Saturday, December 1, 2007

Recession Watch: Buiter vs. Summers

Lawrence Summers is worried - like totally having a cow, as we used to say - about the subprime mortgage crisis and attendant credit crunch. In the a column for the Financial Times, he wrote:
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.
Summers calls for monetary and fiscal policy need to stimulate aggregate demand:
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.
The Fed may be seeing things the same way - markets responded positively to a hint that the fed may lower the federal funds rate at its Dec. 11 meeting. The Times reported:
Speaking one day after another top Fed official signaled that policy makers might have to reduce interest rates to head off trouble, Mr. Bernanke pledged that the Fed would remain “exceptionally alert and flexible” in setting policy.
Maybe they're just stretching, and drinking more coffee? Amidst all this freaking out, the BEA reports that the US economy grew at an annual rate of 4.9% in the third quarter (revised upward from the preliminary estimate of 3.9%, Ecconbrowser breaks down the numbers). A growth rate like that is normally cause for concern that the economy is "overheating," to which the Fed would respond by raising rates. Willem Buiter offers an incisive, contrarian assessment of the US economic situation under the headline "Should the Fed raise interest rates?":
Judging from the noise, moans and calls for policy relief coming from the financial sector, one could be forgiven for believing that the end of the world is neigh. It's not...

The good news in all this is that much of the financial sector has become quite detached from the real economy. The implosion of much of this formerly privately profitable but never socially productive financial intermediation will have little if any adverse macroeconomic effect. Many, perhaps most, financial institutions today are engaged in a gigantic, worldwide game of musical chairs in which vast fortunes are won and lost every day, but nothing of macroeconomic significance happens...

All the Sturm und Drang in the financial sector today only matters from a macroeconomic perspective, if it has a material effect on household consumption and on household and corporate investment. In my view, rather little of it does.

He goes on to argue directly against Summers, making a case that fiscal and monetary policy should not be used stimulate consumption now because a shift away from consumption into saving is exactly what's needed to correct the current account deficit:

There can be no doubt that private consumption expenditure (about 70% of US GDP and also by far the most stable component of GDP) is going to weaken significantly. And so it should. The long-overdue and necessary increase in the US private saving rate is a necessary domestic counterpart to the long-overdue and necessary reduction in the US external trade deficit, which is the contribution of the US (necessary and long overdue) to global rebalancing....

Surely the time for a consumption slump in the US is now, when the weakness of the US dollar and the strength of global demand will mitigate the impact on aggregate demand and employment? If not now, then when or under what circumstances?

And he also has harsh words for the Fed:

Throughout the crisis, the Fed's communication policy with the markets has been atrocious. My fear is that this communication policy mess reflects a deeper confusion/disagreement in the Fed about how to respond to the crisis, and about both the ultimate and the proximate objectives of monetary policy.
In addition to communicating poorly, Buiter believes the Fed is too responsive to financial markets:
They fear a large fall in the stock market; they fear financial market turmoil; and they can be moved to cut rates if there is a sufficient crescendo of anguished voices from the financial markets and money centre banks. We all know that the Great Depression of the 1930s started with a stock market collapse and was aggravated by bank runs and a misguided monetary policy. The collapse of the multilateral trading system was the final nail in the coffin. Perhaps our central bankers have studied the 1930s too much.
Ouch. That's a swipe at Bernanke, who was a noted academic expert on the depression before becoming Fed chair.

On a related note, Economists' View has a useful summary of a recent speech by St. Louis Fed President William Poole, defending the Fed against the accusation that it is too concerned with bailing out financial markets.

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