Lawrence Summers: SIEPR: March 7, 2008:
My message this morning is not going to be a cheery one. I believe that we are facing the most serious combination of macroeconomic and financial stresses that the United States has faced in at least a generation--and, possibly, much longer than that.
I want to do several things this morning:
- to try to describe in dimension the challenge,
- to draw some lessons from past financial crises, and
- to suggest some policy approaches going forward.
The right policy presumption is that the US economy will be judged to currently be in recession… [with] quite remarkable dislocations that we are current seeing in housing and credit markets…. It is a matter of arithmetic to calculate the number of mortgages that will be on homes with negative equity with a 25% decline in housing prices…. 15 million such mortgages worth 30% of all the mortgages in the United States with a combined value of over $3 trillion dollars…. Current estimates of mortgage losses are $400 billion dollars… [and] there is every reason to believe that those estimates are substantially optimistic….
Borrowers who, as recently as six months ago, were regarded as bullet-proof are finding it difficult to borrow at almost any price…. Many of the nation’s major financial institutions now are forced to pay more than 2 percentage points above the US Treasury rate in order to borrow for even five years… institutions that, as recently as nine months ago, were borrowing at spreads of 30 or 40 basis points…. We are in unusual territory with respect to recession. We are in nearly unprecedented territory with respect to financial strength….
First is the traditional Keynesian vicious cycle: People spend less; therefore, other people and firms have less income, hey, therefore, spend less, leading to less income, and the cycle goes on. That is the mechanism that has been dominant in economists’ thinking about recessions historically.
A second mechanism is probably more serious… the liquidation vicious cycle…. Economics hinges heavily… on the idea that supply curves slope upwards…. But… [if] a security… is bought on margin when its price goes down there are margin calls which force liquidations… a falling price is… a de-stabilizing mechanism. This process is multiplied many times over when the falling prices of financial assets lead to reductions in the level of capital in banks… [and] to a situation where even if they wish to maintain a constant leverage ratio--and in a more threatened environment, they wish to maintain a lower leverage ratio--they are forced to sell the assets that have gone down and to sell any other assets that are liquid and available.
The third vicious cycle… is… the credit accelerator… that comes from the interaction of these [first] two…. A deteriorating economy leads to deteriorating asset prices and declining credit quality, which leads to reduced lending which leads to a deteriorating economy and so forth.
All three of these mechanisms are now operating strongly….
It is a grave mistake to believe in the self-equilibrating properties of the economy or markets in the face of large shocks…. With respect to small shocks… there is tremendous resilience in market economies…. But… markets balance fear and greed. And when fear takes over, the capacity for self-stabilization is not one that can be relied on.
The very measures that should have been pursued to prevent financial crisis are often counter-productive once financial crisis comes. Put simply, the problem in the United States eighteen months ago was too much greed and too little fear. The problem today is too much fear and too little opportunistic buying. If the priority was to restrain imprudent lending eighteen months ago, the priority going forward has to be to try to stimulate and push the economy forward.
Third, confidence is essential and confidence depends on a perception of transparency and a perception of credibility. Confidence will not return in any environment where there is an expectation that heavy, but unknown, shoes will drop soon…. Denial as policy in support of confidence is counter-productive.
What, then, should be done?…
First, the traditional tools of macroeconomic policy…. It may well be necessary, and planning should begin now, to enact further fiscal stimulus measures. If this proves necessary, high priority should be attached to supporting heavily strapped state and local governments so as to be able to maintain their level of spending. Monetary policy faces complex challenges…. We have already engineered negative real interest rates. There is probably further to go. But in a world with excess capacity--and in a world where the constraint on the provision of credit is not that borrowers cannot afford it but that suppliers are reluctant to provide it because of the losses they have recently suffered--we should not exaggerate the potential benefit of further reductions in interest rates, appropriate as they are.
Macroeconomic policy… can address the Keynesian vicious cycle and perhaps… mitigate the credit accelerator…. But it cannot and will not, in and of itself, address the positive feedback coming from cascading liquidation.
The second area where we need more aggressive policy is with respect to the housing and mortgage markets…. The key determinant of foreclosures is the behavior of house prices and the decline in the value of house prices, rather than the income and cash flow circumstances of the borrowers. The essential policy dilemma is this: Foreclosures are enormously costly… on the order of 40% of the mortgage being foreclosed…. We expect that there will be on the order of 15 million houses with negative equity…. Many people with negative equity will continue to pay their mortgages on a regular basis in order to avoid foreclosure…. The policy challenge is to find ways to target foreclosures without inducing potential non-payment…. I have concluded that [we need] a modest set of changes in the bankruptcy law… [it is] ironic and probably inappropriate that our bankruptcy law is currently contrived so that a wealthy person with a second house receives more protection from his creditors on the second house than a less-wealthy person with only a principal residence receives from his creditors….
I am sure that it would be desirable to provide substantial funding to state and local governments to permit them to purchase foreclosed homes, convert them into rental housing so as to save potentially distressed neighborhoods and so as to allow them to experiment and see whether there are schemes in which they can provide financial support or guarantee authority to enable reductions in the level of foreclosure. I believe careful study should be given to a number of proposals that are now out there for repurchasing mortgages, writing down their value, and passing the benefit on to homeowners to see if they can be carried out in a way that is financially responsible and will be productive, rather than counterproductive….
Regulatory policy. Regulation has not been a success over the last decade in this sphere. It is, to me, less obvious than to many others that the right general conclusion is that this is a warrant for more regulation rather than for less. The institutions that have behaved the most imprudently… are the most heavily regulated…. But the question of overall financial regulation is a question for tomorrow. The question for today is what to do about the financial institutions that are currently under such stress…. History has demonstrated again and again… that policies that have as their premise seeking to maintain asset values by avoiding market-to-market in order that institutions will in an accounting sense have more capital and, therefore, lend more vigorously, are policies that are usually overwhelmed by history…. Far better to promote transparency to engage in capital forbearance explicitly, if that is judged to be the right policy so as to encourage lending--as it may well be--and to place urgent emphasis on insisting on the raising of the new capital that is the only mechanism through which this liquidation vicious cycle can ultimately be controlled….
Three final thoughts:
The fiscal stakes here are not small. Past financial crises have, in the end, been resolved at costs of several percents of GNP…. I hope that that will never prove necessary with respect to this crisis. I believe it is more likely not to be necessary if policy moves forward aggressively.
I have talked… of these issues as an abstraction. As a Recession. As a Cyclical Down-Turn. As Declining Asset Values. Make no mistake: there will be millions of people who have never heard of a CDO or a CLO and who think triple A refers to the American Automobile Association whose lives will be very much affected by the wisdom with which macroeconomic financial policy is made… the difference between staying in a home and the humiliation of a bailiff removing one’s kids from one’s home… the difference between having a job and not having a job, between being able to afford to borrow and not being able to afford to borrow. The stakes are not small.
Finally, I would suggest to you the stakes are not small for our country…. We are in a difficult period… when errors of hubris going back 10 or 15 years have cost us very substantial goodwill in the world…. Much of our strength derives from the strength, resilience, and vigor of our economy which, in turn, depends on the successful and effective functioning of our financial markets. With that in doubt, it is critical that there be a bias towards aggressive and effective action.