Opinion

Lawrence Summers

Austerity has brought Europe to the brink again

Lawrence Summers
Apr 29, 2012 22:13 EDT

Once again European efforts to contain crisis have fallen short. It was perhaps reasonable to hope that the European Central Bank’s commitment to provide nearly a trillion dollars in cheap three-year funding to banks would, if not resolve the crisis, contain it for a significant interval. Unfortunately, this has proved little more than a palliative. Weak banks, especially in Spain, have bought more of the debt of their weak sovereigns, while foreigners have sold down their holdings. Markets, seeing banks holding the dubious debt of the sovereigns that stand behind them, grow ever nervous. Again, Europe and the global economy approach the brink.

The architects of current policy and their allies argue that there is insufficient determination to carry on with the existing strategy. Others argue that failure suggests the need for a change in course. The latter view seems to be taking hold among the European electorate.

This is appropriate. Much of what is being urged on and in Europe is likely to be not just ineffective but counterproductive to maintaining the monetary union, restoring normal financial conditions and government access to markets, and re-establishing economic growth.

The premise of European policymaking is that countries are overindebted, and so unable to access markets on reasonable terms, and that the high interest rates associated with excessive debt hurt the financial system and inhibit growth. The strategy is to provide financing while insisting on austerity, in hopes that countries can rein in their excessive spending enough to restore credibility, bring down interest rates and restart economic growth. Models include successful International Monetary Fund programs in emerging markets and Germany’s adjustment after the expense and trauma of reintegrating East Germany.

Unfortunately, Europe has misdiagnosed its problems in important respects and set the wrong strategic course. Outside of Greece, which represents only 2 percent of the euro zone, profligacy is not the root cause of problems. Spain and Ireland stood out for their low ratios of debt to gross domestic product five years ago, with ratios well below Germany’s. Italy had a high debt ratio but a very favorable deficit position. Europe’s problem countries are in trouble because the financial crisis under way since 2008 has damaged their financial systems and led to a collapse in growth. High deficits are much more a symptom than a cause of their problems. And treating symptoms rather than underlying causes is usually a good way to make a patient worse.

The cause of Europe’s financial problems is lack of growth. In any financial situation where interest rates far exceed growth rates, debt problems spiral out of control. The right focus for Europe is on growth; in this dimension, increased austerity is a step in the wrong direction.

Systematic comparisons suggest that when economies are demand-constrained and safe short-term interest rates are near zero, policy measures that reduce the deficit by 1 percent have a multiplier of 1 to 1.5 – implying that a 1 percent reduction in a country’s ratio of spending to GDP or an equivalent tax increase reduces its GDP by 1 to 1.5 percent. Essentially, cutting deficits will have a disproportionately adverse effect on GDP because the multiplier is larger than 1 on the growth-reduction side of the equation. This means that austerity measures at the national level are likely to be counterproductive in terms of creditworthiness. Fiscal contraction reduces incomes, limiting the capacity to repay debts. It achieves only limited reductions in deficits once the adverse effects of economic contraction on tax revenue and benefit payments are accounted for. And it casts a shadow over future growth prospects by reducing capital investment and raising unemployment, which inevitably takes a toll on the capacity and willingness of the unemployed to work.

These considerations are magnified at the continental level. Slowdowns in one country reduce the demand for the exports of other countries. As a matter of arithmetic, increases in saving and exporting in some countries have to be offset by increases in spending and importing in others. Germany’s enormous success in recent years has been achieved by becoming a large-scale net exporter – it would not have been possible without large-scale borrowing and importing by Europe’s periphery. The periphery cannot possibly succeed in substantially reducing its borrowing unless Germany pursues policies that allow its surplus to contract.

Skeptics will rightly wonder how a prescription for more spending by countries that already have trouble borrowing can be correct. The answer lies in the difference between borrowing by individuals and countries. Normally, an individual helps his creditors by borrowing less; but a person who stops borrowing to finance commuting to his job does his creditors no favor. A country’s income is determined by spending, so a country that pursues austerity to the point where its economy is driven into a downward spiral does its creditors no favor. Yes, there will ultimately be a need to raise retirement ages, reform sclerosis-inducing regulations and restructure benefit programs; phased-in commitments in these areas would be constructive. But the prospect for political and economic success in these endeavors depends on growth being restored.

Only if growth is restored can the euro endure and European financial problems be resolved. If there was ever a situation that called for a collective response, this is it. Going forward, the IMF and international community should condition further support not merely on individual countries’ actions but on a common European commitment to growth.

PHOTO: European Central Bank (ECB) President Mario Draghi addresses the European Parliament economic and monetary affairs committee in Brussels, April 25, 2012. REUTERS/Yves Herman

COMMENT

Wow…the world’s top economic experts have all gathered here…for no use.

The EU & USA are gone, collapsed, finished,
…China, here I come….

Posted by GMavros | Report as abusive

The general election’s political calculations

Lawrence Summers
Apr 26, 2012 18:45 EDT

Arithmetic done under the constraints of politics is always suspect, and one should always examine carefully the claims of those seeking votes. But smart observers have learned to distinguish between the claims of political candidates and their advisers on the one hand, and proposals that have been evaluated by independent scorekeepers like the Congressional Budget Office on the other.

This principle has never been better illustrated than by the “budget analysis” put forward by Governor Romney’s chief economic adviser, Glenn Hubbard, in a recent Wall Street Journal column. Hubbard constructs a budget plan he imagines that President Obama might propose someday, engages in a set of his own extrapolations and then makes a set of assertions about it. He does not discuss President Obama’s actual plan or how it has been evaluated by the CBO. Nor does he invest his credibility in defending the claims that Governor Romney has made regarding his own fiscal plans – he simply states that, “Yes, President Obama and Mitt Romney have budgets with competing visions. But Governor Romney’s budget makes tough choices…” without delving into the specifics or trade-offs that Romney’s “tough choices” entail.

President Obama put forward a plan earlier this year that would reduce deficits by more than $4 trillion over the next decade. It would bring discretionary spending to its lowest levels since the 1960s. It includes $2.50 in spending cuts for every $1 in additional revenue. It also asks everyone to pay their fair share of taxes, repealing the Bush tax cuts for families making more than $250,000, and closing loopholes and shelters like preferences for private jets, hedge fund managers and offshore investments.

The independent Congressional Budget Office confirms that it would stabilize the debt as a share of the economy – thus returning us to a tenable fiscal path. It would do that while allowing increased investments in education, research and infrastructure that are critical to stronger, shared economic growth in the years to come. By focusing on building a strong economy for the future, it expands the tax base and reduces pressures for future tax increases.

But rather than criticize this approach, Hubbard ignores it – and instead chooses to invent a set of assumptions that bear no relationship to the president’s actual policies. His figures are not explained, but they apparently arbitrarily assume that the president must raise taxes to pay for spending above a level of Hubbard’s choosing.

Rather than filling imaginary gaps in the president’s budget, which has been spelled out in sufficient detail to permit evaluation by independent experts, Professor Hubbard should perhaps fill in some of the many gaps in Romney’s plans.

Start with his tax plan. The Romney campaign has been very clear about what he is promising: $5 trillion in tax cuts on top of extending the Bush tax cuts, with those benefits heavily weighted toward the country’s wealthiest taxpayers. Romney claims to pay for this plan by ending tax shelters, principally for the wealthy, but he hasn’t specified a single tax break that he would close. Romney himself has acknowledged the lack of details in his plan, stating in reference to his tax plan that “frankly, it can’t be scored.” I have been party for many years to searches for “high-income tax shelters” than can feasibly be closed. I know of no reputable expert in either political party who would find that there is anything even approaching $5 trillion in potential revenue to be generated from this source.

Romney has also proposed a massive defense buildup, even while he says he will cut spending deeply enough to balance the budget. I think it’s clear why he won’t tell voters which cuts he would make: because in the past, disclosing his planned budget cuts was politically damaging.

We have seen this movie before. When President Clinton left the White House, our country was paying down its debt on a substantial scale. I was privileged as secretary of the treasury to be buying back federal debt. President George W. Bush campaigned on a program of tax cuts supported by economic advisers not subject to the rigors of official budget scorekeeping. The results – trillions of dollars of budget deficits – speak for themselves.

This is a very consequential election. As we continue to recover from the largest economic crisis in generations, we face a continuing need to strengthen the job market, address large fiscal challenges and build an economy that is based on sustainable, shared economic growth. Voters should have a chance to choose between clear alternatives. President Obama – consistent with his obligations as president – has laid out a multiyear budget embodying his vision for the future, and it has been evaluated by independent experts. It is time for Romney to do the same.

COMMENT

The Paul Ryan budget is the Romney budget. A budget that would put us in the same recession that the UK is going through now. The UK is a map of what the Ryan budget would do to the USA. But Republicans cannot see well, they are so focus on trashing the middle class and making the rich more wealthy.

Romney has NO plans for anything, he continues his attack on Obama, as the Republicans want him defeat in any way they can get it done.
We have had Republicans control the House since 2010 and NOTHING has been accomplished, in fact the House is on vacation 65% of the time. They have one been in session 52 days in 2012. This is nonsense. What are we paying them for? Also the ALEX bills passed and approved by Republican controlled states tell the real picture of the Republican mission.

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It’s too soon to return to normal policies

Lawrence Summers
Mar 25, 2012 20:00 EDT

Economic forecasters divide into two groups: those who cannot know the future but think they can, and those who recognize their inability to know the future. Shifts in the economy are rarely forecast and often not fully recognized until they have been under way for some time. So judgments about the U.S. economy have to be tentative. What can be said is that for the first time in five years a resumption of growth significantly above the economy’s potential now appears as a substantial possibility. Put differently, after years when the risks to the consensus modest-growth forecast were to the downside, they are now very much two-sided.

As winter turned to spring in 2010 and 2011, many observers thought they detected evidence that the economy had decisively turned, only to be disappointed a few months later. A variety of considerations suggest that this time may be different. Employment growth has been running well ahead of population growth. The stock market level is higher and its expected volatility lower than at any time since the crisis began in 2007, suggesting that the uncertainty hanging over business has declined. Consumers who have been deferring purchases of cars and other durable goods have created pent-up demand. The housing market seems to be stabilizing. For years now, the rate of family formation has been way below normal as young people moved in with their parents. At some point they will set out on their own, creating a virtuous circle of a stronger housing market, more family formation and demand, and further improvement in housing conditions. Innovation around mobile information technology, social networking and newly discovered oil and natural gas is likely, assuming appropriate regulatory policies, to drive significant investment and job creation.

True, the risks of high oil prices, further problems in Europe, and financial fallout from anxiety about future deficits remain salient. However, unlike in 2010 and 2011, it is probable that these risks are already priced into markets and factored into outlooks for consumer and business spending. There has already been a significant escalation in oil prices. The European situation is hardly resolved but is unlikely to deteriorate as much in the next months as it did last year. And market participants report great alarm about the deficit situation. So it would not take great news in any of these areas for them to actually contribute to upward revisions in current forecasts.

What are the implications for macroeconomic policy? Such recovery as we are enjoying is less a reflection of the natural resilience of the American economy than of the extraordinary steps that both fiscal and monetary policymakers have taken to offset private-sector deleveraging — a process that is far from complete. A convalescing patient who does not finish the full course of treatment takes a grave risk.  So too the most serious risk to recovery over the next several years is no longer the possibility of either financial strains or external shocks but that policy will shift too quickly away from maintaining adequate demand toward a concern with traditional fiscal and monetary prudence.

On even a pessimistic reading of the economy’s potential, unemployment remains 2 percentage points above normal levels; employment, 5 million jobs below potential; and GDP, close to $1 trillion short of potential. Even with the economy creating 300,000 jobs a month and growing at 4 percent, it would take several years to reattain normal conditions. So a lurch back this year toward the kind of policies that are appropriate in normal times would be quite premature.

Indeed, recent research on what economists label hysteresis effects suggests that slowing could have highly adverse consequences. Brad Delong and I argue in a recent paper that it is even possible that premature and excessive movements toward fiscal contraction by shrinking the economy risk exacerbating long-run budget problems.

How then to respond to valid concerns about fiscal sustainability, excessive credit creation and the eventual return to normality in a world where policy credibility is essential? The right approach is to pursue policies that commit to normalize conditions but only when certain thresholds are crossed. The Federal Reserve might commit to maintain the current Fed Funds rate until some threshold with respect to unemployment or expected inflation is crossed. Commitments to fund infrastructure over many years might include a financing mechanism such as a gasoline tax that would be triggered when some level of employment or output growth has been achieved. Tax reform could phase in new rates in pace with the rising economic performance.

Contingent commitments have the virtue of providing clarity to households and businesses as to how policy will play out, and in areas where legislation is necessary, eliminating political uncertainty. They allow policymakers to project a simultaneous commitment to near-term expansion and medium-term prudence — exactly what we require right now. An element of contingency in policy is always there in a volatile world. Recognizing it explicitly is the way to provide confidence and protect credibility in a world whose future no one can gauge with precision.

PHOTO: A help wanted sign hangs on the door of an Autozone shop in Golden, Colorado September 17, 2009. REUTERS/Rick Wilking

COMMENT

A good way to test the bias of a forecaster is to see what he does when he knows the future.

Let’s take a look at what Mr Summers recommends when he “Knows” the economy in advance. It’s exactly what the Obama 2013 budget is all about.

If we have 10 years of 5% GDP growth (a major assumption Obama’s budget), here is his plan.

From Obama’s 2013 Budget and the Printing Office.

2008 Spending = $3 trillion
2012 Spending = $3.8 trillion (27% more)
2022 Spending = $5.1 trillion

Add 5% GDP growth compounded for 10 years (~65% total growth) and they recommend.

Double taxes
2008 receipts = 2.5 trillion
2022 receipts = 5.1 trillion

More than double Debt
2012 debt = $9.2 trillion
2022 debt = $23 trillion

Every man woman and child owes the federal government $80,000 in 2022. We clearly don’t have any nest egg if the economy goes south in 2022. Oh, I forgot, that’s our children’s problem and my man is no longer in office.

Maybe Mr. Summers needs to re-read Keynes and stop believing his overly complicated rhetoric.

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Time nears for an American tax overhaul

Lawrence Summers
Feb 26, 2012 17:35 EST

However the U.S. presidential election turns out, the trifecta of the Bush tax cut expiration, the debt limit ceiling on the horizon once again, and the Congressionally mandated sequesters – cuts in domestic spending – will force the president and Congress to wrestle with fiscal issues either in a lame duck session after the election or in early 2013. The decisions they make will have profound impacts on America’s fiscal future.

For many observers, the central question on the table is about entitlement programs: What will be done with them? Growth in entitlement spending associated with our aging population and its rising health care costs is the major factor in overall federal spending growth. But the capacity of near-term policy changes to have large impacts on that spending is less than many would suppose. The rising ratio of retirees to workers means that Social Security benefits at current levels will not be sustainable without some kind of tax increase. Sooner or later, revenue will have to rise or else outlays will have to be curtailed. While it is surely better to act sooner, the reality is that, out of necessity, action on entitlements is inevitable.

While almost everyone agrees on the desirability of containing federal health care spending, this is likely to be more difficult than we’d like to believe. Certainly beneficiaries can bear more of the cost of their government insurance than others, and there are steps like malpractice reform and the further encouragement of preventive medicine that should be taken. Yet without intrusions into the private health care system that are unlikely to be politically acceptable, there are severe limits on what can be done. Otherwise the result will be unacceptable cuts in the availability of care for the clients of federal programs. Given all the uncertainties associated with new technologies, changing lifestyles, and ongoing changes in the private system, health care reform will and should be a continuing project.

But let’s place health care aside for now. Less discussed in the context of major deficit reduction is tax reform. For a variety of reasons, 2013 should be the year when the tax code is overhauled in a substantial way.

First, the United States will need to mobilize more revenue. This year the federal government will collect less than 16% of GDP in taxes—far below the post World War II average. The combination of an aging society, rising health care costs, debt service costs that will skyrocket whenever interest rates normalize, a still-dangerous world in which our allies’ defense spending is falling even as that of potential adversaries rises rapidly, and a growing fraction of the population unable to hold steady work means that in all likelihood federal spending will need to be larger not smaller relative to GDP in the future.

Raising marginal corporate rates or increasing individual rates beyond their Clinton-era level raises serious issues about incentive effects or encouraging tax shelter activities. Raising rates is, in any event, unlikely to be politically feasible. A much better strategy for raising necessary revenue would start from the premise adopted by the Simpson-Bowles bipartisan commission that tax expenditures are a form of government expenditure and presumptively should be cutback unless they can be justified.

Second, the current tax system is, in certain ways, manifestly unfair at a time of rising inequality. As is well recognized, America’s rich have gotten richer with the top 1 percent’s income share rising from the 10 percent range to the 20 percent range over the last generation, while middle class incomes have stagnated or worse. There is plenty of room for debate about the causes of rising inequality, and the extent to which reducing inequality should be a central objective of government policy and about the possible disincentive effects of excessively progressive taxes.

But there are fairly expensive aspects of the current tax system that favor the most fortunate – aspects that border on the indefensible. Recent political debates have pointed to loopholes that permit a few of the very fortunate to accumulate tens of millions of dollars in a tax-free IRA when almost everyone else is constrained by a $2,000 contribution limit. Can the observation that Ireland, Bermuda, and Luxembourg are three of the five jurisdictions where the U.S. corporate sector earned the most profits reflect anything other than rampant tax sheltering? Anyone who doubts this should ponder the fact that in 2007, U.S. corporate profits in Bermuda totaled 646% of Bermuda’s GDP. The treatment of profit incentives paid to investment operators who make no investment of their own money but simply receive the “carry” as they invest other people’s money is another example of an inappropriate provision.

These examples and many others are not only significant because of revenue the government could recoup while also making the tax system fairer. They matter because they illustrate the power of special interests to shape fundamental aspects of economic policy. Reform could be an important step towards rebuilding citizens’ confidence in the federal government, which is sorely lacking today.

Third, even while raising too little revenue and giving much away to various shelter efforts, the current tax system also manages to excessively burden economic activity. Corporate rates at the very high end of the world range encourage firms to manage their affairs so as to minimize reported U.S. profits using devices like transfer pricing, and to encourage the use of debt rather than equity finance. Employers who know that their workers face high tax rates work to find ways of providing compensation in the form of tax free perquisites rather than money income. High marginal rates on individuals, along with a substantial capital gains differential, encourages individuals to spend time and effort that should be used more productively on engineering conversions of ordinary income into capital gains.

While the U.S. tax code is altered frequently, serious reform is no more than a once in a generation happening. The last serious tax reform effort took place in 1986, meaning we are overdue. The Simpson-Bowles proposal for eliminating all tax expenditures and radically reducing tax rates provides an excellent starting point for a debate the country should have.

The delicate question is: How should Washington prepare for serious tax reform during what is likely to be a unique window of opportunity in late 2012 and 2013? The timing is essential, both because of all of the deficit reduction activity, but also because spending-side reforms will have a much more difficult time moving forward if revenue is not addressed as well.

It is tempting to say presidential candidates should put forward their tax reform proposals in detail and allow voters to choose. However, this is unlikely to work. Indeed, the more tax issues are discussed during the campaign, the more the candidates will be driven to make pledges about things they will never do—pledges that might make tax reform that much more difficult.

Here is an alternative: Leaders in both parties should commit themselves to the goal of tax reform for growth, fairness and deficit reduction. They should acknowledge that every tax expenditure or special break has to be on the table. They should have their staffs are compile a large inventory of options. The relevant Congressional committees should take testimony from experts of all persuasions. And then right after the election, the negotiations should begin. Nothing that is likely to be done during the next four years will be more important.

Photo: U.S. President Barack Obama receives a standing ovation as he addresses a Joint Session of Congress inside the chamber of the House of Representatives on Capitol Hill in Washington September 8, 2011.

COMMENT

Larry, you know as well as we all know that your statement about tax problems, “….will force the president and Congress to wrestle with fiscal issues either in a lame duck session after the election or in early 2013. ” simply has no validity. Congress hasn’t wrestled for so long that it is only a showplace in the Capitol Building. Without political consequences for each member, they’ll continue to do nothing in order to fool the public into thinking that it is the other side whom is ineffective. It is such a charade as to be shameful.

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Davos needs to address uncertainty

Lawrence Summers
Jan 23, 2012 12:01 EST

The year has begun well in markets. Stock markets in 2012 are generally up, and European sovereigns have experienced less difficulty borrowing than many expected. And economic data, particularly in the United States, has come in ahead of expectations. So as President Obama prepares to give his State of the Union address, and as a large group of policymakers and corporate chiefs come together in Davos this week, there is if not a sense of relief at least some diminution in the sense of high alarm that has gripped the global community for much of the last few years. Yet anxiety about the future remains a major driver of economic performance.

The news coming from financial markets is in important ways paradoxical. On the one hand, interest rates remain very low throughout the industrial world. While this is partially a result of very low expected inflation, the inflation-indexed bond market suggests that remarkably low levels of real interest rates will prevail for a long time. In the United States, for example, the yield on 10-year indexed bonds has fluctuated around -15 basis points. That is to say: On an inflation-adjusted basis, investors are paying the government to store their money for 10 years! In Britain, inflation-linked yields are negative going out 30 years.

One might expect that with low real interest rates, assets would sell at unusually high multiples to projected earnings. If anything, the opposite is the case, with the S&P 500 selling at only about 13 times earnings. Stocks also appear cheap to earnings in historical perspective through much of the industrial world. And similar patterns are observed with respect to most forms of real estate.

The combination of low real interest rates and low ratios of asset values to cash flows suggests as a matter of logic an abnormally high degree of fear about the future. This could reflect expectations that earnings or other cash flows will rise more slowly than anticipated, or simply result from a higher discount associated with future earnings because of abnormally high uncertainty.

This idea that future uncertainties are driving financial markets is supported by the observation that in the recent period there has been a much stronger tendency than normal for higher interest rates to be associated with a stronger stock market and vice versa. This is exactly what one would expect in an economic environment like the present one — on days when people become more optimistic, both interest rates and stock prices rise as the expectation is of more profits and demand for funds.

This is in contrast to the usual situation, in which interest rates and stock prices often move in opposite directions because of reassessments about future fiscal and monetary policies, with expectations of higher rates driving down stock prices. For example, if an important driver of markets was confidence that foreigners would hold U.S. debt, one would expect to frequently see days when interest rates went up and the market went down as concerns rose, and vice versa when concerns declined.

Uncertainty about future growth prospects as a major driver of markets also correlates with other observations, such as the abnormally high level of cash sitting on corporate balance sheets, the reluctance of businesses to hire, and the sense that consumers are hesitant about discretionary big ticket purchases even as borrowing costs and capital goods prices are at near record lows.

All of this suggests that for the industrial world as a whole, the most important priority for governments must be giving confidence that recovery will continue and accelerate in the United States and that the downturn in Europe will be limited. How best to do this remains an area of active debate. At Davos and beyond there will be many who argue that top priority must be given to increasing business confidence and that government stimulus is useless at best and potentially counterproductive. There will be others — more economists than businesspeople — who will argue that top priority must be given to government stimulus and that issues about business confidence are red herrings.

Keynes saw through this sterile debate 75 years ago, writing to Roosevelt that either “the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees” or “public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money.” The right current approach involves borrowing from both contending lines of thought.

Government has no higher responsibility than insuring that economies have an adequate level of demand. Without growing demand, there is no prospect of sustained growth, let alone significant reduction in joblessness. And without growth and reduced unemployment, there is no chance of engineering reductions in government debt-to-income ratios. Of course risks of inflation, of promoting excessive risk-taking in the future, and of spending that is not ideally efficient need to be balanced. But the simple fact is that markets in the large concur with the judgment of individual business managers that increasing demand is the sine qua non of a return to economic health.

At the same time, businesses are understandably uncertain about their prospects after the events of recent years. This is not the right time to add unnecessarily to their worries. Except where the rationale is both urgent and compelling, new regulations that burden investment should be avoided. Inequality is a growing problem that will have to be addressed in the United States and beyond — it cannot be ignored. But there is the risk that policies introduced in the name of fairness that excessively burden job-creating investment could actually exacerbate the challenges facing the middle class. At a moment of substantial doubt about the functionality of government, government could do much to increase confidence in its functioning by devising a clear plan to better align spending and taxing once recovery is established.

By working both to directly increase demand and augment business confidence, governments have the best chance of creating economic recovery. At Davos and beyond that should be the near-term focus of economic debates.

PHOTO: People walk past the logo of the World Economic Forum (WEF) in front of the congress center in the Swiss mountain resort of Davos, January 22, 2012.  REUTERS/Arnd Wiegmann

COMMENT

Quite possibly, consumers cannot afford to pay for the “adequate level of demand,” deemed necessary to generate a vibrant economy. A more realistic view is that the world has limited per-capita growth potential, rising population, diminishing real resources, and considerable population aging. Consumers would do well to save more, cut back spending, and anticipate a nation of diminished personal wealth. With all that, citizens will be among the wealthiest in human history, with levels of comfort and health undreamed of by the richest rulers of centuries past.

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Why isn’t capitalism working?

Lawrence Summers
Jan 9, 2012 07:13 EST

Americans have traditionally been the most enthusiastic champions of capitalism.  Yet a recent American public opinion survey found that just 50 per cent of people had a positive opinion of capitalism while 40 per cent did not.  The disillusionment was particularly marked among young people 18-29, African Americans and Hispanics, those with incomes under $30,000 and self-described Democrats.

Three elections in a row in the U.S. have been bloodbaths by recent standards for incumbents, with the left side doing well in 2006 and 2008 and the right winning comprehensively in 2010.  With the rise of the Tea Party on the right, and the Occupy movement on the left, this suggests far more is up for grabs than usual in this election year.

So how justified is disillusionment with market capitalism?  This depends on the answer to two critical questions. Do today’s problems inhere in today’s form of market capitalism or are they subject to more direct solution? Are there imaginable better alternatives?

The spread of stagnation and abnormal unemployment from Japan to the rest of the industrialized world does raise doubts about capitalism’s efficacy as a promoter of employment and rising living standards for a broad middle class.  This problem is genuine. Few would confidently bet that the U.S. or Europe will see a return to full employment as previously defined within the next 5 years. The economies of both are likely to be constrained by demand for a long time.

But does this reflect an inherent flaw in capitalism or, as Keynes suggested, a “magneto” problem (like the failure of a car alternator) that can be addressed with proper fiscal and monetary policies, and which will not benefit from large scale structural measures? I believe the evidence overwhelmingly supports the latter. Efforts to reform capitalism are more likely to divert from the steps needed to promote demand than to contribute to putting people back to work. I suspect that if and when macroeconomic policies are appropriately adjusted, much of the contemporary concern will fade away.

That said, sharp increases in unemployment beyond the business cycle—one in six American men between 25 and 54 are likely to be out of work even after the U.S. economy recovers—along with dramatic rises in the share of income going to the top 1 and even the top .01 per cent of the population and  declining social mobility do raise serious questions about the fairness of capitalism. The problem is real and profound and seems very unlikely to correct itself untended. Unlike cyclical concerns there is no obvious solution at hand. Indeed the observation that even Chinese manufacturing employment appears well below the level of 15 years ago suggests that the problem’s roots lie deep with the evolution of technology.

The agricultural economy gave way to the industrial economy because progress enabled demands for food to be met by only a small fraction of the population, freeing large numbers of people to work outside agriculture. The same process is underway today with respect to manufacturing and a substantial range of services reducing employment prospects for most citizens.  At the same time, just as in the early days of the industrial era, the combination of substantial dislocations and greater ability to produce at scale is enabling a lucky few to acquire great fortunes.

The nature of the transformation is highlighted by the 50-fold change in the relative price of a television set of a constant quality and a day in a hospital over the last generation.  While it is often observed that wages for median workers have stagnated, this obscures an important aspect of what is occurring. Measured via items  such as appliances or clothing or telephone service where productivity growth has been rapid, wages have actually risen rapidly over the last generation.  The problem is that they have stagnated or fallen measured relative to the price of housing, health care, food and energy or education. As fewer and fewer people are needed to meet the population’s demand for goods like appliances and clothing, it is natural that more and more people work in producing goods like health care and education where outcomes are manifestly unsatisfactory.  Indeed as the economist Michael Spence has documented, a process of this kind is underway; essentially all employment growth in the U.S. over the last generation has come in non-traded goods.

The difficulty is that in many of these areas the traditional case for market capitalism is weaker. It is surely not an accident that in almost every society the production of health care and education is much more involved with the public sector than the production of manufactured goods.  There is an imperative to move workers from activities like producing steel to activities like taking care of the aged.  At the same time there is the imperative of shrinking or least slowing the growth of the public sector.

This brings us to the charge that the governments of industrial market capitalist societies are bankrupt. Even as market outcomes seem increasingly unsatisfactory, budget  pressures have constrained the ability of the public sector to respond.  How and when–and not whether–basic programs of social protection will be cut back, is now back on the table.  The basic solvency of too many capitalist states seems in question.

Again the problems are very real.  While I believe more than most that the U.S. government will be able to borrow on very attractive terms for a long time, if as I fear private borrowing remains depressed, there is no denying that the current path of planned spending and planned revenue collection are inconsistent.  And Europe is teaching us that markets can take significant fiscal problems and make them catastrophic  by becoming too alarmed too rapidly.

At one level the answer here is simply to insist on more political will and courage.  But at a deeper level, citizens of the industrial world who believe that they live in progressive societies are right to wonder why increasingly affluent societies need to roll back levels of social protection. Paradoxically, the answer lies in the very success of capitalism which has made the opportunity-cost of an individual teaching or nursing or administering that much more expensive.

When outcomes are unsatisfactory, as they surely are at present, there is always a debate between those who believe that the current course needs to be pursued with increased vigor and those who argue for a radical change in direction. That debate  is somewhat beside the point in the case of market capitalism. Where it has been applied it has been an enormous success.  The challenge for the next generation is that while that success will increasingly be taken for granted and indeed will become an increasing source of frustration in these pinched times, its success cannot be matched outside the market’s natural domain.  It is not so much the most capitalist parts of the contemporary economy but the least—those concerned with health, education and social protection–that are in most need of reinvention.

COMMENT

Capitalism only works if you drop the notion that corporations will adequately police themselves. Too many politicians believe such claims from the corporations.

Posted by AlkalineState | Report as abusive

It’s time for the IMF to step up in Europe

Lawrence Summers
Dec 8, 2011 14:58 EST

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.

REUTERS/Issei Kato

COMMENT

Keynesian Economics – Failing since 1936

Posted by ato | Report as abusive

The fierce urgency of fixing economic inequality

Lawrence Summers
Nov 21, 2011 06:00 EST

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

COMMENT

I am slightly amused by Mr Summers reference to switching from “an industrial to a knowledge economy”. This seems to infer that America, due to the wonders of her knowledge and innovation, has no need to produce any manufactured goods. Or is this statement meant to justify the gross, unhealthy expansion of the financial sector in western economies today as a valid forfeit for manufactured and traded goods?

Sorry just won’t do Mr Summers. How can you put forward such blurry economic assumptions when America is limping uncompetitively along with a manufacturing sector that represents only 12% — 13% of US GDP ?

And no, you will not now be able to manipulate the Debt/Treasury cycle or the Floating dollar exchange rate to America’s advantage because many powerful mercantilist countries are so actively working against the dollar now.

Next time, try and avoid propaganda fluff Mr Summers.

Posted by slowsmile | Report as abusive

To fix the economy, fix the housing market

Lawrence Summers
Oct 24, 2011 07:00 EDT

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

COMMENT

Ironic that so much of what’s wrong is the result of policies Summers supported.

Posted by Sechel | Report as abusive

The perils of European incrementalism

Lawrence Summers
Sep 19, 2011 07:01 EDT

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.”

COMMENT

Larry-”I Lost $1,800,000,000.00 for Harvard Betting on Derivatives”-Summers: He’s got some other serious claims to fame, Obama is considering him for the top post at the World Bank, he helped Alan Greenspan muzzle Brooksley Born who wanted to regulate derivatives in the 1990s. You can watch that here. I wouldn’t let Summers advise me on investing for my late dog. He must have been impressed with how Summers falls asleep at White House meetings. This year Larry is attacking “Capitalism” and says it needs to be reformed. We don’t have capitalism, if we did the banks that made decisions would have failed. We have Corporatcracy as I wrote about here and on this one site it got 145,000 reads which indicates that people–other than those at Davos–get this.”

Posted by devilliers123 | Report as abusive
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