Larry Summers, Obama, & a Fed Counterfactual

Larry Summers
Former Secretary of the Treasury Lawrence "Larry" Summers. Photo: Chip Somodevilla/Getty Images
William D. Cohan
June 15, 2022

Here’s an interesting thought experiment: What if our old friend Larry Summers had gotten his wish and President Obama had appointed him Chairman of the Federal Reserve, in 2013, instead of Janet Yellen? This was in fact the plan, according to the first volume of Obama’s memoir, wherein he acknowledged that he—coaxed on by his onetime chief of staff, Rahm Emanuel—had promised Summers that he would get the top Fed job if he agreed to become the National Economic Advisor, a step-down from the role of Treasury Secretary, a position Summers held at the end of the second Clinton administration. But as word circulated that Summers was Obama’s preferred pick to replace Ben Bernanke, the progressive wing of the Democratic Party pushed back hard, forcing Obama’s hand and clearing the path instead for Yellen.

Was that a gigantic mistake, courtesy of Senators Elizabeth Warren, Jeff Merkley, and Sherrod Brown? It sure seems that way now. Inflation, at an annual rate of 8.5 percent, is at the highest level in 40 years, and the financial markets are in turmoil, largely as a result of Yellen’s, and then her successor, Jerome Powell’s, slavish devotion to Bernanke’s policies of historically low interest rates, which ignited one asset bubble after another. Now we are paying the price with rising prices, rising rates, and a serious bear market. “I do think there needs to be considerable soul-searching at the Fed as to how they missed this as badly as they did,” Summers told David Ignatius on May 31. 

To his credit, while Powell was sticking with the idea that inflation was “transitory,” Summers saw things differently as early as February 2021. Starting more than a year ago, he believed that inflation was becoming a real problem and would not be fading away anytime soon. He all but begged the Fed, in opinion piece after opinion piece and in television appearance after television appearance, to take the growing problem more seriously. “There is a wise apocryphal saying,” Summers wrote in the Washington Post last November, “often attributed to John Maynard Keynes: ‘When the facts change, I change my mind. What do you do?’ After years of advocating more expansionary fiscal and monetary policy, I altered my view this past winter, and I believe the Biden administration and the Federal Reserve need to further adjust their thinking on inflation today.”

He also believed, and has said to me and others, that the Fed, under both Yellen and Powell, stuck way too long with Quantitative Easing, a process by which the Fed became the biggest buyer of debt securities in the market and then installed them on its ever-expanding balance sheet. Between just before the 2008 financial crisis and today, the Fed’s balance sheet has increased some ten-fold, to $9 trillion. The effect of the Fed’s wanton buying was to drive long-term interest rates to their lowest levels in recorded history, and to unleash an unprecedented explosion of debt issuance at almost every level of our society. The national debt, according to statistics released by the Federal Reserve Bank of St. Louis, stood at more than $30 trillion, as of May 27, up from about $9.5 trillion at the start of 2008 and the beginning of the Bernanke/Yellen/Powell easy-money policies. (The national debt increased to around $28 trillion, from $20 trillion, under Donald Trump, an increase of 40 percent during his one term as president.) 

Corporate debt also skyrocketed, much of it with loose covenants that fail to protect the buyers of the debt. According to the Securities Industry and Financial Markets Association, the total amount of corporate debt outstanding at the end of 2021 was nearly $52 trillion, up from $31 trillion at the end of 2008, when the financial crisis was in full bloom. That’s a 67 percent increase, brought on by the Fed manipulating interest rates downward for more than a decade. Corporate executives, as well as the people who make money from money, such as hedge fund managers and private-equity titans, came to the utterly rational realization that the years between 2009 and 2021 were a once-in-a-lifetime opportunity to load up on debt at unprecedented low rates. When the average yield on a high-yield bond—a bond issued by a company with less-than-stellar credit ratings—dropped below 4 percent last fall, trouble appeared to be brewing, and just around the corner. To account for the risk of owning a bond issued by a corporation with poor credit, the yield really ought to be at least 10 percent, and perhaps more, as it used to be in the days when Mike Milken, of Drexel Lambert fame, created and then controlled the market for high-yield bonds. And that was before Milken often demanded warrants—a form of equity kicker—from the issuer to further sweeten the returns for investors. Loyal readers, I know you’ve heard me reiterate this point in the past, but it is just astonishingly true.

“Behind the Curve”

Summers was not alone in realizing that the Fed had gone on too long with Quantitative Easing, and that risk was being mispriced left and right. But he was among the few leading economists and hedge fund managers to call out the Fed and to demand that the manipulation of interest rates come to an end. During the summer of 2021, Summers said the Fed was “behind the curve” and the continuation of buying mortgage securities, as part of the ongoing Q.E. program, made no sense given the increase in housing prices. He told Ignatius on May 31 that the Fed’s Q.E. program had “needlessly exacerbated the housing bubble” we now find ourselves trying to escape.

Summers has a history of seeing around economic corners without being heeded. In a speech at Stanford, in March 2008, just a week before the collapse of Bear Stearns, he predicted the financial crisis that would soon start to unfold. “I believe that we are facing the most serious combination of macroeconomic and financial stresses that the United States has faced in at least a generation—and, possibly, much longer than that,” he said. He identified “secular stagnation” and the slow economic recovery in 2013 when Bernanke and Yellen didn’t see it. He opposed the interest rate increases under both Yellen and Powell that were later reversed. 

Finally, the Powell Fed appears to have come to the realization that Summers has been right all along and that soul-searching has begun, albeit belatedly. Now, of course, we are paying the price for years of negligence. The price of nearly everything (gasoline, food, services) seems to have suddenly exploded. The price of money, too, has skyrocketed upward. The yield on the two-year U.S. Treasury bond, at 3.3 percent, is at a level last seen in 2008. The increase in the last year—more than 2,000 percent—is nothing short of astounding, as traders and investors grapple with the end of one era (zero interest rates, quantitative easing) and the beginning of a new one (rising interest rates and quantitative tightening).

A year ago, the yield on the two-year Treasury was .1429 percent, or about as close to zero as you can get. Since hitting that sub 4 percent yield last fall, the average yield on a high-yield bond has also exploded, and now stands at 8.44 percent, an increase of 113 percent in nine months, or so. And with the Fed poised to play catch-up—Powell hiked the benchmark rate by 75 basis points today, and is expected to raise them again at each of the Fed’s four remaining meetings this year—the yield on Treasuries, as well as on riskier debt will keep moving higher, perhaps even to the yields that Milken commanded in the late 1980s and early 1990s. Global high-yield bond issuance has tumbled so far in 2022, to the lowest levels since the 2008 financial crisis.

“The Optimists Were Wrong”

The ubiquitous Summers was a guest on Sunday’s State of the Union on CNN. Once again, he calmly and effectively made his points. He told Dana Bash that the key driver for the inflation outlook was the war in Ukraine and its effect on oil prices. He said that there “is a risk” that inflation will move higher and that its decline will not be rapid. “The Fed’s forecasts have tended to be much too optimistic,” he said. “And I hope they’ll recognize fully the gravity of the problem in their forecasts when they meet” this coming week. He said there were steps that Biden could take, such as reducing tariffs on goods made in China entering the U.S., repealing the Trump tax cuts for corporations, and lowering prescription drug costs that could reduce the inflation rate. “This is a challenge that we can meet if we’re prepared to be serious,” he said. (He made similar points on Don Lemon’s CNN show on Tuesday night.)

He also told Bash that he disagreed with Yellen’s assessment that “there was nothing to suggest a recession is in the works.” Said Summers, “When inflation is as high as it is right now, and unemployment is as low as it is right now, it’s almost always been followed, within two years, by recession. I look at what’s happening in the stock and bond markets. I look at where consumer sentiment is. I think there’s certainly a risk of recession in the next year. And I think given where we’ve gotten to, it’s more likely than not that we’ll have a recession within the next two years. That is something we can manage. We’ve had them for the whole history of the country. We need to be prepared and to respond quickly. If and when it happens. But I think the optimists were wrong a year ago, in saying we’d have no inflation, and I think they’re wrong now, if anyone’s highly confident that we’re going to avoid recession.”

He also made an important point about what he called the “Banana Republicans” who continue to say that what happened on January 6 was “nothing or okay.” He said they were “undermining the basic credibility of our country’s institutions,” which he argued also exacerbated the inflation problem. “If you can’t trust the country’s government, why should you trust its money?” he said. “So I think it’s terribly important that we take the temperature down in Washington, that we recognize behavior that’s just out of bounds of reasonableness and decency, that we give the Fed the room it needs. Bring down the budget deficit. We take down prices directly through prescription drugs. This is a challenge that we can meet if we’re prepared to be serious.”

Lightning Larry

I know Larry can be a bit of a lightning rod, infuriating those in his own political party who otherwise would support him for important positions such as the one he coveted, as Chairman of the Federal Reserve. The first piece I wrote for Vanity Fair, in 2009, was a profile of Larry. At the time, everyone seemed to be hating on him, for his tenure as Harvard’s president, for his tenure as Treasury secretary and for his tenure as Obama’s national economic advisor. 

Back then, I went to see him at the White House, in his cramped office a flight of stairs above the Oval Office. He was surrounded by an endless stream of Diet Coke cans and had parked himself behind a huge desk. He was utterly charming, even as he pontificated and evaded many of my questions. Larry is hard not to like and admire, especially because he is so damned smart, as many people are once again coming to realize as inflation rages on and interest rates spiral upward. (He declined my kind invitation to be interviewed for this piece.) 

We’ll never know for sure what would have happened if Larry Summers had been named Fed chairman instead of Yellen. But it’s safe to say, he would have pushed for higher interest rates well before now and would have stood up to Donald Trump in a way that Jay Powell did not. (Would still love to know what really happened at Powell’s February 2019 White House dinner with Trump.) He also would have realized far sooner than Powell did that inflation was for real and he would have set about tackling it in the ways he suggested to Dana Bash. I am sure this is an unpopular view, especially among progressives, but I dare say we wouldn’t be in the economic fix we’re in now if Obama had made good on his promise all those many years ago.