THE TEACHING ECONOMIST - William A. McEachern                 

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Issue 36, Spring 2009

William A. McEachern, Editor


It is said that geologists learn more about the nature of the earth's crust from one major upheaval, such as a huge earthquake or volcanic eruption, than from a dozen lesser events. Similarly, extreme brain disorders allow neurologists to explore how the brain works under normal conditions. In that same way, we should learn more about how the economy works from the wrenching events of recent months than from the more modest business fluctuations of recent decades. But all that learning will take time (after all, we are still sorting out the causes and cures of the Great Depression). Yet people want answers, and they want them yesterday.

How can we best use this teachable moment to help our students understand what's going on? Merely keeping up with the events of the meltdown is complicated enough, particularly because one source of the trouble, complex financial derivatives, is relatively new and because government remedies are in flux. There's no shortage of information (some useful Web sites appear on the final page). The Wall Street Journal alone publishes a dozen stories a day that bear on these pressing matters. Simply trying to digest events and put them in perspective is daunting.

How do we tell the story without overwhelming students with information? One way to proceed is to bring students into the conversation. By asking during class discussions some open-ended questions along with some specific questions, we can draw on their experience and help put that experience in a larger context. I believe that the most teachable moments are not so much in teaching students but in engaging them in the discussion of a lifetime. Ask questions that focus on various aspects of the recession, and try to move beyond the grim rhetoric coming from the media and from Washington . What follows are some possible discussion questions along with some answers, beginning with the housing bubble then moving on to how the recession affects students.

Most agree that the housing bubble was the proximate cause of the current recession. What's a housing bubble?

Every decade or two, housing prices begin to rise rapidly. With prices rising, housing seems like a sure bet, so buyers try to make the biggest bet they can. Rapidly rising prices also attract speculators, who buy houses not to live in but to "flip," or resell quickly for a higher price. This increased demand drives housing prices even higher, inflating the housing bubble in a buyers' frenzy until prices reach unsustainable levels. Once the bubble bursts, housing prices turn down sharply. The entire cycle can take years. Although the timing and the size of the bubbles are not uniform across the country, the recent one began early in the decade and peaked around 2006. The biggest bubbles were in Arizona , California , Florida , and Nevada .

How did the president, Congress, and federal regulators contribute to the housing bubble?

In an attempt to promote home ownership, particularly among low-income households, about three decades ago federal officials began encouraging and even requiring lenders to relax lending standards for underserved groups. Banks faced fines if they failed to lend enough to "nontraditional customers," such as those with no credit history. More recently, down-payment requirements declined and in some cases disappeared because borrowers could pay the down payments by taking out a second loan. This encouraged some people to buy houses they could not afford and to speculate in the housing market.

How did the Federal Reserve Bank contribute to the housing bubble?

Some economists have criticized the Fed for keeping interest rates too low for too long, especially between 2003 and 2005. This easy-money policy helped keep mortgage rates low, making home purchases more attractive. Low interest rates and rising home prices encouraged excessive risk taking in the housing market.

How did mortgage brokers contribute to the housing bubble?

Some unscrupulous brokers encouraged people to take out mortgages that they could not afford. Some loan officers would even prompt borrowers to exaggerate their income on the loan application to qualify for a larger loan. And some borrowers often did not understand the terms of the loan.

Why would lenders make loans that might not be repaid?

First, lenders believed that rising housing prices would leave the lender with a valuable asset, should the borrower default on the loan. Second, those who originated these risky loans could quickly resell them up the lending chain, where they would be bundled with other loans, given a seal of approval by credit-rating agencies, then sold to investors as mortgage-backed securities. Loan originators earned commissions up front so they were less concerned whether the loan was ultimately repaid.

How did borrowers contribute to the housing bubble?

Mortgage fraud escalated during the housing bubble. Because of relaxed lending standards, income claims on loan applications were often not verified. These became known derisively as "liar's loans." By exaggerating their incomes, borrowers could buy houses they could not afford and buy more than one. When the housing bubble burst, speculators were the first to abandon their properties since they had little of their own money in them anyway. About one sixth of all homeowners in the nation are now "under water," meaning that the balance owed on the mortgage exceeds the market value of the home. Still, about 88% of all mortgage holders are current on their payments. Most of the bad loans got rolled into mortgage-backed securities, which were purchased by financial institutions and now sit on balance sheets as "toxic assets."

Who benefits when the price of housing falls?

Those looking to rent or to buy a home. According to the housing affordability index, which compares average housing costs to average incomes, housing in the United States has never been more affordable.

With home prices relatively affordable, why might someone who needs one and can afford one still not buy one?

Based on their recent experience with falling home prices, would-be buyers may believe that home prices will continue to decline, so they hold off. That's the self-perpetuating nature of falling home prices and of price deflation more generally. A housing bust is the reverse of a housing bubble, and often overshoots on the downside.

What negative externalities are generated by vacant, foreclosed, and abandoned homes?

A neighborhood's vibrancy and attractiveness suffer as the number of vacant, abandoned, and foreclosed homes increases. Thus, demand for all housing in a neighborhood declines. This negative externality has a depressing effect on home prices that is in addition to the depressing effect of an increaseed housing supply.

The word "credit" comes from the Latin credo, meaning "I believe." In what sense does extending credit require belief? And why does credit availability decline during a recession?

Those who extend credit, or lend money, believe with a certain probability that they will be repaid with interest. As a way of securing a loan, lenders usually require some asset as collateral, such as the car with an auto loan or the house with a home loan. But if the value of the asset falls below the balance of the loan, the lender loses money if a borrower defaults. As a result, that lender has less to lend in the future; that lender also has less faith, less belief, in a loan applicant's probability of paying back a loan. Credit becomes scarce because lenders have lost both money and faith.

How has the recession affected your experience in the job market?

Whatever their answers, students should compare their recent experience with earlier experience, especially before the recession began.

What impact is the recession having on the opportunity cost of college?

As the job market weakens, the opportunity cost of college declines. The same goes for graduate school.

What impact is the recession having on the choice between public and private colleges?

As family budgets tighten, public colleges, as the low-cost alternative, become more attractive.

What impact is the recession having on the choice between two-year and four-year colleges?

As family budgets tighten, two-year colleges, as the low-cost alternative, become more attractive. State policies are also making it easier to transfer credits from two-year to four-year institutions. Two-year colleges across the country are reporting higher enrollments, even as state revenue shortfalls squeeze budgets.

What impact is the recession having on tuition and financial aid?

Public institutions are strapped because state revenues decline with a slowing economy. Private institutions that rely more on endowments than do public institutions are also suffering because the stock market crash has reduced the value of endowments (Harvard's endowment fell from $37 billion to $24 billion). The slumping stock market has also cut the wealth of high income households by more than one-third, so they donate less to colleges. This squeezes funds available for financial aid and pressures colleges into cutting costs and raising tuition. State budgets, however, should get some relief from the "state fiscal-stabilization fund," which is part of the $787 billion federal stimulus plan.

What specifically in the federal government's stimulus plan is aimed directly at college students?

The plan raises the maximum Pell Grant from the current level of $4,731 to $5,550 by 2010. This is expected to help seven million students. The federal income tax credit for tuition was raised from $1,800 to $2,500 per year for the next two years. Even students who don't owe income taxes can claim a tax credit of up to $1,000 (and textbook costs now count towards the credit). Increased money for job training will help pay for such courses at two-year colleges, where these technical courses are typically offered. And Work-Study funds have increased by $200 millionóenough to pay an additional 130,000 students an average of $1,500 a year. As before, colleges must pay Work-Study students at least the federal minimum wage, scheduled to increase to $7.25 per hour this July. Higher minima will apply in 13 states, with the State of Washington the highest at $8.55 per hour.

Who will pay for these and other benefits and tax cuts funded by the $787 billion stimulus plan?

The stimulus plan will be paid for with government borrowing, which means the day of reckoning is pushed into the future. The resulting debt itself will likely not be repaid, at least not in our lifetimes; rather it will simply be rolled over as the bonds come due. But interest on that debt must be paid either through higher taxes or through reductions in other public programs. Government borrowing could also crowd out other borrowers by pushing up interest rates.

Some economists have found that a recession can actually be "good for your health." Specifically, death rates at the state level decline during recessions. How could that be?

When the economy slows, there is less shopping and less commuting to and from work, so traffic lightens. With less traffic, road fatalities decline. This explains the drop in death rates when the economy slows.

Has the sour economy affected your eating habits and those of your family? If so, how?

Some students will say they have experienced no change, but between the third and fourth quarters of 2008 consumer spending on food declined and inflation-adjusted 3.7% (at an annualized rate), the largest quarterly drop since the government began collecting statistics 62 years ago. While restaurant spending fell sharply on average, some fast food restaurants survived with "dollar menus." Consumers are not only eating at home more, they are preparing less expensive food and buying lower-cost brands of the same foods. Spending on less expensive staples like milk and eggs rose slightly, but spending on meat, sweets, pet food, and alcohol declined, with the latter dropping 11%.

What's meant by the phrase "consumer sovereignty" and why is this more relevant during a recession?

In market economies, consumer demand determines what gets produced. Sovereignty means "supreme power and freedom from external control." Thus, consumers are considered the kings and queens of the marketplace. During a recession, the consumer's power becomes more obvious as business bankruptcies pile up—from home builders, to car dealers, to retailers such as Circuit City . To survive, some producers must slash prices. Even Saks Fifth Avenue is discounting designer clothing up to 70%.

President Obama's chief economist, Larry Summers, said that we are facing the worst economy since the Great Depression. How does this recession so far compare with the Great Depression and with the worst post-war recession prior to this?

Between 1929 and 1933, the U.S. economy lost 21% of its jobs. In the 14 months of this recession through February 2009, the economy has lost 3.2% of its jobs, though this will surely rise. Current job losses so far are more in line with the 3.1% lost during the recession of 1981-82, what had been the worst recession since World War II. The unemployment rate during the Depression peaked at 25.2% in 1932; during the 1981-82 recession, it reached 10.8%; and the February 2009 figure was 8.1%, though, again, that will rise. Between 1929 and 1933, real GDP fell nearly 30%; during the 1981-82 recession it fell about 2.6%; although the fourth quarter of 2008 was down sharply, real GDP for all of 2008 actually increased 1.1%. President Obama's budget proposal assumes real GOP will decline by 1.2% in 2009.

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