Lawrence Summers and the Crisis: 2007-9 Realtime
In the FT this morning, I see the learned and thoughtful James Hamilton joining Team Janet, writing that:
At the outset of the crisis, however, Ms Yellen was also one of the people who saw most clearly the magnitude of the problems facing the economy…. Her speech to the National Association for Business Economics in 2007, when reread today, strikes the reader as amazingly prescient. Many Fed officials at the time felt that, since the subprime mortgages represented only 10 to 15 per cent of all mortgages, problems with these loans would not be enough to cause major economic damage. But Ms Yellen noted that the complex system of derivative instruments linked to subprime mortgages, such as collateralised debt obligations and credit default swaps, could lead to great uncertainty among lenders about the vulnerability of particular borrowers and a devastating withdrawal of credit. Ms Yellen further emphasised that the mathematical models companies had used to evaluate the risks of those instruments took insufficient account of the consequences of a significant downturn in house prices. Again, her assessment proved to be right on the mark…
Let me point out that this is an equally strong reason to join Team Larry, for Lawrence Summers was even more aggressive in shouting "Fire! Fire!" in 2007-8--as anybody who reads his Financial Times columns can see.
I don't, however, think in her heart-of-hearts Janet Yellen was more complacent than Larry Summers, for she was then President of the Federal Reserve Bank of San Francisco, while he was just a professor. My memory is that both were equally in the "scared s---less" box of economists.
But I do want to note that the whisperers that "Summers didn't understand the dangers" repeatedly trot out one quote--Larry Summers calling Raghu Rajan a Luddite at Jackson Hole in 2005--and don't dare admit that Larry ever wrote or said anything else.
Larry Summers in the FT, 2006-8:
October 29, 2006: The global middle cries out for reassurance: "As the great corporate engines of efficiency succeed by using cutting-edge technology with low-cost labour, ordinary, middle-class workers and their employers… are left out… median family incomes lag far behind productivity…. It is this vast group that lacks the capital to benefit from globalisation and is desperately seeking either reassurance or a change in course. Yet without its support it is very doubtful that the existing global economic order can be maintained…"
December 10, 2006: Only fairness will assuage the anxious middle: "With this kind of cleavage between the economic fortunes of companies and their workers, it should not be surprising that ordinary American families do not feel they are in the same boat as US corporations and their chief executives…. It is neither fair nor efficient to audit disproportionately the tax returns of those in the bottom half of the income distribution at a time when most of the $500bn tax gap comes from those with high incomes…. John Kennedy famously challenged Americans: 'Ask not what your country can do for you. Ask what you can do for your country.' In the years ahead, this question will be put with increasing force to US corporations…"
December 26, 2006: Lack of fear gives cause for concern: "Financial markets are pricing in an expectation of tranquillity as far as the eye can see…. The risk premiums to cover the possibility of default that corporations or developing countries have to pay to borrow money are at or near historic lows. In addition, estimates of the volatility of the stock, bond and foreign exchange markets inferred from the prices of options are near record lows…. Changes in the structure of financial markets have enhanced their ability to handle risk in normal times…. We do not yet have enough experience to judge what happens in abnormal times. As we observed in 1987 and again in 1998, some of the same innovations that contribute to risk spreading in normal times can become sources of instability following shocks to the system as large-scale liquidations take place…. It is fair to point out to those who take comfort from the markets’ comfort that they hardly ever predict serious disruption and historically the moments of greatest complacency have been the moments of greatest danger…. At least as far as the markets are concerned, perhaps the main thing we have to fear is lack of fear itself."
March 25, 2007: As America falters, policymakers must look ahead: "With clear evidence of a crisis in the subprime US housing sector, risks of its spread to other credit markets, sharp increases in market volatility, reminders of the fragility of global carry trades and signs of slowing economic growth, there is enough apprehension to go around…. How should economic policy respond to a potential fall-off in US demand? The great irony is that just as the worst investment decisions are made by those who do today what they wish they had done yesterday – buying assets that have already risen and selling those that have just lost their value – so also the worst economic policy decisions are made by policymakers who, instead of responding to current circumstances, seek to rectify past mistakes…. The problem is… to avoid a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and more foreclosures…. Economic policymakers who seek to correct past errors by doing today what they wished they had done yesterday actually compound their errors. They are in their way as dangerous as generals fighting the last war…"
August 26, 2007: This is where Fannie and Freddie step in: "I am among the many with serious doubts about the wisdom of the government quasi-guarantees that supported the government-sponsored entities, Fannie Mae, the Federal National Mortgage Association, and Freddie Mac, the Federal Home Loan Mortgage Corp , as they have operated in the mortgage market. But surely if there is ever a moment when they should expand their activities it is now, when mortgage liquidity is drying up. No doubt, credit standards in the subprime market were too low for too long. Now, as borrowers face higher costs as their adjustable rate mortgages are reset, is not the time for the authorities to get religion and discourage the provision of credit."
September 23, 2007: Beware moral hazard fundamentalists: "Central to every policy discussion in response to a financial crisis or the prospect of a crisis is the concept of moral hazard. Unfortunately, there is great confusion in many quarters about the circumstances when moral hazard is, and is not, a problem. The world has at least as much to fear from a moral hazard fundamentalism that precludes actions that would enhance confidence and stability as it does from moral hazard itself…"
November 25, 2007: Wake up to the dangers of a deepening crisis: Three months ago it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth. This is… no longer the preponderant probability… the odds now favour a US recession…. Economic policy needs to be governed by the clear and public recognition that restoring the normal functioning of the financial system and containing any damage its breakdown may do the real economy is the central macro-economic and financial challenge facing the US…. Maintaining demand must be the over-arching macro-economic priority. That means the Fed has to get ahead of the curve… policymakers need to articulate a clear strategy addressing the various pressures leading to contractions in credit…. The time for worrying about imprudent lending is past. The priority now has to be maintaining the flow of credit…. Third, there needs to be a comprehensive approach taken to maintaining demand in the housing market to the maximum extent possible. The government operating through the Federal Housing Administration, through Fannie Mae and Freddie Mac, or through some kind of direct lending, needs to assure that there is a continuing flow of reasonably priced loans to credit worthy home purchasers…. All of this may not be enough to avert a recession. But it is much more than is under way right now."
January 27, 2008: Beyond fiscal stimulus, further action is needed: "Policy measures have seemed ad hoc and reactive: measures to increase bank liquidity one week; to help homeowners avoid foreclosure another; to work towards fiscal stimulus another; to lower interest rates most recently. Confidence would be well served by a comprehensive programme…. Financial institutions are holding all sorts of credit instruments that are impaired but are difficult to value, creating uncertainty and freezing new lending. Without more visibility, the economy and financial system risk freezing up…. Proper policy regarding valuing assets and forcing their sale depends on distinguishing between prices that reflect fundamentals and prices that reflect current illiquidity…. The essential element, if there is to be more transparency in the financial system without a major credit crunch, is increased levels of capital…. It is critical that sufficient capital is infused into the bond insurance industry as soon as possible…. Normal economic performance will not return without a return to normality in the credit markets. The fear that pervades the markets will not abate of its own accord, nor is there a silver bullet. But consistent, determined approaches to doing what is needed to resolve each of the problems that arise will, in the end, re-establish confidence."
February 24, 2008: America needs a way to stem foreclosures: "Policy towards America’s failing housing sector is in a far less satisfactory state…. Foreclosures are extremely costly. Between transaction costs that typically run at one-third or more of a home’s value and the adverse impact on neighbouring properties, foreclosures can easily dissipate more than the total value of the home being repossessed. They also inflict collateral economic damage…. When the current owner is able and willing to pay more than the lender can get by foreclosing on a house, it makes no sense to go through with a foreclosure. Yet because of conflicts among lenders, legal uncertainties and concerns about encouraging defaults, there are grounds for fearing that wasteful and unnecessary foreclosures will take place on a large scale…. How can this problem be addressed? The string has pretty much been played out on hortatory policy…. Bankruptcy laws currently provide that almost every form of property (including business property, vacation homes and those owned for rental) except an individual’s principal residence cannot be repossessed if an individual has a suitable court-approved bankruptcy plan. The rationale is the prevention of costly and inefficient liquidations. It is hard to see why similar protections should not be prudently extended to family homes…. At a time when there are great advantages to inducing lenders to let families to remain in their homes – and when families facing foreclosure are prepared to do things they might not do in ordinary times – it would be desirable to pursue suggestions by the Office of Thrift Supervision for so-called negative equity certificates to support shared appreciation work-outs…. As with fiscal stimulus, rapid bipartisan co-operation between Congress and the administration would benefit the financial system, the real economy and millions of Americans."
March 30, 2008: Steps that can safeguard America’s economy: "Wise policymakers hope for the best but plan for the worst…. A priority for financial policy has to be increases in the level of capital held by financial institutions. Capital infusions to date fall far short of prospective losses. Without new capital, the financial sector will operate with too much risk and leverage or will put the economy at risk by restricting the flow of credit…. The policy approach should start with the GSEs. These institutions’ viability with anything like their current operating model depends on the implicit federal guarantee of their several trillion dollars of liabilities. It is appropriate at a time of crisis in the mortgage markets that they become, as their regulator put it last week, the “lender of first, last and every resort”…. As part of its dialogue with financial institutions, the Fed should push for further efforts to raise capital… collective actions designed to destigmatise cutting dividends or raising equity…. At a time when much is being given to financial institution shareholders and management, action to help the economy and protect the taxpayer should be expected in return."
June 29, 2008: What we can do in this dangerous moment: "It is quite possible that we are now at the most dangerous moment since the American financial crisis began last August. Staggering increases in the prices of oil and other commodities have brought American consumer confidence to new lows and raised serious concerns about inflation, thereby limiting the capacity of monetary policy to respond to a financial sector which – judging by equity values – is at its weakest point since the crisis began. With housing values still falling and growing evidence that problems are spreading to the construction and consumer credit sectors, there is a possibility that a faltering economy damages the financial system, which weakens the economy further…. Policy has again fallen behind the curve…. The much debated housing bill should be passed immediately by Congress and signed into law…. Failure to pass even this minimal measure would undermine confidence…. Congress should move promptly to pass further fiscal measures…. With long-term unemployment at recession levels, there is a clear case for extending the duration of unemployment insurance benefits. There is now also a case for carefully designed support for infrastructure investment…. There are legitimate questions about how rapidly the impact of infrastructure spending will be felt. But with construction employment in free fall, there will be a need for stimulus tied to the needs of less educated male workers for quite some time…. Policymakers need to make a clear commitment to addressing the non-monetary factors causing inflation concerns…. There is the real possibility that significant financial institutions will encounter not just liquidity but solvency problems…. Regulators should… assure that in the event of an institution becoming insolvent they can manage the resolution…. It was fortunate that a natural merger partner was available when Bear Stearns failed – we may not be so lucky next time…. The policy choices made in the next few months will matter to the lives of millions…"
July 27, 2008: The way forward for Fannie and Freddie: "Anyone who cares about the health of the US economy should welcome the enactment of the Treasury’s rescue plan for Fannie Mae and Freddie Mac…. There is no question that we need the GSEs to be highly active in support of the housing market and financial system in the months ahead. If the authorities can see a path to their being able to play such a role in a framework where it can honestly be said that their borrowing is based on confidence in their financial position rather than primarily on federal guarantees, then this is obviously the preferred alternative. But after what we have seen, such a judgment cannot be based on the GSEs’ own claims…. The government should use its new receivership power to protect taxpayers and the financial system…. Stock holders, holders of preferred stock and probably subordinated debt holders [should] be wiped out, conserving cash for the benefit of taxpayers…. With [my] approach, the federal government would be in a position to support the housing market in the years ahead without encouraging dubious financial practices or denying financial reality…. The stakes here are high. The choices made in the coming months will bear on the housing market, future taxpayer burdens, the credibility of US financial authorities in times of crisis and the integrity of the political system. It is a time for decisive action."
August 7, 2008: How to build a US recovery: "Today, the end of the current financial crisis looks further away than it did in August 2007. Policy has not yet gotten ahead of the curve. I used to remark in the context of the emerging market crises of the 1990s that I would date the moment of recovery from the first time an official pronouncement proved to be too pessimistic. By this standard, recovery is not at hand. The best prospects for managing a very difficult situation involve a comprehensive effort both to support the real economy through temporary fiscal stimulus and the financial system through a programme of measures directed at capital rather than liquidity problems. These steps offer no assurance of success but reactive drift raises the risks of costly failure."
September 28, 2008: The $700bn bail-out and the budget: " The idea seems to have taken hold in recent days that because of the unfortunate need to bail out the financial sector, the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis actually suggests that dismal conclusions are unwarranted and the events of the last weeks suggest that for the near term, government should do more, not less…. The American experience with financial support programmes is somewhat encouraging. The Chrysler bail-out, President Bill Clinton’s emergency loans to Mexico, and the Depression-era support programmes for housing and financial sectors all ultimately made profits…. Second, the usual concern about government budget deficits is that the need for government bonds to be held by investors will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect. Third, since Keynes we have recognised that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. After using the economic expansion of the 1990s to bring down government indebtedness, the US made a serious error in allowing deficits to rise over the last eight years. But it would be compounding this error to override what economists call “automatic stabilisers” by seeking to reduce deficits in the near term. Indeed, in the current circumstances the case for fiscal stimulus – policy actions that increase short-term deficits – is stronger than at any time in my professional lifetime. Unemployment is now almost certain to increase – probably to the highest levels observed in a generation. Monetary policy has very little scope to stimulate the economy…. The more people who are unemployed the more desirable it is that government takes steps to put them back to work by investing in infrastructure, energy or simply through tax cuts that allow families to avoid cutting back on their spending…. The best measures would be those that represent short-run investments that will pay back to the government over time or those that are packaged with longer-term actions to improve the budget. Examples would include investments in healthcare restructuring or steps to enable states and localities to accelerate, or at least not slow down, their investments. A time when confidence is lagging in the household, financial and business sectors is not a time for government to step back. Well-designed policies are essential to support the economy and given the seriousness of healthcare, energy, education and inequality issues, can make a longer-term contribution as well."