U.S. Financial Distress

Larry Summers, the former Harvard president who earlier was Clinton’s Treasury Secretary, is worried about where the U.S. economy is going. He makes these cautionary points (comments no Harvard president, even Summers, would utter in public):

1. forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. . . nationwide house prices could fall from their previous peaks by as much as 25% over the next several years. . . it is hard to believe declines of . . . this magnitude will not lead to a dramatic slowing in . . . consumer spending . . .

2. only a small part of the financial distress that must be worked through has yet been faced. . .the rate of foreclosure will more than double over the next year . . .total losses in the American financial sector would be several times the $50bn or so in write-downs that have already been announced, [spreading] to the credit card, auto and commercial property sectors.

3. the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. . . powerfully demonstrated last week when the yield on the two-year Treasury bond dropped below 3% for the first time in years.

So Summers offers these recommendations:

1. the Fed has to get ahead of the curve and recognise – as the market already has – that levels of the Fed Funds rate that were neutral when the financial system was working normally are quite contractionary today.

2. policymakers need to [adopt] non-traditional [measures], given how much of the problem lies outside bank balance sheets. . . The priority [is] maintaining the flow of credit.

3. [we need to maintain] demand in the housing market to the maximum extent possible. The government . . . needs to assure that there is a continuing flow of reasonably priced loans to credit worthy home purchasers.