Monday, December 16, 2013

Larry Summers, Bubbles, Fiscal and Monetary Policy, and Financial Regulation; The IMF’s Fourteenth Jacques Polak Annual Research Conference Speech

As I have noted previously, Larry Summers delivered an interesting speech at the IMF’s Fourteenth Jacques Polak Annual Research Conference in November. Some commentators have jumped all over the speech, claiming that Summers is advocating that the Federal Reserve create bubbles in order to stop it from falling into recession or worse. (To find such comments, all you need to do is google “Larry Summers bubbles.”)
I was in the audience when Summers delivered his speech, have watched it again online, and have read a transcript of the speech.* What Summers is saying about bubbles is ambiguous. In fact, the word “bubble” appears only once in the speech. This is what Summers said:

“Let me say a little bit more about why I’m led to think in those terms. If you go back and you study the economy prior to the crisis, there is something a little bit odd. Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody believes that wealth, as it was experienced by households, was in excess of its reality: too much easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilization wasn’t under any great pressure. Unemployment wasn’t at any remarkably low level.  Inflation was entirely quiescent. So, somehow, even a great bubble wasn’t enough to produce any excess in aggregate demand.”  
This, however, is Summers' interpretation of what happened prior to the financial crisis. It is not his policy prescription going forward. In fact, he does not offer policy prescriptions but argues that what we need “to think about” is “how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity holding our economies below their potential.”

Near the end of his speech is the one statement about asset prices that could be interpreted as Summers’ advocacy of bubble:
“Now, this may all be madness, and I may not have this right at all. But it does seem to me that four years after the successful combating of crisis, since there’s really no evidence of growth that is restoring equilibrium, one has to be concerned about a policy agenda that is doing less with monetary policy than has been done before, doing less with fiscal policy than has been done before, and taking steps whose basic purpose is to cause there to be less lending, borrowing, and inflated asset prices than there were before.”
It is not clear from that how “inflated” asset prices before Summers might want to do something. It is, however, fair to assume that Summers is concerned about a premature cessation of quantitative easing of monetary policy.

With respect to fiscal policy, Summers is pretty clear about what he advocates:
“But imagine a situation where natural and equilibrium interest rates have fallen significantly below zero. Then, conventional macroeconomic thinking leaves us in a very serious problem, because we all seem to agree that whereas you can keep the federal funds rate at a low level forever, it’s much harder to do extraordinary measures beyond that forever; but, the underlying problem may be there forever. It’s much more difficult to say, well, we only needed deficits during the short interval of the crisis if equilibrium interest rates cannot be achieved given the prevailing rate of inflation.”
It is, though, surprising that, even by those inclined to agree with Summers about deficit spending, there has not been much criticism, if any, about another controversial argument Summers made in this speech. Right after the paragraph quoted above, Summers says:

“If this view is correct, most of what might be done under the aegis of preventing a future crisis would be counterproductive, because it would, in one way or another, raise the cost of financial intermediation, and therefore operate to lower the equilibrium interest rate on safe liquid securities.”
It appears that Summers is hinting that, in his view, Dodd-Frank goes too far. Perhaps he is concerned about a Volcker rule that he considers too restraining on banks. The argument that some of what is being done in the regulatory arena could be characterized as closing the barn door after the cows have left or as overkill is not obviously ridiculous even if one is inclined to disagree with it. There were, though, regulatory failures that were clearly an important part of the story of the events leading up to the financial crisis. It is hard to argue against doing something about that, even if one finds fault with particular regulatory initiatives.  

I have criticized Dodd-Frank for not attempting to deal with the regulatory capture issue and not reducing the number of agencies involved in federal regulation. Also, the failure of the regulatory agencies in the years leading up to the financial crisis was more due to a failure to use existing authority rather than due to a lack of authority. For example, it is common to hear the argument that financial derivatives were unregulated prior to Dodd-Frank; however, the bank regulators could have told the banks that certain uses of derivatives constituted an “unsafe and unsound banking practice.”  That they did nothing while major banks were buying credit default swap protection from one source, AIG, was a clear failure. Nevertheless, it is hard to fault the government from trying to rein in excesses in financial markets that pose systemic risks or could result in the taxpayer being on the hook. If Summers made his argument more explicit here, he might find himself in a politically uncomfortable position. Democrats who preferred Janet Yellen over Summers as Fed chair because they felt he might be lax on regulation had a valid concern. (I have previously written about the regulators’ dilemma and regulatory organizational issues.)
Now that Summers is not likely to be appointed to a government position in the near future, I hope he will clarify his thoughts on regulatory issues, as well as resolve the ambiguity of his speech with regard to monetary policy. Even if some of us do not agree with everything he says in this regard, it would certainly be thought provoking. And most of us would probably not disagree with everything.

* The video of the entire panel session during which Larry Summers gave his speech can be found here. It is the last video of the research conference. The video quality is better than what can be found on YouTube.  An unofficial, but it seems to me to be accurate, transcript of the speech can be found here. Summers has posted a “lightly edited” version of the speech on his blog. The major edit is the elimination of his calling “stupid” what “people in Chicago and Minnesota” might write in his hypothetical scenario.  

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