Larry Summer’s latest comment at the Financial Times, “What we can do in this dangerous moment.” is troubling both for its analysis of our economic mess and its remedies.
Start with his first paragraph:
It is quite possible that we are now at the most dangerous moment since the American financial crisis began last August. Staggering increases in the prices of oil and other commodities have brought American consumer confidence to new lows and raised serious concerns about inflation, thereby limiting the capacity of monetary policy to respond to a financial sector which – judging by equity values – is at its weakest point since the crisis began. With housing values still falling and growing evidence that problems are spreading to the construction and consumer credit sectors, there is a possibility that a faltering economy damages the financial system, which weakens the economy further.
There is not a shred of acknowledgment in this entire piece that the crisis we are now in is the product of many years of misguided policies. If you believe Thomas Palley, the genesis goes back to the 1980s, when we made a devil’s pact of eliminating labor’s bargaining power as a method of containing inflation and relying on growth increasingly fueled by debt and financial innovation rather than rising worker incomes. Palley has argued that that program is inherently self limiting and we have run its course.
Even if you don’t agree with Palley, the inattention as consumer savings went from low to zero was irresponsible, nay, reckless, as was cutting taxes in the face of a war, watching debt to GDP rise to a level never witnessed before, save prior to the Great Depression, and seeing the focus of investment be consumer housing, which does nothing for American competitiveness. And that’s before we get to the Fed sponsoring overly lax monetary policy by not factoring in the inflation-suppressing impact of cheap imports on inflation.
Thus as I read the article (and readers are welcome to differ), the subtext is that if we can find a way to steer through this juncture, we will, after a difficult period, be back to clear sailing.
Perhaps I am lacking in imagination, but I see lower living standards for Americans an an unavoidable outcome. We’re seeing it now, via rising food and energy costs with stagnant wages. If you were to describe what ails this economy in its most fundamental terms, we have gone on a borrowing binge to support an unsustainable level of consumption. Merely having consumption fall to a healthier level would precipitate a slowdown. And that’s before we get to the problem of “and what do we do with the debt hangover?”
The other noteworthy lapse in Summer’s analysis is that he depicts our situation and our remedies as strictly domestic. But the commodity inflation that Summers mentions in passing is due not to US or advanced economy demand, but emerging economies. Some of them, China in particular, are overheating due to the fact that they effectively have no independent monetary policy. Their dollar pegs and not-fully-successful efforts to sterilize their dollar purchases gives them an overly expansive monetary policy.
Instead of using the bully pulpit of an FT op-ed to address the real problem and possible (although admittedly unlikely) remedies, such as coordinated action, Summers falls back on leading edge conventional wisdom: pass the housing bill, engage in more aggressive fiscal stimulus (increased unemployment benefits, infrastructure spending), end ethanol subsidies, and make it easier for banks to raise new capital.
There are some good observations in the piece, but too often they come as asides. For instance, Summers notes that changes in bankruptcy laws would have been beneficial, and calls for legislative changes to make it easier for the powers that be to manage the failure of a major financial institution. Yet these points are juxtaposed with wishful thinking. For instance, Summers urges regulators to encourage banks to cut dividends, yet seems to believe that like making it easier for private equity funds to invest in them will have a meaningful impact.
From the Financial Times:
After a period of intense activity at the beginning of the year with the passage of fiscal stimulus legislation, strong action by the Federal Reserve to cut rates and provide liquidity and the introduction of anti-foreclosure legislation, policy has again fallen behind the curve. The only important policy actions of the past several months have been those forced on the Fed by the Bear Stearns crisis. It would be a mistake to overstate the extent to which policy can forestall the gathering storm. But the prospects for a more favourable outcome would be enhanced if four actions were taken promptly.
First, the much debated housing bill should be passed immediately by Congress and signed into law. It provides some support for mortgage debt reduction and strengthens the government’s hand in its troubled relationship with the government-sponsored enterprises – Fannie Mae and Freddie Mac. While it is an imperfect vehicle – too limited in the scope it provides for debt reduction, insufficiently aggressive in strengthening GSE regulation and failing to increase the leverage of homeowners in their negotiations with creditors through bankruptcy reform – it would contribute to the repair of the nation’s housing finance system. Failure to pass even this minimal measure would undermine confidence.
Second, Congress should move promptly to pass further fiscal measures to respond to our economic difficulties. The economy would be in a far worse state if fiscal stimulus had not come on line two months ago. The forecasting community is having increasing doubts about the fourth quarter of this year and beginning of the next as the impact of the current round of stimulus fades. With long-term unemployment at recession levels, there is a clear case for extending the duration of unemployment insurance benefits. There is now also a case for carefully designed support for infrastructure investment, as financial strains have distorted the municipal credit markets to the point where even the highest-quality municipal borrowers are, despite their tax advantage, paying more than the federal government to borrow. There are legitimate questions about how rapidly the impact of infrastructure spending will be felt. But with construction employment in free fall, there will be a need for stimulus tied to the needs of less educated male workers for quite some time. Fiscal stimulus measures must be coupled to budget process reform that provides reassurance that, once the crisis passes, the fiscal policy discipline of the 1990s will be re-established.
Third, policymakers need to make a clear commitment to addressing the non-monetary factors causing inflation concerns. Though this could change rapidly and vigilance is necessary, it does not now appear that there are embedded expectations of a continuing wage price spiral. Rather, the primary source of inflation concern is increases in the price of oil, food and other commodities. Even if structural measures to address these issues do not have an immediate impact on commodity prices, they may serve to address medium-term inflation expectations. Appropriate steps include reform of misguided ethanol subsidies that distort grain markets to minimal environmental benefit, allowing farm land now being conserved to be planted; measures to promote the use of natural gas; and reform of Strategic Petroleum Reserve Policy to encourage swaps at times when the market is indicating short supply. Major importance should be attached to encouraging the reduction or elimination of energy subsidies in the developing world.
Fourth, it needs to be recognised that in the months ahead there is the real possibility that significant financial institutions will encounter not just liquidity but solvency problems as the economy deteriorates and further writedowns prove necessary. Markets are anticipating further cuts in financial institution dividends; regulators should encourage this to happen sooner rather than later and more broadly to reduce stigma. They should also recognise that no one can afford to be too picky about the timing or source of capital infusions and rapidly complete the review of regulations that limit the ability of private equity capital to come into the banking system. Most important, regulators should do what is necessary, including possibly seeking new legislative authority, to assure that in the event of an institution becoming insolvent they can manage the resolution in a way that protects the system while also protecting taxpayers. It was fortunate that a natural merger partner was available when Bear Stearns failed – we may not be so lucky next time.
Unfortunately we are in an economic environment where we have more to fear than fear itself. But this is no excuse for fatalism. The policy choices made in the next few months will matter to the lives of millions of Americans, to America’s economic strength and to the global economy.