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Larry Summers: What is to be done?

FT editorial on the importance of rapid and flexible IMF action titled "All the world's a stage as fear grows":

During past crises, the fund demanded tough cuts in budget deficits, privatisation of industries and liberalisation of markets. In light of the response of the US and western Europe to the current crisis, such conditions are clearly not tenable now. The IMF has to soften its stance and there are encouraging signs that it is prepared to do so.

The speed at which risks are spreading is such that timely action from the fund is paramount. Knowing that it would act swiftly should shore up confidence – a rare commodity at the moment.

But is the IMF ready for large-scale rescues? It has about $207bn directly available for loans, and could draw on another $53bn. Compared with recent banking bail-outs in high-income countries, this is not very much. In the Asian crisis the fund lent only about $36bn, but a lot more came from countries that could now prove harder to tap.

If rescues remain confined to smaller economies, such as Iceland, Hungary, Ukraine, Belarus and Pakistan, the IMF coffers should suffice. But the fund may not have the resources to deal with several large economies, say Brazil or Turkey, at the same time. Bigger countries are holding up, but contingencies need to be in place in these extraordinary times. Asian reserves and those of oil exporters could be used as further stabilising devices, in return for overdue IMF reform.

Harvard economist Dani Rodrik on the importance of prompt IMF action:

Paul Krugman frets that we are about to witness the mother of all currency crises in emerging markets, and I am afraid that he is right. As I wrote in my previous post, the financial crisis in the developing world has just started and there are indications that it will get a lot, a lot worse. What is different with this phase of the crisis is that it cannot be addressed by governments in the affected countries issuing their own fiscal guarantees and domestic currency. These countries need external lines of credit, and they need it fast before the scale of the problem becomes truly unmanageable.

The solution is clear. The IMF, possibly along with central banks of the G7, has to act as a global lender of last resort to emerging markets. These countries have to have ample access to liquidity in reserve currencies--quickly and with few strings attached--for them to be able to fend off what may otherwise become a historic rout of their currencies. And China should join in: it should make a portion of its near-$2 trillion of reserves available in support of this global enlargement of credit lines.

Emerging markets have every right to say that they are being swept under by a crisis that is not their own doing. But the real reason the rest of the world needs to move on this front is naked self-interest. Combine a deep recession in the advanced countries with an uncontrolled depreciation of emerging-market currencies, and the pressure to erect trade barriers in the U.S. and Europe will be impossible to withstand. A vicious cycle of unemployment and protectionism feeding on each other a la 1930s could transform the deep recession everyone is already expecting into a second great depression. It can get worse...

And with this bit of good news just in, Dominique Strauss-Kahn should have no distractions to prevent him from focusing on this most urgent task. There are some reports that the IMF is moving in this direction. I have a feeling that this will be the make-it-or-break-it week for emerging markets. I hope the IMF will make an announcement in time to make a difference.

Krugman column from today titled "The Widening Gyre" (here's the NYT story Krugman mentions below on US banks hoarding cash titled "So When Will Banks Give Loans?" and here's an earlier Joe Stiglitz column on why the Paulson plan was far too generous to the banks without enough government control):

Even as Mr. Paulson and his counterparts in other countries moved to rescue the banks, fresh disasters mounted on other fronts.

Some of these disasters were more or less anticipated. Economists have wondered for some time why hedge funds weren't suffering more amid the financial carnage. They need wonder no longer: investors are pulling their money out of these funds, forcing fund managers to raise cash with fire sales of stocks and other assets.

The really shocking thing, however, is the way the crisis is spreading to emerging markets — countries like Russia, Korea and Brazil.

These countries were at the core of the last global financial crisis, in the late 1990s (which seemed like a big deal at the time, but was a day at the beach compared with what we're going through now). They responded to that experience by building up huge war chests of dollars and euros, which were supposed to protect them in the event of any future emergency. And not long ago everyone was talking about "decoupling," the supposed ability of emerging market economies to keep growing even if the United States fell into recession. "Decoupling is no myth," The Economist assured its readers back in March. "Indeed, it may yet save the world economy."

That was then. Now the emerging markets are in big trouble. In fact, says Stephen Jen, the chief currency economist at Morgan Stanley, the "hard landing" in emerging markets may become the "second epicenter" of the global crisis. (U.S. financial markets were the first.)

...It was good news when Mr. Paulson finally agreed to funnel capital into the banking system in return for partial ownership. But last week Joe Nocera of The Times pointed out a key weakness in the U.S. Treasury's bank rescue plan: it contains no safeguards against the possibility that banks will simply sit on the money. "Unlike the British government, which is mandating lending requirements in return for capital injections, our government seems afraid to do anything except plead." And sure enough, the banks seem to be hoarding the cash.

Nobel economist Joe Stiglitz Time Magazine column titled "How to Get Out of the Financial Crisis":

The Administration has veered from one half-baked solution to another. Wall Street panicked, but so did the White House, and in that panic, they had a hard time figuring out what to do. The weeks that Paulson and Bush spent pushing Paulson's orignal bailout plan — in the face of massive opposition — were weeks that could have been spent actually fixing the problem. At this point, we need a comprehensive approach. Another failed faint attempt could be disastrous. Here's a five-step, comprehensive approach:

1. Recapitalize banks. With all the losses, banks have insufficient equity. Banks will have a hard time raising this equity under current circumstances. The government needs to provide equity. In return, it should have voting stakes in the banks it helps. But equity injections also bail out bondholders. Right now the market is discounting these bonds, saying there is a high probability of default. There needs to be a forced conversion of this debt to equity. If this is done, the amount of government assistance that will be required will be much reduced.

...2 Stem the tide of foreclosures. The original Paulson plan is like a massive blood transfusion to a patient with severe internal hemorrhaging. We won't save the patient if we don't do something about the foreclosures. Even after congressional revisions, too little is being done. We need to help people stay in their homes, by converting the mortgage-interest and property-tax deductions into cashable tax credits; by reforming bankruptcy laws to allow expedited restructuring, which would bring down the value of the mortgage when the price of the house is below that of the mortgage; and even government lending, taking advantage of the government's lower cost of funds and passing the savings on to poor and middle-income homeowners.

3 Pass a stimulus that works. Helping Wall Street and stopping the foreclosures are only part of the solution. The U.S. economy is headed for a serious recession and needs a big stimulus. We need increased unemployment insurance; if states and localities are not helped, they will have to reduce expenditures as their tax revenues plummet, and their reduced spending will lead to a contraction of the economy. But to kick-start the economy, Washington must make investments in the future. Hurricane Katrina and the collapse of the bridge in Minneapolis were grim reminders of how decrepit our infrastructure has become. Investments in infrastructure and technology will stimulate the economy in the short run and enhance growth in the long run.

4 Restore confidence through regulatory reform. Underlying the problems are banks' bad decisions and regulatory failures. These must be addressed if confidence in our financial system is to be restored. Corporate-governance structures that lead to flawed incentive structures designed to generously reward ceos should be changed and so should many of the incentive systems themselves. It is not just the level of compensation; it is also the form — nontransparent stock options that provide incentives for bad accounting to bloat up reported returns.

5 Create an effective multilateral agency. As the global economy becomes more interconnected, we need better global oversight. It is unimaginable that America's financial market could function effectively if we had to rely on 50 separate state regulators. But we are trying to do essentially that at the global level...,8816,1851739,00.html

World Bank president Bob Zoellick column titled "A World in Crisis Means A Chance for Greatness":

Aspiring U.S. politicians dream of being FDR, but rarely do the times and the person converge. The next president will have the chance to be a 21st-century FDR.

...The parallels with FDR offer a striking starting point. The new administration will need to recapitalize banks. It will also need to offer millions of American families a lifeline by helping homeowners manage their mortgage debts while staying in their homes. This modernized New Deal would simultaneously extend a hand to the broad middle class while countering the continuing slide in house prices that continue to drive down communities, lenders' portfolios and trust. The new president will need to overhaul a failed financial regulatory and supervisory system in a way that preserves innovation.

He will need to establish clearing and settlement mechanisms to ensure that failing firms do not freeze credit markets, to set strong liquidity as well as capital standards for the financial sector, and to thwart irresponsible behavior. And beyond all that, the new team will need a fiscal-stimulus package that the New Deal left out.

...A new president should build on his predecessor's financial innovations for development, including for HIV/AIDS treatment, the Millennium Challenge Corporation and the new Climate Investment Funds. The aftershocks of the developed countries' financial crisis and recession will also require the United States to work with other countries, the World Bank and the IMF to help the most vulnerable. We need a human rescue, not just a financial rescue.

Jeffrey Sachs column titled "Boom, bust, and recovery"

At the core of the crisis was the run-up in housing and stock prices, which were way out of line with historical benchmarks. Greenspan stoked two bubbles — the Internet bubble of 1998-2001 and the subsequent housing bubble that is now bursting. In both cases, increases in asset values led US households to think that they had become vastly wealthier, tempting them into a massive increase in their borrowing and spending — for houses, automobiles, and other consumer durables.

...As for the US, the current undeniable pain for millions of people, which will grow next year as unemployment rises, is an opportunity to rethink the economic model adopted since President Ronald Reagan came to office in 1981. Low taxes and deregulation produced a consumer binge that felt good while it lasted, but also produced vast income inequality, a large underclass, heavy foreign borrowing, neglect of the environment and infrastructure, and now a huge financial mess. The time has come for a new economic strategy — in essence a new New Deal.

Krugman blog post on possible need for even larger bailout ("Big rescue money"):

Via Yves Smith, an important article in FT Alphaville about the inadequacy of the bailout so far: despite the big-sounding numbers, financial institutions are losing capital faster than governments are putting it in.

I'd add a couple more data points: Japan's bank bailout in 1998 was more than $500 billion, in an economy whose dollar GDP was only about 1/4 that of the United States today. Do the math. And the just-announced IMF loan to Iceland is $2.1 billion — that's for a country with only 300,000 people. Both of these numbers seem to suggest that an eventual outlay of $2 trillion is in the realm of possibility.

WP story titled "AIG Has Used Much of Its $123 Billion Bailout Loan":

The troubled insurance giant American International Group already has consumed three-quarters of a federal $123 billion rescue loan, a little more than a month after the government stepped in to save the company from bankruptcy.

AIG has borrowed $90.3 billion from the Federal Reserve's credit line as of yesterday, the bulk of it to pay off bad bets the company made in guaranteeing other firms' risky mortgage investments. That's up from roughly $83 billion AIG had borrowed a week ago, and the $68 billion level it reached a week before that. The news comes as the company's new chief executive warned Wednesday that the government's financial lifeline may not be enough to keep AIG afloat.

The high volume of taxpayer funds that the trillion-dollar corporation tapped within five weeks also has others fretting that the largest government bailout in history may still not be adequate.

The writer is Charles W. Eliot university professor at Harvard

The pendulum swings towards regulation

By Lawrence Summers
Published: October 26 2008
The Financial Times

Events as well as ideas shape policy choices in democracies. Who would have predicted a year ago that a Republican ad­ministration would demand that Congress make the largest set of investments in public companies in US peacetime history? Would anyone have supposed that President George W. Bush would convene a global effort to renew Bretton Woods through strengthened international financial regulation? It reminds us that in the economic sphere, as in the national security sphere, dramatic events can make the inconceivable become inevitable. Discussions of the policy implications of the crisis have primarily focused on the immediate economic demands. The need to ensure the capital adequacy of financial institutions, maintain important credit flows, support the housing sector and the real economy, contain international spill­overs and reform regulation to prevent any recurrence of the crisis have rightly been the priority. In all these areas there will be many crucial policy choices to make in the months ahead.

However, policies that contain the crisis, support the economy and generate recovery are not sufficient to meet the historic challenge of this moment. Even with the best conceivable fiscal, monetary, financial and regulatory policies, economic performance depends on deeper and more structural policy choices. Nations cannot fine tune their way to delivering a prosperity that is more broadly based. In important ways, then, the crisis creates space to address longer standing problems. Just as patients hear advice regarding diet and exercise differently after a heart attack, so recent events should make it possible for the next US administration to accomplish more than might previously have been thought possible.

These broader goals depend on achieving the rapid and sustained growth that restores business confidence and generates the resources for investment. Economists do not understand what drives productivity growth very well. However, we know these facts: productivity grew rapidly after the second world war and then sometime between the late 1960s and mid-1970s it slowed dramatically only to re-accelerate to record levels in the mid-1990s. Unfortunately, even before the downturn, underlying productivity growth appeared to be slowing.

The most plausible explanation is that an array of transforming investments and technologies – the interstate highway system, widespread air travel and the expansion of electronics – were spurs to growth during the postwar period. Eventually their impact dissipated and, as energy costs rose, growth slowed until the information technology revolution kicked in during the 1990s. Unfortunately, the IT supply shock that powered the economy in the 1990s and early part of this decade appears to be diminishing.

So there is a need to ensure that the pressure to increase spending is directed at areas where it will have the most transformational impact. We need to identify those investments that stimulate demand in the short run and have a positive impact on productivity. These include renewable energy technologies and the infrastructure to support them, the broader application of biotechnologies and expanding broadband connectivity, an area where the US has fallen behind.

The crisis has also reminded us of the lessons of the technology bubble, Japan's experience in the 1990s and of the US Great Depression – that finance-led growth is problematic. The wealth and income gains from the easy availability of credit were highly concentrated in the hands of a fortunate few. The benefits also proved temporary. In retrospect, the fact that 40 per cent of American corporate profits in 2006 went to the financial sector, and the closely related outcome – a doubling of the share of income going to the top 1 per cent of the population – should have been signs something was amiss.

Therefore we need to reform tax incentives that encourage financial risk taking, regulate leverage and prevent government policies that give rise to a toxic combination of privatised gains and socialised losses. This offers the prospect of a prosperity that is more firmly grounded and more inclusive. More fundamentally, short and longer-term imperatives come together with respect to policies that seek to ensure that any future prosperity is inclusive. The policies that are most effective in helping to support demand are those that help households struggling either because of low incomes or because they have recently lost part of their income. Recent events also remind us that individuals can become impoverished or lose health insurance through no fault of their own. This reinforces the need for people to have basic health and re- tirement security protection regardless of what happens to their employers.

All of these considerations suggest that the pendulum will swing – and should swing – towards an enhanced role for government in saving the market system from its excesses and inadequacies. Policymakers need to be attentive to potential government flaws as well. For example, they need to recognise that, even as events compel larger deficits in the short run, they reinforce the need for longer-term measures to keep government finances on a sound footing. They must also be wary of measures that have a short-term superficial appeal, yet have adverse long-term consequences.

It is said in all presidential election years that the choices made by the next president are uniquely important. This time the cliché is true. The gravity of our situation is matched only by the opportunity it presents.

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