Opinion

Lawrence Summers

Why the UK must reverse its economic course

Lawrence Summers
Sep 17, 2012 11:32 UTC

It is the mark of science and perhaps rational thought more generally to operate with a falsifiable understanding of how the world operates. And so it is fair to ask of the economists a fundamental question: What could happen going forward that would cause you to substantially revise your views of how the economy operates and to acknowledge that the model you had been using was substantially flawed? As a vigorous advocate of fiscal expansion as an appropriate response to a major economic slump in an economy with zero or near-zero interest rates, I have for the last several years suggested that if the British economy – with its major attempts at fiscal consolidation – were to enjoy a rapid recovery, it would force me to substantially revise my views about fiscal policy and the workings of the macroeconomy more generally.

Unfortunately for the British economy, nothing in the record of the last several years compels me to revise my views. British economic growth post-crisis has lagged substantially behind U.S. growth, and the gap is growing. British GDP has not yet returned to its pre-crisis level and is more than 10 percent below what would have been predicted on the basis of the pre-crisis trend. The cumulative output loss from this British downturn in its first five years exceeds even that experienced during the Depression of the 1930s. And forecasts continue to be revised downward, with a decade or more of Japan-style stagnation now emerging as a real possibility on the current course.

Whenever policy is failing to achieve its objectives, as in Britain today with respect to economic growth, there is a debate as to whether the right response is doubling down – perseverance and intensification of the existing path – or recognition of error or changed circumstances and a change in course. In Britain today such a debate rages with respect to the aggressive fiscal consolidation that the government has made the centerpiece of its economic strategy.  Until and unless there is a substantial reversal of course with respect to near-term fiscal consolidation, Britain’s short- and long-run economic performance is likely to deteriorate.

An effective policy approach to Britain’s economic problems must start with the recognition that the principal factor holding back the British economy over both the short- and medium-term is the lack of demand. It is certainly true that Britain faces important structural issues, ranging from difficulties in promoting innovation to deficiencies in the system of worker training. But it is apparent from the relatively low level of vacancies, the reluctance of workers to leave jobs, the pervasiveness across industries and occupations of increased unemployment and the testimony of firms regarding the formation of their investment plans that it is lack of demand that is holding the economy back from producing as much as it could.

Keynes writing during the Depression compared Britain’s economic problems to a “magneto” problem, referring to the fact that a car might have many infirmities, but if its electrical system did not work, the car would not go, and if it were fixed, the car would go even with other problems. So it is today. Moreover, to an extent that is greatly underappreciated in the policy debate, short-run increases in demand and output would have medium- to long-term benefits as the economy reaps the benefits of what economists call hysteresis effects. A stronger economy means more capital investment and fewer cutbacks to corporate R&D; it means fewer people lose their connection to good jobs and get addicted to living without work; it means that more young people get first jobs that put them on ladders to success; and it means more businesses choose leaders oriented to expansion rather than cost-cutting. The most important structural program for raising Britain’s potential output in the future is raising its actual output today.

The debate about shrinking government is mostly wishful thinking

Lawrence Summers
Aug 19, 2012 15:52 UTC

With the selection of Paul Ryan as the Republican vice-presidential candidate, it is clear both political parties agree that the central issue in the coming presidential election will be the scale and scope of government involvement in the U.S. economy. There will be disagreement over what constituted “normal” levels of spending in the past and indeed over what constitutes “spending.” But there is a widespread view in both parties that it is feasible and desirable that in the future the federal government will be no larger as a share of the overall economy than it has been historically.

Unfortunately, this aspiration is unlikely to be achieved. Even preserving the amount of government functions the U.S. had before the financial crisis will require substantial increases in the share of the economy devoted to the public sector. This is the case for several structural reasons.

First, demographic change will greatly expand federal outlays unless politicians decide to degrade the level of protection traditionally provided to the elderly. Between Social Security, Medicare and Medicaid, and other smaller programs, about 32 percent of the U.S. federal budget, or about 7.7 percent of gross domestic product, is devoted to supporting those over 65. The ratio of this age group to those of working age will rise from 1:4.6 to 1:2.7 over the next generation, implying an increase in federal spending of 5.6 percentage points of GDP, if no other adjustments are made. True, as Americans’ health and life expectancy improve, it may be appropriate to revise upward the assumed retirement age. However, it will be unlikely to counteract the expected 34 percent increase over the next generation in the share of the population that will be within 15 years of estimated life expectancy.

Focus on equality of opportunity, not outcomes

Lawrence Summers
Jul 15, 2012 21:52 UTC

Even if the process of economic recovery proves protracted, the American economy will eventually recover, and cyclical issues will cease to dominate the economic conversation. It is likely that issues relating to inequality will move to the forefront. There is no question that income is distributed substantially more unequally than it was a generation ago – with those at the very top gaining share as even the upper middle class loses ground in relative terms. Those with less skill, especially men who in an earlier era would have worked with their hands, are losing ground, not just in relative but in absolute terms.

These issues frame an important part of the economic debate in this election year. Progressives argue that widening inequality jeopardizes the legitimacy of our political and economic system. They contend that at a time when the market is generating more inequality, we should not be shifting tax burdens from those with the highest incomes to the middle class, as has taken place over the last dozen years. And while they recognize that Steve Jobs earned his billions providing great value to consumers and making a substantial contribution to the American and global economies, they also point out that the social value associated with the activities giving rise to many other fortunes, especially in the financial sector, is less apparent.

Conservatives argue that in a world where everything is increasingly mobile, high tax rates run more risk of driving businesses and jobs overseas than they once did. They point out the central role of entrepreneurship in advancing economic growth and note that since most new ventures fail, the returns of success have to be very large if entrepreneurship is going to flourish. They take umbrage at the suggestion implicit in some political rhetoric on inequality that there is something wrong with success on a grand scale. And they worry that policy measures taken to directly combat inequality will have perverse side effects.

Europe must be persuaded to make a permanent fix

Lawrence Summers
Jun 18, 2012 19:37 UTC

As the G20 leaders prepare to conclude their meeting today, once again good news has had a half-life in the markets of less than 24 hours. Just as news of European plans to stand behind Spanish banks rallied markets and sentiment for only a few hours, a Greek election outcome that was as good as could have been hoped did not even buoy markets for a day. There could be no clearer evidence that the current strategy of vowing that the European system will hold together, addressing each crisis as it comes in the minimally sufficient way and vowing at every juncture to build a system that is sound in the long term has run its course.

Nor is the G20 likely to change anything, at least not immediately. The troubled European economies and their sympathizers will demand more emphasis on growth, lower interest rates on their official debts and more transfers. The Germans will show sympathy with the objective of reform but will insist that financial integration must coincide with political integration, noting that no one gives away a credit card without maintaining control over its use. And the rest of the world will express exasperation with Europe’s failure to get its act together and demand that more be done. Officials blessed with more diplomatic ability than economic insight or courage will produce a communiqué that politely expresses a measure of satisfaction with steps under way, recognizes the need to do more, and looks forward to continued coordination and dialogue. The only good thing is that expectations are so low that this is not likely to disappoint the markets very much.

The unfortunate truth is that European debtors and creditors are both right in their main lines of argument. The borrowers are right that austerity and internal devaluation have never been a successful growth strategy, certainly not in an environment where major trading partners are stagnating. The suggested counterexamples, where fiscal consolidations have preceded growth, involve either stagnation relative to previously attained levels of income (Ireland and the Baltics) or buoyant demand associated with surging export demand, increasing competitiveness and low borrowing costs (many euro members in the early years). They are also right in their claim that even a previously healthy economy will quickly become very sick if forced to operate for several years with interest rates far above growth rates, as is the case across Southern Europe. And experience is clear in suggesting that structural reform is always difficult and slow-acting but much more difficult when an economy is contracting and there is no sector to absorb those displaced by reform.

Those chary of institutionalizing financial integration without major political integration are right as well. A sound system must involve those with deep pockets who are on the hook for liabilities, either as borrowers or guarantors, having control over borrowing decisions. A system where I borrow and you repay is a prescription for unsustainable profligacy. This is why there is now so much discussion of eurobonds and Europe-wide deposit insurance being linked with much deeper political integration. But there are two problems that lie behind the soft references to greater integration. The first is the question of who really has control. If decisions are to be made on a genuinely euro-area basis, it is far from clear, especially after the French election, that there is any kind of majority or even plurality support for responsible policies. If the idea is that the euro area’s future will be on the ECB model – a European façade behind which Teutonic policies are pursued – it is far from clear that this will or should be acceptable across the continent.

Breaking the negative feedback loop

Lawrence Summers
Jun 3, 2012 22:36 UTC

With the past week’s dismal U.S. jobs data, signs of increasing financial strain in Europe, and discouraging news from China, the proposition that the global economy is returning to a path of healthy growth looks highly implausible.

It is more likely that negative feedback loops are again taking over as falling incomes lead to falling confidence, which leads to reduced spending and yet further declines in income. Financial strains hurt the real economy, especially in Europe, and reinforce existing strains. And export-dependent emerging markets suffer as the economies of the industrialized world weaken.

The question is not whether the current policy path is acceptable. The question is, what should be done? To come up with a viable solution, consider the remarkable level of interest rates in much of the industrialized world. The U.S. government can borrow in nominal terms at about 0.5 percent for five years, 1.5 percent for 10 years, and 2.5 percent for 30 years. Rates are considerably lower in Germany, and still lower in Japan.

Austerity has brought Europe to the brink again

Lawrence Summers
Apr 30, 2012 02:13 UTC

Once again European efforts to contain crisis have fallen short. It was perhaps reasonable to hope that the European Central Bank’s commitment to provide nearly a trillion dollars in cheap three-year funding to banks would, if not resolve the crisis, contain it for a significant interval. Unfortunately, this has proved little more than a palliative. Weak banks, especially in Spain, have bought more of the debt of their weak sovereigns, while foreigners have sold down their holdings. Markets, seeing banks holding the dubious debt of the sovereigns that stand behind them, grow ever nervous. Again, Europe and the global economy approach the brink.

The architects of current policy and their allies argue that there is insufficient determination to carry on with the existing strategy. Others argue that failure suggests the need for a change in course. The latter view seems to be taking hold among the European electorate.

This is appropriate. Much of what is being urged on and in Europe is likely to be not just ineffective but counterproductive to maintaining the monetary union, restoring normal financial conditions and government access to markets, and re-establishing economic growth.

The general election’s political calculations

Lawrence Summers
Apr 26, 2012 22:45 UTC

Arithmetic done under the constraints of politics is always suspect, and one should always examine carefully the claims of those seeking votes. But smart observers have learned to distinguish between the claims of political candidates and their advisers on the one hand, and proposals that have been evaluated by independent scorekeepers like the Congressional Budget Office on the other.

This principle has never been better illustrated than by the “budget analysis” put forward by Governor Romney’s chief economic adviser, Glenn Hubbard, in a recent Wall Street Journal column. Hubbard constructs a budget plan he imagines that President Obama might propose someday, engages in a set of his own extrapolations and then makes a set of assertions about it. He does not discuss President Obama’s actual plan or how it has been evaluated by the CBO. Nor does he invest his credibility in defending the claims that Governor Romney has made regarding his own fiscal plans – he simply states that, “Yes, President Obama and Mitt Romney have budgets with competing visions. But Governor Romney’s budget makes tough choices…” without delving into the specifics or trade-offs that Romney’s “tough choices” entail.

President Obama put forward a plan earlier this year that would reduce deficits by more than $4 trillion over the next decade. It would bring discretionary spending to its lowest levels since the 1960s. It includes $2.50 in spending cuts for every $1 in additional revenue. It also asks everyone to pay their fair share of taxes, repealing the Bush tax cuts for families making more than $250,000, and closing loopholes and shelters like preferences for private jets, hedge fund managers and offshore investments.

It’s too soon to return to normal policies

Lawrence Summers
Mar 26, 2012 00:00 UTC

Economic forecasters divide into two groups: those who cannot know the future but think they can, and those who recognize their inability to know the future. Shifts in the economy are rarely forecast and often not fully recognized until they have been under way for some time. So judgments about the U.S. economy have to be tentative. What can be said is that for the first time in five years a resumption of growth significantly above the economy’s potential now appears as a substantial possibility. Put differently, after years when the risks to the consensus modest-growth forecast were to the downside, they are now very much two-sided.

As winter turned to spring in 2010 and 2011, many observers thought they detected evidence that the economy had decisively turned, only to be disappointed a few months later. A variety of considerations suggest that this time may be different. Employment growth has been running well ahead of population growth. The stock market level is higher and its expected volatility lower than at any time since the crisis began in 2007, suggesting that the uncertainty hanging over business has declined. Consumers who have been deferring purchases of cars and other durable goods have created pent-up demand. The housing market seems to be stabilizing. For years now, the rate of family formation has been way below normal as young people moved in with their parents. At some point they will set out on their own, creating a virtuous circle of a stronger housing market, more family formation and demand, and further improvement in housing conditions. Innovation around mobile information technology, social networking and newly discovered oil and natural gas is likely, assuming appropriate regulatory policies, to drive significant investment and job creation.

True, the risks of high oil prices, further problems in Europe, and financial fallout from anxiety about future deficits remain salient. However, unlike in 2010 and 2011, it is probable that these risks are already priced into markets and factored into outlooks for consumer and business spending. There has already been a significant escalation in oil prices. The European situation is hardly resolved but is unlikely to deteriorate as much in the next months as it did last year. And market participants report great alarm about the deficit situation. So it would not take great news in any of these areas for them to actually contribute to upward revisions in current forecasts.

Time nears for an American tax overhaul

Lawrence Summers
Feb 26, 2012 22:35 UTC

However the U.S. presidential election turns out, the trifecta of the Bush tax cut expiration, the debt limit ceiling on the horizon once again, and the Congressionally mandated sequesters – cuts in domestic spending – will force the president and Congress to wrestle with fiscal issues either in a lame duck session after the election or in early 2013. The decisions they make will have profound impacts on America’s fiscal future.

For many observers, the central question on the table is about entitlement programs: What will be done with them? Growth in entitlement spending associated with our aging population and its rising health care costs is the major factor in overall federal spending growth. But the capacity of near-term policy changes to have large impacts on that spending is less than many would suppose. The rising ratio of retirees to workers means that Social Security benefits at current levels will not be sustainable without some kind of tax increase. Sooner or later, revenue will have to rise or else outlays will have to be curtailed. While it is surely better to act sooner, the reality is that, out of necessity, action on entitlements is inevitable.

While almost everyone agrees on the desirability of containing federal health care spending, this is likely to be more difficult than we’d like to believe. Certainly beneficiaries can bear more of the cost of their government insurance than others, and there are steps like malpractice reform and the further encouragement of preventive medicine that should be taken. Yet without intrusions into the private health care system that are unlikely to be politically acceptable, there are severe limits on what can be done. Otherwise the result will be unacceptable cuts in the availability of care for the clients of federal programs. Given all the uncertainties associated with new technologies, changing lifestyles, and ongoing changes in the private system, health care reform will and should be a continuing project.

Davos needs to address uncertainty

Lawrence Summers
Jan 23, 2012 17:01 UTC

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.

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