How Much Did Larry Summers Fear the Invisible Bond Market Vigilantes in December 2008?: The Obama Economic Policy Memo
My conclusion is that he did not fear them much, if at all.
Remember that this memo http://delong.typepad.com/20091215-obama-economic-policy-memo.pdf is not Larry Summers's view as of December 2008. It is, instead, the rough consensus of an initial Obama economic policy team whose members spread out on the policy spectrum from left to right roughly in the order: Romer-Summers-Orszag-Geithner. This is Larry Summers being honest broker: his own personal views at the time were probably a couple of steps to the left of the broad thrust of the memo.
Reading the memo, the piece of it that I thought summarized the memo's view of the "bond market vigilantes will come to kill us all if we try to give the economy a fiscal boost!" argument was this:
From the perspective of raising demand and creating jobs there is a case for a very large program of stimulus. Considerations on the other side include… [a]n excessive recovery package could spook markets or the public and be counterproductive. Given where the public discussion is moving and given the "flight to treasuries" present in markets at this point, we do not believe this should deter escalation well above $600 billion - a view shared by senior Federal Reserve officials. It does speak to the importance of accompanying recovery actions with strong measures to reinforce medium term fiscal credibility…
This seems to me to raise the argument that the administration-to-be should do less than it was planning to do out of fear of bond market vigilantes--and then to rebut that argument. The bottom line I get is that the economic team believed that the invisible bond market vigilantes were simply not an issue for policies in the range that the administration-to-be was thinking of proposing.
The other place in the memo where the invisible bond market vigilantes are mentioned is this:
To accomplish a more significant reduction in the output gap [than in the four illustrative policy proposals] would require stimulus of well over $1 trillion based on purely mechanical assumptions - which would likely not accomplish the goal because of the impact it would have on markets…
If you read the memo as expressing the opinions of a single rational mind--which is probably a mistake: such memos are by their nature a compromise, and coherence and consistency of thought across sections is invariably sacrificed to the need to get the memo out the door when participant X says that §Y must say Z or they will demand another meeting to thrash out the issues--then the midpoint of the Obama economic policy team as of December 2008 thought that a $600 billion fiscal boost was too small while a "well over $1 trillion" fiscal boost was too big. The Recovery Act that we got was about $600 billion of real stimulus, plus $200 billion of stimulus-ineffective congressional gee-gaws like AMT relief.
Given the situation and forecasts as of December 8, 2008, this looks like the right number to me. Remember that as of December 8, 2008 the economy looked much brighter than it turned out to be--and that as a result the magnitude of "flight to quality" demand for Treasuries looked to be much smaller than it turned out to be, which means that it was rational then to think that the bond market vigilantes were much closer than they have turned out to be.
Don't complain about excessive fear of the bond market vigilantes.
And be very grateful that we had President Obama rather than President McCain advised by Greg Mankiw:
Greg Mankiw is the only economist we have consulted with who refused to name a number and was generally skeptical about stimulus.
You want, nevertheless, to complain, when you should be grateful? You can complain--but wait until the very end of this post…
Ezra Klein has thoughts:
What the Summers memo tells us about the Obama White House: The economic policy memo that Larry Summers sent to Barack Obama in December 2008, and that the New Yorker’s Ryan Lizza has posted in full, is the ur-text for the Obama administration…. This memo is best understood as the rough consensus of the members of the economic team…. The economic team clearly thought it was counseling the president to embrace a more aggressive response than anything that had previously been proposed. “We have become convinced there there is a compelling case for a recovery package considerably larger than the $500 to $600 billion that we were originally contemplating,” the memo reads. “The rule that it is better to err on the side of doing too much rather than too little should apply forcefully to the overall set of economic proposals.”…
But the team made two huge miscalculations — one political, one economic. The political miscalculation was that “it is easier to add down the road to insufficient fiscal stimulus than to subtract…” That was clearly untrue…. The economic miscalculation was that “forecasters now expect output to contract at least a five percent annual rate in 2008 Q4.” In fact, the contraction in the fourth quarter of 2008 was 9 percent….
The controversial takeaway from the memo is that Summers suggested that a stimulus in excess of $1 trillion would spark a counter-reaction from the bond markets…. The line in question is slightly more ambiguous:
To accomplish a more significant reduction in the output gap would require stimulus of well over $1 trillion based on purely mechanical assumptions — which would likely not accomplish the goal because of the impact it would have on market…
Summers defenders argue that he was making a more limited claim: Not that anything over $1 trillion should be off the table, but that the mechanical relationship between stimulus dollars and growth only goes so far…. Summers and his team clearly thought they were fighting for a larger stimulus than was currently on the table, and designed the memo — complete with outside validators — to achieve that goal.
But for all the attention given to the sentence on the bond market, the memo quickly moves onto other topics. Much more attention is paid to a different constraint: the operational constraints in trying to put so much money into the economy in a way that was both quick and smart:
While the most effective stimulus is government investment, it is difficult to identify feasible spending projects on the scale that is needed to stabilize the macroeconomy. Moreover, there is a tension between the need to spend the money quickly and the desire to spend the money wisely. To get the package to the requisite size, and also to address other problems, we recommend combining it with substantial state fiscal relief and tax cuts for individuals and businesses.
The memo deals with this question in great detail, and concludes that “we can only generate about $225 billion of actual spending on priority investments over the next two years”…
Summers and Stimulus | Jared Bernstein | On the Economy: I’m not saying we did enough, but I am saying Larry was among those who recognized the urgency of the Keynesian imperative. And not just in January of 2009, but for the duration of his tenure.
How does that square with a section like this, from Lizza’s piece?
Summers advised the President that a larger stimulus could actually make things worse. “An excessive recovery package could spook markets or the public and be counterproductive,” he wrote, and added that none of his recommendations “returns the unemployment rate to its normal, pre-recession level. To accomplish a more significant reduction in the output gap would require stimulus of well over $1 trillion based on purely mechanical assumptions—which would likely not accomplish the goal because of the impact it would have on markets.”
Again, look at the actual memo. On page 11, Larry cites four reasons for not going big on the stimulus, including spooking the bond markets. And in each case, he stresses the counterargument…. [T]he President may have been longing for Truman’s one-handed economist, but with respect to Lizza’s otherwise excellent piece, the thrust of Larry’s emphases here is consistent with his view that the risk was doing too little on stimulus, not too much.
And yes, Larry was wrong, as was I and many others, that it would be easier to add than subtract. In fact, the evolution of that view is at the heart of the Lizza’s trenchant analysis, which at its core is an anatomy of the level of partisanship with which we are currently stuck.
It’s fair to say that too few of us recognized that dynamic coming out of the gate. It’s also fair to say that such die-hard, mindless opposition by those whose primary goal is to defeat the President is…um…antithetical to good government, to put it nicely.
The Most Important Passage from the Secret Larry Summers Memo: [A] 57-page memo that Larry Summers wrote to Barack Obama to frame the debate over the stimulus…. [O]nly one passage is underlined, or bolded, or italicized. In fact, it was so important to Summers, it got all three treatments. It's this one:
But it is important to recognize that we can only generate about $225 billion of actual spending on priority investments over next two years. and this is after making what some might argue are optimistic assumptions about the scale of investments in areas like Health IT that are feasible over this period.
Here's why this passage was critical. The recession was so deep that it might require up to $1 trillion in stimulus, according to economists surveyed by Summers' team. But the federal government could "only generate about $225 billion of actual spending" in Summers' estimation. To fill the gap, the White House would have to rely on less-than-ideal sources of stimulus spending. Those sources were tax cuts and state relief…. [T]ax breaks are more likely to be saved, especially when families are in debt, which dampens their effect as stimulus (since the point of stimulus is to circulate money, not to increase families' savings). State relief wasn't Summers' idea of perfect stimulus, either. States would likely use the money to offset tax increases, support old spending programs, or fortify rainy day funds…. The gap between the needs of the economy and Summers' doubts about the capacity of government to spend money effectively is all over this memo, and it's summed up nicely in this paragraph:
Constructing a package of this size, or even in the $500 billion range, is a major challenge. While the most effective stimulus is government investment, it is difficult to identify feasible spending projects on the scale that is needed to stabilize the macroeconomy. Moreover, there is a tension between the need to spend the money quickly and the desire to spend the money wisely. To get the package to the requisite size, and also to address other problems, we recommend combining it with substantial state fiscal relief and tax cuts for individuals and businesses….
The fact that this memo has been out of the public eye for the last three years might suggest to you that the administration would be embarrassed by it. Indeed, the now-famous prediction that the stimulus would hold unemployment closer to 7 percent was proved wildly inaccurate. The White House also clearly underestimated the scale of the housing mess, and failed to come up with a way to address the housing crisis on par with its severity.
But there's quite a lot that Summers and his team got right. He was right to suspect that the tax cuts might be saved by indebted families. He was right to suspect that Republicans would attack state relief as unproductive and rewarding to profligate states. He was right that using the stimulus to fulfill the president's campaign promises wasn't ideal…. He was right that the president would inevitably be on the defensive about deficits caused by lower tax revenues and exacerbated (in the short term, at least) by the stimulus. He was right to predict that deficits would lasso entitlement reform into the big picture. He was right that financial reform was a necessary item on the president's agenda, but that it would prove difficult to build political support for major reform while the banks still seemed sick. And so on.
History might remember this memo as the document that killed any hope for a trilion-dollar stimulus, but it's a rich and complicated report that offers a wonderful look at how Obama's team was grappling with an economic downturn that turned out to be even worse than they imagined.
Larry and the Invisibles: One problem with interpreting the memo is that it does read like an imperfectly fused merge of stuff from several people; I told Ryan Lizza that I felt like someone doing textual analysis of the Bible, trying to identify which passages came from author S, which from author O, which from author R. The ones I agree with most look like R; the ones I dislike probably came from O. Jared is right that the really, really key misjudgment was the notion that they could come back for more — a failure to understand the bitterly partisan nature of the situation. And this remains totally baffling and frustrating to me, because I thought it was dead obvious…. And this, I have to say, goes back to Obama. He came into office believing, in the teeth of all the evidence, that he could transcend partisanship. This is the thing I worried about all through the primary; and his reluctance to give up on this vision arguably did major damage in those crucial first few months. Barney Frank quipped that Obama gave him “post-partisan depression”. Yeah. But he is expected to be a very different guy tonight…
The key thing I took away from the memo is that it does not read at all like the current story the administration gives for the inadequate size of the stimulus, which is that they knew it should be larger but had to face political reality. Instead, the memo argues that a bigger stimulus would be counterproductive in economic terms, because of the “market reaction”. That is, Summers et al were afraid of the invisible bond vigilantes. And to the extent that there is a political judgment, it’s all in the opposite direction: if the stimulus is too big, we’ll have trouble scaling it back…. That was deeply naive — and I said so in real time. Now, you can still argue that politics made a bigger stimulus impossible. But that’s not at all the argument being made internally within the administration at the time.
Where I think the Obama economic policy team erred on December 8, 2008 was in not taking seriously enough its injunctions that:
In thinking about the risks to the forecast, further negative revisions seem more likely than positive revisions. A significant worry is that the accelerated real decline in output could cause further deterioration in asset prices and further financial market distress…
The rule that it is better to err on the side of doing too much rather than too little should apply forcefully to the overall set of economic proposals...
Where the team, in my 20-20 hindsight view, erred after December 2008 was in:
not raising its estimates of the desired size of the Recovery Act as the economy and the forecast deteriorated between December 8, 2008 and inauguration day.
not setting up an alternative, Reconciliation-process track to create the option to do a second Recovery Act fiscal boost in late 2009 with a simple Senate majority should forecast revisions in fact be negative.
not creating the power to do a serious financial-sector boost to the economy via the role of the GSEs in the housing market by prioritizing appointment of a Director of FHFA who would believe that his job was to use the GSEs as instrumentalities of stabilization policy should that become necessary.
not prioritizing the appointment of a Federal Reserve Chair and of Federal Reserve Governors who would take an employment-population ratio of 58.5% (rather than 63%) as as large an economic policy disaster as an inflation rate of 7% (rather than 2.5%) would be.
the premature rhetorical switch away from macroeconomic recovery to long term fiscal balance in January 2010, based not on a plan but simply on the hope that there would not be a jobless recovery.
the insistence by the political and communications teams to this very day that the Recovery Act was the right size for the economy, or was the best that could be accomplished--could not have been amplified via either Reconciliation, the FHFA, or the Federal Reserve.
Want to complain about Obama and his economic policy team? Complain about those. Don't complain about excessive fear of the invisible bond market vigilantes.
And then there are the further lost opportunities, not on macroeconomic but rather on other forms of policy:
not grabbing equity in the large money-center banks in the winter of 2009 in order to neutralize their ability to lobby to neuter financial regulatory reform.
not grabbing Mitt Romney and Olympia Snowe the day after Election Day 2008 and saying: "You write the health care reform universal coverage bill: I will endorse it and make sure enough Democrats fall into line to pass it."
not using Reconciliation to uncap FICA in March 2009 so that you could then negotiate a long-term Social Security deal from a position of strength.
not using Reconciliation to impose a carbon tax in April 2009 so that you could then negotiate a cap-and-trade environmental deal from a position of strength.
The December 8, 2008 Obama Economic Policy Team Memo: http://delong.typepad.com/20091215-obama-economic-policy-memo.pdf