Archive for category: Financial Times

June 1, 2008

After a modest interval with no big financial shocks, policy attention is turning to the task of preventing future crises and managing those that occur. While the deliberations will take quite a while to play out, there is some time pressure – because of the moral hazards created by the Federal Reserve’s extension of credit to investment banks and authorities’ desire to act before the sense of alarm created by recent events abates and complacency returns.

Proposals for changes in regulation and crisis response have come from many quarters, including the US Treasury and private sector groups. They offer important ideas on rearranging regulatory responsibilities – such as the Treasury’s suggestion of an enhanced role for the Federal Reserve with respect to investment banks and its call for a consumer financial regulator – and raise critical issues, such as that of procyclicality induced by regulation. They also contain a certain amount of essentially content-free calls for worthiness. So far missing from the debate has been a set of principles describing the properties of any desirable regulatory regime, against which proposals can be evaluated. Different observers will assign priority to different issues – here would be my list of six principles.

First, there should be a strong presumption against having regulators competing to supervise particular institutions or activities. Experience suggests that even when firms do not have the option of switching, there are substantial risks that regulators will be co-opted. Adding “forum shopping” exacerbates the problem.

Second, it should be recognised that to a substantial extent self-regulation is deregulation. Allowing institutions to determine capital levels based on risk models of their own design is tantamount to letting them set their own capital levels. We have seen institutions hurt again and again by events to which their models implied probabilities of less than one in a million. Where it is desired to impose capital requirements, this should be done in a way that can be monitored by supervisors on the basis of balance sheet data.

Third, regulation must be premised on the inability of institutions or their regulators to predict future market conditions with much confidence. As obvious as the subprime crisis may look in retrospect, it was not widely foreseen 18 months ago even by those worried about complacency in credit markets. As the fact that the Dow Jones index was below 6,500 when Alan Greenspan famously spoke of irrational exuberance illustrates, it is also easy to see bubbles even when assets are undervalued or properly valued, as US stocks were in 1996. Rather than judging where and when the next crisis will occur, regulators need to try to assure the resilience of the system with respect to economic shocks or problems in any one sector or institution.

Fourth, the focus of regulation must shift from the prudential practices of individual institutions to the health of the financial system. The proper focus of government regulation is not on how good a job managements do of looking out for their shareholders and bondholders. It is on the potential external consequences of their actions. This will require efforts to limit excesses when times are good and institutions appear robust – and efforts to avoid deleveraging in difficult times if that increases pressures on others. Prudence at the level of any one institution does involve more leverage at times when volatility is low than when it is high. The problem is that when any institution seeks to do what is prudent for it and sell off assets, it impairs the environment in which all others are operating and creates the kind of vicious cycle, in which liquidations beget declining prices and further liquidations, that we have just been through.

Fifth, any regulatory regime must address the risks arising from “parallel banking activities” in a realistic way. We have been reminded by recent events of the old truth that borrowing short and lending long with limited capital is always at the root of financial crisis. This type of activity is not confined to banks and their offshoots. It is practised by bond guarantors, hedge funds, mortgage institutions and some insurance companies among others. If capital requirements are raised only on one set of institutions, problems may be exacerbated as activity migrates to those that are not regulated. On the other hand, regulating all potentially highly leveraged entities is a formidable task. There is no ideal answer. But the fear is that regulation that ensures the regulated can compete fairly with the unregulated is regulation that either promises government subsidy or does not raise capital requirements much above market levels.

Sixth, regulatory policy must to the maximum extent possible create a situation in which the failure of an individual institution is not itself a source of systemic risk. Only in this way is it possible to contain the moral hazards associated with government support. The authorities had no realistic choice but to provide support as Bear Stearns faced bankruptcy. They do have a choice as to whether to put in place a regime where such problems can be managed with no government financial support provided directly or indirectly to shareholders or unsecured creditors. A resolution regime that could apply to any financial institution that became a source of systemic risk should be an urgent priority.

These principles are more easily asserted than they are reflected in an actual regulatory system. I hope to return in future columns to the question of regulatory system design.

The writer is the Charles W. Eliot university professor at Harvard University and a managing director of the D.E. Shaw group. The opinions here are his own

Copyright The Financial Times Limited 2012.

August 7, 2008

Macroeconomists, like medical scientists, use case studies to teach their students about the maladies to which the system is susceptible. For supply shocks and stagflation, the example is the 1970s. The financial dislocations that occur when bubbles burst are illustrated by the Great Depression and Japan’s problems in the 1990s. The importance of central bank credibility in resisting inflation emerges from discussion of the experience of the late 1960s and the 1970s.

What is most remarkable and troubling about our current difficulties is that all these elements – supply shocks, financial dislocations and concern about rising underlying inflation – are present at once. Moreover, the crisis is global in scope. Concerns about recession are spreading from the US to much of the industrialised world. Significant slowdowns appear more likely in a number of emerging markets, with inflation concerns worldwide at their highest level in more than a decade. There is a growing consensus that the west is facing the most serious financial crisis since the second world war.

Perhaps unsurprisingly in the face of so many adverse surprises, the policy debate has become cacophonous. Some emphasise the necessity of the painful adjustments under way, while others urge their mitigation. Some focus on product price inflation, some on asset price deflation as the principal problem. Some focus on assuring that imprudent lending by financial institutions is discouraged, others on assuring that financing for investment by households and businesses remains available. Some focus on slowing market adjustments to prevent panic, others on the need for rapid adjustment of prices to true fundamental levels, even if this is painful in the short run.

Equally unsurprisingly given the chaotic debate, policymaking has become increasingly reactive and erratic, with a growing tendency to repeat traditional errors. While US policymakers have long cited Japan’s indecisiveness with respect to troubled financial institutions, its resort to gimmickry and market manipulation, and its lack of transparency in the management of financial crisis in the 1990s as a negative example, they are increasingly repeating Japan’s errors.

Within the past month, the Treasury has made explicit the implicit guarantee on the $5,000bn (£2,500bn, €3,250bn) balance sheet of Fannie Mae and Freddie Mac in order to prevent a run on the government-sponsored enterprises while imposing no penalties on shareholders or forcing any changes on management – not even the cessation of dividends.

The Securities and Exchange Commission has sought to make short-selling harder, with the stated objective of raising (many would say manipulating) the stock prices of financial institutions, while some in the Congress have proposed to prevent certain investors from going long on commodity futures. Without much sign of official resistance, the global banking industry is pushing for less reliance on market prices and more on managerial judgment in valuing the assets where bad credit and investment decisions have led to hundreds of billions of dollars of losses over the past year.

Setting policy in a more proactive and principled way requires reaching a number of judgments regarding where things currently stand and the likely effects of potential actions or failures to act. In an effort to advance the debate, the remainder of this article poses and provides my answer to what seem to me to be the crucial questions for American economic policy.

How long will the economy stay weak on the current policy path?

The best available estimates suggest that the American economy is operating between 2 and 2.5 per cent below its sustainable potential level. This translates into more than $300bn, or $4,000 for the average family of four, in lost output. Even if, as I think unlikely, recession is avoided, growth is almost certain to be so slow that the gap between actual and potential output comes close to doubling over the next year or so. Given that unemployment peaked nearly two years after the end of the last recession, output and employment are likely to remain below their potential levels for several years in the best of circumstances.

Given the combined impact of rising commodity prices, falling house prices, reduced availability of credit and rising uncertainty, it is surprising that the economy has shown as much strength as it has in recent months. While it is possible that this speaks in some way to its enormous resilience, the preponderant probability is that, as the effects of tax rebates wear off and those of tighter credit conditions feed through, the economy will take another downwards turn.

Just as the bottom was called early a number of times in Japan in the early 1990s and in the US in the early 1930s, we have seen and no doubt will see moments of sunlight that create hope that the worst is past. Yet it bears emphasis that in the current context there can be no confident reliance on the equilibrating powers of the market.

Alan Greenspan has been fond of explaining that the resilience of the American financial system and economy results from reliance on two pillars: banks and capital markets. When the banks were in trouble, as in 1991, capital markets took up the slack; when the capital markets were in trouble, as in 1998, the banks took up the slack. Unfortunately, today both the banks and the capital markets show signs of crisis.

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.

Are substantial output losses necessary or desirable? or desirable?

It is often argued that the current economic downturn is an inevitability that cannot be prevented, or that is necessary and desirable. Some observers almost seem to suggest that a recession is a kind of just desert for a country that has lived beyond its means. The more serious concerns are that an economic downturn is a necessary concomitant of increasing US national saving and reducing current account deficits, or of preserving the credibility of the Federal Reserve’s commitment to price stability.

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. More-over, 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.

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. Even if commodity prices do not fall but only stop rising, the result will be an improvement in standard inflation measures. Moreover, if the principal problem is commodity price inflation, there are surely better ways to address it than increasing unemployment and reducing capital utilisation.

Crucially for the inflation process, there is not yet evidence of rising wage pressures or increases in the growth rate of unit labour costs. Nor do indexed bond markets reveal a significant change in longer-term inflationary expectations. In an environment of rising unemployment, greater worker insecurity and constantly 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.

On balance, in the US at least, the risk that output will be too low over the next several years seems considerably greater than the risk that it will be too great and cause the economy to overheat or overborrow.

Can policy stimulate demand without adverse side-effects?

With the Federal Funds rate at 2 per cent, the remaining scope for monetary policy to stimulate the US economy is surely very limited. Even here, those who see a case for raising rates should remember that in the current environment the Fed funds rate is a very misleading indicator, as widening credit spreads and increased term premiums have caused borrowing costs to fall much less than the policy interest rate.

There remains considerable scope, however, for fiscal policy to stimulate demand on both the tax and spending sides over the next several years. The limited available evidence suggests that the propensity to consume out of the recent round of rebates was larger than many suspected. More important, given the pressures on state and local budgets and the dramatic increase in some inputs (the cost of building highways has risen 70 per cent since 2004), there is now a substantial backlog of infrastructure construction projects that have been interrupted or put on hold. Allowing these projects to go forward on a significant scale would stimulate the economy and would channel demand towards the construction workers – mostly men with relatively little education – who have borne the brunt of the economic downturn and whose medium-term prospects are bleakest.

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.

In the current global context, there is no reason why fiscal stimulus should be confined to the US. Measures that increased spending in countries where high saving has led to large current account surpluses are necessary if the global economy is to be rebalanced without a big downturn as US saving eventually increases. China, where household consumption has fallen below 40 per cent of GDP – a record peacetime low for any big economy – stands out in this regard.

How serious are remaining financial problems?

This is unknowable given uncertainties about market fluctuations and the real economy. While there surely will come a time when things hit bottom, it is not yet clear that it is at hand.

Several sources of evidence suggest that house prices will fall for some time to come, perhaps by 10 per cent or more. Big further declines would be necessary to restore their traditional level relative to rents, incomes or the price of other goods. There are growing signs that rates of default and foreclosure will rise considerably even well outside the subprime sector.

Beyond housing, there are also grounds for considerable concern about consumer and automobile credit, particularly if the economy turns down. Big and as yet not reported losses on commercial construction lending lie ahead. While the rate of default on corporate debt has not yet reached high levels, this is likely to change in the near future. For example, the pricing of the debt of the big American automobile companies now suggests a probability well over 90 per cent that one or more of them will go into default in the next five years – and the probability would no doubt be greater if markets did not recognise the possibility of extraordinary Federal support.

Then there is the problematic situation of the banking system. Where traditional non-mark to market accounting is in use, banks have not yet revised estimates of their capital to reflect likely future losses. In many cases, they have instead assumed that the market’s valuation of their assets reflects transient liquidity factors rather than underlying problems, and so are planning with assumptions considerably more optimistic than those embodied in market prices. Perhaps they will prove correct – but nothing in the experience of the past year gives confidence in the judgment of those who believe that market prices substantially undervalue their assets.

In all likelihood, the financial system will require very substantial capital infusions over the next year or two if it is to remain healthy. It is not clear where the capital will come from. Most of those who have provided financial institutions with capital over the past year have been badly burned. As valuations fall, it becomes increasingly difficult for financial institutions to raise capital necessary for them to retain market confidence, leading to further declines in valuation and yet another vicious cycle.

How can the authorities best support the financial system?

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.

First, as the ad-hoc nature of the policy response to Bear Stearns and the GSEs illustrates, we do not have a framework in place in which the authorities can do what is necessary to counter systemic risk when a systemically important institution gets in trouble and at the same time protect the interests of taxpayers and the broader financial system.

Second, there is as yet no framework in place for handling the large quantity of bad assets sitting on financial institution balance sheets. During the last US banking crisis in the early 1990s, the Resolution Trust Corporation was established to manage impaired assets of banks and savings and loan institutions that the government had taken over. But it acquired assets only after the government took over banks. Consideration should be given to whether the government should establish a mechanism for purchasing assets from stressed banks in return for warrants or other consideration.

Third, there is the question of whether the 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 serious problems down the road. Government involvement in recapitalising financial institutions is like devaluation. It is a very unattractive last resort. Delay is very tempting, but it can be enormously costly.

* * *

Today, the end of the current financial crisis looks further away than it did in August 2007. Policy has not yet gotten ahead of the curve. I used to remark in the context of the emerging market crises of the 1990s that I would date the moment of recovery from the first time an official pronouncement proved to be too pessimistic. By this standard, recovery is not at hand.

The best prospects for managing a very difficult situation involve a comprehensive effort both to support the real economy through temporary fiscal stimulus and the financial system through a programme of measures directed at capital rather than liquidity problems. These steps offer no assurance of success but reactive drift raises the risks of costly failure.

Copyright The Financial Times Limited 2012.

September 28, 2008

Congressional negotiators have now completed action on a $700bn authorisation for the bail-out of the financial sector. This step was as necessary as the need for it was regrettable. There are hugely important tactical issues regarding the deployment of these funds that the authorities will need to consider in the weeks and months ahead if the chance of containing the damage is to be maximised. I expect to return to these issues once the legislation is passed.

In the meantime, it is necessary to consider the impact of the bail-out and the conditions necessitating it on federal budget policy. The idea seems to have taken hold in recent days that because of the unfortunate need to bail out the financial sector, the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis actually suggests that dismal conclusions are unwarranted and the events of the last weeks suggest that for the near term, government should do more, not less.

High quality global journalism requires investment. Please share this article with others using the link below, do not cut & paste the article. See our Ts&Cs and Copyright Policy for more detail. Email ftsales.support@ft.com to buy additional rights. http://www.ft.com/cms/s/0/290ca9f6-8d8b-11dd-83d5-0000779fd18c.html#ixzz28pg1RLDL

First, note that there is a major difference between a $700bn (€479bn, £380bn) programme to support the financial sector and $700bn in new outlays. No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700bn programme on the fiscal position depends on how it is deployed and how the economy performs.

The American experience with financial support programmes is somewhat encouraging. The Chrysler bail-out, President Bill Clinton’s emergency loans to Mexico, and the Depression-era support programmes for housing and financial sectors all ultimately made profits for taxpayers. While the savings and loan bail-out through the Resolution Trust Corporation was costly, this reflected enormous losses in excess of the capacity of federal deposit insurance programmes. The head of the FDIC has offered assurances that nothing similar will be necessary this time. It is impossible to predict the ultimate cost to the Treasury of the bail-out programme and of the other guarantee commitments that financial authorities have – this will depend primarily on the economy as well as the quality of execution and oversight. But it is very unlikely to approach $700bn and will be spread over a number of years.

Second, the usual concern about government budget deficits is that the need for government bonds to be held by investors will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.

Third, since Keynes we have recognised that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. After using the economic expansion of the 1990s to bring down government indebtedness, the US made a serious error in allowing deficits to rise over the last eight years. But it would be compounding this error to override what economists call “automatic stabilisers” by seeking to reduce deficits in the near term.

Indeed, in the current circumstances the case for fiscal stimulus – policy actions that increase short-term deficits – is stronger than at any time in my professional lifetime. Unemployment is now almost certain to increase – probably to the highest levels observed in a generation. Monetary policy has very little scope to stimulate the economy given how low policy rates already are and the problems in the financial system. And experience around the world with economic downturns caused by financial distress suggests that while they are of uncertain depth, they are almost always of long duration.

The economic point here can be made more straightforwardly. The more people who are unemployed the more desirable it is that government takes steps to put them back to work by investing in infrastructure, energy or simply through tax cuts that allow families to avoid cutting back on their spending.

Fourth, it must be emphasised that nothing in the short-run case for fiscal stimulus vitiates the argument that action is necessary to ensure the US is financially viable in the long run. We still must address issues of entitlements and fiscal sustainability.

From this perspective the worst possible actions in the current context would be steps that have relatively modest budget impacts in the short run but that cut taxes or increase spending by growing amounts over time. Examples would include new entitlement programmes or exploding tax measures. The best measures would be those that represent short-run investments that will pay back to the government over time or those that are packaged with longer-term actions to improve the budget. Examples would include investments in healthcare restructuring or steps to enable states and localities to accelerate, or at least not slow down, their investments.

A time when confidence is lagging in the household, financial and business sectors is not a time for government to step back. Well-designed policies are essential to support the economy and given the seriousness of healthcare, energy, education and inequality issues, can make a longer-term contribution as well.

The writer is the Charles W. Eliot professor at Harvard University and managing director of D.E. Shaw & Co

Copyright The Financial Times Limited 2012.

October 27, 2008

Events as well as ideas shape policy choices in democracies. Who would have predicted a year ago that a Republican ad-ministration would demand that Congress make the largest set of investments in public companies in US peacetime history? Would anyone have supposed that President George W. Bush would convene a global effort to renew Bretton Woods through strengthened international financial regulation? It reminds us that in the economic sphere, as in the national security sphere, dramatic events can make the inconceivable become inevitable.

Discussions of the policy implications of the crisis have primarily focused on the immediate economic demands. The need to ensure the capital adequacy of financial institutions, maintain important credit flows, support the housing sector and the real economy, contain international spill-overs and reform regulation to prevent any recurrence of the crisis have rightly been the priority. In all these areas there will be many crucial policy choices to make in the months ahead.

However, policies that contain the crisis, support the economy and generate recovery are not sufficient to meet the historic challenge of this moment. Even with the best conceivable fiscal, monetary, financial and regulatory policies, economic performance depends on deeper and more structural policy choices. Nations cannot fine tune their way to delivering a prosperity that is more broadly based. In important ways, then, the crisis creates space to address longer standing problems. Just as patients hear advice regarding diet and exercise differently after a heart attack, so recent events should make it possible for the next US administration to accomplish more than might previously have been thought possible.

These broader goals depend on achieving the rapid and sustained growth that restores business confidence and generates the resources for investment. Economists do not understand what drives productivity growth very well. However, we know these facts: productivity grew rapidly after the second world war and then sometime between the late 1960s and mid-1970s it slowed dramatically only to re-accelerate to record levels in the mid-1990s. Unfortunately, even before the downturn, underlying productivity growth appeared to be slowing.

The most plausible explanation is that an array of transforming investments and technologies -the interstate highway system, widespread air travel and the expansion of electronics – were spurs to growth during the postwar period. Eventually their impact dissipated and, as energy costs rose, growth slowed until the information technology revolution kicked in during the 1990s. Unfortunately, the IT supply shock that powered the economy in the 1990s and early part of this decade appears to be diminishing.

So there is a need to ensure that the pressure to increase spending is directed at areas where it will have the most transformational impact. We need to identify those investments that stimulate demand in the short run and have a positive impact on productivity. These include renewable energy technologies and the infrastructure to support them, the broader application of biotechnologies and expanding broadband connectivity, an area where the US has fallen behind.

The crisis has also reminded us of the lessons of the technology bubble, Japan’s experience in the 1990s and of the US Great Depression – that finance-led growth is problematic. The wealth and income gains from the easy availability of credit were highly concentrated in the hands of a fortunate few. The benefits also proved temporary. In retrospect, the fact that 40 per cent of American corporate profits in 2006 went to the financial sector, and the closely related outcome – a doubling of the share of income going to the top 1 per cent of the population – should have been signs something was amiss.

Therefore we need to reform tax incentives that encourage financial risk taking, regulate leverage and prevent government policies that give rise to a toxic combination of privatised gains and socialised losses. This offers the prospect of a prosperity that is more firmly grounded and more inclusive. More fundamentally, short and longer-term imperatives come together with respect to policies that seek to ensure that any future prosperity is inclusive. The policies that are most effective in helping to support demand are those that help households struggling either because of low incomes or because they have recently lost part of their income. Recent events also remind us that individuals can become impoverished or lose health insurance through no fault of their own. This reinforces the need for people to have basic health and retirement security protection regardless of what happens to their employers.

All of these considerations suggest that the pendulum will swing – and should swing – towards an enhanced role for government in saving the market system from its excesses and inadequacies. Policymakers need to be attentive to potential government flaws as well. For example, they need to recognise that, even as events compel larger deficits in the short run, they reinforce the need for longer-term measures to keep government finances on a sound footing. They must also be wary of measures that have a short-term superficial appeal, yet have adverse long-term consequences.

It is said in all presidential election years that the choices made by the next president are uniquely important. This time the cliché is true. The gravity of our situation is matched only by the opportunity it presents.

The writer is the Charles W. Eliot university professor at Harvard and managing director of D.E. Shaw & Co

Copyright The Financial Times Limited 2012.

June 12, 2011

Even with the 2008-2009 policy effort that successfully prevented financial collapse, the US is now halfway to a lost economic decade. In the past five years, our economy’s growth rate averaged less than one per cent a year, similar to Japan when its bubble burst. At the same time, the fraction of the population working has fallen from 63.1 per cent to 58.4 per cent, reducing the number of those in jobs by more than 10m. Reports suggest growth is slowing.

Beyond the lack of jobs and incomes, an economy producing below its potential for a prolonged interval sacrifices its future. To an extent once unimaginable, new college graduates are moving back in with their parents. Strapped school districts across the country are cutting out advanced courses in maths and science. Reduced income and tax collections are the most critical cause of unacceptable budget deficits now and in the future.

You cannot prescribe for a malady unless you diagnose it accurately and understand its causes. That the problem in a period of high unemployment, as now, is a lack of business demand for employees not any lack of desire to work is all but self-evident, as shown by three points: the propensity of workers to quit jobs and the level of job openings are at near-record low; rises in non-employment have taken place among all demographic groups; rising rates of profit and falling rates of wage growth suggest employers, not workers, have the power in almost every market.

A sick economy constrained by demand works very differently from a normal one. Measures that usually promote growth and job creation can have little effect, or backfire. When demand is constraining an economy, there is little to be gained from increasing potential supply. In a recession, if more people seek to borrow less or save more there is reduced demand, hence fewer jobs. Training programmes or measures to increase work incentives for those with high and low incomes may affect who gets the jobs, but in a demand-constrained economy will not affect the total number of jobs. Measures that increase productivity and efficiency, if they do not also translate into increased demand, may actually reduce the number of people working as the level of total output remains demand-constrained.

Traditionally, the US economy has recovered robustly from recession as demand has been quickly renewed. Within a couple of years after the only two deep recessions of the post first world war period, the economy grew in the range of 6 per cent or more – that seems inconceivable today. Why?

Inflation dynamics defined the traditional postwar US business cycle. Recoveries continued and sometimes even accelerated until they were murdered by the Federal Reserve with inflation control as the motive. After inflation slowed, rapid recovery propelled by dramatic reductions in interest rates and a backlog of deferred investment, was almost inevitable.

Our current situation is very different. With more prudent monetary policies, expansions are no longer cut short by rising inflation and the Fed hitting the brakes. All three expansions since Paul Volcker as Fed chairman brought inflation back under control in the 1980s have run long. They end after a period of overconfidence drives the prices of capital assets too high and the apparent increases in wealth give rise to excessive borrowing, lending and spending.

After bubbles burst there is no pent-up desire to invest. Instead there is a glut of capital caused by over-investment during the period of confidence – vacant houses, malls without tenants and factories without customers. At the same time consumers discover they have less wealth than they expected, less collateral to borrow against and are under more pressure than they expected from their creditors.

Pressure on private spending is enhanced by structural changes. Take the publishing industry. As local bookstores have given way to megastores, megastores have given way to internet retailers, and internet retailers have given way to e-books, two things have happened. The economy’s productive potential has increased and its ability to generate demand has been compromised as resources have been transferred from middle-class retail and wholesale workers with a high propensity to spend up the scale to those with a much lower propensity to spend.

What, then, is to be done? This is no time for fatalism or for traditional political agendas. The central irony of financial crisis is that while it is caused by too much confidence, borrowing and lending, and spending, it is only resolved by increases in confidence, borrowing and lending, and spending. Unless and until this is done other policies, no matter how apparently appealing or effective in normal times, will be futile at best.

The fiscal debate must accept that the greatest threat to our creditworthiness is a sustained period of slow growth. Discussions about medium-term austerity need to be coupled with a focus on near-term growth. Without the payroll tax cuts and unemployment insurance negotiated last autumn we might now be looking at the possibility of a double dip. Substantial withdrawal of fiscal stimulus at the end of 2011 would be premature. Stimulus should be continued and indeed expanded by providing the payroll tax cut to employers as well as employees. Raising the share of payroll from 2 per cent to 3 per cent is desirable, too. These measures raise the prospect of sizeable improvement in economic performance over the next few years.

At the same time we should recognise that it is a false economy to defer infrastructure maintenance and replacement, and take advantage of a moment when 10-year interest rates are below 3 per cent and construction unemployment approaches 20 per cent to expand infrastructure investment.

It is far too soon for financial policy to shift towards preventing future bubbles and possible inflation, and away from assuring adequate demand. The underlying rate of inflation is still trending downwards and the problems of insufficient borrowing and investing exceed any problems of overconfidence. The Dodd-Frank legislation is a broadly appropriate response to the challenge of preventing any recurrence of the events of 2008. It needs to be vigorously implemented. But under-, not overconfidence is the problem, and needs to be the focus of policy.

Policy in other dimensions should be informed by the shortage of demand that is a defining characteristic of our economy. The Obama administration is doing important work in promoting export growth by modernising export controls, promoting US products abroad and reaching and enforcing trade agreements. Much more could be done through changes in visa policy to promote exports of tourism as well as education and health services. Recent presidential directives regarding relaxation of inappropriate regulatory burdens should also be rigorously implemented.

Perhaps the US’ most fundamental strength is its resilience. We averted depression in 2008/09 by acting decisively. Now we can avert a lost decade by recognising economic reality.

The writer is Charles W. Eliot University Professor at Harvard and former US Treasury Secretary. He is an FT contributing editor.

Copyright The Financial Times Limited 2012.

July 12, 2011

As the debt negotiators square off in Congress, much attention will focus on the size of the 10-year budget deal they come up with. As almost everyone agrees, there is much more risk of doing too little than too much given the scale of America’s fiscal challenge.

The truth is that the expected impact of the deal over a 10-year period will not be its most important aspect except in the context of the current media cycle. Very little hinges on whether the deal picks up the low-hanging fruit with respect to entitlements and revenues – or even breaks some new ground – this year or in the next couple of years.

Agreements reached now are subject to revision, potentially radical revision following next year’s election. Businesses are basing their investment decisions on the size of their current order books, not their guesses of fiscal policy in 2015. Consumers are deciding whether or not to spend based on how confident they are that they can hold on to their jobs.

Here is what is not getting its due attention. Decisions about spending and taxing over the next year or two will have a significant impact on job creation over the next year, the economy over the next decade and on the path of US national debt over an even longer horizon.

Suppose any proposed deal could be adjusted, thereby adding an extra 1 per cent to gross domestic product growth over the next year. A reasonable assumption is that the increase in output might not be sustained as inflation slows down, investment is increased, fewer workers abandon the search for jobs, and so forth.

Assume the impact falls from 1 per cent to 0 per cent over the course of a decade. The consequence would be an increment to GDP of 0.5 per cent or about $1,000bn over the period. That would represent close to 4m job years. And it would reduce deficits by about $400bn – more than it looks like Democrats will be able to come up with in revenue raising or Republicans in cuts to the cost of healthcare.

Is there scope for adding fiscal measures that would contribute 1 per cent of GDP or more over the next year and a half? Absolutely. With economic demand constrained and in a liquidity trap where interest rates cannot fall further, fiscal policies have larger than normal effects. With even very conservative estimates of multiplier effects, a combination of continuing payroll tax cuts, maintaining support for unemployed workers, and accelerating infrastructure maintenance could add closer to 2 per cent of GDP growth over the next year and a half.

Usually the media and Washington take too short a view. Now is the rare time when all need to remember that you only get to the long run through the short run. Given the current weakness of the US economy what is most important is that any budget deal be pushed forward as soon as possible.

The writer is Charles W. Eliot university professor and president emeritus at Harvard University. He was Treasury secretary under President Bill Clinton.

Copyright The Financial Times Limited 2012.

July 27, 2008

Anyone who cares about the health of the US economy should welcome the enactment of the Treasury’s rescue plan for Fannie Mae and Freddie Mac, along with other measures to support the housing market. While there is room for argument about details, the risks to the financial system were too great to allow delay.

No one should suppose, however, that the issue is now satisfactorily resolved, even for the short term. Emergency legislation was necessary because market participants were unwilling to buy Fannie and Freddie’s debt; investors doubted that the government-sponsored enterprises were healthy enough to repay it and did not draw sufficient reassurance from the implicit guarantee of federal support. If their debt proves easier to place now, it is only because this guarantee has been strengthened, not because anything has changed at the GSEs.

This, to put it mildly, is a highly problematic posture for policy. While I strongly supported the Federal Reserve’s policy response to the crisis at Bear Stearns because it was necessary to avoid systemic risk, it is easy to sympathise with those who fear that bailouts inhibit market discipline. Consider how much more problematic the Bear Stearns response would have been had policymakers signalled their commitment to back the company’s liabilities without limit; left management in place with no change in the business model; and allowed dividends to be paid and shareholders to keep going with hope for a better tomorrow. Yet all of these elements are present in the cases of Fannie and Freddie.

To see the temptation and danger inherent in a situation of this kind, one need only look back to the mismanagement of the savings and loans crisis during the 1980s. Policymakers protected depositors, allowed institutions to operate even when their fundraising depended on government support, and suspended regular standards in order to attract private capital. With gains privatised and losses socialised, taxpayers ultimately ended up with a $300bn-plus bill measured in today’s dollars.

Allowing the clearly undercapitalised GSEs to continue operating within their current paradigm carries similar risks. The principal difference is that the GSEs are much larger than the thrift institutions, while the housing crisis is more serious than anything we have seen since the Depression.

To be sure, if one supposed that the GSEs’ problems were all issues of confidence and was certain of their underlying financial health, there might be a case for government guarantees with no onerous conditions. But almost every outside observer agrees that pre-crisis, the GSEs could only borrow because of their implicit government guarantees. Since the crisis their position has sharply deteriorated, and will deteriorate further.

There is no question that we need the GSEs to be highly active in support of the housing market and financial system in the months ahead. If the authorities can see a path to their being able to play such a role in a framework where it can honestly be said that their borrowing is based on confidence in their financial position rather than primarily on federal guarantees, then this is obviously the preferred alternative. But after what we have seen, such a judgment cannot be based on the GSEs’ own claims, the understandable desire of government officials to maintain confidence and attract private capital, or the fact that they are able to borrow – which only reflects the strength of federally provided credit assurances.

If this preferred alternative is, as I fear, not realistic given the state of GSE finances, the government should use its new receivership power to protect taxpayers and the financial system. In the process, payments to stock holders, holders of preferred stock and probably subordinated debt holders would be wiped out, conserving cash for the benefit of taxpayers. The GSEs’ borrowing costs would fall considerably, helping prospective homeowners.

In this scenario, the government would operate the GSEs as public corporations for several years. They would then be in a position to extend credit where appropriate to support resolution of the current housing crisis. Once the crisis has passed, the federal government would divide their functions into government and private components, the latter of which would be sold off in multiple pieces. The proceeds could be used to fund the low-income housing support activity that was previously mandated to the GSEs.

With this approach, the federal government would be in a position to support the housing market in the years ahead without encouraging dubious financial practices or denying financial reality, as is the case today. In the longer term, it would provide an opportunity to rebuild the housing finance system on far stronger foundations.

A major concern is that receivership would endanger the financial health of the US by taking on to the federal government’s balance sheet all the liabilities of the GSEs. This argument confuses appearance with reality. Recent statements by the Treasury and the Fed have removed any doubt that the US will stand behind the senior debt of the GSEs. Surely everyone should have learned by now that keeping liabilities off balance sheets does not make them any smaller or less real.

The stakes here are high. The choices made in the coming months will bear on the housing market, future taxpayer burdens, the credibility of US financial authorities in times of crisis and the integrity of the political system. It is a time for decisive action.

The writer is Charles W. Eliot university professor at Harvard and a managing director of D.E. Shaw & Co

Copyright The Financial Times Limited 2012.

October 23, 2011

Construction of new single family homes has plummeted from about 1.7m in the middle of the last decade to about 450,000 at present. With housing starts averaging well over a million during the 1990s, the shortfall in housing construction now dwarfs the excess during the bubble and is the largest single component of the shortfall in gross domestic product.

Losses on owner-occupied housing have reduced consumers’ wealth by more than $7,000bn over the past five years, and uncertainty about the future value of their homes and the inability to refinance at reasonable rates deters household outlays on durable goods. The continuing weakness of the housing sector is a major risk for US financial institutions, raising significantly the costs of the loans they offer.

In retrospect it would have been better if financial institutions and those involved in regulating them, especially the Federal Housing Finance Agency, recognised that house prices can go down as well as up, if more rigour had been applied in providing credit, if the government-sponsored enterprises (GSEs) had been more careful in monitoring those originating and servicing loans, and if there had been more vigilance about fraudulent behaviour.

The central irony of financial crisis is that while it is caused by too much confidence, too much borrowing and lending and too much spending, it can only be resolved with more confidence, more borrowing and lending, and more spending. Most policy failures in the US stem from a failure to appreciate this truism and therefore to take steps that would have been productive pre-crisis but are counterproductive now with the economy severely constrained by lack of confidence and demand.

Thus even as the gap between the economy’s production and its capacity increases, fiscal policy turns contractionary, financial regulation focuses on discouraging risk-taking and monetary policy is constrained by concerns about excess liquidity. Most significantly US housing policies especially with regard to Fannie Mae and Freddie Mac, institutions whose purpose is to mitigate cyclicality, have become a case of disastrous procyclical policy.

The question now is what should be done to address the housing market given the drag it represents on the economy. With virtually all mortgages in the US provided by the federal government or guaranteed by the GSEs, this is inevitably a matter of government policy.

Unfortunately past policy has been preoccupied with backward-looking attempts to address the consequences of errors in mortgage extension by addressing homeowners on a case by case basis and decisions regarding the GSEs have been left to their conservator, the FHFA, which has taken a narrow view of the public interest. The FHFA has not acted to ensure the GSEs stabilise the US housing market, and taken no account that the narrow financial interest of the GSEs depends on a national housing recovery. Instead of focusing on the stabilisation of the market, it has been reversing its previous policies heedless of changes in the environment and in treating mortgage finance as a morality play involving homeowners, financial institutions and banks rather than an important component of economic policy. A better approach would involve several changes in policy.

First, and perhaps most fundamentally, credit standards for those seeking to buy homes are too high and rigorous. This reduces demand for houses, lowering prices and driving increases in foreclosures, leading to further tightening of credit standards and a vicious growth-destroying cycle. Statistics suggest the characteristics of the average applicant in 2004 would make an applicant among the most risky today. Of course the pattern should be the opposite given that the odds of a further 35 per cent decline in house prices are much lower than they were at past bubble valuations.

Second, as Barack Obama stressed in presenting his jobs programme, there is no reason why those on GSE-guaranteed mortgages should not be able to take advantage of lower rates. From the point of view of the guarantor, lower rates are good since they reduce the risk of default. Yet, until now the GSEs have made refinancing very difficult by insisting on significant fees and requiring that any new refinancier take on all the liability for errors in underwriting the original mortgage at a cost to American households of tens of billions of dollars a year.

Third, stabilising the housing market will require doing something about the large and growing inventory of foreclosed properties. The same property sold in a foreclosure sale nets about 30 per cent less than if sold in the ordinary way and the knowledge that there is a huge overhang of foreclosed properties deters home purchases. Aggressive efforts by the GSEs to finance mass sales of foreclosed properties to those prepared to rent them out could benefit both potential renters and the housing market.

Fourth, there is the prevention of foreclosures which was the initial focus of policy efforts. The truth is it is far from clear what the right way forward is. While the Obama administration’s home affordability modification programme has been criticised for overly restrictive eligibility criteria, the reality is that a large fraction of those receiving assistance have ultimately been unable to meet even their reduced obligations. This suggests the task of helping homeowners without either damaging the financial system or simply delaying inevitable outcomes is more difficult than often supposed. Surely there is a strong case for experimentation with principal reduction strategies at the local level. The GSEs should be required to drop their posture of opposition to experimentation and move to a more constructive position.

Fifth, there were substantial abuses by financial institutions and almost everyone in the mortgage industry during the bubble. Just compensation to the victims is a legitimate objective of public policy. But allowing negotiation over the past to dominate present policy creates overhangs of uncertainty that impose huge costs on the financial system and inhibits lending. It is equally in the interests of bank shareholders and the housing market that a rapid resolution of disputes be achieved. The FHFA should strive to quickly end this uncertainty.

While the GSEs are the most important actors in the mortgage market and hence the FHFA is the most important player in housing policy, others can make a difference. Bank regulators could facilitate inevitable restructuring of underwater mortgages by requiring banks to treat second mortgages and home equity loans in realistic ways. The Federal Reserve could support demand and the housing market by again expanding purchases of mortgage-backed securities.

With a constructive approach by independent regulators, far better policies could be in place six months from now. The anticipation of a change to supportive policies could change the tone of the market even sooner. There is nothing else on the feasible political horizon that can make as large a difference in driving American economic recovery.

The writer is Charles W. Eliot university professor and president emeritus at Harvard University. He was Treasury secretary under President Bill Clinton and former director of the National Economic Council under President Barack Obama.

Copyright The Financial Times Limited 2012.

December 9, 2011

European leaders will meet on Thursday and Friday for yet another “historic” summit at which the fate of Europe is said to hang in the balance. Yet it is clear that this will not be the last meeting convened to deal with the financial crisis.

If public previews from France and Germany are a guide, there will be commitments to assuring fiscal discipline in Europe and establishing common crisis resolution mechanisms. There will also be much celebration of commitments made by Italy, and a strong political reaffirmation of the permanence of the monetary union. All of this is necessary and desirable, but the world economy will remain on edge.

Given that Europe is the largest single component of the global economy, the rest of the world has a stake in helping to avoid major financial accidents. It also has a stake in aiding continued growth in Europe and ensuring that the European financial system supports investment around the world – particularly as cross-border European bank lending dwarfs that of banks from any other region.

Now is also a historic juncture for the International Monetary Fund. The focus of the policy response to the crisis must now shift from Brussels and Frankfurt to the IMF’s boardroom.

From the problems of the UK and Italy in the 1970s, through the Latin American debt crisis of the 1980s to the Mexican, Asian and Russian financial crises of the 1990s, the IMF has operated by twinning the provision of liquidity with strong requirements that those involved do what is necessary to restore their financial positions to sustainability. There is ample room for debate about the precise policy choices the fund has made in the past. But, the IMF has consistently stood for the proposition that the laws of economics do not and will not give way to political considerations. At key points the IMF has offered prescriptions, not just for countries in need of borrowed funds, but also for those whose success is systemically important for the global economy.

Christine Lagarde, the head of the IMF, highlighted the seriousness of problems in Europe to members of the international financial community assembled in Jackson Hole in August. She pointed to capital shortfalls in the European banking system and the need for adjustment to be carried on in ways that were consistent with continuing growth. Now the IMF needs to speak and act on several fronts.

First, it is essential that Italy’s adjustment be carried out within the context of an IMF programme. After European authorities emphasised that Greece was fully solvent and able to service all debts in full, it is unlikely that they, acting alone, have the capacity to reassure markets. Moreover, there are profound intra-European political problems if northern Europe either does or does not impose conditions on Italy. It would be much better to outsource those traumas to the IMF.

Second, as the IMF deals with individual European countries, it needs to recognise more than it did in the past that they are embedded within a monetary system and community of nations with an increasing number of common institutions. It would be inconceivable that the IMF would lend money to a country whose central bank was not committed to an appropriate monetary policy, or that was ignoring contingent liabilities in the banking system. IMF support for any European country should be premised on understandings with the European Central Bank that controls that country’s monetary policy.

Third, when engaging with individual members of a monetary union, the IMF cannot assess the prospects of one member of the monetary union in isolation. If some countries are to enjoy reduced trade deficits, others must face reduced surpluses. If there is no clear path to reduced surpluses there is no clear path to reduced deficits and hence to solvency. More generally, the sustainability of any programme must be assessed in the context of realistic projections of the economic environment. The IMF must be careful not to approve adjustment programmes that are not realistic.

Fourth, the IMF has a responsibility to speak clearly about threats to the global economy. Even if debt spreads in Europe fall and modest growth is reattained, the global economy is threatened by the large-scale deleveraging of European banks. An improvement in the fiscal position of sovereigns will help but this is insufficient. If banks are not recapitalised on a substantial scale soon, there will be a large contraction of credit in the global economy.

After the summit attention will and should shift to the IMF. It must act boldly but no one should ever forget a fundamental lesson of all past crises. The international community can provide support but a nation or a region’s prospect for prosperity depends ultimately on its own efforts.

The writer is Charles W. Eliot university professor at Harvard and was Treasury secretary under President Bill Clinton.

Copyright The Financial Times Limited 2012.

March 25, 2012

Economic forecasters divide into two groups. There are those who cannot know the future but think they can – and then there are those who recognise their inability to know the future. Major shifts in the economy are rarely forecast and often not fully recognised until they have been under way for some time. So judgments about the US economy have to be tentative. What can be said is that for the first time in five years a resumption of growth significantly above the economy’s potential now appears a substantial possibility. Put differently, after years when growth was more likely to surprise below expectations than above them, the risks are now very much two-sided.

As winter turned to spring in 2010 and 2011, many observers thought they detected evidence that the economy had decisively turned, only to be disappointed a few months later. Several considerations suggest that this time may be different. Employment growth has been running well ahead of population growth for some time now. The stock market level is higher and its expected volatility lower than at any time since 2007, suggesting that the uncertainty weighing on business has declined. Consumers who deferred purchases of cars and other durable goods have created pent-up demand that now seems to be emerging. At last the housing market seems to be stabilising. For years now, the rate of new families setting up households has been well below normal as more and more young people have moved in with their parents. At some point they will set out on their own, creating a virtuous circle of a stronger housing market, more “family formation” that boosts demand, further improvement in housing conditions and so on. And, assuming there is no punitive regulation, innovation in mobile information technology, social networking and newly discovered oil and natural gas seems likely to drive investment and job creation.

True, the risks of high oil prices, further problems in Europe and financial fallout from anxiety about future deficits remain salient. However, unlike the situation in 2010 and 2011, these risks are probably already priced into markets and factored into outlooks for consumer and business spending. There has already been a significant rise in oil prices. Europe’s situation is hardly resolved but is very unlikely to deteriorate as much in the next months as it did last year. And market participants report great alarm about the deficit situation. So even modestly good news in any of these areas could drive upward revisions in current forecasts.

What are the implications for macroeconomic policy? Such recovery as we are enjoying is less a reflection of the American economy’s natural resilience than of the extraordinary steps that both fiscal and monetary policy makers have taken to offset private sector deleveraging – a process that is far from complete. A convalescing patient who does not finish their course of treatment takes a grave risk. So too the most serious risk to recovery over the next few years is no longer financial strain or external shocks, but that policy will shift too quickly away from its emphasis on maintaining adequate demand, towards a concern with traditional fiscal and monetary prudence.

On even a pessimistic reading of the economy’s potential, unemployment remains 2 percentage points below normal levels, employment remains 5m jobs below potential levels and gross domestic product remains close to $1tn short of its potential. Even if the economy creates 300,000 jobs a month and grows at 4 per cent, it would take several years to restore normal conditions. So a lurch back this year towards the kind of policies that are appropriate in normal times would be quite premature.

Indeed, recent research suggests that, by slowing investment and increasing long-term employment, such policies could seriously damage the economy’s long-term performance. Brad Delong and I argued in a recent paper that premature and excessive fiscal contraction could even, by shrinking the economy, exacerbate budget problems in the long run.

How then to respond to valid concerns about fiscal sustainability, excessive credit creation and the time it may take to return to normality in a world where policy credibility is essential? The right approach is to use contingent commitments – policies that commit to action to normalise conditions, but only when certain thresholds are crossed. So, for example, it might be appropriate for the Federal Reserve to commit to maintain the current Fed Funds rate until some threshold with respect to unemployment or expected inflation is crossed. Commitments to fund infrastructure over many years might include a commitment that a financing mechanism such as a gasoline tax would be triggered when some level of employment or output growth has been achieved for a given interval. Tax reform legislation might propose that new rates be phased in at a pace that would depend on economic performance.

Contingent commitments have the virtue of giving households and businesses clarity as to how policy will play out. In areas where legislation is necessary, they can help to eliminate political uncertainty. They also allow policy makers to make a simultaneous commitment to near-term expansion and medium-term prudence – exactly what we require right now. In a volatile and uncertain world, there is always an element of contingency in policy. Recognising it explicitly is the way to provide confidence and protect credibility in a world whose future no one can gauge with precision.

The writer is former US Treasury secretary and Charles W. Eliot university professor at Harvard.

Copyright The Financial Times Limited 2012.