Seven Questions: How Bad Will It Get?

TIM SLOAN/AFP/Getty Images Bens dilemma: A small recession now or a worse recession later?

Foreign Policy: Whats your diagnosis of what happened to Fannie Mae and Freddie Mac?

William Poole: First of all, they had too little capital to withstand adverse circumstances. And the adverse circumstances were the severe downturn in housing, the decline in house prices, and the rising default rate on mortgages. I dont know of anyone who early enough was saying that there would be a major national decline in house prices, so I cant hold them to that standard, but I can hold them to a standard of holding adequate capital to be able to withstand unforeseen circumstances. Thats what capital is for.

FP: In 2003, you called for the government to eliminate its implied guarantee for Freddie Mac and Fannie Mae. Do you feel that Alan Greenspan, the Federal Reserve chairman at the time, didnt listen to you?

WP: No. I never had any inkling that he disagreed with what I was saying. Greenspan was pretty much out in front also, saying we should try to scale back these companies and the implied guaranteemake them fully private companies so theyd be subject to market discipline. If Greenspan thought that I was way off base, he would have talked to me about it or had a staff member talk to me about it. That, I can attest, did not happen.

FP: Now, there has obviously been some turmoil in the banking sector. IndyMac, a regional California bank, collapsed last week. Analysts are wondering where the line is in terms of what banks are considered too big to fail. Where would you draw that line?

WP: I like the way that Greenspan used to put it and probably still does put it, that no firm should be too big to fail. Some might be too big to liquidate quickly and may require some support until they can be wound down, but there should be no firm too big to fail. We dont know yet what the nature of the bailout of Fannie and Freddie is going to be, but I believe the plan would be to pay off at par all of the regular obligations. They are being turned into full faith and credit obligations of the United States government.

FP: So, what happens now?

WP: Heres an analogy I like to use. In a formal bankruptcy, the court appoints a receiver. The receivers job is to, in some cases, reorganize a firms capital structure. Sometimes, the shareholders get wiped out and the bondholders become shareholders. Sometimes a company is liquidated and the creditors are paid according to certain legal rules. Depending on how particular credits are set up, a receivers job is to keep the company going long enough to obtain the maximum possible benefit for the creditors as a whole. In some cases, the company might be shut down quickly.

So thats the analogy, and now the secretary of the Treasury is de facto in that position. But hes operating under no established law. For the most part, everything that is now done to deal with Fannie Mae and Freddie Mac, to reorganize them financially or scale them back, is done now by negotiation between the secretary of the Treasury, Congress, and the companies. The companies have what you might call a well-oiled political machine. They have many members of Congress they talk to regularly who will represent their interests in this negotiation.

FP: NYU economist Nouriel Roubini, who has been sounding the alarm for quite a while, told Bloomberg News that were seeing the worst U.S. financial crisis since the Great Depression.

WP: I think thats right, but lets go back and revisit the Great Depression for a moment. In 1932, the economy was spiraling down and there were large numbers of bank failures. Eventually, in early 1933, various states started to declare banking holidays. They closed the banks and allowed them to continue to exist, but the depositors were not permitted to take any money out. They shut the doors.

When Franklin Roosevelt took office, he declared a national banking holiday. All the banks were closed, including the Federal Reserve banks. There was a total and complete collapse of the banking system, and the economy that had functioned on credit and deposits was suddenly left to function on hand-to-hand currency. We arent anywhere close to that and we wont get close to that because of ample Federal Reserve resources and also intellectual understanding that would not permit that to happen.

FP: How bad will it get, then?

WP: We are going to have failures of large numbers of firms, financial firms in particular. A traditional important piece of business for community banks and regional banks are loans to real estate developers and builders. And now that some of those are going into default, its leading to failures of smaller commercial banks, and the ones that were the most heavily involved in real estate are the ones at the greatest risk. The longer these things go, the greater the depletion of capital. In time, the losses accumulate and exhaust capital and the firm fails, so the [Federal Deposit Insurance Corporation] shuts it down. It looks like theres more of that to come, because there is no sign of a revival in home-building.

FP: Meanwhile, consumer prices are rising at their fastest rate in 17 years. Does that mean the Fed is running out of tools to keep growth going?

WP: All the financial turmoil that weve just been talking aboutthe tightening of credit, the fact that so many banks have impaired capitalthats putting downward pressure on the economy, and the big increase in fuel prices is also putting downward pressure on real activity. You see that in transportation, the airlines, the auto industryanything that has a big fuel cost. There is a growing amount of unemployment in those sectors, and the Federal Reserve is trying to support economic activity by holding the federal funds ratethe interest rateat its current level. If the downturn in employment becomes much more severe, the Fed might even cut rates.

Now, to me, the inflation problem is actually part of what is depressing economic activity, because the generalized inflation that I think we have underwayalthough its not showing up in core inflation and wages just yetis showing up in the depreciating dollar, and the depreciating dollar directly feeds through to increased energy prices and food prices. So, the depreciation itself is leading to depressed economic activity.

Moreover, if the inflation really starts to go into wages and into the corethe non-energy, non-food partof the price indices, it will probably develop a fair amount of momentum and the Federal Reserve is not going to be able to reverse it even with a tighter monetary policy for probably a year or two, maybe even three. If the policy is too expansionary too long and we end up with a real inflation problem, all were doing is trading a bigger recession later for a smaller recession now.

William Poole is the recently retired president of the Federal Reserve Bank of St. Louis.