Professor Summers took on the task of defending the indefensible.  Naturally, he, like the policies he promoted and supported, failed.

He starts by asking the question of did we get the policy response to the Great Financial Crisis right.  Of course, the answer is no, but let me debunk his attempt to argue the answer is yes.

If you looked at what was happening to the economy in 2007, at the runup to Bear Stearns failing and what happened to after Bear Stearns failed, there was obviously a gathering storm. Nobody did much except react. Banks were allowed to continue paying dividends. Nobody was forced to recapitalize. The situation drifted along. There should have been shock and awe of capital, a recognition that maintaining demand was the most important objective of macro-economic policy. Yet nobody did much. It was an obvious mistake, even at the time.

He is right nobody did much.  But his suggestion for what should have been done is fundamentally flawed.

The opaque banks having more capital would not have stopped the market from asking “are they solvent”.  The opacity that prevented the market from being able to answer this question when banks had less capital would also have prevented the market from answering this question when banks had more capital.  Remember, these institutions are leveraged and nobody had any idea what their exposure was to valueless opaque securities.  As a result, the market would have still moved on to the next question of “do they have any value at all”.  Again, opacity would have prevented the market from answering this question.

Market participants know when the value of an opaque security is called into doubt, run and try to get their money back.  So panic would not have been avoided.

But in the crucial period of six months between the time Lehman Brothers fell and the period after the stress test, America rose to the occasion. The banks were substantially recapitalized; significant fiscal stimulus was delivered; substantial interventions to provide liquidity to the financial markets were engineered; and the sharpest “V” in the history of the major economies was recorded between the first and second quarters of 2009. On the precipice of a truly historic economic calamity, we acted decisively, appropriately, and effectively. And this was by far the most important period to get it right.

I agree with his description of what happened except they got it wrong and the result was to undermine both the social contract and the real economy.

By design, banks don’t have to be recapitalized.  Deposit insurance makes the taxpayers an insolvent bank’s silent equity partner.  Bailing out the banks by injecting taxpayer funds makes this silent partnership explicit.

More importantly, bailing out the banks prevents the bailed out banks from performing their critical function to protect the real economy from the fallout from a financial crisis.  That function is to absorb the losses on the excess debt in the financial system.  After injecting taxpayer money into the banks, it was impossible to have debt cancellation and the banks absorb the losses they were designed to absorb.

So instead of protecting the real economy from the financial crisis, the policy response forced the fallout of the financial crisis onto the real economy.

Suddenly, it was the creditors rather than the borrowers who were being protected (so much for the social contract and the idea investors were responsible for their losses).

Of course, by not canceling the excess debt, the burden of servicing this debt was placed on the real economy.  As Japan has shown, this leads to economic malaise.

Could we have avoided a populist backlash?

There are reasons rooted in financial crises in general that serve as catalysts for populist uprisings: in particular the need to provide support to existing financial institutions, especially powerful ones, at the same time that masses of people suffer dislocation. But had we adopted more draconian policies towards the financial institutions, would it have somehow curbed the populist pressure? The best natural experiment says no.

Actually, the best natural experiment says Yes.

I understand Professor Summers works for the Harvard Economics department.  This is important as we know not to expect anything remotely resembling competence when a member of the department does any sort of analysis.  One of his colleagues, Ken Rogoff, showed just how low the bar is set at Harvard with the fundamentally flawed analysis including spreadsheet errors in This Time is Different.

So naturally, Professor Summers missed the best natural experiment was Iceland’s response.  It didn’t bailout its banks.  It forced the banks to take losses on the debt that would never be repaid.  It now has a self-sustaining recovery and there hasn’t been a rise in populism.

Should we have nationalized banks?

When you nationalize an institution, the first question everyone asks is, “What happens next?”

Except nationalizing the banks is a straw man argument.  There is never a need to do so.  The combination of deposit insurance and the Fed as lender of last resort guarantee a bank can remain in operation supporting the real economy until such time as the regulators close it.

There were those who said at the time, “Well, what about the Swedish model?” But the Swedish government already owned 80 percent of the banks before the crisis started: The government putting additional capital into a bank that it already 80 percent owns really isn’t analogous to the situation we were facing.

Confession:  I was one of those calling for the Swedish Model rather than the Japanese Model that was pursued.  What Professor Summers conveniently forgets or does not know about the Swedish Model is it was first implemented in the US during the Great Depression.

This is worth repeating.  The FDR Administration was the originator of the Swedish Model.  Under this model, banks take losses on the excess debt before addressing the hole in their equity accounts.  It worked in the US in 1933.  It worked in Sweden in the 1990s.  It worked in Iceland in 2008/2009.

In contrast, the Japanese Model has never ended a financial crisis and left a self-sustaining recovery.