KM Investigates: An Academic's View on the Current Economic Crisis

Katherine Mehr

It’s not news that the U.S. economy is taking a nose-dive. We are continuously seeing this with the buy-outs and M&As of some of our largest banks and investment companies. The government and the Bush administration passed their $700 billion bailout plan after two tries—the first of which was voted down by pollsters on September 29. And what we watched just hours later after the first rejected plan, which was approved and repackaged as the $700 billion rescue plan on October 3, was frightening—the Dow dropped a little over 770 points, the worst single-day drop in two decades. Three days later we yet again watched the Dow take a plunge—this time close to 350 points. The plummeting financial market has instilled a large amount of fear among people across the nation.

Aswath Damodoran, a professor of finance from the NYU Stern School of Business, explains that the fear factor is because of people getting nervous about a banking crisis that will spin out of control. Nervous people feed off one another, which causes an even greater fear and leads to a vicious cycle that is very difficult to recover from. Katherine Mehr speaks with Damodaran, who explains that examining and analyzing the problem and creating a plan—one that has the actions to reinforce the words—is a good possible approach for the economy to take to overcome this near recession.

What was your initial reaction to last Monday's rejection of the $700 billion bailout plan?

The bailout plan was dead in the water because when you say bailout, what comes to mind? The $700 billion is going to somebody, and you’re getting nothing in return. That was a loser right there. The $700 billion is not being paid out to anybody, it’s going to be used to buy out securities that can be sold for 400, 500 or even 700 billion dollars in the future, so the net cost—there probably will be a net cost—isn’t going to be that $700 billion. It could be as low as zero or as high as $200 billion. And I think that once it got labeled "the bailout plan," people, not surprisingly, thought and looked at it and said, "Why should $700 billion go to somebody when I need a thousand dollars to make my mortgage payment?" That’s labeling. Once it was labeled, it was stuck to it.

When the Dow dropped 770 points and then almost 350 points, both in the same week, what kind of atmosphere was created for the American people?

You have to focus on one day, then focus on the second day. Much of that [Dow dropping] happened because people reacted to the vote on the floor. They saw the bailout plan going down. And I think it’s more a sense of people feeling that there is nobody in control. It’s not just that the bailout plan went down, it’s that "Who do we turn to?" feeling. Historically, we have always turned to the Feds or the Treasury to prevent these things from happening. The sense was that they lost control of the process and that no one’s in charge, and when you get that feeling in any economy, you get scared. That’s the fear factor right there—the sense that nobody is essentially stepping in and calling the shots scares investors, and then they run for exit doors.

What is this fear doing to organizations? How will they be able to address and plan strategically for future success during and after the crisis?

Everybody is going to feel an impact. When the economy is slow it affects everything. I think, in a sense, what’s scaring people is they feel that everything about their lives is uncertain. They are not certain about their jobs, they are not certain about their pension funds. In other words, nothing in their financial world looks like it is stable and predictable. It’s in a sense a perfect storm for a lot of people because the same time they see their portfolio liquidating itself, they are also seeing their jobs put at risk. It just adds to the fear. That fear is going to percolate throughout the organization. Organizations are just collections of people. So if the people are scared, the organization is going to be scared as well.

I think the organizations that will survive the best are the ones that are dealing with the fear frontally rather than forcing people to hide it, the ones essentially saying, "You know what, I know you are scared and this is what we are going to be doing about it." In other words, what people want right now is not denial—[they want] a feeling that people are trying to confront the problem and plan their way out. The organizations that are looking forward and saying, "We are in troubled times, we might lay off people, but this is where we want to be in two, three, five years." This is what they are doing for the future. Organizations that are doing this will come out much stronger than when they went in because they are going to be able to get market share, they are going to lose a lot of their competitors through the process. So there will be winners in this game—but they won’t be random. The winners are going to be the people who are looking past this crisis and saying, "This is how we plan to get out of the crisis and this is the plan that we have."

If I were advising organizations now, I would say: "Get out in front of this crisis and let people know that you know they are scared and they have good reason to be scared. Let them know you are still thinking ahead rather than reacting to what the market did yesterday or what the bailout plan will do today. You can’t be reactive in this atmosphere." If you are reactive, people will sense you are reactive and it is going to add to the fear.

What is your prediction of the consequences of the bailout plan? To what degree will its objectives be met?

The bailout plan is not going to disband this year. The problem now is that the liquidity has dried up in the credit market. People are not lending, banks are not lending to each other, banks are not lending to people, banks are not lending to corporations. If lending freezes up then the real economy is going to have to slow down, because if you can’t borrow money to do things, it becomes difficult to do things. One of the objectives of the bailout plan is to put a little bit more liquidity on the table by taking the securities off these banks. Ideally, what it should say is, "OK, now you can go back to lending and you don’t have to worry about these securities dragging you down." Now will that happen tomorrow? Even if the bailout plan passes tomorrow, it’s not like on Friday banks are going to start lending like crazy.1 It’s going to take a while.

The healthiest scenario is, bailout plain or no bailout plan, banks start to feel a little safer about going out and lending to people. And the liquidity done for the markets and the numbers to watch for that are the Interbank Labor Rate. The labor rate is at 7, 8 percent, and banks are very reluctant to lend to each other. You want that rate to fall back to what it usually is—1.5, 2 percent. You want see the three-month T-Bills, which are now at the 0 percent rate because people are pulling their money out of banks and saying, "Look, I want to make sure that my principle doesn’t hurt." You want to see that part of the credit market become healthy. Then, in the sense, you have a more conventional recession recovery cycle instead of this doomsday scenario that people worry about. That doomsday scenario causes people to think, "What if everyone stops lending and the entire economy comes to a complete standstil?"

Do you think job cuts and losses within certain areas of organizations are just impulse reactions to this fear, or is there a strategy behind it?

I think it is realistic. I think companies are looking at their short-term prospects. They look at consumers and realize that those people are not going to be buying for Christmas. So they think, "Why am I loading up with 50 people when I may only have five customers?" I think that job cuts are rational for companies that feel that things are going to slow down. Are some companies overreacting? Probably. That’s part of a normal cycle. That is less worrisome because we have been through recessions before. What we are worrying about is the long-term slowing down of the economy where we are not going to bounce back like we have for the last 65 or 70 years. That is what worries people. Not that they will be laid off, but that they will be out of a job for a very long time.

Organizations should look at the long term. The fact that they are laying off people doesn’t mean that they can’t have a long-term plan. They have to do what is good for them in the short term and think about the long term at the same time.

1Editor’s note: This question was posed before the bailout plan was passed Friday, October 3rd, 2008 by the United States House of Representatives.

First published on Human Resources IQ.