Lawrence Summers

One striking statistic suggests the magnitude of the opportunity that is before us in restoring our economy to its potential. Earlier this week, the Dow Jones Industrial Average, adjusting for inflation according to the standard Consumer Price Index, was at the same level as it was in 1966, when Brookings scholars Charlie Schultze and Arthur Okun were helping to preside over the American economy.

While there could be many ways to question this calculation, that the market would be at essentially the same real level as it was in 1966 when there were no PCs, no internet, no flexible manufacturing, no software industry, and when our workforce was half and our net capital stock was a third of what it is today, may be regarded by some as the sale of the century. For policy-makers, it suggests the magnitude of the gains from restoring sustained economic growth.

Economic downturns historically are of two types. Most of those in post-World War II-America have been a by-product of the Federal Reserve’s efforts to control rising inflation. But an alternative source of recession comes from the spontaneous correction of financial excesses: the bursting of bubbles, de-leveraging in the financial sector, declining asset values, reduced demand, and reduced employment.

Unfortunately, our current situation reflects this latter, rarer kind of recession.

The Fed has rightly made clear that its decisions will be data dependent. The further key point is that it should allow the flow of information on inflation rather than on real economic activity to determine its timing in adjusting interest rates. And it should not raise rates until there is clear evidence that inflation, and inflation expectations, are in danger of exceeding its 2 per cent target.
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None of this is to say that rates should never be raised or that inflation indicators might not justify a rate increase before long. It is to say that the Fed could inject much needed confidence in the economy today and minimise future risks by announcing and following a strategy of not raising rates until it sees the whites of inflations eyes.