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. 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 ... 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 ... 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.
So Secretary Summers attributes our current predicament to the collapse of the housing bubble; the fact that the contagion has not yet fully propagated through the global financial system; and the continuation of a flight to quality in credit markets, making liquidity scarce just when troubled banks need it most. I agree.
Dr Summers' remedies:
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 recognize—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 ... 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 ... Third, there needs to be a comprehensive approach taken to maintaining demand in the housing market to the maximum extent possible. The government [directly or indirectly] needs to assure that there is a continuing flow of reasonably priced loans to credit worthy home purchasers.
Summers thus identifies a solution in three parts: More aggressive Fed funds rate lowering; a strategy to reduce portfolio-liquidation pressures (he cites the so-called super conduit, but he is, as I am, skeptical); and a plan to bolster credit for homebuyers.
All of this may not be enough to avert a recession. But it is much more than is under way right now.
Secretary Summers is as astute an observer as anyone, and his policy prescriptions make sense, so what is the hold up?
First, I do not believe that monetary policy, particularly from The Fed's view, is quite so unambiguous. Inflation still looms, not helped by surging oil prices. Moreover, Chairman Bernanke readily makes clear his determination to brutally club long-term inflation, prioritizing a stable price level well before a growing economy (although the market is pricing in a rate cut, and the fact that Wall Street thinks Bernanke is bluffing only forces his hand). The Fed has shown themselves an able steward of the money supply. Chairman Bernanke has a longer term mandate than next quarter's earnings reports, and nothing as-of-yet suggests they won't strike the right balance.
It is also politically risky to start trashing the economy: No one wants to use the R word. While the incumbent party is least likely to diss the product of their own policies, no major candidate has made preventing (or recovering from) an economic downturn part of his or her stump speech. Indeed, the Democrats are still arguing for a more equitable distribution of benefits from the allegedly-booming economy. That talk will end, as will calls to lower the deficit and raise taxes (both politically harder and economically less wise), if the economy gets ugly.
Methods to bolster credit and protect portfolios from a fire sale have the right intention, but it is not clear to me what steps would best realize that goal. We do not want to continue to fuel an asset bubble. For example, Florida is considering laws to implement property tax portability, allowing homeowners to take their tax liability with them when they move homes. This sounds like a boon to consumers, but the policy will have the unintended effect of maintaining Florida's absurd home prices. It should not be surprising that homebuilders are the bill's largest supporters.
We also do not want to create a moral hazard by bailing out imprudent investments. If Wall Street can coordinate a rescue fund amongst themselves—and if anyone can arrange that, its Secretary Paulson—the lack of government involvement mitigates that risk. But the details on that plan are meager; Dr Summers is correct to call for a clear explanation.
Nor do we want a knee-jerk painting of new legislation across the regulatory landscape. To be sure, a refactoring of current lending regulation is needed. Regulation should be based around the credit type, and not the credit lender—from brokers to thrifts, varied institutions issued subprime mortgages, each subject to different Federal regulation, some subject to none at all. This mosaic needs to be replaced with a single Federal regulator, with clear-cut rules and an understanding of modern debt instruments. But these changes need to be made cautiously, striking a balance between consumer protection and market efficiency.
Intrade is pricing the risk of recession in 2008 at 47%, and that presupposes any policy action. This is a big jump in just the last few months; the pricing was at 30% as recent as August. With nearly even odds, it is well past time to rejigger your asset allocation.