In an interesting exchange on CNBC’s Squawk Box yesterday morning, Larry Summers told his interviewers, who had suggested the possibility that raising interest rates could make a positive contribution to investment, that they were practicing “flat earth economics.”
Of course, when an esteemed professor of economics at Harvard, the President Emeritus of Harvard University, the former Secretary of the Treasury and the former Chief Economist of the World Bank, announces in a somber voice that you are practicing “flat-earth economics,” you tend to worry whether you ought to have enrolled in a few more economics courses in college, or at least paid more attention to those you did attend.
The charge of “flat-earth economics” was enough to silence his interviewers yesterday, but who was right? The serious issue that the CNBC interviewers were raising was whether the short term impact of higher borrowing costs to buyers of homes, autos and investment, might be outweighed by the far-greater costs of massive distortions and risks of a tsunami of free money flowing to the banks, the big corporations and the owners of assets, as a result negative real interest rates for an unprecedented period.
We know that the negative real interest rate has accelerated the “corporate cocaine” of share buybacks (some $3.4 trillion in the last ten years). We know that it has aggravated income inequality by pumping up the stock market and benefitting those who own assets. We know that there is a massive explosion of mergers and acquisitions as a result of the free money. We know that companies are staying in business far longer than they ever should have been, because they can roll over debt and not fail when they should have. We know that publicly owned companies are investing much less than privately owned companies.
What we don’t know is what risks and distortions are building up inside the system as a result of incentives to make short-term profits in a negative real-interest-rate environment. An extended period of negative real-interest rates has occurred twice before in history and each time it has ended very badly. Thus from 1974 to 1976, we had a persistent level of negative real rates and it drove serious mis-allocations of capital. From 2002 to 2004, we had negative real interest rates and we know what happened after that: global financial meltdown.
The fact is that we have seen this movie before, and Larry Summers played a leading role in a key episode.
What Summers Got Wrong In 2005
The book, Masters of Nothing: How the Crash Will Happen Again Unless We Understand Human Nature by Matthew Hancock and Nadhim Zahawi (2011) details how in 2005 Larry Summers played a leading role in allaying concerns that a financial crisis might be brewing.
Thus in 2005, the chief economist of the International Monetary Fund, Raghuram Rajan, made a speech at Jackson Hole Wyoming in front of an all-star gathering of the world’s most important bankers and financiers, including Alan Greenspan and Larry Summers. Rajan argued that technical change, institutional moves and deregulation had made the financial system unstable. Incentives to make short-term profits were encouraging the taking of risks, which if they materialized would have catastrophic consequences.
Rajan explained that “because pay was tied to short-term returns, financial managers would want to take so-called ‘tail risks’: risks that almost always paid off with higher returns, but when they went wrong would be catastrophic. That way, most of the time the managers would take home a higher pay packet. If the risk did materialize, they might be fired: a small cost compared to the super-sized bonuses they got while the going was good. Similarly, because these managers’ pay was set relative to their peers, financial managers were incentivized to follow the herd.”
The speech was not well received.
“One of the first members of the audience to respond was Larry Summers. He said he found ‘the basic, slightly lead-eyed premise’ of the paper ‘to be largely misguided’ and cited the Swedish and Japanese banking crises of the 1990s as evidence that systemic risk was caused by irresponsible lending from plain old retail banks, or ‘vanilla banking’ rather than the financial alchemy practiced by the high-rollers on Wall Street.”
Incredibly, but successfully, Summers argued that the world was safer because of the new financial instruments like credit default swaps. He said that if credit default swaps been available to investors back in the 1980s, then the situation following the 1987 stock market bust would have been a lot more stable.
Of course it was precisely those credit default swaps that brought about the global financial system to the brink of total collapse in 2008.
Eerie Symmetry
“The symmetry is eerie,” write Hancock and Zahawi. “The lesson is that people in all ages dangerously overestimate their ability to remain in control of events, when all too often it’s the mad internal logic of the system they’ve created which is really in control. Far from making the system safer, technical development actually augments this effect.”
Now once again Summers is ridiculing those who see a problem with zero-real interest rates by saying they are practicing “flat-earth economics.”
In effect, what Summers is arguing is that the known risk of increased costs of borrowing to buy houses, cars or make investments outweighs the unknown but possibly catastrophic risk of massive distortions and misallocations of capital. Apparently, the experience of 2008 taught Summers little, because his mental model doesn’t allow for unknown risks.
Where Could Those Risks Lie Today?
In 2005, Larry Summers and the banking community couldn’t, or didn’t want to, see the risk of credit default swaps, which in due course nearly destroyed the global financial system. What could they be missing today?
One possibility that was suggested in March this year by Kevin Warsh, Fed governor from 2006 to 2011, is “covenant-lights.”
If you had never heard of credit default swaps before 2008, you have probably never heard of “covenant lights.” The term “covenant-lights” is financial jargon for risky loan agreements that do not contain the usual protective covenants for the benefit of the lender. In such loans, the lender cannot intervene if the financial position of the borrower or the value of underlying assets deteriorates. Around 2006, there was a “race to the bottom”, with syndicates of banks competing with each other to offer ever less invasive terms to borrowers in relation to leveraged buy-outs. Such loans are very profitable for banks and their traders in a low interest rate environment. But they are riskier because they lack the early warning signs that lenders would otherwise receive through traditional covenants. Where risks are further dispersed through derivatives, the scale and location of the risks are opaque, with significant implications if things turn bad: nobody knows who owes what to whom. This can lead to the whole financial system freezing, precipitating a major crisis. Covenant-lights were a significant factor in the 2008 financial meltdown.
Now, apparently, covenant-lights are back.
“Covenant-lights” said Warsh, “are two and half times the level they were back in 2007. Investors’ willingness to take on these loans has never been higher. Chair Yellen said that the gradualist approach is not without risks. This is the central bank understatement that we have come to expect. We would feel better about these risks if our understanding of these risks and macro-prudential policing had improved dramatically since 2007. The new ways of policy monitoring are important but they are still nascent in their creation.”
Warsh argues that the Fed has paid most of its attention to the risks of raising rates. It should now pay more attention to the risks of keeping rates low too long.
The Problem Of Investment
What then is Summers' world view? He agrees that there is a problem of insufficient investment, as the economy continues to sputter along in a state of "secular economic stagnation"--not really in recession, but not fully recovering. But this is because there is a problem of “lack of demand.”
“We need more investment if we are going to grow this economy,” Summers told CNBC. “The biggest single reason why companies don’t invest is that they don’t have demand for their products. We are caught in a vicious cycle. Therefore incomes are too low. Therefor too few people are working and we have got to get out of that cycle. We have to do things that motivate companies, the right kind of tax reform, rules that discourage activist hedge funds that strip the cash out of companies, and investment in infrastructure. Investment isn’t just the private sector. We haven’t spent less on investment in infrastructure since after the Second World War. With the low interest rates we have an unbelievable opportunity to invest in America.”
Summers thus embraces the Traditional Economy view of the world, where companies should wait to invest until there is demand for their products. The possibility that in today’s economy—the Creative Economy—these firms should be continuously innovating and creating their own demand doesn’t enter his mechanistic mental model. “The key is that you’ve got to have demand if you want companies to invest,” says Summers. “Otherwise they are investing in capacity that they don’t need.”
Summers is willing to concede that “in some companies CEOs are discouraged from making investments by activists. Some of the rules in the market haven’t been adjusted to deal with the tilt in favor of activists, which is something that the SEC and financial authorities need to be looking at if we are going to get investment.”
Short-termism is also a problem. Neera Tanden, president of the Center for American Progress, pointed to studies which show that 55% of executives say they wouldn’t make an investment if it affected their quarterly profits.
“Some people,” suggested CNBC's Joe Kernan, “think that the lack of demand is the result of the extended period of zero interest rates at the Fed. Firms are doing things that they wouldn’t normally do. Companies find it much more lucrative to borrow at low interest rates and buy back their stock. Normally they wouldn’t do that. Could that be part of the reason why there is a lack of demand in the first place?”
“That,” said Summers, “is flat earth economics. There is no economics that suggest that raising interest rates is going to somehow increase the level of demand. By raising interest rates, you make it more costly to borrow and invest. You make mortgages more costly.”
What Summers doesn’t see or accept is that the tsunami of free money, along with the practice of share buybacks, has created massive incentives to do the opposite of what the economy needs—more investment. No one is denying that raising interest rates will raise the cost of borrowing on houses, cars and investment. The question is: is that cost outweighed by the risk of a much larger distortion in the allocation of capital and the risk of another global financial crisis in the making?
Who Is Practicing Flat Earth Economics?
Flat-earth economics could be seen as economics that mistakes apparent reality for actual reality in the same way that flat-earth thinkers mistakenly see the earth as flat simply because it obviously looks flat.
Today the apparent reality espoused by Larry Summers and the Fed is the Potemkin prosperity of the stock market. It is facilitated by massive free money to big banks and corporations. The stock market is booming. Asset owners are doing well. Things look rosy.
The economic reality behind the facade however is that distortions and risks are building up within the economy after an unprecedented period of negative real interest rates. The only question is where the consequent distortions and risks will have their impact and when the house of cards will fall down.
By failing to see these risks, it is Summers and the Fed who are practicing flat-earth economics.
And read also:
Are We Sliding Into Another Financial Crisis?
Why The Fed Can’t Tell The Truth
Our House Of Cards Economy
Why Another Financial Crisis Is Inevitable
Blue Chips Are Addicted to Corporate Cocaine
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