Larry Summers, Economic Recovery, And Ben Bernanke

In a memo to Congress on Tuesday, Larry Summers – the head of the White House National Economic Council – laid out his view of where we are and what is likely to happen next in our economic recovery.

His tone was more upbeat than we’ve heard in recent utterances, although he has been heading in this direction for a while – contrast this April speech with this appearance in July.

What is beginning to turn the economy around?  Summers claims great effects from the fiscal stimulus Recovery Act, but much of that money has not yet been spent.

He also puts weight on “an aggressive effort to tackle the foreclosure crisis.”  There have been sensible steps in that direction, but so far the effects have been decidedly modest.

The main explanation has to be that the administration prevented the financial system from collapsing.  In an economy as large and diverse as that of the United States – with much more government spending than at the time of the Great Depression – as long as the entire provision of credit does not disintegrate, we will recover.

Summers refers to “A Financial Stabilization Plan”, but this is ex post grandiosity.  In fact, the government simply demonstrated unflinching support for all big financial firms as currently constituted.  We the taxpayer effectively guaranteed all these firms debts, unconditionally.  Once the market figured out that the Treasury, Federal Reserve and other officials could pull this off, the panic was over.

But this victory brings also real danger.

Rahm Emanuel, the White House Chief of Staff, put it well recently, “The [finance] industry is already back to their pre-meltdown bonuses.  We need to make sure we don’t slip back to risky behavior where the institutions have all the upside and the taxpayers have all the downside, which is why we need regulatory reform.”

Summers does not shy from this issue.  In his letter to Congress he says we need, “Comprehensive reform of the nation’s financial regulatory system so that a crisis like this never happens again,” and “Financial regulatory reform is vital to preventing against (sic) the asset market bubbles that have characterized previous recoveries.”

There are, however, three problems with what he proposes.

First, he says that the administration “has unveiled a sweeping set of regulatory reforms.”  But the reality is more modest.  There will be some slight strengthening of capital requirements, somewhat more attention paid to “systemic risk” (although this is not well defined), and mildly tougher regulation of derivatives.  Most of this amounts to essentially business as usual.

Second, to the extent that the administration does have a few good ideas – for example on a new consumer protection agency for financial products – it has let opposition build to the point where the lobbyists may well be able to prevent progress.  The time to push for change was earlier this year, when banking was still in political disarray; now the sector is stronger than even on Capitol Hill.

Third, the administration can’t even bring its own regulatory agencies along with its modest reforms.  Last week, Treasury Secretary Tim Geithner expressed extreme frustration with the efforts of these agencies to block reform.  This week, appearing before the Senate Banking Committee, the same people were still in serious blocking mode.

Even the Federal Reserve chairman, Ben Bernanke, does not seem to be on board with reform as proposed by Geithner and pushed by the White House.  It’s not clear if Bernanke has become too close to the banking industry or too captured by his staff, but in any case Treasury feels that he is not fully on board.

If the administration really wants to put the economy on a path to sustainable bubble-free growth, it looks increasingly likely that it will want to replace Bernanke when his term is up early next year.

Secretary Geithner is the most plausible replacement.  He was previously head of the New York Fed and vice chair of the Federal Open Market Committee, so he knows the system intimately.  He has spearheaded all the financial rescue efforts of the past few years; better than anyone he knows what went wrong.  The markets see him as a safe and friendly pair of hands.

And, increasingly, if he wants any kind of real reform, it looks like Secretary Geithner will have to go to the Fed and implement it himself.