For the first time since the 2007 financial crisis, investors pushed the Standard & Poor’s 500 index into record territory before closing for the Easter weekend. U.S. stocks have rebounded despite vulnerabilities in Europe and the slow pace of the U.S. economic recovery. While investors are riding a wave, many are wondering why it is taking so long for economic output, consumer demand and employment to return to pre-recession levels.
According to Lawrence Summers, former director of President Barack Obama’s National Economic Council and former U.S. Treasury Secretary — he is also President Emeritus of Harvard University at the top of a shortlist of potential candidates to replace current chairman of the U.S. Federal Reserve Ben Bernanke — the events of the last few years have thrown into question much of what he learned and taught about coherent economic models.
Earlier this week, as Europe was in the throes of yet another crisis, this time centred in the tiny island of Cyprus, Summers told an audience at the London School of Economics that the thinking on how markets function and recover has changed. Summers was joined in the rare panel discussion by Fed Chairman Bernanke, Bank of England Governor Mervyn King and Axel Weber, former president of Germany’s central bank. Canada’s own central banker, Mark Carney was in the audience.
“The events of the last years suggest that the traditional breakdown between the structural and the cyclical that is central to economic thinking has become highly problematic. If there is anyone in this room that believes that a reasonable forecast for the U.S. or British economy at any future date would be represented by a trend line constructed through to 2007 from any previous point, I have a bridge I want to sell you,” Summers quipped.
Fourteen years ago, Summers was one in the trio of economists Time magazine anointed “The Committee to Save the World.” The other two members of the superhero league were then-Federal Chair Alan Greenspan, and U.S. Treasury Secretary Robert Rubin — Summers was deputy U.S. Treasury Secretary and became treasury secretary later that year. At the time, the troika was credited with saving the world’s financial markets from collapse and slowing the spread of the “Asian Contagion,” a wave of financial market panic that began with the rapid devaluation of Thailand’s currency and spread to other parts of Asia, Russia and Latin America, soon affecting the real economy as well. The U.S. appeared inoculated from the financial stresses afflicting other parts of the world, posting record GDP growth rates of five per cent.
Fast-forward to 2008, though, and the U.S. economy was teetering on the verge of the abyss. The committee no longer seemed so infallible — worst still, it looked guilty. As Bloomberg’s Ian Katz wrote, “their model of unfettered capitalism eventually invited disaster. The trio’s deregulatory approach encouraged banks to take risks that later threatened the U.S. financial system.”
For his part, Summers says the moniker bestowed on the three was unrealistic: “I think if anyone had the idea that somehow it was given to bankers or economists to make the world always be stable, that was a very bad idea.”
In conversation with Maclean’s, Summers spoke about lessons learned from the financial crisis, as well as Carney’s new job as Britain’s central bank governor and the Keystone XL.
Q: A 1999 Time magazine cover labeled you, Rubin and Greenspan the “Committee to Save the World.” Since then, economists have been taken to task for failing to foresee the problems in the financial sector. What do economists and central bankers need to do to restore trust?
A: The policies the U.S. led the world in pursuing were constructive during the 1990s in preventing emerging market crises from cascading completely out of control, though there was an enormous amount of suffering in the countries that were affected. The policies that were pursued in 2009 and 2010 were very successful in the sense of avoiding a depression that could easily have happened. The downturns were, in all the major statistics, worse in the six months after the fall of 2008 than they were in the six months after the fall of 1929. In that sense, the policy was successful. I think if anyone had the idea, that somehow it was given to bankers or economists to make the world always be stable, that was a very bad idea. And I warned at a number of junctures in 1999 before the Internet bubble, and again in the winter of 2007, that the main thing we had to fear was the lack of fear itself, precisely because a sense that everything is stable is a self-denying prophecy, because if there is a sense that everything is stable, [...] people will take on more risk and that will then create the conditions for future instability. The fact that we can take some satisfaction from the responses to various crises cannot divert concern from the reality that a financial sector, which has the objection of spreading and mitigating risk, has been a repeated source of instability over the last generation. More needs to be done to keep finance a source of opportunity rather than instability. No one involved in the financial sector, neither private nor public, should be satisfied with the record to date.
Q: A worrisome feature of this economic downturn is that there is no consensus on how to fix it, the battle between monetarists and Keynesians persists. How would you characterize this lack of consensus?
A: You are always going to find many different opinions among economists but there is a general awareness that financial instability is not self-curative and that strong action is necessary in the face of financial panic, that is a more settled idea today than it would [have been] five years ago. There is a more settled idea that it is better to deal decisively with financial problems, than it is to simply try to address them piecemeal. There is a sense that one should try and use all the tools at one’s disposal, and that means fiscal tools, monetary tools, tools for intervention in financial institutions, and that there is more risk of doing too little than there is of doing too much.
Q: What crisis on the horizon most concerns you?
A: It is never the bullet you see. I think it is difficult to know where the next crisis will come from, and, in general, it is better to have a system that is safe from errors in judgment and surprise than it is to try and avoid errors in judgment and surprises because as along as you are dealing with human beings, there will be errors and surprises.
Q: Is Cyprus a microcosm of a larger problem in Europe?
A: In some ways, Cyprus is a microcosmic caricature. Other parts of Europe don’t have eight times [their] GDP in banking assets. Other parts of Europe are not so dominantly financed by foreign deposits. The issues in Cyprus have connections to issues in other parts of Europe but they are not the same issues.
Q: Is there too much optimism in the markets and disaster fatigue setting in?
A: Every investor will have to make their own judgment about the market, it does seem like measures of volatility are relatively low given all the uncertainties at present. On the other hand, it is important to note that the spread between earnings price ratios and real interest rates are at near record levels, and that is a crude measure of the equity risk premium. One possible explanation is that earnings are at an unusually high level and likely to revert to normal levels that would be a reason why earnings-price ratios are low. Another reason [is] that given all the traumas, risk premiums are very high in which case, it is a relatively attractive time to buy equity risk assets. There is probably truth in both of those, but I do think it is important, in considering claims of irrational exuberance, to note that the earnings price ratio-interest rate relationship is in a very difference place than it has been in past peaks.
Q: U.S. Senator Elizabeth Warren has been very critical of the fact that the issue of “too big too fail” has not been addressed. Ben Bernanke says he agreed with her 100 per cent and that it is a real problem. Other critics have suggested that these banks have not been sufficiently humbled. Yet, there are still banks that are too big to fail. Given your time in the Obama administration, how do you respond to criticism that not much has been done to correct this?
A: Dodd-Frank has made an important set of steps, [it] has raised capital requirements substantially, taking some of the riskiest activities out of banks, by seeking to put in place resolution regimes, so the world is moving in the right direction. Whether it is moving rapidly enough, and aggressively enough is a judgment we will have to make in the next several years. The market evidence on the cost of borrowing for banks does give some grounds for concern. The last word in bank regulatory policy has not been said and the last act in bank regulatory policy has not been taken. These issues will require our continuing attention.
Q: How much pressure is on central banks to become more transparent and accountable?
A: Almost all institutions feel more pressure to be more transparent and accountable. Central banks have learned that predictability is important in reducing uncertainty and that predictability is facilitated by transparency. It is also true that it is more difficult to be an institution that is highly legitimate and highly non-transparent. And that has operated to affect central banks as well and that is a good thing.
Q: Some have been very critical of the Fed’s use of quantitative easing, saying that it is simply transforming private debt into public debt. Do you agree?
A: No, I think that when interest rates are constrained by the zero bound, it is appropriate for central banks to look, if conditions warrant, for other ways to be expansionary and swapping short term assets for long term assets or what is the equivalent of a liquidity trap, printing money and buying long term assets, can be a reasonable solution. Obviously, there has to be a lot of sensitivity to the exit strategy, obviously there has to be a lot of sensitivity to possible distortions in the functioning of the asset markets. Obviously, one wants to return to a more normal paradigm as rapidly as possible but I don’t think that those who condemn it on principle are coming to the right judgment.
Q: How difficult will Mark Carney’s appointment to the Bank of England be, given that he is not a British citizen?
A: I’m a good friend of Mark Carney and have admired the job he has done for some years now in Canada. I am proud that he was a Harvard undergraduate during my time on the faculty at Harvard and I think that the Bank of England is fortunate to have someone with his degree of experience in public policy and also experience as a participant directly in financial markets, at the helm at what will be a challenging time for the city of London and England and the global financial system. It is unusual for a major country to appoint a citizen of a different country to head its central bank and it will be interesting to see. I think a lot of people will be watching that experiment, and I think how that experiment goes will affect a great deal of what happens going forward.
Q: One of the growth strategies you advocate for the U.S. is approving the Keystone XL pipeline. Why?
A. One of the first things to say is the oil is coming out of the tar sands. The question is whether it will be shipped to North America via Keystone and it’s going to come out of North America on North American smoke stacks and North American filtration devices or is it going to be shipped to China and come out of Chinese smoke stacks with Chinese filtration devices. It is far from clear to me that on pure environmental grounds, it is better for it to go to China. I rather suspect the opposite. I think there is a substantial commercial and economic opportunity both in the construction of the pipeline and in the advantages of lower priced oil that would result from the pipeline for the United States and for Canada. So my hope that the project will go forward after rigorous review but I hope it can be demonstrated that reviews can be both rigorous and rapid.
(Note: This interview has been edited for form and the original order of the questions has been changed.)