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UC Irvine Shaping the Future

Unprecedented Times:

Or Are They?

Economic Commentary by

Andrew J. Policano

Dean

The Paul Merage School of Business

November 2008

Global Opportunities

These are unprecedented times. Or are they? Consider the following description of the overall environment we are experiencing today:

A Republican is in the White House. War is fresh on everyone's mind. Immigration is fueling dramatic changes in society. New technologies are changing peoples everyday lives. Business consolidators and their Wall Street advisors are creating large new combinations through mergers and acquisitions, while the government is investigating and prosecuting prominent executives. The public's attitude toward business leaders is largely negative. The government itself is becoming more intrusive. Much of this is stimulated by an expansion that involved borrowers and creditors overreaching in their use of debt lowering the margin of safety in the financial system.

Does this paragraph portray an accurate description of what we Americans are observing right now? You would probably agree that is does. However this paragraph is actually adapted from a description of the Banking Panic of 1907 (see Robert F. Bruner and Sean D. Carr entitled The Panic of 1907: Lessons Learned from the Markets Perfect Storm). In fact, not only did a similar set of circumstances occur in 1907, but between 1814 to today, the U.S. economy has experienced no less than 14 different episodes of banking panics.

Our current financial crisis is really nothing new but it is different from previous episodes in several important ways. For a number of reasons, primarily due to a decreasing regulatory environment and the rise of new derivatives that were inaccurately priced, the impact of this crisis on the global financial system is significantly greater than in previous panics. But the effect on the macroeconomy, while painful, will be much less than experienced in the past and certainly much less than what occurred during The Great Depression. Thanks to massive global macroeconomic policy reaction as well as a number of normal safeguards in the U.S. economic system, the unemployment rate, rather than peaking at 25% of the labor force, as it did during the Depression, is likely to hit no higher than 8.0 8.5% in the U.S.

How are the current policies working?

Right now, the global economy faces two critical challenges: first, there is a widespread lack of confidence and second, a lack of liquidity. Much analysis has been done of these periods; in fact Ben Bernanke himself has studied financial crises and The Great Depression in great detail. The basic lesson learned is that when people need more liquidity, the Fed should give it to them. Simple enough, but the Fed doesn't drop cash from the sky, although it is likely that right now Bernanke wishes he could. Rather, the Fed traditionally adds liquidity to the economy through open market operations whereby it buys bonds from banks and provides cash in exchange. Banks then lend this cash to both businesses and consumers who increase spending and boost the economy. The problem currently is that banks are reluctant to lend due to very shaky balance sheets and a bleak economic outlook. Rather, they are building their cash position to restore capital adequacy ratios that deteriorated due to poorly performing assets on their balance sheets. Thus, while the Fed has been willingly providing cash to the banking system, the corresponding boost to lending has not yet occurred.

The inappropriately named Bail Out Program evolved as an attempt to remove poorly performing assets from bank balance sheets and allow loans to once again flow freely. While $700 billion is certainly a large number, life (and economics) is always a relative game. Estimates of one of the most significant class of assets in trouble (credit default swaps) are in the range of dozens of trillions of dollars. The intent, rather than to solve the entire liquidity short fall, is first to restore confidence. Still, many lenders will continue to increase reserves rather than lend.

Rather than removing bad assets, the Treasury has recognized it can have a much more significant impact by adding equity, taking an ownership position in banks and increasing capital adequacy ratios directly. In addition to freeing funds for loans, as an owner, the government can encourage additional lending. Over time U.S. Treasury and Fed actions combined with global central bank infusions should increase liquidity and restore well-functioning credit markets.

When will the market bottom and what strategy should individual investors follow?

Bear markets historically tend to settle at roughly 30% below the markets previous high. We have already hit the 30% market in both the Dow and the S & P indexes. Now, some math. If you have lost 30% (so every $1 is now worth 70 cents) you will need about a 43% return on that 70 cents to get back to your original $1. How should you allocate your portfolio to do so?

In money market funds you might take as long as 12-15 years to earn 43%; in bonds maybe 7-10 years. With equities that have historically averaged 8% returns, the time to recover your losses would be substantially less. As always, diversification is a must; how aggressive you are depends on your attitude toward risk.

While the U.S. economy will certainly survive the current financial morass, the long-term outlook is not nearly as bright as the period of prosperity that existed during the 1990s. Rather, long-term growth in the U.S. is likely to be slower and inflation and interest rates are likely to be higher during the next decade than in the past ten to twenty years.

One of the major issues challenging President-elect Obama is that the U.S. debt currently exceeds $9 trillion without including the impact of a significant future shortfall in both the Social Security System and Medicare. The consequence is that over the next decade, we must all face the following realities:

(1) The growth in government spending must slow (by much more than earmarks);

(2) Income taxes must rise;

(3) Social Security benefits must fall and/or social security taxes must rise, and;

(4) Medicare benefits must fall and/or taxes rise.

So how can President-elect Obama soften the effects of these realities?

Tax cuts alone are not the answer.

Households are unlikely to spend right now and spending is what the economy needs to rebound from the current recession. In a capitalistic economy, two critical roles that the government must take on are to act as first, the lender of last resort (as the Fed and the Treasury are now doing) and second, the spender of last resort. When consumers are reluctant to spend, the government must spend but it must spend wisely. Now is the time to enact a new New Deal. President-elect Obama's plan in fact includes several facets of such a plan. What is necessary is a significant government investment in infrastructure and research; roads, high speed rail, energy, education, communication, research in new and emerging areas of science and technology and other areas that over time provide opportunities for businesses to flourish, for the creation of higher paying jobs and for the development of innovations that continually support sustainable growth.

These investments and the easing of liquidity along with the resulting effects on growth will take time. So, how should individuals best prepare?

First, as always, diversify your portfolio based on your attitude toward risk and the time until retirement. Too safe a position will imply that you will miss excellent opportunities that are available right now in stocks that are considerably undervalued. At the same time, be careful not to absorb more risk than you can tolerate. Emerging stock markets, for example, can and have fluctuated by 40% or more each year. As one smart investor once said,You can either eat well or sleep well.

Second, increase your savings as appropriate based on a smaller than expected social security benefit, a higher cost of long-term health care and slower income growth.

Third, expect a broad market recovery but think carefully about which sectors may be long-term growth candidates.

Finally, always be a student of history. The fact that the world economy repeats cycles over and over again provides ample credence to this well known observation by Edmund Burke: Those who don't know history are destined to repeat it.

About Dean Andrew Policano

Andrew J. Policano has been Dean of The Paul Merage School of Business at the University of California, Irvine since August, 2004. Prior to that, he was Dean of the University of Wisconsin-Madison School of Business.

During the ten years while he was dean, the School's endowment rose from around $6 million to over $100m.

The Paul Merage School is highly recognized and acclaimed. In 2006, The Wall Street Journal ranked the school 6th in Information Technology; in 2003, Business Week ranked the intellectual contributions of the faculty 5th and in 2008, the Financial Times ranked the Executive MBA program 11th in the U.S. In the last four years, the School has received over $50 million in pledges to support its vision and mission.

Policano has a Ph.D. in Economics from Brown University and a B.S. in Mathematics from Stony BrookUniversity. His work in macroeconomics has been broadly published and he is an award winning teacher. He serves on the Board of Directors of two publicly traded companies, is a member of the Board of Directors of the Graduate Management Admissions Council and serves on the Investment Committee of the Orange County Community Foundation.

About The Paul Merage School of Business The Paul Merage School of Business at UC Irvine offers four dynamic MBA programs plus PhD and undergraduate business degrees that deliver its thematic approach to business education: sustainable growth through strategic innovation. We graduate leaders with the exceptional ability to help grow their organizations through strategic innovation, analytical decision-making, IT infrastructure and collaborative execution. In class and on-site experiences with real-world business problems give students the edge needed to help companies compete in today's global economy.

Six Centers of Excellence and an Executive Education program provide numerous and varied opportunities for students and the business community at large to enhance their education experience and update their professional expertise. While the Merage School is relatively young, it has quickly grown to consistently rank among the top 10% of all AACSB-accredited programs through exceptional student recruitment, world-class faculty, a strong alumni network and close individual and corporate relationships.

The Merage School combines the academic strengths and best traditions of the University of California with the cutting-edge, entrepreneurial spirit of Orange County in the heart of America's Tech Coast. Visit our website at merage.uci.edu.