No More Business as Usual
By John Grennan
Illustration by Chris Buzelli
Saint Mary’s professors teach economics and business during a financial crisis
With Wall Street wizards and Washington policymakers struggling throughout the fall to comprehend the most challenging economic paradoxes to emerge since the Great Depression, professors in the School of Business and Economic Administration (SEBA) would have been forgiven for canceling classes.
It was a tall order to teach students the fundamentals of a discipline as it went through a paradigm shift that had even financial high priests at Goldman Sachs and the Federal Reserve scratching their heads in disbelief.
Yet the SEBA faculty soldiered on as a major crisis of capitalism unfolded in real time. On the Moraga campus and in graduate business classrooms around the Bay Area, SMC professors continued to teach students about everything from basic supply-and-demand curves to more arcane nuances of subprime mortgages. With Americans glued to stock tickers crawling across the bottom of their television and computer screens, professors had little trouble keeping their students’ attention.
“What I teach is on the front page of the newspaper every day,” says Asbjorn Moseidjord, an economics professor at Saint Mary’s since 1983. “Students are tremendously interested. They listen intently and ask many good questions.”
As the College’s first-year students were engaged in an interdisciplinary study of the theme of “Feast or Famine,” they turned to Moseidjord and other economics and business professors for guidance on booms, bubbles and busts. It was one of the most interesting — if unnerving — times to be a SEBA faculty member.
Darker by the Day
Interviews with SEBA faculty members for this story coincided with the early days of the crisis in mid-September. At that point, casual market observers had noticed that the Dow was off its 14,000-point all-time high, but it remained at a relatively reassuring 11,000. Treasury Secretary Henry Paulson had already propped up mortgage lenders Fannie Mae and Freddie Mac with taxpayer-funded relief packages, hoping those interventions would stanch further losses.
In his Garaventa Hall office, economic historian Jack Rasmus remained skeptical.
“There’s a major deflationary cycle coming up — that’s the big news, not the 400-point drop in the stock market today,” he said, noting that deregulated markets and easy credit had created asset price bubbles that were about to burst.
The next month bore out Rasmus’ ominous predictions. Major financial companies like Lehman Brothers and Washington Mutual were wiped out or bought out with stunning rapidity. Investors came to grips with how little was known about exactly which financial companies were on the hook for record levels of corporate and consumer debt — especially mortgage-related debt — that had been masked in complex off-the-books derivatives and credit-default swaps.
This debt of dubious provenance began scaring lenders and tightening credit markets, leading to problems throughout the economy when companies needed to borrow to cover standard expenses. Saint Mary’s was not immune, as its endowment investments lost value and forced the College to tighten its operating budget. In his November message to the College, Brother President Ronald Gallagher said he had tasked his cabinet to reduce administrative expenses, travel and staffing needs “where possible.”
With the U.S. economy teetering on the brink of collapse in early October, Congress approved a $700 billion infusion of taxpayers’ money into troubled financial companies. But even this unprecedented intervention did not prevent the Dow from plummeting to less than 8,000, losing more than 20 percent of its value in one week.
Rasmus, who was teaching SMC’s Economic History of the United States class, framed the 2008 bailout in unfavorable historical terms. As in analogous downturns, things would likely get worse before they got better.
“Liquidity solutions in cases of severe debt-asset deflation crises have worked only when asset prices have reached bottom, such as in 1990 and in 1934,” Rasmus said. “We may have to wait until housing asset prices drop further.”
Cycling into Recession
As the crisis unfolded, Rasmus, Moseidjord and other College economists borrowed metaphors from their science colleagues over in Brousseau Hall to describe the perilous situation. A “herd mentality” had overtaken investors who raced for the exits. The U.S. government needed to act quickly to keep bad debts from “infecting” otherwise healthy sectors of the economy. Financial companies required an injection of “liquidity” to keep credit markets from freezing up.
Under these conditions, it was impossible to escape the feeling that the U.S. economy was headed for a recession if it wasn’t in one already. By the end of 2008, the Treasury Department was confirming it: a U.S. economic bubble, inflated with easy credit premised on the notion of eternally rising home prices, had burst and the recession had begun. Moseidjord said the recession happened because many people were simultaneously making the same economic mistakes.
“Under normal conditions, mistakes cancel each other out. In a cycle, a lot of people make the same mistake,” he explains. “In this case, the cycle came from lousy decisions that happened in the financial market, channeling way too much money into the mortgage market. Many times, clever people will go in the same direction, creating a particular risk that they are not hedged against. They may not be aware of that or may not take it seriously.”
Those who remember the U.S. recessions beginning in 1990 and 2001 know what it’s like to feel the economic pendulum swing back from an ecstatic high. Financial policymakers’ decisions, SEBA professors tell their students, have an impact on these oscillations.
“Capitalism at its heart has cycles,” Rasmus explains. “Do you regulate sufficiently to dampen the cycles, or do you let the cycles run? With the total deregulation of the market, the cycles have an increasing magnitude.”
As the U.S. recession spreads to the global economy, financial experts are asking something akin to what seismologists ask the moment an earthquake hits the Bay Area: Is this the big one? Perhaps, says SEBA Dean Roy Allen.
“There are elements about this crisis that might be different than other recent episodes,” Allen says. “Financial liberalization, deregulation, technological change and globalization have played a role in increasing the speed and risk of financial cycles.”
Boom and Bust: All Part of the Bargain?
As every SEBA student knows, economics is fundamentally about trade-offs. Few developments qualify as an absolute plus or minus on the global balance sheet. A weak dollar is bad news for a Fremont factory that buys steel from South Korea, but good news for Detroit automakers looking to export sedans to Shanghai. When you ask an economist a yes-or-no question, more often than not the answer is “It depends.”
So it bears consideration that factors contributing to the 2008 crisis — deregulated markets, easy credit and the globalization of finance — have also recently allowed for the creation of substantial wealth. Northern California startups like Google and Cisco would not have grown as significantly in the dot-com boom if more conservative investment strategies had prevailed. SEBA graduates working at high-tech companies founded on capital of the intellectual, rather than financial, variety can testify to the benefits of less restrained approaches to credit and investors willing to take on higher risks.
Yet extending credit even under the best of conditions, Allen points out, is essentially an act of faith in the intentions and capabilities of others. Even the word “credit” comes from the Latin credere, “to believe.”
“What is a financial transaction other than a belief?” Allen says. “You are exchanging money with the expectation that something will happen over time.”
Those beliefs were profoundly tested in late 2008, as more and more borrowers and lenders realized they’d been drawn into increasingly abstract and complicated webs of relationships. The Saint Mary’s graduate who took out a mortgage in the past few years may have negotiated it with a local bank, but the loan probably didn’t stay there. Instead, it was packaged with thousands of other loans, sold to a financial company on Wall Street and then sold again in pieces to investors anywhere from Tokyo to Dubai.
“There are more international causes to this instability and greater financial globalization than in previous experiences,” Allen says.
News reports and congressional hearings revealed an intercontinental financial shell game, with even savvy financiers losing track of where $21 trillion in new debt created since 2001 actually was at any given moment. Distributing risk more broadly did not make it disappear, as a wide range of investors — and financial giants like Bear Stearns, Lehman Brothers and AIG — began painfully realizing in 2008.
And as homeowners in places like Contra Costa County experienced record levels of foreclosures, financial markets around the world collapsed. The credit and credulousness that sustained the economic acts of faith Allen described disappeared, deflating the asset bubble that had inflated well beyond the point where it reflected actual values. The upheaval that sparked fears of a global recession not only angered retirees watching their nest eggs plummet in value, but also left people scrambling to figure out economic systems they thought they understood.
“The degree to which you believe in an economic idea depends on whether there’s some kind of underlying truth to your construct,” says Allen. “A financial construct is something you can build and can take down in an instant — it happens at the speed of light.”
With market turmoil dominating every news cycle during the fall, several other urgent economic issues have fallen by the wayside. But even as the financial panic occupies center stage for the foreseeable future, other problems are waiting in the wings, including an increasing U.S. budget deficit, underfunding of Social Security into the 21st century and escalating health care costs. SEBA professors try to make sure that their students don’t lose sight of these impending challenges.
“Go back a year and there were headlines about global warming,” says Moseidjord, who teaches environmental economics at SMC. “With the bailout, the environment doesn’t make it to the front page.”
With gas prices reaching $4 a gallon in spring 2008 before the financial crisis set in during the fall, Moseidjord noted that efforts to address greenhouse gas emissions and climate change appeared to be gaining traction. But with people preoccupied with the cratering values of their houses and 401(k) accounts, environmental concerns may take a back seat for now.
“Almost all the proposals in environmental economics are costly, and in a weakened economy people are less willing to consider them,” Moseidjord says.
Yet some aspects of the recession’s impact on the environment illustrate another core economic principle: what Adam Smith, father of modern economics, described as the law of unintended consequences. Even if people aren’t directly thinking about the environment, recession-driven changes in their economic behavior may have positive effects.
“When it’s all over, Americans will be driving smaller cars shorter distances,” Moseidjord says. “They’ll be more frugal.”