January 28, 2008
Beyond fiscal stimulus, further action is needed
By Lawrence Summers
Markets and perceptions of the economic outlook change rapidly. Even two months ago most observers doubted predictions of a US recession, saw no need for a fiscal stimulus, and thought that inflation fears should constrain monetary policy. Now, Washington is more or less settled on a stimulus package that will exceed $150bn; markets at one point last week expected a Fed funds rate below 2 per cent by September. The debate about recession is now about how deep and global its impact will be.
There is enormous uncertainty around economic or financial forecasts. It is possible that pessimism will recede as declining interest rates and dollar exchange rates increase demand. It is more likely, though, that the situation will deteriorate further as perceptions of declining growth increase credit spreads and risk premiums in financial markets, leading to reduced lending, borrowing and spending exacerbating the pessimism about growth.
Perhaps inevitably given the complexity of the problems, policy measures have seemed ad hoc and reactive: measures to increase bank liquidity one week; to help homeowners avoid foreclosure another; to work towards fiscal stimulus another; to lower interest rates most recently. Confidence would be well served by a comprehensive programme of measures that offers the prospect of accelerating growth and insures against a prolonged downturn. Until that happens, it will be difficult for confidence to return.
Substantial monetary and fiscal stimulus is now in train. This will reduce the severity of any recession and provide some insurance against a protracted downturn. Along with macro-economic stimulus in the US, there is the need for further policy development in three other areas – repair of the financial system, containing the damage caused by the housing sector and assuring the global co-ordination of policy.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Willem Buiter: If a fiscal stimulus can be designed and implemented that reaches just the liquidity-constrained households before the middle of 2008, it may be just about worth doing, if all you care about is minimising the depth and duration of the current economic slowdown/recession. If you care about the need to achieve a permanent increase in the USA national saving rate, to provide for a dignified old age for the median American and to prevent all of the US being owned by sovereign wealth funds by 2050, you would not wish to implement even a temporary fiscal stimulus now. Instead you would consider the coming slowdown/recession a price worth paying to secure decent standards of living during retirement for all and national sovereignty for the long run. “It’s meant to be temporary”, I hear a voice calling out. And so it is. But since the same recipe will be administered every time a recession threatens, the repeated application of temporary stimuli looks pretty permanent.
Given that, in the USA, the long run never extends beyond the end of an election year, the best we can hope for is a fiscal stimulus that delivers the greatest aggregate demand bang per buck with the least possible delay. That means tax cuts or increases in transfer payments that put cash in the pockets of those most likely to be liquidity-constrained. That means either those with steeply rising age-earnings profiles (e.g. students and young yuppies) or those with large temporary spending commitments (e.g. those with large mortgages whose interest rates have just reset to very much higher levels). This does not have much to recommend it on equity grounds, as the tax cuts or benefit increases that are most effective in stimulating demand would not benefit those with permanently low incomes, but only those with temporarily low incomes or temporarily high spending commitments. Increased public spending on goods and services is unlikely to enter the income-expenditure circuit on time. Tax cuts or public spending increases aimed at the business sector would likewise only boost demand well into the next recovery. Tax cuts benefiting those who are not liquidity- or current disposable-income constrained are a waste of tax payers’ money.
I agree with Larry that “Normal economic conditions will not return without a return to normality in the credit market”. It must, however, be clear that a return to normality in the credit market does not mean a return to the conditions existing during the final years of the credit bonanza that started around 2002. We do not want to lay the foundations for the next financial boom and bust scenario while cleaning up the mess created by the last one.
We should expect there to be higher credit risk spreads across the board and higher volatility of equity and fixed income instruments than during 2005 and 2006.
There will have to be uniform treatment for the official banking sector and the shadow-banking sector that has grown up around it.
There should be no distinction made for accounting, reporting, other regulatory requirements and tax purposes between off-balance sheet and on-balance sheet assets and liabilities. Any and all exposure should be recorded in the same way and marked to market where possible.
The adverse incentives created by securitisation for gathering information at the loan origination stage and for monitoring the ultimate borrower over the life of the loan will have to be mitigated. One way this could be achieved is by requiring the originator of the loans to continue to hold the equity or first-loss tranche of the loan, but there may be other, more effective ‘bonding measures’ aimed at mitigating the information-destroying and information-misplacing consequences of the delegated monitoring problem created by securitisation.
The terms and conditions of access to funds for households, both in the unsecured consumer credit markets and in the secured markets (car loans, mortgages) will have to be significantly tightened. The laudable intentions behind the creation of the subprime mortgage market – giving a whole new category of Americans their first chance at home ownership – were perverted by ignorance, greed, perverse incentives for originating and securitising subprime mortgages and outright deception and fraud. The sustainable level of the subprime mortgage market will be a small fraction of what it was before the blow-out of 2007.
Special measures to support the mortgage market, financially challenged mortgage holders, the home lending institutions and indirectly the US residential construction industry would be undesirable, because they would prevent the necessary structural contraction of these sectors and market segments. It would also provide a dreadful set of incentives for borrowers and lenders alike, by rewarding reckless and ignorant borrowing and reckless and dishonest lending. Of course, mortgate-encumbered home owners are the sacred cows of partisan politics in most of the industrial world. With the USA in election mode, there is bound to be a fiscal or quasi-fiscal handout for financially distressed mortgage borrowers. And why not? After all, it’s only public money.
I also agree with Larry that recapitalisation of the banks is essential. Restoring the capital adequacy ratios should definitely be achieved at least in part by raising the numerator (raising capital) rather than by just by lowering the denominator (restricting lending to the real economy). I would however, not expect the size of the balance sheets to regain their early-2007 levels for many years to come. The banking and shadow-banking sectors in the US and the UK (and indeed the financial sector as a whole), have over-expanded in the latest boom and needs to contract relative to the rest of the economy. The status quo ante is therefore not the benchmark we ought to aim at.
Collective action/free rider problems (and the legitimate fear that collective action could mean collusive behaviour at the expense of bank customers everywhere) have made the recapitalisation of the monolines problematic. Some public sector banging together of heads, as attempted by the New York State Superintendent of Insurance, may therefore well be required. The monolines seem badly undercapitalised, even if there were to be no recession. The ratio of assets insured to capital is of the order of 160, which means that a default rate (without recovery) of less than 0.7 percent would wipe out all the monolines’ capital. And until very recently, they were all rated AAA: an example of how undercapitalisation can be disguised by excessively generous ratings. How this sector can be put on a sound footing by injection between $ 5.0 billion and $15.0 billion of new capital is a mystery to me. Perhaps the decimal point should be shifted one place to the right?
The fundamental problem I have with Larry’s analysis (and earlier contributions along the same lines by him), is his failure to recognise that the USA was, in 2005, 2006 and early 2007 (and possibly much earlier) on an unsustainable path, with a grossly inadequate national saving rate and an under-regulated and poorly supervised financial sector. Both the Fed and the proponents of a quick-fix temporary tax cut appear to be focused only on putting out the rather small fire on the surface, without being aware of or caring about the massive fire burning up the peat bog underground.
Posted by: Willem H. Buiter | January 28th, 2008 at 6:12 pm | Report this commentGuillermo Calvo: I agree that we need “consistent, determined approaches” which will probably take us far beyond conventional monetary and fiscal policy. The main problem, however, is that we don’t seem to have a consistent macro view that is widely agreed upon and is itself consistent with the stylized facts of the current crisis. Thus, for example, policy has strongly relied on lowering the reference interest rate, a policy that is typically justified in models that abstract from credit market difficulties. The same applies to fiscal expansion. This lack of intellectual consistency is bound to create further confusion. Thus, I would encourage Larry and the other high-profile commentators to give a simple but clear view of their underlying assumptions.
To be consistent with my preaching, let me say that I am of the view that the current subprime crisis is starting to look more and more like those in emerging markets. The big but somewhat superficial difference, however, is that initially the problem did not entail a whole country but a sector (and, incidentally, since a sector does not print its own money, its situation is similar to that in emerging markets which suffer from Liability Dollarization, or Original Sin). Since the subprime sector hit the global financial market, it had the potential to damage other sectors through contagion, much like it happened in emerging markets after the Russian August 1998 crisis. Thus, we are witnessing the effects of a “supply” shock, implying that the crisis is unlikely to be fully resolved by a stimulus to aggregate demand through lower interest rates. And even less by transitory fiscal expansion, for the additional reason that credit crises involve “stocks,” while transitory fiscal policy involves “flows.” Thus, if you agree with my view, a key to resolving the current crisis is to reinforce the financial sector which, incidentally, leads me to enthusiastically agree with Larry’s thrust in his column. But, on the other hand, I have a much less favorable opinion about expansionary monetary and fiscal policy. These aggregate demand policies are easy to implement in the short run, while strengthening the financial sector is time consuming. Since the latter would be key for avoiding a slowdown, expansionary aggregate demand policies are likely to bring about a period of stagflation, seriously undermining the credibility of policymakers.
Posted by: Guillermo Calvo | January 28th, 2008 at 9:17 pm | Report this commentRobert Skidelsky: Guillermo Calvo urges “Larry [Summers] and other high-profile commentators to give a simple but clear view of their underlying assumptions”, pointing out that policies of lowering interest rates and fiscal expansion rely on models that “abstract from credit market difficulties”. One could go further and argue that some of the policies now being advocated have no justification in any of today’s mainstream economic models. This is particularly true of the fiscal “stimulus”, proposed by President Bush, and widely canvassed, even by the IMF.
The canonical theory of macro-economic policy, in UK at least, dates back to Nigel Lawson’s Mais Lecture of 1984. “It is the conquest of inflation, and not the pursuit of growth and employment, which…should be the objective of macro-economic policy. And it is the creation of conditions conducive to growth and employment…which should be the objective of micro-economic policy.” Lawson said nothing about policy for business cycles or in responses to shocks. His own published view (though he can speak for himself) was that cycles were part of the normal ebb and flow of business life, and central authorities should avoid any deliberate policy to stabilise real variables.
The monetary and fiscal regime operated in UK since mid- to late-1990s has stuck broadly to Lawson formula, as refined by Kenneth Clark and more clearly by Gordon Brown. In 1997 Gordon Brown mandated the Bank to keep inflation at 2.5 per cent a year. The symmetrical character of the target allows room for monetary fine-tuning. Any expected slowdown in output growth is taken to indicate that inflation will fall below target, allowing the MPC to lower interest rates to bring inflation back to target over the forecast period. Interest rate policy, in effect, can be set to accommodate (or smooth out) short-run fluctuations in output and growth. Fiscal policy aims to “balance the budget” over the cycle. As the economy slides into recession, the budget will automatically go into deficit as revenues fall relative to spending, allowing for the operation of the “automatic stabilizers”. This regime may be thought of as a kind of heavily diluted Keynesianism.
The assumption behind it is that an economy with a set of rule-governed expectations would be more stable than one subject to old-style Keynesian “demand management”. This was reinforced by the intellectual doctrine that markets were efficient and becoming more so as markets for risk expanded, so that risk could be effectively managed by the private sector just as expectations could be by the public authorities.
It seemed as though financial shocks were largely confined to the ‘emerging’ market economies, with ‘immature’ banking’ and political systems, and that we in the west had got beyond this point. This applied, even, I think to the interpretation of the Japanese stagnationary experience of the 1990s, though the stagnation of the Japanese economy did cause economists to rediscover Keynes’s half forgotten notion of the ‘liquidity trap’.
Of course, there would still be “shocks”. But the kind of shocks which western policy-makers might still have to deal with were conceived mainly as “political shocks”, ie, exogenous to the working of the economic or financial system. The favourite example from the 1990s was German reunification which caused a long period of stagnation in the German economy, and spread collateral damage through the soon-to be eurozone. Sept 11 2001 was another political shock. This may have amplified the simultaneous but autonomous collapse of the dot com bubble. The first Bush “stimulus package” was more a response to the political shock than to the economic shock. Friedman called it “crude Keynesianism risen from the dead”. In fact, it served a number of purposes at once. In President Bush’s economics, budget deficits are justified by war, recession, or national emergency and – as he put it in 2001 –“we’re still in all three”.
The sub-prime mortgage crisis and its spread through the capital market is the first genuine endogenous shock to the western financial system since the completion of the transition from the Keynesian to the post-Keynesian era of macro policy. Politics were not part of it. (The problem of ‘massive external balances’ which Martin Wolf considers to be at the root of the US’s financial fragility does seem to have a strong political component. But the sub-prime crisis is independent of that.)
Professor Calvo’s request for assumptions is thus very pertinent. The truth may well be that the assumptions about the economy held by policymakers deny the need for any such “stimulating” measures, because they abstract from the kinds of situations which justify them. I am reminded of Keynes’s remark about economists being unable to maintain a consistency between their practical suggestions and their theories. The quotation from his General Theory (p 23) is worth reproducing:
“Contemporary thought is still deeply steeped in the notion that if people do not spend their money in one way they will spend it in another. Post-war economists seldom, indeed, succeed in maintaining this standpoint consistently; for their thought to-day is too much permeated with…facts of experience too obviously inconsistent with their former view. But they have not drawn sufficiently far-reaching consequences; and have not revised their fundamental theory.”
Are we not in something like the same quandary now? The key feature of the present crisis - what makes it a crisis - is the “flight into money”. Evidently a banking system that needs periodic re-capitalising by the taxpayer and an economy which needs periodic fiscal “stimulation” does not conform to the precepts of the efficient market hypothesis. So where do we go from here?
If policymakers have a trend rate of output growth in their minds and believe that monetary and, if necessary, fiscal policy has to keep the economy growing to trend this to me is Keynesian, and contradicts the Lawson doctrine of targeting nominal variables only. On the other hand the Lawson doctrine was backed up by a reasonably coherent view of the economy (“monetarism”) whereas what Friedman called the “crude Keynesianism” of today seems to be driven by political and economic ad hocery. So, pace Calvo, do we need temporary approaches “which will take us far beyond conventional monetary and fiscal policy” or do we need to revise our view of what conventional monetary and fiscal policy ought to be?
Posted by: Robert Skidelsky | January 31st, 2008 at 12:58 pm | Report this comment