Larry Summers Warns of "Deepening Crisis"

While a number of analysts, investors, and commentators have said for some time that the credit crisis is serious and is likely to damage the real economy, the only views that the Fed takes seriously are those of highly regarded economists, fellow regulators, and senior industry executives (oh, and of course, that of Fed futures prices). And the Fed’s forecasts do not acknowledge the possibility of a significant credit contraction producing real-world consequences. From the minutes of the October FOMC meeting. Take note of the 2008 GDP growth and unemployment projections:

So when Larry Summers, both an A-list economist and a former Treasury Secretary, says Things Are Bad and Could Get A Great Deal Worse, it may have some impact in policy circles.

Summers makes some arguments directly (the Fed will have to cut rates) and some a bit more cagily (the powers that be will have more credibility if they shade their forecasts to the pessimistic). He recommends fiscal stimulus if looser monetary policy is insufficient. He criticized the SIV bail-out plan as looking like Japan-style papering up of losses, but is willing to be persuaded otherwise.

One can take issue with Summers’ prescription. He places top priority on “maintaining demand” both on a macroeconomic level and in the housing market, thus favoring stimulus over preserving the dollar’s reserve currency status or trying to moderate inflationary pressures. Nevertheless, you can’t have an informed discussion of what to do about a problem unless you achieve agreement on its nature and magnitude. Summers is trying to get the officialdom to recognize the severity of the situation.
From the Financial Times:

Three months ago it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth. This is still a possible outcome but no longer the preponderant probability.

Even if necessary changes in policy are implemented, the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses than have been observed to date, moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.

Several streams of data indicate how much more serious the situation is than was clear a few months ago. First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. Single family home construction may be down over the next year by as much as half from previous peak levels. There are forecasts implied by at least one property derivatives market indicating that nationwide house prices could fall from their previous peaks by as much as 25 per cent over the next several years.

We do not have comparable experiences on which to base predictions about what this will mean for the overall economy, but it is hard to believe declines of anything like this magnitude will not lead to a dramatic slowing in the consumer spending that has driven the economy in recent years.

Second, it is now clear that only a small part of the financial distress that must be worked through has yet been faced. On even the most optimistic estimates, the rate of foreclosure will more than double over the next year as rates reset on subprime mortgages and home values fall. Estimates vary, but there is nearly universal agreement that – if all assets were marked to market valuations – total losses in the American financial sector would be several times the $50bn or so in write-downs that have already been announced by big financial institutions. These figures take no account of the likelihood that losses will spread to the credit card, auto and commercial property sectors. Nor do they recognise the large volume of financial instruments that depend for their high ratings on guarantees provided by credit insurers whose own health is now very much in doubt.

Third, the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. The extent of the flight to quality and its expected persistence was powerfully demonstrated last week when the yield on the two-year Treasury bond dropped below 3 per cent for the first time in years. Banks and other financial intermediaries will inevitably curtail new lending as they are hit by a perfect storm of declining capital due to mark-to-market losses, involuntary balance sheet expansion as various backstop facilities are called, and greatly reduced confidence in the creditworthiness of traditional borrowers as the economy turns downwards and asset prices fall.

Then there are the potentially adverse effects on confidence of a sharply falling dollar, rising energy costs, geopolitical uncertainties especially in the Middle East, or lower global growth as economic slowdown and a falling dollar cause the US no longer to fulfil its traditional role of importer of last resort.

In such an environment, economic policy needs to be governed by the clear and public recognition that restoring the normal functioning of the financial system and containing any damage its breakdown may do the real economy is the central macro-economic and financial challenge facing the US. In the US today, as in many other countries in the past, confidence will return the first day an official statement about the economy proves to have been too pessimistic.

What concrete steps are necessary? First, maintaining demand must be the over-arching macro-economic priority. That means the Fed has to get ahead of the curve and recognise – as the market already has – that levels of the Fed Funds rate that were neutral when the financial system was working normally are quite contractionary today. As important as long-run deficit reduction is, fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens.

Second, policymakers need to articulate a clear strategy addressing the various pressures leading to contractions in credit. Very likely this will involve measures that are non-traditional, given how much of the problem lies outside bank balance sheets. The time for worrying about imprudent lending is past. The priority now has to be maintaining the flow of credit. The current main policy thrust – the so-called “super conduit”, in which banks co-operate to take on the assets of troubled investment vehicles – has never been publicly explained in any detail by the US Treasury. On the information available, the “super conduit” has worrying similarities with Japanese banking practices of the 1990s that aroused criticism from American authorities for their lack of transparency, suppression of genuine market pricing of bad credits, and inhibiting effect on new lending. Perhaps there is a strong case for it, but that case has yet to be made.

Third, there needs to be a comprehensive approach taken to maintaining demand in the housing market to the maximum extent possible. The government operating through the Federal Housing Administration, through Fannie Mae and Freddie Mac, or through some kind of direct lending, needs to assure that there is a continuing flow of reasonably priced loans to credit worthy home purchasers. At the same time there need to be templates established for the restructuring of mortgages to homeowners who cannot afford their resets, so every case does not have to be managed individually.

All of this may not be enough to avert a recession. But it is much more than is under way right now.

Print Friendly, PDF & Email


  1. a

    “First, maintaining demand must be the over-arching macro-economic priority.” WTF? When this is over, can we just ban all economists (and especially the “A-list ones)? Before the crisis, everyone agreed the American consumer was in too much debt and needed to save more. Now that the problem is being addressed – by credit for the consumer drying up – we’re supposed to find a way to support demand and have the consumer continue consuming. Double the limit on everyone’s credit card? Give everyone a free house? Have the government go even further into debt (so it won’t be able to afford to honor its Social Security obligations??). Borrow and spend, borrow and spend. At some point it just can’t go on.

  2. Independent Accountant

    What is this “comprehensive” nonsense? Immigration reform? Is Larry Summers (LS) a Bush Administration flak? Does LS want to leave Harvard for a say, $50 million a year job at, drumroll please, Goldman Sachs? LS now sees things are worse than three months ago. So? Where has he been all along? Is Hank Paulson writing LS’s scripts? Or vice versa? LS seems to want to reduce interest rates. Has he followed the dollar on the foreign exchange markets? The Euro was $1.48 last time I looked. Is there any US Kafkian “person of consequence” with the guts to say, “liquidate Citigroup”? The alternative: liquidate the dollar. My answer: got gold?

  3. Anonymous

    If we forget, for the moment, Summers interest rate prescription, and just focus on “maintaining demand in the housing market”, one thing becomes painfully obvious. Demand at THESE PRICES cannot be maintained for the people who would live in the overpriced housing stock produced in the recent boom. If you look at the annual rise of Fannie and Freddie loan limits over the past 5 or 6 years, the growth has been at a nearly 9 % rate. Inflation adjusted income growth has been almost stagnant for a large percentage of the potential occupants. Only a price reduction or 50 year mortgages or subsidized rates can bridge this gap. RHK

  4. Anonymous

    Summer writes “On the information available, the “super conduit” has worrying similarities with Japanese banking practices of the 1990s that aroused criticism from American authorities for their lack of transparency, suppression of genuine market pricing of bad credits”; however, in the next paragraph he indicates that the government needs to do everything possible to prop up prices for a different asset class…residential real estate. Isn’t holding up the housing market going to lead to the same problem…a distortion in the market place resulting in a slow multi-year grind down in home prices that limits economic growth for years to come? I feel like Larry needs to address why we shouldn’t take our bitter medicine in the near term and get it behind us.

    Imagining government sponsored work-outs that permit homeowners to plow money/savings into an overvalued asset for the next several years is actually quite sad.

  5. Independent Accountant

    William Buckley once said he “would rather be governed by the first 100 names in the Boston phone directory than Harvard’s faculty”. Summers is a Harvard economics prof. Of course, we should note that Buckley never said he would “rather be governed by the first 100 names in the New Haven phone directory than Yale’s faculty”. Boolah boolah. Buckley was a Yale man.

  6. Been there

    It seems that Summers’ focus upon trying to stoke demand by lowering interest rates is misplaced. The obvious acute symptom is lack of demand for real estate. Some think a particular cause for this is the high cost of capital available to potential real estate purchasers(Rates are too high). Lower rates = increased demand, Right? Don’t think so. Real estate prices probably got ahead of themselves over the past few years relative to other assets, relative to the increase in earned income, etc. However, it seems to me that the chronic underlying problem that we’re currently experiencing is really one about trust… or the lack thereof. Investors have lost faith in the value of the financial products that they’ve been asked to buy-and by default- in the credit reporting agencies’ abilities to articulate a realistic risk assessment of the financial instruments that they are supposed to rate. When the accounting profession blew it in the late 1990’s, trust was restored only after there was a great deal of media attention attuned to the audit failures, creation of a new oversight agency(PCAOB) that was given real teeth, and the passage of new laws and regulations(Sarbanes Oxley, etc). It seems that those steps went a long way to restoring faith in the in the financial reporting system. I’ve observed nothing similar to that happening now to rectify the current crisis of confidence. There seems to be very little focus upon the rating agencies, other than what took place after the first few weeks in August and early September when significant problems first became apparent. Unfortunately, trying to solve this problem with interest rate tweaks would have been like telling all those folks who became ill eating tainted food at fast food establishments a few years ago. “Don’t worry, from now on we’ll ship the product to our restaurants using the quickest, most modern transportation equipment available.” The reality was that the food was actually spoiled from the moment it was processed/ manufactured. Increasing logistical efficiencies just increases the speed at which rotten food can change hands.

  7. Anonymous


    You are behind the curve and off the mark. Good thing my clients did not listen to your fundamentally-flawed policy prescriptions.

    Pretty obvious he has other agendas with this rubbish.

    I love how these guys think they can parachute in and parachute out. Larry, you my friend are out of your league, finance has changed dramatically in the last 10 years while you were stuffing undergrads.

  8. Juan


    Please don’t include all economists, as some, though a still small number, are heterodox and recognize that demand-side solutions can well be non-solutions and further undermine.

    You see, Summers et al are proto-typical neoclassic types, which is to say dependent on a set of theories based on very questionable assumptions of methodological individualism, instrumentalism and equilibrium.

    Their general theory stands against reality, demands that the latter conform with the former…

Comments are closed.