ECON 252: Financial Markets (2008)

Lecture 26

 - Okun Lecture: Learning from and Responding to Financial Crisis, Part II (Guest Lecture by Lawrence Summers)


In the second of his two lectures in honor of Arthur Okun, Professor Summers points out that real interest rates have been very low in the current subprime crisis. This indicates that the shock to the economy was more a financial breakdown shock than a disinflation shock. But financial breakdown shocks are not necessarily very harmful to the economy, so long as financial intermediation capital is not destroyed. In a financial crisis like the present one, financial firms are likely to take the step of decreasing their leverage, often by contracting loans, which creates its own risks for the economy. Regulators should place pressure on financial institutions to raise their capital and should intervene in near foreclosure situations, but should not attempt to support housing prices.

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Financial Markets (2008)

ECON 252 (2008) - Lecture 26 - Okun Lecture: Learning from and Responding to Financial Crisis, Part II (Guest Lecture by Lawrence Summers)

Chapter 1. Introduction and Recap [00:00:00]

Professor Robert Shiller: This is the second of two lectures from Lawrence Summers. Let me just say, again, this is the Okun Lecture Series created by an anonymous donor in honor of Arthur Okun. At the last lecture, I was very pleased to hear the number of fond memories that Larry Summers has of Arthur Okun. At today’s lecture, I think some people felt that we didn’t have enough time for question and answer, so we plan to allocate a half hour to that. Does that sound good? Larry will wrap up just before the hour and we’ll have a good discussion.

Professor Larry Summers: Judging by the discussions I had an opportunity to have at lunch and dinner, I would suggest a proposal for you, Bob, with respect to next year’s Okun lecturer. Invite the Okun lecturer to give his first lecture, then let him have dinner and let him have lunch with the Yale faculty; then, let him ponder what he’s been told for three weeks and invite him to come back and encourage him to emphasize what he was told rather than any ideas he might have. You would get substantially better Okun lectures, I suspect, as a consequence, if the feedback that I got is any guide. I want to thank everybody for their hospitality and having seen a certain number of these kinds of lecture series over time. When I was President of Harvard, my deepest nightmare, one of my deepest nightmares — some of my nightmares actually came true — but some of my lesser nightmares as President of Harvard were the sequential lecture series, where at the third lecture no one came. As a lecturer, I was concerned the judgment of those who had seen the product is of more interest than the judgment of those who have not. So, the fact that the room looks a little bit like the room looked yesterday, I take as at least mild encouragement and validation to proceed.

Chapter 2. Understanding Recessions in Terms of the IS/LM Model [00:02:51]

Yesterday, I talked about two types of recessions. What I referred to as disinflation recessions, in which the Fed stepped on the brakes, the economy slowed, the Feds stepped off the brakes, the economy reaccelerated. And, what was my larger focus, financial system breakdown recessions, in which in one way or another, bubbles burst or banks face liquidity problems or the supply of finance dried up and the economy suffered. I suggested that the latter category of recession was the historical pattern of recession. That there were some signs that the more relevant problem for the United States going forward might well be the latter kind of recession as well. I implied a thought I will develop in the course of these remarks — that the incipient recession in the United States is almost certainly of the latter financial breakdown variety rather than the disinflation variety.

We have had instructive, for me, conversations at both dinner and lunch on the question of how one thinks about these two categories of recession in the context of an ISLM model or in the context of a simple — some kind of simple — macroeconomic model. The correct answer to that question, I think, is that it’s pretty unambiguous that a disinflation recession is best thought of as the Federal Reserve tightening money, which represents some kind of leftward movement of the LM curve — that output declines and interest rates rise and that that’s the proximate shock that is bringing about the recession. That it turns out to be a matter of semantic ambiguity — how to think about a financial crisis recession in the context of a simple macroeconomic model. Everybody agrees on the movement of three variables in such a recession. Output goes down; q goes down; and short-term interest rates go down. One instinct, which is probably not the first instinct in the City of New Haven, is to think of that recession in a traditional ISLM curve, with the IS curve and the LM curve being plotted in a space determined by the level of output and the short term interest rate. In that formulation, it is clearly an IS shock. The level of output declines; the level of interest rates decline as well.

An alternative formulation and a formulation that is probably more in the spirit of Yale economics is to think of the ISLM diagram as having been drawn in a space that focuses on output and the required return to capital or focuses on output and q. In a formulation of that kind, there hasn’t been a shock to the relationship between investment and the price of capital. There’s been a shock to the price of capital at any given level of the short-term interest rate. And so, one thinks of it as part of the dynamics of the LM curve.

However one views that question of the IS curve versus the LM curve, the operative distinction between the two kinds of shocks is that in a disinflation shock, interest rates are up and that is why output is down. In a financial breakdown shock, output is down and that is why policy interest rates or safe interest rates are reduced. From that perspective, it’s very clear what the current episode is. As expectations of future output have declined, as asset prices have declined, one is seeing very substantial declines in Treasury bond yields and in the Federal Funds Rate. For those who are aficionados of such things, I will mention that for a period of a week, the five-year TIPS yield was significantly — it was negative — at one point reaching negative twenty-two basis points. There was a brief three-hour period in Japan when the one-month Treasury Bill was yielding not two basis points, not one basis point, but literally zero basis points as a consequence of various machinations in the money market that had the character of an extreme flight to safety.

If one thinks about the duration and the policy response to recessions of these two kinds, they are usefully distinguished. The policy response and the dynamics of disinflation recessions are not profoundly complicated. The Fed steps on the brakes; depending on how hard the Fed steps on the brakes, the recession’s duration is uncertain. At a certain point, when it is satisfied that sufficient disinflation has taken place or when it feels that other imperatives take precedence, the Fed removes its foot from the brakes, allows short-term interest rates to decline, and eventually the economy expands. There’s no great mystery about it. The length and depth of the recession is closely tied to the strength, force, and length of the Fed tightening and the speed with which it eases. Hence, there was much more disinflation to be done in 1980-82 and the recession interest rates were pushed up much further; the recession was that much more severe.

The matter is much more complex when one turns to financial overextension recessions. Thinking about the limited sample of data, it falls into two broad categories. The first is the recessions that didn’t happen or happened only barely. There was a pretty exciting financial crisis in 1987 and nothing really happened. There was a pretty exciting financial crisis for those involved in 1998. In neither case, if I gave you the data on unemployment, GNP, consumption, any real variable and I didn’t give you the time scale and I said — What year did we have a 20% stock market crash? What year did we have a really dramatic set of dislocations in financial markets as a major hedge fund failed? You wouldn’t be able to see it. Even the 2001 recession, which was associated with the bursting of the NASDAQ bubble, is a pretty minimal recession. In retrospect, with the data revised, there is no two-quarter period when GDP declined. There are two quarters in which GDP declined, but they’re separated by a quarter of modest positive growth.

Chapter 3. Financial Intermediation Capital: Essential for Economic Growth [00:12:35]

It is not the case that all financial crises, or even most financial crises, lead to economic downturns. Some have a natural explanation of that. Essentially, they explain that the financial sector is only one small part of the economy — that the decline in the financial sector of the economy is not of that much consequence. With reasonable policy responses, either with monetary policy or with fiscal policy, and automatic stabilizers any loss in demand can be offset. Not a typical calculation of this kind would say, suppose the stock market lost 20% of its value. If the value of the stock market is on the order of the value of GNP, that’s a loss of 20% of GNP. If the marginal propensity to consume out of wealth is 4%, the loss is 8/10% of GNP — an amount that an economy would rather not lose, but hardly the difference between economic success and economic failure and something that’s potentially offset if there is some policy response.

There is data and evidence for the view that a significant amount of financial disruption can take place with relatively little consequence for the real economy. The difficulty is that there are other data points as well as 1987 and 1998 and 2001. There are data points that come from the United States in the aftermath of 1929, while those, perhaps, are in so different in institutional environment, with such egregious errors as to not be relevant. There are data points from Japan during the 1990s. There are any number of data points from emerging markets in which the reality of financial problems created very large losses in output. It’s natural to ask, why is the response to financial crises so heterogeneous with some episodes in which they seem to have very little consequence and some episodes in which they seem to have so very much? I think the natural explanation, though it’s difficult to prove in any kind of conclusive way, is an idea that runs through the work of many economists and probably in recent decades most strongly through Ben Bernanke’s work, suggesting that financial intermediation capital is a substantial contributor to the production process. When it is destroyed, suddenly there are substantial losses, both to aggregate supply and to aggregate demand.

I made this point — tried to make this point — graphic in a conversation with one of your colleagues by asking the question, suppose one considered the following macroeconomic shock. For the next six months, it will not be possible to make and complete a phone call in the United States. What would be likely to happen to the GDP of the United States and what would be likely to happen to the performance of the American economy? It’s actually sort of an interesting question and I don’t have a clue exactly what the right answer is. My strong suspicion is that it would really be quite a bad event for the performance of the economy. The question of whether the telephone lines would transmit bits would obviously be very important in — or it would only stop working for the human voice — would be a very important determinant. In either case, it’s hard to believe that there would not be substantial loss of output and significant loss of employment as well.

There would be many methods for seeking to estimate the value of the losses, but I would argue that a particularly poor method would be to ask, what’s the market value of all the telephone companies? Let’s say the market value of all the telephone companies is a trillion dollars. If they’re not going to earn anything for a year, then their market value will go down by $400 billion dollars. So, we’ll multiply $400 billion dollars by a marginal propensity to demand — marginal propensity to consume — and we’ll add something for the fact — and we’ll call that lost demand. We’ll say, there needs to be some increased demand because we need to fix the telephones; so, that’ll be some increased investment. That would, it seems to me, be the wrong mode of analysis. In some way, one would want to capture the idea that the production potential of the economy would be lower because the opportunities to generate output out of a given amount of capital and a given amount of labor would be impossible without the intercommunication that the telephone makes possible.

The results, I would suggest, of that telephone shock would be lost output and would also be lost output without substantial disinflation benefit because the lost output would not come in a way that created lots of goods hanging over markets that led to declines in prices. The benefit, in terms of disinflation, of a downturn induced by the inability to make a phone call would be much less than the benefit of a similar loss of output achieved through the more standard tools of fiscal and monetary policy. I emphasize this last point because it connects with the observation with which I began yesterday — that declines in output associated with financial crisis recession, if avoidable, probably create a welfare gain of the kind that Art Okun focused so much on and of the kind that Jim Tobin emphasized when he spoke of all those Harberger triangles filling an Okun gap. And [they] are not susceptible to the critique that what you lose on the swings you gain on the swerves that’s associated with the more conventional view of cyclical fluctuations.

It should be clear, from what I have said, where I am going. My suggestion is really, to echo Ben Bernanke’s suggestion, that the destruction of financial intermediation capital should be thought of as reducing the economy’s potential to generate output and, in that process, making people poorer and reducing the level of demand as well. When that process kicks in to a substantial extent — that, I would suggest, is the occasion on which financial crises prove to be exciting events outside of the precincts of Manhattan and Chicago. The crucial question for economic policy in responding to these crises, I would suggest, is preventing that kind of destruction of intermediation capital from taking place on a large scale.

Chapter 4. U.S. Fiscal Policy Challenges and Objectives [00:23:08]

That brings me to the policy task that the U.S. authorities face at the current moment. I’d like to define the problem as managing and containing three separate vicious cycle mechanisms. The first is the one that I spoke about at length yesterday — what one might call the liquidation cycle. The tendency, more than a tendency, in the market for fixed-income instruments, particularly mortgage-backed securities, to some degree in the market for housing for declines in value to give rise to selling pressures that create further declines in value reinforcing the vicious cycle. The second vicious cycle, which builds on that, is what is traditionally referred to as the credit-accelerator cycle. A deteriorating financial economy leads to less lending; leads to a deteriorating real economy; leads to less capacity to pay back debt; leads to declining values of financial instruments; leads to further reductions in lending and the cycle continues.

The third cycle — the third potentially destabilizing mechanism is the one that’s perhaps most familiar — the Keynesian mechanism in which reduced spending leads to reduced income leads to reduced spending and on. Containing these mutually reinforcing cycles is, I would suggest now, the central challenge for economic policy. I am not in a position to make authoritative estimates of some of the relevant magnitudes and I don’t want my estimates to be given more seriousness than their crudity deserves, which is why I’m not projecting them on a screen.

Let me give you some round numbers that are quite close to the judgment of the various investment banks and informed observers who have studied these questions. The equity capital of leveraged financial institutions in the United States totals about two trillion dollars. It totaled a little more than two trillion dollars a few months ago; it probably totals a little less than two trillion dollars today. That two trillion dollars of capital supported about twenty trillion dollars of asset holding. In other words, those institutions were levered ten-to-one; some were levered much more than ten-to-one. Fannie Mae or Freddie Mac are, for example, levered thirty-to-one. A bank with an 8% capital requirement is levered twelve-to-one; others — hedge funds pursuing certain strategies — are levered considerably less than ten-to-one. On average, the leverage works out to about ten-to-one — two trillion dollars of equity capital, twenty trillion dollars of lending.

The losses that have taken place over the last nine months and the projected losses based on reasonable models of fundamentals — these are not marked-to-market losses that build in what might be market overreactions. These are estimates of what will happen to mortgage securities based on assumptions that, for example, house prices will decline by another 15% from current levels. Estimates of those total losses are about a trillion dollars. That trillion-dollar figure sounds very scary, relative to two trillion dollars of capital in the intermediation sector. But, good news — about half those losses are outside the financial intermediary sector. They’re Bill Brainard’s pension; they’re the State of Nebraska’s pension fund; they’re the Yale endowment; they’re life insurance companies, and the like. So, about half are held by levered intermediaries. And more good news — the levered intermediaries are mostly, sooner or later, in one way or another, going to get tax deductions of various kinds. When all is said and done, the losses of capital to the intermediation sector represent about $300 billion dollars. $300 billion dollars of lost capital has been offset so far by about $150 billion dollars of capital that has been raised in Citigroup’s deal with Abu Dhabi and the like.

Lost capital, which can be estimated with some degree of accuracy compared to the next step in this calculation, represents about $150 billion dollars. $150 billion dollars of lost capital at ten-to-one leverage means a trillion and a half dollars of lost intermediation capacity or about 7.5% of the financial asset holding that was previously taking place. Now, here comes a wild card; what should happen to the leverage of intermediaries in the face of the events of the last nine months? Well, first of all, they probably should have learned from the last nine months that the degree of leverage with which they were operating nine months ago was excessive. Second, they almost certainly will judge that the volatility associated with the assets they hold and the degree of uncertainty about their portfolios is today very substantially greater, not just than they thought it was nine months ago, but than it objectively was nine months ago. Third, the magnitude of tail risk of existential events, which will cause the solvency of their institution to come into fundamental doubt, has surely increased as well.

I don’t think we have a sound basis for estimating how much prudent institutions will reduce their leverage. The leverage choices they may make will, of course, be very much influenced, in some cases, by the way in which the government applies capital rules. If one makes the conservative, but in my view not absurd, assumption that leverage will be reduced by 10%, 10% leverage — a 10% reduction in leverage on a $20 trillion base of asset holding represents the loss of another $2 trillion in lending capacity. Add the $1.5 trillion and the $2 trillion and you are looking at the loss of, on the order of, $3.5 trillion or on the order of 15% of the previous financial intermediation capacity. It is not unreasonable at all to suppose that this is a shock that is of substantial magnitude relative to the functioning of the financial system and to the extent that the economy is dependent on the ability to get credit to the functioning of the economy. At root, it is the challenge of policy to address this shock in this environment.

What are the tools that are available to policymakers? The first imperative of a policy and one that has been pursued in this crisis since the beginning of 2008, albeit in my judgment somewhat belatedly, is to seek to maintain aggregate demand. Whatever else is happening, an environment of this kind is likely to be a disinflationary environment over time. It is likely to be an environment in which if spending is reduced, asset values will decline, further compounding the degree of economic damage. How do policymakers seek to maintain aggregate demand? Before the events of the last eighteen months, if asked to comment on this subject, I would have said the dominant tool of short-run stabilization policy should be monetary policy not fiscal policy. I would have explained that fiscal policy, except in the shortest of runs, was likely to be offset by the Federal Reserve. So, it would end up affecting the composition of output, not the level of output. I would further have explained that it was much more destructive of long-run values to try to vary spending or the tax structure in a short-run way in order to stabilize the economy; that was best accomplished through monetary policy. I continue to regard that as a reasonable judgment about policy in normal times.

Chapter 5. Caution against Overdependence on Monetary Policy and the Federal Funds Rate [00:36:44]

It seems to me that, while it is appropriate in this environment to seek to use monetary policy as a tool of stimulus, there are several considerations that suggest that it should not be the sole tool of stimulus in this environment. First, there is much more than the normal degree of uncertainty about what the impact of changes in interest rates will be on the level of aggregate demand. Imagine, for example, an intermediary that is capital-constrained. It only has a billion dollars of capital and it therefore can only lend ten billion dollars. Imagine now that the rate of interest is brought down; it can still only lend ten billion dollars and the rate at which it lends will still be the point at which the demand curve for its loans is at ten billion dollars. The only result of bringing down the interest rate will be a reduction in its cost of funding, which over time will allow it to rebuild its capital, but that is a very slow process — a very different situation than the more normal situation in which the intermediary is not constrained. Is this the case for most intermediaries? It’s very difficult to know.

Most intermediaries are not at their capital constraint, but they probably are planning for some given cushion relative to their capital constraint. In this environment, it is likely that the multiplier for monetary policy is less and it is surely more uncertain and that is an inhibition to the use of monetary policy. Second inhibition to the use of monetary policy as a sole tool is: most of the time, with respect to most economic policies, we may not know what the multiplier associated with the instrument is, but we know where we have set the policy dial. Through all of modern economic experience, until nine months ago, it would be completely impossible to use any known econometric technique to say anything about the impact of changes in the Fed Funds Rate, as distinct from changes in LIBOR, on the behavior of the aggregate economy. They were perfectly multi-linear as the spread between them was small and little fluctuating.

In the last nine months, a substantial spread has emerged between the Fed Funds Rate — the rate at which banks lend to each other overnight — and the Interbank rate that prevails over longer horizons. For a variety of reasons that I don’t have time to get into, it is almost certainly the case that large parts of this spread reflect the credit risk that banks experience when they lend to each other. Probably, the right indicator for monetary policy is not the Fed Funds Rate, but is LIBOR, in which case there has been rather less easing of monetary policy than looking at the Fed Funds Rate would suggest; but, one cannot make that decision in a definitive way. So, easing monetary policy as the Fed has been doing for some time and as the Fed did today in lowering the rate another twenty-five basis points is almost certainly appropriate. But it is almost certainly not appropriate to rely only on a single instrument in this context because one is uncertain about how much of that instrument one is applying, because one is uncertain about what the multiplier of that instrument is, and because in the current context there are reasons to be concerned about the pernicious side effects of excessively low interest rates.

Two stand out. The first — while in general I am very much with the Keynesian consensus that the inflation process depends upon aggregate demand, in the current context, lower interest rates may well contribute directly to the inflation process through their impact on the dollar and through their impact on commodity prices. The second — while I give less weight than most to critiques of a policy environment that blame our current problems on the fact that interest rates were kept low for a long time responding to the last recession, it seems to me reasonable to give some weight to the concern that excessively low interest rates set the stage for future bubbles.

I, therefore, think it’s appropriate that the Congress acted — and I suspect the Congress won’t need to act again — to provide fiscal stimulus to the economy. In advocating fiscal stimulus just after the turn of the year, I urged that the stimulus be timely because experience suggests that the difficulty of lags and implementation have traditionally been serious with respect to fiscal policy. That it be targeted — designed to generate as much spending as possible as quickly as possible, which meant that tax breaks should be channeled to those with lower incomes rather than those with higher incomes. That recommendation if adopted; means that taxes — means that benefit programs would go to people like food stamps and unemployment insurance recipients, who were likely to have a very high-margin propensity to consume. The political process was unwilling to do that. And that the fiscal stimulus must be temporary in light of the seriousness of the country’s long-run fiscal problems.

Macroeconomic policy in this environment can help to maintain aggregate demand, but it does not address the disruption in the productive mechanism associated with the decline in the financial sectors capacity for intermediation. There are a number of tools of policy directed at the maintenance of financial stability. One has received overwhelming emphasis to date and it is entirely appropriate, but I would suggest presumptively insufficient. That is, the Fed, through a dizzying array of new facilities and ad hoc actions, has made clear that it stands ready against good collateral to provide liquidity to financial institutions. Now, go back to the calculations that I went through a moment ago. I emphasized the loss of capital and I represented the desired reduction in levels of leverage associated with a more risky environment. I did not say anything in doing those calculations about the difficulty of attracting funds, about the difficulty of borrowing funds. I did not raise the concern about bank runs and the like.

The provision of liquidity by the Fed is necessary; without it, in my judgment, it is very likely that we would have seen problematic runs on a number of institutions. I believe the Fed behaved in a broadly correct way in responding to the events at Bear Stearns. It is certainly possible that if the Fed had not acted, the losses to Bear Stearns shareholders would have been total. There would have been substantial disruption in the bond markets for a period of five days. A valuable lesson would have been taught and the matter — and the world would have moved forward. It is certainly possible that that is the case. It seems to me, one doesn’t need to assign a very high probability to the alternative scenario in which runs on Bear Stearns cascaded to other institutions, which then cascaded to other institutions and led to substantial destruction of many institutions that were thought previously viable. I don’t think one has to assign a very great probability to the latter event to believe the rescue of Bear Stearns was worthwhile. I, myself, would assign a much greater than 50% probability to a major systemic-risk incident if the damage at Bear Stearns had not been contained.

Chapter 6. Obstacles in Introducing New Capital into and Increasing Direct Regulation of Financial Markets [00:48:12]

In any event, while noting the necessity of all of that, I want to emphasize its insufficiency — that it does nothing about either the reduction in capital and it does very little about the reduction in desired degrees of leverage, that I would suggest are at the root of the problem. That brings me to what is, I think, the second crucial tool of financial stability, which is the most important financial policy issue in the current environment. Unfortunately, by its nature, it is difficult to tell the vigor with which it is being pursued. That is the infusion of new capital into financial institutions. Notice that if financial institutions raised their level capital, then at any given level of leverage they are able to raise their degree of lending and you are able to reinstitute the intermediation capacity that has been lost. There is a crucial un-internalized externality in our current system of financial regulation. Institutions are regulated and their soundness is judged on the basis of a capital ratio — on the basis of their degree of leverage. They are pressured rationally enough not to have deposits that are short-term liabilities that are too large relative to their degree of capital.

Notice that an institution can acquire — can reduce its — can improve its capital ratio or reduce its leverage in one of two ways. It can reduce its leverage by shrinking its balance sheet or it can reduce its leverage by expanding its level of capital. If the institution is indifferent between those two choices, society is clearly not indifferent between those two choices. It has a strong preference for the issuance of capital. Or to put essentially the same point in a different way, if an institution raises capital, it dilutes its shareholders and a substantial part of the benefit of that extra capital goes to the holders of its risky debt, whose claims have now become more secure. As a consequence, the private incentive for capital raising, even with a capital rule operating as regulation, is substantially less than the social incentive. One hopes that the regulatory system is internalizing this externality — is placing substantial pressure on institutions, who after all are enormously dependent on their relationship with the financial authorities to raise more capital than they otherwise would. It is very difficult to know from the outside to what extent that is taking place.

A prudent regulator who was forcing an institution to raise more capital would conspire with that institution to not have it be known that the regulator was forcing the institution to raise more capital, lest the health of the institution come into question. Certainly there have been a number of favorable developments involving the raising of capital in recent months, but in my judgment and the kind of numbers I presented suggest that we have a long way to go.

I would suggest, of particular importance in this regard is the capital situation of the government-sponsored enterprises, which are levered thirty-to-one and which have a crucial role in this environment in supporting the mortgage market. To date, they have been encouraged to buy more mortgages through a reduction in their capital requirement and there have been rather diffuse statements about it as their hope and intention to raise more capital in the future. We’ve been moving towards the future; they have not yet raised the capital. Some rather skeptical statements about the need to raise capital have come from their management with as yet relatively little criticism from the public authorities — liquidity, raising capital.

The third broad policy question involves more direct intervention in markets. In my judgment, any attempt to support the housing market, in general, at current levels would be misguided. There is little reason to believe that house prices have yet fallen to fundamental levels, let alone fallen through fundamental levels. The lesson of the Japanese experience is that price keeping operations by governments delay processes of adjustment. Why would anyone want to buy something whose price is being supported by the government since it’s likely that there will be further downwards adjustment rather than upwards adjustment?

Where there is a much stronger case is for policy to support the mortgage-backed security market where prices reflect expectations of terribly high default performances. Some mortgage-backed securities on some classes of subprime debt are building in the expectation that more than half the houses will be foreclosed; estimates that go way beyond what even fairly pessimistic forecasts suggest. By stealth, a rather substantial program of support for the mortgage-backed securities market is under way. Key elements include the actions of the government-sponsored enterprises that I referred to that will enable $180 billion of increased purchasing of mortgage-backed securities. A similar change on the part of the federal home loan banks and if, with that thirty-to-one leverage ratio, the GSE’s are caused to raise significantly more capital, there is the prospect of significantly further support for the mortgage-backed securities market, whose greater health would impact both the availability of credit to potential new homeowners and the availability — and the health — of the financial institutions that are holding their securities.

I think — and I will not dwell on the point for reasons of time — that there is also a strong case for policy measures directed at strategic intervention in near foreclosure situations to promote the writing down of mortgages as an alternative to foreclosure. Given that, available estimates suggest that the losses associated with the foreclosure process itself can easily add up to more than half the value — the residual value — of the home.

Chapter 7. Fiscal Policy Coordination in the International Context: Observations and Suggestions [00:57:50]

Finally, I would highlight the international dimension of policy and would stress two aspects. The global dynamic here is that two things are happening. First, U.S. aggregate demand is falling. Second, the fall in the dollar associated with all the various ramifications of these financial events are switching expenditure from the rest of the world towards the United States. Third, some of the forces operating in the United States are also operating to reduce aggregate demand in the rest of the world. A crucial priority for policy coordination in that context has to be the stimulation of aggregate demand in the rest of the world and, probably, the achievement of a more balanced pattern of dollar depreciation. To date, the dollar has depreciated disproportionately against a very small number of currencies, principally the Euro, that stand for countries that do not have problems like those of the United States and that allow their exchange rate to fluctuate; a more balanced path would be desirable. Second priority for policy coordination is with respect to the very large quantities of liquidity that are now managed by governments. They represent, potentially, an enormously important resource in the current context — pools of patient capital that can be managed for the long term and that could provide liquidity to badly distorted fixed-income markets, but have not yet done so on a substantial scale.

These sets of measures represent, I believe, a policy approach that offers a very good, though not certain, chance of containing the current situation. The risks, it seems to me, are much more on the side of it being pursued with too little vigor than on the side of it being pursued with too much. In particular, the imperative of the rapid recapitalization of financial institutions stands out. I will for reasons of time leave a discussion that I had intended, raising questions about the regulatory structure and changes that might make crises of these kind less likely in the future, to the question period. But, I will just make five telegraphic observations.

First, it is the irony of financial crisis that the very forces that caused it are the opposite — are also the very forces that are necessary to get out of it. If the world’s problem eighteen months ago was that there was too much greed and too little fear, the world’s problem today is that there is too much fear and too little greed. The policies that would have been highly constructive eighteen months ago in inhibiting undesirable lending are potentially counterproductive today in inhibiting constructive lending.

Second, there’s an overwhelming case for stronger consumer regulation in all financial areas. If one studies carefully the extent to which subprime mortgages at egregious interest rates were taken on to help people get out of credit card debt at super egregious rates, one has a sense of the greater complexity of the problem and the need to view it from an integrated consumer perspective.

Third, the government should be paid for providing the safety net and the modalities that are necessary to do that — need to be much more carefully designed so that if everything works out splendidly in, for example, the Bear Stearns transaction, the government would be a beneficiary of the success since it surely will be a beneficiary — surely will bear the burden if everything else is lost.

Fourth, the dominant — the single most important area for thought in thinking about the future of financial regulation is the problem of pro-cyclicality. Prudent behavior by individual institutions involves shrinkage of balance sheets in bad times. Everyone’s effort to shrink balance sheets in bad times has potentially catastrophic consequences for the system. How to regulate to avoid pro-cyclicality is a fourth crucial imperative.

Fifth, these issues should be addressed slowly, carefully, and deliberately; as I suggested, the problems of getting us out of a situation of this kind are in many ways the opposite of the problems of preventing future financial crises. It will be tempting, but would be unfortunate, to address the concerns through whatever officials do when they’re not sure what to do, which is reorganize. Our central challenges involve the questions of how we define capital, how we regulate capital, for whom we regulate capital, how we avoid pro-cyclicality. Until we know the answers to those questions, it will be difficult to think intelligently about what the right bureaucratic structure of regulation is.

All of this is to suggest to the students here that the macroeconomics of the early twenty-first century will be no less important than the macroeconomics of the latter part of the twentieth century. That macroeconomics has a good chance of being much more centrally involved with financial issues than the macroeconomics of the late twentieth century — or perhaps fairness requires me to say, the macroeconomics practiced outside of New Haven in the late twentieth century. The many, many imprecisions and speculations in these remarks, I apologize for, but offer as a modest and inadequate defense that they point up that there’s a great deal of very valuable research to be done that will contribute to our understanding of economies. Also, I believe, to Art Okun’s vision, of harnessing that understanding to help make better and more secure lives for our fellow citizens. Thank you very much.

Chapter 8. Q&A: From Paulson’s Proposal to Regulation of Lending and Leverage [01:06:56]

I went over my time, but I’ve got some time for questions. Jeff?

Student: Larry, do you think that Secretary Paulson’s recommendations are appropriate to the problem? Or do they that seem to be a dusted off failed answer to a different set of problems. Secretary Paulson’s recommendations last year addressed a presumed crisis overregulation diminishing. You seem to suggest that the real problems are misperceptions of risk and not mistaken regulation. Will the Secretary’s repurposed proposals die on the vine or will they still get political traction despite your warning? Sorry about the mixed metaphor!

Professor Larry Summers: Get traction on the vine, I guess. There’s certain — I’m going to not associate myself with all the words you used in describing the Secretary’s proposals, though I can’t understand why — I can understand why you use them. I think that it is almost always a good idea to bet on inertia in anything political. I suspect that in the remainder of this election year it is very unlikely that anything will get done that doesn’t appear necessary to respond to current difficulty. And usually, when there’s a new administration or a new secretary, the problem is not excessive fealty to the visions of the previous secretary, the problem is a desperate effort at artificial product differentiation.

There were a number of issues I found when I was at the Treasury where there was a certain way to do it that was kind of a good idea and, actually, our predecessors had more or less figured it out. It was my experience that we never decided to say, let’s really work to get Secretary Brady’s good idea in place. We always found a few points of minor difference and found a variety of ways of relabeling it. That was when we thought the ideas were good and he had it right. In the cases where we didn’t, it was much more dramatic. So, I would be surprised if the ideas contained in that report prove to be a dominant starting point for discussion.

To be sure, I do want to say one thing. There is one thing that that report was getting at and there is one aspect of our system that I think we need to think very carefully about and it goes deep. That is, do we believe in competitive regulation of financial institutions? We have a banking system and it has for a long time been a fairly sacred principle that we have a so-called “dual banking system.” The idea is, well you get to choose your regulator and therefore no regulator can be too stupid because if they’re unreasonable or stupid, then people will choose a different regulator. Well, that’s one way of thinking about it. Another is that if regulators like to have more jurisdiction and they like to do more stuff, competitive regulation is a prescription for limited regulation. Implicit in Secretary Paulson’s — sort of, in the language one might expect from a Republican, emphasis on efficiency and the avoidance of duplication was a moving away from competitive regulation. I suspect that maybe quite an important idea. T,N?

Student: It is all very well to say in a general way that it is good to avoid duplication and to move away from competitive regulation without going to where the trade-off lies in different contexts. After all there is a lot of experience to draw upon. For example U.S., India, the E.U. and many others have more than one regulaory authority for different parts of the financial sector sector while the U.K. has just one. All the time the sector itself expanding with new agents, poroducts etc entering all the time, in part as a response to the system in place. Based on your experience and analytical skills where do you come out on this issue?

Professor Larry Summers: The question said — I’m going to rephrase the question. The question was, okay Larry that’s good, but don’t duck all the interesting questions. There’s a lot of experience in a lot of places. In particular, England has a single financial regulator. If you had to guess right now, what’s the best way to do it? Is that a fair rephrase of the question, T.N.? I think that the three things I would emphasize are: competitive regulation is probably a mistake if you believe in regulation. The central bank does need to have a role in financial regulation of major institutions because if it doesn’t have a role in the regulation of financial institutions, it’s not going to know things that it should know and it’s going to end up living with the consequences.

So, the central bank should be crucially involved in the regulation of major financial institutions. That — it’s a — if you believe in regulations that are pursuing objectives that are not immediately in the interest of financial institutions — If you believe in those regulations — consumer regulations, community regulations and the like — If you believe in those regulations and you want them carried out with vigor, you need to give them to their own regulator, who is not responsible for the health of the institutions in the way that the Federal Reserve is. Separation of consumer regulation, elimination of competitive regulation, and regulation of major financial institutions by an entity — by a single entity — in which the central bank has a role would be the three principles that I would suggest. John?

Student: I would like to make a comment and ask two questions. My comment is, like everyone I’m sure, we all enjoyed your talk very much.

Professor Larry Summers: The comment is he enjoyed the talk. That tends to — that’s the kind of thing you say before the devastating question and I knew John when we were in graduate school together and nothing in my four years of going to graduate school with him makes it less likely that after he said, he really enjoyed the talk, that the devastating question was going to come. So I am braced.

Student: It took me five years of graduate school. But anyway, your story of the leverage cycle, as I called it, where people leveraged too much in good times and then in bad times just when you want them to leverage, the leverage drops in the system and there’s not enough — there’s too little leverage to get you out of the doldrums. I think it’s a very important story. So, that was my comment, but the question though is —

Professor Larry Summers: I thought at least I got the comment, which was that he really liked the talk; that didn’t even count at all. Okay go right ahead.

Student: The question is, you don’t seem to have follow through to the end of the story, which is that if you think that the leverage is not being set by supply and demand properly — too much in good times and not enough in bad times — then I would have thought — maybe you’re saving this for the question period, so I’m giving you a chance to say it — then you would think that regulators ought to intervene to change the leverage. So for example, in good times they can prevent people from leveraging so much and in bad times — it’s a little more difficult to see what you can do, but particularly what I want you to talk about — how can the Fed intervene in a way to increase the leverage? For example, should it directly lend against collateral. But, they’ll lend more money against collateral than the market is willing to do, not lend at lower interest rates. But, just staying on your mortgage derivative, which the market will only lend $50 on, the Fed will take that as collateral, lend it the same interest rate the market will, but lend $60 on it instead of $50. Do you think the Fed should do that and if it has been doing that? That’s the first question.

The second question is, you talked about the housing crisis and there’s 50% of houses and people may be [Inaudible] subprime borrowers — that’s 2.5 million of them that have been tossed out of their houses. You said at the same time that you think innovation sometimes prolongs a problem and makes it worse. But getting rid of this $180 billion that you spoke of is not going to make much of a dent in 2.5 million families being tossed out of their houses. So, do you think there should be some more, bigger intervention? One that I would suggest is the people doing the lending are the ones who are going to lose all the money when these people are thrown out of their houses. They’re the ones with the biggest interest to seeing something done. They’re paralyzed because the bondholders are split up so completely that they can’t coordinate. They’re remodifying the terms of the loan and no single banker would let 2.5 million families be thrown out on the streets and have their houses sold for 50% of the loan. Can you think of a way of coordinating these people — these lenders — who are uncoordinated, so that they themselves, without the government having to put up any money, can help solve the problem?

Professor Larry Summers: There are two characteristically good questions. On the first question, which was about pro-cyclical leverage — as I tried to explain, I’m not sure the focus on leverage is right rather than the focus being on lending. Those are quite different things. I actually think that the world is more risky; the uncertainty surrounding what’s going to happen to loans is greater than it was a year — certainly than people perceived it to be a year and a half ago. So, I’m not sure institutions should have much higher leverage today than they did a year and a half ago. That’s why I put emphasis on what I think is the right thing. I’m not sure they should have more leverage; they should have more lending and there’s a way of getting to more lending without having more leverage, which is raising more capital. That’s why I emphasized the importance of pressuring institutions to raise more capital and that’s why, without having any terribly compelling way to concretize it, I think in our thinking about regulation we need to get a bit away from the capital ratio as the central variable since what we want is capital raising now, not balance sheet shrinking. An emphasis on the capital ratio treats those two as equivalent when they’re not in fact equivalent.

The one suggestion that has been made, and I have no idea whether it actually works out in a viable way, is to force institutions to issue some kind of security that is a reverse convertible that becomes — that converts from debt to equity in difficult times. It’s hard to see why that security is going to feel a lot like debt when you buy it in the good times, so I’m not sure whether that works out, but that’s the type of thing that one has to think about. I would resist the idea of framing the question through the leverage ratio.

Should the government try in good times to require levels of capital or limits on leverage that go beyond what appears to be prudential for individual institutions in the name of protection of the system? I’m probably one big financial mess away from being in favor of that. Not quite there because I think you’ve got to be very careful about the adverse effects if you don’t do it very carefully. Once you’re talking about a punitive capital requirement that’s not related to your institution’s prudential needs, the incentive to avoid it is very strong. So, if you don’t do it for every institution, the action is going to migrate away and if you do do it for every institution, you’re getting to a pretty dirigiste place, in which the government is regulating in a lot of places where it’s probably not going to be so good at regulating.

Your other question was about the foreclosure and mortgage problem. I think one of the easiest judgments to make, in the sense that there’s a measure available that has a reasonable chance of doing good and has, I think, roughly no chance of doing bad, is the legislation that’s been introduced by Senator McCaskill and others to remove legal liability from servicers for any decisions they make to renegotiate the total value of these mortgages. I think there’s considerable doubt as to how much activity — how much positive activity — that would generate, but there’s no downside and potentially some upside. There’s also another interesting problem in this area, which is many subprime mortgages, probably more than a third, have second liens against them that are serviced by somebody other than the original originator. Anybody’s good plan for working these things through where you reduce the value of the house is, in effect, going to wipe out that second mortgage. But, it is going to require the consent of that second mortgage and that second mortgage doesn’t have any very strong incentive to give consent.

There’s a long and dubiously honorable financial tradition of being paid to be a holdout. How one handles that is a potentially serious problem, not least because it’s financially and economically advantageous to do so. People who are good at being holdouts are likely to acquire a substantial number of these second mortgages and so the holdout rights will be exercised more skillfully than they would be by their current holders.

I guess my reaction is — to your question is — can the capital markets handle it? Yes, at a price and the price will be that de facto in this environment. The demand curve for equity slopes downward, so if a lot of equity needs to be raised, the price will be lower than if a small amount of equity needs to be raised. So, shareowners of these institutions are not wrong to be hoping to reduce the amount of capital they have to raise. That is rational behavior on their part, but it may not be desirable from the point of view of the system.

Student: Then the question would be, I guess, where would they have to take capital from in order for lenders to do something?

Professor Larry Summers: I don’t think we have a — I think, with the trillions of dollars sitting in sovereign wealth funds with a very large volume of assets that are held by pension funds, and endowments, and life insurance companies, I don’t think one needs to fear that if $200 billion more in capital was infused into U.S. financial institutions that somehow there would be a generalized — relative prices would adjust in various ways. But, I think the least of the concerns is that somehow we’d have a general shortage of capital for other purposes. I think there is a — this is a tricky subject, in the sense that everybody’s got the same idea, which is that they want to be the last dollar of equity in because you want to be in after the dilutions rather than in before the dilutions. So, there’s the concern that, when you speak of large needs for capital, that the incentive to be a partial solution may not be that great. On the other hand, the strategy of sort of deception — we only need a little and then we’ll be done — also is probably not a strategy that can be carried on very successfully for a long period of time. That’s why somewhat more comprehensive, somewhat larger approaches to capital raising would, it seems to me, be desirable. Gus?

Student: You were mentioning that additions to the agreed short-term stimulus package might be warranted. What would you include in such a second package?

Professor Larry Summers: I suspect there should be a contingency plan that is in place to give more rebates during the tax filing season next spring that somebody can decide to pull the trigger on or not to pull the trigger on late next fall, as we see where the economy is. There should be some supplementation of unemployment insurance and food stamps and there should be — almost certainly be — some effort to reduce the pro-cyclicality of the state and local sector, which because of balanced budgets and less tax collections, spending of all kinds is being cut back. I say “almost certainly” because there is a bit of a problem in the history of fiscal federalism in the United States in that whenever times are good, governors cut taxes and whenever times are bad, the federal government provides support to respond to the emergency. That’s not a terribly healthy set of arrangements and there was a lot of tax cutting going on in the good times. But on balance, I think there are a variety of mechanisms, including Medicaid reimbursement, for doing it; but, doing something for state and local governments would be the other piece I would emphasize. Yeah?

Student: What do you think is the main cause of the housing crisis? Why did it happen?

Professor Larry Summers: I think most of positive feedback mechanisms that I talked about yesterday were operative both going up and going down in the housing and mortgage security market. It’s not that you can’t understand why people made these loans. The truth is that in the period from the late 1990s through 2006, no matter how crummy the person — no matter how crummy the credit of the person — you lent money to, you did not get defaulted on. The reason was that if he bought a house, the house went up in value and he was able to borrow more to pay you back. So, the lesson that was learned was that lending money to people, even people who didn’t look like they’d be very good credits, was a safe thing to do. Now, ex post, we can see what the error in the inference was — that it presumed the continued strong behavior of house prices — but that wasn’t completely obvious. That was less completely obvious at the time and then you had various other things. People made the investments and they — if you were in the mortgage business, you bought mortgages; you succeeded; your mortgages went up in value as risk premiums went down. Then, you had more capital; you got paid on the basis of how much you invested. With more capital, you decided to invest more. So, you had all the kind of positive feedback mechanisms I described on the upside and then you more or less had all those mechanisms on the downside.

Student: But isn’t that an issue for regulators?

Professor Larry Summers: Those of an anti — those of a very strong, if you like, Chicago School bent make the point, so let’s see who did well in this situation; let’s see who did badly, let’s see who did reasonably well in this situation. Hedge funds — nobody much regulates them; they seem to have done okay. Individuals — some of them got to — some of them got in trouble but some of them got loans on terms that weren’t very attractive; that wasn’t so bad. Who really made a huge mess? Well, the big money center banks made a huge mess. Who’s most extensively regulated? Well, the big money center banks are most extensively regulated. I get it; we need more regulation — is this sort of Chicago argument and it should give one — I don’t think it’s the end of the subject. I think, it probably doesn’t point in the right direction at the end of the day, but it’s not a point to be taken lightly.

Since I like the spirit of your observation, here’s another observation in the spirit of yours. So, all these banks lost a lot of money; who made money? Well, a ton of the gain that is opposite the banks loss is a bunch of relatively poor people who sold their houses for substantially more than they otherwise would have because of the bad credit that the financial sector was prepared to give. I think the thing you have to say is that there are a fair number of people who are having to explain to their children why a policeman is knocking at the door and telling them they have to leave within six hours because they signed documents that they didn’t understand and that weren’t explained to them — that locked them into an arrangement that was, for them, going to be highly problematic. You can call it predatory borrowing and you can explain how they lived in a house, in a sense, rent-free for a significant period of time; but, I think it would be mistake to discount the trauma that has been imposed. But, there is a sense in which more regulated entities have performed worse and suffered more than less regulated entities. Last question?

Student: How does our current crisis compare with Japan’s since the 1990s?

Professor Larry Summers: Look, I think there are structural similarities between our problem and Japan’s problem. I think there are a variety of reasons to think that the bubble was substantially greater in Japan. I think, if one compares U.S. policy in the last nine months with Japanese policy between 1989 and 1992, we are acting with substantially more aggressiveness to get in front of the problem. U.S. regulators, fortunately from my perspective, have been very resistant to what was a major Japanese idea, which was mark assets in ways that will — that it is thought will — contribute to confidence rather than in ways that reflect market realities. I think that the rather arbitrary accounting that was pursued as a major tool of policy in Japan inhibited a great deal of necessary adjustment. That said, while I think the probability is low, one can’t rule out the kind of situation that developed in Japan. I think we do — I think these issues of levels of capital in troubled financial institution are very important issues.

One way of responding to an externality is with a subsidy. The idea of subsidizing institutions to raise capital seems quite untenable in the context of the institution’s shareholders holding onto their shares. So in a way, we operate a system where the government can’t infuse capital into an institution until the situation is very far gone, but once the situation is very far gone, it is very far gone. I don’t think it’s inconceivable that the government will have to infuse capital into institutions on a significant scale in the course of this crisis; but, I don’t think we’re ready yet to start planning for Nordic style or Mexican style, or Japanese style socialization of the financial system, though I wouldn’t — I think that probability is very low. I wouldn’t preclude that as a possibility and I think, in retrospect, it came significantly later in Japan than would, in retrospect, have been ideal. Thank you very much.

[end of transcript]

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