The perils of European incrementalism

By Lawrence Summers
September 19, 2011

By Lawrence H. Summers
The views expressed are his own.

In his celebrated essay “The Stalemate Myth and the Quagmire Machine,” Daniel Ellsberg drew out the lesson regarding the Vietnam War that came out of the 8000 pages of the Pentagon Papers.  It was simply this:  Policymakers acted without illusion.  At every juncture they made the minimum commitments necessary to avoid imminent disaster—offering optimistic rhetoric but never taking steps that even they believed offered the prospect of decisive victory.  They were tragically caught in a kind of no man’s land—unable to reverse a course to which they had committed so much but also unable to generate the political will to take forward steps that gave any realistic prospect of success.  Ultimately, after years of needless suffering, their policy collapsed around them.

Much the same process has played out in Europe over the last two years.  At every stage from the first signs of trouble in Greece to the spread of problems to Portugal and Ireland, to the recognition of Greece’s inability to pay its debts in full, to the rise of debt spreads in Spain and Italy, the authorities have played out the quagmire machine.  They have done just enough beyond euro-orthodoxy to avoid an imminent collapse, but never enough to establish a sound foundation for a resumption of confidence. Perhaps inevitably, the gaps between emergency summits grow shorter and shorter.

The process has taken its toll on policymakers’ credibility.  As I warned European friends quite some time ago, authorities who assert in the face of all evidence that Greece can service on time 100 percent of its debts will have little credibility when they later assert that the fundamentals are sound in Spain and Italy, even if their view is a reasonable one.  After the spectacle of stress tests that treat assets where credit default swaps exceed 500 basis points as riskless, how can markets do otherwise than to ignore regulators assertions about the solvency of certain key financial institutions.

A continuation of the grudging incrementalism of the last two years risks catastrophe, as what was a task of defining the parameters of too big to fail becomes a challenge of figuring out what to do when key insolvent debtors are too large to save.  There are many differences between the environment today and the environment in the Fall of 2008 or any other historical moment.  But any student of recent financial history should know that breakdowns that seemed inconceivable at one moment can seem inevitable at the next.

To her very great credit, new IMF managing director Christine Lagarde has already pointed up the three principles any approach to Europe’s financial problems must respect.  First, Europe must work backwards from a vision of where its monetary system will be several years hence.  The reality is that politicians have for the last decade dismissed the widespread view among experienced monetary economists that multiple sovereigns budgeting and bank regulating independently will over time place unsustainable strains on a common currency.  The European Monetary Union has been a classic case of the late Rudiger Dornbusch’s dictum that “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”  So it has been with the buildup of pressures on the Euro system.

There can be no return to the pre-crisis status quo.  It is now clear that market discipline within monetary union is insufficiently potent and credible to assure sound finance, and equally apparent that when banks and sovereigns do not have access to lender of last resort financing the risk of self fulfilling confidence crises becomes substantial.  The respective responsibilities of the ECB, financial regulatory authorities and EU officials can be defined in different ways.  But there must simultaneously be an increase in the central financial commitment to the financial stability of member states and reduction in their financial autonomy if the common currency is to survive.

Second, the Managing Director is right to point up serious issues of inadequate capital in European banks.  Taking even relatively optimistic views about sovereign debt and growth prospects, European banks in at least as problematic a condition as American banks were in the summer of 2008.  Unfortunately in many cases they are far larger relative to their national economies.  Now is the time for realistic stress testing and then resorting to private capital markets if possible and to public capital infusions if necessary.  With delay, private capital markets will close completely and nervous managements will rein in the provision of credit just when credit contraction is most likely to damage real economic prospects.

Third, like her predecessor, Ms. Lagarde has broken with IMF orthodoxy in recognizing that expansionary policies are necessary in the face of substantial economic slack.  The oxymoronic doctrine of expansionary fiscal contraction is being discredited every month.  Europe needs a growth strategy.  Yes, almost everywhere and certainly in the most indebted countries, binding commitments to eventual deficit reductions are a necessity.  And in some places credibility has been lost to the point where immediate actions are necessary.  But Europe only has a chance of handling its debts and contributing to a stronger global economy if it grows.  This will require both aggregate fiscal and monetary expansion.

This last point is an essential lesson of recent American experience.  Even though credit spreads and equity values had normalized by the end of 2009 and the financial system was again functioning reasonably normally a year after the 2008 panic, lack of demand has continued to constrain growth.  While any one household or one nation can improve its balance sheet by saving more and spending less, the effort by all to cut back means reduced incomes and ultimately less saving for all.  Germany in particular needs to recognize that if other European nations are going to borrow less, then it will be able to lend less and that as a matter of arithmetic this will mean a smaller trade surplus.

The world’s Finance Ministers and Central Bank Governors will gather in Washington this weekend for their annual meetings.  The meetings will have been a failure if a clearer way forward for Europe does not emerge.   Remarkably, the European authorities that drove Ms. Legarde’s selection just 3 months ago have rejected important components of her analysis.  In normal circumstances comity would require deference by others to European authorities on the resolution of European problems.  Now when these problems have the potential to disrupt growth around the world all nations have an obligation to insist that Europe find a viable way forward.

Failure would be yet another example of what Churchill called “want of foresight, unwillingness to act when action would be simple and effective, lack of clear thinking, confusion of counsel until the emergency comes, until self preservation strikes its jarring gong–these are features which constitute the endless repetition of history.”

21 comments

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Well done Mr Summers for a succinct history of the Euro drama to date. It is panning out like an Opera, or perhaps a Greek tragedy where someone is going to die. “Continuation of the grudging incrementalism of the last two years” I fear will continue as it seems certain that European Governments are gearing up for both a Greek default and a Greek exit from the Euro. Sadly there are no Euro Ministers who have either Statesman like qualities or the appetite to drive forward the necessary measures to avoid the €’s demise.

Posted by AlgarvianMan | Report as abusive

The dilemma is worse than painted. The glue holding everything together is Germany, and Germany is stable because it did a ‘quiet China’, dumping exports on the U.S. and others to fuel growth. German growth is now slowing, and America is in no shape to buy their exports. Vicious circle economics for all involved.

Posted by ARJTurgot2 | Report as abusive

We need leadership who will look at todays Euro zone and recognise that it will not work as it stands. certain countries need to leave and then a great commitment is needed to those that stay – including very strict fiscal discipline and shrinking of the state and associated costs. If only someone would stand up with a plan that is believable – even if it is painful in the short term. Instead they procrastinate endlessly. Fiddling whilst the EU burns.

Posted by pavlaki | Report as abusive

“With this bill, the American financial system takes a major step forward towards the 21st Century.” 1999 Summers on the Gramm-Leach-Bliley Act. Enough said.

Posted by Pablito | Report as abusive

While it is undeniable that the doctrine of expansionary contraction is oxymoronic, the conclusion that Europe can grow only it it embraces fiscal and monetary expansion’ is a non-sequitur. The reconfiguration of a given level of fiscal spending can be expansionary if the components of the total spending quatum are properly recalibated. Much has already been written about the likelihood that even the left-of-centre Zapatero Government in Spain will lose the coming elections partly because it had allowed inappropriate fiscal spending in the high-speed rail service (the TGV) more on the basis of vote-catching calculation than on any consideration of the energy-consumtion/transporation-logistic s equation for me not to have to repeat it here. Months ago, the early retirement age of Greek civil servants had made news. But these required sectoral and structural reforms have never been seriously discussed during the build-up of the ongoing crisis. Structural Adjustment is a dirty phrase in economic policy-making, one reserved for ‘less-developed countries’

Posted by MohamedMalleck | Report as abusive

After the results of yesterday’s Berlin elections, and fate of FDP which acrued just 1.8% total vote after demanding Greece to be forced into default and/or chased out of Euro Zone, Meerkel and her coaltion government days are now certainly numbered. Either she will be going down withe the Bundestag vote of the new stability fund or she will be voted nout by lack of political support in her own CDU faction.

Summers and his good advise notwithstanding, EU will muddle along until Greece is able to get its house in order….

Posted by hariknaidu | Report as abusive

Wasn’t this the same guy who helped cook up the original batch of KoolAid? – isn’t this the same guy who bailed on the Obama administration when he finally discovered how badly he had screwed the financial system up?!?

How credible can anyone consider the writting of this complete fraud?

Mr. Ponzi and perhaps Mr. Keynes might be proud but the rest of us should be ashamed of the fact that we let this guy teach at a major US university let alone help structure US fiscal/monetary policy.

“In a country well governed, poverty is something to be ashamed of. In a country badly governed, wealth is something to be ashamed of.”
Confucius

Posted by Hinch | Report as abusive

Listen to LARRY SUMMERS?
Why does Reuters even give him a forum?

This is the AynRandian NUT whose wacko Friedmanesque (Supply-Side=TRICKLE DOWN) economic policies, criminally contributed to the recession.
The man should be in jail – NOT quoted on Reuters.

(BTW, mentioning Keynes here was a mistake, whoever did it.)

Posted by rhytonen | Report as abusive

@Lawrence H. Summers

“Even though credit spreads and equity values had normalized by the end of 2009 and the financial system was again functioning reasonably normally a year after the 2008 panic, lack of demand has continued to constrain growth.”

The problem isn’t “lack of demand” (for a large segment), it’s credit. The banks, after getting the largest bailout in the history of humanity, in 2008-9 in 2011-12 REFUSE TO LEND!

Even to credit worth individuals.

I sell central-air units (heating and cooling). I sell in RICH to upper-middle-class neighborhoods.

If a rich guy’s central-air dies and he needs a new one; I visit the home, quote a price and attempt to arrange financing.

The customer is a professional (a lawyer, a doctor – I’ve had dentists, podiatrists, anesthesiologists) who makes over $250,000 a year come back CREDIT REJECTS.

They have money in the bank, good credit (720 or higher), and are not others delinquent or over extended.

If the bank does approve them or if it does, it’s at a stupidly high interest rate, requires 20% down and has lots of fees.

It’s usually cheaper to pay out of pocket – and the well off do.

If a rich doctor with good credit can’t get a loan or a reasonable one, how does a middle class “systems analyst” who makes 70k a year? Even if they have good credit and are not otherwise over extended?

Answer: They don’t.

The BANKS don’t work! Period.

They serve NO function but to gouge consumers, pay no return on deposits (they fee deposits away actually) and contribute nothing to the easing of the gears of the economic machine.

They exist only to make money; which would be find if they made it by actually BANKING and not playing the stock-market or by rolling-casino-like-derivative dice which is what they mostly and still continue to do.

Maybe I should try to get loans for my customers at “casinos.” At least I know mobsters are in the racket game; they don’t pretend to be anything else.

Posted by FoxxDrake | Report as abusive

Advice from the fellow who deregulated Wall Street banks?

Posted by Discovery451 | Report as abusive

I am not an economist but I have the feeling that something very odd is happening both on a national scale and on a global scale. We are redistributing wealth from the poor to the wealthy. In the US, $1 trillion was delivered to the hands of bankers and now that same money has to be found by reducing services for the ordinary people. There may be arguments for why it is better to put money in the hands of investment banks than in the hands of bank tellers; just as there may be arguments for doing the opposite: getting cash into the hands of “consumers” of basic goods. Whichever side you come down on, it seems important not to cover what you are doing with jargon. Europe is being asked to redistribute the pensions and benefits of Greek workers to the banks of France and Germany and through them to the “compensation packages” of people earning a hundred times more than the average Greek worker. It is redistribution of wealth, tout point. And that seems odd in a “free market” economy.

Posted by comments | Report as abusive

I echo the same sentiments as my fellow commentators: Mr. Summers, please stop writing. You have no advice to give. You are part of the problem. Your support for OTC derivatives, with your buddies Greenspan and Rubin, helped to spiral our economy out of control. Go back to your ivory tower.

Posted by represent90 | Report as abusive

Whatever his prior misdeeds, Summers does have a point: if we all keep on contracting, we go into a tailspin. But, after decades of debt-driven froth – at a time when we could easily have managed to cut back a bit – we now simply don’t have space left for Keynesian expansionism. There is no way we can avoid deleveraging and that is going to hurt us all (eventually including the BRICs) for some time to come. One would have thought that Japan taught us something, so maybe Summers could include this conundrum in his teaching during the next semester.

Posted by Lambick | Report as abusive

Summers is a shill for Wall Street, inflation, and phony greenbacks. He is as believable as “The Maestro” and his ilk of “Masters of the Universe.”

Posted by neahkahnie | Report as abusive

This is precisely how things are playing out with this administration. The Commission on Fiscal Responsibility and Reform laid out what steps needed to be taken to get control of our runaway debt. Unfortunately, the administration backed away from the agreement made on July 21st between Obama and Boehner that called for $4 trillion debt reduction and an increase in tax revenues of $800 billion. Now the President is calling for $1 trillion less.

Politicians seem all too interested in looking out for their next election. But as a parent and grand parent, I am far more concerned about future generations and my posterity in particular.

We drastically need to rout out the inefficiencies in government now . . . land begin the lengthy process eliminating our education deficit. The dropout rate in America is at historic highs, for high school as well as for college. If we don’t solve our education problem, we’ll decrease our global competitiveness . . . while increasing the wage disparity.

The NEW middle class will no longer work in factories, but in jobs that require more technical skills. Because of this gap in the middle, corporations are competing for average middle of the curve graduates thereby increasing their salaries. This causes the widened 50/90 gap, i.e., middling workers in the middle (with salaries higher than their true value) and the low-end workers in the 90th percentile.

Former Chief Economist for the International Monetary Fund, R. Ragan, enunciates the problem in a rather objective way in his book “Fault Lines”.

Posted by neilc23 | Report as abusive

Mr. Summers,

I just for the life of me don’t understand why your and Krugman always trying to solve this problem by throwing more money at the problem, or slack as you call it. Most of the developed countries have a structural debt problem and a lazy work ethic problem caused by (1) The social freebies from each government. (2) The inability of a government to refrain from thinking it always has the answers to the challenges faced in the public. (3) Lastly, but more poisonous than everything combined; Government has now become the sole entity that chooses which businesses can fail and which can not.

The problems we face today don’t have anything to do with ours or Europe’s decisiveness. It’s all about debt and the thought that someone in Government thinks that no one should be held accountable for their actions. The citizens who have been so unjustly given a free ride are responding as they have been taught too Mr. Summers.

Posted by RSDallas | Report as abusive

Mr. Summers has good enough advice once he satiated himself at the trough doesn’t he. But back when he could have made a difference, he was busy taking payment for creating this mess and could not be bothered worrying about the mess he was helping create as he counted his money. They all do this: make a fortune and then confess how troubled it had all been while they sit in comfort having reaped a profit while they built doom. The man should be in prison but if not, at least destitute like so many his action brought that upon. And the fool above who thinks recessions and depression are not a failure of demand but of supply (credit) needs to go back and study more and stop his myopic greedy thinking.

Posted by advocatusdiabol | Report as abusive

Another interesting piece Mr summers, and I see from reader responses just as inflammatory as earlier ones. That you’ve made policy mistakes in prior careers is undeniable, but that very vantage point is what I believe gives your words credibility today.

People don’t want truth, they want easy and we’re way past easy in attempting to dig ourselves, and by “ourselves” I mean the world, out of this dank dark deep hole we find ourselves in.

Raise some taxes, cut some dead weight, accept what is and move firmly and positively forward. If we’re going to eat this elephant we all have to take big bites.

Posted by CaptnCrunch | Report as abusive

When the sub-prime crisis flashed though the financial world, many banks lost billions of euros. The governments in the EU had to prevent these institutions to topple by lending again billions of euros. This was the beginning of the current recession and nothing else. American greed and – I call it fraudulent practices – from banks issuing sub-prime mortgages and selling those wrapped in financial packages to the worlds financial institutions caused all this and where we are now. Commentators and bloggers need to have an attention span of more than a few minutes to write valuable insights in my opinion.

Posted by Mahal | Report as abusive

@FoxxDrake-Well said!

@Summers-Where was the big-enough-to-get-it-done plan when you were around? You punted with just enough to keep in the game. To bash the Europeans for something you did as well is rather hypocritical, don’t you think?

Posted by thinkintoit | Report as abusive

Larry-”I Lost $1,800,000,000.00 for Harvard Betting on Derivatives”-Summers: He’s got some other serious claims to fame, Obama is considering him for the top post at the World Bank, he helped Alan Greenspan muzzle Brooksley Born who wanted to regulate derivatives in the 1990s. You can watch that here. I wouldn’t let Summers advise me on investing for my late dog. He must have been impressed with how Summers falls asleep at White House meetings. This year Larry is attacking “Capitalism” and says it needs to be reformed. We don’t have capitalism, if we did the banks that made decisions would have failed. We have Corporatcracy as I wrote about here and on this one site it got 145,000 reads which indicates that people–other than those at Davos–get this.”

Posted by devilliers123 | Report as abusive