Davos needs to address uncertainty

By Lawrence Summers
January 23, 2012

The year has begun well in markets. Stock markets in 2012 are generally up, and European sovereigns have experienced less difficulty borrowing than many expected. And economic data, particularly in the United States, has come in ahead of expectations. So as President Obama prepares to give his State of the Union address, and as a large group of policymakers and corporate chiefs come together in Davos this week, there is if not a sense of relief at least some diminution in the sense of high alarm that has gripped the global community for much of the last few years. Yet anxiety about the future remains a major driver of economic performance.

The news coming from financial markets is in important ways paradoxical. On the one hand, interest rates remain very low throughout the industrial world. While this is partially a result of very low expected inflation, the inflation-indexed bond market suggests that remarkably low levels of real interest rates will prevail for a long time. In the United States, for example, the yield on 10-year indexed bonds has fluctuated around -15 basis points. That is to say: On an inflation-adjusted basis, investors are paying the government to store their money for 10 years! In Britain, inflation-linked yields are negative going out 30 years.

One might expect that with low real interest rates, assets would sell at unusually high multiples to projected earnings. If anything, the opposite is the case, with the S&P 500 selling at only about 13 times earnings. Stocks also appear cheap to earnings in historical perspective through much of the industrial world. And similar patterns are observed with respect to most forms of real estate.

The combination of low real interest rates and low ratios of asset values to cash flows suggests as a matter of logic an abnormally high degree of fear about the future. This could reflect expectations that earnings or other cash flows will rise more slowly than anticipated, or simply result from a higher discount associated with future earnings because of abnormally high uncertainty.

This idea that future uncertainties are driving financial markets is supported by the observation that in the recent period there has been a much stronger tendency than normal for higher interest rates to be associated with a stronger stock market and vice versa. This is exactly what one would expect in an economic environment like the present one — on days when people become more optimistic, both interest rates and stock prices rise as the expectation is of more profits and demand for funds.

This is in contrast to the usual situation, in which interest rates and stock prices often move in opposite directions because of reassessments about future fiscal and monetary policies, with expectations of higher rates driving down stock prices. For example, if an important driver of markets was confidence that foreigners would hold U.S. debt, one would expect to frequently see days when interest rates went up and the market went down as concerns rose, and vice versa when concerns declined.

Uncertainty about future growth prospects as a major driver of markets also correlates with other observations, such as the abnormally high level of cash sitting on corporate balance sheets, the reluctance of businesses to hire, and the sense that consumers are hesitant about discretionary big ticket purchases even as borrowing costs and capital goods prices are at near record lows.

All of this suggests that for the industrial world as a whole, the most important priority for governments must be giving confidence that recovery will continue and accelerate in the United States and that the downturn in Europe will be limited. How best to do this remains an area of active debate. At Davos and beyond there will be many who argue that top priority must be given to increasing business confidence and that government stimulus is useless at best and potentially counterproductive. There will be others — more economists than businesspeople — who will argue that top priority must be given to government stimulus and that issues about business confidence are red herrings.

Keynes saw through this sterile debate 75 years ago, writing to Roosevelt that either “the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees” or “public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money.” The right current approach involves borrowing from both contending lines of thought.

Government has no higher responsibility than insuring that economies have an adequate level of demand. Without growing demand, there is no prospect of sustained growth, let alone significant reduction in joblessness. And without growth and reduced unemployment, there is no chance of engineering reductions in government debt-to-income ratios. Of course risks of inflation, of promoting excessive risk-taking in the future, and of spending that is not ideally efficient need to be balanced. But the simple fact is that markets in the large concur with the judgment of individual business managers that increasing demand is the sine qua non of a return to economic health.

At the same time, businesses are understandably uncertain about their prospects after the events of recent years. This is not the right time to add unnecessarily to their worries. Except where the rationale is both urgent and compelling, new regulations that burden investment should be avoided. Inequality is a growing problem that will have to be addressed in the United States and beyond — it cannot be ignored. But there is the risk that policies introduced in the name of fairness that excessively burden job-creating investment could actually exacerbate the challenges facing the middle class. At a moment of substantial doubt about the functionality of government, government could do much to increase confidence in its functioning by devising a clear plan to better align spending and taxing once recovery is established.

By working both to directly increase demand and augment business confidence, governments have the best chance of creating economic recovery. At Davos and beyond that should be the near-term focus of economic debates.

PHOTO: People walk past the logo of the World Economic Forum (WEF) in front of the congress center in the Swiss mountain resort of Davos, January 22, 2012.  REUTERS/Arnd Wiegmann

9 comments

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I agree completely that “Government has no higher responsibility than insuring that economies have an adequate level of demand. Without growing demand, there is no prospect of sustained growth, let alone significant reduction in joblessness. And without growth and reduced unemployment, there is no chance of engineering reductions in government debt-to-income ratios.”

Having said that, I wonder if you could explain in a follow-up article why the US government has vigorously pursued legislative and tax policies that have handsomely rewarded investment in countries other than the US, which has undeniably resulted in “job outsourcing” on a massive scale (especially of our vital manufacturing industries) for the past 30+ years, such that the middle class US consumer demand has essentially disappeared as a factor in our economy?

It is a given that without immediate and meaningful job growth (i.e. manufacturing jobs, which bring in real revenue) being restored to the US once again, there can be no recovery of any kind.

What do you think the US government should do at this moment — in terms of trade legislation and tax policies, specifically — to reverse this trend that has devastated our economy?

PseudoTurtle
CPA/MBA

Posted by Gordon2352 | Report as abusive

On the contrary, I disagree that “Government has no higher responsibility than insuring that economies have an adequate level of demand. Without growing demand, there is no prospect of sustained growth, let alone significant reduction in joblessness.”

I think government’s highest responsibility is to ensure the health and safety of its citizens. Our health and safety is not necessarily linked to demand or growth, and in fact, our health and safety often suffer as a result of unchecked growth.

The concept of sustained growth is a toxic, cancerous concept. The goal of a tumor is to grow without limitation, using up all available resources in the pursuit of just one thing: unchecked growth. In doing so, the tumor eventually kills its host. Contrast that tumor with a healthy cell, which maintains a process of homeostasis. The human body undergoes a period of rapid growth, but after adolescence there is a plateau. Following that, there is a decline in which the body slows down and eventually dies. Then, a new generation has its chance.

The very phrase “sustained growth” is a contradiction in terms, because growth can only occur with adequate natural resources, and our natural resources – though extremely robust and surprisingly resilent – cannot support infinite, unchecked growth. Imagine if humans continued to grow until all available resources were consumed. Eventually the situation would become untenable. Giants battling for diminishing returns increasingly scarce resources. And that’s exactly what we see today on the world stage.

No, the idea of “sustained growth” is obsolete. It’s 20th century capitalism, and anyone who supports the idea – a proven failure, evident in our currently broken system – is still thinking inside the box. The mindless and irrational drive towards “sustained growth” is _the_ reason for the current state of things. It’s wrecked formerly stable economies, changed the climate, and made much of the natural world unfit for habitation or resource extraction. Growth will not fix anything. It just pushes catastrophe further into the future. The natural world can only give so much and it’s clear that we’re already stepping past those limitations and turning into a tumor that is quite obviously destroying its host.

The old Einstein quote comes to mind: “We can’t solve problems by using the same kind of thinking we used when we created them.” The big minds of Mr Summers’ generation created the problem and, since it seems that their thinking is unlikely to change, I’m skeptical that they will be able to find solutions.

Posted by Nullcorp | Report as abusive

Meanwhile, over on planet Reuters Mohamed El-Erian is coming closer to the truth when he says:

“In either case, these key players do not want to give up control of their narratives, and they certainly do not wish to delegate any meaningful part of their personal agenda to Davos…”

http://blogs.reuters.com/mohamed-el-eria n/2012/01/17/davos-at-a-distance/

For some reason I think El-Erain is all around a better Economic, Financial, and Political analyst than Larry Summers. Can’t quite put my finger on why…

Posted by ARJTurgot2 | Report as abusive

Humankind is presented with an incredible and unprecedented situation. We are spectacularly successful at doing something potentially ruinous of all we claim to be protecting and preserving by ever increasing natural resources exploitation and continually increasing food production. Stupidly we hold fast to a wicked delusion that, if we do NOT do these things, a catastrophe will follow. This upside down, delusional thinking is leading us to precipitate a disaster of some unimaginable sort because the continuous exploitation of limited resources, including continually increasing food production to feed a growing population, is precisely what is actually causing humanity to careen toward a colossal global ecological wreckage.

Posted by stevensalmony | Report as abusive

Summers continually regurgitates the traditional economic viewpoint that growth is the primary goal. Rather that taking the current economic crisis as an opportunity to re-orient our focus to enhancing the common wealth he opts to continue down the path of squeezing the last bit of profit out of an increasingly dysfunctional system. When our measure of success is the number of Steve Jobses that are produced we neglect the truth in the statement:

“The test of our progress is not whether we add more to the abundance of those who have much; it is whether we provide enough for those who have too little.” FDR

Posted by tcolgan001 | Report as abusive

This article is a bit disgusting in the shameless call on the government to help on demand creation on one side while asking for it to back off on regulations (for ethical compliance and other) on the other side.

This is what analytics and growth addiction craves for, once it gets used to the recent quick gains at the cost of local systems and their competitiveness.

Posted by Mott | Report as abusive

How can confidence in our economic future thrive in the face of the colossal failures in risk evaluation that precipitated the financial crisis of 2008?

The recent years have starkly demonstrated that decision making in human organizations superseded the human mind’s inherent penchant for prudence with devastating consequences. The responsibility does not rest only with government. Before confidence in the economy can be restored globally, vital financial institutions also of the private sector need to devise improved tools for realistic risk assessment. Perhaps a sharp look at nature may help. Much can be learned from the simple behaviors of a little toad.

Read more here:
http://brainmindinst.blogspot.com/2011/1 2/professor-ewerts-toad.html

Posted by PeterMelzer | Report as abusive

With all due respect, Mr. Summers is wrong. He and his financial economist friends need to read the brillinant exposition of uncertainty and risk–not academic analyses of it–by the former and late University of Chicago economics department head for some thirty years: http://www.econlib.org/library/Knight/kn RUP6.html#Pt.III,Ch.VII

The alpha-males of finance have so far managed to use Regulatory Capture, a concept for which Prof. Knight’s student George Stigler earned a Nobel Prize, to “manufacture” certainty that they can then use to their advantage and as a condition for supporting healthy economic growth. Game over.

Posted by DrPatil | Report as abusive

Quite possibly, consumers cannot afford to pay for the “adequate level of demand,” deemed necessary to generate a vibrant economy. A more realistic view is that the world has limited per-capita growth potential, rising population, diminishing real resources, and considerable population aging. Consumers would do well to save more, cut back spending, and anticipate a nation of diminished personal wealth. With all that, citizens will be among the wealthiest in human history, with levels of comfort and health undreamed of by the richest rulers of centuries past.

Posted by Marvinlee | Report as abusive