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Economist will dissect train-wreck economy in Tuesday speech

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One way to think about the complexity of the world's financial markets is to envision a vast electrical grid, an interconnected mass of transmission lines and power stations.

"When a transmitter goes out in one area, it sends shock waves through the system," said Dick Erb, a research professor in economics at the University of Montana and a former top official of the International Monetary Fund.

"Only the financial system is much more complicated than the electrical grid. It exists in multiple dimensions."

That's just one way of saying that fixing the train-wreck economy won't be easy.

Erb will address that topic on Tuesday night in a speech presented by the World Affairs Council of Montana.

"I had thought about addressing the problem with a Top 10, like Letterman, but there are a lot more than 10 problems," said Erb, who has also worked for the Federal Reserve.

To begin to dissect what's happened to both the American and global financial systems, it's helpful to look at three essential changes that now define the world's financial markets - computers, communications and financial engineering.

Computers have allowed the creation of myriad financial instruments. Telecommunication and the Internet have created 24/7 markets where the transaction costs are cheap.

And starting in the 1950s, economists and mathematicians began using their methodologies to understand markets and create new classes of investments, namely mutual funds.

"Now we have more mutual funds than we have individual stocks, and something seems amiss in that," Erb said.

Erb's concern with the changes isn't that they happened. That's a given. The trouble is that the financial institutions charged with regulation and oversight haven't kept up with the new technologies.

"Basically, what you have is a Model T system of institutions watching over a landscape of high-speed cars," Erb said.

Those changes came at a time when interest rates were extremely low and the financial markets were awash in cash.

"Basically, we had a period where there was too much money and it was too easy to get," Erb said. "The problem is, that's hard to see in real time. So can we look at the Fed and say they should have been more responsive? Should they have seen the housing bubble coming? I don't know the answers to those questions, except in hindsight."

It's easy to see now, for instance, that a huge spike in home prices accompanied by loan programs that gave money to anyone with a pulse probably wasn't a good idea.

"There's a herd mentality when things are going well, and it's hard to recognize problems, or it's convenient to look the other way," Erb said.

While others have offered more political explanations for problems such as the subprime mortgage explosion, Erb prefers more systemic explanations.

"I do agree that there is a political aspect to some of this, but that's not my field," Erb said. "And I do think that much of what's happened is a result of the speed at which things happen in the system. I don't think we've been able to keep up with all that's going on, and that's caused some of our problems."

Take the subprime crisis. That was precipitated in part by a rapid increase in loan defaults, but the loan default rate was actually in decline into 2006. What changed was a new category of subprime loans given to people with no capacity to pay and no collateral.

That fits Erb's premise for financial breakdown - a new category of financial instrument that came to market so suddenly that no one seems to have considered the possibility it was doomed to crash.

"Those loans failed pretty quickly and the whoosh down began," said Erb. "Those loans should never have been made, and somewhere in the system there has to be a way to recognize that."

The whoosh down still hasn't ended. The markets suffered yet another round of severe declines last week, and Erb said they aren't likely to end until the housing and credit markets stabilize.

While part of the fix is structural, an equal part is perception.

"What we have is a complete loss of confidence and trust, and the question is how to restore that," Erb said.

Erb favored injecting cash into the financial markets - the so-called bailout - but he's less than enthused about how the program is working.

"If we're giving the banks all this cash, it has to be made available for credit," he said. "It can't be handed out just to bolster a bank's capital base."

And yet, just last week, banks were using federal money to buy other banks rather than lending it.

"Whether this works depends on how the money is used," Erb said. "And now of course, other industries are pushing for bailouts."

Homeowners. Auto companies. Even cities are asking for federal bailout money.

Before the government throws more billions at problems, it needs to slow down, Erb believes.

"This is fixable, but we need to slow down and study the situation before we make any major structural changes in the system," he said. "But we also need to resolve the crisis. It's a very tough situation because we need action at the same time that we need to be very careful."

Late last week, the George W. Bush administration decided it didn't want to use bailout money to buy banks' distressed assets, and said it would look for other ways to spend the cash.

Erb would urge both the current administration and the new Barack Obama administration to tread carefully.

"This is a chance to create a stronger financial system, but we need a special commission to really take a hard look at everything that's happened here before we go passing major legislation," he said.

Reporter Michael Moore can be reached at 523-5252 or at mmoore@missoulian.com.

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