Summers: Steps To Safeguard America’s Economy

Larry Summers, who is becoming a bit more optimistic about economic conditions, says monetary and fiscal policy measures enacted or likely to be enacted have helped to reduce the chances of severe problems, but there are still dangers to worry about and the next step for policymakers is to increase the amount of capital held by financial firms:

Steps that can safeguard America’s economy, by Lawrence Summers, Commentary, Financial Times: Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers...

At the same time, processes are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac ... to purchase more than an additional $300bn in mortgage-backed securities. ...

Moreover, legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.

The confidence engendered by all of this has led to some normalisation in credit markets. ... It is sometimes darkest before the dawn. For the first time since last August, I believe it is not unreasonable to hope that in the US, at least, the financial crisis will remain in remission. ...

While spreads have come in somewhat, markets continue to price in significant probabilities of default for even the most apparently strong financial institution, reflecting in part concerns about their solvency. At the same time it needs to be recognised that the federal government is bearing credit risk in extraordinary ways through its implicit guarantee to the GSEs, the lending activities of the Fed and the general backstop it is providing to the financial system.

All of this implies that 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 ... depends on the implicit federal guarantee of their several trillion dollars of liabilities. ...

It is not appropriate that their shareholders’ “heads I win, tails you lose” bet with the taxpayer be expanded for this purpose. Given their past and prospective losses, their regulator – supported by the Treasury, the Fed and, if necessary, Congress – should insist that they stop paying dividends and raise capital promptly and substantially as they expand their lending. ...

Because they do not have a similar public mission and are operated with more financial rigour and closer regulation, the situation is somewhat different with respect to other financial institutions.

As part of its dialogue with financial institutions, the Fed should push for further efforts to raise capital. Consideration should be given to collective actions designed to destigmatise cutting dividends or raising equity. The idea of linking access to Fed credit and measures to attract capital should also be explored. 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.