March 26, 2007
As America falters, policymakers must look ahead
By Lawrence Summers
Three months ago I was able to write in this space that in economics “the main thing we have to fear is the lack of fear itself”. This is no longer true today. With clear evidence of a crisis in the subprime US housing sector, risks of its spread to other credit markets, sharp increases in market volatility, reminders of the fragility of global carry trades and signs of slowing economic growth, there is enough apprehension to go around. While it would be premature to predict a US recession, there are now strong grounds for predicting that the US economy will slow down very significantly in 2007. Whether in retrospect 2007 will prove to have been a “pause that refreshed” a nearly decade-long expansion like the growth slowdowns in 1986 and 1995 or whether it will see the end of the expansion is not yet clear. It is clear though that the global economy has been relying on the US as an importer of last resort; that the US economy has been relying on the consumer for its primary impetus; and that until now consumers have been encouraged to spend their incomes fully or more than fully by being able to access the wealth in their homes.
This growth syllogism has appeared fragile for some time, but has continued longer than many observers expected as US consumers have kept spending even after it was clear that the housing market had peaked and foreigners – particularly those in the official sector in Asia and the Middle East – have been willing to continue financing, on very attractive terms, the US in importing nearly 70 per cent more than it exports.
But the growth syllogism is now in doubt. Recent developments in the subprime sector exacerbate housing’s brake on US economic growth. Foreclosures will bloat the supply overhang of houses. At the same time reductions in capital in the housing finance sector and more rigorous credit standards will reduce the demand for new homes.
Even as these developments reduce housing prices and the construction of new houses, housing finance problems are likely to magnify wealth effects on consumption as consumers face upward resets on their mortgage rates and are unable to refinance as they had planned, and as home equity, car and credit card lending conditions tighten.
If consumer spending declines and interest rates fall or appear likely to fall, there is the real possibility that the foreign lending to the US that has financed imports far in excess of exports will start to dry up, leading to a combination of higher long-term interest rates and a weaker dollar. This would tend to raise inflationary pressures, transmit US weakness to the rest of the world and could, by discouraging foreign demand for US assets, lead to further downward pressure on investment in plant, equipment and commercial real estate.
How should economic policy respond to a potential fall-off in US demand? The great irony is that just as the worst investment decisions are made by those who do today what they wish they had done yesterday – buying assets that have already risen and selling those that have just lost their value – so also the worst economic policy decisions are made by policymakers who, instead of responding to current circumstances, seek to rectify past mistakes. It would have been desirable if policymakers had done more to restrain imprudent subprime lending to households with dubious credit in recent years.
But with the sector littered with bankruptcies, this is not today’s problem. The problem is the opposite: to avoid a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and more foreclosures.
Some argue that the Federal Reserve should have started tightening monetary policy earlier in the current cycle and avoided what they see as liquidity-driven bubbles. Regardless of the merits of this position, the theory that this constitutes a reason to avoid easing monetary policy, come what may, hardly follows.
If, as may prove the case, the dominant economic concern becomes a shortage of demand, it is incumbent on the Fed to provide stimulus so as to maintain conditions for growth and financial stability. Those in the rest of the world who have been insisting on the global imperative of increased US saving and a reduced US current account deficit should fear getting what they want too quickly. So also should those US observers who have insisted that foreign countries stop artificially holding their currencies down by purchasing dollar assets.
While US current account adjustment is a medium-term imperative, an effort to bring it about rapidly in the face of an already declining economy could turn a soft landing into a hard one. Similar principles can be extended to almost every macroeconomic policy area from fiscal policy to financial regulation.
Good economic policies operate counter-cyclically, slowing booms and mitigating downturns. It follows that when the dominant risk changes from complacency and overheating to risk aversion and economic slowdown, the orientation of policy must change as well. Economic policymakers who seek to correct past errors by doing today what they wished they had done yesterday actually compound their errors. They are in their way as dangerous as generals fighting the last war. We do not yet know how much economic conditions will change or whether current concerns will prove transitory.
But if recent developments mark a genuine change, let us hope that policymakers look forwards rather than backwards.
The writer is Charles W. Eliot professor at Harvard
Willem Buiter: Larry worries about policy makers fighting the last war and trying to correct past mistakes when doing so is in fact likely to compound these mistakes. He urges policy makers to look forward. I don’t think that is very helpful advice: with the curvature of space-time, if you look far enough ahead, you will end up looking at your own backside again. We can only anticipate the future by studying the past; policy making improves only by learning from past mistakes, not from anticipated future mistakes. It is true that we should probably not confine our retrospective to the recent past, but look backwards further. Even more important, for at least one key policy maker, the Fed, the problem is not that it is fighting the last war. It is instead that no-one – least of all the Fed - knows which war the Fed is fighting. The problem is not that the Fed is not looking far enough ahead (or back), but that no-one knows what the Fed is looking at or for.
The Fed’s monetary policy framework is a mess. Officially, the Fed has a triple mandate – not a dual mandate as is so often asserted (most recently by Governor Mishkin of the Fed in a speech on inflation dynamics given to the Fed of San Francisco on March 23). Section 2A of the Federal Reserve Act states that the monetary policy objectives are: maximum employment, stable prices and moderate long-term interest rates. So the Fed is the only monetary authority known to mankind to have a real economy objective, a nominal target and an asset market objective. The first fundamental target is unclear: maximum subject to what? The second fundamental target needs to be operationalised (given quantitative expression) to be useful. The third fundamental target is poorly defined. I assume the Act has long-term nominal interest rates in mind, but who knows? Perhaps the ‘Greenspan put’ was an expression of the third mandate of the Fed! Why the Fed insists it has a dual rather than a triple mandate is unclear. Perhaps it believes that if it achieves price stability and maximum employment, moderation of (nominal?) long-term interest rates is automatically assured. If that is indeed the reason, we should all be worried.
In addition to the confusion about the Fed’s fundamental objectives, there is the further problem that the Fed does not make any attempt to operationalise any of these three fundamental objectives, say by giving numerical targets for employment, inflation or long-term interest rates. The result is that both financial markets and those negotiating wage and price contracts in the markets for real goods and services are unnecessarily uncertain and confused about the future actions of the Fed. The Fed is a model of democratic centralism as regards monetary policy decision making, with the Chairman having virtually dictatorial powers within the Board. When a Chairman has been in office for many years, as was the case with Alan Greenspan in his twilight years as Chair, the markets develop the capacity to (gu)estimate the Fed’s reaction function even without the benefit of knowing the Fed’s objectives. Unfortunately, it takes many years to get to that point, and the new Chairman is still a long way away from that position.
A recognition of the bind the Fed is in can be gauged from Mishkin’s speech. It was, first, a coded call to introduce an explicit inflation target, and, second, a proposal to put the point inflation target at about 2 percent per annum for the PCE deflator rather than in the ‘comfort zone’ of 1-2 percent that may have been at the back of the mind of leading Fed officials past and present. The two parts of Mishkin’s proposal can be unbundled. Mishkin believes that bringing down core PCE inflation from its current level of 2.25 percent per annum to below 2.0 percent would involve large transitory output and employment costs, because he believes the Phillips curve has become very flat – the responsiveness of inflation to the output gap or to the excess of the actual over the natural rate of unemployment is now very low. Even if that is correct, a further reduction of inflation need not be costly if ‘core inflation’ – the augmentation term in the Phillips curve - can be lowered without going through a slump. The formal adoption of an inflation target might offer a unique opportunity to re-anchor inflation expectations and kick core inflation to a lower level without much pain.
Unfortunately, the odds against the Fed adopting an inflation target are overwhelming. Congress simply would not stand for it. So the private sector will continue to be in the unenviable position of having to guess at the true operational objectives of the Fed. Even knowing that the Fed looked backwards would, as long as we knew what the Fed was looking at, be an improvement over not knowing what the Fed is really shooting for.
Posted by: Willem Buiter, London School of Economics | March 26th, 2007 at 11:43 am | Report this commentJeffrey Frankel: I don’t necessarily disagree with the specifics of what Larry Summers says. But I have some thoughts about his generalization regarding looking forward versus “fighting the last war.” There is no question that fighting the last war is a common mistake. To take obvious military examples, how could US presidents in the 1980s have made the big mistake of helping Saddam Hussein (after he had already committed his well-known crimes of torture, gassing the Kurds, and invading neighbors)? They were fighting the last war against Iran: the 1980 taking of American hostages). How could the current Administration have made the big mistake of invading Iraq? They were again fighting the last war, trying to correct their mistakes of the 1980s. So a simple rule of responding the way you wish you had responded last time – whether regarding military intervention or monetary tightening – will not very often give you the right answer.
Nevertheless, a simple rule of doing the opposite of what you should have done last time will – of course — also not give you the right answer. Instead, the merits of each situation needed to be considered and the pros and cons of possible actions weighed, in light of past history and current analysis, before deciding what to do. This sounds obvious, but it has not been the national approach in recent years.
Larry Summers does not need to be told this. This philosophy was a hallmark of decision-making in the Rubin-Summers Treasury. Nevertheless, I worry that part of the current national approach, for which the media and many pundits are almost as guilty as the Bush Administration, is an excessive hurry to let bygones be bygones. No doubt Larry does not want to be heard saying “I told you so,” and in this his social antennae may be more accurately tuned than, say, Paul Krugman’s. But I am not sure we are doing the country any favors by assiduously looking forward, and never glancing backward. It seems to me that one of the reasons we as a country keep making so many mistakes is that we are not in the habit of pausing momentarily after each new development and asking for the record “who got this right and who got this wrong?” Staying on my off-subject subject of Iraq, why is the media still full of discussion of what the neo-cons have to say, or what the surprisingly numerous liberals who also got it wrong have to say. They should instead be asking what, for example, Richard Clarke has to say. (Clarke was ignored by his bosses in 1990 when he warned that Iraq might invade Kuwait, ignored in 2001 when he warned “Al Qaeda determined to strike in the US,” and then ignored after September 11 when he said that invading Iraq would be an irrelevant and unhelpful response.) His views weren’t available to the outside when he was at the NSC. But the views of others, such as Al Gore, were, and yet went largely unreported. Isn’t it time the media highlightedtheir views more as to what we should do now, instead of the views of all the people who got it wrong?
Coming finally to the subject at hand, the problem of sub-prime mortgages in 2007, I have been surprised to hear the media talk as if this was a great unexpected surprise. The best of the media says that “everybody is to blame” — by which they mean investors, borrowers and public policy — which is true. But many many economists warned of this problem ahead of time. We said that some people were being pushed to buy houses who couldn’t afford it, that (mirabile dictu) there was such a thing as too high a rate of national homeownership, and that the default rate would shoot up as soon as real interest rates rose or house prices stopped rising. Can we please just look backward long enough to record this fact, before we amnesiatically move forward to commit the next folly.
Posted by: FT Forum - Jeffrey Frankel | March 26th, 2007 at 6:43 pm | Report this commentLawrence Summers: A column has many functions I suppose. I am glad that mine was the Rorschack test that called forth Willem Buiter Jeff Frankel’s pet peeves du jour.
The common element in their comments is some discomfort with looking forward rather than backwards. Of course it is good to learn from history, and of course it is a good idea to give weight to those who have been right in the past. I don’t think I suggested otherwise.
But there is in economic policy the ever present danger of policy being procyclical rather than countercyclical and as business cycle phases change or even as the balance of risk changes the focus of policy changes. The similar idea in financial markets is that value or contrarian investing will over time beat trend chasing.
Focusing on excessively available credit, bubble creation, and the need to reduce capital inflows to the United States may well be fighting the last war now. That does not mean that past mistakes should not be acknowledged, studied and so forth. But it does mean that we need to be very careful about becoming procyclical as the economy turns down.
Willem is more troubled about the framework for monetary policy than I. Since all central banks in fact have multiple objectives and act on them, I am not sure that it is all bad to acknowledge this as the US framework does. Today, I worry more about straitjacketing than assuring credibility.
It occurs to me that the issues here at least in part are amenable to empirical analysis. Is there evidence from for example fed funds options that there is more uncertainty about fed actions than those of other central banks? Or that with appropriate controls for conditions they have risen since Alan Greenspan left? I doubt it on both counts but evidence that I was wrong in this guess would influence my view and I think those of other observers on the merits of a more rigorous inflation targeting framework.
I yield to no one and certainly not to Jeff Frankel in my distaste for the faith and conviction rather than reality based approach to Federal policy in the last 6 years. But I would caution that for reasons that are explicated at length in Bob Rubin’s book decisions can be badly made and turn out well or well made and turn out badly. So I think that Jeff overstates the case for a “results standard”.
Posted by: FT Forums | March 27th, 2007 at 6:29 pm | Report this commentAllan Meltzer: We all have heard many times that those who forget their history are likely to repeat it. One of the main reasons that the Great Inflation continued from 1965 to 1979 was that the Federal Reserve (and the Bank of England) put great weight on unemployment and too little weight on inflation. In the 1970s the Federal Reserve waited for unemployment to get above 7 per cent before it abandoned any effort to lower inflation.
The US saw both inflation and the unemployment rate rise to postwar peaks. Paul Volcker ended this policy by letting unemployment rise as required to bring down inflation. The public supported him.
Larry Summers wants to repeat the earlier mistakes. Even before the unemployment has started to rise, he wants the Fed to anticipate the rise and react against it by lowering interest rates.
An economy that cannot accept some temporary increase in the unemployment rate will live with increasing inflation followed by low investment, declining real wages, and higher unemployment. Fortunately, most of the members of the Open Market Committee understand that. And the public as in 1979-80 will demand an end to the policy.
Posted by: FT Forum - Allan Meltzer | March 28th, 2007 at 1:37 pm | Report this commentMartin Wolf: Larry Summers makes one cogent point: policy should be forward looking. I agree. But the debate cannot end there, as Larry’s critics point out.
The question surely is how to make the best forward-looking policy decisions. I agree with the critics that this can only be achieved by trying to learn from past mistakes, by recognising the dangers of unconstrained discretion, by having the best possible institutional set up and by understanding the impact of today’s decisions on the long-run environment within which policy operates.
Larry asks what evidence there is that the US has paid for its relatively unclear policy framework. This is a good question. My response would only be anecdotal: market commentators seem to spend an inordinate amount of time guessing what the Fed will do next. I would have thought that a more precise description of what the Fed is trying to achieve (while allowing for the fact that exceptional situations require exceptional measures) would be useful. It would also help to remove the cult of personality from discussions of the institution.
I am fairly close to Allan Meltzer on the biggest issue of all. The Fed must indeed keep inflation securely and credibly under control. If it fails
to do so the US - and the world - will end up in serious trouble: confidence in the dollar will be undermined and the Fed will lose the capacity to respond flexibly to emergencies. For this reason, I believe the Fed needs to err on the side of caution today. Thus, avoiding a (modest) slow-down is not the only objective of policy. On the contrary, a slow-down may be helpful if it eliminates worry about the resurgence of inflation and confirms the awareness of risk across markets.
I also believe that paying attention to medium term inflation would help achieve the Fed’s objectives. So I concur with Willem. If following that objective turns out to mean a modest degree of pro-cyclicality, in today’s circumstances, so be it. A central bank cannot - and should not try to - eliminate the cycle altogether.
Posted by: FT Forum - Martin Wolf | March 28th, 2007 at 4:13 pm | Report this commentLawrence Summers: I yield not even to Alan Meltzer and Martin Wolf in my antipathy towards inflation and awareness of the importance of central bank credibility. I cannot believe they really disagrees with my judgement that “if the dominant problem becomes a lack of demand” the Fed should be prepared to act, and not be restrained by concerns about asset price inflation. This is all that I asserted. On the question of a more elaborated framework for policy, I think of the present moment of price stability and very stable economic activity as an odd one in which contemplate radical changes in the monetary policy framework.
Posted by: Lawrence Summers | April 4th, 2007 at 10:10 am | Report this comment