Ex-IMF Official: Money Crisis Not Over

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ROBERT SIEGEL, host:

A few weeks ago, when there was still some guarded optimism about Fannie Mae and Freddy Mac, Kenneth Rogoff made a speech in Singapore. The Harvard economist, formerly chief economist of the International Monetary Fund, said the U.S. is not out of the woods. The financial crisis is at the halfway point, perhaps. The worst is yet to come.

And that, he said, would likely include one of the big banks or investment banks going under. Markets, as they say, tumbled on his remarks.

Well, Professor Rogoff joins us from Cambridge, Massachusetts. Welcome back to the program.

Professor KENNETH ROGOFF (Public Policy and Economics, Harvard University): Thank you.

SIEGEL: And first, is Lehman Brothers, say, the very big investment bank you had in mind, and if we were perhaps midway through the crisis a month ago, are we up to maybe 60 percent through it by now?

Prof. ROGOFF: Well, I don't think I had any one in mind. There are, certainly, the industry is bloated and consolidation was ahead. And I think that we're going to see something like that, yes.

SIEGEL: When you say it's bloated and consolidation was ahead, in this case, consolidation means what, exactly?

Prof. ROGOFF: Well, I mean, first, let me say what I mean by bloated. I mean, here's an industry which was just reaping in epic profits more than the tax sector, more than biotech. And just like any industry that goes through a boom, it's not unusual to need to see some pruning.

In the airline industry, we still have tens of millions of people flying, but periodically, a big airline goes out of business. And that's what will happen with the financial industry, that these profits just couldn't continue, and it's going to get somewhat smaller.

Now, that can happen because everybody shrinks 20 percent, what you might call and immaculate contraption of the industry. But that's not the way capitalist systems work. Big businesses go out of business. That's more typical. The strong survive, and the weak fail.

SIEGEL: Now, I realized that there are lots and lots of properties with mortgages on them. But as a layman, I find this very puzzling. It would seem to me that by now, the banks and the regulators would have at least plumbed the depths of that crisis and come up with a good sense of who's exposed to how much risk of delinquency or default.

Have they not done that, and if not, why not? Why does that crisis seem to grow?

Prof. ROGOFF: Well, the point is it's not just a matter of some bad debts. If that were all that were, you could recapitalize the system, so to speak, give them fresh infusions of cash, and they'd be off to the races again.

But the problem is, the subprime crisis has exposed weaknesses in a lot of the investment banks and some of the banks' most profitable lines of business in these very complicated rocket science, so-called derivatives, these trades that nobody understand except a few people.

And this has been incredibly profitable, and it's gone. And just putting in some capital is not going to bring all this business back. And that's part of the problem.

SIEGEL: That the business was simply overgrown, it assumed more financial sector activity than our economy actually can sustain.

Prof. ROGOFF: Yeah. I mean, otherwise, investors would be jumping in. They'd think these were fantastic buys. But they're nervous that the whole model, you know, isn't going to be quite what it was, and having some consolidation is going to leave more room for the remaining firms to make profits.

So I don't think we want to get hysterical about this, but this is what we mean by consolidation. It is, indeed, a euphemism for some firms failing.

SIEGEL: Yeah. If the problem is a bloated financial sector and the solution is consolidation, then the failure of banks or investment banks are signs that the situation is actually playing out and healing and correcting itself. So, we should there to be - by that analysis, we should expect failures if things are actually happening according to schedule.

Prof. ROGOFF: So that's the silver lining. That's the good side of it. The difficult side of it is the financial system is so complicated that we don't quite know if Lehman, you know, were to default, what happens to General Motors, who - they're very dependent on their lending. What happens to, you know, some of the other big investment banks like Merrill Lynch? We don't know.

On the one hand, you want consolidation. You want to let an airline go out of business. You don't want all the airlines to go out of business. You don't want all the airlines to go out of business. But it's - this is a very delicate moment. I don't want to pretend this is easy. I'm putting an optimistic spin on what is the worst financial crises since World War II.

SIEGEL: Ken Rogoff, thank you very much for talking with us.

Prof. ROGOFF: My pleasure.

SIEGEL: That's Professor Kenneth Rogoth, economist at Harvard University, used to be chief economist at the International Monetary Fund.

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