Larry Summers’ Biggest Blunder
The prospect of seeing Larry Summers as chair of the Fed has angered many policy types in Washington and across the country. There is a multi-count indictment that includes his support for the repeal of Glass-Steagall, his opposition to regulating derivatives, his notorious comment about women possibly lacking the ability for sophisticated mathematical reasoning, and his protection of the big banks in his years as President Obama’s National Economic Adviser.
These are reasonable issues to raise as Summers is being considered for the country’s most powerful economic position. But the most important charge has generally been left off the list. Summers played a major role in creating the economic imbalances that fostered the housing bubble and explain the weakness of the economy right up to the present. This is the problem of the huge U.S. trade deficit, which was in turn caused by the over-valued dollar.
To understand what is at issue we have to go back to the East Asian financial crisis in 1997, when Larry Summers helped lead the bailout of the countries of the region as part of the “Committee to Save the World.” The crisis at the time involved the fast-growing Asian tigers that suddenly found themselves facing a run on their banks and their currencies.
One country after another found it necessary to abandon their fixed exchange rate. Since much debt was denominated in dollars or other foreign currencies, many banks and major corporations were pushed to the edge of bankruptcy.
Summers and his friends stepped into this situation with the money and power of the IMF at their command. They engineered a bailout that gave countries the money they needed to get through the crisis, but required that they would pay their debts in full. The flip side was that the United States would maintain an open door to exports from the region.
However it was not just East Asia that increased its exports to the United States. The experience of the East Asian countries led developing countries throughout the world to begin to accumulate vast amounts of dollar holdings to ensure that they would never be in the same situation of the East Asian countries being forced to accept whatever terms the IMF handed down.
This led to a huge run-up in the value of the dollar, which in turn caused the U.S. trade deficit to soar. A high dollar makes imports cheap for people living in the United States, so we buy more imports from overseas. A high dollar also makes U.S. exports more expensive to people living in other countries, so we are able to export less. As a result of the Larry Summers high-dollar policy the trade deficit exploded from a bit over 1 percent of GDP in 1996 to 4.0 percent of GDP ($640 billion in today’s economy) in 2000. The trade deficit continued to rise in the next decade peaking at almost 6.0 percent of GDP ($960 billion in today’s economy) in 2006.
The trade deficit created a huge gap in demand as a large portion of the income generated in the United States was spent outside of the country. In the late 1990s this gap was filled by the demand generated from the stock bubble. Record high stock prices led to a consumption boom as people spent more based on their bubble-generated stock wealth. It also led to a surge in investment as every crazy Internet start-up was able to raise hundreds of millions of dollars on Wall Street.
The bubble burst in 2000-2002, giving us the 2001 recession. While the recession was officially short and mild, it is not easy to recover from a recession caused by the collapse of an asset bubble. We did not recover the jobs lost in the recession until February of 2005. At the time, this was the longest period without job growth since the Great Depression.
Of course when the economy did start to create jobs again it was on the back of the housing bubble. And we know where that one got us.
But now that the housing bubble has burst, we are still left with a gap in demand from U.S. trade deficit. Since the dollar has fallen over the last decade the gap is smaller, but it is still close to 4 percent of GDP or around $600 billion a year.
Presumably the dollar will fall further in coming years, which will eventually eliminate the trade deficit as a drain on demand. But this adjustment is not going to happen tomorrow. In the meantime we can only get the economy back to anything resembling full employment with very large budget deficits (much larger than we are now running) or with another bubble.
The budget deficit route does not seem politically feasible and the bubble route is not likely to end any better the third time than it did the last two times. That leaves us with a prolonged period of high unemployment with tens of millions of people unemployed or underemployed. This will ruins lives of workers and their children.
That’s the world that Larry Summers has given us. Hey, why not give him the country’s most important economic post? He’s supposed to be really smart.
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The End of Loser Liberalism: Making Markets Progressive. He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues.