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Home Publications Blogs Beat the Press Larry Summers’ Bad Math

Larry Summers’ Bad Math

Thursday, 25 July 2013 09:30

The debate over Larry Summers’ potential appointment to Fed chair provides an excellent opportunity to explain the logic behind one of his biggest policy missteps. During the East Asian financial crisis he worked alongside Robert Rubin and Alan Greenspan to impose a solution that required the countries of the region to repay their debts in full. The quid pro quo was that they would have the opportunity to hugely increase their exports to the United States in order to get the dollars needed to make their payments.

This bailout put muscle behind Robert Rubin’s strong dollar policy. Robert Rubin’s predecessor as Treasury Secretary, Lloyd Bentsen, was happy to have the dollar fall. This was part of the textbook story of the deficit reduction being pursued by the Clinton administration. Lower deficits were supposed to mean lower interest rates.

One of the dividends of lower interest rates was supposed to be that investors would hold fewer dollars, causing its value to fall relative to other currencies. This would make U.S. exports cheaper to people in other countries, leading them to buy more of our exports. A lower valued dollar would also make imports more expensive for people in the United States, leading them to buy fewer imports.

More exports and less imports means an improved trade balance which would increase demand and growth. And to some extent this is the story we saw in the first years of the Clinton administration with the trade deficit falling to its lowest non-recession levels as a share of GDP since the Carter years.

However Robert Rubin’s high dollar policy reversed this story. The rise in the dollar led a predictable rise in the trade deficit. Because of the harsh terms imposed in the bailout from East Asian financial crisis developing countries began to accumulate foreign exchange (i.e. dollars) on a massive basis in order to avoid ever being in the same situation. This caused a huge run-up in the dollar, which pushed the trade deficit ever higher.

The deficit reached 4 percent of GDP ($640 billion a year in today’s economy) in 2000 before falling back somewhat in the 2001 recession. It eventually peaked at almost 6 percent of GDP in 2006.

The trade deficit creates a huge gap in demand that must be filled by some other source. This is income that people are spending overseas rather than in the United States. In the late 1990s this gap was filled by the stock bubble. The $10 trillion in wealth generated by the bubble led to a huge surge in consumption as the saving rate was pushed to then record lows. The bubble also led to an increase of investment, although much of it was in hare-brained start-ups like Pets.com.

After the stock bubble burst the economy needed some other source of demand to replace the money lost through the trade deficit. Contrary to conventional wisdom, the economy was very slow to emerge from the 2001 recession. It did not regain the jobs lost in the recession until 2005. At the time this was the longest period without job growth since the Great Depression.

When the economy did emerge from the 2001 downturn it was on the back of the housing bubble. The bubble generated huge amounts of demand both by pushing construction to record levels and through the wealth effect on consumption. Of course it was predictable that this bubble would also end badly, as it did.

While Summers did not hold the levers of power through the housing bubble years, he did set the process in motion in the 1990s with his high dollar policy. He was also a major cheerleader at the time, denouncing those who raised questions about the exotic financing that was supporting the run-up in house prices as “luddites.”

Furthermore, we still have the basic math problem that he left us from his years in the Clinton administration, how do we fill the gap in demand that resulted from his high dollar policy. While a subsequent fall in the dollar has reduced the trade deficit, it is still close to 4.0 percent of GDP ($640 billion). This can be filled by the government’s deficit spending, but Summers has repeatedly warned that this is only a short-term strategy.

So how does Summer want to solve the math problem? Is he going to push for another bubble to juice the economy again or perhaps he has changed his mind and decided that a strong dollar really wasn’t such a good idea after all.

Anyhow, there is no way around this math. You either want a lower dollar, you want to sustain high budget deficits, you want another bubble, or you want high unemployment. That is the math, what is Summers’ answer? We should know this before he gets appointed to the country’s most important economic post.


Note: Correction made on imports becoming more expensive when the dollar falls. Thanks to the people who called it to my attention.

Comments (9)Add Comment
written by AlanInAZ, July 25, 2013 10:08
A lower valued dollar would also make imports cheaper for people in the United States

I think Dean means to say more expensive rather than cheaper.
Excellent criticism
written by jm, July 25, 2013 10:12
You hit the nail exactly on the head as to why Larry Summers shouldn't be the Fed chair -- and exactly why he will.
written by JSeydl, July 25, 2013 1:08
Last paragraph is gold.
written by Last Mover, July 25, 2013 3:27
Anyhow, there is no way around this math.

Well yes, but isn't Summers known for understanding that as a man, he's better at math than Yellen?
written by AlanInAZ, July 25, 2013 3:54
About a year ago I saw a video of a debate at Stanford between John Taylor and Larry Summers on economic policy. In that debate Summers said he would defer to Taylor on monetary policy since he made no claims to expertise in that area. That doesn't sound like a Fed chairman to me.
written by skeptonomist, July 25, 2013 4:17
Dean gives his usual story of household debt being solely a matter of wealth effects. Other economists don't look at debt in such a highly oversimplified way. Krugman has a post today "Stiglitz, Minsky, and Obama" which takes a broader view. Insofar as Dean's wealth-effect story relates to what Krugman is talking about, it presumably comes under the Minsky view - people forgetting about previous crashes and building new bubbles. But obviously Stiglitz and others take a different view, in which inequality plays a major role.

Note that Krugman's graph, household debt as % of personal disposable income, does not show the trends that would be expected if asset wealth is critical: there is no big drop after the stock market crash of 2000, instead there is an immediate turn upward; and there is nothing at all corresponding to the long and very large buildup of stock prices since 2009.

(This has little to do with Summers - on the whole I think Dean's criticisms of him are valid.)
The wealth effect is on consumption, not debt
written by Dean, July 25, 2013 5:20

Krugman's chart follows very closely on changes in wealth. There is a big run-up in the stock market and some increase in house prices in the 1980s, corresponding to a large rise in debt (and lower savings rate at the end of the decade), bigger run-up in stock prices in the 1990s, leading to a larger rise in debt (and further fall in the savings rate), and big run-up in house prices in the 2000s, leading to further rise in debt and sharper fall in savings rate.
I could use Krugman's chart to demonstrate the wealth effect very well, but the savings rate data show it more clearly.
written by ibilln, July 26, 2013 3:52
Strong dollar yes, but don't forget Summers' de-regulation push. Arguably even a bigger cause of the crisis.
Summers will be the death of the Middle Class
written by jumpinjezebel, July 26, 2013 8:07
I've never see anyone on the TeeVee that was such a sweating, stammering, shady-eyed lout. He is still against regulating the banks derivative casino and indeed was a major proponent of the elimination of Glass-Steagall. Yes for sure we need more of his help. He was in the front seat when we went into the ditch and now we should give him the wheel!!!! NOt!!!!!!

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.