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Sunday, January 27, 2008

Lawrence Summers: Beyond Fiscal Stimulus

Larry Summers says now that we have the ball rolling on fiscal policy (if only barely so), and interest rate cuts are in place, the time has come to take the next steps and begin to repair the financial system, to begin containing the damage caused by the housing sector, and to begin work on global coordination of policy. This addresses the first of these steps, repairing the financial system:

Beyond fiscal stimulus, further action is needed, by Lawrence Summers, Commentary, Financial Times: Markets and perceptions of the economic outlook change rapidly. Even two months ago most observers doubted predictions of a US recession... The debate about recession is now about how deep and global its impact will be.

There is enormous uncertainty... It is possible that pessimism will recede as declining interest rates and dollar exchange rates increase demand. It is more likely, though, that the situation will deteriorate further...

Substantial monetary and fiscal stimulus is now in train. This will reduce the severity of any recession and provide some insurance against a protracted downturn. Along with macroeconomic stimulus..., there is the need for further policy development in three other areas – repair of the financial system, containing the damage caused by the housing sector and assuring the global co-ordination of policy. This column addresses the first of these imperatives...

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 as Japan’s did in the 1990s. ...

The essential element, if there is to be more transparency in the financial system without a major credit crunch, is increased levels of capital. More capital permits more recognition of impairments and makes asset transfers easier by increasing the number of potential purchasers. ... A critical element of regulatory policy should be insisting on increased capital in existing financial institutions. ...

Efforts to infuse capital into existing institutions should be matched by a greater effort to ensure transparent and fair valuations. A capital market where the same loan is valued at one price in a bank, another in a different bank, another in a conduit and yet another as a hedge fund asset to be margined cannot be the basis for sound economic performance.

It is critical that sufficient capital is infused into the bond insurance industry as soon as possible. Their failure or loss of a AAA rating is a potential source of systemic risk. ... It appears unlikely that repair will take place without some encouragement and involvement by financial authorities. ...

While attention to date has focused on capital infusions into existing institutions, it would be desirable for capital to be injected into new institutions that do not have the legacy problems of existing ones and can meet the demand for new lending. Warren Buffett’s recent entry into bond insurance is an example. There are grounds for concern about the adequacy of the flow of lending for student loans, automobiles, consumer credit and non-conforming mortgages. In each of these areas, there may be a need for collective private action or for government measures.

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.

    Posted by on Sunday, January 27, 2008 at 06:26 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (5)

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