FOR two years the Obama Administration’s economic policy has been caricatured from the right as an invasive expansion of government and from the left as a cowardly capitulation to Wall Street free market fundamentalism.
How can it be both things at once? It helps to understand the philosophy of the man who most embodies that policy, Larry Summers, who today delivered perhaps his final public speech as Barack Obama’s National Economic Council director. The “Summers Doctrine” fuses microeconomic laissez faire with macroeconomic activism. Markets should allocate capital, labour and ideas without interference, but sometimes markets go haywire, and must be counteracted forcefully by government.
The most liberal economists concede the intrinsic superiority of markets in allocating real economic resources but many make an exception for financial markets. Mr Summers doesn’t, and that’s what critics from the left most hold against him. In his tenure in the Clinton Administration he championed the repeal of Glass-Steagall and blocked Brooksley Born’s efforts to regulate over-the-counter derivatives. Mr Summers holds regulators in low esteem, doubting their ability (no matter how smart or well-intentioned) to understand the risks of a complex financial system better than the people whose livelihoods depend on it. He brought this view with him to the White House, battling efforts on the Hill and inside the Administration to nationalise banks, corral bankers’ pay, or curb derivatives and trading activity.
Yet Mr Summers’ mistrust of government is not the same as a trust in markets. In a famous essay in 1985 he compared financial economics to studying whether two-quart bottles of ketchup cost twice as much as one-quart bottles. His point was that markets may be efficient without being right. “It is unfortunate that researchers in economics pay so little attention to finance research, and perhaps more unfortunate that financial economists remain so reluctant to accept any research relating to asset prices and fundamental values,” he wrote, anticipating much of the criticism of the profession today.
Mr Summers supplemented his academic appreciation of markets’ limitations with real-world experience in the Clinton Administration. The Mexican and east Asian financial crises demonstrated to horrific effect how markets could rapidly go from complacency to panic. Mr Summers sums up the lesson with a line he attributes to former Mexican president Ernesto Zedillo: “Markets overreact—and that means policy has to overreact.” Crises call for the financial equivalent of the “Powell Doctrine”: the application of overwhelming monetary force so that market participants have no doubt about the ability and will of policymakers. Austrian economists fret that this simply sows moral hazard; to Mr Summers, this was precisely the point: with the government providing insurance against catastrophe, investors could take more risks, generating more innovation, more growth, and more welfare.
Those lessons infused everything the Administration has done since the end of 2008, and a lot of what went before, thanks in part to the presence of former Summers protégé Tim Geithner at the Federal Reserve Bank of New York, and now at the Treasury. The Fed’s liquidity operations and bail-outs, the TARP, and the fiscal stimulus horrified free market purists in their scale but are completely consistent with the Powell/Summers doctrine. When Mr Summers reflected on his two years in the White House in today’s speech, he dwelt on the consequences of those actions:
Scholars … will continue to debate just how close the American financial system and economy came to all-out collapse in the six months between September of 2008 and April of 2009… Had it not been for President Obama’s willingness to support a sufficiently aggressive response … I have little doubt that we would be looking at a vastly different world today.
He framed the recent tax deal Mr Obama negotiated with Republicans the same way. Excluding the extension of expiring tax provisions, it contains about $280 billion of new stimulus. Only by the standards of the last few years is that less than overwhelming. Mr Summers went on:
It is right and necessary for government to counteract private sector deleveraging. … Even with our deficits, the amount of extra debt is less than the amount of reduced borrowing in the private sector… the recent tax agreement … averts what could have been a serious collapse in purchasing power and adds far more fiscal support than most observers thought politically possible.
What will scholars’ verdict of Mr Summers’ contribution be? Rightly or wrongly, the financial deregulation that Mr Summers championed in the 1990s has given way to re-regulation now; Mr Summers himself has happily bashed bankers when it suited Mr Obama’s priorities. The verdict on macroeconomic activism will depend on the fate of the economy. The optimistic view is that the economy is now in a sustained, though restrained, recovery that will prove Mr Summers right. The pessimistic view takes two paths. One follows Ireland, a country that applied more Powell doctrine than it could afford; by guaranteeing all its banks’ liabilities it has undermined the solvency of the sovereign. This seems unlikely. The other follows Japan into a trap of stagflation and deflation, one that Mr Summers is unwilling to dismiss: “The risks of deflation or stagnation in the United States exceed the risks of uncontrolled growth or high inflation.”
If that is indeed America’s fate, we may conclude that macroeconomic activism failed because its success in the decades before the crisis sowed the seeds of ever more risk-taking and complacency—and ultimately a crisis so large that it overwhelmed all the Powell doctrine that Mr Summers and his allies could muster; it would be the triumph of the Austrians