How Likely Is a Recession?

Larry Summers is at it again. The coal mine canary is warning of recession as the Federal Reserve tries to curb inflation without triggering a slump.

For now, economists put the chance of a recession developing over the next year at 27.5 percent, according to a Bloomberg survey earlier this month. Still, the downbeat call by the Harvard professor and former Treasury Secretary isn’t easily dismissed, even by optimists. Summers famously cautioned that the federal government was being overly generous with its Covid-19 bailout payments, and he dismissed the idea that inflation would be “transitory” well before that attitude was fashionable.

In a wide-ranging chat with Stephanie Flanders, head of Bloomberg Economics and host of its Stephanomics podcast, Summers says the Biden administration could be doing much more to help ease inflation. He says the Fed should be more forthcoming in admitting what he sees as its mistakes and suggests Americans need to sacrifice more in the effort to thwart Russia’s war on Ukraine.

First, he gives some historical perspective on why he sees a recession being more likely than a soft landing:*

Larry Summers:  If you look at history, there has never been a moment when inflation was above 4 percent and unemployment was below 5 percent when we did not have a recession within the next two years. So I think the odds on a hard landing within the next two years are certainly better than half, and quite possibly two-thirds or more. I don’t think the idea that is still embodied in Fed forecasts, that we could have continuing super-tight labor markets at 3-1/2 percent unemployment and we could have inflation come down rapidly, is a terribly plausible one. That’s a residue of “team transitory.”

The key fact one has to recognize, I think, to grasp the current situation is that wage inflation is now running above 6 percent on the best data, which is the Atlanta Fed indicator. And if wage inflation is running at 6 percent, that’s pointing to price inflation at 4-1/2 percent or 5 percent. So I think we’re either going to live with that for quite a while, in which case we’ll have an even bigger recession later, or some set of events involving monetary policy and involving what happens in the real economy are going to force a hard landing. I’m much more agnostic on how high interest rates are going to have to go to generate a hard landing and disinflation than I am on the likelihood that, at the end of the day, we’re going to see a fairly hard landing.

Stephanie Flanders:  Just to dig in a little bit in terms of what you think the mechanism is going to be that will bring the U.S. into a recession. We know—and, in fact, it was part of your argument—that the stimulus that was so large a year ago in the United States that it left household excess savings quite high, certainly by historical standards, even in the lower half of the income distribution. Debt service from households is now at a 40-year low. They are coming into this with quite a strong position, even with the inflation that we’re seeing. So what is the mechanism that’s going to bring the U.S. into a recession?

Summers:  I think there are two classes of mechanisms that are operative, and which one is going to get there first, and their relative timing, is something where I don’t have a confident judgment. One class of mechanisms is monetary policy. I think monetary policy is going to have to keep going until we see disinflation, and we’re not going to see disinflation back towards the target range until we see unemployment rise meaningfully. That’s one source of uncertainty—monetary policy doing what it has to do. The other is the countervailing mechanisms to what you described, the fact that inflation has eroded real incomes and the value of savings. The fact that there’s significant fragility in financial markets. The fact that mortgage rates have risen by 200 basis points in the last four months.

And we are seeing, for the first time in many years, that lots of people are starting the mortgage process and not finishing the mortgage process. We’re seeing evidence in certain sectors of significantly reduced traffic. So I think it’s hard to know when, and to what extent, the economy is going to turn over itself. And to what extent it is going to be induced by monetary policy. But I think the judgment that’s hard to escape is that inflation is not going to get near reasonable levels if the economy doesn’t at least substantially slow.

Flanders:  You talk about the need for unemployment to go up. Some of your critics would say we’ve gotten to an amazing point in the U.S. economy, in which U.S. workers have been on the back foot for so long that you have the unemployment rate at this previously unheard-of 3.6 percent. We’ve got reporters in Indiana, where there’s less than 1 percent unemployment, and workers in those places have a position of power that they haven’t had in many years. What is wrong with having produced that situation?

Summers:  Look, Stephanie, it’s a hugely important question. The first academic work I did was on how important high-pressure labor markets were for the disadvantaged. So, I showed what was novel at that moment, that a 1 percent increase in the employment ratio for White men was associated with a 6 percent increase in the employment ratio for African-American teenagers. So I yield to no one in my belief in the importance of helping the disadvantaged and in recognizing that tight labor markets do benefit those who are traditionally left behind. But there are three problems.

The first is that, overall, this higher inflation has gone with falling, not increasing, real wages. If you look at a graph of the nominal wage growth in the U.S. on one axis and growth in purchasing power on the other axis, it looks like a turned-over parabola. Living standards grow most rapidly when wages are rising at 4 percent, and then they fall off as you start to see wage growth at 5, 6, 7, 8 percent. So the first thing to say is that what we’re doing is we’re having lower real wage growth for the vast majority of the populations and consequences.

The second is the core lesson we have learned is that there’s not a stable tradeoff between unemployment and inflation. There’s a stable tradeoff between unemployment and the acceleration of inflation. And if we run an overheated economy, it’s not that we’ll have to live with 4 percent inflation forever. It’s that we’ll live with steadily rising inflation and set up an ever-greater price that we have to pay.

Prudent policymakers don’t just pay attention to the current moment. They pay attention to what happens over the longer term. And the consequence of overheating is that it has to be followed by something that ultimately stabilizes things. And the history is that if you look at the overall path, the poor are worse off once you go through that whole process than they would’ve been if you kept things stable all along. That’s why the Fed’s new woke rhetoric in 2021 was so dangerously misguided. And I fear that, down the road, the people who they were most concerned to help with that rhetoric are going to be the victims if, as I expect, we have some kind of hard landing.

Flanders:  Given that you’ve started by saying you think that’s the most likely scenario and that you want the Fed to be looking down the track, I guess the other inevitable question is, how do you think they should be responding to a recession?

Summers: I think the Fed has to stay focused on bringing down the inflation rate and the expected inflation rate. I don’t think there is any alternative that doesn’t set the stage for greater pain. We can have an argument about 2 percent versus some other number a bit greater than two. But I think we need to recognize that price stability is when people aren’t focused all the time on the overall changes in the price level.

By that definition, we had about 35 years of price stability, between the mid-1980s and 2021. And by that definition, we have lost price stability in the United States. Inflation is now the number one economic issue. It’s driving a vast erosion in confidence in government. And the Fed has to do what’s necessary to restore a sense of price stability. I can’t say exactly what that means in numerical terms, but I know that we are well away from it now in the judgment of the American people. I think that’s what’s going to be necessary in terms of monetary policy. I welcome, particularly, the most recent speech of Chairman [Jerome] Powell, which I think moved a long way toward being in the right place.

I’d like to see the Fed signal a commitment to raise interest rates until real rates are clearly positive, or until it’s clear that price stability has been restored. And I think they’ve moved a long way in that direction. That’s good, if late, but I think they’ve got some distance to go before they achieve it.

Flanders:  Inflation has become an extraordinarily salient issue, politically. I mean, President [Joe] Biden, in his State of the Union, said bringing down inflation is going to be one of his primary objectives in the next year and beyond. And I think some of us were left sort of scratching our heads thinking, ‘Well, hang on, what can the administration do, since it’s the Fed’s job to be reducing inflation? What can the administration do to reduce inflation?’

Summers:  Look, the things the administration is talking about in terms of micropolicies to reduce inflation are frivolous, non-serious, and utterly ineffectual. A gas price holiday would ultimately push up prices by raising demand. The student loan relief is injecting resources into the economy at an annual rate of $100 billion a year when the economy needs to be cooled off, not heated up. The administration could be much more constructive than it has been with respect to energy supply. And the administration’s “Buy America” policies work to raise prices. The microeconomic policies of the administration have been a wash, at best, with respect to inflation.

What could they do? The Peterson Institute just release a study that I helped instigate—it’s on their website—that estimates that a realistic program of trade liberalization could take 1.3 percent off the CPI [consumer price index]. Their scope for policies to increase immigration could take substantial pressures off the labor market. But the approaches that would work are approaches that would emphasize increasing the level of competition for American producers, not seeking to protect American producers. That’s the element of microeconomic policy that has a prospect for success. And I fear that the more popular themes around corporate gouging and the like are simply diversionary.

Flanders:  The Fed had one job. It has monumentally failed on that job in a consistent way for the last year and potentially into the future with this strategy. If a fund manager made that kind of bad call for such a long time, there would be pretty concrete consequences. If an elected politician made that kind of mistake, there would almost certainly be consequences. Do you think there should be greater accountability for this particular failure, for the forecasting system that produced it, and even potentially for individuals?

Summers:  I think the Fed should be much more visibly acknowledging that it’s been wrong and seeking to understand and learn from its errors than has been the case. I am concerned about the failure for there to be some institutional review. After bad battles, armies have after-action reviews. The IMF [International Monetary Fund] has blundered in various situations, and there’ve been very thoughtful reviews of what in its culture and what in its mode led to those errors. I think the Fed should be engaged in more of that.

In fairness to the Fed, the views they were expressing were relatively close to consensus views. Not, frankly, this last fall, when I think they were behind the consensus and still sticking with their views. But for much of last year, their views were tracking with consensus views. And so I think the soul searching is less about accountability for individuals at the Fed than about how those consensus views were formed. And I guess I have been struck by a certain blitheness with which some of my friends in the economics community have pivoted to addressing the current moment without thinking about what led them to be wrong in the past.

Flanders:  OK. Let’s get onto Ukraine, Russia, and the fallout from the crisis. You were a senior Treasury official throughout those two Clinton administrations in the ’90s, which were really trying to think through, after the end of the Cold War, how Russia was going to fit into the international economic system, whether it should join the G-7, those types of things. Should we be doing more to hurt Russia economically now? What’s your take on the coordinated sanctions that have been imposed and the other actions that have been taken?

Summers:  I think by the standards of history and tradition, we’ve done a great deal. By the standards of the magnitude of the problem, there’s a lot more to do. Understand this: The ruble is now trading at the same exchange rate that it was before the war started. Russian banks are not experiencing runs. Every day, Russia is getting revenues from the export of its energy products that are comparable to, or greater than, they were receiving before the war because of increased energy prices. The limitation on the sale of goods to Russia has not been nearly as comprehensive as was imposed on Iran at earlier moments. The truth is that, in a sense (and I strongly support this), using economic tools is trying to fight a war without costs in blood. That is the right thing, but in important respects, we’ve been trying to fight an economic war without costs to households.

From the first moment when the sanctions were introduced, and as it was explained that simultaneously we were going to be doing everything we could to keep gas prices under control, I have felt that there was a moral failure. If this is a unique and extraordinary worst threat in 75 years of naked aggression, then we need to be prepared to make sacrifices at the level of accepting higher energy prices, wearing sweaters on days with cool weather, being a little hotter when we can’t run air conditioners as strongly as we did before, sacrificing luxury exports to Russia, and sacrificing mercantile commercial interests. I do not believe that enough has been done. I believe that much more needs to be done. I was glad to see the step that was taken to stop the Russians from using their frozen reserves to pay debt, but in a way it was an extraordinary and remarkable thing that for the six previous weeks, they had been allowed to use their frozen reserves to prevent them from doing it.

So I think that we have a long way to go in raising the pressure that we impose on sanctions. And frankly, I would prefer less rhetoric about the war criminality of what’s going on, which it seems to me does not bring pressure to produce peace. If anything, slightly the opposite by meaning that there’s no exit strategy from this. Less emphasis on that rhetoric and much more emphasis on the imposition of economic pain.

We saw in the U.S. in 2008 what cascading lack of confidence in finance can do to destroy the performance of an economy. It’s extraordinarily counterintuitive for any financial person, but I think we need to engage exactly those forces as forces of destruction with respect to the Russian economy right now, recognizing that that may have some collateral implications for some few financial institutions in the West and being prepared to provide the necessary kind of support.

I don’t think we have yet stepped up fully in terms of engaging the tools of financial warfare. That’s how I see it from the outside. But I have an outsider’s view—and I’ve been an insider, and I have seen outsiders with naive views making it sound simpler than it is. And in fairness to those who are making the decisions, it may be that there are a whole set of collateral costs that they have thought through very carefully. But my instinct is that there’s a good deal more that could be done.

I’d like to see some long queues outside some Russian financial institutions. I’d like to see some Russian defaults followed by seizures of key Russian assets. And I’d like to see the ruble in free fall as part of judging the efficacy of a sanctions program.

Flanders:  You know, one of the other things that happened under your watch at Treasury in the late ’90s was the beginnings of the G-20, which was pretty evident in the global financial crisis and the global response to that, but has been pretty absent in recent years. And certainly in response to this crisis, or even the inflation crisis and cost-of-living crunch that’s coming for so many countries. I wonder, do you think it’s the end of the G-20?

Summers:  Look, I think the G-20 had a premise. The premise of the G-20 was that all countries wanted all other countries to do better, that we all gained from a more open, more rapidly growing economy. The United States wanted China to grow faster; China wanted the U.S. to grow faster; we all wanted to solve global problems together. And that was the premise of the G-20. And that was basically true in the 2008 financial crisis. Everybody wanted the crisis to be successfully weathered and the global economy to grow again.

That is in very profound question today. Self-evidently, it is not the objective of most of the other members of the G-20 to support Russia’s economic flourishing. It is a substantial question whether we are hoping for the success of the Chinese economy and whether China is hoping for the success of our economy.

So the premise of the G-20, which was a forum for devising a means to shared ends, is much less evidently true today. And before one talks about what you should convene a G-20 meeting to do, and what kind of statement a G-20 should make, it seems to me that one has to get straight these questions about which communities have which shared ends.

Right now, I perceive a bit of a vacuum in clear thinking on this, with some traditionalists wanting to just keep going with the G-20 and have G-20 do stuff. And others have what seem to me to be rather naive, given the world we live in, conceptions of communities of democracy, which it seems to me do so much to exclude so many major stakeholders in the economic system that there’s a real question as to whether they can be meaningfully effective.

So I think we need some serious reflection on the mechanisms of international fora and consultation. I don’t know that we are in the right place right now, but I think it takes a realism that balances two cliches. One is that some sharing of ends is a prerequisite to successful cooperation. And the other is: You don’t make peace with your friends. You make peace with your potential adversaries. And so I suspect we need to use the European term, some kind of variable architecture in which there are some fora where there’s more in common among the participants, but less reach, and other fora in which there is less in common among the participants but more reach.

This is a place where I’ve gone from naive and stupid to less naive and stupid. I used to think that serious people discuss serious things and diplomats discuss the shape of tables. And I’ve come to realize how important the shape and composition of groups can be. Anyone who doubted that proposition needs to consider how consequential the rather loose statements that were made about allowing Ukraine into NATO proved to be in terms of what they set off.

—With assistance from Magnus Henriksson.

* The podcast transcript has been edited for clarity.

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