Published: Sun, Mar. 22, 2009 02:00AM

Editor's Note: Campbell R. Harvey is the J. Paul Sticht Professor of International Business at Duke's Fuqua School of Business. Here are some highlights from a Q&A posted last week on a blog featuring commentary from Fuqua faculty, www.dukeresearchadvantage.com.

Q: How did Southern California homeowners bring down the global economy? Southern California home prices were not the cause of the crisis. There were many different causes. Cheap money policy at the Greenspan Fed led to an expansion of debt in general. Financial institutions employed a high degree of leverage. Rising home prices made it easy for a bank making a loan to an unqualified customer (because the future home price appreciation could be used to pay the interest). In short, there was extreme risk-taking on the part of financial institutions and many individual home buyers. As for the financial institutions, given the leverage they employed, it made them extremely vulnerable to a downturn.

Q: The stimulus plan and the now seemingly endless bailouts of banks and insurance firms don't seem to be moving the needle on the stock exchanges. Is this just panic, or are the markets saying the government investments still aren't enough? Some of the bailouts are simply wasting taxpayer money. We had thousands of financial institutions fail during the S&L crisis. We simply shipped their assets to a Resolution Trust Corporation to be unwound – in an orderly way – not in a fire sale. In this crisis, we have had only 50 institutions fail. I contend that there are thousands of Zombie (alive but really dead) financial institutions.

One problem we have is that there are some institutions that are “too big to fail.” As a result, they take reckless risks because they know they will be bailed out. Essentially, in good times, they get huge rewards (and huge bonuses) and in bad times, the taxpayers bail them out. That is not a very good system – as we now know.

Q: When do we hit bottom, and what will it look like? Right now, there are no positive indicators. Most believe that the bottom will occur in early 2010. In the last recession, strong housing price appreciation pulled us into recovery as people refinanced and withdrew equity from their houses for spending. That will not occur this time. Housing will be very slow to recover – especially when you have 19 million vacant houses.

You will see a sharp movement up in the stock market at the beginning of the recovery. However, there will likely be a few false starts.

Q: In every big market turmoil, there seem to be some winners. Is anybody winning right now? The clear winners are the distressed investors – fondly referred to as the vulture investors. They have been circling for about a year and are waiting to swoop down to get deals of a lifetime. We hear about houses being sold for $1,000. There are plenty of other assets out there at amazingly cheap prices.

To make things even sweeter, the Treasury secretary wants to lend money to some of these investors to get them to buy the so-called toxic assets. This is a bad idea. It means that the private investors get all the upside profits and the taxpayer gets the downside losses.

Q: What's the difference between a depression and where we are now? I've heard some people start to use the D-word, and others say, no it's not that at all. What's the definition? There is no official definition. However, the informal definition is a drawdown in GDP of 10 percent in real terms. So far in this recession we have had a drawdown of 2 percent. (Remember that the quarterly GDP numbers are annualized, so -6 percent is really -1.5 percent). We would need a GDP growth rate of -8 percent in all of 2009 to qualify as a depression. To me, that seems unlikely. In the Great Depression the drawdown in GDP was an astounding 25 percent.

While it will be bad, there are a number of factors that will moderate the recession.

First, there are substantial government safety nets that did not exist in the 1930s. Second, the U.S. economy is much more diversified today and able to withstand large shocks. Third, the government can actually afford to bail out the banks. That is not true for all countries, especially in Europe.

Fourth, the leverage of U.S. non-financial corporations is moderate to low, giving most of them the ability to dodge bankruptcy. Fifth, if protectionist sentiment increases in the world, the U.S. is in a position to win. That is, other countries have much more to lose than the U.S. from protectionist measures.