CROSSPOST/HOISTED: Larry Summers from 2022 on the "Polycrisis"

Larry in conversation with Martin Wolf, back in October 2022, during the flameout of Liz Truss and Kwasi Kwarteng in Britain as their "minibudget" ran into the buzzsaw of the bond vigilantes & the...

Larry in conversation with Martin Wolf, back in October 2022, during the flameout of Liz Truss and Kwasi Kwarteng in Britain as their "minibudget" ran into the buzzsaw of the bond vigilantes & the emergence of the "moron premium” in British interest rates. I find myself looking back and referring to this often these days, and so I feel a need to highlight it. Most of it is right. But I still think some of it is wrong—mostly, that by October 2022 the inflation problem had started to solve itself, even with the Putin shock of his attack on Ukraine.

Subscribe to the Financial Times <http://ft.com>, people! It is, as Jeff Sachs told me now long ago when I was a young whippersnapper “the only real newspaper”…

---

In my view, Larry was and remains 100% right in his view of the extraordinary fragility of the financial system—too many places to sell unhedged puts of one sort or another in extremely opaque ways, and nearly all claims to generating alpha being underpinned by such strategies, so that even a small asset-valuation reversal can have potentially large consequences without immediate action by the lender of last resort. (I wish he had talked about the self-undermining when used political credibility of the lender of last resort—that at some point the political system will pull the plug, in which case we are then in Great Depression territory.)

In my view, Larry was 80% right on inflation danger as the big risk: those of us who saw a return to the zero lower bound as the big risk was wrong. The 20% on which Larry was wrong consisted of (a) not taking seriously the rock-solid stable bond-market inflation-expectations indicators as a sign that the deänchoring of inflation expectations was still far away, and (b) not understanding that the vacancy data are now close to meaningless and we should be looking at direct measures of wage pressure rather than the Beveridge Curve to understand the inflation-relevant state of the labor market. Thus as of the time of this conversation, October 2022, monetary tightening as indicated by the runup of the Ten-Year TIPS rate from -1% to 1.5% had already done the job of inflation control: the soft landing was well underway and was to be accomplished as of June 2023. The fact that inflation expectations had not become entrenched was more than a silver lining: it was the bright-shining cloud. And the firm action to restrain inflation had already been taken.

And, in my view, Larry was and is 100% right on our “polycrisis”.

---

The Conversation

MW: It is a critical juncture for the world economy, with the legacy of Covid, war in Ukraine, high inflation (especially soaring food and energy prices), tightening monetary policy and a strong dollar. This was the background when late last month, Kwasi Kwarteng, chancellor of the exchequer in Liz Truss’s new government, delivered his “mini” Budget. The statement included a costly energy plan as well as substantial permanent tax cuts, including an unexpected reduction in the top rate of income tax from 45p to 40p in the pound. This, he said, was the government’s new “growth plan”. He also offered no estimates of the cost nor implications for debt sustainability.

The market reaction was devastating, causing a sharp fall in the value of the pound and the price of gilts. Early the following week the Bank of England was forced to intervene in the gilts market to limit the damage done to pension funds — some of which were threatened with bankruptcy as complex trades in derivatives came under market pressure. Substantial opposition emerged on the Conservative backbenches to the large, planned tax cut for those earning over £150,000 a year, which forced the government to back down. It was also forced to accept an early forecast of the fiscal implications from the Office for Budget Responsibility.

So what impression has this astonishing episode had on informed outside observers? One who knows the UK and global macroeconomics well is Larry Summers, former US treasury secretary. I asked him for his view of these events in a discussion last weekend, just before the government’s U-turns on the proposed cut in the top rate of tax.

LS: I think there’s an element of perfect storm in it. You had misguided fiscal policy coupled with lack of central bank credibility coupled with toxic leverage creating positive feedback loops that led cumulatively to a disastrous outcome. The UK did not have room for a massive ineffectual fiscal expansion. The uncontained energy subsidies were themselves substantially problematic and did not leave room for large, permanent tax cuts. That called the credibility of the government into substantial question. The government’s disregard for process on the fiscal policy, insistence on personnel change in the civil service at the Treasury and rhetoric of questioning the central bank called into question the credibility of the central bank.

And all of this together raised the spectre of fiscal dominance, in which the central bank is effectively forced to finance the government.

You went from a stable though not particularly desirable situation to a catastrophic one within a matter of a few days. That then led to the toxic correlation, this being a tendency for bond yields to rise as the currency was declining. And that in turn was followed, given the situation of the British pension funds, with a cascading deleveraging that led prices to disconnect from fundamentals and led to the phenomenon of positive feedback, which is at the root of all financial crises.

It is frequently the case that financial crises have more to do with assets that were previously perceived as being completely safe becoming risky, than risky assets becoming riskier than was previously expected. And that’s what happened in the UK. It was less a situation of a single fatal act than a situation of several dangerous acts combining to produce catastrophe, and that is what happened.

I think the Bank of England did the correct, or reasonable, thing in the extremely difficult situation it found itself in by engaging in a “market maker of last resort” operation. But nothing in my experience suggests that an operation of that kind will provide more than a temporary respite, unless there is more action to come. It is not, I believe, the case that British pension funds only owned pound-denominated assets. And there is, I think, the underestimated phenomenon of what others would call contagion and an economist might call “reputational externalities”, where seeing something happening in one place raises concerns about it happening in other places. And so, I think, the destabilisation wrought by British errors will not be confined to Britain.

I was therefore glad when the IMF spoke up to express concern about the situation, though I felt the IMF comments underplayed the financial risk aspects of the situation and overplayed the regressiveness of the tax cuts. And while I agreed with the IMF’s judgment about that very much, I felt their appropriate role was more to focus on the macroeconomic and, particularly, the global financial stability implications.

MW: I agree. It’s my job as a British columnist to point out the consequences for inequality and social harmony. It’s not really the fund’s job. But let’s think about what can be done now to rectify this, because obviously they’ve opened Pandora’s box and it’s possibly not just a British box. We are concerned, and you’ve already touched on that, that the Bank of England promised that its new quantitative easing programme would last for just 13 days, and that started last Wednesday, so it doesn’t leave that much time. But if they just stop, there must be a serious risk that the crisis will reignite, and that might then force them back into supporting the market, which might look even worse. The situation, in other words, looks to me still very fragile and that might have some worrying implications for wider global stability.

LS: Martin, I think the situation is indeed, as I suggested, very fragile. I suspect that the reputational externality aspect is the more important aspect for the global system, and that has already happened. And so, I’m not sure that just how well or poorly it plays out from here will have huge global implications. And I think it must be acknowledged that once investors are primarily watching other investors rather than judging the fundamentals for themselves, matters have become highly problematic in any financial crisis. And we are now at the stage where the focus is on the hydraulics rather than the economics. It’s on the flows and who is moving in what direction. It seemed to me surprising, given that it was going to reverse itself on QE versus QT, by engaging in this market maker of last resort operation, that the Bank of England gave such a firm time limit on its activity.

I think in general that military interveners make a mistake when they promise a fixed date for withdrawal, because it emboldens the opposition. I think it would surely be constructive if the government were to back off from its radical permanent tax-cutting. And I think lenders of last resort make a mistake — well, financiers of last resort make a mistake — when they declare how time-limited their operation is going to be. And I would not be surprised if the Bank of England finds it necessary to adjust its position.

I think it would surely be constructive if the government were to back off from its radical permanent tax-cutting, and it also seems to me that the geopolitical moment would provide something of an excuse for doing so: “in light of the extraordinary uncertainties created by what is happening in Ukraine, it is appropriate to defer consideration of fiscal measures beyond energy subsidies until after the war is over”.

I frankly fear over the difficulty of quickly re-establishing full credibility in the Bank of England. The decision to move 50 basis points rather than 75 basis points was a credibility-challenging blunder. The existence of a vote for only 25 basis points further challenges credibility. To sum up, the bank is likely to have to open the possibility of a longer period as “market maker of last resort”.

There must also be a retreat on fiscal policy and some signals from the Bank of England and the Treasury that will restore the former’s credibility. I think these steps would cumulatively offer the best prospect for success. I also think it’s important to remember that there is much that is functional in the British economy and especially in London, as one of the world’s leading global cities. And there is the prospect of attracting substantial capital inflows, which will lay the groundwork for recovery and re-stabilisation.

MW: As far as we can see, the government is going to propose quite significant spending cuts in November as its way of restoring fiscal stability or credibility [since this discussion, there have been suggestions that the announcement will be brought forward]. And there is very real doubt whether they will be able to get these through parliament. And that will, of course, certainly not encourage the markets.

The other striking feature is that this reversal on QE was carried out by the Financial Policy Committee of the Bank of England without the direct engagement of the Monetary Policy Committee. And so, in a way, what we’re seeing is not so much fiscal dominance, at least directly. We’re seeing financial sector worries override monetary policy concerns. And that’s a dreadful position for the institution to be in. So, I would suggest that the job of restoring credibility to British policymaking might turn out quite difficult.

LS: One of the lessons one learns as one gets older is that not all problems can be solved. And I intended to offer suggestions as to best ways forward, not to imply, with confidence, that they would be successful. I hear you on the political exigencies, both with respect to spending and the internal dynamics of the Bank of England.

My instincts tell me that those dynamics have a way of evolving in the face of serious crises, and so I suspect the range of possibility for what actors might do three weeks from now is rather broader than what those actors are currently proclaiming. And I think it is a good idea to recognise that.

MW: We’ve got the IMF annual meetings coming up in just a little over a week. This looks an alarming backdrop for their discussions, and indeed for the sort of decisions that are being made by British policymakers. How worried should we be about this combination — what some people call a “perfect storm” for the world economy?

LS: I disagree with the historian Adam Tooze about many things, but I think he has found an apt term in using the term “poly-crisis” to refer to the many aspects of this situation. I can remember previous moments of equal or even greater gravity for the world economy, but I cannot remember moments when there were as many separate aspects and as many cross-currents as there are right now.

Look at what is going on in the world: a very significant inflation issue across much of the world, and certainly much of the developed world; a significant monetary tightening under way; a huge energy shock, especially in the European economy, which is both a real shock, obviously, and an inflation shock; growing concern about Chinese policymaking and Chinese economic performance, and indeed also concern about its intentions towards Taiwan; and then, of course, the ongoing war in Ukraine.

Start with America.

I remain convinced that a failure of central bank policy in the US to remain resolute will be very unlikely to bring about a return to inflation stability in the US and, therefore, to any foundation for healthy global growth. I am baffled by the many critics of the central bank who assert that they need not take substantial further actions because expectations are anchored, seeming to ignore that the only reason expectations have remained anchored is that the central bank has moved towards making clear their determination to move rates substantially.

It is an encouraging sign for the central bank that as bad inflation data has come in, the tendency has been for real rates to rise rather than market-based inflation expectations. But that is no argument at all for not doing what is necessary. And if the Fed were to heed the counsel of the diehards of “team transitory”, whose conclusions remain constant but whose arguments constantly evolve, I think that would be a prescription for much higher interest rates and a sustained and very difficult stagflation that would have serious global consequences.

I think the Fed is now in the range of signalling appropriate monetary policy. My suspicion, but it is only a suspicion, is that they will have to raise rates ultimately a bit more than their “dot plot” forecasts suggest, or the market is now anticipating. My much stronger conviction is that there is still an underestimation of what the economic consequences of all of this will be. I would be very surprised if we were to simultaneously — as the Fed believes or the Fed forecasts — bring inflation down to something approaching the 2 per cent range and, at the same time, see unemployment rise no higher than 4.4 per cent. It continues to be my view that we are unlikely to achieve inflation stability without a recession of a magnitude that would take unemployment towards the 6 per cent range.

To be crystal clear, I yield to no one in my hatred for unemployment, for its consequences for inequality, for its consequences for subsequent economic capacity. My earliest work as an academic was about the benefits of hot labour markets. I worked very hard with Olivier Blanchard on so-called hysteresis theories that emphasise the adverse effects of unemployment.

The question is not some trade-off of inflation against unemployment. The question is what policy path would minimise the total amount of unemployment distress over time. And just as the patient who doesn’t complete his regimen of medicines does herself no favour, or the oncologist who prescribes too few courses of chemotherapy does their patient no favours, I believe the prospects for robust American and global growth will be greater if we do not allow inflation expectations to become fully entrenched.

The only silver lining in this moment is, as Paul Krugman and others suggest, that long-term inflation expectations have not yet become entrenched. It is crucial that we take advantage of that by acting firmly to restrain inflation.

The global situation is no less problematic. I think there is an increasing chance that when historians look back at the views that prevailed of China in 2020, they will compare them to the views that prevailed of Japan in 1990 or the views that prevailed of Russia in 1960 and find them almost as bizarre. The pressure for capital flight, the dependence on real estate, the magnitude of the demographic challenge, the complexity of running an economy in a way that both enforces political loyalty and spurs innovation, all of this suggests to me that there are likely to be very challenging years ahead in China.

With a tendency to turn substantially inwards and the real prospect of economic weakness in both the US and China, and with a European economy that will be held back at best and hobbled at worst by high energy prices, it is difficult to be optimistic about the global prospect.

My hope, but not my expectation, would be that there would be serious dialogue, led by the international financial institutions, on the need for a global stability strategy coming out of these meetings. That would involve an appropriate combination of policies in each of the major regions. It would involve the development of capacities to provide substantial additional resources to the developing countries and more satisfactory approaches than now exist for managing debt, for debt relief. It would involve a capacity for looking beyond the current moment, by providing large-scale financing of a green transition and for fortifying the world against the next pandemic, which I would guess will come within the next 15 years.

This is a moment for the kind of signalling, albeit with very different problems, that took place at the London 2009 summit during the financial crisis. My fear is that the preoccupations will be with questions like whether the World Bank president is or is not a climate denier and with much more business-as-usual proposals about who will or will not contribute sums in the hundreds of millions of dollars to various funds that the global institutions are seeking to raise. It seems to me to be a moment for boldness and imagination. And while the ministers have not yet delivered their pre-meeting speeches and so one can remain hopeful, I can’t honestly say I am hugely optimistic that we will see substantial boldness coming forward at these meetings.

MW: I think that’s a very good end and very appropriate. So, thank you very much. That was extremely helpful.

<https://www.ft.com/content/20117143-2084-4ac1-98a5-5c48fae7fc23>

If reading this gets you Value Above Replacement, then become a free subscriber to this newsletter. And forward it! And if your VAR from this newsletter is in the three digits or more each year, please become a paid subscriber! I am trying to make you readers—and myself—smarter. Please tell me if I succeed, or how I fail…