Larry Summers on Preventing and Fighting Financial Crises

This fall I am taking a course on the “international financial crisis” taught by Jon Macey and Greg Fleming (yes, the former COO of Merrill Lynch). The first assigned reading is a speech that Larry Summers gave at the AEA in 2000 entitled “International Financial Crises: Causes, Prevention, and Cures,”* summarizing the state of the art in preventing and combating financial crises. It’s based on experiences from emerging market crises in the 1990s, and doesn’t even contain a hint that something similar might happen here; however, few people could fault Summers for making that oversight back in 2000, and I certainly won’t.

Many people, including Simon and me, have discussed the similarities between our recent financial crisis and the emerging market crises of the 1990s, so I’ll be brief. The main similarities are excessive optimism that creates an asset price bubble, a sudden collapse of confidence that causes the rapid withdrawal of money and credit, a liquidity crunch, and rapid de-leveraging that threatens solvency. (We have also argued that there are political similarities, but let’s leave that aside for now.) The biggest difference is that instead of being compounded by flight from the affected country’s currency and government debt, in our case the exact opposite happened; investors fled toward the U.S. dollar and Treasuries, making things easier for us than for, say, Thailand. Also, to a partial extent, the parallel requires an analogy between emerging market countries and United States banks; for example, the issue of bailouts and moral hazard arises in the context of the IMF bailing out Indonesia and in the context of the United States government bailing out Citigroup.

Summers’s speech makes a lot of sense, so I’ll just highlight a few points he makes that I think are particularly instructive given our recent experience. I think these are all excellent points. For each one, I’ll quote from Summers, and then comment on its relevance to our situation.

1. Financial crises result from fundamental problems that should be fixed.

“It seems difficult to point to any emerging-market economy that experienced a financial crisis but did not have significant fundamental weaknesses that called into question the sustainability of its policies.”

“Bank runs or their international analogues are not driven by sunspots: their likelihood is driven and determined by the extent of fundamental weaknesses. … Preventing crises is heavily an issue of avoiding situations where the bank-run psychology takes hold, and that will depend heavily on strengthening core institutions and other fundamentals.”

In other words, you can’t blame a crisis entirely on investor psychology; there is something rotten. The panic of September-March was not, as some argued, simply a liquidity crisis; the premise of the liquidity crisis theory is that the fundamentals are sound (institutions are solvent), and Summers doesn’t believe that.

2. The strength of domestic financial systems and institutions matters more than aggregates such as the amount of debt.

“When well-capitalized and supervised banks, effective corporate governance and bankruptcy codes, and credible means of contract enforcement, along with other elements of a strong financial system, are present, significant amounts of debt will be sustainable. In their absence, even very small amounts of debt can be problematic.”**

The fact that U.S. consumers and banks had a lot of debt isn’t itself a cause of anything; if our financial system were effectively governed, debt alone would not have brought it down as spectacularly as it did.

3. Short-term funding is dangerous because it can be difficult to roll over in a crisis.

“Policy biases toward short-term capital need to be avoided.”

“A measure of sound management of short-term flows is implicit in any prudential regulation of banks.”

The U.S. failed on this count. A large portion of the shadow banking system – SIVs and SPVs raising short-term funds and investing them in long-term assets – was entirely dependent on short-term capital. It also turned out that most of the large corporate sector was dependent on commercial paper, which is also short-term. When short-term funding vanished in September, everyone was stuck.

4. Transparency matters.

“If one were writing a history of the American capital market, I think one would conclude that the single most important innovation shaping that market was the idea of generally accepted accounting principles. The transparency implicit in the generally accepted accounting principles (GAAP) promotes efficient market responses to change, and it supports stability. Furthermore, if as Ken Galbraith has observed, conscience is the fear that someone may be watching, it may be the single most effective means of promoting self-regulation.”

I think Summers is right on a historical scale – standard accounting conventions promote transparency. But looking only at the last two decades, I thnk that GAAP did not keep up with the realities of financial innovation, for example in accounting for SIVs. For the beneficial effect cited by Summers to hold – accounting standardization promotes effective self-regulation – the accounting has to accurately reflect the true risk being taken by institutions. If not, the causal chain breaks down.

5. Expectations of bailouts are bad.

“While conditioned, precautionary financial support is constructive in some cases, the risk inherent in systematic availability of unconditional credit to countries can be summarized in two words: moral hazard.”

“It is certain that a healthy financial system cannot be built on the expectation of bailouts.”

Enough said.

6. Rapid intervention in unhealthy institutions is critical.

“Prompt action needs to be taken to maintain financial stability, by moving quickly to support healthy institutions and by intervening in unhealthy institutions. The loss of confidence in the financial system and episodes of bank panics were not caused by early and necessary interventions in insolvent institutions. Rather, these problems were exacerbated by (a) a delay in intervening to address the problem of mounting nonperforming loans; (b) implicit bailout guarantees that led to an attempt to “gamble for redemption”; (c) a system of implicit, rather than explicit and incentive-compatible, deposit guarantees at a time when there was not a credible amount of fiscal resources available to back such guarantees; and (d) political distortions and interferences in the way interventions were carried out.”

Again leaving aside (d), I think our government was guilty of (a), (b), and maybe (c) in the recent crisis. It’s not clear that (a) has yet been satisfactorily addressed (even PPIP seems to be evaporating), especially when it comes to commercial real estate, and we clearly have (b). As for (c), we did move to explicit deposit guarantees, but we still have implicit guarantees on other bank funding (bonds); and though the government probably has a credible amount of fiscal resources, there is still the question of whether Congress or the Fed will come up with the money in a pinch.

So again, I think the Summers of 2000 was basically spot-on. However, I think the Obama Administration – of which Summers, of course, is a central figure – is doing a spotty job of implementing his lessons. Most notably, we have increased the expectation of bailouts by supporting unhealthy institutions, increasing moral hazard; and we have left the problem of toxic assets largely untouched, hoping that economic recovery will make it go away. I think this has been due largely to political realities, not to any failing of Larry Summers to understand his own thinking; the United States government has a lot more power negotiating with itself than an emerging market country has negotiating with the IMF.

The big current question is whether financial regulatory reform will fix the underlying problems that, according to the Summers, are the root of financial crises. For example, according to Summers (2000), we want a regime that discourages dependence on short-term funding, we want more transparency, and we want something that reduces rather than increases expectations of bailouts. Whether we get that – or whether the administration prefers to let regulatory reform fade away in the wake of the health care war – is the remaining test.

* The offiical online home of that paper doesn’t allow free downloads, so I don’t think I should post my copy, although other people may have.

** Citing a paper by Simon, Peter, Alastar Breach, and Eric Friedman!!

By James Kwak

28 responses to “Larry Summers on Preventing and Fighting Financial Crises

  1. Bottom line, many of the people, ideas, tendencies and incentives that were in place leading up to a stupid and easily avoided greed based debacle, remain in place.
    Instead of “yes we can” – maybe, sorta, but don’t rock the boat.

  2. Regarding your point “we want more transparency”- it’s hard to pin down exactly who the “we” might be.
    Chairman Bernanke doesn’t want it – he is on record as being opposed to having to reveal the Fed’s balance sheet, bail out recipients etc.

    The HFT operators in dark pools don’t seem too keen on transparency either.

    So where is the special interest group that’s in favor of it?

  3. American exceptionalism lives!

  4. 1) Can you explain what’s rotten in the financial sector that caused such a massive run on Lehman, Bear Stearns? If you hear insiders talk, Bear Stearns was ruined by “rumors.” Lehman destroyed by the Goldman cabal.

    What were the inherent weaknesses that brought these institutions and the entire financial sector to oblivion?

    2) Amount of debt not as relevant as the strength of the domestic financial systems.

    How can you have a strong financial system if the organizations within the sector are top heavy with “toxic” debt? Seems like the amount of debt is inextricably linked to the health of the system. How can a bank be “well-governed” when the business objective is to make money on crappy loans that should never have been approved?

    3) There is no prudent regulation of the shadow banking system at all – so short term/long term funding seems almost irrelevant. Shadow banks got to do what they wanted with their money, no strings!

    4) Didn’t “accounting principles” fly out the window of Arthur Anderson’s offices? Are there really any accounting standards today in finance?

    5) TBTF has grown even bigger…. see no failure of bailouts in the future.

    6) What interventions are we left with if no bailouts are allowed? When should the feds have intervened in the system – and how should they have intervened?

  5. 2000 Summers was actually the bizzaro doppelgaenger of 1999 Summers who collided in a matter-antimatter collison producing Harvard Summers and some economic black holes. Harvard Summers was an unstable politically incorrect isotope which broke down first into Hedge Fund Summers, and then into the highly radioactive Summers whom we all know and love (half life of 2 years).

  6. 2000 Summers was actually the bizzaro doppelgaenger of 1999 Summers who collided in a matter-antimatter collison producing Harvard Summers and some economic black holes. Harvard Summers was an unstable politically incorrect isotope which broke down first into Hedge Fund Summers, and then into the highly radioactive Summers whom we all know and love (half life of 2 years).

  7. I’ll try:

    1. The most fundamental weakness was the excessive exposure to structured securities on the asset side of the balance sheet (or off the balance sheet). I don’t know Bear in particular, but this is what really hurt Citigroup, for example. For Bear and Lehman, there was also addiction to overnight funding.

    2. A simplistic answer is that if the assets are not toxic, then you can hold a lot of them and be OK. A strong financial system is one where someone – managers, shareholders, regulators, doesn’t matter – ensures that banks do not take on excessive levels of toxic assets with insufficient capital to support it. The fact that so many of the assets were toxic is a symptom of a weak system.

    3. I agree. But the short-term funding made them more susceptible to collapse in a crisis.

    4. Good question. Summers was making a general point; whether it applies to finance today I doubt as well.

    6. “Intervention” in Summers’s paper is code for government takeover and restructuring. The contrast is between “support” and “intervention.” The conventional wisdom, which I believe he was echoing, was that if the institution is healthy you support it (lend it money when it needs it, inject capital if necessary), but if it is unhealthy you “intervene,” meaning you take it over and restructure. Simon and I argue that what we did is we supported unhealthy institutions.

  8. Summers has been very quiet for someone who understands exactly what is going on, and how extensively the US taxpayer and future generations have been screwed.

    Providing limited support for a soft landing is one thing, but attempting to reflate a multi-trillion credit bubble is quite another.

    Where are we headed James?

  9. Thank you James!

    But an additional question about #2. Is debt considered an asset? (Not in my household, but what passes for a negative in the consumer home is probably viewed as a profitable asset in finance.) What is the difference between a toxic debt and a regular one?

    (I am not an economist – and though I’ve been learned much about this science in the last year – thanks in part to this blog – I still remain woefully ignorant of such a vast and important topic.)

    And I agree with you on #6 – that we support (and continue to support) unhealthy institutions. Strange how some who work at such places will enjoy nice bonuses this year….

    Do you believe that many of the institutions are healthy today, with just a few sickies still in the system or is our financial sector still seriously ill?

  10. Summers is one of the prime architects of the whole accumulated disaster. Apart from Rubin and Greenspan, nobody was more responsible or more clueless about the recent meltdown. The problem is simple: our financial system is fueled by usury and speculation. Lending for productive purposes takes a back seat. Right now, the hedge funds are moving full speed ahead enabled by prime brokers like JPM. Lending for speculation is much more profitable for the banks and the loans are all short term and collateralized by ‘marketable’ assets. Why should a bank lend for any other reason? There is no cure for this except refusing to bail out any bank, letting the stockholders and bondholders go balls up, but Summers wants the taxpayer standing ready with unlimited handouts for any large bank which screws up. He actually thinks that Ponzi finance creates prosperity and jobs, which is idiotic. What it creates is bubbles at the expense of productive activity. Studying finance under Summers is like attending flat earth society meetings. If you find anything he says persuasive you might enjoy astrology even more.

  11. Nassim Taleb claimed in The Black Swan that the Latin American sovereign debt crisis of the early 1980’s wiped out all of the commercial bank profits from the beginning of the US banking system to date. If true, with the S&L crisis and the current crisis between then and now, lending money for interest, taken broadly, has been a net value-destructive activity across US history. If we account for losses covered by the various government guarantors, such as FDIC, FNMA, SLMA, etc, the total looks terrible.

    Given this, how can we justify a revival of the industry without sweeping changes in how it manages risk? Is it acceptable to have banking require government intervention roughly once every twenty-years?

  12. Given this, how can we justify a revival of the industry without sweeping changes in how it manages risk?

    By pointing to the outsized compensation packages of the managers?

    Is it acceptable to have banking require government intervention roughly once every twenty-years?>/i>

    No, that’s completely unacceptable. It should require new infusions of capital every five years.

  13. “Is debt considered an asset? (Not in my household, but what passes for a negative in the consumer home is probably viewed as a profitable asset in finance.)”

    when I took care of my boss’ private assets in the late seventies I realized after a while that the fees his bank charged were very on the high side. When I phoned the bank for a reduction, I learned that customers with assets were considered less esteemed customers by the bank than those with large loans and thus not really eligible for low fees.

    at the same time I learned that an investment guru at the same bank who was feted by managing the stocks for the lawyers, certified accountants etc. of my boss’ group because of the impressive figures listed as “realisierte Kurs-Gewinne” i.e. selling stocks profitably had managed the portfolio so, that my boss would have been richer had he stored the money under his mattress.

  14. I just finished teaching a course on financial crises in June, so let me suggest two papers for your reading list.

    – BIS (2004) “Bank Failures in Mature Economies” Working Paper #13, Basel Committee on Bank Supervision. (http://www.bis.org/publ/bcbs_wp13.htm)

    – Honohan and Klingebeil (2003) “The fiscal cost implications of an accommodating approach to banking crises” Journal of Banking and Finance, 27, 1539-1560.

  15. Re: “But looking only at the last two decades, I think that GAAP did not keep up with the realities of financial innovation, for example in accounting for SIVs.”

    I’m no expert, but it seems to me that many “innovative” accounting practices were nothing more than efforts to game GAAP, with no truly useful purpose.

    There will always be attempts to game whatever standards may be in force, but it seems to me that this is an area that needs some attention.

  16. “The biggest difference is that instead of being compounded by flight from the affected country’s currency and government debt, in our case the exact opposite happened; investors fled toward the U.S. dollar and Treasuries…”

    Those are the most important words written to date about what has happened. All of current economic understanding is based on the historical fact that currency exchange – even with multiple manipulations and controls – has always rebalanced both excessive government debt and excessive trade deficits. It has never happened before that one country was elevated “above” this rebalancing so that it’s currency strengthened under such conditions. Either it’s a short-term distrubance in the Force (in which case be very afraid) or the now-ubiquitous phrase “we have entered uncharted waters” is a gross understatement – all existing economic knowledge gives us no clue whatsoever about the future. If the American exceptionalists are right, we have been chosen by God and are not subject to the limits everyone else is subject to; if this the thinking, there will be reducing of the deficits, ever.

  17. Sorry for the typo. There will be no reeducing of the deficits, ever.

  18. It is obvious that American ‘exceptionalism’ now depends upon China’s appetite for dollar assets. No one bothers to ask why China is enabling our Ponzi finance. To me, China is temporarily serving its own interest in catching up on Western technology. For example, it buys aircraft from Boeing but demands the location of ever increasing productive capacity on Chinese soil. Meanwhile, among its billion odd people are an ever increasing number of engineers educated in the West. Suppose it now occupies the same economic position in the world that Japan occupied in 1955? Does anyone remember that ‘made in Japan’ was once a joke? This suggests America has perhaps ten years to get its economic house in order, assuming momentarily that our so called leaders have any interest other than their own plutocratic ambitions at heart, which would be making a giant leap in view of the evidence. So far, fiddling comparisons between President Obama and Nero are not so far fetched, unless one believes that Nero has been grossly maligned in popular history.

    The preoccupation of mainstream economists with the mere dimensions of GDP are papering over a sordid reality, in which the collapse of domestic wages is ‘financed’ by consumer usury. But there will be no bailout for consumers, and no wage growth in a shrinking employment market, so it will not be long before even the false prosperity claimed by our cheerleading ‘growth’ peddlers will prove unrealizable. The likely response of the financial sector will be continued escalation in the rate of interest charged consumers, and the response of our captive government will be continued free money for the monopoly capitalists, until one day the Chinese stop swallowing everything available at those Treasury auctions. Then what?

  19. Then the smart ones move to China and start all over. Seriously, people are abandoning ship and getting to shore while others complain it’s sinking.

  20. at the time a railway line of this type (the first) http://www.youtube.com/watch?v=hUATDtZble0
    was built in China radio was full of complaints by engineers about how they and their corporation were maneuvered into transferring more technical knowledge to the Chinese than was initially agreed upon
    the smart ones who move to China to make it on an even plane with the Chinese i.e. not as customers will be made to feel who has the superior culture – the engineers telling their stories on radio gave me the impression that the Chinese were very good at haughtiness

  21. Summers joined the Obama team with the expectation that he would be named the next head of the Federal Reserve. Perhaps in four years, he still will be.
    But this assumes Obama will be re-elected, which I think is pretty doubtful. Summers is, therefore, between a rock and a hard place within the administration. He is stuck with supporting the weak Obama policies being implemented by Tim Geithner. Even if Summers knows that these policies cannot work, it is probably too late for him to oppose them because he went along with the package proposed in the first place–in no small part, I believe, because he hoped they’d lead to his being named head of the Fed next year.
    Giethner is the real disastor in the Obama administration. He really, really believes his old bosses (the board members of the Federal Reserve Bank of New York made up of Wall Street executives and their minions) have all the answers. He continues to act as their water boy to the detriment of the economy and the American people.
    Obama-Geithner-Summers is a very weak team. Summers is the strongest of the three, but that ain’t saying much at this sorry juncture.

  22. Michael Siteman

    If Mr. Kwak’s assertion is correct regarding Larry Summers’ “Spot On” diagnosis, then how is it that Mr. Summers was unable to predict that the complete deregulation of the financial markets and resulting collapse of the financial system would occur by repealing the Glass-Stegall Act of 1933 by encating the Financial System Modification Act of 1999 and its companion bill the Commodoties System Modification Act of 1999 (which he created in association with Phill Graham)? The situation was further exacerbated when in 2004, Henry Paulson, then CEO of Goldman Sachs, led a consortium of the five largest investment banking companies, met with the SEC and prevailed upon them to loosen the leverage/equity ratio imposed on those companies when purchasing securities. The fox has been in the hen house since the mid-1980’s. It’s not a conspiracy; it’s the confluence of a number of uncoordinated decisions made by unethical, greed inviduals leading companies that must continually show growth or suffer the results of market down gradation. The first mistake actually occurred in 1971 when then President Richard Nixon separated the Gold Standard from the US Currency in order to finance the expansion of governmental programs.

  23. Re: 6. I don’t think you would get much of a counter-argument against this claim. The contrast between what Summers said and what he did is revealing and should be pointed out to those who would support him for responsible position based on his intellect.

  24. In the words of the boxer Muhammed Ali: “It’s hard to be humble, when you’re as great as I am”, and “I’m not the greatest. I’m the double greatest.” I’m sure the Chinese feel the same way.

  25. Where are you taking this class, and is it open for enrollment?

  26. I doubt it – the Chinese I had to deal with seemed completely pragmatic, knowing always who had the upper hand and thus was to be deferred to

  27. First insightfull comment of the thread,

    Thanks

  28. Much of what you write Jake, is a straight rant. Direct quotes in this very blog, let alone the extensive writings of Summers shows an academic with exceptional insight into the subject at hand. You have not even bothered to refute the very arguments James is discussing.

    The point of the post, and the key issue here is that despite Summers deep subject matter expertise and maverick credentials, within whispering distance of the presidents ear, few of his policy proposals were adopted. This is not a testament of the failings of Summers, although their are many-see hilarious radioactive larry comment above, rather this is a testament to the power of the forces, political, inertial, or financial, arrayed against the policies he advocated as an independent academic, circa 2000.