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Larry Summers: U.S. default would make Lehman look like a baby truck

Although many people have some idea, I consider the opinions of Lawrence Summers concerning the state of the U.S. economy to be more relevant than the opinion of others - at least those in the Democrat Party.

In the video above, he says that the daddy truck - the U.S. government - was carrying a baby truck - Lehman Brothers. So the U.S. default would make the demise of the Lehman brothers look like a rather small event.

It's likely - just compare the size of the two toy trucks - but given the probable temporary character of the crisis, it's not guaranteed. Moreover, I find it very important to stress that the decision not to raise the debt ceiling doesn not imply default. There's lots of money within the ceiling to pay the interest etc. which should almost certainly be a priority if some money would have to be slashed.

In a continuation of the video above, he talks about the deficit. He praises the second black president among those who were his bosses for his will to make a compromise.

Compromises are fine but they still don't cure the unsustainable dynamics of the U.S. budget deficit that Summers used to attack in the past.

Finally, in the exchange embedded below this paragraph, he is asked by Charlie Rose why the Republicans believe that the growing debt is responsible for the economic stagnation.

Summers has to think a bit. It looks like he is very slow at this moment but I guess that what is actually happening is that many different ideas and considerations are fighting inside his brain at his moment.

So when he's provoked by another question "does the reasoning of the Republicans makes any sense?" he makes a reflexive reaction and screams "no!" :-) but he also quickly realizes that this answer is oversimplified, to say the least. Summers realizes that he used to say the same thing so he says that in 1993, it was desirable to reduce the interest rates - by reducing the amount of money the government was borrowing every year - because the investment was low and the capacity utilization was high. He is even more authoritative so he defends the validity of the proposition even more vigorously than when he said that the Republicans were nuts.

But he's also clever enough to point out the difference between 1993 and 2011: today, the market (10-year and such) interest rates are low and can't be the reason that prevents anyone from investing. There's no reason to invest because the capacity utilization is low - the existing factories remain unused. Well, even though this reflects some Keynesian reasoning, I do agree that it has a point.

However, what this reasoning doesn't appreciate is that the wrong budget dynamics of the U.S. government has become a medium-term or long-term problem while the low value of the interest rates is arguably just a short-term anomaly. Given current numbers, it takes (or will take) a very long time to substantially change the budget deficit. If the growth of the U.S. public debt continues at the rate comparable to the current one - and there's no good reason that anything will qualitatively change in this "everything is OK" atmosphere that Summers is also helping to maintain - the debt/GDP ratio of the U.S. will approach the current Greek levels in 5 years or so.

Just say: Fire truck!

At that moment or earlier, the interest rates will inevitably go up as well. And it may already be too late to try to struggle with the budget deficit because it takes time and the initial attempts to reduce the budget deficit inevitably lead to a decrease of the GDP which means that they will make the fiscal situation even worse.

Because of this timing issue, the current tension about the debt ceiling is actually an optimum moment to try to dramatically reduce the budget, maybe even by a shock therapy which means a 40% reduction of the expenses. You may say that it's hard to reduce the expenses by 40% and you're right. It's hard. But a more important point is that it will be even harder in the future when there's no good "stimulus" in the form of a nearby debt ceiling.

I just feel that if the U.S. can't do something radical about the imbalance now, it will never do it and in a couple of years, it will inevitably approach some countries whose fiscal situation is considered really bad today.

Moreover, Summers' reasoning is based on the idea that the fiscal policy is a key method to regulate quantities such as the capacity utilization. Well, I am not so sure. There are other factors that regulate it - naturally as well as government-made - from the loose monetary policy to the dollar's exchange rate that may still be too strong as the trade deficit shows. So while it's true that continuing with the deficits may contribute to the pressure to increase the capacity utilization, it doesn't follow that it's necessarily the most sensible way from other viewpoints.

Also, in 2015, America may find out that the unsustainable budget deficits themselves were a much more important issue the country will should have focused upon than the capacity utilization in 2011.

Finally, I want to make my real point. Summers is a very intelligent economist so he knows what to do with variables X if he wants to increase or decrease Y. But at the very end of this causal chain, he can't hide that he is still a left-wing economist. He wouldn't ask whether it's actually a good thing to increase or decrease Y. The capacity utilization is a typical example.

The current capacity utilization may subjectively "look" low to Summers so he is defending policies that might increase it. However, he doesn't spend much time asking the question whether he knows that the low value is actually a bad thing. In particular, the capacity utilization is such a technical quantity that the market probably knows very well how to adjust it. If it is low, it may simply mean that the existing companies are producing goods that no one needs and no one wants and it is therefore counterproductive to try to artificially force these companies to produce "more of the old stuff". The old stuff isn't needed and the companies might be naturally going towards a healthy decline, being superseded by something else along the way. The effort to increase the capacity utilization could be just an artificial action of a big government to save the dinosaurs.

These are the questions Summers should be asking to himself much more frequently. The economy has many parameters but he is trying to prescribe the value of all of them which makes it likely that he is wrong. Ideally, the politicians should only prescribe a minimal number of such parameters. In particular, the Feds should determine an interest rate that leads to a sensible money supply - in which the interests of borrowers and lenders are balanced according to some rule. And the government should influence the economy primarily by balancing its budget which it clearly failed to do in recent 40 years. The magnitude of all other, more microscopic and "relative" parameters about the economy should be determined by the markets which actually reflect what makes people happy more accurately than Larry Summers' guesses about the optimum value of the capacity utilization that the government should achieve.

P.S. If you don't know why this article is full of baby trucks, it's because baby trucks and daddy trucks stripped Summers of his Harvard presidency that he liked. On a conference on women in science in January 2005, he was trying to make a point that girls may naturally have different priorities.

He mentioned a story how he educated his twin daughters in a politically correct way, buying them toy trucks. One of them told the other, "look, the daddy truck is carrying the baby truck" is if they were dolls. At that moment, Summers realized that something about his way of education could have been irrational.

When MIT feminist Nancy Hopkins heard it, she immediately escaped the room, claiming the she saved herself from vomiting, and called her politically correct contacts in the media, promoting the absolutely innocent, self-evident, and uncontroversial remarks by Summers to a nationwide scandal on the following morning.

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