Lawrence Summers

By Lawrence Summers
The opinions expressed are his own.

European leaders will meet today for yet another “historic” summit at which the fate of Europe is said to hang in the balance. Yet it is clear that this will not be the last convened to deal with the financial crisis.

If public previews from France and Germany are a guide, there will be commitments to assuring fiscal discipline in Europe and establishing common crisis resolution mechanisms. There will also be much celebration of commitments made by Italy, and a strong political reaffirmation of the permanence of the monetary union. All of this is necessary and desirable, but the world economy will remain on edge.

Given that Europe is the largest single component of the global economy, the rest of the world has a stake in helping to avoid major financial accidents. It also has a stake in aiding continued growth in Europe and ensuring that the European financial system supports investment around the world – particularly as cross-border European bank lending dwarfs that of banks from any other region.

Now is also a historic juncture for the International Monetary Fund. The focus of the policy response to the crisis must now shift from Brussels and Frankfurt to the IMF’s boardroom.

From the problems of the UK and Italy in the 1970s, through the Latin American debt crisis of the 1980s, the Mexican, Asian and Russian financial crises of the 1990s, the IMF has operated by twinning the provision of liquidity with strong requirements that those involved do what is necessary to restore their financial positions to sustainability. There is ample room for debate about the precise policy choices the fund has made in the past. But, the IMF has consistently stood for the proposition that the laws of economics do not and will not give way to political considerations. At key points the IMF has offered prescriptions, not just for countries in need of borrowed funds, but also for those whose success is systemically important for the global economy.

Christine Lagarde, the head of the IMF, highlighted the seriousness of problems in Europe to members of the international financial community assembled in Jackson Hole in August. She pointed to capital shortfalls in the European banking system and the need for adjustment to be carried on in ways that were consistent with continuing growth. Now, the IMF needs to speak and act on several fronts.

First, it is essential that Italy’s adjustment be carried out within the context of an IMF program. After European authorities emphasized that Greece was fully solvent and able to service all debts in full, it is unlikely that they, acting alone, have the capacity to reassure markets. Moreover, there are profound intra-European political problems if northern Europe either does or does not impose conditions on Italy. It would be much better to outsource those traumas to the IMF.

Second, as the IMF deals with individual European countries, it needs to recognize more than it did in the past that they are embedded within a monetary system and community of nations with an increasing number of common institutions. It would be inconceivable that the IMF would lend money to a country whose central bank was not committed to an appropriate monetary policy, or that was ignoring contingent liabilities in the banking system. IMF support for any European country should be premised on understandings with the European Central Bank that controls that country’s monetary policy.

Third, when engaging with individual members of a monetary union, the IMF cannot assess the prospects of one member of the monetary union in isolation. If some countries are to enjoy reduced trade deficits, others must face reduced surpluses. If there is no clear path to reduced surpluses there is no clear path to reduced deficits and hence to solvency. More generally, the sustainability of any program must be assessed in the context of realistic projections of the economic environment. The IMF must be careful not to approve adjustment programs that are not realistic.

Fourth, the IMF has a responsibility to speak clearly about threats to the global economy. Even if debt spreads in Europe fall and modest growth is reattained, the global economy is threatened by the large-scale deleveraging of European banks. An improvement in the fiscal position of sovereigns will help but this is insufficient. If banks are not recapped on a substantial scale soon, there will be a large contraction of credit in the global economy.

After Friday’s summit, attention will and should shift to the IMF.  It must act boldly but no one should ever forget a fundamental lesson of all past crises.  The international community can provide support but a nation or a region’s prospect for prosperity depends ultimately on its own efforts.

Photo: IMF Managing Director Christine Lagarde attends at a news conference in Tokyo.

By Lawrence Summers
The opinions expressed are his own.

The principal problem facing the United States and Europe for the next few years is an output shortfall caused by lack of demand. Nothing would do more to increase the incomes of all citizens—poor, middle class and rich—than an increase in demand, which would bring with it increases in incomes, living standards, and confidence. A more rapid recovery than now appears likely would reverse, at least partially, a growing disillusionment with almost all institutions and doubts about the future.

It would be, however, a serious mistake to suppose that our only problems are cyclical or amenable to macroeconomic solutions. Just as evolution from an agricultural to an industrial economy had far reaching implications for society, so too will the evolution from an industrial to a knowledge economy. Witness structural trends that predate the Great Recession and will be with us long after recovery is achieved: The most important of these is the strong shift in the market reward for a small minority of persons, relative to the rewards available to everyone else. In the United States, according to a recent CBO study, the incomes of the top 1 percent of the population have, after adjusting for inflation, risen by 275 percent from 1979 to 2007. At the same time, incomes for the middle class (in the study, the middle 60 percent of the income scale) grew by only 40 percent. Even this dismal figure overstates the fortunes of typical Americans; the number unable to find work or who have abandoned the job search has risen. In 1965, only 1 in 20 men between ages 25 and 54 was not working. By the end of this decade it will likely be 1 in 6—even if a full cyclical recovery is achieved.

To highlight the disturbing trends in a different way, one calculation suggests that if income distribution had remained constant in the U.S. over the 1979-2007 period, incomes of the top 1 percent would be 59 percent or $780,000 lower and the incomes of the average member of the bottom 80 percent of the population would be 21 percent or over $10,000 dollars higher.

Those looking to remain serene in the face of these trends, or who favor policies that would disproportionately cut taxes at the high end and so exacerbate inequality, assert, for example, that what could be called “snapshot inequality” is not a problem, as long as there is mobility within people’s lifetimes and across generations. The reality is that there is too little of both. Inequality in lifetime incomes is already only marginally smaller than inequality in a single year. And tragically, according to the best available information, intergenerational mobility in the United States is now poor by international standards, and, probably for the first time in U.S. history, is no longer improving. To take just one statistic, the share of students in college coming from families in the lowest quarter of the income distribution has fallen over the last generation, while the share from the richest has actually increased. Given the pressures associated with recession, it appears that more elite American colleges and universities have dropped need-blind admissions than have adopted it in recent years.

Why has the top 1 percent of the population done so well relative to the rest of the population? Probably the answer lies substantially in changes in technology and in globalization. When George Eastman revolutionized photography he did very well, and because he needed a large number of Americans to carry out his vision, the city of Rochester had a thriving middle class for two generations. When Steve Jobs revolutionized personal computing, he and the shareholders in Apple (who are spread all over the world) did very well, but a much smaller benefit flowed to middle class American workers, both because production was outsourced and because the production of computers and software was not terribly labor intensive. In the same way, the moves from small independent bookstores to megastores like Barnes and Noble, and now to Amazon and e-books, have meant that more books at less cost are available to consumers, but also mean fewer jobs for middle class workers in retail, publishing and distribution, and greater rewards for superstar authors and entrepreneurs who are transforming the way content is delivered. One other manifestation of progress is that increasingly sophisticated financial markets have provided ever-greater opportunities for those like Warren Buffett, with the ability to detect errors in prevailing valuations, to profit handsomely.

There is no issue that will be more important to the politics of the industrialized world over the next generation than its response to a market system that distributes rewards increasingly inequitably and generates growing disaffection in the middle class. To date, the dialogue has been distressingly polarized. On one side, the debate is framed in zero-sum terms and the disappointing lack of income growth for middle class workers is blamed on the success of the wealthy. Those with this view should ask themselves whether it would be better if the U.S. had more entrepreneurs like those who founded Apple, Google, Microsoft and Facebook, or fewer. Each did contribute significantly to rising inequality.  It is easy to resent the level and the extent of the increase in CEO salaries in the United States, but it bears emphasis that firms that have a single owner, such as private equity firms, often pay successful CEOs more than public companies do. And for all their problems, American global companies over the last two decades have done very well compared to those headquartered in more egalitarian societies. When great fortunes are earned by providing great products or services that benefit large numbers of people, they should not be denigrated.

At the same time, those who are quick to label any expression of concern about rising inequality as either misplaced or a product of class warfare are even further off base. The extent of the change in the income distribution is such that it is no longer true that the overall growth rate of the economy is the principal determinant of middle class income growth—how the growth pie is sliced is at least equally important. The observation that most of the increase in inequality reflects gains for those at the very top—at the expense of everyone else—further belies the idea that simply strengthening the economy will reduce inequality. Indeed, focusing on American competitiveness, as many urge, could easily exacerbate inequality while doing little for most Americans, if that focus is placed on measures like corporate tax cuts or the protection of intellectual property for companies who are not primarily producing in the United States.

What then, is the right response to rising inequality? There are today too few good ideas in the political discourse, and the development of better ones is crucial to our democracy. But here are several:

First, government must be careful to insure that it does not facilitate increases in inequality by rewarding the wealthy with special concessions. Where governments dispose of assets or allocate licenses, there is a compelling case for more use of auctions to which all have access. Where government provides insurance—implicit or explicit—it is important that premiums be set as much as possible on a market basis rather than in consultation with the affected industry. A general posture for government of standing up for capitalism rather than particular well-connected capitalists would also help.

Second, there is scope for pro-fairness, pro-growth tax reform. A time when more and more great fortunes being created and government has larger and larger deficits is hardly a time for the estate tax to be eviscerated. With smaller families and ever more bifurcation in the investment opportunities open to the wealthy, there is a real risk that the old idea of “shirt sleeves to shirt sleeves in three generations” will be obsolete, and those with wealth will be able to endow dynasties. There is no reason why tax changes in a period of sharply rising inequality should reinforce the trends in pretax incomes produced by the marketplace.

Third, the public sector must insure that there is greater equity in areas of the most fundamental importance. It will always be the case in a market economy that some will have mansions, art, and the ability to travel in lavish fashion. What is far more troubling is that the ability of children of middle class families to attend college has been seriously compromised by increasing tuitions and sharp cutbacks at public universities and colleges. At the same time, in many parts of the country, a gap has opened between the quality of the private school education offered to the children of the rich and the public school educations enjoyed by everyone else. Most alarming is the near doubling, over the last generation, in the gap between the life expectancy of the affluent and the ordinary.

Neither the politics of polarization nor those of noblesse oblige on the part of the fortunate will serve to protect the interests of the middle class in the post-industrial economy. We will have to find ways to do better.

Photo: An Occupy Wall Street demonstrator projects a message on the side of the Verizon Building during what protest organizers called a “Day of Action” in New York. REUTERS/Jessica Rinaldi

By Lawrence H. Summers
The views expressed are his own.

The central irony of financial crisis is that while it is caused by too much confidence, too much borrowing and lending and too much spending, it can only be resolved with more confidence, more borrowing and lending, and more spending.  Most policy failures in the United States stem from a failure to appreciate this truism and therefore to take steps that would have been productive pre-crisis but are counterproductive now, with the economy severely constrained by lack of confidence and demand.

Thus even as the gap between the economy’s production and its capacity increases and is projected to increase further, fiscal policy turns contractionary, financial regulation turns towards a focus on discouraging risk taking, and monetary policy is constrained by concerns about excess liquidity.   Most significantly the nation’s housing policies especially with regard to Fannie Mae and Freddie Mac–institutions whose very purpose is to mitigate cyclicality in housing and who today dominate the mortgage market–have become a textbook case of disastrous and procyclical policy.

Annual construction of new single family homes has plummeted from the 1.7 million range in the middle of the last decade to the 450 thousand range at present.  With housing starts averaging well over a million during the 1990s, the shortfall in housing construction now projected dwarfs the excess of construction during the bubble period and is the largest single component of the shortfall in GDP.

Losses on owner-occupied housing have reduced consumers’ wealth by  more than $7 trillion over the last 5 years, and uncertainty about the future value of their homes, as well as the inability to refinance at reasonable rates, deters household outlays on durable goods.   The continuing weakness of the housing sector is a major source of risk for major U.S. financial institutions raising significantly the costs of the loans they offer.

In retrospect it obviously would have been better if financial institutions and those involved in regulating them–especially the FHFA–recognized that house prices can go down as well as up; if more rigor had been applied in providing credit; if the GSEs had been more careful in monitoring those originating and servicing loans; and if all those involved had been more vigilant about fraudulent behavior.

The question now is what should be done to address the housing market, given the drag it represents on the national economy.  With virtually all mortgages in the United States provided by the Federal government or guaranteed by the GSEs, this is inevitably a matter of government policy.

Unfortunately, for the last several years policy has been preoccupied with backward-looking attempts to address the consequences of past errors in mortgage extension by addressing homeowners on a case-by-case basis, and decisions regarding the GSEs have been left to their conservator FHFA which has taken a narrow view of the public interest. FHFA has not acted on its conservatorship mandate to insure that the GSEs act to stabilize the nation’s housing market, and taken no account of the reality that the narrow financial interest of the GSEs depends on a national housing recovery.  Instead of focusing on the stabilization of the housing market, its focus has been on reversing its previous policies heedless of changes in the environment, and in treating mortgage finance as a morality play involving homeowners, financial institutions and banks rather than an important component of national economic policy.  A better approach would involve a number of changes in policy.

First, and perhaps most fundamentally, credit standards for those seeking to buy homes are too high and rigorous in America today. This reduces demand for houses, lowers prices and increases foreclosures, leading to further tightening of credit standards and a vicious growth-destroying cycle.  Publicly available statistics suggest that the characteristics of the average applicant in 2004 would make an applicant among the most risky today.  Of course the pattern should be opposite, given that the odds of a further 35 percent decline in house prices are much lower than they were at past bubble valuations.

Second, as President Obama stressed in presenting his jobs bill, there is no reason why those who are current on GSE guaranteed mortgages should not be able to take advantage of lower rates.  From the point of view of the guarantor as distinct from the mortgage holder, lower rates are all to the good since they reduce the risk of default.  Yet, at least until now the GSEs have made refinancings very difficult by insisting on significant fees and by requiring that any new refinancier take on all the liability for errors in underwriting the original mortgage, at a cost to American households of tens of billions a year.

Third, stabilizing the housing market will require doing something about the large and growing inventory of foreclosed properties. The same property sold in a foreclosure sale nets about 30 percent less than if sold in the ordinary way and the knowledge that that there is a huge overhang of foreclosed properties deters home purchases.   Aggressive efforts by the GSEs to finance mass sales of foreclosed properties to those prepared to rent them out could benefit both potential renters and the housing market.

Fourth, there is the issue of preventing foreclosures which was the initial focus of housing policy efforts.  The truth is that it is far from clear what the right way forward is.  While the Obama administration HAMP effort has been widely criticized for overly restrictive eligibility criteria, the reality is that a large fraction of those receiving assistance have ultimately been unable to meet even their reduced obligations.  This suggests that the task of helping homeowners without either damaging the financial system or simply delaying inevitable outcomes is more difficult than is often supposed.  Surely there is a strong case for experimentation with principal reduction strategies at the local level.  The GSEs should be required to drop their current posture of opposition to experimentation and move on a more constructive posture.

Fifth, there were clearly substantial abuses by major financial institutions and most everyone in the mortgage industry during the bubble period.  Just compensation to the victims is a legitimate objective of public policy.  But allowing negotiation over the past to be the dominant thrust of present policy creates overhangs of uncertainty that impose huge costs on the financial system and inhibits current lending.   It is equally in the interests of bank shareholders and the housing market that a rapid resolution of disputes be achieved.  The FHFA should be striving to bring the current period of uncertainty to a rapid conclusion.

While the GSEs are by far the most important actors in the mortgage space (and hence the FHFA that serves as their conservator is the most important player in housing policy), there are others who can make a constructive difference.  Bank regulators could facilitate inevitable restructuring of underwater mortgages by requiring banks to treat second mortgages and home equity loans in realistic ways.  The Fed could support demand and the housing market by again expanding purchases of mortgage backed securities.

With constructive approaches by independent regulators, far better policies could be in place six months from now.  The anticipation of a change to supportive policies could change the tone of the market even sooner.  There is nothing else on the feasible political horizon that can make as a large a difference in driving American economic recovery.

PHOTO: The framework for a single family home currently under construction is seen in Los Angeles, California October 18, 2011. REUTERS/Fred Prouser

By Lawrence H. Summers
The views expressed are his own.

In his celebrated essay “The Stalemate Myth and the Quagmire Machine,” Daniel Ellsberg drew out the lesson regarding the Vietnam War that came out of the 8000 pages of the Pentagon Papers.  It was simply this:  Policymakers acted without illusion.  At every juncture they made the minimum commitments necessary to avoid imminent disaster—offering optimistic rhetoric but never taking steps that even they believed offered the prospect of decisive victory.  They were tragically caught in a kind of no man’s land—unable to reverse a course to which they had committed so much but also unable to generate the political will to take forward steps that gave any realistic prospect of success.  Ultimately, after years of needless suffering, their policy collapsed around them.

Much the same process has played out in Europe over the last two years.  At every stage from the first signs of trouble in Greece to the spread of problems to Portugal and Ireland, to the recognition of Greece’s inability to pay its debts in full, to the rise of debt spreads in Spain and Italy, the authorities have played out the quagmire machine.  They have done just enough beyond euro-orthodoxy to avoid an imminent collapse, but never enough to establish a sound foundation for a resumption of confidence. Perhaps inevitably, the gaps between emergency summits grow shorter and shorter.

The process has taken its toll on policymakers’ credibility.  As I warned European friends quite some time ago, authorities who assert in the face of all evidence that Greece can service on time 100 percent of its debts will have little credibility when they later assert that the fundamentals are sound in Spain and Italy, even if their view is a reasonable one.  After the spectacle of stress tests that treat assets where credit default swaps exceed 500 basis points as riskless, how can markets do otherwise than to ignore regulators assertions about the solvency of certain key financial institutions.

A continuation of the grudging incrementalism of the last two years risks catastrophe, as what was a task of defining the parameters of too big to fail becomes a challenge of figuring out what to do when key insolvent debtors are too large to save.  There are many differences between the environment today and the environment in the Fall of 2008 or any other historical moment.  But any student of recent financial history should know that breakdowns that seemed inconceivable at one moment can seem inevitable at the next.

To her very great credit, new IMF managing director Christine Lagarde has already pointed up the three principles any approach to Europe’s financial problems must respect.  First, Europe must work backwards from a vision of where its monetary system will be several years hence.  The reality is that politicians have for the last decade dismissed the widespread view among experienced monetary economists that multiple sovereigns budgeting and bank regulating independently will over time place unsustainable strains on a common currency.  The European Monetary Union has been a classic case of the late Rudiger Dornbusch’s dictum that “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”  So it has been with the buildup of pressures on the Euro system.

There can be no return to the pre-crisis status quo.  It is now clear that market discipline within monetary union is insufficiently potent and credible to assure sound finance, and equally apparent that when banks and sovereigns do not have access to lender of last resort financing the risk of self fulfilling confidence crises becomes substantial.  The respective responsibilities of the ECB, financial regulatory authorities and EU officials can be defined in different ways.  But there must simultaneously be an increase in the central financial commitment to the financial stability of member states and reduction in their financial autonomy if the common currency is to survive.

Second, the Managing Director is right to point up serious issues of inadequate capital in European banks.  Taking even relatively optimistic views about sovereign debt and growth prospects, European banks in at least as problematic a condition as American banks were in the summer of 2008.  Unfortunately in many cases they are far larger relative to their national economies.  Now is the time for realistic stress testing and then resorting to private capital markets if possible and to public capital infusions if necessary.  With delay, private capital markets will close completely and nervous managements will rein in the provision of credit just when credit contraction is most likely to damage real economic prospects.

Third, like her predecessor, Ms. Lagarde has broken with IMF orthodoxy in recognizing that expansionary policies are necessary in the face of substantial economic slack.  The oxymoronic doctrine of expansionary fiscal contraction is being discredited every month.  Europe needs a growth strategy.  Yes, almost everywhere and certainly in the most indebted countries, binding commitments to eventual deficit reductions are a necessity.  And in some places credibility has been lost to the point where immediate actions are necessary.  But Europe only has a chance of handling its debts and contributing to a stronger global economy if it grows.  This will require both aggregate fiscal and monetary expansion.

This last point is an essential lesson of recent American experience.  Even though credit spreads and equity values had normalized by the end of 2009 and the financial system was again functioning reasonably normally a year after the 2008 panic, lack of demand has continued to constrain growth.  While any one household or one nation can improve its balance sheet by saving more and spending less, the effort by all to cut back means reduced incomes and ultimately less saving for all.  Germany in particular needs to recognize that if other European nations are going to borrow less, then it will be able to lend less and that as a matter of arithmetic this will mean a smaller trade surplus.

The world’s Finance Ministers and Central Bank Governors will gather in Washington this weekend for their annual meetings.  The meetings will have been a failure if a clearer way forward for Europe does not emerge.   Remarkably, the European authorities that drove Ms. Legarde’s selection just 3 months ago have rejected important components of her analysis.  In normal circumstances comity would require deference by others to European authorities on the resolution of European problems.  Now when these problems have the potential to disrupt growth around the world all nations have an obligation to insist that Europe find a viable way forward.

Failure would be yet another example of what Churchill called “want of foresight, unwillingness to act when action would be simple and effective, lack of clear thinking, confusion of counsel until the emergency comes, until self preservation strikes its jarring gong–these are features which constitute the endless repetition of history.”

By Lawrence Summers
The opinions expressed are his own.

September 11, 2001, was the day before classes were to start at Harvard College during my first year as Harvard president. I first heard of the planes crashing into the World Trade Center as I left a routine breakfast at the Faculty Club. Neither I nor anyone around me had full confidence about how to respond to such an event, one without precedent in our life experience. But, by midday, we had decided to hold a kind of service late that afternoon to commemorate what had happened, to try to provide reassurance to a scared community of young people.

It naturally fell to me, as president of the university, to deliver remarks. Those I drafted expressed shock at the magnitude of the tragedy and sympathy for the victims and their families. I promised the support of our community for the victims and those assisting them, but my draft also stressed that the tragedy we’d witnessed was quite unlike an earthquake or tornado: The attacks of September 11 were acts of malignant agency that rightly called forth outrage against the perpetrators. I wrote, too, of the imperative that we be intolerant of intolerance, and I suggested that we would best prevail by simply carrying on the university’s everyday, yet vitally important, work.

My draft remarks seemed to me appropriate and, even, anodyne. I was therefore quite surprised when some whose advice I sought, and some who heard my remarks as delivered, took strong exception to my suggestion that outrage against the 9/11 perpetrators was appropriate. Others objected to my use of the word “prevail.”

It was not just Harvard where such sentiments were strong. A year after September 11, I attended a meeting of the Association of American Universities along with other presidents of the nation’s leading research schools. On that occasion, a hapless young Bush administration staffer had come to address the new national security threats raised by 9/11. The reverential way this young staffer invoked “the president” grated on our ears, but he also raised some concerns that seemed reasonable to me: whether, for instance, it was appropriate to offer the full nuclear-engineering curriculum to students from terrorist states; or whether, in certain circumstances, it might be necessary for universities to cooperate with search warrants served on those suspected of representing terrorist threats. I confess I was nonplussed by the reactions of some of my fellow presidents—some of whom delivered glib lectures on academic freedom without so much as acknowledging the new security threats the nation faced. Did not universities, I wondered, have obligations as institutional citizens, responsibilities as well as privileges?

These responses to 9/11, at Harvard and elsewhere, spoke to the ambivalence about national security that developed at U.S. universities over the last 35 years of the twentieth century. It had begun with Vietnam, reviled not just as a costly and imprudent application of American power, but also as a profoundly immoral enterprise. In the Vietnam years, some American government officials could not visit universities without making security precautions. Students participating in ROTC at the time were wary of wearing their uniforms, lest they be assaulted verbally or even physically.

Even after the Vietnam war ended, ambivalence on campuses about American power and the use of force to defend it persisted. University communities were for the most part appalled when Ronald Reagan spoke of the Soviet Union as an “evil empire.” They were excited by proposals that the West freeze its nuclear weapons and dubious about the first Iraq war. Much of the opposition to the United States and its military was rhetorical, but there were concrete ways, too, in which America’s universities withdrew from engagement with national security concerns. Many insisted, for instance, that ROTC leave their campuses. Harvard refused to permit undergraduates doing their ROTC training at MIT to note their service in the Harvard yearbook. While university presidents are routinely called upon to be on hand to cheer athletic triumphs and to lend their presence to student cultural performances, no Harvard president spoke at a ROTC commissioning ceremony from 1969 until 2002. In the decade before 2001, the nation’s law schools had banded together to mandate severe restrictions for military recruiters on their campuses. The argument was that the “don’t ask, don’t tell” policy approved by multiple presidents and Congresses was as discriminatory as that upheld by all-white or all-male law firms and so warranted the same sanction against on-campus recruiting.

September 11 made such arguments seem less and less reasonable. Terrorists who killed American innocents in our most iconic city without provocation reintroduced the plausibility, the necessity, of greater moral clarity. In 2001, I argued that policy in every area must be debated vigorously, but respect for those who risk their lives for our freedom must be a basic value. Now, in 2011, we take such ideas for granted. Students urged that ROTC return to the Harvard campus. Applications to programs in public service have risen sharply. Interest in issues of international relations in general, and the Middle East in particular, has soared. And the number of students answering the military’s call has risen in kind.

Where are we today? Relative to any expectation of ten years ago, the greatest surprise—and blessing—is that there has been no significant terrorist incident on U.S. soil since 9/11. As George Orwell allegedly put it, “Men sleep peacefully in their beds at night, because rough men are prepared to do violence on their behalf.” As the United States seeks to build good will with the world—rather than to impose its seigniorial will—and as “don’t ask, don’t tell” recedes into history, U.S. universities must remember an important lesson: that, just as we are strong because we are free, we are also free because we are strong.

This essay is reprinted from the September 15 issue of The New Republic.

By Lawrence H. Summers
The opinions expressed are his own.

At last Washington has reached a deal that raises the debt limit and averts a default that would have been a national embarrassment and an economic and geopolitical catastrophe.   The forces shaping the deal and the deal itself are multifaceted–and so is the right reaction to it.  Mine has a number of elements.

Relief. There will be no first default in U.S. history; no economy-damaging short-run austerity; no attack on the nation’s core social protection programs or on universal health care; and no repeat of the last month’s shabby spectacle for at least 15 months.  All of this was in doubt even a week ago as Congressional intransigence threatened to make the problem of acceptably raising the debt limit insoluble.  The Hippocratic Oath applies in economics as well as medicine and so it is no small thing for the Administration to have reached an agreement  that does no immediate harm.  It may well be that no better agreement was achievable given the political dynamics in Congress.

Cynicism. An objective observer would predict larger U.S. budget deficits in the outyears than he or she would have predicted a few months ago.  The economic forecast has deteriorated (see chart below), and it is reasonable to estimate that even a half-a-percent reduction growth averaged over 10 years adds well over a trillion dollars to the national debt in 2021.

Despite claims of spending reductions in the $1 trillion range, the actual agreements reached so far likely will have little impact on actual spending over the next decade.   The deal confirms the very low levels of spending already negotiated for 2011 and 2012, and caps 2013 spending about where most would have expected this Congress to end up.  Beyond that outcomes are anyone’s guess—the reality is that Congress votes discretionary spending  annually and the current Congress cannot effectively constrain future actions.  True, there are caps and sequester threats present in the debt limit legislation, but these are virtually certain to be reformulated in 2013 so the reality was and still is that discretionary spending going forward will largely reflect the will of future Congresses.

Remarkably for a matter so consequential the agreement that the Supercommittee will seek to reduce the deficit by $1.5 trillion comes without any agreement on what the baseline is from which the $1.5 trillion is to be subtracted.  Is the $1.5 trillion from a baseline that includes or excludes the Bush tax cuts? Includes or excludes tax extenders and the annual AMT fix?  These and other similar questions are unresolved at this moment.

Baseline arguments are mind-numbing but highly consequential.  Perhaps a current-law baseline will be employed, assuming a phaseout of the Bush tax cuts, in which case there will be no motivation to assure repeal of the high-income tax cuts because it will not count toward the goal.  Perhaps, and more likely, in an effort to make deficit reduction easier a baseline following current policy will be adopted.  This would treat the nonextension of the Bush high-income tax cuts as a $1 trillion tax increase—hardly a likely outcome given the probable composition of the Supercommittee.

Economic Anxiety. The United States’s current problem is much more a jobs and growth deficit than an excessive budget deficit.  This is confirmed by the fact that a single bad economic statistic more than wiped out all the stock market gains from the avoidance of default and the fact that bond yields reached new  lows  at the moment of maximum apparent danger on the debt limit.

On the current policy path which involves a substantial withdrawal of fiscal stimulus when the payroll tax cuts expire at the end of the year, it would be surprising if growth was rapid enough even to bring unemployment down to 8.5 percent by the end of 2012.  With growth at less than 1 percent in the first half of the year, the economy is now at stall speed—with the prospects of adverse shocks from a European financial crisis that is decidedly not under control, spikes in oil prices, and confidence declines on the part of businesses and households.  Based on the flow of statistics, the odds of the economy going back into recession are at least 1 in 3 if nothing new is done to raise demand and spur growth.

If these judgments are close to correct, relief will soon give way to alarm about the United States’s economic and fiscal future.  Among all the machinations ahead, two issues stand out. First, the single largest and easiest method of deficit reduction available is the nonextension of the Bush high income tax cuts.  The President should make clear that he will not accept their extension on any terms.  Clarity on that trillion-dollar point, along with very modest entitlement reform, will be sufficient to hit current deficit reduction targets.

Second, it is essential that the payroll tax cut be extended and further measures such as infrastructure maintenance and unemployment insurance extension be taken to spur demand.  There is still time to confirm Churchill’s maxim that the United States always does the right thing after exhausting all the alternatives.

By Lawrence H. Summers
The opinions expressed are his own.

Reuters invited leading economists to reply to Mark Thoma’s Op-Ed on the “great divide” in economics and will be publishing the responses. Below is Reuters columnist Lawrence Summers’s reply.  Here are responses from Roger Martin, Ashwin Parameswaran, James Hamilton, Dean Baker, and a recap of Paul Krugman’s.

Mark Thoma is obviously right that academic economists should listen more to practitioners – both economists who who work outside the academy and also, although he does not stress this point, to those who are active participants in the economy as buyers and sellers of products, labor, securities or anything else.  He is also right that much of what goes on in academic economics is rather removed from any reality and that there are all sorts of important practical problems that should get more attention from academics.  However there are a number of respects in which his arguments is naive, incomplete, or goes to far and his analogy with what doctors do is misplaced.

First, there is a proper division of labor between those who develop theories and those who meet day to day challenges.  It is progress, not regress, that today we have physicists who conceive theories and do experiments and civil engineers who build bridges.  This work was done by the same people centuries ago.  In the same way, it represents progress through the division of labor that it is no longer true that academics are the people best informed about the evolution of next quarter’s GDP as was the case even in the 1960s.  While there are exceptions, much of the progress in modern medicine comes from scientific research done by people who do not on a regular basis see patients.  Watson and Crick would have been slowed down, not helped, if they had spent time with MD’s.

Second, as Keynes’ comments on the advantages of being conventionally wrong rather than unconventionally right illustrate, it is a serious mistake to overstate the insights possessed by practitioners in any field.  Anyone in mutual funds will tell you that active managers regularly outperform the market.  Only economic scientists realized they do not.  Contrary to the the implications of Thoma’s column, the best calls on the real estate bubble came from academics like Bob Shiller and Nouriel Roubini, not from any economists involved with the home building or realty industries.

Every industry’s leaders think they understand the economics of trade — protecting their industry is good.  The difficulty of casual induction from practical experience is not confined to economics.  The double blind controlled clinical trial was one of the great medical innovations of the 20th century, precisely because such trials refuted so much of what clinicians knew.

Third, there is as much of a problem of economists who are too responsive to worldly audiences as too little.  Think about the economists working for right-wing think tanks who proclaim that tax cuts raise revenues, or those who argue for protection of the businesses who employ them.  To believe as I do that  the movie “Inside Job” was wrong in many of its particulars and far too sweeping in its indictment is not to deny that the preservation of disinterest among academic experts is something very important.  Indeed, serious efforts are under way in academic medicine to reduce the linkages between academic physicians and pharmaceutical companies, though these companies obviously have a great deal of practical knowlege to share.

I have spent much of my career as an economist in dialogue with non-academic economists, and much more importantly, in dialogue with non-economists with important experience in the matters economists seek to understand and influence.  I have benefitted enormously from this interaction.  And I was once led to publish a paper entitled “The Scientific Illusion in Empirical Macroeconomics,” because I was frustrated by the lack of real world plausibility of what many macroeconomists do.  So I sympathize with Thoma’s complaints.  But as he follows his own advice and engages more fully with the world of practice, I suspect he will reduce the fervor with which he holds his views.

By Lawrence H. Summers
The opinions expressed are his own.

With last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase. Where the crisis had been existential for small economies on the periphery of Europe but not systemically threatening to either the idea of European monetary union or to the functioning of the global financial system, it now threatens both European integration and the global recovery. Last week’s drama surrounding bond auctions in Europe’s third leading economy should convince even the most hardened bureaucrat that the world can no longer let policy responses be shaped by dogma, bureaucratic agenda and expediency. It is to be hoped that European officials can engineer a decisive change in direction but if not, the world can no longer afford the deference that the IMF and non-European G20 officials have shown towards European policy makers over the last 15 months.

Three realities must be recognized if there is to be a chance of success. First, the maintenance of systemic confidence is essential in a financial crisis. Teaching investors a lesson is a wish, not a policy. U.S. policymakers were applauded for about 12 hours for their willingness to let Lehman go bankrupt. The adverse consequences of the shattering effect that had on confidence are still being felt now. The European Central Bank (ECB) is right in its concern that punishing creditors for the sake of teaching lessons or building political support is reckless in a system that depends on confidence. Those who let Lehman go believed because time had passed since the Bear Stearns bailout the market had learned lessons and so was prepared. In fact the main lessons learned had to do with how to best find the exits, and so uncontrolled bankruptcies had systemic consequences that far exceeded their expectations.

Second, no country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors. Meeting debt burdens at rates currently charged by the official sector for credit – let alone the private sector – would involve burdens on Greece, Ireland and Portugal comparable to the reparations burdens Keynes warned about in The Economic Consequences of the Peace.

Third, whether or not a country is solvent depends not just on its debt burdens and its commitment to strong domestic policies but on the broader economic context. Liquidity problems left unattended become confidence problems. Debtors who are credibly highly solvent at interest rates close to or below their nominal growth rates become likely insolvent at higher interest rates, putting further pressure on rates and exacerbating solvency worries in a vicious cycle. This has already happened in Greece, Portugal and Ireland and is in danger of happening in Italy and Spain. (See interactive graphic.)

Debtor countries can only reduce their debts by running surpluses vis-a-vis the rest of the world. If traditional debtor countries are going to start running surpluses, traditional surplus countries must be willing to reduce their surpluses or move towards deficits.

In short, the approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative. Assertions that the most indebted countries can service their debts in full at current interest rates only undermine the credibility of policymakers when they go on to assert that the fundamentals are relatively sound in Spain and Italy. Further lending at premium interest rates only increases the scale of the necessary restructuring. It is reasonable to argue that the recognition of debt unsustainability in Greece has been excessively deferred. It is not reasonable to argue that Greek reprofiling or restructuring taken alone will address a growing general confidence crisis.

A fundamental shift of tack is required towards an approach that is focused on avoiding systemic risk, restarting growth, and restoring arithmetic credibility, rather than simply staving off imminent disaster. The twin realities that Greece, Italy and Ireland need debt relief and that the creditors have only limited capacity to take immediate losses means that all approaches require increased efforts from the European center. Fortunately the likely consequence of doing more up front is lower cost in the long run.

The precise details are less relevant than having an appropriate broad approach, and of course will need to be aligned with European political reality. But the crucial elements in any viable strategy will include:

European authorities must restate their commitment to solidarity as embodied in a common currency, and the recognition that the failure of any European economy marks the failure of the European economy and is unacceptable. Towards that end they then should make these further commitments.

First, for program countries. Interest rates on official sector debt will be reduced to a European borrowing rate defined as the rate at which common European entities backed with joint and several liability by all the countries of Europe can borrow. A default to the official sector will not be tolerated so there is no reason to charge a risk premium, since charging a risk premium needlessly puts the success of the whole enterprise at risk.

Second, countries whose borrowing rate exceeds some threshold—perhaps 200 basis points over the lowest national borrowing rate in the Euro system–should be exempted from contribution requirements for bailout funds. The last thing the marginal need is to be pulled down by the weak.

Third, there must be a clear and unambiguous commitment that whatever else happens, the failure of major financial institutions in any country will not be permitted. The most serious financial breakdowns—in Indonesia in 1997, Russia in 1998, and the USA in 2008–come when authorities allow there to be doubt about the basic functioning of the financial system. This responsibility should rest with the European Central Bank with the requisite political support and cover provided.

Fourth, countries judged to be pursuing sound policies will be permitted to buy EU guarantees on new debt issuances at a reasonable price payable on a deferred basis.

These measures would do much to contain the storm. They would lead to a reduction in payments for debtor nations, protect states at risk from participation in rescue efforts or from shortfalls in market confidence, and assure that the ECB is able to continue backstopping the stability of European banks.

This leaves the question of what is to be done with sovereign private debt. Creditors gain nothing from breakdown. They have signalled that they will support an approach based on a menu of options. Some will want to sell out of their exposures at prices marginally above their current market value. Others who still regard sovereign European debts as worth par should be provided with appropriate reduced interest rate, longer maturity options Debt repurchases are a possibility if the private sector accepts sufficiently large present value debt reductions. The key standard by which any approach should be judged is the genuine sustainability of program country debt repayments on realistic assumptions.

Much of this will seem unrealistic given the terms of Europe’s debate. It seemed highly unrealistic even 10 days ago that Italy’s solvency would come into substantial doubt. If the political will can be found, the technical economics are not that difficult. But it will require a shift from politically driven arithmetic to arithmetically driven politics. The alternative to forthright action today is much more expensive action – to much less benefit – in the not too distant future. The next few weeks may well be among the most consequential in the history of the European Union.

By Lawrence H. Summers
The opinions expressed are his own.

Even with the massive 2008-2009 policy effort that successfully prevented financial collapse and Depression, the United States is now half way to a lost economic decade. Over the last 5 years, from the first quarter of 2006 to the first quarter of 2011, the U.S. economy’s growth rate averaged less than 1 percent a year, about like Japan during the period when its bubble burst. At the same time the fraction of the population working has fallen from 63.1 to 58.4 percent, reducing the number of those with jobs by more than 10 million. The fraction of the population working remains almost exactly at its recession trough and recent reports suggest that growth is slowing.

Beyond the lack of jobs and incomes, an economy producing below its potential for a prolonged interval sacrifices its future. To an extent that once would have been unimaginable, new college graduates are this month moving back in with their parents because they have no job or means of support. Strapped school districts across the country are cutting out advanced courses in math and science and in some cases only opening school 4 days a week. And reduced incomes and tax collections at present and in the future are the most important cause of unacceptable budget deficits at present and in the future.

You cannot prescribe for a malady unless you diagnose it accurately and understand its causes. Recessions are times when there is too little demand for the products of businesses, and so they fail to employ all those who want to work. That the problem in a period of high unemployment like the present one is a lack of business demand for employees not any lack of desire to work is all but self-evident. It is demonstrated by the observations that (i)the propensity of workers to quit jobs and the level of job openings are at near-record low levels; (ii) rises in nonemployment have taken place among essentially all demographic skill and education groups; and (iii) rising rates of profit and falling rates of wage growth suggest that it is employers, not workers, who have the power in almost every market.

I belabor the idea that lack of demand is the fundamental cause of economies producing below their potential because the failure to recognize the centrality of demand can have catastrophic consequences. But for Hitler and the military buildup up he caused, FDR would have left office in early 1941 a failure, with American unemployment above 15 percent and with the recovery promise of the New Deal shattered by the premature attempt in 1937 to reassert the traditional virtues of deficit reduction and inflation control. When I entered the Clinton administration in 1993, it was generally believed that Japan had the potential to grow its economy by 4 percent a year going forward, enough to have doubled output from that time until now. Instead output has barely grown, a consequence of the post-bubble stagnation that Japan suffered.

A sick economy constrained by demand works very differently than a normal one. Measures that usually promote growth and job creation can have little effect or can actually backfire. When demand is constraining an economy, there is little to be gained from increasing potential supply. In a recession, if more people seek to borrow less or save more, there is reduced demand and hence fewer jobs. Training programs or measures to increase work incentives for those with both high and low incomes may affect who gets the jobs, but in a demand-constrained economy will not affect the total number of jobs. Most paradoxically, measures that increase productivity and efficiency, if they do not also translate into increased demand, may actually reduce the number of people working as the level of total output remains demand constrained.

Traditionally, the American economy has recovered robustly from recession as demand has been quickly renewed. Within a couple of years after the only two deep recessions of the post World War II period–those of 1974-1975 and 1980-1982–the economy was growing in the range of 6 percent or more–rates that seem inconceivable today. (See chart below.) Why?

Inflation dynamics defined the traditional post-War American business cycle. Recoveries continued and sometimes even accelerated until they were murdered by the Federal Reserve with inflation control as the motive. When the Fed became concerned about inflation accelerating, usually too late, it raised interest rates and crunched credit,  stifling housing, business investment, and consumer durable purchases and causing the economy to go into recession. After inflation slowed, rapid recovery propelled by dramatic reductions in interest rates and a backlog of deferred investment was almost inevitable.

Our current situation is very different. With more prudent monetary policies, expansions are no longer cut short by rising inflation and the Fed hitting the brakes. All three American expansions since Paul Volcker brought inflation back under control have run long. They end after a period of overconfidence drives the prices of capital assets too high and the apparent increases in wealth give rise to excessive borrowing, lending and spending.

After bubbles burst there is no pent up desire to invest. Instead there is a glut of capital caused by overinvestment during the period of confidence–vacant houses, malls without tenants, and factories without customers. At the same time consumers discover that they have less wealth than they expected, less collateral  to borrow against and are under more pressure than they expected from their creditors. Little wonder that private spending collapses and that post bubble economic downturns often last more than a decade and are only ended through external events like military buildups.

Pressure on private spending is enhanced by structural changes. Take as a vivid example the publishing industry. As local bookstores have given way to megastores, megastores have given way to internet retailers, and internet retailers have given way to ebooks, two things have happened. The economy’s productive potential has increased and its ability to generate demand that fulfills the potential has been compromised as resources have been transferred from middle class retail and wholesale workers with a high propensity to spend up the scale to those with a much lower propensity to spend. And the need for capital investment in distribution networks has come down.

What then is to be done? This is no time for fatalism or for traditional political agendas that the two parties have pushed in more normal times. The central irony of financial crisis is that while it is caused by too much confidence, borrowing and lending, and spending it is only resolved by increases in confidence, borrowing and lending, and spending. It follows that the central objective of national economic policy until sustained recovery is firmly established must be increasing confidence, borrowing and lending, and spending. Unless and until this is done other policies, no matter how apparently appealing or effective in normal times, will be futile at best.

We should recognize that it is a false economy to defer infrastructure maintenance and replacement and instead take advantage of the a moment when 10-year interest rates are below 3 percent and construction unemployment approaches 20 percent to expand infrastructure investment.

It is far too soon for financial policy to shift towards preventing future bubbles and possible inflation and away from assuring adequate demand. The underlying rate of inflation is still trending downward and the problems of insufficient borrowing and investing exceed any problems of overconfidence. The Dodd-Frank legislation is a broadly appropriate response to the hugely important challenge of preventing any recurrence of the events of 2008. It needs to be vigorously implemented. But under-, not over-confidence is the problem of the moment and needs to be the focus of policy.

More concretely, the fiscal debate needs to take on board the reality that the greatest threat to the nation’s creditworthiness is a sustained period of slow growth that, as in southern Europe, causes debt-GDP ratios to soar. This means that essential discussions about medium-term measures to restrain spending and raise revenues need to be coupled with a focus on near-term growth. Without the payroll tax cuts and unemployment insurance negotiated by the President and Congress last fall we might well be looking today at the possibility of a double dip. Substantial withdrawal of fiscal support for demand at the end of 2011 would be premature. Fiscal support should be continued and indeed expanded by providing the payroll tax cut to employers as well as employees. Raising the share of the payroll tax cut from 2% to 3% would be desirable as well. At a near term cost of a little over $200 billion, these measures offer the prospect of significant improvement in economic performance over the next few years translating into significant increases in the tax base and reductions in necessary government outlays.

It is appropriate that policy in other dimensions be informed by the shortage of demand that is a defining characteristic of our economy. For example, the Obama administration is doing important work in promoting export growth by modernizing export controls, promoting U.S. products abroad and reaching and enforcing trade agreements. Much more could be done through changes in visa policy, for example, to promote exports of tourism as well as education and health services. In a similar vein recent Presidential directives regarding relaxation of inappropriate regulatory burdens should be rigorously implemented to boost confidence.

All of this is important, even essential. But the place to start is with the Hippocratic Oath–Do No Harm. And that means that every measure that comes out of Washington needs to be evaluated on the basis that it will not reduce the demand for goods and services at a time when America’s economy has been and will remain profoundly demand constrained.