Thursday, August 07, 2008

Jam tomorrow, crack today

Larry Summers, who was thrown out of Harvard for saying that men and women are different, and this difference may be biological, is now an MD at DE Shaw. Good for him. He's also on FT opining about how to allocate the $6T or so in losses that the US financial sector has racked up over the past 5 years, which is now the hot potato between banks, tax payers, and the Chinese. The article is long and tedious, but I'll do my best to make sense of it:
The point can be put in another way. Four vicious cycles are simultaneously under way: falling asset prices are forcing levered holders to sell, driving prices further down; losses at financial institutions are reducing their ability to finance investment, which in turn reduces asset values, causing further losses; the weakness of the financial system is reducing growth, which in turn weakens the financial system; and falling output is hitting employment, which in turn leads to reduced demand for output.

Without active efforts to interfere with these mechanisms, there can be no basis for confidence that the American economy will recover even in the medium term.
What Summers classifies as four vicious cycles, I characterize as one. $6T was destroyed from ~2003-2008, but those losses have only now been revealed. We cannot place these losses on those who caused them, because that would be the US financial system. The other candidates we could stick these losses to are the US taxpayer, and the Chinese, but the US taxpayer has no money left, and the Chinese are propping up what's left of the dollar.

At this point you would think that a system that renders itself insolvent ought to be rethought from the ground up, even if the ultimate solution is more minor, but Summers does not seem to agree.
Granting that US consumer spending grew more rapidly than gross domestic product over most of the past decade and that ultimately the consumption share of GDP will have to fall back to more normal levels, it is hard to see why necessary increases in saving require a protracted recession. Instead, declines in consumer spending and improvements in the government’s fiscal position should be sequenced to coincide with improvements in net exports and investment. Allowing consumer spending to spiral downwards without offsetting policy actions risks reducing investment and incomes in the US and transmitting the US slowdown to the rest of the world. More­over, even if the argument for supporting consumption at present were rejected, there would still be a strong argument for supporting investment in areas such as infrastructure, where there is no evidence of a glut and considerable evidence of shortfalls.
When both consumer and government consumption is over leveraged, and has to deleverage, both will shrink. There is no identity for "bubble" or "waste" in Summers' macro models. Incomes have already gone down through inflation, although the official CPI only calculated inflation net of inflation, and so shows no problems. Also, while I agree the US needs better infrastructure, it has outlawed all new construction. Try adding a runway to O'Hare. Or building a tower in Manhattan. Making anything new in the US is almost impossible, the environmental impact statement itself takes 5 years, and then you have the community activists. China and Dubai can build. California and New York no longer can.
As for the inflation question, constant vigilance is necessary. It is certainly true that product price inflation has ticked upwards, though this seems to be heavily commodity-related.
Thank god! At least higher prices have confined themselves to stuff we use to build everything. Finally, a ray of light.
In an environment of rising unemployment, greater worker insecurity and increasing global competition, there are likely to be substantial pressures militating against any rapid increase in wages in the big industrial economies. Without rapid increases in labour costs, which are by far the largest component of production costs, it is hard to see how higher rates of inflation can be entrenched.
And we have a second ray of light! A weak job market will keep wages from rising. We are fortunate to keep consumer spending from falling through stagnant wages and higher prices.
In thinking about fiscal policy, it is essential to consider both near and long term. For the near term, larger deficits are likely to be potent in stimulating demand, especially in the context of an economy where there are constraints on the ability to lend and borrow. This is especially the case when new spending is directed at addressing the “repressed deficit” associated with the failure to maintain an adequate infrastructure.

Success in using fiscal policy will depend on also taking concrete steps that reduce projected deficits in the medium to long term. The enactment of new permanent measures, such as the extension of the 2001 tax cuts, without means to pay for them would be counterproductive. Conversely, measures that pointed to long-term fiscal savings would reinforce fiscal stimulus.
Fantastic! So transferring money from A to B, and burning 30% of it through deadweight loss in the process is a winner. But long term, we must balance the budget. I've heard this song before, and am glad that we have not reached the "balance the budget" phase of the plan, since that sounds unpleasant.
To date the focus of public policy has been on the extension of credit to banks and other financial institutions by the Federal Reserve so as to ensure their liquidity. This strategy is appropriate but may be reaching its limits. Where the problems a financial institution faces are of confidence or liquidity, lending can be highly efficacious. When the problems are of underlying solvency and the constraint on lending is a lack of capital, lending is not an availing strategy. It is necessary, at least on a contingency basis, to plan policy responses to such problems.
But what is the difference between insolvent and liquidity constrained? I used to think I knew, but I no longer do. If "insolvent" means "no one will lend to you" and "liquidity constrained" means someone will, then this becomes a political definition -- will the US taxpayer step up for you or not? The large banks are in good shape here. Detroit automakers I'm not so sure about.
Third, there is the question of whether government will need to find a way to recapitalise institutions through taking some kind of preferred interest, as ultimately proved necessary in the US in the 1930s and Japan in the 1990s. This is obviously a big step that one wants to avoid if possible. But in the absence of any framework for the government infusing capital, there is the danger that liabilities will simply be guaranteed de facto or de jure with no other change made, creating problems down the road. Government involvement in recapitalising financial institutions is like devaluation: a very unattractive last resort. Delay is tempting, but it can be enormously costly.
I'd go for it. Just step in and nationalize everything. It's quick, it's honest, and it's inevitable.


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