Lawrence Summers: ‘A Long Way From The 1970s’

Lawrence Summers, the former Treasury Secretary, is as well credentialed as anyone to assess the global credit crisis. He won the John Bates Clark award for best economist under 40, was chief economist at the World Bank and ran Harvard University. But that almost certainly didn't stop a gasp of relief that he hadn't been in office to witness a financial crisis like this one. NEWSWEEK's Adam B. Kushner chatted with him by telephone about the prospects for recession, and for a new era of tighter regulation. Excerpts:

NEWSWEEKr: Long recession, short recession or no recession?
SUMMERS: It's likely we're in a recession and that it will last less than a year, but that is some considerable distance from a certainty. The strains on the financial system associated with lack of capital make it more likely, based on historical parallels, that the recession will be protracted.

Protracted sounds like more than a year.
Many recessions occur because the Fed puts its foot on the brakes. In those, one can assume that when the Fed takes its foot off the brakes the recession will abate. Here, when the recession is generated from within the economy by the collapse of asset prices, it's much more difficult to gauge the length of the recession. No one in 1990 or '91 could have imagined how long Japan's economic problems would persist. The United States will not follow the same pattern, but even our experience in the early '90s suggests that when you have troubled financial institutions, recovery can be delayed.

How well have Fed chairman Ben Bernanke and Treasury Secretary Henry Paulson handled the crisis?
[They] have come to appreciate the gravity of the problem and have taken a range of strong actions: fiscal stimulus, monetary policy easing, very substantial Federal Reserve provisions of liquidity, emergency assistance to prevent a possible meltdown when Bear Stearns fell. More substantial interventions in the housing markets than the voluntary measures cheered on by the [Bush] administration will, I suspect, be necessary.

What about ripple effects worldwide?
Those who have held out hope for a decoupling between the rest of the world and the United States are likely to be disappointed. Our domestic, demand-led growth has enabled others to enjoy export-led growth. My guess is that the world economy as a whole is going to slow down this year, and the length and depth of that slowdown will depend very much on how the American economy performs.

Will developing economies do better than First World economies?
There are very strong internal factors that would explain why China and India will continue to grow more rapidly than the global economy. But even they are not independent of the global economy, and if it slows, their growth is likely to slow as well.

Should the government have bailed out Bear Stearns? Is there a moral-hazard problem?
I think the Fed had one fundamental decision to make: it was either going to do extraordinary, unprecedented things, or it was going to do the experiment of seeing what would happen to the financial system if a major [institution] fell apart. They made the right decision.

What is the lesson for other banks: Don't buy risky debt? Acquire liquidity sooner?
A fairly constant lesson in the financial industry is the importance of liquidity. It's not enough to have a positive net worth. One has to appear impregnable even if, for no rational reason, there is a rush to the exit by those who have lent you money. Those who walk near the edge by borrowing short term and maintaining low levels of capital are much more likely to be pushed into the abyss when stormy winds blow.

Is this the 1970s all over again?
Anyone who studies the economic history of the 1970s has to be struck by … the very high wage inflation—particularly in relation to slowing productivity growth. I don't see any evidence today of growing labor power or unsustainable wage demands. We're a long way from the 1970s. That doesn't mean that inflation is not a matter of concern, but the analogy is wrong.

Should we worry about foreigners snapping up ownership stakes in the banks?
Life is about choices. It would be better if our banks needed less capital. But given their needs, I don't think we have attractive alternatives to foreign investments. The key issues when you talk about foreign governments to me don't involve the word "foreign"; they involve the word "government." It's important to make sure that they are investing to maximize the value of their investments rather than pursue any kind of national strategic objective.