BY CHARLES McCLURE
news@ltview.com
Describing the current world economic climate as “the worst since the Great Depression,” Tom Gilligan, Dean of the McCombs School of Business at the University of Texas, spoke to the Men’s Breakfast Club March 4 at the Lakeway Activity Center.
His speech chronicled the meltdowns as well as subsequent governmental bailouts, but warned the crowd with gentle humor that he was “an economist.”

“Economists have certain limitations, as many people know,” Gilligan said. “First, economists are embittered pessimists and capable of finding a dark cloud around every silver lining. So there is very little that is optimistic that I can say whatsoever. However, we’re almost always wrong.”
Gilligan noted that one famous American economist predicted in the 1850s the early fortunes of the U.S. were not sustainable.
“Of course, he turned out to be wrong, driven in no small part because of the continued settlement in Texas,” Gilligan said. “An economist at the end of the 19th century said it must subside going into the 20th century. Again, the opposite proved true.”
He noted that Nobel Prize-winning economic historian Robert Vogel said that “science fiction writers out-perform economists when forecasting economic progress.” The ribbing helped ease the gravity of his message.
“In a very significant way, today’s financial crisis is directly connected to the enormous savings of countries in Asia and the Middle East during the mid-to-late 1990s,” Gilligan said. “As most of you recall, the rising price of oil prompted large cash reserves in Russia, Nigeria, Venezuela and the nations in the Middle East. Their productive economies, along with their strong regimes where they can actually think about getting their investments back, contracted a good portion of these reserves, as foreign investors purchased low risk assets [in the U.S.], such as Treasury Bonds, government-sponsored debt such as Fannie Mae and Freddie Mae, as well a riskier assets like mortgage-backed securities.”
Gilligan believes the global savings glut laid the foundation of most of the current economic challenges.
“From 1986-2007, the developing countries of Asia, Eastern Europe and the Middle East went from a combined deficit of $82 billion to a surplus of $762 billion,” Gilligan said. “That turned those nations around from being net-importers to net-exporters of goods and services. Most of these surplus funds found their way back from the developing countries to Europe and the U.S. So a lot of the world accumulated a lot of cash reserves, but didn’t spend them because the didn’t spend the money in their respective countries.”
Instead, that money came back to the U.S. and Europe as investments, which in turn, was spending money on its citizenry in the form of social programs, education and infrastructure.
Gilligan said the U.S. economy is worth about $14 trillion annually.
“No one truly understands how much that actually is,” Gilligan stated. “For example, the Marshal Plan, the program the U.S. launched to rebuild Europe after World War II, would only cost about $150 billion in today’s dollars. That’s ‘billion,’ not ‘trillion.’”
Gilligan said much of the current economic crisis could be traced to the monetary policies of the Federal Reserve during the first part of the 21st century, which was predicated on the NASDAQ Stock Market after the technology bubble of the 1990s burst.
“Then the low interest rates were continued after 9-11 to combat the minor contraction in the economy,” Gilligan said, “So a lot of money from overseas, combined with a fairly expansionary monetary policy.”
The influx of foreign investments juxtaposed to the expansionary monetary policy had an adverse impact on borrowing in the U.S., particularly in the housing market, Gilligan explained.
“Rates on 10 year Treasury Bonds ranged from 3-5 percent from 2003-07,” Gilligan noted. “The average rate during the previous 40 years was 7.5 percent. So borrowing costs were approximately half of what they had been over the previous four decades.”
Gilligan said the low rates were felt in all areas of the bond markets during that same period, as the yield on 10 year, BAA Investment Bonds ranged from 5.6-7.5 percent, whereas it had averaged 9.5 percent over the previous 40 years.
“So it was cheaper for government to borrow money, and it was cheaper for businesses and corporations and private individuals looking for investments,” Gilligan said. “Meanwhile, credit spreads were also very low during this period. From mid 2003-07, credit spreads on junk bonds fell to historic lows of 2.4 percent, as did spreads on all types of investment-grade bonds. These declining spreads, in my view, reflected the unrestricted declining of risk, setting the stage for our current crisis.”
It was a situation fraught with consequences, Gilligan said.
“Here is how it bit the economy, ” he stated. “The under-pricing of risk and the subsequent credit boom helped create the stock market and housing bubbles we began to observe from the 2003-07 period. By nearly any metric, the valuations of in relationships to earnings eclipsed all known historical comparisons. Although these ratios were below the 2000 tech bubble burst, they were the second largest in history and at levels comparable to the Stock Market Crash of 1929.”
Gilligan said equity prices were about what they were in 1929, but lower than they were in 2000.
“Other than that, there are no historical precedence for how high equity prices got during that time,” Gilligan said.
That ratio would prove devastating in the housing market.
“Housing prices increased by stunning rates,” Gilligan said. “From 1999 onward, growth in new and used housing prices outpaced the growth in rents paid by users of this asset class. Average home prices historically have roughly been about 27 times the annual rate that one can earn on property. By January of 2006, average housing prices were 45 times the price of annual rents.”
The housing to rent imbalance was particularly inequitable in certain regions of the nation —California being a prime example.
“This bubble helped fuel consumption and business investments, while lowering credit standards, and increased borrowing, which we see unraveling today,” he said.
Gilligan noted that trend was particularly evident in the home refinancing rage of the last decade.
“When our housing prices went up, what did we do?” he said. “We refinanced and then consumed the money on important things like a dream vacation to Hawaii. That is the way that asset valuation fuels spending.”
That, in turn, led to the current de-leveraging being experienced in the economy — people have stopped spending and borrowing to pay off their debts.
“That is largely related to the prime mortgage markets, particularly after the middle of 2005,” Gilligan said. “Ordinarily, lower cost to borrowing would be a good thing — except when it is mismanaged or abuses occur in the way these funds are used. This was true in our mortgage markets in general. It morphed into a kind of ‘ponzy finance’ in which only borrowers could only service their homes if prices continued to escalate.”
That caused a fundamental shift in the traditional status of the housing market, as owning a home became a way to “originate to distribute,” rather than an “originate to hold” mortgage model, Gilligan explained. That problem was complicated by excessive reliance on credit rating and complex securities like mortgage-backed securities and collateralized mortgage obligations. In concert with insufficient private sector risk management [the failure of insurance giant AIG is a prime example], public sector regulatory efforts failed, causing many government sponsored enterprises to hold assets that turned out to be far more risky than originally thought.
The situation became so pathological that by the second half of 2006, more than 3 percent of sub-prime loans were 60 days past due within the first six months. Just 18 months earlier, just 3 percent of those same loans experienced an inability to pay on the part of borrowers over a similar period.
“Sub-prime mortgages issued after the first quarter of 2005 were twice as risky as earlier equivalent levels, so the economy was getting very bad, very quickly.” Gilligan explained. “Delinquency rates for both fixed and adjustable rate mortgages have increased. Rates of serious delinquency — defined as 90 days past due — in both prime and sub-prime mortgage are at the highest rates they have been since the Mortgage Bankers Association began collecting this data in 1979.”
Approximately 1 million residences have fallen into foreclosure since the beginning of 2006. Many analysts believe there will be an additional 6 million foreclosures in the next four years. Nearly 20 percent of the home sales last year had been previously repossessed. Another 11 percent of homes sold last year in the U.S. were worth less than the mortgage on the debt, Gilligan stated.
“So in other words, the seller came to the closing with a check to the buyer,” Gilligan said.
Banks hold about a half of the mortgage assets in the U.S. So as home prices rose and debt spun out of control, banks were undercapitalized. Much of the rest of those mortgages were backed by Fannie Mae and Freddie Mac. Many insurance companies also hold equity in the mortgage-related securities. However, the problem didn’t end there, Gilligan said. Pension and Hedge Funds also had substantial holdings in mortgage-related securities.
The crisis didn’t stop at the U.S. border.
“Global institutions that invested in these mortgages have reported $1 trillion in loses,” Gilligan said. “That is about one-14th the size of the U.S. economy.”
Many prominent financial institutions have failed in the wake of mortgage mess.
“Many storied financial institutions failed and were subsequently swallowed up by others,” Gilligan said. “Those remaining institutions have tightened standards considerably, reducing liquidity and the availability of credit to households and businesses. Commercial credit had also diminished, reaching historic highs. Private market rates have contracted very substantially.
“Even tremendous infusions of funds public sector have only managed to return capital markets to their pre-1995 level of activity,” Gilligan said. “The lack of lending is having a substantial impact on the economy.”
The problem is particularly being felt in the ability of businesses to obtain short-term loans to meet financial obligations, which also are having a big impact on the contraction of the economy, Gilligan said.
In essence, he said, major investment banks are leveraged roughly 25-1 – in other words, they hold extremely risky portfolios with what amounts to only 4 percent down. The portfolios of commercial banks are not in much better shape – and are leveraged at about 12 percent — or 8 percent down, according to Gilligan.
“It is like going into a casino, putting up $4 and someone gives you $200, and says ‘go play,’” Gilligan said, revealing the stark truth of the current economic debacle.
Investment banks have particularly been hit hard by the credit freeze. These banks were literally barrowing money every day to finance debts, Gilligan said.
“So the financing of their operations, thus, depended on liquid credit markets, which dried up literally overnight,” Gilligan said. “It [short-term credit] ultimately disappeared.”
Gilligan said the state of banks is somewhat reflective of the savings and loan scandal of the late 1980-90s, fueled after interest rates ballooned to double digits in the late 1970s. Eventually, the federal government stepped in, but those thrift organizations failed anyway, defaulting to the Federal Deposit Insurance Corporation [FDIC], which was forced to pay the depositors in full.
Gilligan worked in the Reagan Administration during the early 1980s. The nation, in those years, was in a protracted recession stemming from the late 1970s.
“It was an interesting time,” he recalled.
Because of political interests, laws were changed, allowing S&Ls, only $30 billion undercapitalized at the time [1982], to invest in “virtually anything.” FDIC, in turn, increased its guarantee to accounts from $40,000-$100,000. However, the rust had already cemented the gears of the S&Ls, and the federal government was ultimately forced to step in and take them over at a cost of $150 billion to taxpayers.
That, in comparison to the current crisis, is the proverbial drop in the bucket, even the situation is similar, Gilligan noted, in that the government “waived its magic wand and said, ‘you are not insolvent, continue to function my son,’” when the S&Ls were, in fact, insolvent.
So how bad is the current recession? Gilligan said there have been 11 recessions in the U.S. since World War II. All have lasted less than two years; others have lasted for even shorter periods. The current recession began 15 months ago and gross domestic product [GDP, the total market value of goods and services produced annually] measured over time for prices, tells a partial story of the changing economy.
“Last month, the National Association of Business Economists issued a forecast of a 5 percent decline in GDP in the first quarter of this year,” Gilligan said. “But the annual decline in the last quarter of 2008 exceeded 6 percent. A 2 percent contraction is predicted for the next quarter [the second quarter of this year.]
“Now for the dark part — we hope — the group is predicting a return to growth in the second half of 2009, although at a very low rate,” Gilligan warned. “Many people consider this forecast to be rosy. But even if you believe the current recession, when all is said and one, will be amongst the longest and worst in post-World War II history — I would say that is the best bet.”
He said some economists predict that unemployment could reach double-digits for the first time since 1980s, but the overall picture more historically parallels the early 1950s.
“We are in unique territory where post-War recessions are concerned,” Gilligan noted. “All economists have missed, to some level, the [severity] of the current contraction. For example, this current quarter’s contraction is roughly four times larger than predicted just four months ago.”
Gilligan said Federal Reserve Chairman Ben Bernanke predicted the current recession could end in late 2009 “only if actions taken by the federal administration and Congress are successful in restoring some measure of financial stability.”
“I think recent Stock Market activity indicates that Chairman Bernanke’s hopes will be dashed,” Gilligan predicted.
However, it could be worse, and it is overseas, Gilligan said.
“Economies around the world are in even worse shape,” Gilligan said. “GDP in the Euro zone and Japan are declining at a rate that exceeds 10 percent a year. The emerging economies are doing even worse. Dramatically lower imports are a large part of the contraction overseas. If you read stories about the economy in China, you will see numbers like 70,000 factories closing and 20 million people being put out of work. They built for our market and our market is contracting. That is having a dramatic effect overseas.”
Just when things were sounding grim, Gilligan peppered the crowd with a joke.
“I was going to say that this recession would be the worst we have seen in our lifetime, but looking out on this crowd I am going to have to modify that [in reference to the number of retirees in the audience, many of whom could remember the Great Depression],” Gilligan said.
The laughter helped ease the mood, but didn’t temper the forecast.
“It is clearly the worst economy since the Great Depression,” he said, and the laughter stopped. “More people are going to be unemployed for a longer period of time at a significant cost to the economy and, more importantly, human well-being. This realization, together with the troubles in the evident in the world financial system, causes many to see similarities between our current economic situation and those of the Great Depression.”
As bad as the economy appears to be, Gilligan said “no one is predicting that this will be anything like the Great Depression, when we saw 20 percent unemployment.”
He said he has worked personally with Bernanke, as well as Christina Romer, who is the head of President Barrack Obama’s Council of Economic Advisers.
“Both are experts on the Great Depression, and their approach to government policy on this problem is largely conditioned by that,” Gilligan said.
He said the government’s response to the recession has been essentially ineffectual, and noted that net losses by the end of this recession could reach $10 trillion. Meanwhile, consumer spending could fall $355-$500 billion per year — approximately 3.5-5 percent of the GDP — and that is what he categorized as a “conservative estimate.”
“The contractionary spending habits of consumers is primarily responsible for what we are seeing now,” he noted, which is a direct result of the housing collapse. “Justifiably, people are saving more, spending less and reducing leverage. I don’t know about you guys, but I have friends that are wealthy beyond historical precedent that are canceling vacations. When I ask them ‘why,’ it has a little to do with caution, and more to do with the social stigma and profligate spending in a time of economic hardship for their friends and neighbors. So there is just a different attitude that people have about spending these days.”
He said virtually all markets remain “relatively hostile,” and that as consumer demand continues to fade, businesses have little incentive to invest.
“Regardless of what the government does — private consumption and investment — the two biggest components of the GDP, will be depressed for the foreseeable future,” Gilligan said. “No amount of deficit spending by the government can replace these losses. Quite properly, the government’s approach is predicated on the belief that this current economic climate is the most is the most serious threat to global prosperity since the late 1920s and the early 1930s. Their approach is also predicated on the belief that many of the programs adopted during the Great Depression had little to no effect on the depths or the economic recession. Rather, the lack of liquidity and the contractionary monetary policy deepened the prolonged the depression. Only the return of the liquidity through devaluation of the dollar in comparison to gold will return growth to the economy.”
That is what Romer believes, he said, noting that she is the chief of President’s economic program. He also categorized the President’s latest stimulus package as “a jobs bill, intended to employ during a time of high unemployment.”
“The Fed has responded by lowering the targeted federal fund rates — the overnight rates — to essentially zero,” Gilligan said. “The Fed has also assisted in the provision of liquidity to foreign federal banks and borrowers, as well as key credit markets. So the Fed is actively helping central banks around the world by making certain that international trade flow still exists. The Fed is also literally buying commercial paper — they are lending money to corporations. And lastly, the Fed has expanded its traditional open market operations, buying and selling low maturity government bonds to the purchase of long-term miscellaneous securities.”
In essence, he said, the Fed had purchased about $29 billion of assets in long-term maturity that once belonged to Bear Stearns, before it failed.
“It is very unusual for the Fed to have long-term maturity assets on its balance sheets,” Gilligan said. “The Fed’s balance sheet has grown from $869 billion in August of 2008, to roughly $2.2 trillion. The Fed’s performance has been, I think, exemplary to date. It has been very aggressive and complete in dealing with these problems — but they will also have problems in the long run in dealing with inflation with these problems.”
The Men’s Breakfast Club meets Wednesdays at the LAC at 7 a.m. John Schneider of Schneider & Associates, Inc., will deliver a speech called “Wate Planning in Texas” on March 18. For more information call Dennis Brown at 261-1494 or e-mail dennis.brown1@worldnet.att.net.