FALL 2010 Volume 1 Number 3 F refront New Ideas on Economic Policy from the BANK of CLEVELAND

The Economic Importance of Being Educated

INSIDE: Early Childhood Education Consumer Finance Mortgage Counseling

PLUS: Q&A with Laurence Meyer F refrontrefrontF New Ideas on Economic Policy from the FEDERAL RESERVE BANK of CLEVELAND

6 FALL 2010 Volume 1 Number 3 CONTENTS 1 President’s Message 2 Reader Comments 4 Upfront Battling the next phase of the housing crisis

6 Stop Investing in Stadiums… Start Investing in Kids Interview with Art Rolnick

10 Mortgage Counseling, Plain Language, and Financial Education: What Works? Highlights from the 2010 Community Development Policy Summit

14 Five Big Ideas about Consumer Finance Education Observations of a Federal Reserve researcher 14 18 Overextended, Underinvested: ‹ e Debt Overhang Problem Economists explain how debt kills investment

22 Interview with Laurence Meyer Former Federal Reserve governor on the state of

28 Book Review 18 e Big Short: Inside the Doomsday Machine

President and CEO: Sandra Pianalto Editor-In-Chief: Mark Sniderman, Executive Vice President and Chief Policy Offi cer 22 Managing Editor: Robin Ratliff Editor: Doug Campbell Associate Editors: Amy Koehnen, Michele Lachman Art Director: Michael Galka The views expressed in Forefront are not necessarily those of the Designer: Natalie Bashkin Federal Reserve Bank of Cleveland or the Federal Reserve System. Web Managers: Stephen Gracey, David Toth Content may be reprinted with the disclaimer above and credited Contributors: to Forefront. Send copies of reprinted material to the Public Aff airs Dan Littman Anne O’Shaughnessy April McClellan-Copeland Andrea Pescatori Department of the Cleveland Fed. Filippo Occhino Jennifer Ransom Forefront Editorial Board: Federal Reserve Bank of Cleveland Ruth Clevenger, Vice President, Community Development PO Box 6387 Kelly Banks, Vice President, Community Relations Cleveland, OH 44101-1387 Stephen Ong, Vice President, Supervision and Regulation James Savage, Vice President, Public Aff airs [email protected] Mark Schweitzer, Senior Vice President, Research clevelandfed.org/forefront James Thomson, Vice President, Research CHRIS PAPPAS

Meyer was a professor of economics for 27 years and former department chairman at Washington University. In 1982, he Interview with launched the economic consulting fi rm Laurence H. Meyer and Associates and earned a reputation as one of the nation’s Laurence Meyer leading forecasters. He was named to the Federal Reserve Board of Governors in 1996. His term on the Board lasted until 2002, after which he rejoined his old fi rm, now called Macro- economic Advisers.

“ By the time I completed my fi rst economics class in college, Meyer is a fellow of the National Association of Business I knew I wanted to be an economist.” The college was Yale and Economics, a director of the National Bureau of Economic the narrator was Laurence Meyer, writing in his 2004 book, Research, a scholar with the American Council on Capital A Term at the Fed: An Insider’s View. Meyer did indeed go on Formation, and a member of the Panel of Economic Advisers to become an economist. And not just any economist, but a for the Congressional Budget Offi ce. He received a BA from top-fl ight academic, a central banker, and a principal of one of and a PhD from the Massachusetts Institute the globe’s leading economic forecasting fi rms. of Technology.

What may separate Meyer from so many other economists Mark Sniderman, executive vice president and chief policy is his ability to commu nicate well. The Boston Sunday Globe offi cer at the Federal Reserve Bank of Cleveland, interviewed noted that “Meyer writes about complex economic issues in Meyer on June 9, 2010, in Cleveland. An edited transcript a clear style.” follows.

22 Fall 2010 Sniderman: Larry, thanks so much for as a multiplier. All these things were integrate that. And the other is credit talking with me this afternoon. I’m going to happen, and now they hap- spread variables—Baa corporate rate looking forward to a great conversation. pened, and the unwinding was much relative to, say, a Treasury rate. Th e Let me start with the fi nancial crisis. I’m uglier than it otherwise would have reason that’s important is that a risk interested in your views at a big-picture been. Practices evolve more quickly variable gives an indication of the risk level. How did this all happen? than knowledge. Maybe we weren’t appetites and risk aversion that come Meyer: It’s probably not a good idea to humble enough about what we under- into the system when there are fi nan- think that there’s one single fl aw in stood as bankers, as supervisors, as cial crises. And that variable tends to the system that was exposed. I think rating agencies, or as macroeconomists. be very important in spending equa- that there were several factors. One Sniderman: What does that tell us tions as well. was rapid fi nancial innovation—new about the state of macro modeling? fi nancial products that weren’t tested Meyer: It tells us something very by market downturns and that changed important —something we certainly or morphed as they were being should have learned—that macro developed. Th is is the explosion of modeling should not be static. It subprime. It morphed from being one has to evolve over time, and we’re thing to being something completely continuously learning. We fi nd holes, diff erent and much riskier later on. and we try to close those holes. And the same thing with securitization, But we know in the future there will a new technique, very valuable, and a be crises coming, or shocks in areas very good idea, but then it morphed that we didn’t anticipate. We’ll fi nd again into very complex forms of new holes that we have to fi ll. In this structures that nobody could under- case, there were really so many. stand. I think those fi nancial innova- Th is notion of the fi nancial accelerator tions are very important, and they set wasn’t just a cute idea that the [Federal We didn’t see the fundamental up the system with expanding risk and Reserve] chairman [Ben Bernanke] concentrated risks that weren’t well connection between property busts came up with. It was central to our understood. understanding of how the macro- and collateral in the banking system, Second, there’s always a trigger that economy works, particularly when bringing the banking system toward happens, and the trigger was declining there are intense changes in fi nancial home prices. Many of us believed that conditions. So you do get these adverse insolvency, toward the edge of the home prices never fall. Th ere’s a good feedback loops that the fi nancial abyss. Put on top of that the buildup historical record of that. I think we all accelerator is all about. appreciate now that the subprime of leverage in the system—this acts Most of us as macro modelers came market was not viable if home prices as a multiplier. out of a tradition in which the trans- fell. But since we didn’t think home mission of monetary policy, the prices would fall, we didn’t worry fi nancial sector, is about real interest Sniderman: Should we expect to be about it. rates, about equity values, about the living with our mainstream workhorse Th en third, we just took too narrow dollar, with virtually no variables that macro models for some time, and should a view of the subprime problem. I we would call credit variables—they we feel good about that? Is there enough myself, and I think more generally just weren’t there. In milder times, progress there? many macroeconomists, had this that was OK. Th at probably got the Meyer: I love that question! So I think focus that it’s about subprime— job done. But when the situation we have two kinds of modeling tradi- relative to total mortgages, housing was the drying up of credit markets, tions. First there is the classic tradition. relative to the economy —we’re talking dysfunctional credit markets, you I was educated at MIT. I was a research about tenths [fractions]. How can that simply had to give the model more assistant to Franco Modigliani, Nobel be a problem? information than otherwise. laureate and the director of the project on the large-scale model that was used We didn’t see the fundamental Two things seem valuable that we’ve at the time at the Federal Reserve connection between property busts tried to integrate into our models. Board. Th is is the beginning of modern and collateral in the banking system, First would be “willingness to lend macro-econometric model building. bringing the banking system toward variables” from the senior loan offi cer Th at’s the kind of models that I would insolvency, toward the edge of the survey. Imprecise as it may be, it is use, the kind of models that folks at abyss. Put on top of that the buildup a measure of lending terms beyond the Board use. of leverage in the system—this acts rates. Th at’s very important and that wasn’t there, and I think we can

F refrontF refront 23 Laurence H. Meyer

Current Position: Economic Forecasting Awards: Vice Chairman, Director, and Co-Founder, Business Week, 1986 Macroeconomic Advisers Blue Chip Economic Indicators, 1993 and 1996 Past Positions: Education: Professor of Economics, Washington University Yale University, BA, 1965 Federal Reserve Governor, 1996–2002 Massachusett s Institute of Technology, PhD, 1970 Associations: Board of the National Economic Bureau of Economic Research Fellow of the National Association of Business Economists

Th ere’s also another tradition that My views would be considered out- to do in the smaller, modern macro began to build up in the late seventies rageous in the academic community, models. But I think what you saw is to early eighties—the real business but I feel very strongly about them. exactly what you are suggesting, that cycle or neoclassical models. It’s Th ose models are a diversion. Th ey it jumped out of those models and what’s taught in graduate schools. haven’t been helpful at all at under- became a key area for research and It’s the only kind of paper that can standing anything that would be integration into the large-scale macro- be published in journals. It is called relevant to a monetary policymaker econometric models. “modern macroeconomics.” or fi scal policymaker. So we’d bett er But that doesn’t mean policymakers come back to, and begin with as our should say, “I like these modern macro base, these classic macro-econometric models because they treat expectations models. We don’t need a revolution. the way we should.” Th e Federal We know the basic stories of optimizing Reserve Board’s classic econometric behavior and consumers and businesses model treats expectations the way you that are embedded in these models. think they should, but it’s a richer, We need to go back to the founding more valuable model for policymakers, fathers, appreciate how smart they number one. And number two, do you were, and build on that. really think that you want to model It’s very simple. It’s one part science; Sniderman: Wouldn’t infl ation expecta- individuals as having their forward- that’s the model. One part art, that’s tions be a counter-example? That has looking expectations based on solving your judgment. And one part luck. become an important variable in many a model out 20 years? I don’t think that classical macro models that policymakers makes any sense at all. You need small That’s how you become a really good use to help them construct their infl ation models to do that, but the reality is forecaster! forecasts. Isn’t that at least one place that expectations are formed, they’re where we see this interplay between the forward-looking, but we don’t have any Th e question is, what’s it good for? research agenda in macro modeling and idea what the true world looks like. Well, it’s good for gett ing articles the practical use of models? Our models are caricatures. Everyone published in journals. It’s a good way Meyer: A brilliant question! And you’re has got a diff erent model in his head. I to apply very sophisticated computa- absolutely right. Th is is a good example think we learn something about trying tional skills. But the question is, do of interplay between the classic and to get forward-looking expectations those models have anything to do modern macro approaches. It is true into our model. We model the Phillips with reality? Models are always a cari- we had a push toward smaller models. curve in a way that is very important. cature—but is this a caricature that’s Th is happened because if you want to We have long-term expectations so silly that you wouldn’t want to get use these forward-looking expectations, directly in the model, playing a very close to it if you were a policymaker? in the form in which modern macro important part. Th at’s something that does, forward-looking expectations we didn’t used to do. Th at’s the way the that are model-consistent, it’s really profession advances in these classical hard to do if you have a huge macro- models as they become refi ned. econometric model. It’s very easy

24 Fall 2010 Sniderman: One thing models can do is Sniderman: We’ve seen a lot of innova- So we don’t know, really, what the provide diff erent scenarios about what tions during the fi nancial crisis in terms of impact is if we begin to do asset sales the future might look like; models that monetary policy. Are there any features today. How can we unwind that provide simulations thousands of times in monetary policy design that you think balance sheet without having such to give us a distribution of outcomes that should remain more permanently? adverse circumstances on the markets could help us understand the future Meyer: To begin to address this ques- that we regret it? We’re learning about possibilities a little more richly. Should tion, it’s useful to make a distinction that, too. I think views have changed we as policymakers be looking for more between what I call liquidity policy dramatically even over the last six modeling of that spirit, that spirit of on the one hand and monetary policy months or so with market participants scenario-planning and distributions on the other. By liquidity policy, I about outcomes? mean providing enough liquidity when Meyer: I think the answer is absolutely there’s a panic and the market just yes. It’s not such a simple task to build wants to hold a lot more liquidity. To a sensible, interesting, alternative sce- prevent that from having powerfully nario. I think we should be constantly negative impacts on the economy, you refreshing and coming up with sensible give it to them. ideas in each forecast round of what Th e Federal Reserve and central banks are clearly risks that are on the horizon around the world acted as liquidity we want to work into our alternative providers of last resort. Th ey all found scenario. ways to do that. Th e Fed was extra- Even more important, we’ve got to sit ordinarily creative, very aggressive. down every once in a while and say, You have to give an A-plus to all those “Hmm. What’s the worst thing you operations. Th ey saved the day. You could think of happening? Tell me also have to give high marks to the something really bad. Find a hot spot.” fact that the liquidity programs were Does it matter what the size of the Maybe it’s something nobody is designed so they would naturally go balance sheet is? Does it matter how thinking about. Maybe we could have out of business as the panic dissipated. many reserves you have in the system? thought about this incredibly rapid And now the Fed has closed the door growth in subprime and structured on them because no one was there Or do you just need to raise rates, products and said, “Whoa, what could anymore. using interest on reserves? I’m sure that mean?” Or we could have thought So that’s gone—beautiful. Central about sovereign debt developments that you and I could have a nice debate banks all around the world did a great were going on and were percolating in job. Now we’re talking about monetary on that. Europe. It’s not just looking at these policy and we say, “Th at’s just a lot incremental things—what happens if more complicated!” And we have a much less concerned about the market this fi scal plan is changed? what happens disagreement about what’s really consequences of asset sales. Th ere are if oil prices go up?—but looking at part of this. Does it matt er what the three things that we have to get done, these worst-case scenarios. size of the balance sheet is? Does it and we have tools for every one of Sniderman: Of course, that’s not the matt er how many reserves you have them. For draining reserves, we have model itself issue; that’s the human in the system? Or do you just need to reverse repos and term deposits. For element. raise rates, using interest on reserves? shrinking the balance sheet, we can just let it run off or we can sell assets. Meyer: Absolutely. You always have I’m sure you and I could have a nice And for raising rates, even there we to come back to that. So many times debate on that. have complementary roles of both people ask me, “What are the rules for We’ve never had this superabundant raising interest on reserves and man- forecasting, what are the ingredients?” level of reserves. We’ve never had this aging reserves at the same time. And I say, “It’s very simple. It’s one part size of a balance sheet. So, for reasons science; that’s the model. One part art, I think we can understand, there’s a Th e Fed was more aggressive and more that’s your judgment. And one part desire to do all of these things—shrink eff ective than any other central bank luck. Th at’s how you become a really the balance sheet, drain reserves, and in the monetary policy dimension. good forecaster!” raise rates. But we’ve never taken these Th at’s because other central banks, things away. We put them in, and now whether they admitt ed it or not, were we’re trying to take them away. We’ve doing what we call quantitative easing. never done that before. Th ey were just pushing reserves into the system.

F refrontF refront 25 What the Fed did and other central The good news here is that although do you want to use monetary policy banks didn’t do, because the Fed was we don’t have good supervision and itself, and do you want to lean against in unique circumstances, was make regulation procedures for dealing with bubbles even when the broader use of the mortgage-backed securities, equity bubbles, we do for property macro­economic conditions would or MBS, market. The Fed was allowed bubbles. We’ve got a lot of ways of not lead you to, for example, want to to hold MBS in its portfolio, and yet handling that. We could lower the loan- tighten? That is a taxing issue. MBS was a market that had become to-value ratio—essentially increase The issue is less whether youcan illiquid and distressed. It was tied to the down payment that people have to identify a bubble than what do you the housing market, which was under have on their homes to build a better do if you think it’s emerging. I’ve come incredible pressure. The Fed was able capital cushion. We could do a whole away with a very different under­ to go into that market and have big variety of things on the regula­tory side. standing of the risks of allowing impacts because the market was so We could increase capital requirements bubbles to go unchecked. But that’s distressed and illiquid. against those properties that seem to property bubbles. I’m not so concerned with equity bubbles. Property bubbles I think it’s important for the public to understand two things: the —that can be handled to some extent responsibilities of the Fed—what you should be holding it responsible by supervision and regulation, but I for and what you shouldn’t be holding it responsible for—and then the think we should be very open minded here. We’re searching, we’re debating, limits of what any central bank can do. we’re not sure what monetary policies should or could do in those circum- stances. If we come to that place again, That’s the good news. The bad news I’m sure there will be a very good is now we’ve still got all those assets debate in the Federal Reserve System, on the balance sheet. How do we get as there should be, before deciding rid of them? Being the most aggressive whether to be more pre-emptive than and effective during the stimulus means was the case before. that you’re the most challenged when it comes to exiting. Sniderman: What is it that you wish the general public would better understand Sniderman: There’s been a long-running about central banks and their role in the debate about how central banks should economic system in which we live? deal with asset bubbles. One of the issues be more risky because of bubble-like that’s come out in the wake of the conditions. We could do a whole Meyer: What should the public know? financial crisis has been the interplay variety of things that in principle First of all, the public has its represen- between using regulatory tools and should be, could be, effective. tatives in Congress. And Congress techniques as opposed to, or in conjunc- The question is, would we recognize has a very important job overseeing tion with, monetary policy. Do you have that a bubble was emerging in time to the Fed. I’ve said this many times— thoughts on that spectrum? implement supervisory and regulatory wouldn’t it be good if Congress learned a little bit more about monetary policy Meyer: This is a very important and policies that could have some effect? and how it works? I’m always amused evolving area of thought among My views have changed a lot since I and distressed about how poor the central banks. We really should start was on the Board. I’m a firm believer questions are during Congressional by making a distinction between now that you can always catch bubbles oversight committee hearings. The types of bubbles, between equity and identify them in time to do first part of the public I’d like to see bubbles and property bubbles. We some­thing about them before they understand more about monetary lost something like $7 trillion in the get dangerous. The question is, what policy is the Congress, particularly bust of the tech bubble. Sounds like to do? The first line of defense—and members of the oversight committees. a lot, but the economy just shrugged this is certainly what the chairman it off—with a very shallow and very [Bernanke] and others have said—is Other than that, I think it’s important short recession. supervisory and regulatory policies. for the public to understand two things: the responsibilities of the Fed—what Equity bubbles are just not a big deal. But we have to be realistic. It might you should be holding it responsible But property bubbles are absolute work; it might not. And so the big for and what you shouldn’t be holding killers. We know that from historical question for central bankers is there- it responsible for—and then the limits experience. The difference is that fore, what do you do if it doesn’t of what any central bank can do. property is held by leveraged institu- work? Do you have to do something tions, are the collateral of the banking in addition? That’s the real issue— system, and if you make your banking system insolvent, you’ve got real problems. 26 Fall 2010 It’s partly the limitations of our knowl- edge. It’s partly the limitations of what central banks’ tools can accomplish in the real world. But I would say to understand what they do, what their responsibilities are, and then under- stand how they try to achieve those objectives and appreciate that there are limits. When you want to hold central banks accountable, understand that perfection in central banking is no more possible than it is in any other profession. Sniderman: Maybe you can leave us with some thoughts on things you’ve been reading these days? Meyer: My wife and son always warned me that if anybody asked me that question, I shouldn’t even answer it because they view my reading list as, shall we say, not intellectual enough to go along with my reputation. I have two sets of readings on my night table. One is books on the fi nancial system and recent history in particular. Too Big to Fail [Andrew Ross Sorkin], is like a story unfolding before you, and I’m in the middle of that one. Th e Black Swan [Nassim Nicholas Taleb] has fascinating stories about the weight that should be given to improbable events, brainstorming on catastrophic things that could happen, and how to protect yourself in advance from those possibilities. And then I’ve got the book by Michael Lewis, Th e Big Short [reviewed on page 28 of this issue], that’s on my list. Finally, I read mysteries, spy novels, and my current group is by the author from Sweden, Stieg Larsson, Th e Girl with the Dragon Tatt oo and all the ones that followed. Fantastic reading. Th ese books are insanely popular all around the world. Th is is a series that has really caught my att ention, and I’ve got one more of those to go. Sniderman: Thanks for taking the time to talk with us today. ■

Watch video clips of this interview www.clevelandfed.org/forefront

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