03-26-2007

LET'S NOT FIGHT THE LAST WAR WHEN THE NEXT DOWNTURN COMES

Lawrence H. Summers is a former U.S. secretary of the treasury and the former president of Harvard University.

By Lawrence H. Summers

CAMBRIDGE, Mass. — Three months ago, I was able to write that, in economics, “the main thing we have to fear is the lack of fear itself.” This is no longer true. With clear evidence of a crisis in the subprime U.S. housing sector, risks of its spread to other credit markets, sharp increases in market volatility and signs of slowing economic growth, there is enough apprehension to go around.

Although it would be premature to predict a U.S. recession, there are now strong grounds for suggesting that the U.S. economy will slow significantly in 2007. Whether, in retrospect, 2007 will prove to have been a “pause that refreshed” nearly a decade-long expansion (like the growth slowdowns in 1986 and 1995) or whether it will end that expansion is not yet clear.

What is clear is that the global economy has been relying on the U.S. as an importer of last resort; that the U.S. economy has been relying on the consumer for its primary impetus; and that until now consumers have been enabled and encouraged to spend their incomes fully or more than fully by their ability to access the wealth in their homes.

This growth syllogism has appeared fragile for some time, but American consumers have kept spending even after the housing market peaked. And foreigners, particularly those in the official sector in Asia and the Middle East, have continued financing the United States, on very attractive terms, as it imported nearly 70 percent more than it exported.

Now the growth syllogism is in real doubt. Subprime-sector foreclosures will bloat the supply of houses. At the same time, reductions in capital in housing finance and more rigorous credit standards will reduce the demand for new homes. As consumers face upward resets on their mortgage rates and are unable to refinance, and as home-equity, automobile and credit-card lending tighten, consumption will decline.

If that happens, and U.S. interest rates fall or appear likely to fall, there is the real possibility that the foreign lending to the United States will start to dry up, leading to a combination of higher long-term interest rates and a weaker dollar. This would tend to raise inflationary pressures, transmit U.S. weakness to the rest of the world and, by discouraging foreign demand for U.S. assets, could lead to further downward pressure on investment in plants, equipment and commercial real estate.

How should economic policy respond to a potential falloff in U.S. demand? The great irony is that just as the worst investment decisions are made by those who do today what they wish they had done yesterday — buying assets that have already risen and selling those that have just lost their value — so also the worst economic policy decisions are made by policymakers who seek to rectify past mistakes instead of responding to current circumstances.

Of course, policymakers should have done more to restrain imprudent subprime lending over the past several years. But this is not today’s problem. The current problem is just the opposite: how to avoid a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and ultimately more foreclosures.

Some argue that the Federal Reserve should have started tightening monetary policy earlier in the current cycle and avoided what they see as liquidity-driven bubbles. Regardless of the merits of this position, the theory that this constitutes a reason to avoid easing monetary policy, come what may, hardly follows. If the dominant economic concern in the United States becomes a shortage of demand, the Fed should provide stimulus to maintain conditions for growth and financial stability.

Those in the rest of the world who insist that the U.S. has to increase savings and reduce deficits should fear getting what they want too quickly. So also should Americans who insist that other countries stop artificially holding their currencies down by purchasing dollar assets.

Rapidly bringing about such adjustments in the face of an already declining economy could easily turn a “soft landing” into a “hard” one.

Good economic policies operate counter-cyclically, slowing booms and mitigating downturns. It follows that when the dominant risk changes from complacency and overheating to risk aversion and economic slowdown, policy must change as well.

Economic policymakers who seek to correct their past errors by doing today what they wished they had done yesterday actually compound their errors. They are in their way as dangerous as generals fighting the last war. If recent developments mark a genuine change in economic conditions, let us hope that policymakers look forward rather than backward.

(c) 2007 Global ECONOMIC Viewpoint
DISTRIBUTED BY TRIBUNE MEDIA SERVICES, INC. (3/26/07)