Will the Credit Crunch Steal Christmas? Gallup's chief economist discusses what the credit crisis will do, what the Fed should have done, and whether or not it will hurt the holidays

Gallup Management Journal, Nov 8, 2007

Byline: A GMJ Q&A with Dennis Jacobe, Ph.D., Gallup's chief economist

Synopsis: Gallup's chief economist discusses what the credit crunch will do, what the Fed should have done, and whether or not it will hurt the holidays. He also warns that inflation, high commodity prices, a weak dollar, and potential unemployment are on the horizon.

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."

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.