After the Fall: A World Transformed? - Part 1

Panelists: Amy Gutmann, moderator, Jennifer Amyx, Harold Cole, Don Kettl, Richard Marston, David Skeel

Amy Gutmann: Good afternoon, and welcome to the Inaugural David and Lyn Silfen University Forum. I am Amy Gutmann, President of the University of Pennsylvania and I will serve as moderator this afternoon. I'm delighted to extend a special welcome to David and Lyn Silfen who are here with us today. Their passion for Penn and their generosity have enabled us to create this and future university forums. David and Lynn, will you please stand up and please join me everyone in recognizing David and Lyn Silfen.

I extend a special welcome as well, to all Penn alumni and friends in New York City who are watching today's university forum at a satellite viewing at our Penn Club. We will have time for questions at the end and we'll welcome them from New York, from our audience here, and we also have extended an invitation to Knowledge at Wharton to send in through the internet any questions they may have.

Now, allow me to welcome and briefly introduce our distinguished faculty panelists. Jennifer Amyx is Assistant Professor of Political Science in the School of Arts and Sciences. Her work focuses on the political economy of East Asia. In 2005, Jennifer received the Masayoshi Ohira Memorial Prize for her book "Japan's Financial Crisis: Institutional Rigidity and Reluctant Change."

Harold Cole is Professor of Economics in the School of Arts and Sciences. His work focuses on macroeconomics and international finance. Hal has also served as a consultant to the World Bank and the Federal Reserve Bank of Philadelphia and has been a visiting scholar at the International Monetary Fund.

Don Kettl. Don is the Robert A. Fox Leadership Professor and Professor of Political Science in the School of Arts and Sciences. He has twice won the Louis Brownlow Book Award for the best book published in public administration. In 2008, Don received the American Political Science Associations John Gaus Award for a lifetime of exemplary scholarship in Political Science and Public Administration.

Richard Marston. Richard is the James R.F. Guy Professor of Finance in Economics in the Wharton School and Director of the George Weiss Center for International Financial Research. His research interests include International Economics and Risk Management. Dick is also a Research Associate of the National Bureau of Economic Research and has been visiting professor at more than a dozen foreign universities.

David Skeel is the S. Samuel Arsht Professor of Corporate Law in Penn Law School. His work focuses on Corporate Law and Bankruptcy. David also writes on Law and Religion and Poetry and the Law. We won't probably have much poetry this afternoon, but we will speak a lot about bankruptcy. He is the author of "Icarus in the Boardroom and Debt's Dominion." A history of bankruptcy law in America. Please join me in welcoming our panel of Penn experts.

Before we begin, I want to thank you all for attending today's University forum. Consider this panel as I do an aperitif intended to whet your appetite for further discussion and deliberation. This event is the first in a series of university forums. This event will bring the expertise of distinguished faculty at Penn to bear on quest, a very important question of local, national, and global importance.

Our topic this afternoon, the financial and economic crisis could not be more timely or more fitting to a great teaching and research university. Our goal, as a university as you know is not only the creation but also the transmission of knowledge. Let me just introduce the big topic this afternoon. America's financial house is not in order. Today we find ourselves in the midst of the worst economic crisis since the Great Depression.

News about the economy grows more ominous by the day, and as President Obama noted last week the wrong actions or inactions could easily turn a crisis into a catastrophe. As governments around the world react and work feverishly to prevent their economic houses from collapsing altogether, we must bring the best minds together to assess the situation and begin imagining what the world will look like after the fall. Let's begin.

I've come prepared with some questions for our panelists and my job is going to be to ask some pointed questions and keep this moving from the causes to the effects of the crisis. Let's begin with a question that's on everyone's mind. How did we get here? Are we in another Great Depression? Somebody who's studied the Great Depression, Hal Cole, you're on.

Harold Cole: Okay. I'm on. What happened? Well, I'll give you a brief chronology that I've written out to remind myself of what happened. Around the time of the Great Depression, mortgages were typically short about five years, households rolled them over. This system worked well as long as there wasn't a financial problem, because then what you'd get is a rollover crisis and suddenly households would be asked to repay these mortgages and try and sell their house, they would be unable to do that.

We created entities to develop long run lending, which was Fannie and Freddie, and those entities, the idea was that the banks were unwilling to issue these long-term mortgages because they're worried about the risks of having their deposits show up and try and claim their deposits at short notice. These, especially the first one Fannie was created to buy up these mortgages off the bank's books and now make them liquid, and it created a liquid secondary market for these mortgages.

Originally, the idea was the mortgage market would be pretty limited--limited to what were called prime mortgages--which were very creditworthy borrowers, only a limited loan-to-value ratio. What happened over time is those standards were gradually eroded in a variety of different ways. We had the creation of the subprime market and very high loan-to-value ratio mortgages were issued.

We get a building up democratization of housing. We're trying to make everybody able to buy a house, which generates with low interest rates kind of a housing bubble, which eventually peaked in about 2006 and with a revision downward in housing prices. This created a bunch of bankruptcies on the balance sheets of a bunch of investment banks and now a lot of insolvency in our banking system.

Amy Gutmann: President Obama gave his team a book by Jonathan Alter, gave every member of his team the book entitled "The Defining Moment: FDR's Hundred Days and the Triumph of Hope," sound familiar, hope, right? Many experts though we know say that the Second World War, not the new deal ended the Great Depression. How useful are comparisons between the crisis that FDR inherited in the crisis today and if the comparison holds, are we saying we need another world war to get us out of this fix? Not to put too fine a point on it. Dick, you want to take a stab at this?

Richard Marston: I'm not sure the FDR experience is one we want to repeat. We did go through a very long period during the 1930s with great difficulty. The economy never really did recover.

Amy Gutmann: I think that nobody was here during those days but we've read a lot about it. Yes.

Richard Marston: As you said it was really the Second World War that took us out of the depression, but we've been through a number of business cycles in the last … Well, since 1946, and actually, we've been through 9 from 1950 until the present one, 9 in all. I must say the last two recessions weren't very serious. They were serious if you lost your job, but for the economy as a whole, they weren't very serious recessions.

The 1980-82 recession was a very serious one. We ended up with over 10% unemployment and the 1975 recession was also very serious with very high inflation. We're entering a period where there's at least a reasonable prospect that we're going to have a downturn as serious as we saw either in '75 or '80-'82. Certainly, going to be more serious than the last recession.

The basic reason is, as Hal has talked about is that, we've had the housing market collapse. It's a very important asset for a lot of American households. Let me just give you a couple of figures about… There's a very good index of house prices that are actually based on actual house transactions through time. You watch the same house through time to see how the prices have changed. The country as a whole since the peak, house prices are down 25%. In some parts of the country, they're down over 40% such as in the Miami area or in Las Vegas.

In Pennsylvania, we're boring. We never went up in the first place, and so we're not going down very far. You look around this community and you don't see foreclosures, you don't see many for sale signs, you don't see the distress that you see in other parts of the country. In Florida, most of Florida is in extreme distress. This is very serious because it means a key aspect of household finances collapse for the American family.

On top of that, of course, the stock market is down almost 50%. You have wealth in this country very substantially affected and, of course, that affects the consumer sector. That's one of the reasons why we're a little worried about whether or not this would be substantially deeper recession than we saw either in 1990 or the recent recessions.

Amy Gutmann: Let me push on this point. The point is best I think asked in a question which is, "is Obama's world so different from FDR's that the comparison becomes a moot point?"

"Economists' estimates of the multiplier effect of government spending and tax cuts vary very widely, with equally reputable studies as far as I can tell showing opposite results. More important, the scale of the global slump means that historical multipliers may not mean very much." That I've just quoted from The Economist of January 29, 2009. Does the scale of the crisis, of this crisis, bring us back to the drawing board or can we learn something from the Great Depression? Should we try Don?

Don Kettl: The comparisons in some ways are useful, at least, in a political sense. There's this incredible instinct and credible drive to try to move in the first hundred days to try to change the way people look at the world, but there are a couple of things that are fundamentally different this time. There is always the problem of how much the economic realities match people's own perceptions, but at least in terms of perceptions, there's a sense that first, this is big and broad and global, not that the depression wasn't, but it hit and it hit universally very quickly.

There's a sense of the news cycle out there, which tells everybody for better or worse how, well things are doing. Secretary Geithner gave his address at his press conference last Tuesday and the market responded badly almost instantly. There's this up or down vote that happens just because the way the news cycle operates. There is the sense that as everybody watches the news they get a sense, even if they're not bad off themselves that everybody else may be, that the anxiety about losing their job spreads very quickly around as well. It tends to spread the anxiety around a little bit more.

There's also a sense because it's rooted in housing and spreading to banks that it's unclear where it is the people are going to go. There are people who've spent their entire lives trying to save for their retirements, to try to put money in their houses and it's not clear what is safe anymore as well on top of that. In some ways, the comparisons historically are kind of interesting but in terms of how deep, how broad, how really fundamental this is, there's one question about whether or not this is basically a financial issue, whether it's a banking issue, whether it's a stock issue but it's a real issue for so many Americans because it feels real, because they've been told that it's real and because the global and the media events reinforce that as well.

The economics of it quite apart is putting tremendous political pressure on Obama to act in very similar ways to what had happened with FDR.

Amy Gutmann: Hall, you agree?

Harold Cole:  No.

Amy Gutmann: That's why I called on you. I had a sneaking suspicion you wouldn’t.

Harold Cole: First of all, I want to emphasize something that Dick said. I only disagreed that you didn't say it strongly enough, which is the standard of comparison should be post-war recessions. There are post-war recessions at this point in time through this length of the cycle, which looks substantially worse than what we've seen now. The comparisons to the Great Depression, frankly, in turn, really, I don't want to be insensitive or something, but they're ridiculous. I just want to give you …

Amy Gutmann: Not to put too fine a point on it.

Harold Cole: Yeah. Just go off the deep end right away.

Amy Gutmann: Take that Alter book back and put…

Harold Cole: I just want to put some numbers up.

Amy Gutmann: Okay.

Harold Cole: The trended output per adult was down 42% and…

Amy Gutmann: Say that again.

Harold Cole: … down 42% in 1933 relative to 1929, 42%. In 1939, it was still down 26.5%. These are numbers that Dick knows. Now just to give you an idea. What is output down relative to peak at this point? Forget about … I'm not de-trending or anything. It's 0.2%. Now, employment is down but even in the comparisons of employment the numbers are just much, much bigger during the depression and it was a decade disaster.

Amy Gutmann: Let me just give you another quote here. Last week International Monetary Fund Chief Dominique Strauss-Kahn caused a stir when he said that the world's advanced economies, the US, Western Europe, and Japan are "already in a depression." Is this more than a financial crisis? Is this truly a broad economic crisis or should we be less concerned than it appears? Everybody is.

Harold Cole: They're bad numbers. There are some bad numbers out there, and their finance numbers, and so, if you want to see some frightening numbers you look on the finance side. This picture right here just to be clear to everyone. The red line is, since the peak, the peak is zero. The red line shows what's happened to real GDP in our current downturn. You'll notice what happened was we actually grew from the peak. We can debate whether they got the peak right, but you actually grow in terms of output, employment shrinks.

The blue line is what happens in a median downturn from the peak, and then, the black line is in the harshest. If you look at employment, I was limited on my figures. Employment is down, and then, what's actually below, our recession is now currently below the median, but only slightly. You get a sense that the bad numbers are finance numbers.

Richard Marston: Can I try to clarify further? I actually agree with everything that Hal says. The recession actually began in September. We've had a financial crisis for a year and a half. It got really serious this year, and then, in September it got terrible. September was the month when Lehman Brothers failed. September was the month when the US government had to take over AIG, the largest insurance company in the world. September was awful, and as a result of the financial crisis in September, all of a sudden consumer confidence fell, business confidence fell.

In my view, that's the beginning of the recession. Now, the NBER's committee has told us that the recession actually began in December of 2007. You can see some evidence for that, but the real drop in the economy occurred in September. That means that Hal's figures are showing you a delayed recession. That's actually the truth, that the recession began five months ago. Let me just give you some employment numbers, and I think there's an employment graph that may be available.

Amy Gutmann: Just came up.

Richard Marston: Just came up. Over the last year since the beginning of 2008, we've lost 3.5 million jobs. In the last five months in September, we've lost 2.5 five million, 2.5 million. We lost 600,000 jobs last month. The economy turned down in September in a very dramatic way. Now, we don't know whether it's going to be a long downturn or not. That's the uncertainty.

On the way in here I read a report by the leading economist at Morgan Stanley, Dick Burner, who by the way is a Penn graduate. He said that he thought that he …

Amy Gutmann: He better be right.

Richard Marston: He's usually right. He's usually right. He thought that the recession would end during the winter of 2009-2010. We're just the beginning of it, but so far it is a sharp downturn. You can particularly see it in employment. Now, of course, we lost jobs in the first eight months of the year, but nothing like what we've lost in the last five months. It's been a very dramatic downturn.

Amy Gutmann: Dick has been talking, when he uses the we, he's using the we of the United States, we in the United States have experienced this remarkably sudden and, for us, extreme rise in unemployment. Jennifer, you studied Japan and Asia. What does this financial and economic crisis look like from the Asian perspective?

Jennifer Amyx: Well, Japan saw…

Amy Gutmann: Recognizing there isn't an Asian perspective but compared to what we're talking about is experienced in the United States.

Jennifer Amyx: Well, I think it's very important to think comparatively, and it's not just thinking about the US and other countries, but most of the, if we think about the financial crisis component of this most of the studies of banking crises have to do with the kind of crisis that Japan had, non-performing asset problem. They had a problem in the equity market. The stock market plunged, similar kind of thing.

It doesn't look that different, but the problem is that in the case of the United States the crisis is much larger in scope because it involves securitized assets, which were then sold all around the world.

Amy Gutmann: Why don't you just briefly, what is a securitized asset?

Jennifer Amyx: Oh. Securitized asset. Taking these, how referred to these mortgages and packaging them up and selling them to individuals who have no relationship whatsoever to the borrower. If you go to get your mortgage or to buy a house, you have no relationship to the person who ultimately buys this security but is holding your mortgage in your hand.

These securitized assets that turn bad, these were securitized and spread throughout the global financial system. The repercussions are huge both in scope, but the second element of this is a … that you mentioned September when Lehman Brothers went under. Well, Lehman Brothers, if you look at the global impact in how the crisis spread and is now being thought of more on global terms, up to that point, it was thought of as primarily U.S. and Europeans centered.

The collapse of Lehman Brothers wasn't simply just the collapse of a financial institution. Its collapse represented the undermining of one of the key institutions of credibility of bond ratings around the globe. You have the top rated, most highly rated bonds that are sold out there. There are many decision-making rules that institutional investors have, but they automatically have to sell when certain bond ratings changes. This undermines the whole infrastructure, a part of our capital markets around the globe, not just in the United States. That's a key thing.

But to get back to the Japanese comparison. One thing the US has done well is recognize the problem quickly. Japan didn't do that so well, but the United States is not in such a well-positioned, you might say, is not as well positioned as Japan going into this crisis in some respects. Japan had high savings rates for years historically, and that creditor nation the debt was to Japanese households, not to the rest of the globe, and the US instead has near zero household savings, massive leverage for years, net debtor in the world.

We're relying on the kindness of strangers or foreign investors to help us out of this crisis or to finance the stimulus that will be needed to help bring us out of this recession. One of the key things we did right was recognized the crisis quickly, but I think we can learn from the Japanese case that it's actually a long process in terms of cleaning up even simple bad assets. The Japanese case was a case of very simple compared to what we see today in the United States.

Basically, 20 large commercial banks were the heart of Japan's massive problem that led to a decade and a half of recession, and largely because of the delay in dealing with that it dragged, it led to this impossible outcome but …

Amy Gutmann: Here this isn't the Great Depression, yet the scale and scope seems to have expanded greatly from the initial mortgage crisis into a large-scale financial crisis into a big uptick in unemployment. Here's my question, and David, you're on for this question. Many of us wonder, how deep the rabbit hole we're in? On February 1st Tom Friedman wrote the following, "We have woven such a tangled financial mess with subprime mortgages wrapped in complex bonds and derivatives pumped up with leverage, and then, globalized to the far corners of the earth that much as we may want to think this soon will be over. This is highly unlikely."

Now, Tom Friedman is not sitting and a position of governmental authority, but the question he raises is when will we reach the bottom in unemployment mortgage and loan defaults and declining GDP. How long is this going to last? How can we figure this out?

David Skeel: I think that…

Amy Gutmann: Since the Great Depression--we don't want, we don't think, according to this panel of experts--nobody thinks that what we're going to do is repeat the Great Depression, in part, because we've learned from Japan if nothing else that the government has to move quickly, but how long is it going to last?

David Skeel: I think the honest answer is none of us knows how long it's gonna last, but I think something like a consensus answer is, nobody thinks it's going to be over soon. It's not going to be two or three months. It's going to be a year, two years, three years, four years. I think we'll be in this for a while. Another thing that Friedman quote raises I think is the regulatory implications of all of this. I want to put in a quick vote of confidence in the comparison or not really a vote of confidence, but vote in favor of the comparison to the new deal.

One place where I think this crisis does look a lot like the new deal, is in the new deal,  are financial services, and our securities markets got, the regulation got a stress test, and they failed that stress test. It was clear that in the 1930s, our banking and securities regulation were not up to the task of overseeing the problems of the time. That quote brings out the fact that we're in exactly the same kind of position now. Our financial services regulation is not prepared to deal with this kind of a crisis.

What I'm really looking for in the Obama administration in the coming months is the stimulus obviously is critically important but what are they going to do as a regulatory matter? In the Jonathan Alter book about the first hundred days, it's one of the things that it really focuses on a lot is how much energy the Roosevelt administration put into regulation. Now, why is that important?

Well, one reason it's important is one of the questions we need to be asking is, are we going to have another crisis like this in 10 or 15 years? If we don't want one, what are we going to do to try to prevent it?

Amy Gutmann: We need to talk a little bit more about the bailout and stimulus and regulation, but before I just want to take a quick survey. How long is this going to last? By last, if you ask me, what do you mean by last? When are we going to start seeing a steady upturn in the economy? Just quick. No long sermons just how long is it going to last? Put you on the spot, Jen.

Jennifer Amyx: A couple of years.

Amy Gutmann: A couple of years. Hal?

Harold Cole: Hang a second. I got my facts here. I want to bring those …

Amy Gutmann: The facts have to give you an answer Hal.

Harold Cole: Why am I optimistic? I'll be optimistic so, output is barely down despite the fall in employment, productivity is up. The slope on the employment declines is bad as Dick as emphasized but if we don't think that that lasts too long, we've got some good news lately. January retail sales were up 1%, sales of existing homes went up.

Amy Gutmann: Six months, a year?

Harold Cole: I'm going with the blue-chip forecasters. First of all, they're professional forecasters I'm not. They argued the economy will turn around by the end of the year. I think there should be a lot of uncertainty with that forecast …

Amy Gutmann: Nine months?

Harold Cole: Sure…

Amy Gutmann: You all should write this down with names attached to it. Two years, nine months, Don?

Don Kettl: Two years but this and the consequences occupy all of the first Obama term.

Richard Marston: Let's talk about students. You want to hope that you're a sophomore because as far as jobs are concerned…(laughter)

Male: Those are the sophomores clapping out there…

Richard Marston: As far as jobs are concerned, jobs always lag behind the end of the recession. I think it's going to be a bad job market through 2010. A bad job market through 2010.

Amy Gutmann: One year and nine months?

Richard Marston: Be a sophomore. Do not be a senior. The seniors already know that. The juniors, they know it's coming. Next year is going to be a very tough year for jobs.

Amy Gutmann: If you're a junior and senior, consider graduate schools sooner rather than later, right?

Richard Marston: Yes.

David Skeel: I had a different instinct on that answer for my law students. My answer was be a bankruptcy lawyer now. I would guess a year and a half to two years. I don't think we're going to be out of it this year but next year I think we'll start seeing some effects.

Amy Gutmann: We have one optimist, who may be right. We all hope he's right and…

Harold Cole: But I want to be a little bit careful about what that means is…

Amy Gutmann: This wasn’t…

Harold Cole: No. What it means, where is the bottom? Dick's point…

Amy Gutmann: Do you want to hedge your bet?

Harold Cole: No. What I'm saying is, imagine that I'm right that some time out, near the end of this year we hit the bottom and it turns up, Dick's point is absolutely right and well-known, and then, we also have the fact it's going to take a long time to unravel the financial mess. The quote by Friedman… You can address that better than I can.

Don Kettl: My point is it a V with a sharp down and a sharp back up or is it a U with a long bottom, and that's… The only answer to that nobody knows.

Amy Gutmann: Right. I asked when it will start going steadily up.

Jennifer Amyx: I think if we look at…

Amy Gutmann: It's a different question of how long. Let me go on to the bailout and stimulus because I think it's really important. We're going to make our way to what the world, this panel thinks the world will look like at the end. But governments around the globe have taken unprecedented action with major ramifications for markets, however, as recently as last week, Treasury Secretary Timothy Geithner said and I quote, "That when the crisis began governments around the world were too slow to act. When action came it was late and inadequate. Policy was always behind the curve, always chasing the escalating crisis." How would you rate our government's actions so far? Don?

Don Kettl: It's a middling C at best but the problem is that the problems as Friedman and everyone else has pointed out is that first, we slid into this by failing to regulate the investments that we're out there. There are all these securitized mortgages, all these things getting bundled together. In many ways as a product of government policy that was designed to try to encourage more people to buy homes, which is a great idea, but it encouraged people to buy homes they couldn't afford to be able to maintain.

We didn't regulate the securities very well. We made what now it becomes clearer a series of mistakes in deciding what to bail out and when as we entered all this process. We are now in the process of a bailout package that President Obama has signed that in all likelihood cost us probably hundreds of billions of dollars more than what is actually going to deliver genuine stimulus in the short haul.

We haven't really begun to deal with the real and fundamental long-term questions about how to try to manage the risk that we have in the banking and the financial structure, and probably most importantly, we haven't grappled with the fundamental question about just how deep and how long and how lasting is government's involvement in the financial sector going to be? Just how big of a bite is the federal government going to take out of the decisions that individual financiers are going to be allowed to take as we move forward?

Amy Gutmann: A lot of people point to what Japan did wrong. Are there lessons to be learned from the do's and don'ts of what Japan did and didn't do?

Jennifer Amyx: Mostly lessons of what not to do.

Amy Gutmann: Can you list a few things about…

Jennifer Amyx: Sure. Japan had five injections of capital into banks, public funds into banks. One clear lesson is, has to do with re-capitalization of banking institutions is that the government needs to conduct due diligence. In the Japanese case that actually involved, in the case of two really large financial institutions, temporary nationalization of those institutions so that they could then be resold very quickly to private investors at that time. That was one key thing.

The other thing was that during this period after the burst of the bubble in Japan, massive amounts of money were spent on fiscal stimulus. It didn't work, it didn't bring Japan out of the recession.

Amy Gutmann: We shouldn't be spending massive amounts on stimulus?

Jennifer Amyx: Well, I think one lesson is that it needs to be done judiciously. At the time in Japan, Japan's governing party was undergoing a period of incredible volatility. The greatest period of fluidity and party politics [inaudible 00:33:31] in the post-war era and that meant that this injection of public, the money, this fiscal stimulus that was being used was being directed in very political ways and really had nothing to do with the vision of where the economy or the…

Amy Gutmann: Our Congress doesn't direct anything in political ways, right?

Jennifer Amyx: I think very simple lessons though in terms of thinking about where that money is going.

Amy Gutmann: But seriously, given that we're now depending upon the federal government and the Obama administration and Congress to help get us out of this and as David Leonhardt in The New York Times said the epicenter now of our economy has shifted to Washington and Congress as a democratically elected body, is the lesson here that they have to put politics aside and is that possible?

Don Kettl: It's never going to happen. Politics is the immutable fallout there. This is about the question of what kind of risk citizens should be allowed to take on their own and what role the government's going to play to come and help them out? The real problem is that we've been playing the wrong kind of politics so far. We've allowed this debate over the stimulus to dominate everything else and we've spent a lot of money that we probably didn't need to, to get stimulus that's not really going to help very soon instead of trying to work on trying to fix the banking system because the stimulus is not going to matter unless the banks get fixed. Ultimately, none of this is going to matter without focusing on the central problem that frankly nobody really knows for sure how to attack well now.

Amy Gutmann: A lot of people who study this agree that we have to get the financial crisis address before the real economy is going to recover. The Federal Reserve has lowered interest rates to historic lows but it doesn't look like lower interest rates have worked this time. Dick, has the Fed done anything right that will help and does it have anything left that it can do?

Richard Marston: Actually, I'd like to give an A+ to the Fed. I want the last graph here will help us understand…

Amy Gutmann: Either Don has a harder grade or the Fed…

Don Kettl: I would give the fed a good grade…

Richard Marston: Wharton professors always give high grades. The Fed lowered interest rates from five and a quarter to close to zero percent. It didn't work. As a result of the lowered interest rates, the banks didn't lend any more. There was no expansion of credit. The Fed went back to basics and it said, and by the way, it's led by an expert on the Great Depression. Ben Bernanke did a lot of his academic work on what the Fed did wrong during the 1930s.

The Fed has basically rewritten its rule book in the last five months. You can see this balance sheet of the Fed. Fortunately, Congress doesn't know about this so don't tell them but the balance sheet of the Fed has gone from $900 billion traditional central banking where what you do is you basically give loans to banks if they need it. Basically, just provide currency to the general public.

Now, the balance sheet recently was as high as $2.3 trillion. More than a doubling of the balance sheet. Why did the Fed do this? Because it realized the only way it was going to get the short-term securities market to start working is they had to take things into their own hands. Let me give you the best example, commercial paper. Commercial paper's short-term securities that fund short-term cash needs of corporations like General Electric.

In October-November there was no commercial paper market in this country. No one was willing to buy commercial paper. The Federal Reserve decided there has to be a commercial paper market in this country so we're going to provide it, we're going to invest in commercial paper to the tune of $300 billion. In doing so, they restarted the commercial paper market. Today, the Fed is withdrawing from the commercial paper market. It's now on its own.

Similarly, they have provided financing directly to banks on a much larger scale than in any previous crisis. The Fed has been heroic. As a result, the short-term securities markets have come back. The LIBOR interest rate, which is the interest rate that governs an awful lot of loans in this country as well as the rest the world, the LIBOR interest rate was catastrophically high just a few months ago. It's come back down to normal. The commercial paper market was way, way above Fed funds rates. Now it's back to normal as a result of the Fed being innovative, being willing to take action that a central bank doesn't normally take.

Fortunately, they have the legislative authority to do so. That's what the Treasury is going to have to do in the coming months. They're going to have to rethink what they're doing in terms of bailing out the banks, in terms of restarting the securities market. I think we've made a good start with what the Fed has done in the short-term markets.

Amy Gutmann: Great. Dick, you have mentioned the bailouts which are on lots of people's minds and I think you all know that many ordinary American citizens are concerned to the point of being very angry about the bailout of the banking industry. They suspect that the government is taking failing banks out to dinner and leaving ordinary taxpayers with the check. Is this what's happening or as Secretary Geithner assures us, and I quote, "Will the programs outlined in the financial stability plan involve loans, guarantees and investments with terms and conditions that protect taxpayers and help compensate the government for risk." David, you want to take a stab at that?

David Skeel: I'll take a quick and short stab and say I don't feel like we really know yet. The terms of the bailout are still a work in progress but it's quite clear that Treasury is worried about exactly the kinds of concerns you've articulated. Treasury is worried that the perception in America is, we're bailing out the executives of these banks who caused all this trouble. This is why we're seeing these restrictions on executive compensation in the current bailouts.

Now, I'm not a fan of the form that a lot of these restrictions have taken but that's what that's about. That's the two things that Treasury has done to make very clear they're aware of this public concern. The first is they've wiped out shareholders in these bailouts. When Bear Stearns was bailed out, when AIG was bailed out, shareholders were essentially wiped out. The managers with stock have lost the value of that stock.

The second is they're taking measures to try to restrict executive compensation. I think the bottom line is, executives aren't going to have day at the races in this. I think they are going to be punished but it is clear the energy is going at the banks right now.

Amy Gutmann: That's the most visible and the easiest to explain to ordinary citizens, but what will matter more is what at the backend happens with the banks who succeed. How much the government can recover of taxpayer's money and is that been done well?

David Skeel: I think so, so far. A lot of the investments are stock-related investments, are in preferred stock so that if the banks that the government has a big preferred stock position in do well we will all benefit from that. I don't feel as though the government is throwing money away at this point. They're probably things they could do better and there's some problems with the way these things have been structured, but most of them do involve giving the government and giving us some of the upside if there is an upside.

Amy Gutmann: You'd give a grade of?

David Skeel: Maybe a B. I'd hate to suggest there's great inflation at my …

Amy Gutmann: Penn Law doesn’t have great inflation, right?

David Skeel: My main concern has been, not so much with the terms of the bailout so far, as with the inconsistency in the signals that the Fed and Treasury have sent. I want to quibble a little bit with this A+ we're giving the Fed. Maybe we'll give them an A+ for monetary policy, but they've participated in the bailouts. They've really sent mixed signals. When Bear Stearns ran into trouble a year ago the signal was, we're going to bail out big investment banks that run into trouble. When Lehman runs into trouble last fall, suddenly that shifted without telling anybody the signal was going to shift.

My big concern is not so much with what's going to happen with the executives, not so much with how the taxpayer's stake is being structured, as in, what signal are we sending? Are we going to have a policy of bailing these banks out or not bailing them out?

Amy Gutmann: Yeah. That makes a big difference, a bigger difference than a lot of people recognize because the psychology of a recession is very different from the psychology of a recovery, of that you need more certainty to have a recovery than an uncertainty helps drive recessions, right? Here's a big-picture question as we look to after the fall. Are we creating and do we need to create something that might be called a new social contract, a new understanding or at least a better understanding of the relationship between government, the governmental sector, and the corporate sector?

Is that in some sense what we are struggling with to do? Our own Don Kettl recently argued, I've come prepared with very pointed quotes here. I'm not going to ask you this question, Don. I'm going to just quote you. You've argued that, "everyone realizes that this crisis is an historic opportunity to reshape the nation's economy by using government's cash to promote big economic and social goals."

Is Don right? Are the changes in the economy and the approval of massive bailout programs harbingers of a new social contract? Are we witnessing the makings of a fundamental realignment among government, businesses, and citizens? David signaled as such by saying that it needs, more needs to be communicated about what the terms of the bailouts are. Hal?

Harold Cole: Okay. Let me respond with some negatives. Okay? First off, you face a set of problems here which is you have these entities, in particular, take an investment bank and these are facts I think we know pretty well, which is they have a small amount of equity and a lot of debt. If you're told for every $30, I mean for every dollar you put in you can borrow 30 and moreover that $30 is insured so you can borrow it at the risk-free rate. That's a great deal.

I'm going to want to go and borrow that money and take some wild gambles because I have limited liability. This is the problem we start to confront when we confront entities like investment banks where we have insured or we end up insuring the bondholders in those institutions, which is, no longer will debt appropriately price the risk and whatever you insure you must regulate. There's a sense in which the answer is yes if that's the road we go, but that's a pretty negative road to go down in terms of the problems, the regulatory problems that that confronts us with.

I just put that out, and also I was, anyway I was going to contest some other things but that's all right. I forgot I only get so many shots at the…

Amy Gutmann: That's a pretty direct contestation. Jennifer?

Jennifer Amyx: In terms of thinking of the social contract it's not just between government and financial institutions, but I think we have to recognize that we've had an abnormal situation in our country with consumer finance. That there's no society around the globe, no country where you could talk about these subprime mortgages or you could talk about the way in which Americans could get mortgages and have any empathy towards what's happening right now in the United States. It's abnormal. We need to change expectations.

Amy Gutmann: Why is it abnormal?

Jennifer Amyx: It's abnormal because it's been enabled by these financial innovations that have gotten ahead of regulation. They've been able to get away from basically saying that there is no price on that risk, the borrowers. It doesn't matter what your income is, you could be a dog or cat, you could get the same rate at certain levels.

I just think it's very important to recognize that the tough talk hasn't been done to actual citizens of our country yet because that's too political particularly leading up to the presidential elections, but going down, heading down the road in the future this is something we have to think about because you can't, you actually can't have these kinds of security.

Amy Gutmann: That's a really good point. President Obama inaugural speech was widely thought to have emphasized responsibility again. The responsibility of citizens but if there's going to be a new social contract, what does the responsibility of ordinary citizens need to be? We've talked a lot about what government needs to do? What businesses haven't done and need to do? What about ordinary citizens? Is there an important lesson here? Don, you want to defend yourself?

Don Kettl: I do. At least to the point of arguing that a lot of what's going on is about how much risk individuals ought to take as a consequence for their own decisions. You can make an argument that says, "You know what? People who went out and took out mortgages that they couldn't afford they're just going to lose their homes." It's unfortunate, but a lot of them put very much money in, but we don't seem to be able to accept that, and so, we're putting all kinds of backstops in and the next set of policies is likely to be a set of changes that will allow people to help keep their homes even though that in many cases they may have made decisions that weren't very wise and figuring how to defend that.

But it's not just on the financial side. In case after case where we suffer natural disasters, when we flood a city, when we end up having suffered an earthquake, when we try to deal with imported toys that may have lead in them, when we try to think about how to protect our tomatoes and our peanut butter and the food supply, we increasingly are looking to government as a way to try to protect us from the risk, and case after case after case you could see in lots of ways where we're looking to government as a way to try to provide these protections, at the same time, we're talking about the need to assume more responsibility.

There's a fundamental conflict here between Obama's inaugural and the thrust of American policy for the last 15 years, and as some point, we're going to have to come to grips with what the implications for that might be and the financial question is likely be where that happens.

Amy Gutmann: Here's a quote from President Obama. He says, "The stimulus plan is more than a prescription for short-term spending. It's a strategy for America's long-term growth and opportunity in areas such as renewable energy, healthcare, and education." Can the stimulus be both a short-term stimulus and the beginnings of a long-term plan for renewable energy, healthcare, and education? After all, you can get and Obama did get, President Obama, did get a majority of citizens who probably agree that we need more renewable energy, a better health care system, and a better educational system.

Can this stimulus be both short-term and long-term? We are consummately, as a university, a long-term institution. We plan for the long term that's why we have endowment and a real limit on our endowment spending, and we teach because we believe, and we do research because we believe in long-term effects. Can government, can a democratic government take long-term as well as short-term action?

David Skeel: I think you can, but I think it's very, very difficult. I think the balancing act that the Obama administration is engaged in with the stimulus package is most people seem to believe that the stimulus needs to be immediate to be effective. If it's likely to have any effect on this crisis it needs to be immediate. Many of those things that are going to make America better over the long haul such as restoring our energy grid and investing in renewable energy are not things that are ready to go right now. They involve long-term investments.

There are a few happy investments I think that managed to marry those two things. They're ready to go right now and they have potential long-term payoffs, but in many cases, they don't. I think that's part of what the debate over the stimulus was about.

Amy Gutmann: We know that you don't have to put incentives in democratic politics to do short-run fixes, right? Are there some long-term goals that are being served or can be served at this time in the stimulus? You said it's hard. I think we'd all agree. Everybody thinks it's hard.

David Skeel: I'll repeat something I said earlier as well. I personally, and it's maybe because I focus on regulation in the work that I do. I think one of the most important things we can do right now is restore and create new more effective regulation in a couple of industries. In the financial services industry in particular and in some of the corporate and securities areas as well. One of the few silver linings of a crisis is you get popular attention fixed on things like fixing our banking system or fixing our financial services regulation.

You can make changes that will be good for a generation. That's what happened in the new deal. In the new deal, in the first 100 days, Roosevelt passed securities and banking regulation that was good for 60 years.

Amy Gutmann: Let me give you a view that's held by Gordon Brown Prime Minister of Great Britain. He recently said that "we want free markets but we don't want value free markets." Practically speaking I ask what does this mean. What will capitalism look like if government increasingly insulates losers in the economic game as Hal was worried about what we call moral? It's a form of moral hazard. What will government running the auto industry, what are the longer term ramifications of the government's decision to bail out the auto industry which is in progress? What will that look like?

Again, we're talking about what the social contract looks like when government does do more regulation. What are the values and the practical implications of those values of a government that is ensuring the economic well-being of this country? Which other countries are increasingly looking to us, they say as Jennifer pointed out, "The US got us into this mess. Now, you're going to get us out of it."

Jennifer Amyx: It's not just aspect. Other countries are financing this fiscal stimulus in the United States. I think we need to think both about crisis response, when we need to think about this government-private sector relationship and longer-term response. I think…

Amy Gutmann: But that's also part of the global market. They chose to finance, right?

Jennifer Amyx: That is true. That's absolutely true, but I think in the longer term their choices might grow wider and more diverse. It's clear that there's not going to be a dethroning of the US dollar as the dominant currency anytime in the next few years, but in the longer term, certainly, there's going to be a change in the dynamics of power, to some degree, in the world, in the international system.

But I think this regulation side is absolutely critical because that is important in restoring confidence in foreign investors, in our economy, and in making investments, but also, I just want to point out that it's very common for governments to jump in and create temporary financial institutions or entities to jumpstart markets. We've done it historically with Fannie Mae, Freddie Mac. The difficulty and all political scientists know this is to withdraw that support.

Oftentimes we put a sunset clause in and we say it's going to just be in operation for five years or whatever, and then, it doesn't happen. It goes on forever. In the Japanese case, in fact, when Japan finally did get out of its recession and start to turn around until the more recent reversal, the other direction, which really doesn't have to do with its original crisis, it came when the government established Industrial Revitalization Corporation of Japan and tried to jump in and play a little bit of a role in jump-starting corporate revitalization because that was the corporate entities that were the source of the bad debt the banks had.

Many of those companies need to be turned around and the government jumped in and played a little bit of role there, initially, to get that jump started. Amazingly, for the first time in Japan's post-war history it was, the entity was established, it actually made money, and withdrew from the market. That was a successful example. It's very difficult to do, but I think that it's, we have to think about the shorter term crisis response, and then, the longer term relationship between government and…

Amy Gutmann: I want to just go around and I'll start with Hal, who's our very important skeptic to have here about government doing, what government can do? Here's the question I want to ask you. Hal is ready for the answer, right? Here's the question. Name one thing that you think government or industry should and can practically speaking do to make the world and our country after the fall better than it was before.

Harold Cole: I'm going to say we should approach this with a little bit of humility especially the government regulatory side. If we understand where the regulatory failures came from, first of all, we directed Fannie and Freddie to devote their mortgage buying to below median income households. We had this big program, and Jennifer mentions that, to democracies housing ownership. That was an important ingredient and where we ended up. There was another important ingredient which is…

Amy Gutmann: Hal, could I just stop you a moment because that's… I'll underline that point. That was an interpretation of the American dream that became a nightmare. It was a mistaken interpretation of a dream, which is that every person, no matter what their income and their capacity to hold a mortgage, should own a house.

Harold Cole: I don't want to emphasize, just following up on that. Owning a house loads you up with it… To the extent, you put down a down payment, a big financial risk. That's one point to make. A second point to make is what happened in 2004, when the SEC came along and said, "We're going to raise the leverage limits on our…" I forgot how many investment banks that we had at the time, five? I think it was. Which Paulson showed up representing as the head of one of the investment banks.

They then loaded up with the, then their leverage ratios explode and now we sit there with a bunch of investment banks which went through the Great Depression, survived that catastrophe. Now, essentially we have no investment. No independent investment bank.

Amy Gutmann: But Hal, what one practical measure… We're now in…

Harold Cole: I would think we want to go back…

Amy Gutmann: …we're in this dark tunnel.

Harold Cole: …We want to go back to trying to put in place a fairly stark regulatory structure for the financial markets. I think that's the source of our problem, where we tried limit the adverse incentives that people have. Ensuring all risk is a very dangerous thing to do.

Amy Gutmann: Don?

Don Kettl: I guess that is that we're not going to go back to where we were before all this started. Looking ahead, it's going to be a different kind of world. The problem is we're not sure exactly what that world ought to look like. Given the fact we're not sure exactly how to get to where we want to go, and we know we don't want to go back, then how are we trying to get that? That's the fundamental dilemma and I think the key is since we're not sure what the world looks like, transparency has to be the absolute guide to everything.

That the new regulation that we're talking about has got to be based on financial assets that are bought and sold in a way that people know what's in them. That people know what kind of risk that they're taking. That government knows what kind of incentives it's creating, and individuals know what kind of risks they're assuming. We start with transparency given the fact we're not sure exactly where we want to go. Well, at least we know what road we're on.

Amy Gutmann: What would the implication of transparency be, for example, for the bank bailouts or the auto industry bailout?

Don Kettl: It would mean, for example, that if a bank takes $25 billion that it would have to issue at least a report of what it did with the money. It would have to at least tell people what it is that happened. One of the things that has happened because an executive compensation piece is that the public is furious, and it's because, "Wait a minute, we spent all this money and what do we get? We're not sure except the bank executives got a bonus so that's terrible.

More transparency about what happened in exchange for the public money that went in would make a difference.

Amy Gutmann: Keenly focused regulation, transparency. Dick?

Richard Marston: Well, the first thing, the government has to do two things. The one thing we know is that the redesign of regulation will not occur in the first 100 days. The Obama administration is under siege. It has to focus on the first issue, which is getting the banking system back in business and getting the securities markets to start to work.

There's not even a thought of re-regulating the financial sector at this point. Later on down the road, I expect him to be naming Paul Volcker in a distinguished panel to start thinking about how to change regulation in this country. What's the guiding principle? The financial sector is one of the most important sectors of this economy. Let's not screw it up.

On the other hand, we do not ever want in our lifetimes to see a financial crisis like this again. What we are going to have to do is go back to square one. Think very carefully about what is the minimal regulation which will allow us to have a thriving financial sector, it's the leading financial sector of the world, and yet have a change in this kind of risk appetite that we've seen in the last few years.

Now, it's going to include thinking very carefully about the mortgage market because that's where the problem occurred this time but the next time it will be a different problem. We have to think about that regulation and get it right. This can be extremely important. I think the success of the Obama administration will lie, not on whether we got out of the recession, we'll get out of the recession. It will lie on, whether or not he oversees a sensible re-regulation of the financial sector, which allows the financial sector to thrive in the future.

Amy Gutmann: Dick, you said something important along the way that I just want to ask you to say a little bit more about. You said given the first 100 days he has to focus on the stimulus, but regulation will come. Can we afford to wait for regulation to come?

Richard Marston: Oh, for sure. The banks are not going to misbehave. They are so close to failure. The largest banks in this country could fail overnight if it weren't for the government. The government has to focus on keeping them in business then down the line they'll start misbehaving again. We will need a set of regulation, but we'd better think carefully about it. Remember this is one of our leading economic sectors in this country. Much innovation has occurred over the last 25 years in the financial sector, let's not kill that Golden Goose. Let's just make sure it's pinned up in the future.

Amy Gutmann: The urgency is not to get the regulation now, but to keep the pressure on to get the right regulation after the immediate crisis is over. David?

David Skeel:  Just to add to the comments folks have made so far. The one thing it seems to me we really have not addressed effectively yet. Well, there are a lot of things we haven't addressed effectively yet but one thing we have not addressed effectively yet are the millions of houses that are on the verge of foreclosure right now.

There is a bankruptcy proposal floating around in Washington. It's actually moving pretty quickly in Washington that would allow people whose houses are underwater, who owe more than the house is worth. If they file for bankruptcy to write down the house to, write down their mortgage to the value of the house so that if they have a thousand dollar loan, they owe a thousand dollars but their house is only worth $700. They could write down their mortgage to $700. I think that would make a huge difference in the borrower side of this crisis.

My own view, it's a very controversial, politically difficult proposal, but my own view is, it's the one regulatory move we could make very quickly that could have a big effect.

Amy Gutmann: Good.

Richard Marston: Can we focus on that? Think about what that proposal… Okay.

Amy Gutmann: No. Let's hold because just for… I want to make sure I can ask you another question which you'll want to answer and we should have time for questions. White House Chief of Staff Rahm Emanuel has said, and this is, a re-saying of what we've heard, been attributed to Warren Buffet earlier and I've heard this requoted over and over again, "You never want a serious crisis to go to waste. A crisis is an opportunity to do things you could not do before."

Now, question. Is this crisis a blessing in disguise, an opportunity? Being told that this is a blessing in disguise may make many people feel a little like Winston Churchill felt when his wife told him after his defeat at the polls in 1945 that it could be a blessing in disguise, and I think Winston Churchill's response was, "If so, it is very well disguised."

Well, if there are blessings here they are very well disguised but I ask you as a final question before I open it up to your questions. If there is any blessing in disguise, if there could be a blessing in disguise here, what would it be?

Jennifer Amyx: Well, I think many of the regulatory issues which we've talked about perhaps need to be longer-term kinds of projects. These are issues that other countries, financial regulators have brought to the table annually at every kind of bilateral negotiation we've had with any country. For example, hedge, and also after the Asian financial crisis, hedge funds were a big focus of "shouldn't we reform hedge funds and the regulation there." Now, finally is an opportunity now that the U.S. has been hit to rewrite the rules of regulation. Actually, have hurt a lot of other economies over the years.

Amy Gutmann: Okay, regulation but I don't want to hear just more regulation because I think we've… I think we've actually hit on that. I think it's an important but, and you can say… What else these blessings… Are there blessings for… Are there things universities can take advantage of here in the sense of doing better society not just government?

Jennifer Amyx: As a university professor, I think that this is a wonderful blessing in disguise in terms of teaching opportunities because very rarely do you have the whole globe impacted by prices…

Amy Gutmann: Many sophomores here to understand how they can do better. Yes.

Jennifer Amyx: Yeah. I think, for example, you have regional crises, you have different individual countries that are hit by crisis, but this crisis has really undermined a lot of conventional wisdom that has been developed over the years about how things work, how governments work, and the relationship between government and regulators and that kind of thing.

I think there are numerous teaching points that will emerge out of this and a lot of data that's going to emerge. For example, on how, not just the United States, but how every country around the globe has responded. Particularly, after September when Lehman Brothers went under. Here we have a case, incredible data set to work with hereafter. I'm just trying to be optimistic here, in terms of really enriching our research on how do countries respond to financial crisis. That's probably not what you're looking for.

Richard Marston: I'm not sure that we can say there's anything coming out of this crisis that is good where we've already lost 3.5 million jobs. We're going to run up $2 trillion worth of debt, which you're going to have to pay off. In the meantime, if we just think of universities. University portfolios between July and November, we don't know December yet for all the universities, but the country as a whole the average university portfolio is down between 20 and 25%.

Nonprofits around this country, let alone all the retired people trying to live on their portfolios, have been devastated. There are layoffs across the nonprofit sector. What can we see good from this crisis? I'm not sure there is anything. I think it's a disaster.

Amy Gutmann: There are a lot of lemons and so far no lemonade?

Richard Marston: No lemonade.

Don Kettl: But let me try to suggest maybe where the lemonade stand might be. Three quick points. The first is that to answer your question about a quote with another quote. Herb Stein who used to be an economic adviser said, "the things that can't go on forever won't." One of the things that this crisis did was it put the exclamation point on a whole series of things that were bad ideas and bad policies that came to a sudden screeching and very painful end as Dick has pointed out.

The second thing is that while, if you listen to us, there's a fair consensus about the need for new regulation, it's not altogether clear what it ought to look like, and so many different ways we have run out of intellectual capital. We're trying to figure out exactly what it is that we want to do. One of the fundamental problems right now with trying to figure out what the next stage of the banking bailout ought to be is that we're not sure exactly how to do what it is that we said we want.

We're at the end of the tracks, we're trying to build new track before the locomotive runs us over, which gets in a sense to what our job is and part of our job is to try to find a way to build that intellectual capital and to understand that none of these problems are things that any department, any school, that any one discipline could own. That these are issues that are going to require some of the most fundamental and wide-ranging thinking of the sort that we haven't engaged in a very long time, but it has to be across disciplines.

That's the way in which we're going to get our way out of this. By trying to build the intellectual capital, the chart word is we'd want to go.

Amy Gutmann: There's an urgency of learning from this, which is the only blessing not further about the crisis, but for the fact that we have people who are invested in that learning. Abigail Adams wrote to her husband, wrote to her son actually, not to her husband, her son, John Quincy, during a very serious crisis that "This is the time when geniuses would want to live."

Now, nobody would want to experience the enormous downsides of this crisis, but we've got to figure out how to learn from it by bringing great minds like you all together and I want to, before opening it up for questions. Thank you all for being so good at answering our questions and there'll be more. (Continue to Video, Part 2)