Economist Says Fixing Finance System Is Key To Ending Recession

Big Think recently approached five leading economists for their best predictions on when we will be out of the mess known as our national economy.

Watch for their commentary in the Big Think blog in the coming days. And after you listen to their ideas, you can let the countdown begin.

Today's prediction is from Professor Donald Nichols of the University of Wisconsin at Madison. Nichols is Professor Emeritus of Public Affairs and Economics with a specialty in macroeconomic theory and policy. His federal service includes a posting on the Council of Economic Advisors, the U.S. Senate Budget Committee and the U.S. Department of Labor. He holds his doctorate in economics from Yale University.

So, Professor Nichols, when will the recession end?

"The breaking of three bubbles led to the current recession. The first bubble is that we built too many houses in the 2003-2007 period. The second bubble is that housing became over-priced. And the third bubble is that housing and other forms of credit were irresponsibly financed. 

By my estimate, the work-down of the excess housing stock is just about over. If 1.6 million starts per year is our norm, in a few months we will reach a point where the over-building of the 2003-2007 period has been offset by the under-building of the 2007-2009 period.  By mid 2009, housing construction will start to grow and housing will once again be a source of strength for the overall economy.
Surprisingly, the over-pricing of houses will also be worked down in a few months. If the Case-Shiller national index is deflated by per capita Personal Income, it, too will reach a level in a few months that is normal by historical standards. Young people will be able to buy houses using the same amounts of income that their parents did.
Unfortunately, the bubble in finance is no where near resolved and the working down of the excesses in finance will depend on policy actions yet to be take. A credit default swap is a guarantee on the payment of a financial asset. So many of these swaps were made many by parties that had no other stake in the viability of the asset in question that it will be a tedious job to unwind them to find out which of the major banks' own promises to be paid by others that exceed its promises to pay others. Market prices would be needed to unwind the tangle immediately and there are no market prices to use because the markets have frozen up. If we could get the economy to recover, many of the underlying assets would be sound and the insurance against default would not need to be paid. We could then get the financial system to function normally. But to get the economy to function we need normally functioning financial system.
How do we break the cycle? We need sound finance to have a strong economy: we need a strong economy to have sound finance? Ending the recession will require the government to step in and buy private financial assets in order to simulate the existence of a sound financial system.  We don't yet know how to do that well."

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