Wow!  The architects of the policy response to the Great Financial Crisis cannot stop themselves from showing how unfit they were for the positions they held or how bad their choice of how to respond to the crisis was.

Larry Summers provided the latest example.

What set him off was an editorial written by George Soros and Rob Johnson.  The authors had the nerve to suggest the appropriate way to respond to a financial crisis is to pursue the Swedish Model under which the real economy is saved as oppose to the Japanese Model which the policymakers chose under which the banks are saved.

Under the Swedish Model, banks are required to recognize their losses on the excess debt in the financial system upfront.  This protects the real economy and allows it to continue to grow.

Under the Japanese model, banks are protected from losses and it is the real economy that has to adjust.  The adjustment the real economy makes to having the burden of excess debt placed on it is stagnation.  Stagnation policymakers like Professor Summers tried to overcome with fiscal stimulus and accommodative monetary policy.  In doing so, they created a host of other problems like a dramatic growth in inequality.

He offered up six reasons Soros and Johnson were wrong.  Of those six, it is worth taking a little bit of time to debunk five of them.

First, many commentators, experts, and political figures argued for capital infusions into banks rather than asset purchases to support the financial system.

This objection is tricky because it cloaks the fact both choices are wrong behind the myth of credentials.  Both choices are just different ways of bailing out banks.

By design, there is never a reason to use taxpayer funds to bailout banks either through equity injections or asset purchases.  The combination of deposit insurance and the central bank as lender of last resort makes this unnecessary.  Deposit insurance makes the taxpayers each insolvent bank’s silent equity partner.  Deposit insurance also makes it possible for the central bank to provide as much liquidity as the insolvent bank needs.  As a result, the combination allows insolvent banks to continue in operation indefinitely supporting the real economy.  The US Savings & Loans showed this in the 1980s.

Second, the decision to infuse capital into all banks, rather than doing so selectively, was taken well before the presidential election of 2008, won by Barack Obama. It was a fait accompli from the point of view of the Obama administration when it took office in January 2009.

This objection sweeps under the rug the fact Obama chose to endorse the decision by the Committee to Save the Banks (Paulson, Geithner and Bernanke) to save the banks rather than the real economy.  It also sweeps under the rug Obama’s Administration could have chosen a different policy of saving the real economy when it took office.

Fourth, bank stock prices were down as much as 90% for institutions, such as Bank of America, that were holding large amounts of mortgage debt. There wasn’t much more to take from them. …

Most of the benefit of mortgage reduction flows to consumers only over time. As a result, careful calculations about the impact of mortgage reductions on aggregate demand (which we performed and which Johnson and Soros have not) do not bear out their claims: The extra spending per dollar of relief was likely to be less than a dime on the dollar of government resources expended.

This objection is flawed on many different dimensions.  We could start off with his observation bank stock prices were down.  Who cares?  Shareholders recognize they are responsible for all losses on their investments.

We could go on to his revealing he doesn’t understand that by design bank equity accounts are where losses in the financial system are suppose to be recognized.  As stated above, there is no reason the government has to spend a single dollar of its resources rebuilding these bank equity accounts.

Or we could simply go to his comment about only consumers benefitting from a mortgage reduction.  People who borrow for a mortgage tend to have a propensity to consume that is significantly greater than zero (in non-economics terms, most of the money saved from the reduction in debt service is used to buy goods and services in the real economy).  So we know more than just consumers benefit (and to think Professor Summers is suppose to be among the very best the Economics profession has to offer).

Fifth, in the political environment that prevailed in 2009, it would have been difficult or impossible to get more money for the Troubled Asset Relief Program. …

There were trillions of dollars of outstanding mortgages and hundreds of billions in second mortgages and home equity lines, most of which were held by banks. Any large-scale program of mortgage reduction would have required wiping out subordinated mortgages and would have created a capital hole much larger than we could be confident of filling.

At least Professor Summers is consistent in his failure to recognize the US financial system is designed so the banks need the US, but the US doesn’t need any particular existing US bank.

As I have stated numerous times in this post, it isn’t the taxpayers’ responsibility to recapitalize the banks.  So requiring the banks to have recognized their losses doesn’t cost the taxpayers a dime.

The issue the banks faced was showing after they recognized these losses that they were still capable of generating earnings.  Earnings that would have then been used to rebuild their book equity.  If they weren’t, bank regulators could take as much time as the regulators needed to close them.

Sixth, the authors admiringly cite the British experience. It is not the case that Britain has avoided slow growth, right-wing electoral success, or toxic populism, so I’m not sure what this argument proves. Obama’s political advisers were emphatic that he should select the best policy, but with the awareness that mortgage relief that would disproportionately benefit those who borrowed most imprudently was highly unpopular.

I had to read the last sentence in Professor Summers’ objection multiple times to get how truly awful it is.  Consider his concern over those “who borrowed most imprudently.”  Professor Summers refuses to recognize it is 100% the Lender’s responsibility not to lend more than the borrower can afford to repay.  Let me repeat this because it is very important.  Nobody held a gun to the lender’s head and said you must make a loan the borrower cannot afford to repay.

Of course, I am not surprised Professor Summers said this.  It is simply another twist on the banks need to be bailed out from the imprudent loans and investments they made, but the borrowers cannot be.

As for political popularity, Professor Summers appears to be asserting bank bailouts were politically popular.  So popular, Obama was elected president…

Iceland showed how to handle the issue of mortgage relief under the Swedish Model in a politically acceptable manner.  Iceland wrote down the mortgages to the greater of what the borrower could afford or an independent third party would pay for the property.  It was seen as fair.  After all, if you had borrowed most imprudently, it was highly likely someone else would step in and buy your house.