Larry Summers’ blog

Plan for Puerto Rico should be the basis for prompt Congressional action 


Last week, the Treasury announced their recommended approach to the profound economic and financial crisis engulfing  How things play out from here will be an important test of whether or not Washington is, as some allege, controlled by financial interests.

The Puerto Rican economy has declined by more than 10 percent since 2006 and employment has declined by 14 percent.  Nearly 2.5 percent of the population left the island in 2014.

The problems are in part structural, coming from the combination of labor costs close to the US level but productivity more comparable to the richer nations of the Caribbean. They are in part cyclical, as the bursting of a real estate bubble has led to sustained bank deleveraging: the overall balance sheet of Puerto Rican banks has declined more than that of Greece. And they are in part a result of weak Puerto Rican policy going back many years.

This rate of decline is only likely to increase, as Puerto Rico starves basic public functions to service its debts to the greatest extent possible, and eventually defaults in an uncontrolled way that produces financial chaos.

Unfortunately that is what lies ahead for Puerto Rico without Federal government action.  Already Puerto Rico’s debt exceeds its GNP, and debt service takes one third of its tax revenue, compared with the 5 percent average for US states.  Debts are currently being serviced only through emergency measures that cannot be sustained even to the end of the year.  This is well recognized by markets.    The benchmark Puerto Rican bond carries yields of over 11 percent, and in some cases, Puerto Rican bonds trade at only 30 cents on the dollar.

Right now the situation is frozen.  Puerto Rico has little to gain from reforms that increase economic growth if the extra resources will all go to its creditors. In any event it has proven itself incapable of responsible economic management.  On the other hand no individual creditor or group of creditors, even if they bought a claim for 30 cents on the dollar, is motivated to accept less than full payment as long as other creditors are going to be paid in full.  So Puerto Rico’s economy spirals down and the value of its debts declines alongside it.

What needs to be done?  There are two crucial requirements that parallel any situation of financial distress.  First, Puerto Rico needs to adjust its policies so that its economy can compete in the modern world and its government has sustainable finances.  Second, a realistic settlement needs to be reached where Puerto Rico is protected from its creditors and their claims are adjusted to realistic levels.   These two elements are present when a company goes into Chapter 11, a country goes to the IMF or a municipality files for bankruptcy.

Unfortunately, there is no legal provision in the bankruptcy code under which Puerto Rico can file, because it is a territory not a municipality.  This means that there is no overall framework in which debts can be written down in an equitable way that respects their legal status,  and there is no way in which support for Puerto Rico can be officially tied to policy reforms.  Without an extension of the bankruptcy code to cover territories, there is no way of resolving Puerto Rico’s situation.

An extension of the bankruptcy code to cover Puerto Rico is the centerpiece of Treasury’s proposal.  The proposal makes the judgement that a comprehensive plan is necessary.  The development of the plan it leaves to Puerto Rico, its creditors and the judiciary.  Treasury takes the bold and, I believe, appropriate step of proposing a bankruptcy procedure that can address all of Puerto Rico’s debt and pension issues, rather than excluding some debts from consideration altogether.

It is hard to see why people of good will should oppose such a measure.  Some argue that there has as yet been insufficient forensic accounting.  At one level this is true.  Before an actual restructuring in bankruptcy plan could be agreed, much more financial analysis is surely required.  But enough is known now to leave no doubt: Puerto Rico’s debts cannot be serviced in full and so a bankruptcy procedure is required, even if its precise outcome cannot be predicted.   One of the many virtues of a bankruptcy procedure is that it will provide the financial analysis that is required to move forward.

Others suggest that if Puerto Ricans just tighten their belts all debts can be paid.  This is absurd given the size of the debts, the prices at which they are trading, and the rate of collapse of Puerto Rico’s economy. This is a case like most where insolvency is being acknowledged too late.  If Puerto Rico had acknowledged its insolvency earlier – rather than trying to paper things over by issuing debt with a yield of close to 9 percent to a group of hedge funds – its creditors, its people, and the American economy would all have been better off.

The constituency opposing bankruptcy is largely comprised of those who are hoping for large capital gains on Puerto Rican debt.  If they are able to block the establishment of a framework for dealing with Puerto Rico’s debt, it will be a tragedy for Puerto Rico.  It will also be a profoundly troubling reflection on the power of special interests in Washington.  Let us hope that the Treasury’s prudent approach will prevail.


Canadian elections proof that an anti-austerity message is a winning one


The Canadian liberal party won an overwhelming victory in yesterday’s election.  Voters decisively rejected the ruling Conservative party and placed the Liberal Party far ahead of the left wing New Democratic Party.  This is obviously important for Canada.  But there are also two lessons here for American political observers.

First, polls often get it wrong.  As in Britain, and now the Canadian election, results were much more decisive than had been expected.  A Liberal majority looked extremely unlikely two months ago.  Even three days ago, I suspect Liberals would have been thrilled if they could have counted on a clear plurality of the vote.  An era when less than 10 percent of voters respond to pollsters, and where mass opinion changes rapidly, will be one where Election Day is again a day of drama.

Second in an era of extraordinarily low interest rates and slow growth, it is becoming increasingly clear that progressives do best when they reject austerity and embrace public investment.  The British Labour party and the Canadian NDP sought to demonstrate their soundness by embracing budget balancing as an objective.  Their results were terrible.

The Canadian Liberals on the other hand were rewarded for a very different choice.  As incoming PM Justin Trudeau told the Financial Times “people keep telling me we have made a risky choice in this time when there is this political mantra of balanced budgets as a way to demonstrate responsible leadership.  I am on the side of economists who say: Why put off investing when we have an opportunity now?”

Indeed many Canadian political commentators noted the strategic importance of the Liberals’ infrastructure pledge. Martin Patriquin in Maclean’s called the infrastructure plan “the all-important wedge to isolate the NDP”; Michelle Gagnon in CBC news identified the announcement of deficit-funded infrastructure spending  as “the first turning point”; and, as  noted on Bloomberg, “Trudeau entered the campaign in third place and his numbers began to increase after he broke from his rivals to favor three years of deficit spending, in part to fund an infrastructure blitz aimed at stoking Canada’s sluggish economy”.

More infrastructure investment is not just good economics.  It is good politics.  Let us hope that American presidential candidates get the word!

Pandemic bonds have potential to be win-win-win


During the annual IMF-World Bank meetings last week in Lima, Peru, I was part of a discussion on a proposed pandemic emergency financing facility. The subject brought together two things I am very interested in. First, The Lancet Commission on Global Health 2035, which I recently chaired, argues that under-investment in health-related global public goods is a major problem–and that in particular the world is badly under-investing in epidemic and pandemic protection relative to the risks involved. Second, after all that has gone wrong in recent years, it seems incumbent on all of us involved in finance to think about how financial innovations can address the real problems of real people.

The idea under discussion is a potentially powerful one: some public entity would issue bonds to investors which would be deemed to default in the event of an epidemic, assuring the availability of resources to respond before the epidemic takes on pandemic proportions. The facility would complement the new WHO contingency fund as well as its existing financing mechanisms. Such bonds are routinely issued to mobilize resources that will trigger in the event of hurricanes or earthquakes. So called catastrophe bonds or cat-bonds offer higher yields to investors in return for taking risks that are not correlated with the normal risks of business cycle downturns.

This has the potential to be a win-win-win. The World Bank is using financial innovation to mitigate a major threat to the world, and especially the world’s poor. The vast resources of the global capital market are being tapped to provide vitally important insurance – and bring much-needed financial discipline to pandemic preparedness and response. And investors who, at this time of zero rates, are desperate for return are getting a new vehicle in which to invest. Little wonder that the session brought together health advocates, national aid agencies and leading financial firms, all of whom were very positive.

I hope 2016 will see the advent of epidemic or pandemic bonds. But there are two hurdles that will have to be overcome if this initiative is to succeed. These hurdles, amidst the happy talk of cooperation, were I thought somewhat elided in the conversation.

First, a suitable price has to be found for these bonds: a price that works for both investors and for those who will issue them. Experience with hurricane and earthquake bonds suggests that in order to accept a 1 percent chance of default, investors require about a 3 percent yield premium. The same is likely true of epidemic or pandemic bonds. In an expected value sense the bonds are expensive for issuers and attractive to investors. So the question posed is this: As an aid agency concerned with, say, health in sub-Saharan Africa, is it better to pay $3 million to support the issuance of a bond that will with 1 percent probability pay off $100 million or is it better to give the $3 million to support improvements in local health care systems?

Second, a suitable contract has to be drafted specifying when exactly the bonds will default. Investors will expect something observable that does not involve any discretion so that actuaries can make rigorous models. The health community seems to see these bonds as vehicles for driving all sorts of good things like reform of local systems and very rapid response at the first instant in an epidemic situation. A way of satisfying both constituencies needs to be found.

I think these problems are solvable. But it will take more than rhetoric of cooperation and good will. It will take good ideas and hard negotiation. We can all hope that they will be forthcoming.

Another argument for infrastructure repair


There are many compelling arguments for increasing American infrastructure investment. Capital costs are exceptionally low. Construction labor is highly available. Materials costs are low as commodity prices have fallen. Investment is low by historic standards. Investing today relieves the burden for deferred maintenance from future generations.

Here is another one. Maintaining our infrastructure directly benefits American families and businesses because with fewer potholes they have to spend less maintaining their vehicles. This effect turns out to be surprisingly large. TRIP, a transportation research group, estimates that the cost to motorists of driving on roads in need of repair in 2013 was $109 billion. 1 This includes only extra vehicle repair and operating costs, and not the delays caused by driving on poor roads, so is almost certainly an underestimate. On the other hand, even with proper polices some potholes would remain. To be very conservative assume that proper infrastructure investment policies would save motorists half the total, or $54 billion a year.

How large is this figure? It is comparable to total consumer spending of $49 billion on air transportation or $53 billion on personal computers 2. As another way of seeing its magnitude, it works out to 40 cents per gallon gasoline consumed in the United States 3.

So if we were able to raise the gas tax by 40 cents and repair our highways and roads, we would create no new net burden on consumers: the benefit in reduced vehicle operating costs would at the very least offset their higher gas bills. In fact since our cost estimate is conservative, the net effect on consumers would most likely be positive. And as is fair, those who drive the most would both pay the most and benefit the most from reduced repair costs.

Even after a 40 cent gasoline tax, gas would still be only 82% as expensive as a year ago and 79% as expensive as 2 years ago 4. A gas tax to finance road repair is about as close to a free lunch as we can ever get in economics.

  1. TRIP, Additional Vehicle Operating Cost per Motorist 2013
  2. BEA National Income Table 2.4.5U: Personal Consumption Expenditures by Type of Product, 2013
  3. EIA SEDS Table F3: Motor Gasoline Consumption, Price, and Expenditure Estimates, 2013
  4. EIA Petroleum Data: U.S. All Grades All Formulations Retail Gasoline Prices, Monthly

The Importance of Global Health Investment


One of the things I am proudest of having done in Washington was having the idea as Chief Economist of the World Bank that the Bank should devote its annual World Development Report to making the case for improving both the quantity and quality of global health investment. The 1993 report produced by a team led by Dean Jamison proved more influential than I could have hoped, not least because it drew Bill Gates into the global health arena.

The Report made a strong case that the benefits of the right health investments far exceed the costs.  Indeed, I believe the moral and economic case for investments in health care–both prevention and treatment–is as or more compelling than in any other area in the developing world.  The dramatic declines in child mortality and increases in life expectancy demonstrate that policy can make an immense difference.

Dean and I chaired a commission, timed to coincide with the 20th anniversary of the initial report, under the aegis of the LANCET.   The commission took stock of the remarkable progress made over the last 20 years and emphasized what is possible over the next generation.

The primary conclusion of our commission was that our generation has the opportunity to achieve a “grand convergence” in global health reducing preventable maternal, child, and infectious diseases to universally low levels by 2035.   We further concluded that the necessary investments would have benefits that exceeded their costs by a factor of 10.  But we cautioned that grand convergence would not just happen.  It would require commitments to health system reform and to new domestic and international resources that go well beyond what is in place today.

All of this seems immensely relevant as world leaders gather in New York this week to to agree on a bold new global agenda for sustainable development.  The breadth of ambition embodied in the 17 Sustainable Development Goals and the associated 169 targets is truly inspiring and a tribute to the moral energy of many leaders in and out of government.

But there is the risk that with so many priorities, there will be insufficient focus on the most important and achievable objectives.  I was therefore excited when the Rockefeller Foundation asked me to work with them to develop a Declaration that a broad spectrum of economists could issue underscoring the importance of global health efforts.  The 266 economists who have joined our declaration come from 44 countries and at least as many political and ideological perspectives.  But they are united in their belief in the importance of expanding and improving health care globally.

Our Declaration was published in the LANCET last week and is summarized in a full page New York Times ad that is running today.  I hope the world listens.  Millions of lives are at stake.

The relationship between Universities and the Military


I had occasion to address a gathering of Congressional Medal of Honor recipients visiting Harvard last week. It was an opportunity to reflect on the meaning of courage, and also on the relationship between universities and the military. Our freedom, including our academic freedom, depends on the existence of a strong military, and of people who are prepared to serve in it. Universities have a responsibility to support the individuals and the institutions which defend that freedom.

The good news is that ROTC is back at Harvard, and that military recruiters are allowed on campus. The bad news is that our cooperation with the military appears to be contingent.  It reflects less a sense of our obligations of citizenship than our lack of major disagreement at this moment with the country’s military policies. I did not support the Don’t Ask Don’t Tell policy, nor the invasion of Iraq, but I do not believe that support for the military should be contingent on the political decisions of those who exert civilian control over it.

Given that the harmony between universities’ values and the military’s policies is unlikely to endure permanently, I think the issue of universities and the military is profoundly important.

Good news from Ukraine


The Ukrainian parliament today voted to ratify Ukraine’s debt reduction deal by a massive majority embracing all major factions.  This is important positive news in several respects.  First, as I have explained elsewhere it enables Ukraine to get the various benefits of debt reduction.  Second, the unity of support for Finance Minister Natalie Jaresko is encouraging with regards to future economic reform in Ukraine.  Third, today’s action puts Ukraine in the best possible position for coming debt negotiations with Russia and for receiving the further support it requires from the international community.

What to watch on Fed day


Today the Federal Reserve will makes its most consequential announcement in years.  Much attention has rightly focused on whether the fed funds rate is increased.  Ultimately though what matters is the posture of monetary policy, which depends on both the fed funds rate tomorrow and the path of expected rates.  My views are clear; this is not the time for a tightening in monetary policy.

Whether the fed funds target is increased or not is obviously an indicator of monetary policy. A better reflection is the 2 year Treasury rate which is largely determined by expectations of the fed funds rate the fed will set over the next 2 years.  It is this 2 year Treasury rate that I will be watching as the market digests the Fed’s policy announcements and forecasts and Chair Yellen holds her press conference.

I think it likely that the 2 year will move contemporaneously with the fed funds rate.  If rates are not raised I’d expect the two year to fall and if they are raised, I’d expect it to rise.  But this is not certain.  A “hawkish” holding of the rate where the Fed moved towards locking in future increases could raise 2 year rates.  Conceivably but less likely a “one and done” type announcement could on balance lower expected rates and so 2 year yields.

The figure below shows that two year yields and the chance of a rate increase in September have mostly moved together but that very recently markets have started to anticipate policy tightening that is not rooted in a September fed funds hike.  I see a risk that the fed will not move this afternoon but will appease hawks with such firm language on future rate hikes that their overall impact will be contractionary.  This would be very unfortunate.


Monetary policy should seek to avoid major surprises


In recent writings, I have laid out the strategic case against the Federal Reserve tightening this week. There is a compelling tactical case as well.

Monetary policy should seek to avoid major surprises.  Right now the fed funds futures market is assigning only a 28 percent chance to a September tightening. In the last 20 years, the Fed has never tightened without guiding the futures market to at least a 70 percent chance of a tightening.  So a move now, given how expectations have been managed, would be an extraordinary shock at a highly uncertain time.

To find a relevant precedent, one has to go back to 1994, when the Fed raised rates by 25 bps despite the market assigning only about a 30 percent chance (around what is expected now) of a tightening.  What followed was dubbed by Fortune Magazine as the Bond Market Massacre.”  Over the ensuing nine months, the interest rate on the 10-year bond rose by 2.2 percentage points — nearly twice as big an increase as any subsequently — with mortgage rates rising in tandem.   Volatility spiked dramatically across the world, and Orange County had the then-largest municipal bankruptcy in U.S. history.  Mexico and Argentina moved towards financial crisis.

There is a point here quite separate from the issue of what monetary policy should be.  Communication is a key part of the art of monetary policy.  The Fed for a generation has caused its tightening moves to be anticipated because it learned from the 1994 experience.   The same approach should be taken going forward.  Even if it were otherwise a good idea to tighten, no adequate predicate has been laid for a rate increase this week.


Why Ukraine’s debt deal is important not just for Ukraine, but for the West


I have spent the last two days in Kiev attending the Yalta European Strategy meeting, where I have had the chance to discuss Ukraine’s economic reform efforts with key officials, including the finance minister and prime minister.  I was encouraged to see a country where, despite huge challenges, including Russia’s war of aggression against Ukraine, economic reforms are being carried out and receiving support from the international community.

The Ukrainian parliament will this week vote on a historic debt reduction agreement that finance minister Natalie Jaresko negotiated with Ukraine’s private-sector creditors. The case for approval is overwhelming, both because Ukraine has made a good deal and because disapproving the deal would be catastrophic for Ukraine’s economy. But approval of the debt deal is only one component of the ambitious economic cooperation among Ukraine, Europe and the United States – cooperation that is essential to the geopolitical moment.

I have been watching debt negotiations closely for more than 30 years, since the Latin American crisis of the 1980s. Ukraine has gotten as good and fast a deal as any I have ever seen.

The deal has many virtues:

  • It reduces the principal value of Ukraine’s debt and eliminates principal payments for the next four years.
  • It unlocks substantial support from the International Monetary Fund and other international financial institutions on a large-scale.
  • It brings forward the day when Ukraine can attract significant private capital flows.
  • It establishes clear principles that will enable Ukraine to defer all principal payments on its obligation coming due to Russia.

Even if Ukraine’s economy does very well, the “value recovery instrument” issued as part of the debt deal, which aligns debt repayment with economic growth, is shrewdly designed so that the vast majority of future growth will still flow to the Ukrainian people, not to its creditors. This is because: (i) the instrument only kicks in at scale in a decade; (ii) it is subject to repurchase on the open market and to subsequent renegotiation; and (iii) it is carefully designed to ensure that only the initial benefit and not the continuing benefit of Ukraine’s growth flows to creditors.

In the unlikely event that Ukraine’s parliament disapproved the deal, all these benefits would be lost. International financial support would dry up as Ukraine would be seen as unable to carry through on commitments. Confidence in the stability of Ukraine’s currency and banking system would be put at risk. And its leverage vis-a-vis its debt to Russia would vanish.

So I hope and expect that the Ukrainian parliament will ratify the debt deal in the very near future. To paraphrase Churchill, this may not be the end, or even the beginning of the end of Ukrainian economic reform, but it may be the end of the beginning.

Make no mistake – the United States and Europe have an immense stake in Ukraine’s economic success. Our leaders rightly assert that military force is often not the right solution to international conflict. Enabling Ukraine to provide greater improvements in living standards for its citizens than Russia does would be a major triumph for the West. In this regard what we do for Ukraine is likely more important than what we do to Russia.

Support for Ukraine should not be seen as foreign assistance to a striving economic reformer, though it is that. Rather, with Ukraine invaded, support should be seen as investment in forward defense of core U.S. and European security interests. If Ukraine succeeds economically, investments will pay for themselves several times over as loans are paid back with interest, and as Russia’s government is both deterred by Ukraine’s stronger economy and pressured by its economic example.

Historians will wonder why the international community has invested more than 10 times as much money in supporting a recalcitrant Greece as in supporting a reforming Ukraine, since the start of their crisis.  Perhaps intra-European Union loans are in some special category, but as of this moment the IMF’s potential exposure to Greece is $41 billion compared to only $22 billion for Ukraine.

Now is the moment for Ukraine at long last to embrace the market and the rule of law.  It has the best, most market-oriented economic team in its history. And it is the time for global community to do whatever it takes—much more than is being done today—to provide support at a critical juncture.


Thoughts on Freeman’s Bargaining for the American Dream


Yesterday, I participated in a Center for American Progress forum where a new study on unions and social mobility was released. The study, by my Harvard colleague Richard Freeman and collaborators, showed a significant correlation across American metropolitan areas between the extent of union membership and social mobility. Freeman, who based his research on data in the famous studies of Raj Chetty and his collaborators, also showed that the children of union members earn higher wages and are healthier than other children.

This is important work. From Ted Cruz to Bernie Sanders, there is agreement across the political spectrum that equality of opportunity is an American ideal — that Thomas Jefferson was right in saying that America should be an aristocracy of talent. Yet equality of opportunity in the U.S., no matter how measured, lags behind other countries and certainly has not progressed over the last several decades.

Chetty’s celebrated “equal opportunity map,” reproduced below, shows that there are no grounds for fatalism. Different parts of the U.S. deliver very different levels of social mobility, while all in the same global economy, with the same technology, and the same increasing proclivity of able men and women to marry each other. There is nothing immutable about the existing inadequate level of equal opportunity.


The map demonstrates that equality of opportunity is particularly bad in the old confederacy and particularly good in some of the old bastions of abolitionism. It is not therefore surprising that unions, which were concentrated in the North, turn out to be correlated with equal opportunity. More impressive is the research result that looking across families, fathers who are union members have children who earn at least 15 percent more than those who are not in union families, and that this stands up even with various control variables added. The implication is that supporting unions not only helps workers who are members themselves but also helps their children and communities as well.

Few people believe that private unions in the United States had excessive power in the 1970s. Yet the share of private sector workers in unions has fallen from over 24 percent in 1973 to under 7 percent today. Unions are surely too weak today. Their weakness most clearly shows up in workers who have difficulty maintaining a middle class lifestyle. In a more profound way, the weakness of unions leaves a broad swath of the middle class largely unrepresented in the political process, paving the way for the kind of disillusionment that has driven the Trump candidacy. After all, no society is going to remain stable and confident in its central institutions if parents do not believe their kids can lead better lives than they did.

In 2009, at the Brookings Institution, I spoke about the important role of unions in generating broadly shared growth. I said, “If we want to propel this economy forward and we want to have a sound expansion, it has to be an expansion whose benefits are more broadly shared. And that goes to the question of tax policy and progressivity, it goes to the question of education over the longer term, and it goes to the question of having a healthy and well-functioning trade union movement.”

Broadly shared prosperity is even more elusive today, so what is needed going forward? I would suggest three important steps.

First, we need serious enforcement of laws to stop employers from punishing workers seeking to engage in collective action. Enforcement has historically lagged badly as it typically takes at least four and often as many as seven years for cases to be decided. And even if employers are eventually found guilty of violating the rules, the penalty is generally under $10,000 per harmed worker. Anti-union employers can violate the law with near-impunity worrying only about slaps on the wrist years in the future. As Morris Kleiner and David Weill found: “expected costs [for being found guilty of violating labor laws] represent a fraction of the benefits to employers … from thwarting organizing drives. It is therefore not surprising that there has been a sevenfold increase in the percentage of violations of the act”.1

Second, the union movement needs to expand on its efforts to build models of collective action that are not rooted in traditional command and control corporation. This may include increased emphasis on profit sharing, on labor management dialogue, on industry wide bargaining, and many other ideas as well. Organized Labor needs to adapt to the pervasiveness of white collar, pink collar, and no collar work in addition to traditional blue collar work.

Third, there is a compelling case even if it does not appear politically realistic right now for labor law reform to give more scope to those seeking to organize workers. There are detailed agendas of possible reform. What is important now is that a consensus form around the idea of reducing burdens on union organizers.

Thanks to the work of Freeman and his collaborators, we now know that stronger unions are not just good for their members, they are good for our country and our descendants. Strengthening collective worker voice has to be an important component of any realistic American inclusive growth agenda.




Why the Fed must stand still on rates


Two weeks ago I  argued that a Federal Reserve decision to raise rates in September would be a serious mistake.  As I wrote my column, the market was assigning a 50 percent chance to a rate hike. The current chance is 34 percent. Having followed the debate among economists, Fed governors and bank presidents I believe the case against a rate increase has become somewhat more compelling even than it looked two weeks ago.

Five points are salient.

First, markets have already done the work of tightening.  The U.S. stock market is worth $700 billion less than it was 2 weeks ago and credit spreads have widened noticeably.  Financial conditions as measured by Goldman Sachs or the Chicago Fed index have tightened in the last 2 weeks by the impact equivalent of more than a 25 BP tightening.  So even if resisting inflation required a 25 BP tightening as of two weeks ago, this is no longer the case.

The figure below makes a crucial point.  It shows that even though the federal funds rate is very low (negative one and a half percent after adjusting for inflation), financial conditions are helping the economy less than in previous years when interest rates were much higher.


Second, the data flow suggests a slowing in the U.S. and global economies and reduced inflationary pressures.   Employment growth appears to have slowed down, commodity prices have fallen further, and the general data flow has been on the soft side.  Comprehensive measures of data surprises, such as the Bloomberg Economic Surprise Index, bear out this impression and the Atlanta Fed’s GDP Now model is currently predicting only 1.5% growth in Q3.

Third, the case for concern about inflation breaking out is very weak.  Market based expectations suggest that inflation over the next decade on the Fed’s preferred core pce basis is near record lows and well below 2 percent.  The observation that 5 year inflation, 5 years from now is expected to be below target calls into question arguments that current low inflation is somehow transitory.

The recent analysis presented by Fed Vice Chair Stanley Fischer asserting to the contrary relies on assumptions about exchange rates and inflation.  When actual empirical estimates are used his conclusions are substantially weakened.  Indeed as the figure below shows, there is no correlation of late between deceleration in inflation and import share looking across PCE components.InflationAndImportSharePCE.xlsx

Also on inflation, it bears emphasis that (i) we have some room for inflation acceleration (ii) prices are now fully 2 percent below a 2 percent inflation path taking off from 2010, (iii)  the Phillips curve is so unstable that it provides little basis for predicting inflation acceleration.  To take just two examples — first, unemployment among college graduates is 2.5 percent yet there is no evidence that their wages are accelerating. And unemployment in Nebraska has been below 4 percent for the last 3 years and growth in average hourly earnings has been basically constant at the national average level.

Fourth, arguments of the “one and done” variety or arguments that the Fed can safely raise rates by 25 BP as long as it’s clear that there is no commitment to a series of hikes are specious. If as some suggest a 25 BP increase won’t affect the economy much at all, what is the case for an increase? And when the same people argue that 25 BP will have little impact and that it is vital to get off the zero rate floor, my head spins a bit.

In a highly uncertain world, the Fed cannot be both data dependent and predictable with respect to its future actions. Much better that it stick with data dependence than that it put its credibility at risk by seeking to mitigate a current rash action by trying to reassure with respect to future steps.

I understand the argument that zero rates are a sign of pathology and the economy is no longer diseased so policymakers have to increase rates.  The problem is that the case for hitting the brakes in an economy with sub-target inflation, employment and output is not there; regardless of whether the brakes are to going to be pressed hard or softly, singly or multiple times.

From the Vietnam War to the Euro crisis, from the Iraq war to the lessons of the Depression we surely should learn that policymakers who elevate credibility over responding to clear realities make grave errors.  The best way the Fed can maintain and enhance its credibility is to support a fully employed American economy achieving its inflation target with stable financial conditions.  The greatest damage it could do to its credibility would be to embrace central banking shibboleth disconnected from current economic reality.

Fifth, I believe that conventional wisdom substantially underestimates the risks in the current moment.  It bears emphasis that not a single post war recession was a predicted a year in advance by the Fed, the Federal government, the IMF or a consensus of forecasters.  Most were not recognized till long after they started.  And if history teaches anything it is that financial interconnections are pervasive and not apparent till it’s too late.   Russia’s 1998 default, problems in subprime lending, and the Asian financial crisis were all moments when financial dislocations had far more pervasive effects than was generally expected.

We know that the world’s largest economy, China, is in its most uncertain state since it began economic reform in 1979 and may well be experiencing a larger volume of capital flight than any economy in history.  We know that the central banks  of Japan and Europe are likely to have to double down in the months ahead on already extraordinary quantitative easing.  We know that American households, firms and markets are processing what appears to a kind of “reverse 1990s” moment of sharply decelerating productivity growth.  We know that liquidity conditions in markets have worsened and there is at least some reason to believe that “positive feedback” trading strategies where investors sell when prices go down may well have become increasingly important.  We know the current U.S. recovery is in its 7th year and that confidence in public institutions is at a low ebb.

More likely than not, these fears are overblown and 2015 and 2016 will not go down in financial history.  If so, and the Fed does not act, inflation will start to accelerate, volatility will subside and policy can step in.  Regret may come in the form of inflation a few tens of basis points too high or a bit of euphoric relief in markets.  If on the other hand, some portion of these fears are warranted and the Fed tips towards tightening, it risks catastrophic error.

Now is the time for the Fed to do what is often hardest for policymakers.  Stand still.

September 9, 2015


Larry’s new blog


Over the summer, I have expanded my website to include a new blog that will enable me to comment on economic policy issues and current events more generally.  I will continue to write my monthly Financial Times/Washington Post column, and their websites will also feature my blog content.  This blog will enable me to address issues immediately, informally, and at varying lengths and to pose questions that I think economists have inadequately considered.   It will also provide an opportunity to disseminate various commentaries and discussions that I present at conferences.

As I have often noted, policymakers in political environments are most constructive when they find approaches that are appealing from a variety of perspectives and command widespread support.  Academics, on the other hand, are most useful when they provoke thought and debate and present new approaches.  In that spirit, I will regard this venture as successful only if it incites disagreement and debate.  My goal will often be to expose fallacy or misguided opinion.  However, I shall never try to impugn the motives of those with whom I disagree.

Comments and questions are welcome, but we will only be able to select a few to post with each blog.  I may, from time to time, respond to questions or comments in a new blog posting, but will not be able to respond to each individual comment received.

I hope you will find some interesting ideas in this new blog and share it with your colleagues and friends.


Thoughts on Ukrainian Debt Restructuring


I was very glad to see Ukraine reach a deal involving reduction in the principal value of its debt with major creditors. This would not have happened without the tenacity and determination of Ukrainian finance minister, Natalie Jaresko, and Ukraine’s political leadership. Congratulations also to the IMF and the U.S. Treasury for their strong efforts. continue

The Astonishing Returns of Investing in Global Health R&D


By Lawrence H. Summers and Gavin Yamey

How to reach a “grand convergence” by 2035

We have a once-in-human-history opportunity to achieve a “grand convergence” in global health—a reduction in infectious, maternal, and child deaths down to universally low levels everywhere on the planet. continue

Tomorrow Greece votes


Tomorrow Greece votes. No one can know the outcome yet. Indeed, my bet is that a third of the voters are not yet sure how they will vote. If polls could not get the British election right, I doubt that they can get this one right. Anything can happen, and it would not surprise me if the vote is a landslide, one way or the other. continue

Comments from ECB Conference


I commend Mario Draghi and the ECB for their openness in hosting this conference and allowing the presentation of so many perspectives. In the spirit of that openness I shall offer some iconoclastic observations. continue

Feldstein Argues Price Indices Underestimate Real Income Growth


Yesterday, in the Wall Street Journal, Marty Feldstein argues reasonably that conventional price indices underestimate real income growth because they take inadequate account of quality improvements and new products.  Marty asserts very plausibly that properly measured real incomes and wages have not been completely stagnant in recent decades. continue

Rethinking Secular Stagnation After Seventeen Months


IMF Rethinking Macro III Conference

I am glad to be here and I salute Olivier (Blanchard) and the IMF for so open a dialogue on so wide a range of macroeconomic hypotheses. What I want to do this morning is talk about three things: I want to tell you why I think that the risk of secular stagnation is an important problem throughout the developed world. I want to contrast the secular stagnation viewpoint with two views that I regard as heavily overlapping – the debt super‐cycle view that Ken Rogoff put forward and the savings glut view that Ben Bernanke has put forward – and explain why I think they’re very similar, but insofar as their nuances of difference, I prefer the secular stagnation view. And then I want to reflect on the policy implications of this general view of the global economy over the next decade. continue

On Secular Stagnation: A Response to Bernanke


Ben Bernanke has inaugurated his blog with a set of thoughtful observations on the determinants of real interest rates (see his post here) and the secular stagnation hypothesis that I have invoked in an effort to understand recent macroeconomic developments.  I agree with much of what Ben writes and would highlight in particular his recognition that the Fed is in a sense a follower rather than a leader with respect to real interest rates –  since they are determined by broad factors bearing on the supply and demand for capital – and his recognition that equilibrium real rates appear to have been trending downward for quite some time.  His challenges to the secular stagnation hypothesis have helped me clarify my thinking and provide an opportunity to address a number of points where I think there has been some confusion in the public debate. continue