Larry Summers is a very smart man with an impressive academic record and job resume. But that does not mean he should be the next chairman of the Federal Reserve Bank. Anyway, among Mr. Summers' accomplishments are that of president of Harvard University, where he made some intemperate statements about the qualifications of women in mathematics and had a run in with the Afro-American studies department that resulted in the departure of Professor Cornel West, allegedly because he recorded a pop CD, and for publishing books that were more likely reviewed by NYT than by his academic peers. These conflicts offer peeks into the man's character traits, but in no way disqualify him for the job as chairman of the Federal Reserve Bank. Part of the job description of the bank chairman is to promote economic growth (with little inflation). In normal times, one can expect any Fed chairman to commit to this. And the tools available to him are interest rates (federal funds rates), and open market activities--the trading of government securities on the open market. Chairman Bernanke has been pursuing this quantitative easing policy since 2008. And while it has not harmed the economy, the prevailing low interest rates don't seem to be doing much to speed up economic growth. One can only speculate about the rate of economic growth absent this policy of keeping interest rates low--if interest rates were not low, the economy would be in worse shape. But since you can't prove a negative this becomes a futile enterprise.
Mr. Summers
was also a chief economist at the World Bank (WB) and Bill Clinton's Treasury Secretary. In 1991, while chief
economist at the WB, Mr. Summers floated the notion that dirty industries should
promote migration to developing countries. He put forward three justifications
for this: (1) there is opportunity cost of pollution, which can be mitigated by
shifting it to poor countries--so, dumping toxic waste on low wage countries
makes sense; (2) he laments the costs of trade in solid waste because "Africa are
vastly UNDER-polluted, their air quality is probably vastly inefficiently low
compared to Los Angeles or Mexico City." Finally, a clean environment has a high income elasticity
(sensitivity) of demand. In high-income countries the concern about prostate
cancer producing pollution is greater than in low-income countries, so trade in
goods with "aesthetic pollution concern could be welfare enhancing." In a
nutshell, what he is saying is simply that the opportunity costs of pollution
is higher in rich countries relative to poor countries. This cost
differentiation suggests opportunities for mutually beneficial trade between
rich and poor countries in pollution.
The problem with pollution is that it is what economists
like to label a "bad." A "bad" is the converse of a "good"--most things such as
a cup of coffee, a computer, or a car, is a "good." We like to think that a
"good" is something humans produced and it is something we want more of. But a
"bad" includes nuclear waste, sewage, second-hand cigarette smoke, and
untreated exhaust from your car's tailpipe. We hardly want more of any of this.
So why in the world would poor African countries want to import toxic waste? We
have too much waste and they (developing countries) don't have enough. Well,
for this trade to take place, they would have to pay a negative price for a
glob of waste--or to put it differently, you got to pay them to take your waste.
This is an argument made way back in 1991 and it would be on the wrong side of
fairness to hold him accountable for it--considering, too, that he signed the
comment but allegedly did not write it. No one should be held accountable for
politically inartful commentaries, even when such commentaries are articulated
with some care and economic insight.
But there are more serious issues that we trace back to Mr.
Summers. Some the actions that he took part in that affect all our lives in
some way are listed by Barry
Ritholtz. Among them are:
- He oversaw the repeal of
Glass-Steagall via the passage of the Gramm-Leach-Bliley Act;
- He oversaw passage of the
Commodity Futures Modernization Act of 2000, preventing ALL Federal regulation
of derivatives; The CFMA also exempted derivatives from state insurance
oversight and anti-gambling laws.
- Thanks to Summers, derivatives
still have no minimum reserve requirements, no disclosure obligations, no
transparency and no exchange listing / reporting requirements.
It would be unfair to Mr. Summers
to review his history and include what is unflattering, but
leave out the positive contributions to the economy he had a hand in. For
example, he was President Obama's first director the National Economic Council,
and in that position he participated in drafting the president's $830 billion
stimulus program, a significant financial regulatory overhaul, and the rescue
of the automobile industry.
But
the derivatives issue remains, and is a problem of huge proportions. Derivatives
are financial contracts that derive their value from the price of an underlying
commodity such as stocks, bonds, indexes, etc. (See Randall Dodd primer
OTC Derivatives Markets) Examples of derivatives are the set of financial
instruments such as futures, forwards, options, and swaps. A farmer might sell
a futures contract to mitigate the potential loss of his crop from a drop in
price; an international commodity trader might obtain a forward contract to
cover the risk to an exchange rate fluctuation, an investor might buy an option
to sell (ask) or buy (bid) a stock--a bid option gives her the right to sell the
stock at a strike price, so if the price rises she could buy it at her strike
price and turn around and sell it at the higher price; finally a swap is an
agreement between two private parties in an over-the-counter market to exchange
sequences of cash flows for a specified period of time. Derivatives are different.
They are not traded in a market. They represent agreements between two parties
known to each other in the form of a one-off contract between the parties
directly--the only insurance is trust.
Derivatives
inhabit a monster universe with a notational value of $1.2 quadrillion. A
quadrillion is a thousand times a trillion. World Gross Product (WGP) is
estimated to be about $72 trillion according to the CIA
the World Fact Book. This number represents all the goods and services
produced by all the countries of the world yearly. The credit default swaps and
other derivatives dwarf this figure.
The real economy is about 6 percent of the derivative market. There are
two parties to a swap of an interest-earning asset such as a bond. The buyer of
the bond will get interest payments. But if the instrument involved in the
swap, namely the bond, defaults, someone, the seller, loses money equal to
notational value of the bond. Now in the case of the $1.2 quadrillion
outstanding derivatives, there is no enough money in the world to pay this off
and if something goes haywire the world economy may implode.
Thanks
in part to Larry Summers derivatives are traded in completely unregulated
markets. Glass-Steagall
had created a wall of separation between commercial banking activities and
investment banking activities. Larry Summers oversaw the repeal of Glass-Steagall.
This made investment banks deposits they did not have access to before, and it
might have had role in the collapse of the global financial market.
Wall
Street has recovered as Main Street struggles and inequality has become a
problem of growing proportions in the United States. The US has the distinction
of also being the country with the highest degree of income inequality among
the developed countries. Inequality can be explained by a number of factors
unrelated to derivatives whose growth may have been precipitated by
deregulation. These other factors include both fewer and weaker unions, a stagnant
minimum wage, tax policies that favor the rich, trade liberalization and
globalization, and an anemic recovery from a deep recession. Mr. Summers' role
in this state of affairs is worthy of analysis, and should not be ignored.
Dodd-Frank
(the Wall
Street Reform and Consumer Protection Act), signed into law by President
Obama on July 21, 2010, was an attempt to repair some of the damage inflicted
on the global economic because of the repeal of Glass-Steagall
among other things--though the Volker rule restores its provisions in a weakened
form; ends too big-to-fail by ending bailouts of big institutions; and the
Durbin Amendment puts a cap of $0.21 plus 5 basis points per debt card
transaction (Fed
Press Release 2011). Recently, a federal court ruled against the Fed's
effort to implement Dobb-Frank to limit interchange fees. It seems that the Fed
had overreached (The
Business Journals). Anyway, with these provisions (protections) in place
even in weakened form any Fed chairman can do little harm, except perhaps one
whose guiding principle is tight monetary policy, a strong dollar, and low
inflation. I am not entirely sure what Mr. Summers' philosophy or views are on
the Fed broadly speaking or on monetary policy in particular.
Janet
Yellen is another possible candidate to fill the chairman slot when Bernanke
steps down. Janet Yellen's own position on the Fed and monetary policy is also
worthy of review. And her nearly two-decade record as a Fed governor, regional
bank president and vice chairman, all else being equal, gives her the edge
given her hands-on experience. If she has not voiced any opposition to current
Fed policy under Chairman Bernanke, she might just provide the continuity that
would not roil the financial market (such as the inevitable reversal on easing)
and put a brake on the slow growing economy. Although it is increasingly that the quantitative easy has
not worked as expected. A Bloomberg News Survey of private economists makes
Janet Yellen is the best-qualified candidate for the Fed job (Financial
Post).
Ultimately,
however, the selection of the next Fed chairman is entirely up to President
Obama who recently has been publicly voicing his admiration and support for Mr.
Summers. I don't know if he is signaling his choice and whether Mr. Summers'
selection is already a fait accompli. Whoever it is that is finally chosen, the mandate and the rules of the Fed are such that he or she cannot do much to harm the economy.
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