Summers Discusses Causes of Great Recession, Sounds Optimistic Note

From Summers' prepared remarks:

Economic downturns historically are of two types.  Most of those in post-World War II-America have been a by-product of the Federal Reserve’s efforts to control rising inflation.  But an alternative source of recession comes from the spontaneous correction of financial excesses: the bursting of bubbles, de-leveraging in the financial sector, declining asset values, reduced demand, and reduced employment.

Unfortunately, our current situation reflects this latter, rarer kind of recession.  On a global basis, $50 trillion dollars in global wealth has been erased over the last 18 months. This includes $7 trillion dollars in US stock market wealth which has vanished, and $6 trillion dollars in housing wealth that has been destroyed.  Inevitably, this has led to declining demand, with GDP and employment now shrinking at among the most rapid rates since the second World War.  4.4 million jobs have already been lost and the unemployment rate now exceeds 8 percent. 

Our single most important priority is bringing about economic recovery and ensuring that the next economic expansion, unlike it’s predecessors, is fundamentally sound and not driven by financial excess.

This is essential
. Without robust and sustained economic expansion, we will not achieve any other national goal.  We will not be able to project strength globally or reduce poverty locally. We will not be able to expand access to higher education or affordable health care. We will not be able to raise incomes for middle class families or create opportunities for new small businesses to thrive.  

And so today, I will explain the rationale behind the President’s recovery program and our strategy for long-term economic growth.    Our problems were not made in a day, or a month or a year, and they will not be solved quickly.  But there is one enduring lesson in the history of financial crises: they all end.  

I am confident that with the strong and sound policies the President has put forward and the passage of time, we will restore economic growth and regain financial stability, and find opportunity in this moment of crisis to assure that our future prosperity rests on a sound and sustainable foundation.

First, I’d like to describe how best to think about this crisis.  

One of the most important lessons in any introductory economics course is that markets are self-stabilizing.

  • When there is an excess supply of wheat, its price falls. Farmers grow less and others consume more. The market equilibrates. 
  • When the economy slows, interest rates fall. When interest rates fall, more people take advantage of credit, the economy speeds up, and the market equilibrates. 

This is much of what Adam Smith had in mind when he talked about the “invisible hand.” 

However, it was a central insight of Keynes’ General Theory that two or three times each century, the self-equilibrating properties of markets break down as stabilizing mechanisms are overwhelmed by vicious cycles.  And the right economic metaphor becomes an avalanche rather than a thermostat.  That is what we are experiencing right now. 

  • Declining asset prices lead to margin calls and de-leveraging, which leads to further  declines in prices.
  • Lower asset prices means banks hold less capital. Less capital means less lending. Less lending means lower asset prices.
  • Falling home prices lead to foreclosures, which lead home prices to fall even further. 

A weakened financial system leads to less borrowing and spending which leads to a weakened economy, which leads to a weakened financial system. 

Lower incomes lead to less spending, which leads to less employment, which leads to lower incomes. 

An abundance of greed and an absence of fear on Wall Street led some to make purchases – not based on the real value of assets, but on the faith that there would be another who would pay more for those assets. At the same time, the government turned a blind eye to these practices and their potential consequences for the economy as a whole. This is how a bubble is born. And in these moments, greed begets greed. The bubble grows.

Eventually, however, this process stops – and reverses.  Prices fall. People sell. Instead of an expectation of new buyers, there is an expectation of new sellers.  Greed gives way to fear. And this fear begets fear.

This is the paradox at the heart of the financial crisis
.  In the past few years, we’ve seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying. Today, however, our problem is exactly the opposite.

It is this transition from an excess of greed to an excess of fear that President Roosevelt had in mind when he famously observed that the only thing we had to fear was fear itself.  It is this transition that has happened in the United States today. 

What is the task of policy in such an environment?

While greed is no virtue, entrepreneurship and the search for opportunity is what we need today.  We need a program that breaks these vicious cycles. We need to instill the trust that allows opportunity to overcome fear and enables families and businesses to again imagine a brighter future. And we need to create this confidence without allowing it to lead to unstable complacency. 

While the economy is falling far short today, perhaps a trillion dollars or more short, we should never lose sight of its potential.  We have the most productive workers in the world, the greatest universities and capacity for innovation, an incredible amount of resilience, entrepreneurship, and flexibility, and the most diverse and creative population of any major economy.

One striking statistic suggests the magnitude of the opportunity that is before us in restoring our economy to its potential.  Earlier this week, the Dow Jones Industrial Average, adjusting for inflation according to the standard Consumer Price Index, was at the same level as it was in 1966, when Brookings scholars Charlie Schultze and Arthur Okun were helping to preside over the American economy. 

While there could be many ways to question this calculation, that the market would be at essentially the same real level as it was in 1966 when there were no PCs, no internet, no flexible manufacturing, no software industry, and when our workforce was half and our net capital stock was a third of what it is today, may be regarded by some as the sale of the century. For policy-makers, it suggests the magnitude of the gains from restoring sustained economic growth.

Producing recovery and harnessing these opportunities, however, will depend upon the choices we make now.  This is what the President’s program sets out to achieve.

Towards this end, the President is committed to an approach that moves aggressively on jobs, credit and housing, thereby attacking the vicious cycles I described earlier at each of their key nodes.  In this effort, he has insisted that we all recognize that the risks of over-reaction are dwarfed by the risks of inaction.