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Sunday, March 25, 2007

Summers: Policymakers Should Look Forward, Not Back

Larry Summers gives U.S. policymakers advice on how to respond to the possibility of an economic slowdown:

As America falters, policymakers must look ahead, by Lawrence Summers, Commentary, Financial Times (free): ...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 ... apprehension...

While it would be premature to predict a US recession, there are now strong grounds for predicting that the US economy will slow down very significantly in 2007. ...

It is clear though that the global economy has been relying on the US as an importer of last resort; that the US economy has been relying on the consumer for its primary impetus; and that until now consumers have been encouraged to spend their incomes fully or more than fully by being able to access the wealth in their homes.

This growth syllogism has appeared fragile for some time, but has continued longer than many observers expected as US consumers have kept spending even after it was clear that the housing market had peaked and foreigners ... have been willing to continue financing ... on very attractive terms, the US in importing nearly 70 per cent more than it exports.

But the growth syllogism is now in doubt. Recent developments in the subprime sector exacerbate housing’s brake on US economic growth. ... Even as these developments reduce housing prices and the construction of new houses, housing finance problems are likely to magnify wealth effects on consumption as consumers face upward resets on their mortgage rates and are unable to refinance as they had planned, and as home equity, car and credit card lending conditions tighten.

If consumer spending declines and interest rates fall or appear likely to fall, there is the real possibility that the foreign lending to the US ... will start to dry up, leading to a combination of higher long-term interest rates and a weaker dollar. This would tend to raise inflationary pressures, transmit US weakness to the rest of the world and could, by discouraging foreign demand for US assets, lead to further downward pressure on investment...

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.

It would have been desirable if policymakers had done more to restrain imprudent subprime lending... But ... this is not today’s problem. The problem is the opposite: to avoid a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and more foreclosures.

Some argue that the Federal Reserve should have started tightening monetary policy earlier ... and avoided what they see as liquidity-driven bubbles. Regardless of the merits of this position, the theory that this constitutes a reason to avoid easing monetary policy ... hardly follows. If ... the dominant economic concern becomes a shortage of demand, it is incumbent on the Fed to provide stimulus...

Those in the rest of the world who have been insisting on the global imperative of increased US saving and a reduced US current account deficit should fear getting what they want too quickly. So also should those US observers who have insisted that foreign countries stop artificially holding their currencies down by purchasing dollar assets. While US current account adjustment is a medium-term imperative, an effort to bring it about rapidly in the face of an already declining economy could turn a soft landing into a hard one. ...

Good economic policies operate counter-cyclically, slowing booms and mitigating downturns. ... 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. We do not yet know how much economic conditions will change or whether current concerns will prove transitory. But if recent developments mark a genuine change, let us hope that policymakers look forwards rather than backwards.

Though he doesn't say so directly, I think we can put him in the column of those favoring a reduction in interest rates now as insurance against future declines in demand and employment.

He's right that policymakers should look forward, but I think we should also remember Mishkin's cautions about inflation expectations losing their anchor. Mistakes of the past become part of the present and future course of the economy and thus limit the choices that policymakers have to deal with any new shocks that hit the economy.

Summers' main worry appears to be that the Fed will tighten or at least fail to loosen policy as needed. I don't think this is the time for the Fed to tighten, and I don't know of too many people calling for interest increases presently. Given the mixed signals regarding inflation and growth we have seen recently, I think a policy of holding firm is correct for now. However, I do agree that current conditions indicate the Fed should maintain an elevated sensitivity to any signs of accumulating weakness in the economy and respond accordingly.

Update: Dean Baker comments:

Larry Summers Says "Let's Not Worry About Who Killed Who", by Dean Baker: Alright, he didn't exactly use this classic Monty Python line, but in his column discussing the imminent collapse of the U.S. housing bubble, he did make a point of urging us not to look backward. I actually find myself largely agreeing with his main point, monetary policy should be forward looking. The Fed should act to support the economy going forward, not trying to rectify past sins. However, some backward glances are important if we are to get the economy on a sound footing and to avoid a repeat of the same mistakes.

Specifically, the goal of Fed policy should absolutely not be to delay the deflation of the housing bubble.   

Every week, 140,000 families are buying into the housing market, many at bubble inflated prices. These are the families who will suffer the greatest harm when housing prices return to their trend values. I can see no justification in having the Fed act to sustain this bubble so that more families can take a devastating hit on their major financial asset. ...

[T]he Fed should certainly look to try to support the economy, even at the risk of higher inflation, in order to offset the damage from the collapse of the housing bubble. ...

The obvious reason that the Fed may have looked favorably on the inflation of the housing bubble is that there was nothing else to boost the economy out of its weakness following the stock crash induced recession of 2001. Of course the stock crash recession was the result of the Fed and Treasury looking the other way as the stock bubble inflated to dangerous levels. And, who do we find on the list of villains for letting the stock bubble get out control? It is easy to see why Larry Summers doesn't think that we should be looking backwards.

It's a stretch to blame the Treasury for the run-up in stock or housing prices, and I'm not quite sure how the Fed can "absolutely not ... delay the deflation of the housing bubble" and "try to support the economy, even at the risk of higher inflation" at the same time. But on the general point, if loans to unqualified borrowers were and still are the issue, an approach that targets the problem directly through increased enforcement of existing regulations or the imposition of new ones rather than a general increase in interest rates that has consequences beyond the problem we are trying to fix is preferable.

    Posted by on Sunday, March 25, 2007 at 02:06 PM in Economics, Policy | Permalink  TrackBack (0)  Comments (17)


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