Academic peeves revisited: Larry Summers edition

Another kind of academic shilling that really grinds my gears is when an academic/policy luminatus, who has lots of celebrity and political untouchability within academe, demands a stronger dose of the activism he originally implemented, which itself sowed the seeds of the current crisis. It is politically impossible for your typical risk-averse, but still quite ambitious young academic to point out the flaws of the argument, and the failures of the person who made it. So Larry Summers gets to pass off proven snake oil as a necessary policy remedy for the “problems” we’re facing.

Larry Summers, along with Robert Rubin and Alan Greenspan, originated the subprime economic policy with the Mexico bailout and the LTCM bailout.

Summers, you may recall, loudly banged the drums for monetization of banks’ debt (also known as “restoring the normal functioning of the financial system,” “restoring confidence in the markets,” and “improving the flow of information by restoring liquidity” among many others) back in August. I professionally predicted, as did many professionals with more intelligence and experience than myself, that rate cuts would do nothing to solve the problem, and would only socialize Wall Street’s losses, after Wall Street had privatized years of enormous gains.

I don’t have the credentials of Feldstein, Summers, or any of the other luminati who are fear-mongering their way to more Fed rate cuts–but I do have the cynicism to say that Wall Street knew this was coming, and knew it could count on narrowly brilliant, broadly useful idiots in academe and government to bail it out of its own collective fiasco.

Anyway, here’s Summers:

Three months ago it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth…

“Reasonable” to the willfully blind …

This is still a possible outcome but no longer the preponderant probability.

Even if necessary changes in policy are implemented, the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses than have been observed to date, moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.

Several streams of data indicate how much more serious the situation is than was clear a few months ago. First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. Single family home construction may be down over the next year by as much as half from previous peak levels. There are forecasts implied by at least one property derivatives market indicating that nationwide house prices could fall from their previous peaks by as much as 25 per cent over the next several years.

Recessions happen. People have been forecasting and investing on the basis of this inevitability for years. There is no “policy response” to stop it, no free lunch, and nothing wrong with the self-corrective process. Recessions are, by definition, “adverse” in the short term. They also sow the seeds of healthier long-term growth.

Free markets are an evolutionary mechanism. A necessary part of market evolution entails destruction of wasteful capital. This is Japan in the 1990’s, all over again–an aging establishment that would rather strangle its economy than come to grips with downward volatility. The rest of the world has better places to put its money than an America that is “exceptional” only in its refusal to hold its institutions accountable for mistakes.

Second, it is now clear that only a small part of the financial distress that must be worked through has yet been faced. On even the most optimistic estimates, the rate of foreclosure will more than double over the next year as rates reset on subprime mortgages and home values fall. Estimates vary, but there is nearly universal agreement that – if all assets were marked to market valuations – total losses in the American financial sector would be several times the $50bn or so in write-downs that have already been announced by big financial institutions. These figures take no account of the likelihood that losses will spread to the credit card, auto and commercial property sectors. Nor do they recognise the large volume of financial instruments that depend for their high ratings on guarantees provided by credit insurers whose own health is now very much in doubt.

Stupid choices were made. Stupid choices have painful consequences, sooner or later.

Third, the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. The extent of the flight to quality and its expected persistence was powerfully demonstrated last week when the yield on the two-year Treasury bond dropped below 3 per cent for the first time in years.

Mistakes accumulated, and deadwood must be cleared. Since American monetary institutions obviously have difficulty coping with this reality, foreigners have begun dumping dollars on a massive scale. All actors are rational, on one time horizon or another. Dollar holders will not wait for their dollars to be monetized by an American government-financial priesthood that believes itself above responsibility, and above short-term pain.

What concrete steps are necessary? First, maintaining demand must be the over-arching macro-economic priority. That means the Fed has to get ahead of the curve and recognise – as the market already has – that levels of the Fed Funds rate that were neutral when the financial system was working normally are quite contractionary today. As important as long-run deficit reduction is, fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens.

Remember how Bernanke “moved ahead of the curve” with that audaciously unexpected 50-50 cut in mid-September? How that was a one-time fix for a “temporary” “liquidity shock”? And now we need more fiscal liquidity pumping, as well as rate cuts?

Second, policymakers need to articulate a clear strategy addressing the various pressures leading to contractions in credit. Very likely this will involve measures that are non-traditional, given how much of the problem lies outside bank balance sheets. The time for worrying about imprudent lending is past. The priority now has to be maintaining the flow of credit. The current main policy thrust – the so-called “super conduit”, in which banks co-operate to take on the assets of troubled investment vehicles – has never been publicly explained in any detail by the US Treasury. On the information available, the “super conduit” has worrying similarities with Japanese banking practices of the 1990s that aroused criticism from American authorities for their lack of transparency, suppression of genuine market pricing of bad credits, and inhibiting effect on new lending. Perhaps there is a strong case for it, but that case has yet to be made.

Third, there needs to be a comprehensive approach taken to maintaining demand in the housing market to the maximum extent possible. The government operating through the Federal Housing Administration, through Fannie Mae and Freddie Mac, or through some kind of direct lending, needs to assure that there is a continuing flow of reasonably priced loans to credit worthy home purchasers. At the same time there need to be templates established for the restructuring of mortgages to homeowners who cannot afford their resets, so every case does not have to be managed individually.

How many times can you repeat “maintaining demand” in one article? Paleo-Keynesianism is alive and well in the United States ruling establishment. Welcome back to the 1970’s.

Charles Gave can rail all he wants about how “the euro is absurdly overvalued” and how “the dollar is poised for a rebound.” Like many establishment forecasters and financiers, he judges the euro to be extremely weak on the basis of demographics, ossified labor-market institutions, and other “long-run” “structural” factors.

That argument is entirely correct, but its time horizon is much longer than the one most investors are currently using. The engine of the euro’s appreciation against the dollar is the abysmal “performance” of the dollar and dollar-denominated assets (bonds) in global asset terms. This was an extremely predictable consequence of the Fed’s conscious monetization of The Global Savings Glut and The Liquidity Shock. The dangers of near-term dollar devaluation by the Fed to foreign investors are so much greater than the present value of Europe’s medium-term economic weaknesses, to the point that European structural factors are probably not on the international time horizon at all.

The ECB knows that credibility is its only remotely “long run” asset, and it is protecting its credibility as much as possible by resisting calls from Sarkozy et al. to devalue the euro. I am increasingly doubtful that the ECB will be able to resist political pressure to join the made-in-China bout of competitive currency devaluation, but at least the ECB is trying.

The latest Summers article is sadly reminiscent of the rhetorical shadowboxing between the Fed and policy “authorities” following Bernanke’s 50-50 September cut, and subsequent reluctance to cut further. Gray eminences of the market responded, both publicly and privately, that that was a woefully insufficient “policy response,” and that for myriad reasons It Was Different This Time. So the Fed caved. The article is also eerily reminiscent of American policy hubris in the 1970’s–the presumption that recession and inflation were but distant memories; the presumption that foreign investors had no choice but to put up with American fiscal profligacy; and the unspoken terror among the bipartisan political establishment of the political consequences of a sharp recession.

Financial commentators are herding to a consensus that the dollar’s depreciation is overwrought. Certainly, the dollar has depreciated quite a bit in the last three months. But that by itself is no more a legitimate forecast than are the “chartist” predictions of trend reversals based upon fibonacci ratios and resistance points, whom higher-ranking financial clergy so eagerly mock.

Instead, I have always striven to predict prices by predicting future events and expected marginal information. There is one external scenario which could arrest the dollar’s collapse (a political fracturing of the “Club Med” from the eurozone). But that is still a distant possibility. The other two major “shock” scenarios–a yuan revaluation and a Gulf-wide currency revaluation–are profoundly bearish for the dollar.

But in the meantime, Washington has shown every indication, at the fiscal and monetary policy levels, of accelerating dollar depreciation. Barring a surge in intra-European political risk (which would scare investors out of the euro even faster than they piled in), I believe that the dollar, after a burp in the near future to 1.46/euro or so, will continue its downward skid.

Gold is looking pretty good right now.