November 26, 2007
Wake up to the dangers of a deepening crisis
By Lawrence Summers
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.
The remainder of this column can be read here. Debate from our guest economists appears below.
Ricardo Hausmann: I always learn a lot from reading Larry Summers. I am not an expert on the US economy and I am sure he must have answers to the questions that his column has made me think about.
Imagine a typical country that has gone through excessive domestic spending fuelled by capital inflows and intermediated through the domestic financial system. Suddenly questions arise regarding the soundness and quality of the credit expansion and the sustainability of the rate at which the economy is accumulating foreign liabilities. We have seen all this before: Mexico 1994, Thailand and Indonesia 1997, Brazil 1999, Turkey 2001, etc. The perception is that the current account deficit is too large and the currency comes under pressure. Would Larry Summers have advised a rapid monetary expansion accompanied by fiscal easing? I believe he is on record suggesting otherwise. So what is so different about the US?
Does the US need to worry about the value of the dollar and support it with appropriate fiscal and monetary policies? Does it not risk inflation if it does not? Or is the important difference the fact that the country does not have a currency mismatch in its balance sheet and can afford to let the currency go because its has sold it short?
Or is the difference the fact that the US is a great exporter of “dark matter” and can run large official current account deficits without having to pay for them?
But even if these were the differences, why would expanding the supply of housing or artificially propping up its demand help if the problem is one of an oversupply of housing?
I am sure that Larry has answers to these questions. I would love to hear what they are.
Posted by: Ricardo Hausmann | November 26th, 2007 at 1:05 pm | Report this commentWynne Godley: An admirable piece by Lawrence Summers today! I particularly appreciate his comment that “fiscal policy needs to be on stand-by to provide immediate temporary stimulus”. This is harmonious with the recommendations in the paper “Is there a way through the woods?” recently written by myself with colleagues. It is time we all became Keynesians once again.
Posted by: Wynne Godley | November 26th, 2007 at 1:35 pm | Report this commentAllan Meltzer: The sky isn’t falling Larry. Few professional forecasters are calling for a recession next year. Slower growth, yes; recession, maybe. And currently it’s a weak maybe.
The Fed’s big mistakes in the past came when they overweighted the risk of a possible recession and let inflation control wait. That gave us the Great Inflation. Summers urges a return to those past errors. Let’s respond to a recession if it occurs, but let’s not rush to anticipate what may - or may not - happen. Economist’s forecasts are often wrong.
The credit problems are not primarily a shortage of liquidity. They come from an excess of bad loans that have to be written off in whole or part. This is a job for management and their auditors. The Fed is not responsible for correcting bad private lending decisions. The markets offer many substitutes for asset backed commercial paper. Other types of commercial paper continue to rise. So do bank loans.
Posted by: Allan Meltzer | November 28th, 2007 at 9:35 am | Report this commentLarry Summers: I appreciate Wynne Godley’s kind comments. I find myself intermediate between Wynne who emphasizes aggregate demand most of the time and Alan who emphasizes it rarely. Now is a time when it should be prominent in our thoughts.
I have puzzled over Ricardo Hausmann’s implicit suggestion that the advice I am giving the United States differs sharply from advice I gave the emerging market crisis countries in the 1990s. I think three points are relevant. First, the absence of currency mismatches is as Ricardo notes an important distinction. Second, there is a difference in the magnitude of the capital flow swing of close to an order of magnitude between the two cases. In the crisis countries you had involuntary swings in the current account of more than 10 percent of GDP. In the US the corresponding figure would be more in the 1-2 percent range and it would be towards sustainability. Third, I think it was very clear to most observers that without lots of inflation, the Korean and Indonesian and Mexican currencies had become way undervalued relative to any notion of long run equilibrium real exchange rates during their crisis periods. Without endorsing Ken Rogoff or Fred Bergsten’s precise calculations, I dont think any parallel claim could be made today.
On housing, the key issue goes to the “transactions cost” associated with foreclosure which even externalities apart can be 1/3 or more of a home’s value which is then multiplied by a whole set of externalities. To the extent that interventions tip balance against foreclosure they will improve economic performance.
Posted by: Larry Summers | November 28th, 2007 at 5:24 pm | Report this commentPascal Stalder (guest): Mr Meltzer indicates that the Fed is not responsible for bad private lending decisions. It is true that they are not directly responsible for each loan decision, however given their regulatory role, they are responsible for making sure that these financial institutions have adequate capital reserves to cover the default nature of the loans they do make. The website of the Board of Governors of the Federal Reserve explicitly indicates below its title, “The Federal Reserve … provides the nation with a safe, flexible and stable monetary and financial system.”
I would put forward that a stable financial system is not exemplified by the widespread need for banks to book large loss reserves resulting from the “irrational exuberance” of selling under-capitalized mortgages/loans. This is acceptable at the margin, but the extent of the problem indicates that the Federal Reserve did not fulfill its duties.
Mr Godley’s comment is quite pertinent in this electoral period in the United States. If you look at the figures on the US Federal budget deficit in detail, i.e. receipts vs outlays, since 2001, it is noticeable that the personal income tax cuts of 2001 created a short-term drop in receipts and an expansion of the deficit, thus creating a stimulus to the economy that minimized the recessionary period of the time. The deficit as a percentage of GDP in the past couple of years has been decreasing especially because the rate of growth of receipts is higher than the rate of growth of outlays. If fiscal stimulus is one of the solutions to a possible recession, then I would put forward that not only do we have to make the Bush tax cuts permanent, but that further tax cuts and simplification are essential, along with a limitation of the general direct taxation rate any individual or business entity may face from all sources. We have not yet reached the equilibrium point on the Laffer curve where a reduction in the overall tax rate does not provide an increase in marginal GDP growth.
Pascal Stalder is the head of portfolio risk management for a large US asset management firm
Posted by: Pascal Stalder | November 29th, 2007 at 3:55 pm | Report this commentSheetal Chand (guest): Larry Summers and his interlocutors air several key issues that arise from the current potentially crippling US predicament, which also bears serious consequences for the rest of the world. But is Summer’s proposed remedy of an easing in monetary stance together with various interventionist enhancements to alleviate the lending bottlenecks appropriate for addressing the prospective pains? Surely not!
Any alleviation from the latter is likely to be temporary as long as there is no longer term and credible vision of how to restore various fundamental virtues and balances, and the critical role of monetary policy in this regard.
The US is living way beyond its means, enabled by excessive financial leveraging. Both need to be curbed, which will require a stable real interest rate policy that provides an adequate return to savers.
Easing the monetary stance at this juncture would not provide an appropriate signal. The likely result will probably be an additional surge in financial market volatilities, futher consolidating an incipient liquidity trap, leaving aside inflationary consequences for the rest of the world. But a well-targeted and temporary fiscal expansion, the opposite of what the US Treasury recommended for the Asian crises countries, and funded in a satisfactory domestic interest rate environment would be helpful.
Sheetal Chand is a researcher in the department of economics at Oslo University
Posted by: Sheetal K. Chand | December 1st, 2007 at 12:36 pm | Report this comment