debt overhang example

Economic Overview on the Eve of 2008 : Views of Larry Summers, Former Treasury Secretary

Employment, productivity and exports are still bright spots. Though the Federal Reserve seems to be monetizing high energy costs and flooding the economy with money to prop up credit markets swamped by the sub-prime lending disaster. Rather than allow some deflation to mop up (painfully) the credit overhang, policy-makers here and abroad are taking the opposite tack, heedless of the inflation potential. Or, perhaps choosing the smaller of evils.

The Brooking Institution hosted a “State of the U.S. Economy” event last week. Here is our reading of the significant insights.

Selected comments from Lawrence Summers, former Treasury Secretary, at Brookings last week:

For the last year, the economic consensus and the policy actions that have flowed from it have been consistently behind the curve in recognizing the gravity of the problems in the housing and financial sectors, and their consequences for the overall economy.

This continues to be the case. In my view, it is almost certain that we are headed for a period of heavily constrained growth, quite likely that the economy will experience a recession as technically defined, and distinctly possible that we’re headed into a period of the worst economic performance since the stagflation of the late 1970s and recessions of the early 1980s.

Experience suggests that downturns like the current one, driven by falling asset prices and credit problems tend to be quite protracted. Two extreme examples are the American experience after 1929, and Japan’s experience in 1990, after the 1989 stock and real estate market collapse. Our last two recessions, associated respectively with the bursting of the savings and loan real estate bubble and the NASDAQ collapse revealed gaps of several years between asset price peaks and the restoration of satisfactory rates of economic growth.

Nationally, housing prices peaked less than a year ago, and credit spreads reached their minimum only about six months ago. History has cautioned that situations like the current one are likely to surprise on the downside for a considerable time, and prove quite protracted is confirmed by forward looking indicators regarding the economy.

The most important driver of U.S. economic growth over the past seven years has been consumption, which has outstripped GDP growth. The combination of a near zero personal saving rate, lost housing wealth, reduced availability of credit, reduced real incomes caused by rising oil prices, falling dollar and rising food prices, as well as increased uncertainty constitute a perfect storm, depressing consumer spending. Even looking five years out, markets suggest that the spread between safe, liquid Treasury borrowing and the rates at which major financial institutions will be able to borrow will remain well above normal levels. The debt of some of our country’s largest and most prominent financial institutions is now trading at levels suggesting a market judgment that their odds of defaulting on their debts over the next five years approach one in 10.

Hundreds of thousands more foreclosures, and greatly increased risks to the financial system. Greatly complicated international relations, as our downturn slows the rest of the world economy, the American economic model is called into question, protectionist pressures rise, and the dollar’s centrality to the international financial system becomes more in doubt. Of course, if a downturn turns into more than a historically mild recession, the risks are that much greater.

In normal times, the spread between the rate at which the Treasury borrows and the LIBOR rate at which banks lend each other money for three months is typically well under half a percentage point. Currently, it is about two percentage points.

In the United States and Europe, large and persistent spreads have also opened between the policy rates of central banks and the lending rates at which banks make credit available to each other and to firms and households.

In this environment, the dominant risk is a downward spiral, in which financial problems curtail credit and spending, thereby reducing economic activity which, in turn, exacerbates financial strains, creating a vicious spiral. Once in progress, such a spiral may prove very difficult to arrest.

It is much more important to establish credibility that policy is ahead of the credit crunch spiral than to reassure, yet again, that it is not behind the inflation curve. I say this, not because I am unconcerned about inflation. The point is, the achievement of price stability over the last generation is one of the most important factors contributing to improved economic performance. It is a matter of balancing risks..

First, it suggests that policy-makers should consider focusing attention, not on their tradition policy rate but, instead, on targeting some more meaningful indicator of the cost of credit to households and businesses, such as the three-month LIBOR rate.

Second, assuring full transparency with respect to the valuation of assets and the recognition of losses and liabilities should be the top regulatory priority. The Japanese experience taught painful lessons about the dangers of government support and encouragement for measures that seek to rearrange balance sheets so as to avoid facing painful financial realities.

Third, regulatory policy needs to focus on assuring that financial institutions raise adequate amounts of capital to maintain their activities, even if this is painful for existing shareholders. If a bank is at the point of indifference between reducing the size of its balance sheet and raising capital by issuing shares or cutting dividends, the broader economy is not.

Fiscal policy can work more rapidly than monetary policy, which has a lag of about a year between the change in the Federal funds rate and its maximum impact. Moreover, the efficacy of monetary policy may well be diminished by capital constraints that limit the ability of banks to lend, or where credit-worthiness constraints can limit the ability of businesses to borrow.

It is reasonable to suggest that stimulus approaching $50 to $75 billion, roughly in the range of one-half of 1 percent of GNP, is likely to be appropriate. The largest part of this stimulus should come in the form of tax cuts distributed equally among all taxpayers and recipients of tax refunds.

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