Larry Summers hopes that the current financial crisis has passed its peak:
Steps that can safeguard America's economy: Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers, the Fed has demonstrated a willingness to take on directly the most problematic parts of Bear Stearns' balance sheet, and the Fed funds rate has been reduced by 200 basis points within 7 weeks.... [P]rocesses are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac (the government-sponsored enterprises) to purchase more than an additional $300bn in mortgage-backed securities... legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.
The confidence engendered by all of this has led to some normalisation in credit markets.... For the first time since last August, I believe it is not unreasonable to hope that in the US, at least, the financial crisis will remain in remission.... Just as cascading liquidations have contributed to a vicious cycle of both real and financial contraction, it is possible that recovery can be a virtuous circle in which improved financial and real economic performance are mutually reinforcing.
Wise policymakers hope for the best but plan for the worst... markets continue to price in significant probabilities of default for even the most apparently strong financial institution... the federal government is bearing credit risk in extraordinary ways through its implicit guarantee to the GSEs, the lending activities of the Fed and the general backstop it is providing to the financial system... a priority for financial policy has to be increases in the level of capital held by financial institutions....
The policy approach should start with the GSEs.... It is appropriate at a time of crisis in the mortgage markets that they become, as their regulator put it last week, the "lender of first, last and every resort."... It is not appropriate that their shareholders' "heads I win, tails you lose" bet with the taxpayer be expanded for this purpose... their regulator... should insist that they stop paying dividends and raise capital promptly and substantially as they expand their lending....
Because they do not have a similar public mission and are operated with more financial rigour and closer regulation, the situation is somewhat different with respect to other financial institutions.
As part of its dialogue with financial institutions, the Fed should push for further efforts to raise capital... destigmatise cutting dividends or raising equity. The idea of linking access to Fed credit and measures to attract capital should also be explored. At a time when much is being given to financial institution shareholders and management, action to help the economy and protect the taxpayer should be expected in return.
What is the analysis that underlies this argument?
Start with a version of Bernanke-Gertler: financial intermediaries can operate in one of two modes: well-capitalized or poorly-capitalized. When financial intermediaries are well-capitalized, they themselves have little problem borrowing on a large scale and serving as conduits for the flow of funds between savers and investors. Thus market demand for risky financial assets is relatively high:
And, given the (fixed in the short run) supply of risky financial assets like mortgages and private-sector bonds, the prices of such financial assets are relatively high as well--which gives businesses an incentive to expand their capital stocks and thus put people to work in the investment-goods industries:
But there is another mode of operation: if financial intermediaries are poorly-capitalized they themselves will have great problems borrowing--savers will fear the moral hazard problems that arise when those who manage their money don't themselves have a large stake in the game, and a financial intermediary without a large equity cushion leads savers to ask the American question "if you're so smart, why aren't you rich?" and shy away. So if financial intermediaries are poorly-capitalized, supply and demand looks very different:
with low demand for financial assets, a low equilibrium price of financial assets--and no incentive for businesses to expand their capital stocks, and mass unemployment, and depression.
The kicker is that large declines in the prices of financial assets--a panic--can switch financial markets from one mode to the other, because their is a large range over which declining prices do sufficient damage to financial intermediaries' capital and reputation to cause the demand curve to slope the wrong way--in what I was taught to call the "Krugman Backwards-S" demand curve:
which produces two stable equilibrium--a good, high-price, high-investment, full-employment one, and a bad, low-price, low investment depression one. The task of central banking is to keep the financial markets and the economy at the good equilibrium, and keep it from jumping to the bad one.
Now let's jump back in time to 2001-2002. It is the aftermath of the collapse of the tech boom and of 911. The Federal Reserve has lowered interest rates to try to forestall deflation and keep the economy near full employment. By lowering interest rates it made safe assets less attractive, and thus pushed demand for risky assets outward--raising the prices of (which is the same thing as lowering the interest rates of) risky financial assets:
The outward push became larger because of two additional factors: Asia's policy of low-currency valuation and thus of providing interest-rate subsidies to America's borrowers, and relaxed lending standards coupled with real estate exuberance. In an environment in which any newly-created financial asset could be sold for a high price, construction companies undertook to build lots more houses--and thus pushed the supply of financial assets out to the right between 2002 and 2006 as all of these new houses--3 million more than trend construction--needed mortgages:
Now comes 2007 an end to irrational exuberance and a little bit of bad macroeconomic news pushes demand for financial assets back to the left. At first--last summer--the Federal Reserve thinks that its job is simply to maintain confidence, to keep the economy at the good equilibrium by making everybody understand that the Fed was not going to let the economy get to the bad, depression equilibrium. But over the fall it became clear that such "Panic Stage I" policy wasn't going to be enough:
Providing liquidity to the market in order to maintain confidence--following Bagehot's rule of lending freely at a penalty rate to organizations that could offer collateral that would be acceptable in normal times--wasn't going to be enough to avoid a depression because it was no longer a matter of maintaining confidence that banks and other financial intermediaries were and would remain well-capitalized. Why wasn't it enough? Because they weren't well capitalized.
So over the winter the Federal Reserve moved on to "Panic Stage II" policy: fight the possibility of deflation and depression by doing what they did in 2002, and lowering safe interest rates in order to boost private-sector demand for risky assets. And that gets us to today, where the Federal Reserve has done almost all that it can do in the way of reducing interest rates on safe assets, and yet financial markets are still not calmed, are still not confident that the good equilibrium exists.
What do we do now? That is the subject of Larry Summers's column. We do two things. First, we have the Federal government reduce the supply of risky financial assets by having the government buy or guarantee (thus making the assets no longer risky, you see) or support the purchase of mortgages (and other things) and so push the private financial-sector supply of financial assets to the left. Second, we have the Federal government "encourage" the financial sector to recapitalize itself, thus pushing the supply up and to the right, like so:
And so pushing up the prices and reducing the interest rates charged on financial assets, making the good equilibrium reappear, and keeping us out of depression, like so:
That, in a nutshell with simple graphs, is what Larry is saying, with the addition that he thinks that we now have in motion enough policy moves to resolve the crisis and save the world economy from depression. But there are four additional points that don't fit easily on the graphs. We need to make sure that we also:
- do smart things to try to keep this from happening again
- assign blame and try as hard as we can--without causing a depression--to make sure that those who bear responsibility don't make out like bandits by looting the Treasury as this is accomplished.
- make sure that others--even if they are still largely innocent bystanders at the moment--do not earn unjustified windfall fortunes in the process.
- make sure that the upward-and-to-the-right orange-arrow movement of the supply curve does in fact take place: make sure that financial intermediaries that survive and profit because of government intervention become not just part of the problem but part of the solution: that because "much is being given to financial institution shareholders and management, [it is only fair that much] action to help the economy and protect the taxpayer... be expected in return."
Now there are three objections to this analysis and this plan of action, roughly: (1) it's immoral, (2) it's unfair, and (3) it can't work in the long run. To expand a bit:
- It's immoral because people have a right to be treated like adults--which means that they have a right not to be rescued by the government from the consequences of their bad judgment, and we are violating that right.
- It's unfair because feckless greedy financiers who caused the problem ought to lose money and aren't-or aren't losing enough money--and because feckless greedy imprudent thriftless borrowers who caused the problem ought to lose money and aren't--or aren't losing enough money.
- It won't work--at least not in the long run.
I dismiss objection (1). It is made, mostly, by those who speak for the Princes of Wall Street. Note that the Princes of Wall Street themselves are not opposed to what the Federal Reserve and the Treasury and the congress doing--anything, anything at all that promises to raise asset prices is something that each of the Princes of Wall Street would trade at least one of their organs of generation for. But those who speak for the Princes of Wall Street--well, they really believed that the Princes earned their fortunes by virtue of their virtue--their intelligence, their nerve, their skill, and their willingness to run great risks for great rewards. The idea that there is a public safety net to catch the Princes when they all fall off the tightrope at once--that they are not actually rugged Randite individualists running great risks--that they are people in the right place at the right time with enough low animal cunning to cover themselves with glue and then step outside at 57th and Park or on Canary Wharf as the money blows by so that a bunch of the money sticks to them--well, this strikes those who speak for the Princes of Wall Street on the editorial page of the Wall Street Journal or in Investors' Business Daily as a betrayal of the moral order.
The response to objection (1) is that the people who make it need to grow up. There is no more a John Galt or a Jane Galt than there is a Santa Clause. There are no Randites in a financial crisis--or no even quarter-sane Randites. The fact that there is a safety net in a financial crisis is something that has been obvious to everything with a spinal column for at least a century and a half--that's what central banks are for, for Jeebus's sake! The Princes of Wall Street did not earn their fortunes by virtue of their virtue, their intelligence, their nerve, their skill, and their willingness to run great risks, et cetera, et cetera, low animal cunning, glue, money sticks as it blows by.
Later on we can talk about the corollary to the refutation of objective (1)--the fact that the existence of a safety net for the rich since 1844 makes it an obvious matter of simple justice that there be a safety net for the poor and the middle class as well, and that Harvard University would have been better served if it had taken Robert Nozick's slot away from the philosophy department so that he would not write Anarchy, State, and Utopia and given it to the economics or the history department. But that's for later, and for the present it's important to make sure that people who argue for tax cuts for the rich or for welfare-state program cutbacks for the poor or for more slots for libertarian political philosophers in elite universities should not be allowed to disrupt the formulation of public policy when there is serious busienss to be done.
The response to objection (2) is "tough." Yes, it is important to design the elements of the rescue package in such a way as to give as few windfalls as possible to the undeserving feckless, greedy, imprudent, thriftless, et cetera. But as Federal Reserve vice chair Don Kohn says, it is bad public policy to hold the jobs of tens of millions hostage in an attempt to teach a few feckless financiers (or even somewhat more thriftless borrowers) even a much-deserved lesson.
Objection (3) is intellectually more interesting and substantive. But that will have to wait for the next lecture.