Morningstar Advisor - February/March 2009 - (Page 41) It would be very helpful if we recognize that the problems in the 1930s and the problems we’re facing today are a result of excessively loose credit policies in the previous decades. That’s a missing piece of analysis. George Cooper crisis, economy, and the long-term ramifications for investors. On Dec. 17, Ibbotson called from New Haven, Conn., Cooper from London, and Mandelbrot from Boston. The discussion has been edited for clarity and length. Paul Kaplan: The Fed took a dramatic step yesterday in lowering its funds rate to close to zero. What does that say about the current state of our financial system? How’d we get here? Roger Ibbotson: Obviously, it’s in really bad shape right now. I don’t think the Fed funds rate has ever been that low. We are trying to regenerate the economy and save the financial system. and, particularly, in the financial sector. This leverage was packaged and put in complex forms of derivatives, which wasn’t always transparent to investors, and sold off around the world. So this crisis is not local to the United States, but it’s a global financial crisis in both developed and emerging countries. What’s different this time is that the government is taking action. The government was paralyzed in the beginning of the 1930s, but today, it’s acting. Maybe what the government is doing is not coherent or structured enough—there seems to be a lot of one-off actions and some panic—but certainly officials are doing a tremendous amount to try to alleviate this crisis. Part of that was what happened yesterday with the Fed rate. George Cooper: What the Fed did yesterday is What was missed in that analysis was that by generating credit, Bernanke and Greenspan created a temporary boom in the economy. But once the credit needed to be repaid, you created a greater slump in the future. We are now reaping the rewards, if you like, of trying to fix the Nasdaq problem with a housing boom, which has compounded the problem into the current mega-credit cycle. I think it would be very helpful if we step back and recognize that the problems in the 1930s and the problems we’re facing today are a result of excessively loose credit policies in the previous decades. That’s a missing piece of analysis. I think we need to fix the problems with the policies being used now, but as we do that, we need to recognize that once the fix is enacted, we need to run monetary policy in a fundamentally different way. Kaplan: Dr. Mandelbrot, since the early 1960s, you’ve been building statistical models of asset returns. Your models differ very significantly from the ones that are taught in business schools. You use fat-tailed distributions, long-term memory, and so on. One of your students was Eugene Fama, who wrote his doctoral dissertation based on your research. Today, of course, Fama is very much in the mainstream of financial economics. Please describe your research. Why is it important for financial advisors to be familiar with it? Benoit Mandelbrot: While working for the IBM As I look back, it’s looking more and more like the 1930s in terms of the financial markets. We haven’t seen these large daily price movements in the market since the Great Depression. We had some really bad results in the stock market in the 1970s; we had the crash of 1987; and we were down 45% in 2000-2002. But why I go back to the 1930s here is that both crises were created by the financial market. Most of the recessions that we have had were not oriented around a breakdown of the financial system. It’s only this one and the one in the 1930s that were related to a breakdown in the financial system. In both cases, you had an overleveraged economy with a lack of transparency and a meltdown of various types of financial instruments. In the 1930s, a large number of banks failed and companies were overleveraged. We have that same sort of leverage today, not so much in companies, but both on the household level part of the necessary policy response here. They clearly have little choice, other than to use monetary policy and fiscal policy to attempt to prop up the financial markets and the economy more broadly. What worries me, though, is that we’re enacting these very aggressive policy responses without really stepping back and analyzing the problem or the reason that we got into this problem. We should go back a few years to when Ben Bernanke was giving speeches about how he could avoid a deflation problem in America by lowering interest rates and injecting liquidity into the economy; he claimed then that the deflation threat could be offset by stimulating more and more borrowing, which he and Alan Greenspan at the time did by lowering rates to 1% and triggering a boom in the housing market. Research Center in New York, I became motivated to look very carefully at cotton prices over a fairly ordinary period of five years. I observed that those prices’ changes had been always very much dominated by special events MorningstarAdvisor.com 41 http://www.MorningstarAdvisor.com
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