Everything You Wanted to Know About the Economy But Were Afraid to Ask

Finance experts from Emory University's Goizueta Business School recently tackled questions from Emory Magazine readers about all aspects of the economy, from housing and retirement to boom and bust cycles.

The full article, and more economic coverage, can be found in Emory Magazine's 2009 winter issue.

Q: If bubbles and crashes are cyclical and (seemingly) inevitable, why do financial experts never anticipate them? Never mind accurately predict, but even expect the end of the latest expansion? Why is “this time” always different?

A: You seem to be asking two questions. The first is why experts can’t predict the timing of economic cycles. The answer is that no business cycle is like the last one, since the structure of the economy and exogenous events (say, weather or wars) are always changing. Until recently, a number of economists were arguing that the days of sharp economic cycles were gone forever!

Your second question seems to ask why experts (and others) often behave as though a downturn in the economy will never happen. Part of the answer to this question is connected to the first: if I don’t know when the end is coming, what am I supposed to do about it? Alan Greenspan’s famous “irrational exuberance” warning occurred in December 1996. If you had heeded his advice and sold then, you would have missed another 75 percent run-up in the Dow Jones Industrial Average. Like the clock that is right twice a day, his crash finally came in 2000—but the Dow still stayed above its level of December 1996.

—Assistant Professor of Finance Ray Hill



Q: I will be 65 tomorrow. In such a bad economy, I wonder about the merits of my selling a house vs. a “reverse mortgage” and staying here. The house is too large for me now. But should I wait out the turnaround we all hope for soon?

A: Have you considered renting? The rental market is really (really) heating up. People who would have been in a position to purchase a home are not having luck either selling their own home to acquire the equity needed to buy a new home or getting approval for loans—these people are turning to renting.

Obviously you understand that getting a reverse mortgage doesn’t help you unload the house—your responsibility to repay the “reverse” starts when you do sell the house. Given that the interest rates on a “reverse” are pegged to the rates of T-bonds (which are at or near zero), it is probably not a good time to use this instrument.

I recommend that you rent your house out, rent a smaller, more affordable condo, and talk to a tax accountant about the implications regarding the rental income. You might be able to take care of all your concerns—your house, a smaller living space, and some extra income.

—Assistant Professor of Finance Tom Smith



Q: Is it accurate for media outlets to speculate in real time why the Dow and NASDAQ rise and fall? They tend to attribute the rise and fall to other current headlines (political elections, U.S. automakers, past employment figures). It seems they are mixing up macroeconomic signals and microeconomic practices.

A: The media (and many stock traders) seem compelled to offer their audiences an explanation for every movement in the stock market indices. As you suggest, however, most of the time these “explanations” are simply unverifiable speculation about events that happened to occur at the same time as the rise or fall in the stock market.


Commentators usually couch their explanations in anthropomorphic language, as if the market was a single-minded person. Instead, the “market” is the sum of thousands (millions?) of investors, all processing information and forming expectations in different ways. When an event is significant, completely unanticipated, and its effect is obvious (say, the 9/11 attacks), the media’s explanations will probably be correct—but who needs an explanation from CNBC on those occasions?

—Assistant Professor of Finance Ray Hill



Q: How long do you think this financial slowdown will last? For baby-boomers who were relying on their investments in the stock market to help fund their retirements, and given the slowdown in the real estate market, what do you suggest now as investments for the coming years?

A: Most economists predict the slump will continue through 2009 with modest growth returning after that, but some of the worst-hit real estate markets may take longer to bounce back. Don’t be afraid to invest your long-term money in the stock market, however. Stocks have had a horrible year, but the stock market tends to improve before the rest of the economy, so you’ll miss out if you wait for good news.

A rule of thumb is to invest “100 percent minus your age” of your retirement money in stocks. If you are 60 and nearing retirement, you should have roughly 40 percent of your retirement money in diversified stock funds (with some exposure to international stocks) and the rest mainly in fixed income securities like bond funds. The idea is that at 60, most people will live for at least two more decades, and bearing the risk of stocks will provide added return in the years to come.

—Associate Professor of Finance Clifton Green


Q: Until recently we saw the U.S. dollar depreciate against the EUR, GBP and the JPY, among other currencies. The boost to exports resulting from a weaker dollar was considered one of the few opportunities to help the U.S. Recently, however, and perhaps as a result of the world financial crisis, the dollar has regained some of its value. What is your opinion regarding the strength of the dollar going forward and the impact that will have on the ability of the U.S. economy to grow by becoming more investment- and export-oriented, as opposed to mostly consumer-oriented?

A: The U.S. dollar fell in value at a strong and relatively steady pace from its high values from 2002 right up to September 2008. The weaker dollar meant that U.S. products, both goods and services, were now relatively inexpensive compared to the products produced by many of our trading partners. America gained competitiveness, boosting exports of products. Further, we could now better compete with imports coming into the U.S. market.
Importantly, U.S. exports were also boosted by a second factor—the increased demand stemming from rapid economic growth abroad, particularly in emerging markets (U.S. exports nearly doubled from the recession of 2001 until autumn 2008). This was a crucial spur to the American economy, as this increased demand for U.S. production offset the rapid decline in housing construction starting in the summer of 2006, enabling us to stave off recession until 2008.

Now, however, the crystal ball of U.S. exports is murky, at best. Recession abroad will curtail demand for U.S. exports. Roughly 70 percent of our Gross Domestic Product has been household consumption. Given the frightening job market and losses in both stock and real estate wealth, it is hard to see this sector restoring U.S. economic growth. The remaining solution is a massive fiscal stimulus package of government spending increases and tax cuts—it seems to be the one engine that can pull us out of recession. The good news is that, if this can spur U.S. economic growth, consumption and business investment will return to growth. Best of all, the U.S. can help lead the world to faster economic growth, and the beneficial growth trend in U.S. exports can resume.

—Associate Professor of Finance Jeff Rosensweig, director, Global Perspectives Program


Q: Everywhere you look, the cost of goods, services, and materials has risen during the past two years. Now with lower fuel costs that affect the transportation cost of the goods we purchase, will the mega-retailers, restaurants, and other companies reduce their retail prices or enjoy the additional profits?

A: If just fuel costs were going down, we might see lower prices and higher profits for retailers and restaurants. Since August of 2008, however, the consumer price index has either dropped or stayed constant each month so we have actually entered a period of general deflation (not just lower fuel costs). These declining prices are not an opportunity for higher profits in the retail and restaurant sectors (which are both highly competitive) but, rather, an indication that sales are down and their businesses are really suffering as we enter a recession. Rather than higher profits, we are seeing business failures in these sectors (e.g., Circuit City).

—Assistant Professor of Finance Ray Hill

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Tax Provisions Hopeful Sign in New Stimulus, Says Tax Expert

The big question on the economic stimulus bill passed by Congress is: Will it work? Federal tax expert Dorothy Brown of Emory Law says one factor in favor of the new plan is that the tax provisions are incremental, rather than one-time payments.

"Studies have shown that one-time payments are likely to be saved," says Brown, "whereas with this bill, one of the tax provisions will adjust payroll withholdings for workers at the lower income level, which studies have shown are more likely to be spent."

"It will be an increase in the check every week, and workers are more likely to think 'this is more permanent, so I can go ahead and spend it' as opposed to a lump sum of $600 that they want to save," says Brown.

And because the tax breaks are hitting payroll withholding, "it's going to kick in sooner," also a positive sign, she says.

"When I look at the tax provisions, most of them go for low- and middle-income workers, which is exactly what President Obama said he was going to do—tax cuts for 95 percent of American families," Brown observes. "This may be one of the rare instances where a candidate said it and then when elected, did it."

On the president's housing policy, Brown says the provision giving bankruptcy judges the ability to renegotiate mortgages or write them down to the fair market value of the house "is a huge deal."

"I imagine they'll be some pushback," she says. "The argument is when you [renegotiate mortgages] then cost of credit for everybody goes up, because banks can no longer be comfortable with the documents they sign; they're going to be affected. But I think people will get over that. This is a crisis the likes of which we haven't seen."

Brown, professor of law, specializes in federal tax law and critical race theory and is known for her work examining the racial implications of federal tax policy. She has been an adviser to J. Stephen Swift of the U.S. Tax Court, an associate with Haynes & Miller in Washington, D.C., and an investment banker at New York’s Drexel, Burnham & Lambert. She also was a special assistant to the Federal Housing Commissioner at the U.S. Department of Housing and Urban Development in the late 1980s under President George H.W. Bush.

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Wall Street's Collapse May Boost Private Equity Markets

The collapse of the housing and credit markets that has crippled some Wall Street giants is likely to have a variety of effects on private equity, say faculty at Emory University and its Goizueta Business School.

The fall of Lehman Brothers, the sale of Merrill Lynch to Bank of America, and the decision by Goldman Sachs and J.P. Morgan to be placed under the purview of the Federal Reserve are driving big changes in financial markets, note faculty members.

One likely shift is a larger role for private equity providers in financing big-ticket deals. But liquidity concerns are likely to rein in their appetite for risk, despite the just-passed $700 billion bailout package, add faculty.

"The consolidation taking place in the financial markets means the playing field is getting a bit smaller," says Thomas More Smith, an assistant professor in the practice of finance. "With fewer investment banking giants available to service big-company deals, we may see smaller private-equity firms swoop in to fill the empty spots."

In fact U.S. private equity firms have picked up the pace of their fund-raising, says the Private Equity Analyst newsletter, published by Dow Jones.

Domestic private equity firms raised $222.6 billion in 264 funds during the first three quarters of 2008, 11% ahead of the $200.4 billion raised by 298 funds in the same time last year, according to Dow Jones.

Distressed firms are seeing strong interest from investors with 18 funds raising $37.9 billion this year, up 28% from $29.5 billion raised by 16 funds at this point last year, according to the Dow Jones analysis.

The newsletter also reports that mezzanine, or layered financing funds attracted $36.9 billion across 13 funds, compared to $3 billion across nine funds through the third quarter last year.

But if the distressed and mezzanine-financing segments were excluded, private equity fund-raising would have been weaker compared to last year, says Jennifer Rossa, managing editor of Dow Jones Private Equity Analyst.

"Buyout fund-raising continues to lag," she notes. "And fresh concerns about the availability of debt won't help."

The credit crunch has still spooked investors and is likely to dampen their enthusiasm for some time, according to Goizueta’s Smith.

"Despite the bank bailout, we’re likely to see reduced capacity," says Smith. "The fact that there are fewer players remaining may also mean a pullback in the variety of services and niche activity that is offered."

Small businesses are finding it tougher to access credit, and that could spur a shift in the direction of venture capital, adds Smith.

"For the most part, VC firms have targeted ‘sexy’ businesses with high-growth potential, like technology companies," says Smith. "That’s in line with their traditional exit strategies that often envision a five-year exit with high returns."

But lately, venture capital providers have been shunning startups and have instead been targeting later-stage companies with a proven track record. That could open the door for more staid firms to catch VC’s eye, says Smith.

"A small but growing advertising company, say, may not offer the same potential as a high-tech business, but it may offer more security," he notes. "As their credit gets choked off, more small traditional businesses may begin to approach venture capitalists. And according to anecdotal evidence, some VCs are paying more attention to them. It’s too early to call it a trend, because we don’t have the data yet. But the potential is there."

A Shift in How Deals are Done

In fact Wall Street’s woes are likely to drive a big shift in the way deals are done, observes Lawrence M. Benveniste, a chaired professor of finance and dean of Goizueta Business School.

"The changes we’re seeing in the investment banking landscape are opening up huge opportunities for private-equity firms," he says. "I expect they will move in to fill the underwriting and other voids that are left as investment banks retreat. Amid the turmoil for example, Blackstone [a global corporate private equity group] has hired some high-level Lehman professionals."

On October 2, the Blackstone Group announced it took on a partner and two managing directors who formerly worked with Lehman Brothers.

Private equity already has a substantial presence in the world market, but as it expands its footprint, companies are likely to see significant changes in the way that deals are financed, says Benveniste.

"Many of the recent transactions have been driven by access to credit and the potential to increase returns through leverage. Leverage ratios of 80% were not uncommon," he explains. "Debt financing has not exactly disappeared, but it is a lot tougher to obtain it. Private equity is available, but I believe that the price-EBITDA multiples on deals will shrink considerably and opportunities for Leverage driven deals will disappear. Instead, deals will be driven more by the potential to add value to the purchased company. This is the traditional model of private equity."

Relating leveraged transactions to the current crisis in the markets, Benveniste remarks that the "The devaluation of much of this leverage debt has contributed significantly to the current weakness in financial institutions."

Klaas Baks, an assistant professor of finance at Goizueta and head of the Emory Center for Private Equity and Hedge Funds, agrees that private equity players may score some gains in today’s financial crisis.

"Many PE firms that rely on leverage to generate returns will need debt financing, but the tight credit markets will put pressure on them," he says. "In this type of market, successful PE firms will add value through channels other than leverage such as improved corporate governance or operational efficiencies."

He says that as investment banks like Morgan Stanley and Goldman Sachs take on the attributes of commercial banks, private equity firms and hedge funds will likely fill some of the void. "We may see private equity and hedge funds start to perform functions traditionally performed by investment banks," Baks predicts. "But if government regulation is expanded to private equity and hedge funds, such a move may be inhibited."

He expresses some concern about the bailout plan, noting that "at this point we just don’t know the true level of toxic debt."

Baks also questions whether a $700 billion taxpayer-financed bailout will lead to a "moral hazard," or more reckless behavior on the part of financial institutions that believe they are "too big to fail and will be bailed out by the federal government if they get into trouble."

Ray Hill, an adjunct professor of finance at Goizueta Business School, also believes that the problems on Wall Street may drive more activity to private equity firms.

"Private equity firms will be able to attract talent from investment banks," he says. "Also, some private equity firms that did not become overleveraged are already moving segments that were traditionally handled by investment banking firms."

But that does not mean that the investment banking segment is about to disappear from the landscape, adds Hill.

"Goldman Sachs is not about to go under," he says. "Instead the group is likely to retreat from its historical risk taking model. I expect Goldman will still engage in merger and acquisition, advisory and underwriting functions, but will probably limit its maximum leverage to 10x, instead of 25x. The company will make its money through smarter investments instead of just riskier ones."

Looking at a broader issue, Hill worries that the financial crisis is now infecting the real economy.

"The argument made for the bailout by [U.S. Treasury Secretary] Henry Paulson and [Federal Reserve Chairman] Ben Bernanke is that we have a crisis in part of the financial system that may spread to the general economy," says Hill. "At the time they proposed the rescue plan, you could say that the real economy was slowing down, but probably not headed to recession. In the last two weeks, the leading economic indicators have become more pessimistic and the current freeze in short-term credit is likely to do further damage."

He notes that the bailout plan is still a few weeks away from being implemented. "It is no surprise that we don't see the benefits of the plan yet, but some of the adverse consequences of the credit freeze will not be reversible."

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Bailout Mess Echoes S&L Crisis of the 1990's

Taxpayers may be howling about the price tag of the $700 billion bailout plan that Congress is considering, but according to Emory University economist Hashem Dezhbakhsh, the current crisis is reminiscent of another huge financial disaster in the not-so-distant past: the savings and loan bailout of the early 1990s.

"Savings and loans took a lot of risks in 1980s, which left a lot of institutions insolvent. Government had to come to rescue." The overall cost to taxpayers then? "Half a trillion," says Dezhbakhsh. "It is, in fact, déjà vu."

The cause of the current bailout is the same now as then, he says. "If you have a financial system with incentives that are not set properly, then the system lends itself to excessive risk taking at the expense of someone else."

The most unfortunate aspect of the current bail out effort is that it is so close to the election, says Dezhbakhsh. "That's why it's really hard to have a real debate about the plan. Both Democrats and Republicans are afraid that if noting were done, there would be a disaster, and they'd be responsible for it--even if they don't believe in bailing out institutions making bad choices."

One other unfortunate aspect is fear. "The public thinks this is subsidy for the rich and Wall Street," says Dezhbakhsh. "That's unfortunate because it shows total lack of trust in what politicians and Fed officials say. There is no doubt that special interests are at work here. One cannot deny that the treasury secretary (Henry M. Paulson Jr.) is a veteran of Wall Street.

"At the same time, no one can deny the psychological impact of a passive approach to the crisis that will be very dangerous," adds Dezhbakhsh. "If there is fear of banks collapsing, then there will be run on banks, you can have a severe credit crunch that spreads from the financial side to the rest of the economy. Then, no one can conduct business. That's the fear."

Dezhbakhsh, a professor of economics, is chair of Emory's Department of Economics. His areas of interest include applied econometrics, the oil market, financial markets and volatility, and economics of crime.

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