Circle of Finance Opportunities

The Current State of the Economy

 

Interview with:
Dr. Karim Pakravan
Associate Professor of Finance
DePaul University

October 27, 2011

Interviewed by Nestor Wozny
Communications Chair
Circle of Financial Opportunity
DePaul University

Nestor Wozny: Professor Pakravan, can you provide a general statement of your opinion on the current state of the economy, focusing on both the US as well as the global economy as a whole?

Dr. Karim Pakravan:  I think the lesson that we have drawn in the last few months from the US economy is that it has been subject to several severe shocks. You have had the debt ceiling impasse in the summer, the European crisis, the Tsunami (in Japan), oil prices surging to almost $100. At the end the economy managed to not go into recession, but it managed to accelerate slightly in the third quarter. The data today shows 2.5% annualized, which is about 1% higher than in the first half of the year.

That is the good news. The bad news is that a lot of the stresses on the economy remain. First of all, we are inching toward a resolution in Europe.  That resolution will be painful for European banks and the European economy. This will also have repercussions for the global economy and as a result on the US economy, although not as bad as if you had a financial crisis in Europe, which potentially would have led to another global recession. The other thing is that domestically we have not resolved anything on the fiscal side. In fact, the two (political) parties are still very far apart. Unfortunately, what we are going to see in any case is fiscal tightening. Fiscal tightening in 2012 and 2013 are going to have a somewhat negative impact on the economy. The other thing is that we had a fairly massive stock market shock, which we seem to be recovering from. Although, I think we are still not out of the woods by any means. The data that has been coming in over the last three months has been mildly positive. In fact, GDP was higher, mainly because consumers have spent more and that is a good part of the story. Ultimately, you want the economy to be driven by consumers, not by government spending. The headwinds remain. You have the potential for another crisis in Europe. You still have potential for political gridlock in this country, especially in an election year. There still are some potential wealth effect shocks from the stock market. But at least the hope is that (a) we have avoided a double dip recession, (b) the economy will be inching along at 2% to 3% (annualized) for the next few quarters. In a nutshell this is how I see the economy right now.

Nestor Wozny: You mentioned the avoidance of a double dip recession in the economy. You do not believe in the potential for a double dip?

Dr. Karim Pakravan: Well, the data showed the economy recovering in the third quarter. Clearly it will not grow much faster because of the overhang of the housing market problem, the mortgage problem, and the high unemployment. But the thing is that economies work on sort of a virtuous or vicious cycle. And we were in a vicious cycle in the past few months of falling consumer and business confidence, falling investment, falling consumption. This results in rising unemployment, which in turn, spreads to further falling consumer confidence and business confidence.  What we need to engineer is virtuous cycle of improved consumer and business confidence, improved investment, improved employment, so on and so forth. I believe we are at the beginning of such a virtuous cycle. But still there are a lot of headwinds. The major danger that we face right now in the US economy comes from the situation in Europe. Today Europeans came up with a much bigger and more realistic plan to deal with their sovereign debt crisis and their banking problems. Nothing is currently resolved and there is potential from additional problems coming from Spain, Portugal, or others. Currently we are dealing with the Greek problem. Greece, which makes up 2% of the European economy, is a story of the tail that wags the dog.

Nestor Wozny: Even though the current problem is with Greece, how about the potential issue with Spain, Portugal, and even Italy?

Dr. Karim Pakravan: Well, again, every country is different. Italy's problem is high debt. But Italy has a lot of its debt held by Italians. The big problem for countries like Greece and other is that most of their debt was held by foreigners. Therefore, you have a much more difficult confidence problem. Yes, Italy is a big issue. You could think that Belgium is not better than Italy looking at its debt to GDP. Germany itself has a debt to GDP ratio of 80% so it is not terribly virtuous itself. It all depends on perception. If markets perceive that there is a solution, that the debt can be rolled over, you gradually get a return to confidence. That is what the Europeans are trying to engineer. Although very belatedly, tentatively, and in a haphazard manner. Finally, they are getting to where they should have been a couple of months ago.

Nestor Wozny: Returning to the notion of confidence, or lack of, do you feel that unemployment in the US market is one of the main factors?

Dr. Karim Pakravan:  Two big issues for household and consumer confidence are clearly unemployment and the housing situation. One interesting thing is that historically the US labor force had been very mobile. Therefore, people had been able to adjust to regional problems and move from region to region in search of jobs. What is happening right now is that the housing market situation has exacerbated the unemployment problem. Even if there are jobs in other states, which are well paying, people cannot move because they can't sell their houses. These two problems together, the fact that households continue to deleverage and unemployment, are the real issues for consumer confidence. If unemployment starts to come down, if we start creating between 200,000 to 250,000 jobs a month, which we hadn't in the first part of the year, then that would have an impact. You are super imposing the short term or cyclical impact of unemployment and the job market over the longer term issue of deleveraging of households.

Nestor Wozny: Most of your experience is associated with risk management and analyzing country wide risk. Can you comment on the downgrading of US debt by S&P?

Dr. Karim Pakravan: I think the rating agencies are trying to make up for their past sins in the rating of the mortgage backed securities. For the US it doesn't really have an impact. The borrowing costs actually went down. That is partly because so much money is coming into the US as a safe haven. I think this is more meaningful in Europe where they finally rated countries, not on the perception of to big to fail and moral hazards aspect, but according to what the country's risks really are. In the long term this is good because it will give a more nuanced risk profile in the world as opposed to one which countries in Europe seem to be protected by the richer ones. We saw that this isn't the case because right not we are talking about a discount of up to 50% for Greek debt.

Nestor Wozny: We have spoken about US and European economies. Most of your work has been focused on developing economies, particularly those in the Asian continent. Can you provide commentary about that region?

Dr. Karim Pakravan:  Well, Asia is very highly leveraged to world trade and the global economy. Therefore, we are seeing a slowdown in the major Asian Tigers. China, Korea, Taiwan, so on and so forth.  They are tied to the global manufacturing cycle. We are also seeing some problems with Chinese banks, which have been pumping out credit like there is no tomorrow. The difference is that the Chinese government and other Asian countries have significant resources. China has $3 trillion+ in foreign exchange reserves. They are in a position to weather a downturn or slowdown. For China it is not really a recession. China's slowdown is 7% growth as opposed to 10% growth. We are seeing a slowdown, which may be structurally good because it will push the Chinese government to encourage domestic consumption, which is what we ultimately want.

Nestor Wozny: Can you comment on the Chinese government's currency policy?

Dr. Karim Pakravan: The Chinese government is resisting revaluation of their currency mainly due to pressure from the US government in the form of the Schumer bill that passed the Senate, but hasn't reached the House where I'd like it to pass. Certainly this comes back to the issue of global imbalances. You cannot have a system where one government or group of countries, with China being a proxy for the rest of Asia, is running huge surpluses and in exchange accumulating huge amounts of US debt. This system is not viable. The G20, which is meeting in November in the United States, is going to have to revisit this issue. Nothing has been done so far and the Chinese are reluctant to let their currency appreciate. What we see is the US dollar being so much stronger, again, because of inflows of foreign capital into the US seeking safe haven.

Nestor Wozny: Please comment on new policies in the US and Europe such as Basel III, Dodd-Frank, and other policies and their effect on economic recovery.

Dr. Karim Pakravan: Dodd-Frank and Basel III are attempts to address the issue of systemic risk, which was not address in the previous iterations of Basel I and Basel II and the patchwork of US regulations. Overall, Dodd-Frank is a good bill. Banks are complaining that it's going to add tremendous amounts of capital and regulations, but that is their job to complain. I think that if we look at that potential loss of output, there are many studies. Bankers show studies that economic growth would be affected by 0.5% to 1.0%, while the Bank of International Settlements shows a decline of a maximum of 0.2% to 0.3%. If you look at the cost of lower potential growth relative to the benefit of avoiding these huge financial crises, I think on balance it is very positive. As has been argued by regulators, if we have more stable markets then banks will be able to fund themselves more cheaply. There are trade-offs between volatility and stability and shaving a few tenths of a percent from global growth versus these very large fluctuations in output and massive losses that are imposed on the economy. Even the smartest economist wouldn't be able to model the impact because economists look at models by keeping things the way they are. But things change.  If we have a more stable banking system, maybe we will be able to grow faster.

Nestor Wozny: Going a little back in history concerning regulation, can you comment on the repealing of the Glass-Steagall act?

Dr. Karim Pakravan: Repealing of the Glass-Steagall act itself was not a major source of the crisis. The regulators had all the tools that they needed. But they either missed stuff, which is normal due to few regulators and a huge banking system, or they were deliberately told to ignore things. So it is more a failure of regulation rather than blaming it on Glass-Steagall or anything else. For 10 to 20 years before Glass-Steagall was repealed commercial banks were chipping at the corners, getting into investment banking. The real issue is the issue of systemic risk and the regulatory framework did not address systemic risk and allowed a lot of leeway to the banks and to the whole financial system to misprice risk.

Nestor Wozny: With respect to the financial industry as a whole, what do you see for the future, and what do students and alums of DePaul have to look forward to?

Dr. Karim Pakravan: Well, I think we are looking at an industry that is going to shrink in terms of employment. I should say that carefully, because the large institutions are going to shrink in size. As an example, because of the Volcker rule, some commercial banks are closing their prop desk. Also, you will see some of the OTC derivatives being pushed onto clearing houses. Again, you can say that the employment situation in large institutions is going to become somewhat worse. But there will be a shift toward an expansion of smaller institutions, which will be either specialized or commercial banks.  On a macroeconomic level with employment for finance due to changes in regulation we may be shifting more toward manufacturing and industrial institutions. One of the many mistakes that graduates make is getting a degree in finance and wanting to go into financial systems. There are a lot of opportunities in finance outside of financial systems.

Nestor Wozny: Is there anything else that you would like to add that would be of value to students and alumni?

Dr. Karim Pakravan: One of the weaknesses that we have seen in the education system in general is a lack of historical perspective. One of the things that was said about the crisis is that the crisis was caused because most people working in the financial system were under age 40 and did not remember the previous crisis. I think a sense of history is very important. I recently read a very good book called "The Lords of Finance", which was about efforts to return to the gold standard after WWI. That is a fascinating book and I would recommend it to your readers very much because a lot of the issues that they were dealing with at that time we are dealing with today. That was almost 100 years ago. We have a different banking system and different technology, but in the end human nature is human nature. It is a question of incentives and responding to incentives. I would say have a sense of history and also broaden your horizon beyond just the technical aspect of finance and business.