By Jake Uitti, Special Writer
Despite a swooning economy, job loss and a credit crisis with some of the world’s largest and most important financial intuitions, Princeton University Economics Professor Mark Watson remains confident that America can — and will — work itself out of its economic troubles.
”I’m confident this will be cured,” he said in an interview with The Packet on Nov. 6. “The question is how much is it going to cost us?”
The credit crisis, he explained, was spurred by sub-prime mortgage lending, where financial instructions lent money to those who, it turned out, couldn’t pay the loans back. The institutions then were left with “risky” assets, which were bundled into packages and sold to institutions like Lehman Brothers that many thought couldn’t fail.
”The finance communities,” Professor Watson said, “thought that they got very smart in bundling these mortgages and really treated much of the risk as pooled risk, idiosyncratic risk, and that turned out to be wrong.”
What they didn’t consider, he said, was the strong interdependence between all of these economic factors.
”There’s two things going on,” he said. “No. 1, they didn’t understand — and of course this is easy to say now, it’s sort of Monday morning quarterbacking — but what they didn’t understand or take into account or model correctly was the co-variation amongst this. It’s not as if one fails and it’s unrelated to another. But if one falls there’s sort of a domino effect.”
The other contributing factor was that the bundles were then re-sliced, making them harder to comprehend as singular entities.
”It’s not as if your mortgage at the end of the day was held by one person,” he said. “It also made them quite complicated. Understanding what circumstances these things were going to go under was hard. Even sophisticated people on Wall Street just underestimated the amount of risk.”
Professor Watson said over the past few months, as a result of this risky trading, capital held by banks was misrepresented. And when the value of the assets fell, banks holding the “toxic” assets began to lose the confidence of other lenders, which lead to an economy that quickly collapsed in on itself, resulting in the American government’s $700 billion bailout.
But what exactly was the main goal of the bailout?
”You have to put new capital in (the banks),” he said. “Part of the government plan is to take an equity, or ownership, position.”
This position, he said, will give the banks a financial cushion with which to lend to other institutions — other banks and small businesses, for example — in order to stimulate the economy again.
Part of the public money will also go toward making a market for the “toxic” mortgages.
Banks, hedge funds and insurance companies weren’t regulated properly, he said, which caused much of the problem. But, Professor Watson added, Federal Reserve Chairman Ben Bernanke, a former resident of Montgomery Township and colleague of Professor Watson’s at Princeton, has a deep understanding of how economies work and, Professor Watson believes, is equipped to get us out of this crisis.
”Ben is a communicator,” he said. “I think Chairman Greenspan was more of a discretion kind of guy, not wanting to tie his hands. I must say, during this time, during this crisis, we couldn’t have picked a better guy than Ben Bernanke. He does deeply understand what went on in the Great Depression and what can happen if things like this can get out of hand.”
Professor Watson noted that the events of 2008 make up the biggest financial crisis he’s seen in his lifetime.
”It seems as if we may have headed this off,” he said, “but we haven’t seen a crisis this potentially big since the Great Depression.”
Professor Watson’s optimism regarding the American economy is tempered with a sense that we are only at the beginning stages of correcting the crisis. More work needs to be done, he said, and there won’t be any quick fixes.
”We’re going to see employment decline for the next three or four months,” he warned.
Changes need to be made in order to rebuild and regain confidence in the American economy, he said.
”You’ve got to go in and regulate our banks and make sure they’re not being too risky,” he said.
President-elect Barack Obama, Professor Watson noted, is looking to some strong economic advisors to help the country through the next few months, and years, of this crisis.
”He’s looking at very good people,” he said, citing Larry Summers, Paul Volker and Allan Blinder as possible advisors.
Now is a turbulent — and interesting — time, Professor Watson admitted. One, he believes, America should find it’s way out.
”We’re going to cure this,” he reiterated, “but I, like all economists I know, want to make sure we cure this while not rewarding the guys who made these bad investments. They made money for a long time by investing in risky stuff and now they need to take a hit. So they should get zero. If we’re going to cure this, we have to make sure we cure it right.”
