically because a lot of households will begin to save more, they’ll spend less, they’ll take on less debt, etc. The other thing is the U.S. tax codes strongly favor debts, not just personal debt and household debt, but corporate debt. We tend to favor debt over equity, debt financing versus equity financing, we tend to give huge allowances for home mortgage interest rates. I’m not saying eliminate it, but you can lower the cap on it.

All of that suggests, indeed, that through tax code changes, through behavior changes, we do need to reduce debt levels in the U.S. and raise saving rates. That is, something should happen, but not now. It’s like, God, please let us save more and reduce our debt, but not now. And the reason is very obvious, because that worsens the recession. But in time, we want that to happen.

Kasriel: Households have been living well beyond their means for nine years. This is over. In 2010 and 2011, interest rates will move higher, which will be the market signal to households to save more rather than borrow more. During most of Greenspan’s Fed chairmanship, he kept interest rates too low, which encouraged households to borrow and spend.

Anderson: Consumers are carrying way too much debt in this economic and financial environment. Households themselves need to de-lever and save more, just as financial institutions are doing to repair their tattered balance sheets, and give them the wherewithal to spend again. Consumer spending is too big a piece of our economy. It rose from about 60% to 70% of our economy. And there’s a need to move back to a more sustainable level.

You’re saying a bigger piece needs to be carried by business and government instead?

Anderson: Yes, exactly. I think there needs to be a rebalancing of the structure of the economy.

Has the dollar’s standing as the single most trusted currency declined because of a lack of confidence globally in the U.S. financial system and government?

Kasriel: It has not yet, but it will. To be trusted currency, the currency has to maintain purchasing power. The dollar has not and will not do this going forward.

Behravesh: No, absolutely not. What’s fascinating is, at the depth of the crisis, even with the U.S. at the epicenter of the crisis, the dollar strengthened. (As of Aug. 1, 2008, it took $1.56 in U.S. dollars to buy 1 euro, for example. As of March 10, the U.S. dollar had improved to $1.27 against the euro.) The reason is the stature of the U.S. as pretty much the principal reserve currency, as the safe haven—that trumped all other fears basically. There are a variety of reasons for it. One is there’s a general sense that the U.S. right now has its act together in terms of policy stimulus, fiscal stimulus and monetary stimulus, whereas, say, the euro zone does not. The euro zone’s fiscal stimulus has been very timid.

The other very important factor is that the U.S. has a unified and huge liquid government-bond market … whereas that is not the case in Europe because it’s still a very fragmented market. Sure, German government bonds are quite safe, but Italian ones are not, Spanish ones are not. In fact, the spread right now between German bonds and Italian bonds, or German bonds and Spanish bonds, has widened quite considerably as a lot of investors start to worry about the bonds in those countries.

Rosensweig: Ironically the U.S. was the epicenter of the current global financial crisis, but the standing of the dollar as the most trusted safe haven for the wealth of people and institutions worldwide has actually been enhanced. Once the extent of the crisis was seen to be truly global, and that some financial systems, such as those in the British Isles, were even worse than that of the U.S., the U.S. dollar as the currency of the sole superpower became in demand.

Confidence in markets and the economic future are now at very low levels. How can that confidence be restored?

Morici: There’s this notion that a lack of confidence in the economy is creating a bad economy. No, I think right now a bad economy is creating a lack of confidence. We face economic difficulties because of errors in judgment of public policy. If President Obama wishes to restore public confidence, the best way for him to do that is to fix the dysfunctional banks, address forthrightly the trade deficit with China and do something about the mileage efficiency of the typical car we drive. Merely having talks with the Chinese won’t help. Merely changing mileage standards for 2011 and beyond is not enough. And taking a few bad assets through a limited “bad bank” or aggregator bank, or some other version of the Resolution Trust, off the books of the banks, will be insufficient. These are the times for radical solutions, “radical” in the meaning of the word “to get to the root” of the problem, because the American economy is systemically broken and it must be systemically fixed. Relying on stimulus packages [alone] won’t get the job done.

This is no normal recession. The economy has shifted down to a lower level of economic activity that is permanent because of structural problems in the economy. These relate to the … dysfunctional state of the banks [and] the trade deficit, which has become too large when we’re operating at [not] anywhere near full employment. [The deficit has] three principal components: energy, trade with China and automobiles from Japan, South Korea and a few other places. We can’t fix the economy unless we fix the banks and the trade deficit.

Slaughter: The economist John Maynard Keynes talked about part of what stimulates demand and growth for companies is what he termed the “animal spirits.” That sense of confidence and excitement about the future oftentimes is what triggers big new capital investments and big new R&D investments for companies. Right now, that’s not the pervasive tone in the boardrooms and in the executive suites.

If businesses and households don’t have confidence, they’re going to demand less, they’re going to buy less, they’re going hire less, and that’s part of what we’re seeing with the downturn in the U.S. and rest of the world. So the policy implication of that is not necessarily this particular tax rate or this particular spending rate. But it’s: can business and government officials project to companies and households a sense of confidence, policy certainty, so that households and companies have a little bit more clarity on how the future might play out? [Can they] try to bring back that sense of optimism and risk-taking that oftentimes underlies those big investment projects for companies, some of that spending for households?

Behravesh: The pendulum has swung from over-optimism about what markets—especially financial markets— can do, to the other extreme, where markets can do no right and only government can do the right things. The truth is somewhere in between. Markets function, and function well, but there are limits, and the same thing with government, there are limits. This notion that the government has all the answers is very scary.

But this is not new. We’ve been here before many times. I remind people of, in 1630, the Tulip Mania; 1720, South Sea Bubble; the 1800s [saw] tons of banking crises. [Those crises] had nothing to do with modern finance, nothing to do with credit default swaps or securitization. This is human nature. We’re talking about greed, we’re talking about the herd instinct. I don’t think we’re going to be able to fix that. Every 20 or 30 years we’re going to go through one of these. That’s not capitalism run amok.

Rosensweig: I believe in self-fulfilling prophecies. If [influential], visible people predict gloom and doom, no one will buy or invest, and they could bring it on. We need leaders to portray a better future and articulate why we are taking positive steps that can help lead to that recovery.

Anderson: Confidence is bad because of the fear of the unknown right now. Some of the bedrock financial institutions no one thought could ever fail have failed, in many cases, or merge into other organizations. Business activity in the markets can’t stand risk and uncertainty, and that’s part of what’s holding everybody back.

They also need confidence their money and investments are safe, and that hasn’t happened yet. We’re seeing investments keep dropping, both stocks and, in many cases, bonds. So people lost a tremendous amount of wealth in a very short period of time, and now they’re in fear of [losing] their jobs. So job security would be a component of building confidence.

Strauss: One of the biggest issues with regard to this whole concept of confidence, especially within the financial markets, is the issue of counter-party risks, that individuals are concerned about the strength of the people they’re giving their money to. There has been this real hesitancy to lend out money. The Fed has been aggressive at trying to liquefy markets that are quite restrained, [and] we’ve come out with a number of different programs, most recently to address some of the limitations that have occurred in the commercial paper markets. Also, we’ve started to deal directly in the government state enterprise market buying Fannie Mae and Freddie Mac securities.