American Enterprise Institute

October 2, 2008

[Edited transcript from audio tapes]

1:45 p.m.	Registration
2:00	Introduction:	Peter J. Wallison, AEI
2:15	Panelists:	Charles W. Calomiris, AEI and Columbia University
		Kevin A. Hassett, AEI
		Desmond Lachman, AEI
		John H. Makin, AEI and Caxton Associates
		Vincent R. Reinhart, AEI
	Moderator:	Peter J. Wallison, AEI
4:30	Adjournment

Proceedings:

Peter J. Wallison:  Okay, I think we’ll get started.  I’m Peter Wallison.  I’m a senior fellow here at the American Enterprise Institute.  I want to thank all of you for coming to what is the third in a series, which we didn’t actually expect to be a series when we started it, but this is a third in a series of learning from our learned economists here at AEI about what the future holds for the U.S. financial system.  It’s been quite a ride.  I’m sure all of you are as puzzled as I am but let’s hope we can get a little bit of enlightenment, maybe a little bit of consensus, coming out of the economists this time that we were not able to find in past conferences of this kind.

The remarkable thing, it seems to me, when we look at what is going on in the credit markets today, is the resilience, up to now, of what you might call the real economy.  When we started back in, I think the first of these was in December, the turmoil in the world’s financial institutions was serious even at that point.  LIBOR spreads were historically high, and there were widespread reports that financing was not available, at that time, for some activities.  The international financial markets were reported to be simply “shut down”, and that was back in December.

In that long ago time, some of our economists predicted that the housing market was headed for an immense bust, which would cause a severe recession in the general economy.  Others thought the housing decline would not be as severe and, in any case, would not create much more than a mild recession.

What everyone was reasonably sure about was that by the spring of 2008, we would have much more data and it would be easy to say, at that time, with some confidence, where the real economy was going.  So we scheduled another conference in April, anticipating a lot more consensus.  For those of you who were here, you know, we didn’t get that consensus in April.  If anything, more data created more controversy.  There was still a lot of uncertainty at that point about how serious the housing decline really was and part of the controversy among our economists was what data to use.

Bear Stearns had been rescued in mid-March and the international financial system was still very fragile, but interbank lending was improving at that point and LIBOR rates were well down from their previous high.  The U.S. economy was still not in recession, it seemed, and indeed, the first quarter, it ended with slight growth.

Because there was still no consensus, we scheduled this conference.  Again, the thought was that by October, we would surely have enough data to produce clarity.  Maybe, maybe not.  Financial market conditions have gotten a lot worse, but it is still not clear that the economy, as a whole, is, yet, in a technical or other kind of recession.  Growth in the second quarter was somewhat over two percent.  That’s not good, to be sure, but it’s certainly not a recession.  Unemployment is increasing, but up to now, not at the rate of previous recessions.  Recently, there have been indications that consumers and business are feeling a severe pinch.  The Wall Street Journal’s headline this morning certainly indicated that.  And consumer spending is down, manufacturing contracted substantially in August.

One thing the last 18 months has shown is that we don’t have a very good idea of the linkages between the real economy and the financial markets.  The financial markets are in a state not seen since the Great Depression, maybe even worse.  But the economy, as a whole, is certainly not in anything like that condition and hasn’t been for 18 months that the financial markets have been in unprecedented turmoil and I think that’s one of the reasons why the Paulson Plan has stimulated so much opposition.  People really still do not feel that that is all worth spending $700 billion to address.  I don’t think most economists would have thought it was possible that the financial markets could be at this level of distress without causing a serious, very serious recession, at the very least.

If the Paulson plan is rejected again, there are predictions that this will lead to a financial market meltdown and a serious worldwide recession, perhaps even a depression.  At this point, it’s not implausible that a really serious recession could occur.  There has been a huge flight to quality, to government debt in most of the developed countries.  And if the cash is in government bonds or notes rather than in banks, it is easier to see how employers might not be able to meet payrolls and companies might not be able to get the credit to meet their obligations.

Cash moves through the banking system to where it is needed, but the system depends on banks to lend to one another.  And by all accounts, this is not happening.  The principal reason appears to be that they are not sure of the solvency of their bank counterparties.  And one of the reasons for this, in my view, has been the requirement for mark-to-market valuation of assets when there is, in fact, no active market.  Now that’s very controversial and some people here on the panel will certainly not agree with it, but I think it is a serious question, and I am happy to see that the SEC now seems to be in the process of reversing itself on the application of mark-to-market accounting.

Six months ago, the agency put out a letter to all the CFO’s of public companies and said, “Only when actual market prices are not available is it appropriate for you to use unobservable inputs -- which is the accounting word for market prices -- for non-market prices for models of various kind -- in pricing an asset or a liability.”  Yesterday, in a clarification, they said -- actually, the day before yesterday, they said actually the opposite.  When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows and include appropriate risk premiums is acceptable.  If the SEC had said this in March, in my view, we might not be in this situation.

The Paulson Plan to remove bad assets from bank balance sheets makes sense, at least to me, if the Treasury buys assets from the banks at a value that takes into account the cash flows that these values produce.  And that is what the SEC is suggesting.  This has a chance of restoring some market confidence that the banks are, in fact, solvent.

For purposes of this conference today, our economists might assume that the Paulson Plan is adopted or that it is not.  They can also assume that if it’s adopted, it just makes things worse.  Whatever they assume, I’m looking forward, like you, to hearing what they think the real economy is going to do in the months ahead.

The way we will do this is the way we have done it in the past, and that is we’ll go alphabetically, from Charlie Calomiris on my right all the way around to Vince on the extreme right.  And each of them will make their statements and then suggest their views.  And then we’ll have a discussion among them and proceed from there, hopefully, to get time for your questions.

Charlie Calomiris is a visiting scholar at AEI and co-director of AEI's program on financial market deregulation.  He and I are co-directors of that.  He’s the Henry Kaufman Professor of Financial Institutions at Columbia Business School and a research associate at the National Bureau of Economic Research.  I won’t read all of the background of every one of our participants here.  They are too extensive and you can read them in the materials that we have available for you.  So we’ll start immediately with Charlie.

Charles W. Calomiris:  Thanks, Peter and thanks to all of you for coming.  I guess I could start by saying, like the SEC, I’d like to clarify some of my remarks.  Actually, I think I’ll try to be a little more consistent than the SEC in its clarifications.

The last two times we met, I said that a deep recession, like those of the credit crunch of late 1980’s, early 1990’s, or the 1930’s, was unlikely to result from the current capital crunch and credit crunch, and that several quarters of sideways motion for the economy or a shallow recession were much more likely.  I argued that the capital crunch that began over a year ago was being mitigated by large amounts of capital being raised by banks and by aggressive Fed and Treasury policy actions.  Also, that housing price declines from the mid-2007 peak were being exaggerated by the flawed Case-Shiller index, and that empirical evidence that I did with a couple of co-authors indicates that the effects of foreclosures on house prices going forward were likely to be mild, in spite of the looming tsunami of foreclosures that we all see coming.

I think it’s noteworthy that the sideways motion of the economy that I talked about then has actually occurred.  I agree with Peter.  I think that one of the surprising things is how robust, how resilient the economy has been despite all of the things that have happened.  So far, we’ve weathered the credit crunch pretty well, I would say.  The U.S. may have entered a recession already, but even if it has, and I believe it has, that would be my guess, so far, it’s a mild one. 

It’s also noteworthy that banks have raised much more capital since our last meeting.  According to Bloomberg, $434 billion of capital, as of three days ago, since this crisis began.  More than $40 billion was raised this month alone, partly in support of stabilizing acquisitions of weak banks.  Furthermore, lending in commercial banks, believe it or not, has continued to grow.  These patterns are a sharp contrast to the 1930’s or the 1988 to ’91 period when lending contracted substantially.

Most importantly, policymakers provided liquidity recently, and more than liquidity, to shore up banks.  Whatever one thinks of those actions, I’m sure were going to talk about them a little bit, one thing is clear, at least unimportant [sounds like] on a forward-looking basis: most of the prior looming risk of the possibility of large financial institutions failing, I would say, has been resolved one way or another.  Weak large banks, in the U.S. at least, are pretty much gone.  The assets of Lehman, now being picked apart by various entities, Bear, Merrill, WaMu, and Wachovia have been acquired or are in the process of being acquired.  Fannie and Freddie are in conservatorship and supporting continuing growth in the supply of mortgage credit under government funding.  Morgan and Goldman survived their mid-September bear runs and raised significant new capital.  Although Goldman and Morgan were briefly at risk on September 17 and 18, that risk has passed, especially in light of their capital raising and the likely passage, and this is significant, of course, to my opinion, the very likely passage, in my view, of the rescue bill tomorrow.

The concentration of the risk of loan losses and derivatives losses in a few remaining big banks also means that we have a much more accurate picture of the distribution of losses among the largest five financial institutions.  In other words, we’re not as confused about where the losses reside.  If we only had one bank, we wouldn’t be confused at all.  We’re getting there.  None is currently at risk of failing; that is, Goldman, Morgan, JPMorgan, Citi, Bank of America.

Now, total worldwide losses on subprime and Alt-A, and this isn’t just my number, but I think it’s a reasonable consensus, will be no more than about $500 billion, just on the subprime and Alt-A, and probably less than that.  Add on other losses from other markets and I don’t think you can possibly, reasonably, get to a total amount of write-downs, long-term losses above $1 trillion.  In fact, I think it’s going to be substantially less.  Given that some of that is in the protected hands of Fannie and Freddie, let me remind you, as Peter and I recently wrote about.  Fannie and Freddie own $1 trillion worth of the claims on the $2 trillion worth of subprime and Alt-A outstanding mortgages. 

And also, given the fact that banks’ retained earnings and capital offerings have raised huge amounts of capital to replace losses, so long as the current financial panic that began on September 17 subsides, and I recognize that’s a big “so long as”, I would say this now seems quite likely.  But so long as, to me anyway, given what I think is quite a good chance that we’re going to get legislation tomorrow, so given this likelihood, I would say it’s also likely that banks will again acquire some additional capital.  Of course, even this week, we’ve seen Warren Buffett digging down into his pockets.

So I believe that we’re going to see the worst aspects of the credit crunch dissipating pretty quickly and I think, believe it or not, we’re going to have a recession and maybe even a protracted recession but I don’t think it’s going to be a deep one.  That is, I still don’t think we’re looking at a capital crunch and credit crunch that’s in any way similar in severity, in loss to the 1930’s or the late 1980’s.

There is little doubt in my mind that the Treasury is about to recapitalize and liquefy U.S. banks to ensure that the currently high credit spreads that we’re witnessing -- today’s LIBOR, I think, may have set new records -- is going to be reduced.  I think credit growth, obviously, it’s been a big problem in the last 15 days, credit growth is likely to resume if capital continues to grow.  So I think that that’s the story about the storyline of why this capital crunch has been so unusual compared to those two previous episodes.

House prices, I think, will continue to decline but only slightly in the face of the rising foreclosures.  There’s a lot of pipeline that’s not coming out on the market that’s going to provide support over the next year.  It doesn’t mean house prices are going to go up, probably, until maybe 2011, but it doesn’t mean they’re going to fall much either.  To me, employment is the bigger concern for consumption than house prices anyway.  As we know, in theory, house prices shouldn’t have a very large effect on consumption.  It seems very likely that consumption and investment aren’t going to do very well over the next several months.  U.S. labor markets, manufacturing and durable goods are all pointing in a southerly direction.  And obviously, the recession is going global in Europe, Asia, and elsewhere.

But I would still say that so long as credit markets stabilize, and I think that they will, there is still reason to believe that the recession will not be as bad as those prior episodes I mentioned.  At core, I would say the things to keep in mind are that panic episodes, like the panic of 1907, which I think what we’re experiencing right now is very reminiscent of, are not the same as episodes in which there are huge amounts of loss.  We’re still looking on the subprime market.  We’re still looking at losses, while very large, nothing like those prior episodes. 

I’ll say for discussion, I hope the details of a couple of other things I hope we’ll get to, which is assuming that the Treasury’s plan does pass, how should it be implemented?  My own view is, and I’m very happy to see that the current legislation actually has this flexibility, that the Treasury should go in the direction of purchasing preferred stock in banks, and it can do that now under this legislation, rather than buy assets.  Buying assets puts the assets into government hands rather than private hands, buys them at prices that we have no idea whether they are sensible or helpful.  So I think this is the right way to go and I would say there is an academic consensus and maybe even a policymaker consensus forming around it.

Second thing I would say is I don’t see why we don’t learn something from what Mexico did in the late 1990’s.  In the face of gridlock where there was not a sufficient amount of efficient renegotiation of debt instruments, the Mexican Government told creditors and debtors, you have six months -- I think it was about six months -- to renegotiate your debt downward.  Whatever write-downs you can agree on, the government will bear a share of.  And what that did was it crowded in compromise.  It crowded in renegotiation and it reduced financial distress and uncertainty.  I think that we could do that to great effect right now and I think the bill would be pretty small.  And if the taxpayers are willing to bear let’s say ten or 20 percent of voluntary privately determined renegotiations between creditors and debitors and mortgage market, that that would probably be a very helpful thing and it wouldn’t cost very much.  Thank you.

Peter J. Wallison:  Thanks, Charles.  Charlie has to leave early.  That’s still true, is it not, Charles?  Well, then, in that case, let me just ask you a question which came up in what you said earlier.  It probably occurred to many of the people here and that is it appears, at least it has been reported, that bank lending is at an end.  It stopped.  The market is basically not -- the banks are just simply not lending to one another.  Now you said commercial lending has continued to grow.  That seemed to me to be inconsistent, maybe not, but you can explain it.

Charles W. Calomiris:  I’m talking about the timeframe of the last year and three months.  So if you look at the weekly reporting banks or the whole banking system in the U.S., C&I lending has continued to grow.  It doesn’t look anything like the 1930’s or the late 1980’s.

Peter J. Wallison:  [inaudible]

Charles W. Calomiris:  It’s mid-September.  So I was just going to say that’s not meant to be a statement about today, meaning September.  In the last couple of weeks of September, I think that that’s the kind -- but during financial panics, which is I think what we’re in the middle of, of course, we know that markets freeze up.  Those LIBOR rates I was referring to are indicative of it.  We have a complete seizing up of the financial system right now.  I’m not trying to, in any way, understate the importance of that, but I’m saying it's reminiscent of a panic situation. 

Remember that during panics in U.S. history, the actual losses underlying the panics were very small, but they could create enormous disruptions to the flow of credit, and that’s what we’re experiencing right now.  I don’t, in any way, want to minimize the sudden sort of seizing up that’s going on.  I’m just saying what’s interesting is over the longer term, credit markets have continued to function.  Although, right now, we’re in the middle of something very different.

Peter J. Wallison:  Okay, thank you.  Our next learned economist is Kevin Hassett.  Kevin is the director of economic policy studies here at AEI and a resident scholar.  He is also a weekly columnist for Bloomberg.  Before joining AEI, Kevin was a senior economist at the Board of Governors, at the Federal Reserve, of course, and an associate professor of economics and finance at Columbia Business School.  He’s got a much longer résumé in your materials, and I’ll leave it to you to take a look at it, but everyone knows Kevin anyway.  So Kevin, go right head.

Kevin A. Hassett:  Thanks a lot, Peter.  When I was a kid, the only movies that had lots of sequels were happy movies like Herbie, the Love Bug, there were about ten of them, and Benjie.  And then, at some point, kind of around the time I was in college, it flipped, and all the movies with lots of sequels were horror movies, like Friday the 13th.  There have been what, a dozen of them now, and I guess this conference is starting to feel a little bit like maybe Nightmare on Wall Street III, which would have been a better title. 

If you look back at my remarks, one of the things that I focused on, which is how I think about the world too, is I tried, to think, to establish with as much precision as possible where we are right now and that helps me think about where we might go and sometimes can be really quite illuminating because the first time that I presented, way back before we knew we would have sequels, I guess the box office was just so glorious that we had to keep doing it, was that everyone said that we were in a recession.  And then I introduced the model that I think one should use in real time when addressing that question and said, “We’re absolutely not in a recession,” which is we aren’t, as you may recall.  And then in April, using the same model, I expressed my enormous discomfort that I was sort of living through one of those lessons that economists, lessons in humility that economists often are served, in that I had written an article in the New York Times with my co-author, who is writing a book on this with me here at AEI, along with Jim Hamilton on recessions, and we had extolled the virtues of our glorious model Marcelle originally developed for dating recessions in real time and had told the New York Times readers around November that, “We’ll let you know as soon as it happens.”  And then more or less, what occurred was that for most of the first half of the year, the model said, “We can’t tell.”  We basically didn’t say we weren’t.  We didn’t say we were.

And so, to begin my remarks, what I want to do is update you on where we are with that and I can announce with some certainty that recession probably began in June.  This is the, again, this model, what it does is it assumes that there’s like an underlying data, driving process for the economy, that you could conceptualize this being there are two urns, a good urn and a bad urn.  And in the good urn, a GDP growth of about three percent is what God draws out of the urn on a ball and says three percent, but there is some noise.  Sometimes it’s one percent and sometimes it’s four and a half percent.  And in the bad urn, God pulls out the ball and tells us what GDP growth is going to be.  The average is maybe about minus one percent and there is a lot of noise.  A problem for the econometrician is to discern which urn God is picking from.

Originally, Jim Hamilton had a paper in Econometrica that my guess is he might win a Nobel Prize for it eventually because it’s had such a huge influence on the profession that did it with quarterly GDP data only.  Subsequently, Marcelle Chauvet has advanced his work significantly by drawing on a whole bunch of monthly indicators but using the same conceptual framework.  And Marcelle has got a model that, in real time, or more or less real time, has called every post-war a recession.  It’s never given a false signal, and it’s now saying this is updated with data through September 4, but only for data through June because of the vagaries of, sort of, which data we believe when we’re willing to run it through the model.  The probability clearly has gone up since then, although we don’t have enough day-to-day report of formal probability.  But if you look way to the right, the shaded areas are recessions, the probability of recession tends to spike during a recession, not outside of that.  These probabilities are smooth, which is only useful information for the time series gurus amongst you.  But you can see that we spiked well above 50 percent in June and are probably a good deal higher now.  This is what it looks like if we don’t smooth, which is just, sort of, interesting because you can see that there are very few blips and essentially no blips this high outside of a recession.  And so yes, the recession has started.

It’s actually kind of interesting in the sense that it could be this is a fundamentally different kind of recession and then in the end, the NBER will decide that they’re going to go back and say it began in December or something like that.  But given almost our first three percent growth in the second quarter and so on, I think that they are going to be forced to say June, as well.  So my guess is that they’ll say June.  If you’re an NBER handicapper; that suggests that the formal announcements that we’ve had a recession will take place about in January.  About in January, maybe December is when we can hear a word from them.  And so we’re in a recession now.

And from the point of view about thinking about where we are, it suggests that there is a fundamental difference right now, which is that we’ve gone through this financial crisis, for, as Peter mentioned, well over a year.  And one of the things that has softened it has been the health on Main Street, the fact that the economy is really doing okay.  Now if you don’t have a financial crisis driving you into recession and you have a recession because there is a war in the Middle East, the price of oil spikes, boom, you’re in recession, then a lot of times, there’s financial distress.  Credit card companies aren’t getting paid and banks start to go have troubles, even absent the kind of problems that we are going in now.  And so the concern would be okay, well, the thing that’s made it so, even though we’ve had this financial distress for so long, it has made it so that we’ve been okay, is now gone.  And in fact, the economy is going to be piling bad news on top of bad news and how should that influence how we think the future is going to play out.

I can tell you that markets are more pessimistic about the future, in ways that I’m about to quantify for you, than they’ve been throughout recorded history, but I really only have the history, to report the things I’m about to show you, back to the ’70s, and so I can’t compare this to the Great Depression or to the 1900’s, 1907.  But right now, markets are basically pricing in a scenario that, if it comes to fruition, means that our way of life will fundamentally change.  And I’ll show you what I mean by that.  Before I get to that, this is -- my friend Mark Zandi at economy.com likes to do a map of where we are in recession using employment data, and I think it’s kind of interesting that it’s starting to spread just about everywhere through August.

Now you’ve heard a lot of talk about the TED spread, and I guess if we’re doing movies, if we had a Bill, we could have Bill and TED.  But I guess nobody knows that movie.  But they had an excellent adventure.  And this would be -- the second one was “Bogus Journey”, which could be what we’re doing right now.

Male Voice:  [inaudible]

Kevin A. Hassett:  But the TED spread, everybody has been -- people have been talking about it, I like to take these interest rates spreads and turn them into things that I can think about, and I’m kind of stupid so I got to make it a really simple thing.  And what I did is I took the TED spread data and I said, okay, well, if markets are behaving so that the people who are deciding to buy this thing as opposed to that thing can expect to break even, then there’s an implied default probability in the TED spread.  So the TED spread, which is the spread between the interest rate, the LIBOR and the T-Bill that is paid by, really the bluest of the world’s blue chip banks, Deutsche Bank, Bank of America, and so on, if the interest rate difference is that big, then that means that the banks’ worry that each of them is not trustworthy, they’re going to go bankrupt.  And so I ask myself, what’s the bankruptcy probability or default probability that’s implied in the TED spread?  And that’s the next chart.

And so what this chart shows you is that, right now, the implied default probability from the TED spread, and this is a default where basically, you give money to say Deutsche Bank and you just don’t get the money back.  So this isn’t kind of like they go into bankruptcy and then you get your half.  This is zero.  This is default.  And the probability of that is about three percent.  It's actually higher than that now, after today.  And that’s over three months.

And so right now, LIBOR is about 15 banks or so.  I should have counted before I came in.  Sixteen?  The 16 best financial institutions in the world, right now, the TED spread is telling us that they’re trading amongst each other as if they think that there’s a three percent chance that you’re going to lose everything if you give your money to that guy.  If you compound that, presume the spread would stay there, then that means that there’s more than ten percent chance that over the next year that a typical thing would default. 

And I can say that that’s very troubling because the odds, I mean, the governments would step in, you would think.  And so for there to be a probability that high, it must mean that people are worried that the governments are going to lose the ability to save you when the thing goes down.  That’s very troubling, but I can tell you that we’re talking happy days, the Shire at Bilbo’s birthday party, if you’re looking at the TED spread, if you compare that to the rest of the bond market.  And this is the same calculation for ten-year bonds, right now, so it tells you the probability, right now, priced into capital markets, that bonds of different types will default over the next ten years.

And so you can see, for me, one of the favorites is Triple-A bonds.  But right now, current market prices suggest that Triple-A rated bonds, bonds that still have a Triple-A rating, as of last week, have a 40 percent chance, just about, of defaulting over the next ten years.  For U.S. financial institutions, the default probability is almost 70 percent.  And for nonfinancial institutions, it’s about 40 percent.  And so what bond markets are telling us right now, if you’re Milton Friedman, and I guess Milton would have a story for this so I don’t want to set him up as a straw man, but if you think that markets are perfectly efficient, then what they’re saying right now is that our lives are fundamentally going to change.  We’re going to see defaults of 70 percent of our financial firms, 40 percent of nonfinancial firms.  It’s going to be something unlike anything you’ve ever seen.  That’s what’s priced in.

And so then the question is, is that a reasonable scenario?  And for me, one thing I like to do when I’m thinking about what can happen and what prices are is just look at what’s happened in the past.  This chart shows the same default probabilities for some of those.  I think I might have dropped a couple because I was running out of space, but the blue line is the worst actual default experience that we’ve ever had.  And the red line is the average default.  And now certainly, we would expect to be above the average default experience, but we’re basically looking at capital markets right now that if we were to interpret their prices as being rational or saying that we’re going to have something like ten times the worst thing that’s ever happened, data go back to about the late ’60s and early ’70s.  So there have been a lot of bad times between then and now but not every bad time.

And so in that scenario then, we could say okay, well, how does the credit crisis end?  How does the credit crisis end?  And for me, I think that government policy; obviously, it’s something that needs to be considered.  But we have to remember that, I just showed you these bonds, but if we could take any bonds, we could take any debt anywhere in the world that it would have similar fundamentals if we were to do these calculations and so what we’re talking about is maybe a total value of world stuff that is being priced at probabilities of default that are really almost implausibly high is in tens and tens of trillions.  It’s not just mortgage debt.  It’s everything.  Everything.  Nobody wants to take risks.  Everybody wants cash.

And so if you’re going to go in there and try to affect prices, then you have to remember that you’re talking $70 trillion worth of stuff or $60 trillion worth of stuff is what you’re trying to affect.  And so you need to be kind of humble about what government alone is going to do.  So what would actually turn it would be people would look at this and they will say okay, well, the worst thing that’s ever happened is there wasn’t much default.  And if 40 percent of Triple-A bonds right now, over the next ten years, default, then I break even relative to treasuries.  That’s a bet I’m willing to take.  Okay, if people start to think that way, that’s how this thing unwinds.  The question is what can move them in that direction?

For me though, my problem is that you have restore calm.  It’s a panic, as Charlie said.  And to restore calm, then you need some good news, I would suppose.  And the problem is that the economy is turning right now and it’s visible in the claims.  As Charlie mentioned, we kind of grew.  It was, kind of, not so bad.  We haven’t really had a recessionary employment report yet.  But the claims are at the level where we could expect the number that we get on Friday to maybe be minus 200,000 jobs, the kind of like a recession employment report.

And if we look at everything else, like vehicle sales just went down, we found out today, and the home sales, they’re terrible, if I back out consumption right now from the data that we have for the current quarter, I get that it might be, if you’re an optimist, down two percent; if you’re a pessimist, down three percent or so, which means that the third quarter GDP, right now, a lot of Wall Street, because I was noodling around, I didn’t take an average but I just looked at what a few different people were saying.  They’re saying sort of minus a half to minus one.  That would be a very happy outcome relative to where we are in the data.  I think it’s possible that third quarter GDP will be about as bad a negative number as we’ve seen in post-war recession history.  So we’re looking, with the start that we have, at a real negative quarter.

And so we’ve got these prices that really, they can’t make sense.  They can’t make sense, especially if you start to unwind the fundamentals of the things that we’re talking about.  Like, look at the balance sheets of U.S. corporations.  Those are actually pretty darn good outside of the financial sector.  They can’t make sense.  The panic will end but there’s not going to be good economic news in the next three months to cause that to happen and so it’s a time looking forward of great uncertainty and great volatility.  I think that in the end, once we start to climb out of this mess, that the climb could be very rapid, as Charlie said, because the prices are basically factoring in right now.  Today’s prices are such terrible things that even if you go from terrible to ridiculously bad, then there’s a huge celebration in markets.  And so there is an upside, but it’s going to be a very, very tough time and it’s significantly worse than it looked like it did, in April.  Thanks.

Peter J. Wallison:  Thank you, Kevin.  I don’t see anyone leaving to make an investment right now.  But yes.

Kevin Hassett:  They outlawed short selling [indiscernible]

Peter J. Wallison:  That’s right.  Now for the bad news.  Our next scholar is Desmond Lachman.  Desmond joined AEI as a resident fellow after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney.  He’d previously been a deputy director in the International Monetary Fund’s Policy and Review Department and was active in staff formulation of IMF policies.  He has written on topics such as economic policy, fund arrangements, monetary reform, import restrictions, and exchange rates.  Desmond.

Desmond Lachman:  Thank you very much, Peter, for arranging this.  I really must compliment you on your foresight in terms of the timing of this crisis.  I’m sure that you saw the calamities that were going to afflict Lehman, AIG, Merrill Lynch, Fannie, and Freddie, and so on.  And my recommendation for solving this crisis is that we don’t have anymore of these seminars.

I’m also deeply relieved that we’re not discussing whether or not we’re in a recession and that the discussion is now focusing on how long and how deep this recession is going to be.  I was certainly the most pessimistic on this panel and I’m going to say three words that are very difficult for most humans to say and certainly for economists to say: I was wrong, that this has turned out to be a whole lot worse than we expected.  And I think that it doesn’t serve any purpose to be in denial, to talk about the resilience of the economy when the economy performs rather poorly with a $100 billion fiscal stimulus package that is now in the process of failing.

I think that really, what we’re seeing right now is the worst economic and financial crisis that we’ve known for the last 80 years.  And I would think that it’s pretty much baked in the cake that this is going to be the deepest and longest recession that we’ve had.  I think that it certainly surpasses that in the 1980’s.  I wouldn’t go as far as to say that we’d go into a depression.  That depends on policy mistakes and I haven’t been too reassured by the performance of our policymakers to date.  But I take comfort that Ben Bernanke, for all his sins, is an expert on depression and Japan.  So presumably, we won’t make those mistakes.

The reason for my pessimism is that there are two basic problems, in my view, that are underlying the crisis.  One is a housing bust of tremendous proportions that we’re doing nothing about.  We’re in the downward spiral.  The second is that we’re in the process of huge amount of deleveraging in the banking system because there’s a shortage of capital, and I don’t see the Paulson plan as really addressing that.

Let me turn to give a more detailed account of why I’m coming to this position.  The first point I would make is that when you look at the credit crisis, what you really have to do is see that this credit crisis is not occurring in isolation.  Indeed, it’s occurring, as I mentioned -- I should just back up and say that both Paul Volcker and Greenspan are describing this as a once in a century or a once or twice in a century event.  So you’ve got a major credit crisis but what you’ve also got is you’ve got a tremendous housing market bust, which I’m going to talk about in a moment, and that there’s nothing stopping house prices from continuing to fall at the same kind of pace that we’re seeing right now, which only compounds the banking problem, compounds the balance sheet position of the households. 

But what we’ve also got is we’ve got asset prices declining in a generalized way that they haven’t occurred before.  Not only do we have house prices declining, but we’ve got equity prices, S&P 500’s fallen a mere 23 percent since the beginning of this year.  We’ve got bond prices, corporate bonds blowing out to ridiculously high spreads.  So what you see is that asset prices have now fallen at the fastest rate that we’ve seen in the last 30 or 40 years.  My calculation is that we’ve just wiped out near 50 or 60 percentage points of GDP and household wealth and it would boggle my mind if that doesn’t have a big impact on consumer spending going forward.

The other thing that I would just say is that this minor problem that we’ve also had a commercial bubble in commercial real estate, and I would have thought that as Lehman and as AIG unwind the property in this kind of environment, we’re going to get a bust there that’s only going to compound bank losses going forward.  So the bank loss story, in my view, is an ongoing saga.

Now, the previous speakers have spoken about the environment in which we are operating.  The starting point isn’t too good, that employment has fallen in each of the last eight months, which is an indication, as Kevin indicates, that the recession has already started.  Consumer sentiment is at something like a 28-year low or so, and when we look at GDP numbers, what Kevin says is right, that you probably got flat or negative GDP in the third quarter.  It means the last four quarters, at best, would’ve be doing something like one percent growth at a time that I’ve said that we had a huge fiscal stimulus package, like $100 billion is like three points of GDP in a particular quarter.  And what we see is if you look at the red line, most of the growth that we have had has come from the export sector.  Meantime, what’s occurred is the dollar has begun to appreciate, and what we see is Euroland is in recession; Japan is in recession, so our export markets aren’t doing too hot.  So as I say, we’re starting from a very bad beginning point.

Let me just turn to the housing story.  If you look at Case-Shiller, what you’ve seen is you’ve already seen a decline, the last year.  It’s been about 16 percent.  It’s probably about 20 percent from the peak.  And the red line there is what the futures market indicates, and I think that the futures market, this time, is correct, not that I’ve got the greatest prospective.  Having worked on Wall Street, I’m reminded of Fischer Black’s remark.  When he came from MIT to work on Wall Street, they asked him what had he learned, and his first thing that he said that he learned was that markets looked a lot better from the Charles River than they did from the Hudson.  And I found the same thing from the Potomac.

House prices are falling at the same time that inventories of unsold homes are rising to record levels.  We’ve got something like a year’s supply of houses overhanging the market.  And to make matters worse is we getting very heavy negative equity positions in houses means that people’s homes are worth a lot less than their mortgages, so people begin to walk away from homes and surprise, surprise, foreclosures are off the charts, that foreclosure procedures initiated are now running at a mere three million units at an annualized rate a year.  Where I come from, that means that there’s more supply in the market, which isn’t too good for home prices; not to mention that unemployment is rising, which doesn’t mean that there are going to be too many buyers, and mortgage lending has all but dried up.  And then we have a little fiasco with Fannie and Freddie, which means that you’re not getting lending from there.  So the housing situation isn’t going to turn, that we’re going to see house prices continue to fall, and I think that that compounds the banks’ losses.

Let me just turn to the story with banks.  As I said, my view is that the bank problem is one of a shortage of capital which induces a process of deleveraging, but not everybody can deleverage at the same time because as they deleverage at the same time, they just drive prices down further, which increases the losses, which means that they’ve got to deleverage a little bit more.  So something has to come from the outside, something like a sovereign wealth fund based in China, who wasn’t burnt, who would come up with more capital, which doesn’t look too likely.  So, I’m afraid that it’s really the government and you and I who are going to be having to foot this bill.

When I look at the bank story, this is a chart taken from a dated report from the IMF.  At that stage, what you had is you had something like losses recognized by the banks globally, $500 billion, but they only raised $350 billion in capital so there was a $150 billion shortage, which, I think, would be compounded by falling asset prices and also by the natural consequences of going into recession.  Banks get losses and that makes their position worse.  This is an indication of bank lending but this was done in July.  I don’t know where we’ll be in September or October given the stress that’s occurred, but basically, banks are already restricting their lending very much.  At the same time, I should mention that what’s called the shadow banking system is all but dead, that something like 75 percent of capital now gets intermediated through the financial markets.  Nothing is going on in the financial markets so we’re getting a contraction of credit at the same time that the markets are frozen means that credit is not going to be available to households and companies, which must mean that you have a downturn.

Of course, what this is doing is the spreads are blowing out, which what it means is that the Fed, much as it tries to cut the short-term interest rate, the Federal Fund’s rate, the rate at which people are borrowing now is much higher than it was before the whole crisis began because spreads are widening, so monetary policy is pretty ineffective in this kind of environment.

Kevin has spoken about this chart.  If ever there’s -- my brother is a cardiologist, and should I show him this as a cardiogram, he’d tell me the patient was long since dead.  But this is really telling you that we’ve got a problem here of major proportions in the financial markets.  This chart is a little complicated to read and this is dated.  These here are the numbers that Charlie was talking about, bank credit or commercial banks.  He’s right that if you look at it year on year, there’s not much of a problem.  It doesn’t look too bad.  But if you looked at the last three months of available data, we haven’t had credit contracting at as rapid a pace in the last 50  years, and my expectation is whether that would be going on in September, this chart is really going to look very ugly.

The reason that I think Paulson’s plan doesn’t work in its existing incarnation is that I don’t see it really addressing the capital shortage problem.  I see it as being basically, as they so colorfully on Wall Street characterize the plan, it’s a cash-for-trash kind of plan.  What it does is it helps in the deleveraging process but unless they’re going to be paying a substantially higher amount than the assets are really worth, it doesn’t do anything for the capital position of banks.  I think it’s a stupid plan for another reason is that it’s not a particularly targeted plan; that it doesn’t distinguish between banks that have got a capital shortage problem and banks that don’t have a capital shortage problem.  So I think that they could have designed this in a very much better way.

My expectation is that we’re not going to get to January 20, 2009 with another real financial market crisis.  But in the event, whoever is elected, I would think that they’ve got to do four things that, and they’ve got to do them simultaneously in a well thought out, coherent kind of manner if we’ve got any chance of having this as being a major recession through 2009, and the four things are: they’ve got to stabilize the housing market; they’ve got to do something about the capital shortage of the banks; they’ve got to be more aggressive on monetary policy; and they’ve got to be thinking about a second fiscal stimulus package.  On that happy note, I end.

Peter J. Wallison:  Thank you.  Now we’ll get a lot of better news from John Makin.  John is a visiting scholar at AEI.  He is also a principal at Caxton Associates.  John has been an adviser to numerous U.S. government agencies and the Federal Reserve System, as well as the Bank of Japan.  He is the author of numerous books and articles on financial, monetary, and fiscal policy, and he writes AEI’s monthly, Economic Outlook, which I assume you are all getting, and if you don’t get it, you should.  John?

John H. Makin:  Thank you, Peter.  Well, let me start out on a light note.  I always read the New York Post because it is so eloquent with regard to current events, and this is their cover which has a senator dressed as a piggy to characterize the Senate version of the Paulson Plan bill.  And it has some delicious details about some of the items that have been added to the bill by our senators who are deeply concerned about the fate of the nation, including, and I’m glad to hear this, $128 million tax credit for land improvement by auto racing tracks.  And since I’m a big fan and I was always a big fan of other tax credit subsidies, I am just to see that the Senate is well focused on our welfare.  But it's business as usual in Washington.

I think the factual coverage here by Desmond of what’s happening to the economy is fully adequate.  And as I’m sitting here and I’m listening to the different presentations, I confess that I’m trying to identify with the audience and try to explain to you why we have such different views on the nature of the credit crisis and the economy.  In order to discipline myself, I read the New York papers and the London papers and the Washington papers and they come from different worlds, and so perhaps, that’s some of it, but I just want to describe the events that have occurred since Labor Day and leave it to you to judge if the financial markets are still in pretty good shape. 

Lehman Brothers has collapsed, leaving their counterparties with virtually valueless claims on the firm.  IndyMac, a California bank, experienced a run and was closed.  Washington Mutual was absorbed by J.P. Morgan in an innovative transaction.  The massive insurance company AIG has collapsed.  The Fed has given an $85 billion loan in exchange for the company or 80 percent of the company.  Goldman and Morgan Stanley are now banks so that they can get under the umbrella offered by the Fed.  The investment banking industry is no more.  Bear, Lehman, Morgan Stanley, Goldman, Merrill are all gone.  Let’s see, what else?  Oh, yes, AIG gone, and then yesterday, the best corporate credit in the United States, GE Capital had to pay Warren Buffett ten percent plus warrants, but the effective cost of the money was about 15 percent or perhaps higher.  We haven’t got all the details.  So that I would ask you if the best corporate credit in the country has to pay Warren Buffett hold-up rates in order to get financing, where he gets free warrants and a good piece of the upside.

If you think the credit markets are in good shape, I invite you to try to get a loan.  If you think the financial markets are in good shape, I invite you to take a glance at your 401(k) statement which will reach you soon for the quarter that’s just ended.  I’m guessing you’ll be down by 15 percent, and nationally, that’s up to trillions of dollars of wealth losses.

The path of the economy, I would just remind you, in the fourth quarter of last year, it grew at 0.2 percent.  These are all annualized numbers.  In the first quarter, it grew at 0.9 percent.  In the second quarter, it grew at 2.8 percent.  But as Desmond has pointed out, we sent $150 billion out to the U.S. economy and that will do the trick anytime to get you a growth that actually, it’s remarkable how weak domestic demand was in that environment and that virtually all the growth was accounted for by net exports.  And as Desmond has pointed out, the buyers of our exports are dropping rapidly.

So I can’t square the things that I see everyday with what I would call, sort of, the sanguine view of capital markets and the economy that I’m hearing here.  C&I loans are rising because companies are drawing their credit lines, much to the chagrin of the banks that have offered them, in which they weren’t drawing them, but any company that has a credit line with a bank is going to draw it down in order to raise capital so they don’t have to go to Warren Buffett and pay up.

But we are in a serious problem.  But let me try to explain kind of how this happened and then suggest how we might get out of it.  The alarm bell was the Bear Stearns collapse in March.  Certainly, that was a loud alarm bell.  There were others but that was very dramatic.  And what the problem with the Bear Stearns collapse in March was that it generated a situation where banks that were claiming that assets that they had on their balance sheets were worth more than they could sell them for if the market had to start financing those assets.  In other words, if you say I’ve got an asset and I say it’s worth 100 units and I’m not going to sell it to you, but I’m going to mark it on my books at 100, if I’m not going to do it, if I’m not going to sell it, then I have to finance it.  And as the underlying situation, that is, the underlying value of the housing stock, to which most of these mortgages were tied continue to drop in value, those who would normally finance the holding of those mortgage-backed securities became reluctant to do so.  And gradually, the financing dried up and of course, Lehman was one of the more highly leveraged investment banks and so they hit the wall first.

But what’s important to recognize here is, I think, the pace of events.  The pace of events in the last 30 days has been so fast that I literally had to write down all the events that have occurred and I listed some of them for you here.  And under the surface there is a serious, I guess you’re not supposed to use the word “financial panic”, but it looks like a financial panic to me.  There are days on which, and part of it is the extreme lack of liquidity in the sector, and then over the past two weeks, there is no liquidity.  Banks will not lend to each other.  That market is closed.  I can assure you, I get a report every morning, that market is closed.  Banks will not lend to each other.  And even though the central banks don’t last [sounds like] for like hundreds of billions of dollars into that market, I think what we have is an interbank liquidity trap because banks just hold on to the money that’s handed to them.

The other problem that we see, of course, is that there are signs of a run on the banking system, which are basically an attempt by households, and Milton Friedman documented this well in the Great Depression; you’re going to run out currency -- sorry, run out of bank money into currency.  So there was a day last week when the yield on four-week T-bills was minus one basis point.  That simply means that everybody wants to own claims on the government and they’re actually willing to pay the government a basis point to store their cash.  Yields on T-bills are still very low and it’s a good measure of how nervous markets are.  But what you have is an incipient massive excess demand for government money or currency or T-bills and an excess supply of bank money.  So what we have, the banking system is frozen, the credit markets are frozen, and households are beginning to, or actually, not beginning to, have been running out of the banks.  Part of the problem, of course, with an institution like Washington Mutual was that roughly 40 percent of the deposits were above $100,000 FDIC limit, and so large depositors in Washington Mutual were rushing their funds out of Washington Mutual because they had no protection.

So again, I guess, being in the markets everyday, I know, can blunt my perspective, to some extent, but it certainly suggests to me that something really bad is happening and I am concerned -- oh, I forgot to mention that Fannie and Freddie are in conservatorship.  Nothing to it, nothing to it.  And actually, the nightmare that I had in April and wrote about in the Wall Street Journal and, I guess, handed out in the last session we had was that we would be attempting a legislative solution to the problem in the midst of a financial panic.  I think that pretty much describes what we’re doing and that’s why I held up the piggy because Congress is not equipped to deal with a situation like this and we’re asking the Congress to do things that they’re really not designed to do.  And the Congress, actually, I think, showed some wisdom when they rejected Secretary Paulson’s three-page plan, which essentially said, “I’ll decide what to do and by the way, you can’t hold me legally responsible.”  I’m guessing that was unconstitutional, but we’ll leave that to the judges to decide.

And so now that we have a financial panic and we’re attempting a legislative solution, and I think, I don’t know, it’d be interesting to see what people say.  As I look at the plan, I’m concerned that the plan will pass and that the problems that I’ve been describing in the banking sector and the household sector will continue.  And I’m glad to hear Charlie say that the idea that the Treasury may implement this by taking a stake in the banks through preferred shares.

Charles W. Calomiris:  I verified that the bill would allow it.  I haven’t verified that the Treasury is interested in it.

John H. Makin:  Oh, okay.  Well, we’ll grab at any straw here.  I take that as a hopeful sign because again, we’ve seen the model.  Warren Buffett is a smart guy and he worked it out basically with Goldman and GE Capital.  He said, “I’ll lend you some money.  I’ll buy preferred stock.  I want warrants.  I want the upside and it’s going to cost you plenty, and if you want to call it in, in three years, it’s going to cost you even more.”  So Warrant Buffett’s risk and the only risk in this is what I would call “systemic risk.”  If GE Capital -- take care, Charlie -- if GE Capital is around next year, Warren Buffett will make a lot of money and probably will be.

The problem is that there aren’t too many, and I know it’s a good time to be a billionaire, always a good time to be, but especially a good time to be a billionaire now.  It’s the JPMorgan model and the panic of 1907.  The JPMorgan model, over many panics, nicely documented in Ron Chernow’s book, The House of Morgan, where if you’re a billionaire, or the equivalent thereof, this is a great time to step up to the plate and write contracts that will make you a lot of money.  I do wish that the Treasury had consulted Warren Buffett on the framework for their proposal because I think it would work better.

So where we go from here is very difficult to say.  I do agree with Kevin that the growth rate in the third quarter will be somewhere between minus two and minus three, but the downward momentum that we’re seeing from the numbers that are now coming out, both in terms of consumption and capital spending, and government spending is not going to be bouncing up here either.  It’s going to be contracting because tax revenues will contract rapidly. 

So I’m guessing we’ll see a bigger negative number in the fourth quarter because what we’re seeing here is something that we didn’t want to see, which has caught the -- and it’s been articulated -- the adverse feedback loop, Vincent’s very familiar with that, where the weakness in the credit market makes the economy weaker and the weakness in the economy makes the credit market weaker.  So what to do?

Well, I hope that we can redesign a program to inject capital into the banks on the terms that Warren Buffett has suggested, that is that the taxpayers, the plan is set up so that the taxpayers who take the risk of putting capital up to purchase preferred shares issued by banks and warrants thereon get the upside.  The upside should be earmarked for tax reductions.  I’m a dreamer, but certainly, that’s a better way to go.

On the monetary policy side, and I’ll leave Vincent to say more about this, I have been somewhat disappointed in the Fed’s passivity in response to this crisis.  More action may be on the way.  They certainly need some help from their brethren abroad in Europe, and they may get it.  But we are probably at a stage where the Fed has to entertain the notion that if everybody wants to have currency, they’ll have to be able to get it, because the way to stop a run on a bank, and we’ve had some, is to simply have anybody who wants to convert their bank money into currency able to do so.  And once they’ve done it and they see that the world is still standing and they’re not earning interest on it while the banks are earning interest, eventually, the process is reversed.  Those are pretty radical measures but I think we’re in a difficult situation.

Lastly, to see about the outlook for the economy, I think the Japanese model, the model from the Scandinavian countries around 1989, 1990 suggest that it usually, after this kind of an episode where you have a credit crisis that causes the economy to get very weak and you have an adverse feedback loop operating, that growth keeps, the economy keeps falling for roughly three years after the peak in the bubble, so that would put us somewhere in 2010 when the economy starts to level out.  I’ll stop there.  Thanks.

Peter J. Wallison:  Thank you very much, John.  Okay, our final economist is Vince Reinhart.  Vince is a resident scholar here at AEI, a former director of the Federal Reserve Board’s Division of Monetary Affairs who has spent more than two decades working on domestic and international aspects of U.S. monetary policy.  He’s worked on topics as varied as economic bubbles and the conduct of monetary policy, auctions of U.S. Treasury securities, alternative strategies for monetary policy, and the efficient communication of monetary policy decisions.  Vincent.

Vincent Reinhart:  Thank you, Peter.  This is my opportunity to talk about what lies beyond the credit crunch.  I suspect that, secretly, the physicists in Switzerland fired up the world’s largest particle accelerator and did, in fact, create that mini black hole which they promised was a very low probability then.  And that giant sucking sound that John and Desmond hear so clearly from markets is our future.  But instead, I’m going to be less pessimistic than them, which isn’t hard, but I would not consider myself an optimist.  I’m going to build a principled case against less intervention than we had but more than we do now.

But to do that, I’d first like to talk about what went wrong, what would have been better and then where are we now?  So the story thus far, which is basically a summary of the previous two panels we’ve had, is that the economy is absorbing an enormous economic drag associated with the correction of overbuilding in housing and the associated house price declines.  That poses three direct drags.  First, there’s a drag on construction spending as builders cope with bloated inventories.  Declines in house prices associated with that excess supply of housing are lowering real wealth and crimping household spending. 

While Charlie correctly pointed out that it is still the case, in Chicago field exams, they asked to explain the case why house prices are not a part of wealth.  We both own it and we own something that we effectively rent from ourselves to provide services, it is actually, historically and statistically, it does appear the case that housing wealth is connected to household spending.  And probably for a very good reason, the pricing of housing wealth lifts the collateral constraint that we all face.  With housing equity, we can borrow against our future incomes.  There is less housing equity now.  There’s less borrowing against future incomes.

And then third, some households see the value of their main assets, their home, go down and walk away from their main liability, their mortgage.  That of course produces the elevated defaults on mortgages, here on the upper left panel of this exhibit, looking for cohorts of mortgages are originated in the first part of this decade, 2005, 2006, and 2007.  Stunningly bad mortgages were made, in part, as housing fundamentals slowed with the increases in interest rates and the slowing in income growth.  But the industry tried to keep, as a metaphor we now [indiscernible] the dance going by easing terms and standards on loans.

Credit markets are magnifying this economic loss, mortgages serve as collateral for securities.  It happens that those securities are complicated, often quite intentionally so.  Investment bankers intentionally create complicated securities because that was the product differentiation that provided above market value to them.  If you look around, in financial markets, those services that are commoditized bear no economic return.  You get an average return.  So mortgage backed securities were intentionally complicated.  And they are held on entities with very opaque balance sheets. 

The net result is we’re seeing this withdrawal from markets for fear of weak counterparties.  Each individual banker does the introspection, “If I’m not actually sure of my own position then the guy I potentially trade with must be in a similar position.”  And we’re also seeing an unwillingness of any of the stronger hands to partake in arbitrage that would better distribute liquidity. 

So the mystery about that elevated LIBOR spread isn’t just why are some banks so suspicious of their counterparties; it’s also why aren’t other banks going to the ECB or the Federal Reserve borrowing funds at their discount window and relending in a market where they could get such high returns?  A short answer is everybody is conserving balance sheet right now.  They don’t want to blow up their capital asset ratios.

The bottom line is financial firms need more capital.  Up until now, the government action has been ad hoc and inconsistent.  In what ways?  Well, is it going to be Lehman or AIG?  And if there is a resolution, either outright done by the FDIC or an encouragement from the government for a strong institution to take over a weak one, will it be like WaMu where uninsured debt holders lost or will it be Wachovia where all the liabilities were protected? 

This inconsistent line has created three bad incentives over this year.  It encourages the management of firms with capital deficiency to delay taking necessary actions.  My favorite example, and I’m going to repeat it, is Lehman.  The week after the Federal Reserve opened its discount window to investment banks, Lehman issued a securitized product.  It took the bits and pieces of mortgage securities that were lying on the cutting room floor, rolled them into a security that had no economic purpose other than it was now eligible for collateral at the discount window.  If the idea of temporarily providing liquidity was to buy time for management to deal with the problems creating a CDO cubed by rolling together those securities evidenced that that wasn’t working.

Now just so you know that investment bankers do have a sense of irony, does anyone know what those notes were called?  Freedom notes.  Okay, second, government actions have emboldened creditors and short sellers to push for outcomes that raised debt values through credit enhancement and lower equity values.  Once you know the government playbook, once you’ve read it in terms of what happened to Bear, what they did with AIG, what did they did with most firms when they stepped in, if you have a perfect self-funding strategy, if you think a firm is going to be taken over by the government, you know the government will delude the existing shareholders and protect the debt holders. 

So you short the stock and use the proceeds to buy the debt.  And so it isn’t an accident that these funding runs ran together because once one firm fails, you look for the next weak antelope.  Together, the encouragement to bad behavior on the part of management and speculation associated with knowing the government playbook; that deters the infusion of private capital.  We have a hole somewhere in the order of an excess of a trillion dollars.  We have seen capital come in, but government actions probably slowed that process.

Now this really matters in financial markets because bad policy can have a large effect because market behavior depends on the expectations of market participants.  And here’s a little tinker toy model I always like to think about: suppose your participation in an activity depends on your expectation that other people will participate in that activity.  If you come to doubt that they will participate, you’ll cut back your participation, and they will justifiably cut back their participation on the anticipation that you’ll cut back yours.  That is, markets with an important role for expectations can produce herding, can produce self-fulfilling prophecies, can produce multiple equilibriums.  That means market outcomes are very sensitive to shifts and expectations, very sensitive to changes in cost.  LIBOR spreads don’t blow up in an afternoon and a half because everybody solved an information problem that says, “Oh, it must be the case that balance sheets are more impaired.”  Everybody was heading for the exit at the same time.  But in that environment, a governmental action that provides even some reason to delay providing capital can have large consequences.

Now, that’s where we are.  Where could we have been extending the physics metaphor to talk about an alternative universe?  [Indiscernible] and splitting paths, we could have gotten back to basics.  The hurdles that -- and let me first say I am not always opposed to government intervention.  I think the government had to protect the debt of Fannie and Freddie because that wasn’t the mistake.  The mistake was allowing Fannie and Freddie to exist with an implicit guarantee for the prior decades.  It wasn’t a bailout of Fannie and Freddie; it was honoring a commitment that had been made sub rosa.  And it would be a worse thing to deny that commitment than accept the moral hazard.  The moral hazard was already there.

So governments sometimes do have to act.  There can be market failures.  There could be coordination problems.  There could be periods in which, because of the self-referencing nature of markets, you got to shift, you got to nudge markets from the bad outcome to the good outcome.  But I think it’s important to pass over four hurdles, four questions to ask before you do that.  First, how sophisticated are the investors in the firm?  That is the equity.  How sophisticated are the creditors?  For instance, in this particular case of Fannie and Freddie, I’d argue that an important class of creditors to Fannie and Freddie were unsophisticated in the sense of their reading of, well, probably very sophisticated in reading the political landscape but unsophisticated in their belief that it really was government guaranteed and therefore, we had to honor that.  Third, how long have everybody had to learn about the firm and, how interconnected is the firm?  And those are the questions we should ask each time in a crisis when we’re asking to expose the public purse.

Having asked those questions, if intervention is needed, the authorities, wherever possible, should ring-fence the part of the balance sheet that has systemic implications.  If Bear Stearns had systemic implications, it wasn’t the entire firm; it was this portion of portfolio probably related to credit defaults problems or its derivatives position generally.  You see, you can act inappropriately in either way.  You can protect too much of the firm Bear Stearns by not looking just at what parts are systemically important, or you can protect too little of a firm like Lehman by not protecting the parts that are systemically important.  This would allow the rest of the institution to be resolved by the market, and as a consequence, authorities don’t have to make a determination about the underlying values of the firm.

Above all, you shouldn’t use instruments designed to provide liquidity as a substitute for capital.  And the fundamental problem we’ve been making is the government has been misdiagnosing the problem as a liquidity one for a capital one.  That means we’ve been using the wrong instruments of policy lending, not capital infusion, and we’ve been using the wrong agents for that action, the nation central bank rather than fiscal authority.

We don’t, however, live in that alternative universe.  And crisis management is all about where you are in the field at this point in time.  And we’re already in that position now, driven by previous actions.  The good news about TARP, and somebody has got to say good news about the pending legislation, is the government is finally recognizing the capitals required.  I think it correctly places the action with the fiscal authority rather than the Central Bank.  And I’d also argue the communication in that need has been inconsistent and unhelpful.  To talk about this plan as potentially profitable doesn’t send an appropriate -- doesn’t convey an appropriate diagnosis of the problem.

And I agree that asset purchases are inefficient relative to other alternatives.  I don’t think there’s any question about that, for many reasons.  You’re trying to move a very large market.  It is indirect.  There’s a question of what price, which actually is critical to how everything works.  And I can imagine a well-constructed scheme that would have direct capital infusions, firm by firm; or offering insurance with government resources. 

The problem with the insurance scheme in the legislation, in variances of legislation, is it assumes that an industry on net, deficient in capitals, can somehow insure itself.  If there was enough capital to solve the problem, then they don’t have to insure each other.  In some sense, it reminds me a lot about the Internet bubble in which everybody was going to profit by selling space on their Web page to other firms who were buying and were selling space on their own Web page.  There has to be real money.  And the legislation provides for real money.

I can also imagine governmental assistance mortgage relief as solving the balance sheet problem by moving that very large housing market to ultimately support the underlying assets, the house, which protects the collateral which then protects the mortgage securities.  But you have to understand some limitations about government action.  Government action has a couple of very important inherent limitations.  And the first is officials are extremely bad at maintaining boundaries on programs.  The perimeter of support expands.  It tends to be bigger in legislation than it needs to be and over time, it grows.  I think if the problem is the systemic strains in financial markets, we can list on one page the number of firms that would need capital infusions.  I’m also pretty sure that every single financial institution in the United States has had their balance sheet hurt by what happened in the housing markets.  And if Congress were to institute institution-by-institution relief, I’m also fairly certain it wouldn’t be that one-page list.  It would be the tens of thousands of financial firms.

Second, any firm-by-firm program where you’re making decisions on capital infusion or house-by-house programs where you’re proving mortgage relief, to be done right, requires infrastructure.  The HOLC, the Depression-era construct from 1935, at its peak, employed 20,000 people and touched one in ten homeowners and lasted until 1951.  It’s also the case that such firm-by-firm negotiation puts the government, the officials, at a decided information disadvantage relative to the private sector.  They’re always going to bring in better MBA’s and lawyers to the table.  They’re going to bring more of them.  They’re going to show the worst assets.

Asset purchases in the market don’t need much infrastructure.  The Treasury can start doing it the day -- the morning after they get the authorization.  They don’t also make distinctions among who is helped, so you can make the argument that it is the incidence is fair than in the individual firms.  Now it is true, reverse auctions of individual mortgages are more complicated but the fact is the government does have experience in conducting auctions.  Peter read my brief bio at the beginning and what I worked on the early part of the ’90s was the Treasury’s experiment in single-price auctions after Salomon Brothers admitted cheating at Treasury auctions. 

The government actually runs some very complicated auctions, including the auctions of spectrum rights, which was a ban to the spectrum by area code of the country in which it was an iterative auction where the entire market, the entire country market would clear each time. 

And true, when you get to the level of individual mortgage or pools of mortgages or complicated securities, that information disadvantage, the asymmetry where the government doesn’t know as much as the private sector is there, but that’s the place to control through the issuance of warrants.  If, in a reverse auction, each pool of mortgage, each claim to a pool of mortgages presented for the government had a warrant stapled to it, the upside on the equity price compensates for the downside associated with the information asymmetry.

TARP also gives considerable discretion to the Secretary.  If you’re an optimist like John, you say, “Maybe it’ll be used appropriately.”  You could look at the record, of today, of the officials who are giving that authority.  But if the authority is broad and it does include basically a blanket systemic risk exception that the Secretary could buy anything that he, with consultation with the chairman of the Federal Reserve, views as important for addressing systemic problems.  And consultation of the Secretary with the chairman of the Federal Reserve, as we’ve seen in the last year, is not a real high hurdle.  So TARP does do some important things.

The legislation, by the way, also makes it more likely that the Federal Reserve will continue to keep its balance sheet at risk.  Why?  Included in the legislation is the provision that the Federal Reserve can pay interest on reserves.  What that means is the Federal Reserve, once exercising that authority, will be able to expand its balance sheet and without pushing the overnight rate to zero.  It’ll push it to the floor established by the deposit rate.  That supports unlimited expansion of the Federal Reserve’s balance sheet.  It basically supports what we used to consider as unusual policy actions; expansions of the existing facilities, expansion of swap lines, potentially more aggressive purchases of assets, generally.

Now, there’s good news there because Peter, at the outset, asked the question what happens if the legislation doesn’t pass?  Well, what’s going to happen is Congress will go home, but the crisis managers will not.  The Treasury does have its authority, under the July housing bill, to buy mortgage backed securities of Fannie and Freddie.  The Treasury can abuse the notion of conservatorship and have those two firms that are currently being run by the government expand its own outright holdings of whole mortgages or private labeled securities, all within its ability and within the scope of the July legislation.  And the Federal Reserve can expand its balance sheet up, if the Treasury is willing to over-issue Treasury securities, as it had in the last few weeks.  And the Federal Reserve does have a policy rate set at two.  It can go down.  And when it goes to zero, there is no constraint on the size of the Federal Reserve balance sheet.

I think that, as many people have mentioned, the landscape of financial markets has changed very much in a short period.  This will one day be over and, perhaps, in version 12 or 13 of this sequel, we’ll be talking about the cleanup legislation required to solve the problem.  We’re going to have to think very hard, among other things, about what do we expect of the Central Bank?  What role should the Federal Reserve have, given that through experimentation, it has significantly expanded the number of its policy tools?  In the future, we’re going to have to ask the question do we want the Federal Reserve to keep using those.

Peter J. Wallison:  Thank you very much, Vince.  Well, we’ve come to the point where the members of the panel can talk to one another, and then we’ll go to questions from the audience.  Do you guys want to say anything about -- Yes, they’ve been waiting a long time, that’s right.  But I have one question that I do want to ask, and that is, Vince, the structure of TARP, I think, is really fascinating and interesting to me.  The idea, that the Secretary came up with, was to buy assets.  I can’t help thinking that what his underlying view was that the assets currently in these banks were undervalued.  Otherwise, it makes absolutely no sense because if you’re going to buy the assets at a market price which is very low, you just make the banks insolvent.  So what do you think he had in mind and why did he structure it this way rather than, for example, as a capital investment?

Vincent R. Reinhart:  I personally think the folks at Treasury came with the idea of conducting these auctions, initially, with the view that they would be the broker and not the principal.  That is, they would be facilitating the financial market clearing -- by organizing these auctions for them.  But I think that’s background.  Why they do what they have, they did. 

There are three prices to think about.  There is the price currently in the market; there is the price of these securities at normal tolerance for risk and normal functioning.  And presumably, the Treasury is going to pick a price somewhere in between so that it provides balance sheet relief by increasing the prices of the assets sitting on these firms’ balance sheet but with enough below the price at normal times so that that will provide the opportunity for some profit.

Importantly, the third price you should think about is the price that makes all financial firms solvent.  That is well above the price associated with normal market functioning and tolerance toward risk.  Why?  Because that price basically compensates for the economic loss associated with mortgage default.  That’s real.  And it would be inappropriate to try to raise prices so high.  What does that mean?  It means that you should think about this bill as being an industry consolidation vehicle.  The strong institutions will get their balance sheets liquefied because they can put their troubled assets to TARP.  The weaker institutions will have a harder time because of mark to market hiding their losses and can then therefore be taken over by the strong ones and their troubled assets liquefied.

Peter J. Wallison:  Do you think the idea was it should cause a lot of defaults?

Vincent R. Reinhart:  I think the idea was to facilitate industry consolidation.  Charlie is not here but an interesting factoid is Chairman Bernanke’s second most cited paper on the Great Depression is actually one that compares the business cycle in the United States and Canada in the 1930’s, and the contraction activity was much more gradual.  The reason?  Canada didn’t have bank failures because Canada had a consolidated banking system.

Desmond Lachman:  Can I just ask Vince, is there a long-run risk getting beyond the crisis that what we could have is a banking system that essentially has three big banks and not sufficient competition?

Vincent R. Reinhart:  I think it’s a very serious risk and essentially, we’ll wind up with several large banks, all of them too big and too interconnected to fail.  I was on a program panel with Paul Volcker two weeks ago, and he said, well, for solace, he went back to The Wealth of Nations to see what Adam Smith would think of all this.  And there’s a chapter, true enough, on the Scottish banking system and the inherent risks in banking.  And Adam Smith’s solution is we got to make sure that banks stay small.

Peter J. Wallison:  Okay, it’s your turn to ask questions.  And what I’d like you to do, we have a microphone somewhere, the mic people are all up and ready.  I’d like you to identify yourself and then ask your question.  And please, ask a question, not just make a statement.  A short statement is okay as background.  In the back, right over there.

Tad Howard [phonetic]:  My name is Tad Howard.  Peter, back when you were with Ronald Reagan at Treasury 25 years ago, every Friday morning, we’d get the alphabet soup of M’s on the money supply.  What is going on with the money supply right now?  I have my own fears, but I haven’t heard any announcements with money supply.

Peter J. Wallison:  I’m not the one to ask about that now.  We haven’t had that meeting in a while.  Vince?

Vincent R. Reinhart:  So the answer is that, yes, the Federal Reserve’s balance sheet, for most of this year, didn’t really expand all that much.  It’s only in the last four weeks with the Treasury over-issuing debt securities in order to fund Federal Reserve balance sheet that you have this huge expansion of Federal Reserve credit.  Actually, it’s the last chart.  If you want to think about what’s happening with the money, let’s go to the narrowest concept, that would be reserves, which is the mirror image of reserve bank credit.  It's been growing slowly over the last year, exploded over the last couple of weeks with the Treasury’s over-issuance.  Monetary aggregates have been growing at a moderate pace, and in fact, that’s what gives solace to some people that the economy won’t [audio glitch].

Kevin A. Hassett:  But we have to stick where -- Des and I were talking about this.  The problem though is that you’re not getting the money multiplier because they’re not lending.

Vincent R. Reinhart:  Oh, sure.

Kevin A. Hassett:  And so the farther down in the M’s you go, the more reasonable it is to assume that it's contracting.

John H. Makin:  What do you think is happening to demand for money and the composition of the demand for money?  The demand for currency is soaring and the demand for bank money is collapsing.  And so the aggregates can be a little misleading here.

Vincent R. Reinhart:  Sure, and this is not a time you would look at the monetary aggregates.

John H. Makin:  Yes, I think that’s probably right.  I have a technical question.  Is it legal for the Treasury to raise money for the Fed to essentially lend to the Fed?  I thought the Treasury could only raise money for the finance of government purchases.

Vincent R. Reinhart:  So the Secretary -- so the ability, the authority to borrow is in the Constitution and it’s given to the Congress and it’s delegated to the Treasury through the debt ceiling.  The Secretary can raise funds up to the debt ceiling.  What they’re technically doing is they are selling more treasury debt than required to fund the government from day to day and building up the cash balance at the Federal Reserve.  So in that respect, they would argue they are not lending money to the Fed; they are just building up their cash balance.  And in fact, the Treasury, in its debt management, does have the ability to vary its cash balance.  Typically, it keeps most of those funds with private banks, but in this particular case, it has moved it to the Fed.

Peter J. Wallison:  The Constitution says that you can’t withdraw money from the Treasury for spending purposes except through an appropriation.  And what they are doing is simply borrowing and depositing with the bank of the government, which is the Federal Reserve.  They look at it as simply a deposit with the government bank, so it’s not really an expenditure.

Vincent R. Reinhart:  And the Federal Reserve is the fiscal agent of the Treasury and the Federal Reserve, in the Federal Reserve Act, is prohibited from borrowing.

Desmond Lachman:  I think that the monetary and credit aggregates would be a good idea to tell you where inflation might be going.  My view is that this concern about inflation right now is totally misplaced, that it’s not simply that the monetary aggregates and credit aggregates are decelerating at a rapid rate, but it’s also that we’ve just had a huge commodity bust so that oil, which used to be at $145, $150 dollars a barrel, is now at $95.00.  All commodities are falling by something like 20 percent.  So if we look forward, it really puzzles me that anybody can seriously, in these kinds of circumstances, be concerned about inflation as a threat.

Peter J. Wallison:  Okay, additional right here.  And we have one, two, three, four, okay.

David Brousseau [phonetic]:  David Brousseau, Treasury, but have nothing to do with TARP.  My question, I came here today trying to figure out why Bernanke and Paulson sort of chose the Treasury as the vehicle rather than the Federal Reserve as a vehicle as to inject what I say is a liquidity operation.  I was wondering if anyone on the panel could -- and then after hearing Kevin’s talk, I figured Hank just decided he’s going to make a lot of money on this deal.  But [audio glitch] as to why they weren’t this way rather than let’s say very aggressive that they use their discount window ala AIG and so forth.

Desmond Lachman:  My view would be that finally, late in this game, they’ve figured out that it’s not a liquidity problem but a solvency problem and that a solvency problem is better addressed by Treasury rather than by the Fed, just opening up this discount window.

Peter J. Wallison:  Yes.  Actually, it’s like that old line about if your only tool is a hammer, everything looks like a nail.  And the only tools we have had in general are liquidity tools through the Fed and this was not a liquidity problem.  It is doubt about the solvency of banks.  Do you want to just follow up with that very quickly?  Because we have others.

David Brousseau:  And my second has to do with that distinction between a liquidity problem and a capital infusion problem.  If you inject enough liquidity into the system, won’t that lead to private investment, eventually, into equities as they see that you cannot -- you stayed on cash.  Cash earns nothing.  I can turn that into a moneymaking enterprise by buying equities.

Peter J. Wallison:  Well, wait a minute.  If you inject liquidity and it’s a loan, you haven’t improved capital at all.  The only way that liquidity, in the sense you’re talking about, improves the capital position is if it isn’t a loan, if it’s a capital infusion that doesn’t have to be paid back.

David Brousseau:  But what you have to do is you have to change expectations.  I mean, people are not going to jump into the market until they’ve hit bottom or they think they have hit bottom.  And I think things are undervalued right now but I’m not going to jump in and buy anything that’s undervalued if I think it’s going to be even more undervalued tomorrow.  So I’m going to wait until I --

Kevin A. Hassett:  Dave’s intuition is similar to what Vincent referred in the sense that there’s this puzzle of why aren’t they taking the free money and then investing in the LIBOR loans and make it -- because then, if they did make a lot of short-term profit on that, then it would help.

John H. Makin:  I wanted actually to [cross-talking] --

Kevin A. Hassett:  And it’s the same puzzle, really.

John H. Makin:  But there was an exception to that pattern that’s consistent to what you were suggesting and exception to the pattern, Vincent, that you were suggesting, which is I thought that the JP Morgan-WaMu deal was the, what I would call, the incipient asphyxiation model, where JP Morgan waited until WaMu was virtually ready to expire and then was able to write off all of WaMu’s liabilities, save those of depositors’, and have the FDIC take over some of the bad assets, which is kind of a little bit different from the pattern you were suggesting.  It's kind of a dangerous pattern.  I mean, if you’re going to say to someone, “Well, I’m going to strangle you but just before you expire, I’ll let go and give you some oxygen.” 

I was having dinner when that happened.  It was breathtaking and it was a break in the pattern, don’t you think?  And I was a little surprised in the case of Wachovia where the pattern was not repeated because there was, and I think Vincent was kind of referring to this, the perverse incentives that came out of the WaMu deal where if you see a bank in trouble, I mean, maybe they were trying to say dump the stock and the bonds and just get out and deposit the money in the bank, and then you’ll get saved. 

But I think, to reinforce Vincent’s important point, the pattern of these things has been ad hoc and reactive.  And so the market can’t figure out what are we doing here.  Every case seems to be different.  In the case of AIG, the Fed says, “Okay, we’ll lend you $85 billion.  Give us the company.”  In the case of WaMu, we’ll let JPM do it.  In the case of General Electric or Goldman, we let Warren Buffett do it and we’re just sort of extemporizing here with remarkable virtuosity, I would say, in Warren Buffett’s case, but not necessarily in the government’s case.  And I think Charlie’s comments kind of brought home to me that we don’t know what the Treasury will do because the legislation apparently gives the Secretary a great deal of discretion.  And so that pattern continues that markets in the position or anybody who’s involved in this is in the position of wondering what will we do with the next institution that’s in trouble?

Just a relevant update here, I have just seen that there’s a group of Republicans who have proposed slashing the package to $250 billion, which again, this just illustrates my fear of taking -- the problem with the Finance Ministry approach is that if you need real money, you have to go to the Congress and you have to give them time to think about it.  And we’re sort of saying, “We don’t have time so don’t think about it.”  And the Congress says, “Oh, yeah?  Well, we might think about it.”  So we’re in a difficult situation here.

Peter J. Wallison:  The Congress thinking is something difficult to imagine.  Okay, over at the wall over here, Greg, could you -- Oh, all right, first there, then Greg, then here, and in the back.

Brian Beary:  Brian Beary, a reporter for Europolitics.  I’m just wondering, looking beyond the United States, of course, in Europe, you said that banks seem to be recapitalizing.  That’s happening at the moment with all the nationalizing of banks in bank locked [sounds like] countries, et cetera.  Just have you any views on -- are they taking the right approach in Europe or are they completely going the wrong way?

John H. Makin:  Well, the European approach, let’s say, is less transparent than the American approach.  And it seems that the kind of dreaded problem has come up that has destabilized the approach; that is the Irish government has taken the step of guaranteeing bank liabilities of Irish banks.  And so in Mayfair, we have wealthy Brits lining up to put their money into Irish banks.  And of course, what we may get out of this is a deposit guarantee contest where actually, the U.S. could be a big winner because with the deposit guarantee, we could probably attract lots of money and it would force other countries’ banks to do the same thing.

As I say, the European case is not transparent.  The Central Bank in Europe, the ECB has thus far suggested that they’re more concerned about inflation than the slowdown in growth, although the language appears to have changed a bit today.  The number of failing institutions in Europe seems to be rising and the capital impediments that European banks have experienced have to be as large as the U.S. banks, I mean, it’s an international banking system.

The other problem that Europe has that’s a little bit unique is the too big to save problem which emerged in Belgium this week with Fortis.  A very large bank in a very small country presents an awkward problem because the government is not large enough to believably rescue that bank.  And what you wonder about is if the Belgian government which suggested in some, a little bit opaque way, that they would guarantee Fortis deposits, it wasn’t clear whether they were guaranteeing the deposits of Belgian citizens only or everybody’s deposits in Fortis.  So it’s getting -- I would say that the problems that are acute here are spreading rapidly to Europe.  And I’m hoping that the central banks are working on that.  But Vincent, maybe you got --

Peter J. Wallison:  Okay.

Greg Wilson:  Greg Wilson with a small consulting firm of the same name.  Thank you for a very sobering set of presentations.  A quick question, forget whether TARP passes or not on Friday, would we be better off with a new and improved version of the RFC to inject capital into the banking system given where we are, given all the issues I’ve heard each one of you present?

John H. Makin:  I vote yes.

Desmond Lachman:  Yes, I’d also say yes because that would be addressing what the problem is rather than simply a liquidity problem.

Vincent R. Reinhart:  I think I would opt for a well designed capital infusion package.  I don’t know the institution that actually would do that well, and so I express some concerns.  I also think we could conceive of an insurance scheme that would also, with the government funds, provide a mechanism to give the needed protection and attract capital.

Kevin A. Hassett:  I’m with Desmond and John.

Peter J. Wallison:  Next, back there, at the -- right there.

Justin Ailes:  I’m Justin Ailes with the American Land Title Association.  My members like real estate transactions but want them to stick.  I appreciated all of the bad news going like this in the charts and the good news going like this in the charts, but any predictions on stability and when the bell curves will --

Peter J. Wallison:  Huh?

Kevin A. Hassett:  If you want to do a numerical guesstimate and use history as a guide, then you could look at past recessions.  This recession will be different because it’s being -- not led by investment but by consumption, so it should last longer.  And so that means if you want to be an optimist, then you should probably pick a recession length that’s closer to one of the longer ones, like maybe 18 months is the longest, I guess, so you could say 14 months, 15 months might be optimistic from June [sounds like].  And I’m guessing that’s -- and then you got to run things out if we go for almost until next summer before we start expanding again.  These will be some tough times, but that’s probably -- I mean, I guess better things could happen because prices are so crazy right now that they maybe they’ll just be a massive and rapid reversal.  But that seems like a very hopeful thing.

Desmond Lachman:  I guess I imagine you are talking about the housing markets, you’re wanting to know when that bottoms.  A point that I would make is that in the same way, as the housing market overshots away from fundamentals on the way up, in the absence of intervention, we could very well have a dynamic in which housing prices undershoot what the fundamental levels are.  I’m particularly concerned about the dynamic that we’re in where lower house prices lead to higher for