Gallup 's chief economist, Dennis Jacobe, doesn't have many positive things to say about the Federal Reserve Board at the moment. And as the holiday season rolls in, you might not either. This is especially true if you're one of the millions of Americans caught in what Dr. Jacobe calls "the credit crunch."
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If you're not caught yet, chances are good that you will be. As Dr. Jacobe relates in this interview, the subprime meltdown has rippled throughout the investment community, and financial institutions have started reevaluating risk. That means even high earners -- depending on their credit scores -- may have trouble borrowing money, and low-income to moderate-income earners could be in a dangerous credit position. Meanwhile, the Fed's response to the crisis has been painfully slow, according to Dr. Jacobe.
And that's just the first lump of coal in America's Christmas stocking. Dr. Jacobe predicts that the combined effects of the credit crunch, the collapse of the housing market, soaring energy prices, the weak dollar, and potential unemployment -- well, let's hope the elves are busy at the North Pole, because Americans may have trouble paying for gifts this holiday season.
On the other hand, his advice to shoppers is get to the store early, because retailers are going to limit their inventories and probably add to their discounting early this holiday season. So those who wait may face limited choices the closer we get to the end of the holiday shopping season.
GMJ: In a Gallup Poll article, you wrote that the consumer credit crunch is already underway and suggested that monetary policy is a trailing economic indicator at this point.
Dr. Jacobe: Yes, monetary policy is trailing the economy now, although with the two recent rate cuts, the Fed has been trying to catch up. Eighteen percent of Americans know someone who's been turned down for a loan. Twelve percent know somebody who's gone bankrupt. But what people don't really understand is that the nation's lending institutions are conducting a risk reassessment. It's similar to the risk reevaluation taking place among global investors, but it's much more traditional in many ways as lenders go back to the proven underwriting standards of the past.
What went wrong with mortgage finance in the United States was the creation of a whole bunch of complicated financial instruments. Both investors and borrowers were confident that those new financial instruments were based on good modeling and superior financial applications.
When the subprime loan industry collapsed, investors around the world realized that those assumptions about how these new investments would perform during a housing downturn were false. As a result, investors who thought that these loans were nearly as good as U.S. treasuries suddenly realized that they didn't understand how risky these instruments were. So now, instead of putting their money into exotic financial instruments, investors are putting their money into more traditional vehicles like treasuries, equities, mutual funds, and bank CDs. At the same time, lending institutions are also reevaluating the kind of consumer loans they want to put into their portfolios.
As a result, we have yet to see some of the major effects of what I call the consumer credit crunch. What we do know is that lending standards are already being tightened, loans are harder to get, and people are being turned down for loans -- people who might not have been in the recent past.
GMJ: But don't you think monetary policy reflects that?
Jacobe: When it comes to financial events like the subprime disaster, the effects are extremely difficult to contain. And Gallup investor polls showed that most investors didn't think that the subprime fallout could be limited to the housing market or the subprime mortgage market. [See "Consumer Credit Crunch Already Underway" and "Are Americans' Views of the Credit Markets Shaken?" in the "See Also" area on this page.]
If you understood that, then you could infer that there would be difficulty in the financial markets overall. And I think the Fed should have known that. Subprime mortgages were spread throughout the investment world. I believe that stress to the financial system almost inevitably creates stress within the real economy, so the Fed's immediate reaction to the debacle in the subprime market should have been what Greenspan did before -- to push interest rates lower more quickly.
GMJ: When you say that people are having difficulty getting loans or credit, do you mean mortgage or car loans, or do you mean credit cards?
Jacobe: In the recent past, people used their home equity like an ATM machine. If home equity no longer exists, then you have to wonder whether consumers will continue to spend the way they have recently. I have a theory about it: People used to save, then spend. Today, consumers have their credit lines in reserve, so their credit line is their emergency fund. So if their credit availability declines, they tend to become less certain that they will have money available if they need it. So they tend to preserve their credit lines and try to reduce their spending.
My guess is in the short term, credit card use might be more prevalent, not less. But in theory, all forms of credit will be restricted. When I talk about a consumer credit crunch, I mean risk reevaluation [by the businesses that offer loans or credit]. It's no longer a matter of interest rates, it's a matter of a borrower's credit history and the lender's expectation that the borrower will be able to handle the debt. So it doesn't matter if somebody's willing to pay an interest rate of 12% to 15% for a mortgage; if they don't have 20% to put down on a house, it will be difficult for that person to get a loan.
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A real credit crunch means that consumers can't get money. It's not that credits costs them more -- instead, they can't get credit at all. People who used to have credit offers pushed at them are unlikely to get home equity loans, mortgages, or consumer loans as easily as they did in the past.
Over the past few years, consumers have substituted home equity financing for purchases that they might have put on credit cards. As home equity financing has dried up, some people will turn to credit cards again. So I think there will be a shift in consumer borrowing. So short term, it may appear that consumer credit cards are growing -- particularly if credit card companies see this as a chance to grow their business. It all depends on the underwriting standards used by the credit card companies and whether consumer credit card defaults increase.
GMJ: What's your opinion of Federal Reserve Board Chairman Ben Bernanke?
Jacobe: When Bernanke was appointed to the Fed, I researched his background. Any fair assessment is that he comes from the world of academia. Actual Fed policy making is a much more real-world operation. There are academic principles and research involved, but in a real sense, he's the nation's banker, so he has to think about things differently.
GMJ: So you think he's in an ivory tower?
Jacobe: I think he's a bit isolated. What the latest drop in [interest] rates shows is that Bernanke and the Fed have been more in touch with people in the financial markets who are on the front line day to day. But I'm not sure they've been in touch with what I'd call Main Street. In a lot of ways, monetary authorities think their responsibility is the financial system first, the financial markets and equity markets second, and Main Street last.
But I think Bernanke is learning. This is his first crisis, and it's too early for Monday morning quarterbacking. We should wait a while and see whether the Fed made the right calls. My guess is that the Fed is behind the curve and that as a result, there will be a more severe downturn in the economy than most people are expecting. In retrospect, many of us would say the Fed should have responded more quickly. But we may turn out to be wrong.
GMJ: So if there's a credit crunch, why hasn't the economy been shaken already?
Jacobe: Well, a couple of different things are happening. High gas prices were supposed to slow the economy, and they did squeeze lower- and moderate-income households. Wal-Mart's sales, for instance, declined. But upper-end retailers' sales increased. A credit crunch tends to hit lower- or moderate-income households first. However, the kind of fallout that we're talking about has more to do with the home-owning consumer. That tends to be consumers at the middle-income and upper-middle-income levels.
What some people don't understand -- but does show in Gallup Polls -- is the whole emotional aspect of this situation. The thing that really bothers me about what's going on, and why I look a little askance at how the Fed reacted initially to the housing downturn, is that what's happening in the residential real estate and related markets is causing an awful lot of pain, and I don't think policy makers take that into account.
Meanwhile, bankruptcy laws have made things much harder for many homeowners -- the debt follows them forever. It's hard for people to imagine what losing a house does to a family. Moving is supposed to be one of the most stressful life events, but the stress of foreclosure far exceeds the stress of moving.
GMJ: What do you think of the much-discussed legislative bailout of subprime loan buyers who are in trouble now?
Jacobe: We asked that question in an investor poll. A large majority of people said that something should be done for home buyers with the awful subprime loans. There is sympathy for the borrowers. But there's no sympathy for the lenders or the investors.
Borrowing is a complex financial decision, and to some degree, consumers think that if they get the loan, the lender feels they can make the payments. Borrowers think getting a loan is a kind of approval from a financial expert that indicates they should take it.
Of course, it is often very difficult to find a way to help the borrower without bailing out the lender and the investor. In fact, some efforts to help borrowers having difficulties today could end up hurting other borrowers when they seek mortgage money in the future.
GMJ: So what impact will all of this have on holiday spending?
Jacobe: In 2006, holiday spending was estimated to have increased about 5% from the prior year. Right now, the general forecast is that holiday spending should be flat or down this year. It's much more difficult to predict exactly how far down it will be because people have a tendency to spend at the holidays regardless of the economic situation.
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My guess is that it depends a lot on employment and gas prices. In this regard, the November jobs report should be good news for retailers. However, record oil prices are just the opposite.
Right now, I think retailers are not anticipating a good holiday season. I don't foresee a good holiday season, and I don't think upper-income consumers will pick up the slack as they have in past years. I think the fact that seasonal employment is predicted to be lower compared to previous years this holiday season simply confirms current retailer pessimism.
So I'm not at all optimistic about the holiday season. My guess is that consumers should buy early; retailers will not overstock. Stores will probably have sales, but if buyers wait too long, some of the things they want might not be available.
GMJ: What do you think will happen with inflation?
Jacobe: Well, it depends on whether you are a consumer or someone looking at the government data. The average American will probably see an increase in inflation from any number of sources over the next year or two. Higher costs for food and energy, although often not seen as "core" inflation by economists, are real and will continue to be problematic for most Americans.
On the other hand, the actual inflation numbers as measured by the government are being affected by many things that most Americans don't pay any attention to. The value of the dollar is a problem. As it declines, many imports go up in relative cost. But as long as China maintains its exchange rates, then a good part of American imports won't go up in price.
Traditionally, exchange rates and so forth are inflationary. A surge in commodity prices is clearly inflationary. But on the other hand, declining housing prices are deflationary. So depending on how you measure inflation, imported items will go up in cost, but the net inflation rate may not go up much because of the offsetting pressure from what's happening in the housing and auto markets.
In fact, those Americans who have a good credit rating and some money in the bank may find some real opportunities out there if they want to buy a new car or home in the coming year.
GMJ: That, for you, is upbeat.
Jacobe: It is, isn't it? I'll call you if I ever have anything else positive to say.
-- Interviewed by Jennifer Robison