By Lawrence Summers

While the financial crisis dominates current discussion on the US economy, questions regarding America’s future approach to globalisation are looming increasingly large.

Since the end of the second world war, American economic policy has supported an integrated global economy, stimulating development in poor countries, particularly in Asia, at unprecedented rates. Yet America’s commitment to internationalist economic policy is ever more in doubt. Even before the significant increases in unemployment likely in the months ahead, the indicators are all disturbing. Presidential candidates attack the North American Free Trade Agreement. The Colombian free trade agreement languishes. There are increasing attacks on foreign investment in the US, not to mention growing support for restrictive immigration policies.

To all of this the conventional wisdom has a well developed response, with four standard elements. First, the sceptic regarding trade deals or other internationalist policies is educated around the many benefits of trade, not just for exporters but also for consumers and the economy more generally. (more…)

On March 17, Alan Greenspan wrote an article for the FT entitled “We will never have a perfect model of risk“, in which he argued: “We will never be able to anticipate all discontinuities in financial markets.” He concluded: “It is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation [do] not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.”

The article attracted a number of critical responses in this forum. For example, Paul de Grauwe wrote: “Greenspan’s article is a smokescreen to hide his own responsibility in making the financial crisis possible.” (Read all the responses.)

The article below is Mr Greenspan’s reply to those criticisms, written exclusively for the Economists’ Forum:

I am puzzled why the remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006 are not seen to have a common cause. The dramatic fall in real long term interest rates statistically explains, and is the most likely major cause of, real estate capitalization rates that declined and converged across the globe. By 2006, long term interest rates for all developed and major developing economies declined to single digits, I believe for the first time ever.

Doubtless each individual housing bubble has its own idiosyncratic characteristics and some point to Fed monetary policy complicity in the US bubble. But the US bubble was close to median world experience and the evidence of monetary policy adding to the bubble is statistically very fragile. Paul De Grauwe depends on John Taylor’s counterfactual model simulations to conclude that the low funds rate was the source of the US housing bubble. Taylor (with whom I rarely disagree) and others derive their simulations from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. This suggests important missing variables. Counterfactuals from such flawed structures cannot form the basis for policy.

De Grauwe asserts that “signs of recovery” (I assume he means sustainable recovery) were evident before 2004 and hence the Federal Reserve should have started to tighten earlier. With inflation falling to quite low levels, that was not the way the pre-2004 period was experienced at the time. As late as June 2003, the Fed reported “conditions remained sluggish in most districts.” Moreover, low rates did not trigger “a massive credit . . . expansion.” Both the monetary base and M2 rose less than 5% in the subsequent year, scarcely tinder for a massive credit expansion. In fact, growth in total credit market debt owed by the U.S. financial sector declined from a 13% gain during 2001 to an 8% gain during 2004. Nonfinancial sector growth was less.
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By Lawrence Summers

Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers, the Fed has demonstrated a willingness to take on directly the most problematic parts of Bear Stearns’ balance sheet, and the Fed funds rate has been reduced by 200 basis points within 7 weeks.

At the same time, processes are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac (the government-sponsored enterprises) to purchase more than an additional $300bn in mortgage-backed securities.

There is substantial scope for further regulatory action as only a third of the punitive capital charge placed on Fannie and Freddie years ago has been lifted. Moreover, legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.

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By Alan Greenspan

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal. Although inventories of vacant single-family homes - those belonging to builders and investors - have recently peaked, until liquidation of these inventories proceeds in earnest, the level at which home prices will stabilise remains problematic.

The remainder of this column can be read here. Comment from our expert panel and guest members can be read below.

By Michael S Barr and Laura D Tyson

The US economy is caught in a vicious downward spiral of declining home prices, escalating foreclosures, rising losses on mortgage-backed securities, and disappearing liquidity. The liquidity crisis has spread rapidly from the mortgage market to engulf other forms of consumer credit, commercial real estate, and municipal and corporate debt.

Alarmed by the spectre of a prolonged economic slowdown, both the Federal Reserve and the US Congress have acted aggressively to stimulate demand through monetary and fiscal levers. The US Treasury has pressed mortgage holders to restructure mortgages and suspend foreclosures on a voluntary basis. But the continuing turmoil in financial markets confirms that these actions are not enough. Restoring confidence and liquidity in credit markets requires bold action to restructure the overhang of distressed assets and contain the losses in the US housing and mortgage markets.
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By Martin Wolf

Last week’s column on the views of New York University’s Nouriel Roubini (February 20) evoked sharply contrasting responses: optimists argued he was ludicrously pessimistic; pessimists insisted he was ridiculously optimistic. I am closer to the optimists: the analysis suggested a highly plausible worst case scenario, not the single most likely outcome.

Those who believe even Prof Roubini’s scenario too optimistic ignore an inconvenient truth: the financial system is a subsidiary of the state. A creditworthy government can and will mount a rescue. That is both the advantage – and the drawback – of contemporary financial capitalism.

In an introductory chapter to the newest edition of the late Charles Kindleberger’s classic work on financial crises, Robert Aliber of the University of Chicago Graduate School of Business argues that “the years since the early 1970s are unprecedented in terms of the volatility in the prices of commodities, currencies, real estate and stocks, and the frequency and severity of financial crises”*. We are seeing in the US the latest such crisis. (more…)

By Lawrence Summers

The American economic outlook remains highly uncertain. But macro­economic policy is now properly aligned, as the economy will benefit over the next several quarters from fiscal and monetary stimulus. To the extent conditions warrant and inflation risks permit, monetary and fiscal policy are appropriately poised to provide further stimulus.

Policy towards America’s failing housing sector is in a far less satisfactory state. All honest analysts accept that policies adopted so far, such as the “teaser freezer” limits on resetting mortgage interest rates and increased federal support for mortgage lending, have had only a marginal impact on what may be the most serious crisis in housing finance since the Depression.

It appears house prices are down by 5-10 per cent from their peak, with derivatives markets predicting further declines of about 20 per cent. Price falls of this magnitude are likely to mean more than 10m would have negative equity in their homes and more than 2m foreclosures would take place over the next two years.

Foreclosures are extremely costly. Between transaction costs that typically run at one-third or more of a home’s value and the adverse impact on neighbouring properties, foreclosures can easily dissipate more than the total value of the home being repossessed. They also inflict collateral economic damage, as reduced wealth and diminished borrowing capacity in homes reduces consumer spending, increases credit market fragility and depresses local tax bases.

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“I would tell audiences that we were facing not a bubble but a froth – lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.” Alan Greenspan, The Age of Turbulence.

That used to be Mr Greenspan’s view of the US housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this question we should ask a true bear. My favourite one is Nouriel Roubini of New York University’s Stern School of Business, founder of RGE monitor.

Recently, Professor Roubini’s scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006*. At that time, his view was extremely controversial. It is so no longer. Now he states that there is “a rising probability of a ‘catastrophic’ financial and economic outcome”**. The characteristics of this scenario are, he argues: “A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe.” (more…)

By Martin Wolf

Whatever else it may be, the Federal Reserve is not boring. Indeed, by the standards of other central banks, it is hyperactive. The shock 0.75 percentage point reduction in the Federal Funds rate of interest last week, particularly if followed by the widely expected 0.5 percentage points on Wednesday, is a dramatic example. The Fed is the exemplar of an activist central bank. But US fiscal authorities are not far behind, as the $150bn (just over 1 per cent of gross domestic product) fiscal package going through Congress demonstrates.

So what are the US monetary and fiscal authorities trying to do? Will it work? What are the risks? Should others follow suit? The urgency of these questions was made clear at the annual meetings of the World Economic Forum in Davos last week. The consensus was gloomy. Comfortingly, the Davos consensus is usually wrong. The Fed is certainly trying to prove it so this time.

The answer to the first question is: apply “risk management”. That approach is associated with Alan Greenspan, the former Fed chairman. But it is also central to the thinking of the Fed under Ben Bernanke.

The remainder of this column can be read here. Debate from our panel of economists appears below.

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.