How bad is the mortgage crisis going to get?

Princeton economist Paul Krugman predicts a 25% drop in housing prices overall - and up to 50% in some places.

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(Fortune Magazine) -- If there is any word that captures the mood in the economy right now, it's uncertainty, along with shadings of bafflement and distrust. We have never seen a credit crisis quite like this. What's next?

Princeton economist Paul Krugman spoke with Fortune's Jia Lynn Yang about the impact on the economy, the outlook for home prices, and the reasons for both fear and hope. Krugman, a former Fortune columnist who now writes a column for the New York Times, will also appear in a one-hour CNN & Fortune special report on the economy that premieres March 28 at 8 p.m. ET.

Fortune: By year-end, 15 million Americans could have mortgages worth more than the value of their homes. What happens then?

Krugman: Actually, I think home prices will fall enough for us to produce about 20 million people with negative equity. That's almost a quarter of U.S. homes. If home prices are rising, or if there's positive equity, you can refinance or sell. But if you have negative equity, you can end up being foreclosed on, and then some people will just find it to their advantage to walk away. We're probably heading for $6 trillion or $7 trillion in capital losses in housing. Some fraction of that will fall on owners of mortgages. I still think the estimates people are putting out there - $400 billion or $500 billion in losses - are too low. I think there'll be $1 trillion of losses on mortgage-backed securities showing up somewhere.

How far do you think home prices will fall?

My preferred metric is the ratio of home prices to rental rates. By that measure, average home prices nationally got way too high. We'll probably basically retrace all that. So that's about a 25% decline in overall home prices. Only a fraction of that's happened so far. Of course, it varies a lot. In places like Houston or Atlanta, where home prices have not risen much compared with underlying rents, the decline will be relatively small. In places like Miami or Los Angeles, you could be looking at 40% or 50% declines.

Is there a risk of a spiral too, where the more homes that are foreclosed on, the lower home prices go?

Not without limit. But if we think home prices overshot on the way up, why can't they overshoot on the way down too? And to the extent that this all produces a recession, that's also bad for housing demand. People at the Fed are talking about feedback loops. At the moment, most of what they're concerned about is that falling home prices are leading to a credit crunch, which is actually driving up mortgage rates and making mortgages unavailable, which is causing home prices to fall even more. I'm not one of those people who thinks the Great Depression is coming back, but there's lots of echoes.

Why not the Great Depression?

Because I think we know something that we didn't then. The Federal Reserve was clueless back then. They were only concerned about protecting the nation's gold reserves, and the federal government believed that austerity and cutting spending was the answer to recession. I think we know more than we did then, and just the fact that we have a big federal government is a stabilizing factor. But the current problem is still pretty awesome.

Can you compare this to other economic crises the U.S. has faced?

The financial stuff looks like a combination of 1990 and 2001, and probably bigger than both combined. You've got the financial disruption, which is probably bigger than the savings and loan crisis. And you've got the loss of wealth from the housing bust, which is bigger than the dot-com bust. So this looks fairly nasty. And then everybody who's paying attention is worrying about the Japan analogy. Japan never had a really severe recession. It just started with a recession and never really had a recovery for a whole decade. And that's the kind of thing we're afraid of.

You've been saying 2010 is when we get out of this recession. How did you arrive at that date?

The last recession officially ended after eight months, but employment didn't start to recover until 30 months later, so I think we go at least that long this time. If the recession started in January 2008, then that would mean July 2010 is the first month we have anything that feels like a recovery. But I wouldn't be surprised if it goes longer than that - maybe into 2011.

What can Fed chairman Ben Bernanke do in terms of cutting rates? You wrote on your blog recently, "Keep cutting, Ben!"

Yeah, that's right. I'm now reasonably sure that they will cut again and again and again. A few cuts of 75 basis points and we'll be down to zero. And there's a pretty good chance that we're heading to zero, and that there's going to be a Japan-style ZIRP, zero-interest-rate policy.

Has that happened in the U.S. before?

Not since the 1930s. They didn't have the Fed funds target rate back then, but effectively we had a zero-interest-rate policy for a good part of the '30s. If the Fed responds this time with as much cutting as it did in the last two recessions, we get to zero. And then the problem is, What if that isn't enough? And there's a pretty good chance it won't be.

If the credit markets are still in paralysis, doesn't that blunt any monetary policy from the Fed?

The effective borrowing costs for a lot of people are rising, not falling, despite the Fed cuts. The rising spreads are more than offsetting it. The mortgage rates have not been falling as you might hope. And, of course, for many types of people who were able to borrow two years ago, they now can't - at any interest rate. We're looking at the classic pushing-on-a-string problem, where the Fed can cut, but it's not clear it does much for the real economy.

One of the criticisms of Alan Greenspan is that his rate cuts helped cause two bubbles, first tech, then real estate. Do we run the risk of creating another one if we keep cutting rates?

His rate cuts helped make the bubble possible, but I'm not sure there was any alternative. I remember the interest rate was down to 1%, and the economy was still losing jobs. What Greenspan did not do was listen to warnings about subprime. The Fed had substantial regulatory and moral-suasion power. They could have done a lot to limit the excesses. It's more what he failed to do during the boom than what he did in response to the last slump.

There's been talk about the 1970s and a return of stagflation. What's the risk of that?

What you worry about with stagflation is that price increases start to feed on themselves. Expectations of inflation get built into the price-setting process. I don't see any sign of that. The inflation happening right now is not being fed by expectations of inflation - there's no self-reinforcing process - it's just mostly commodity prices going through the roof. That's not pleasant, but it's not something the Fed needs to be all that worried about, as long as it stops there.

What do you think about the government's economic stimulus plan?

I wasn't happy with it. Most of the money is given to people who are not much inclined to spend it, people who are not in financial difficulty. And therefore they will just put it in the bank or pay down credit card debt. I've been trying to make the case that since this thing is going to go on for a long time, effectiveness is more crucial than speed. I'm actually for public investment now - repairing bridges, building infrastructure. Normally people say if you try to do any public investment to stimulate the economy, the recession will be over before it can come online. But I don't think that's a problem this time.

Do you think the U.S. economy relies too much on consumer spending?

Oh, yeah. No question. If you looked at the profile of the U.S. economy as it was two years ago, we had what looked like prosperity, based on high consumer spending, huge residential construction, unspectacular levels of business investment, and a huge trade deficit. You want to turn that around and have an economy that does less consumer spending, runs less of a trade deficit, and has more business investment. Of course, the problem is getting there from here.

Is there any solution?

Well, a weak dollar is helping. I look at the euro at $1.53 and cheer - not for this European trip I'm planning to take after classes are done. But for manufacturing plants in the Midwest, it's a very good thing. Arguably the only good thing we have going for the U.S. economy now is the weak dollar and how that helps exports.

A lot of foreboding economic numbers are floating around right now. What strikes you as the most alarming?

I'm looking at the increase in interest-rate spreads, with the LIBOR (London interbank offered rate) pulling away from U.S. Treasury bills. When the spread gets that big, it suggests that banks are losing trust in each other. Various measures of panic in the markets are looking bad again. I've been thinking to myself, This is now the fourth wave. We had a first wave more than a year ago, when subprime first began to go. And everyone said that was contained. We had a second wave last August, when things started going to hell. We had a third wave late in the fall, and heroic efforts seemed to bring the problems under control. And now here we go again. This is starting to look like a much more comprehensive financial crisis.

What's changed?

There has been the realization that the increased nervousness about risk and deleveraging is going to hit a lot of markets a long way removed from subprime - like when people start to see auction-rate securities go. Something has finally tipped the balance. We've got Fannie Mae and Freddie Mac suddenly having to pay substantial spreads. It seems to me like every few weeks there's another $300 billion market I've never heard of that has just collapsed. And there's credit cards, auto loans - I don't know what's next. But it's clear we're going to have a commercial real estate crash not too far short of the severity of the housing crash.

Can the government step in more and deal with this liquidity problem?

What we're having looks like a minor-key version of the bank failures in the early 1930s. Now it's mostly not banks, it's markets that were serving the function of banks and institutions that were doing banklike stuff, and it's not as bad - at least so far. But it's a question. If we were actually having a string of bank failures, then we would know what to do. The government would essentially seize the banks and guarantee the deposits. But what do you do when you have a wave of failures of things like the auction-rate securities market, which was effectively a funny way of doing banking? If you look historically at other financial crises, they typically end up with big government bailouts. But how's that going to work in this case? We don't even know who to bail out. And part of the problem is we don't even know who owes what to whom.

What do you think of the Fed's recent $200 billion temporary bailout of mortgage-backed securities?

I hope it will work, but I doubt it will; $200 billion sounds like a lot of money, but it's small compared with the securities market, so it's probably not effective.

On the other hand, do you think the sense of crisis is turning into a crisis of confidence more than anything else?

I fluctuate on that. I look at the prices on subprime-backed securities. Even the AAA-rated tranche is selling for barely over 50 cents on the dollar, and the rest is essentially worthless, which amounts to a prediction that you're going to get really very little on this stuff. Even if every subprime borrower walks away from his house and a lot of money is lost in foreclosure, it's hard to get numbers that bad. So there might be some overselling in these markets. But on the other hand, a lot of the financial system looks like it's going to shrivel up and have to be rebuilt. And that's not too good.

What's the biggest x factor, the question no one really knows the answer to?

What I don't know is how serious the real consequences of the financial-market stuff ends up being on Main Street. If all of the fancy financial instruments that have been so popular these past couple of decades sort of roll over, it's still not entirely clear to me how that ends up affecting the real economy. Will a lot of business investment just go on unaffected because companies can pay for it out of retained earnings or by borrowing with good old bank loans? How much in the end does the ability of consumers to keep spending get affected by what's going on in fairly abstruse financial markets? So I'm not quite sure how this works. Maybe that's a reason for hope. Maybe it'll turn out that all this Wall Street stuff is just less important than we think it is.

For a vivid look at the fallout from the subprime crisis, tune in to Busted! Mortgage Meltdown, a one-hour TV special report from CNN and Fortune. The program will air on CNN on Friday, March 28, at 8 P.M. ET and repeat on March 29 at 8 P.M. and 11 P.M. and March 30 at 8 P.M.