Lawrence Summers

As the G20 leaders prepare to conclude their meeting today, once again good news has had a half-life in the markets of less than 24 hours. Just as news of European plans to stand behind Spanish banks rallied markets and sentiment for only a few hours, a Greek election outcome that was as good as could have been hoped did not even buoy markets for a day. There could be no clearer evidence that the current strategy of vowing that the European system will hold together, addressing each crisis as it comes in the minimally sufficient way and vowing at every juncture to build a system that is sound in the long term has run its course.

Nor is the G20 likely to change anything, at least not immediately. The troubled European economies and their sympathizers will demand more emphasis on growth, lower interest rates on their official debts and more transfers. The Germans will show sympathy with the objective of reform but will insist that financial integration must coincide with political integration, noting that no one gives away a credit card without maintaining control over its use. And the rest of the world will express exasperation with Europe’s failure to get its act together and demand that more be done. Officials blessed with more diplomatic ability than economic insight or courage will produce a communiqué that politely expresses a measure of satisfaction with steps under way, recognizes the need to do more, and looks forward to continued coordination and dialogue. The only good thing is that expectations are so low that this is not likely to disappoint the markets very much.

The unfortunate truth is that European debtors and creditors are both right in their main lines of argument. The borrowers are right that austerity and internal devaluation have never been a successful growth strategy, certainly not in an environment where major trading partners are stagnating. The suggested counterexamples, where fiscal consolidations have preceded growth, involve either stagnation relative to previously attained levels of income (Ireland and the Baltics) or buoyant demand associated with surging export demand, increasing competitiveness and low borrowing costs (many euro members in the early years). They are also right in their claim that even a previously healthy economy will quickly become very sick if forced to operate for several years with interest rates far above growth rates, as is the case across Southern Europe. And experience is clear in suggesting that structural reform is always difficult and slow-acting but much more difficult when an economy is contracting and there is no sector to absorb those displaced by reform.

Those chary of institutionalizing financial integration without major political integration are right as well. A sound system must involve those with deep pockets who are on the hook for liabilities, either as borrowers or guarantors, having control over borrowing decisions. A system where I borrow and you repay is a prescription for unsustainable profligacy. This is why there is now so much discussion of eurobonds and Europe-wide deposit insurance being linked with much deeper political integration. But there are two problems that lie behind the soft references to greater integration. The first is the question of who really has control. If decisions are to be made on a genuinely euro-area basis, it is far from clear, especially after the French election, that there is any kind of majority or even plurality support for responsible policies. If the idea is that the euro area’s future will be on the ECB model – a European façade behind which Teutonic policies are pursued – it is far from clear that this will or should be acceptable across the continent.

The second is the magnitude of the transfers that could be involved: A good guess would be that during the U.S. savings and loan crisis the American southwest received a transfer equal to at least 20 percent of its GDP from the rest of the country. Is there a real will to commit to potential transfers of this magnitude in Europe? Maybe all of this can be resolved, but it will surely not happen quickly.

Not all problems can be solved. It is not certain that the full repayment of all currently contracted sovereign debts, sustainable growth for all, and maintenance of all nations currently on the euro will prove feasible. The private sector, through its actions, is making clear that it recognizes this painful reality. Official-sector planning needs to recognize it as well. Outside of Europe, even as leaders hope for the best, they need to plan for the worst, ensuring adequate liquidity and demand in their economies even if the European situation deteriorates rapidly. The fortification of the IMF is a start in the right direction, but consideration needs to be given to national policies, to trade finance and to social safety nets as well.

But a euro-area collapse would be an economic disaster that might define this quarter century. Its prospect must concentrate the minds of all those in Los Cabos, not so much on reform as on immediate action. Little needs to be, or probably should be, said publicly. But those outside Europe must persuade those inside Europe that the rules change when the stakes rise. The ECB’s credibility will mean little if there is no longer a common currency. Issues of setting the right precedent seemed much larger 24 hours before Lehman than 24 hours afterwards. Now is the time for radical reductions in the rates charged by official creditors to European sovereigns, for a willingness to subordinate official debts – not for the purpose of privileging private creditors but to offer a prospect for systemic preservation – and for expansionary monetary policies in Europe that prevent deflation and encourage the growth that can create jobs and reduce debt burdens. Only if the system is preserved can its future be debated.

PHOTO: An Oxfam activist wearing a mask of Mexican President Felipe Calderon holds up a checklist during a protest in Los Cabos June 17, 2012. G20 leaders will kick off two days of meetings in the Pacific resort of Los Cabos on Monday. REUTERS/Andres Stapff

With the past week’s dismal U.S. jobs data, signs of increasing financial strain in Europe, and discouraging news from China, the proposition that the global economy is returning to a path of healthy growth looks highly implausible.

It is more likely that negative feedback loops are again taking over as falling incomes lead to falling confidence, which leads to reduced spending and yet further declines in income. Financial strains hurt the real economy, especially in Europe, and reinforce existing strains. And export-dependent emerging markets suffer as the economies of the industrialized world weaken.

The question is not whether the current policy path is acceptable. The question is, what should be done? To come up with a viable solution, consider the remarkable level of interest rates in much of the industrialized world. The U.S. government can borrow in nominal terms at about 0.5 percent for five years, 1.5 percent for 10 years, and 2.5 percent for 30 years. Rates are considerably lower in Germany, and still lower in Japan.

Even more remarkable are the interest rates on inflation-protected bonds. In real terms, the world is prepared to pay the U.S. more than 100 basis points to store its money for five years and more than 50 basis points for 10 years. Maturities would have to reach more than 20 years before the interest rates on indexed bonds become positive. Again, real rates are even lower in Germany and Japan. Remarkably, the UK borrowed money last week for 50 years at a real rate of 4 basis points.

These low rates on even long maturities mean that markets are offering the opportunity to lock in low long-term borrowing costs. In the U.S., for example, the government could commit to borrowing five-year money in five years at a nominal cost of about 2.5 percent and at a real cost very close to zero.

What does all this say about macroeconomic policy? Many in both the U.S. and Europe are arguing for further quantitative easing to bring down longer-term interest rates. This may be appropriate given that there is a much greater danger from policy inaction to current economic weakness than to overreacting.

However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.

There is also an oddity in this renewed emphasis on quantitative easing. The essential aim of such policies is to shorten the debt held by the public or issued by the consolidated public sector comprising both the government and central bank. Any rational chief financial officer in the private sector would see this as a moment to extend debt maturities and lock in low rates – exactly the opposite of what central banks are doing. In the U.S. Treasury, for example, discussions of debt-management policy have had exactly this emphasis. But the Treasury does not alone control the maturity of debt when the central bank is active in all debt markets.

So, what is to be done? Rather than focusing on lowering already epically low rates, governments that enjoy such low borrowing costs can improve their creditworthiness by borrowing more, not less, and investing in improving their future fiscal position even assuming no positive demand stimulus effects of a kind likely to materialize with negative real rates. They should accelerate any necessary maintenance project – issuing debt leaves the state richer not poorer, assuming that maintenance costs rise at or above the general inflation rate.

As my colleague Martin Feldstein has pointed out, this is a principle that applies to accelerating replacement cycles for military supplies. Similarly, government decisions to issue debt, and then buy space that is currently being leased, will improve the government’s financial position as long as the interest rate on debt is less than the ratio of rents to building values – a condition almost certain to be met in a world of sub-2% government borrowing rates.

These examples are the place to begin, because they involve what is in effect an arbitrage, whereby the government uses its credit to deliver essentially the same bundle of services at a lower cost. It would be amazing if there were not many public investment projects with certain equivalent real returns well above zero. Consider a $1 project that yielded even a permanent 4 cents a year in real terms increment to GDP by expanding the economy’s capacity or its ability to innovate. Depending on where it was undertaken, this project would yield at least an extra 1 cent a year in government revenue for each dollar spent. At any real interest rate below 1 percent, the project pays for itself even before taking into account any Keynesian effects.

This logic suggests that countries regarded as havens that can borrow long term at a very low cost should be rushing to take advantage of the opportunity. This is a view that should be shared by those most alarmed about looming debt crises, because the greater your concern about the ability to borrow in the future, the stronger the case for borrowing for the long term today.

There is, of course, still the question of whether more borrowing will increase anxiety about a government’s creditworthiness. It should not, as long as the proceeds of borrowing are used either to reduce future spending, or raise future incomes.

Any rational business leader would use a moment like this to term out its debt. Governments in the industrialized world should do so too.

Once again European efforts to contain crisis have fallen short. It was perhaps reasonable to hope that the European Central Bank’s commitment to provide nearly a trillion dollars in cheap three-year funding to banks would, if not resolve the crisis, contain it for a significant interval. Unfortunately, this has proved little more than a palliative. Weak banks, especially in Spain, have bought more of the debt of their weak sovereigns, while foreigners have sold down their holdings. Markets, seeing banks holding the dubious debt of the sovereigns that stand behind them, grow ever nervous. Again, Europe and the global economy approach the brink.

The architects of current policy and their allies argue that there is insufficient determination to carry on with the existing strategy. Others argue that failure suggests the need for a change in course. The latter view seems to be taking hold among the European electorate.

This is appropriate. Much of what is being urged on and in Europe is likely to be not just ineffective but counterproductive to maintaining the monetary union, restoring normal financial conditions and government access to markets, and re-establishing economic growth.

The premise of European policymaking is that countries are overindebted, and so unable to access markets on reasonable terms, and that the high interest rates associated with excessive debt hurt the financial system and inhibit growth. The strategy is to provide financing while insisting on austerity, in hopes that countries can rein in their excessive spending enough to restore credibility, bring down interest rates and restart economic growth. Models include successful International Monetary Fund programs in emerging markets and Germany’s adjustment after the expense and trauma of reintegrating East Germany.

Unfortunately, Europe has misdiagnosed its problems in important respects and set the wrong strategic course. Outside of Greece, which represents only 2 percent of the euro zone, profligacy is not the root cause of problems. Spain and Ireland stood out for their low ratios of debt to gross domestic product five years ago, with ratios well below Germany’s. Italy had a high debt ratio but a very favorable deficit position. Europe’s problem countries are in trouble because the financial crisis under way since 2008 has damaged their financial systems and led to a collapse in growth. High deficits are much more a symptom than a cause of their problems. And treating symptoms rather than underlying causes is usually a good way to make a patient worse.

The cause of Europe’s financial problems is lack of growth. In any financial situation where interest rates far exceed growth rates, debt problems spiral out of control. The right focus for Europe is on growth; in this dimension, increased austerity is a step in the wrong direction.

Systematic comparisons suggest that when economies are demand-constrained and safe short-term interest rates are near zero, policy measures that reduce the deficit by 1 percent have a multiplier of 1 to 1.5 – implying that a 1 percent reduction in a country’s ratio of spending to GDP or an equivalent tax increase reduces its GDP by 1 to 1.5 percent. Essentially, cutting deficits will have a disproportionately adverse effect on GDP because the multiplier is larger than 1 on the growth-reduction side of the equation. This means that austerity measures at the national level are likely to be counterproductive in terms of creditworthiness. Fiscal contraction reduces incomes, limiting the capacity to repay debts. It achieves only limited reductions in deficits once the adverse effects of economic contraction on tax revenue and benefit payments are accounted for. And it casts a shadow over future growth prospects by reducing capital investment and raising unemployment, which inevitably takes a toll on the capacity and willingness of the unemployed to work.

These considerations are magnified at the continental level. Slowdowns in one country reduce the demand for the exports of other countries. As a matter of arithmetic, increases in saving and exporting in some countries have to be offset by increases in spending and importing in others. Germany’s enormous success in recent years has been achieved by becoming a large-scale net exporter – it would not have been possible without large-scale borrowing and importing by Europe’s periphery. The periphery cannot possibly succeed in substantially reducing its borrowing unless Germany pursues policies that allow its surplus to contract.

Skeptics will rightly wonder how a prescription for more spending by countries that already have trouble borrowing can be correct. The answer lies in the difference between borrowing by individuals and countries. Normally, an individual helps his creditors by borrowing less; but a person who stops borrowing to finance commuting to his job does his creditors no favor. A country’s income is determined by spending, so a country that pursues austerity to the point where its economy is driven into a downward spiral does its creditors no favor. Yes, there will ultimately be a need to raise retirement ages, reform sclerosis-inducing regulations and restructure benefit programs; phased-in commitments in these areas would be constructive. But the prospect for political and economic success in these endeavors depends on growth being restored.

Only if growth is restored can the euro endure and European financial problems be resolved. If there was ever a situation that called for a collective response, this is it. Going forward, the IMF and international community should condition further support not merely on individual countries’ actions but on a common European commitment to growth.

PHOTO: European Central Bank (ECB) President Mario Draghi addresses the European Parliament economic and monetary affairs committee in Brussels, April 25, 2012. REUTERS/Yves Herman

Arithmetic done under the constraints of politics is always suspect, and one should always examine carefully the claims of those seeking votes. But smart observers have learned to distinguish between the claims of political candidates and their advisers on the one hand, and proposals that have been evaluated by independent scorekeepers like the Congressional Budget Office on the other.

This principle has never been better illustrated than by the “budget analysis” put forward by Governor Romney’s chief economic adviser, Glenn Hubbard, in a recent Wall Street Journal column. Hubbard constructs a budget plan he imagines that President Obama might propose someday, engages in a set of his own extrapolations and then makes a set of assertions about it. He does not discuss President Obama’s actual plan or how it has been evaluated by the CBO. Nor does he invest his credibility in defending the claims that Governor Romney has made regarding his own fiscal plans – he simply states that, “Yes, President Obama and Mitt Romney have budgets with competing visions. But Governor Romney’s budget makes tough choices…” without delving into the specifics or trade-offs that Romney’s “tough choices” entail.

President Obama put forward a plan earlier this year that would reduce deficits by more than $4 trillion over the next decade. It would bring discretionary spending to its lowest levels since the 1960s. It includes $2.50 in spending cuts for every $1 in additional revenue. It also asks everyone to pay their fair share of taxes, repealing the Bush tax cuts for families making more than $250,000, and closing loopholes and shelters like preferences for private jets, hedge fund managers and offshore investments.

The independent Congressional Budget Office confirms that it would stabilize the debt as a share of the economy – thus returning us to a tenable fiscal path. It would do that while allowing increased investments in education, research and infrastructure that are critical to stronger, shared economic growth in the years to come. By focusing on building a strong economy for the future, it expands the tax base and reduces pressures for future tax increases.

But rather than criticize this approach, Hubbard ignores it – and instead chooses to invent a set of assumptions that bear no relationship to the president’s actual policies. His figures are not explained, but they apparently arbitrarily assume that the president must raise taxes to pay for spending above a level of Hubbard’s choosing.

Rather than filling imaginary gaps in the president’s budget, which has been spelled out in sufficient detail to permit evaluation by independent experts, Professor Hubbard should perhaps fill in some of the many gaps in Romney’s plans.

Start with his tax plan. The Romney campaign has been very clear about what he is promising: $5 trillion in tax cuts on top of extending the Bush tax cuts, with those benefits heavily weighted toward the country’s wealthiest taxpayers. Romney claims to pay for this plan by ending tax shelters, principally for the wealthy, but he hasn’t specified a single tax break that he would close. Romney himself has acknowledged the lack of details in his plan, stating in reference to his tax plan that “frankly, it can’t be scored.” I have been party for many years to searches for “high-income tax shelters” than can feasibly be closed. I know of no reputable expert in either political party who would find that there is anything even approaching $5 trillion in potential revenue to be generated from this source.

Romney has also proposed a massive defense buildup, even while he says he will cut spending deeply enough to balance the budget. I think it’s clear why he won’t tell voters which cuts he would make: because in the past, disclosing his planned budget cuts was politically damaging.

We have seen this movie before. When President Clinton left the White House, our country was paying down its debt on a substantial scale. I was privileged as secretary of the treasury to be buying back federal debt. President George W. Bush campaigned on a program of tax cuts supported by economic advisers not subject to the rigors of official budget scorekeeping. The results – trillions of dollars of budget deficits – speak for themselves.

This is a very consequential election. As we continue to recover from the largest economic crisis in generations, we face a continuing need to strengthen the job market, address large fiscal challenges and build an economy that is based on sustainable, shared economic growth. Voters should have a chance to choose between clear alternatives. President Obama – consistent with his obligations as president – has laid out a multiyear budget embodying his vision for the future, and it has been evaluated by independent experts. It is time for Romney to do the same.

Economic forecasters divide into two groups: those who cannot know the future but think they can, and those who recognize their inability to know the future. Shifts in the economy are rarely forecast and often not fully recognized until they have been under way for some time. So judgments about the U.S. economy have to be tentative. What can be said is that for the first time in five years a resumption of growth significantly above the economy’s potential now appears as a substantial possibility. Put differently, after years when the risks to the consensus modest-growth forecast were to the downside, they are now very much two-sided.

As winter turned to spring in 2010 and 2011, many observers thought they detected evidence that the economy had decisively turned, only to be disappointed a few months later. A variety of considerations suggest that this time may be different. Employment growth has been running well ahead of population growth. The stock market level is higher and its expected volatility lower than at any time since the crisis began in 2007, suggesting that the uncertainty hanging over business has declined. Consumers who have been deferring purchases of cars and other durable goods have created pent-up demand. The housing market seems to be stabilizing. For years now, the rate of family formation has been way below normal as young people moved in with their parents. At some point they will set out on their own, creating a virtuous circle of a stronger housing market, more family formation and demand, and further improvement in housing conditions. Innovation around mobile information technology, social networking and newly discovered oil and natural gas is likely, assuming appropriate regulatory policies, to drive significant investment and job creation.

True, the risks of high oil prices, further problems in Europe, and financial fallout from anxiety about future deficits remain salient. However, unlike in 2010 and 2011, it is probable that these risks are already priced into markets and factored into outlooks for consumer and business spending. There has already been a significant escalation in oil prices. The European situation is hardly resolved but is unlikely to deteriorate as much in the next months as it did last year. And market participants report great alarm about the deficit situation. So it would not take great news in any of these areas for them to actually contribute to upward revisions in current forecasts.

What are the implications for macroeconomic policy? Such recovery as we are enjoying is less a reflection of the natural resilience of the American economy than of the extraordinary steps that both fiscal and monetary policymakers have taken to offset private-sector deleveraging — a process that is far from complete. A convalescing patient who does not finish the full course of treatment takes a grave risk.  So too the most serious risk to recovery over the next several years is no longer the possibility of either financial strains or external shocks but that policy will shift too quickly away from maintaining adequate demand toward a concern with traditional fiscal and monetary prudence.

On even a pessimistic reading of the economy’s potential, unemployment remains 2 percentage points above normal levels; employment, 5 million jobs below potential; and GDP, close to $1 trillion short of potential. Even with the economy creating 300,000 jobs a month and growing at 4 percent, it would take several years to reattain normal conditions. So a lurch back this year toward the kind of policies that are appropriate in normal times would be quite premature.

Indeed, recent research on what economists label hysteresis effects suggests that slowing could have highly adverse consequences. Brad Delong and I argue in a recent paper that it is even possible that premature and excessive movements toward fiscal contraction by shrinking the economy risk exacerbating long-run budget problems.

How then to respond to valid concerns about fiscal sustainability, excessive credit creation and the eventual return to normality in a world where policy credibility is essential? The right approach is to pursue policies that commit to normalize conditions but only when certain thresholds are crossed. The Federal Reserve might commit to maintain the current Fed Funds rate until some threshold with respect to unemployment or expected inflation is crossed. Commitments to fund infrastructure over many years might include a financing mechanism such as a gasoline tax that would be triggered when some level of employment or output growth has been achieved. Tax reform could phase in new rates in pace with the rising economic performance.

Contingent commitments have the virtue of providing clarity to households and businesses as to how policy will play out, and in areas where legislation is necessary, eliminating political uncertainty. They allow policymakers to project a simultaneous commitment to near-term expansion and medium-term prudence — exactly what we require right now. An element of contingency in policy is always there in a volatile world. Recognizing it explicitly is the way to provide confidence and protect credibility in a world whose future no one can gauge with precision.

PHOTO: A help wanted sign hangs on the door of an Autozone shop in Golden, Colorado September 17, 2009. REUTERS/Rick Wilking

However the U.S. presidential election turns out, the trifecta of the Bush tax cut expiration, the debt limit ceiling on the horizon once again, and the Congressionally mandated sequesters – cuts in domestic spending – will force the president and Congress to wrestle with fiscal issues either in a lame duck session after the election or in early 2013. The decisions they make will have profound impacts on America’s fiscal future.

For many observers, the central question on the table is about entitlement programs: What will be done with them? Growth in entitlement spending associated with our aging population and its rising health care costs is the major factor in overall federal spending growth. But the capacity of near-term policy changes to have large impacts on that spending is less than many would suppose. The rising ratio of retirees to workers means that Social Security benefits at current levels will not be sustainable without some kind of tax increase. Sooner or later, revenue will have to rise or else outlays will have to be curtailed. While it is surely better to act sooner, the reality is that, out of necessity, action on entitlements is inevitable.

While almost everyone agrees on the desirability of containing federal health care spending, this is likely to be more difficult than we’d like to believe. Certainly beneficiaries can bear more of the cost of their government insurance than others, and there are steps like malpractice reform and the further encouragement of preventive medicine that should be taken. Yet without intrusions into the private health care system that are unlikely to be politically acceptable, there are severe limits on what can be done. Otherwise the result will be unacceptable cuts in the availability of care for the clients of federal programs. Given all the uncertainties associated with new technologies, changing lifestyles, and ongoing changes in the private system, health care reform will and should be a continuing project.

But let’s place health care aside for now. Less discussed in the context of major deficit reduction is tax reform. For a variety of reasons, 2013 should be the year when the tax code is overhauled in a substantial way.

First, the United States will need to mobilize more revenue. This year the federal government will collect less than 16% of GDP in taxes—far below the post World War II average. The combination of an aging society, rising health care costs, debt service costs that will skyrocket whenever interest rates normalize, a still-dangerous world in which our allies’ defense spending is falling even as that of potential adversaries rises rapidly, and a growing fraction of the population unable to hold steady work means that in all likelihood federal spending will need to be larger not smaller relative to GDP in the future.

Raising marginal corporate rates or increasing individual rates beyond their Clinton-era level raises serious issues about incentive effects or encouraging tax shelter activities. Raising rates is, in any event, unlikely to be politically feasible. A much better strategy for raising necessary revenue would start from the premise adopted by the Simpson-Bowles bipartisan commission that tax expenditures are a form of government expenditure and presumptively should be cutback unless they can be justified.

Second, the current tax system is, in certain ways, manifestly unfair at a time of rising inequality. As is well recognized, America’s rich have gotten richer with the top 1 percent’s income share rising from the 10 percent range to the 20 percent range over the last generation, while middle class incomes have stagnated or worse. There is plenty of room for debate about the causes of rising inequality, and the extent to which reducing inequality should be a central objective of government policy and about the possible disincentive effects of excessively progressive taxes.

But there are fairly expensive aspects of the current tax system that favor the most fortunate – aspects that border on the indefensible. Recent political debates have pointed to loopholes that permit a few of the very fortunate to accumulate tens of millions of dollars in a tax-free IRA when almost everyone else is constrained by a $2,000 contribution limit. Can the observation that Ireland, Bermuda, and Luxembourg are three of the five jurisdictions where the U.S. corporate sector earned the most profits reflect anything other than rampant tax sheltering? Anyone who doubts this should ponder the fact that in 2007, U.S. corporate profits in Bermuda totaled 646% of Bermuda’s GDP. The treatment of profit incentives paid to investment operators who make no investment of their own money but simply receive the “carry” as they invest other people’s money is another example of an inappropriate provision.

These examples and many others are not only significant because of revenue the government could recoup while also making the tax system fairer. They matter because they illustrate the power of special interests to shape fundamental aspects of economic policy. Reform could be an important step towards rebuilding citizens’ confidence in the federal government, which is sorely lacking today.

Third, even while raising too little revenue and giving much away to various shelter efforts, the current tax system also manages to excessively burden economic activity. Corporate rates at the very high end of the world range encourage firms to manage their affairs so as to minimize reported U.S. profits using devices like transfer pricing, and to encourage the use of debt rather than equity finance. Employers who know that their workers face high tax rates work to find ways of providing compensation in the form of tax free perquisites rather than money income. High marginal rates on individuals, along with a substantial capital gains differential, encourages individuals to spend time and effort that should be used more productively on engineering conversions of ordinary income into capital gains.

While the U.S. tax code is altered frequently, serious reform is no more than a once in a generation happening. The last serious tax reform effort took place in 1986, meaning we are overdue. The Simpson-Bowles proposal for eliminating all tax expenditures and radically reducing tax rates provides an excellent starting point for a debate the country should have.

The delicate question is: How should Washington prepare for serious tax reform during what is likely to be a unique window of opportunity in late 2012 and 2013? The timing is essential, both because of all of the deficit reduction activity, but also because spending-side reforms will have a much more difficult time moving forward if revenue is not addressed as well.

It is tempting to say presidential candidates should put forward their tax reform proposals in detail and allow voters to choose. However, this is unlikely to work. Indeed, the more tax issues are discussed during the campaign, the more the candidates will be driven to make pledges about things they will never do—pledges that might make tax reform that much more difficult.

Here is an alternative: Leaders in both parties should commit themselves to the goal of tax reform for growth, fairness and deficit reduction. They should acknowledge that every tax expenditure or special break has to be on the table. They should have their staffs are compile a large inventory of options. The relevant Congressional committees should take testimony from experts of all persuasions. And then right after the election, the negotiations should begin. Nothing that is likely to be done during the next four years will be more important.

Photo: U.S. President Barack Obama receives a standing ovation as he addresses a Joint Session of Congress inside the chamber of the House of Representatives on Capitol Hill in Washington September 8, 2011.

The year has begun well in markets. Stock markets in 2012 are generally up, and European sovereigns have experienced less difficulty borrowing than many expected. And economic data, particularly in the United States, has come in ahead of expectations. So as President Obama prepares to give his State of the Union address, and as a large group of policymakers and corporate chiefs come together in Davos this week, there is if not a sense of relief at least some diminution in the sense of high alarm that has gripped the global community for much of the last few years. Yet anxiety about the future remains a major driver of economic performance.

The news coming from financial markets is in important ways paradoxical. On the one hand, interest rates remain very low throughout the industrial world. While this is partially a result of very low expected inflation, the inflation-indexed bond market suggests that remarkably low levels of real interest rates will prevail for a long time. In the United States, for example, the yield on 10-year indexed bonds has fluctuated around -15 basis points. That is to say: On an inflation-adjusted basis, investors are paying the government to store their money for 10 years! In Britain, inflation-linked yields are negative going out 30 years.

One might expect that with low real interest rates, assets would sell at unusually high multiples to projected earnings. If anything, the opposite is the case, with the S&P 500 selling at only about 13 times earnings. Stocks also appear cheap to earnings in historical perspective through much of the industrial world. And similar patterns are observed with respect to most forms of real estate.

The combination of low real interest rates and low ratios of asset values to cash flows suggests as a matter of logic an abnormally high degree of fear about the future. This could reflect expectations that earnings or other cash flows will rise more slowly than anticipated, or simply result from a higher discount associated with future earnings because of abnormally high uncertainty.

This idea that future uncertainties are driving financial markets is supported by the observation that in the recent period there has been a much stronger tendency than normal for higher interest rates to be associated with a stronger stock market and vice versa. This is exactly what one would expect in an economic environment like the present one — on days when people become more optimistic, both interest rates and stock prices rise as the expectation is of more profits and demand for funds.

This is in contrast to the usual situation, in which interest rates and stock prices often move in opposite directions because of reassessments about future fiscal and monetary policies, with expectations of higher rates driving down stock prices. For example, if an important driver of markets was confidence that foreigners would hold U.S. debt, one would expect to frequently see days when interest rates went up and the market went down as concerns rose, and vice versa when concerns declined.

Uncertainty about future growth prospects as a major driver of markets also correlates with other observations, such as the abnormally high level of cash sitting on corporate balance sheets, the reluctance of businesses to hire, and the sense that consumers are hesitant about discretionary big ticket purchases even as borrowing costs and capital goods prices are at near record lows.

All of this suggests that for the industrial world as a whole, the most important priority for governments must be giving confidence that recovery will continue and accelerate in the United States and that the downturn in Europe will be limited. How best to do this remains an area of active debate. At Davos and beyond there will be many who argue that top priority must be given to increasing business confidence and that government stimulus is useless at best and potentially counterproductive. There will be others — more economists than businesspeople — who will argue that top priority must be given to government stimulus and that issues about business confidence are red herrings.

Keynes saw through this sterile debate 75 years ago, writing to Roosevelt that either “the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees” or “public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money.” The right current approach involves borrowing from both contending lines of thought.

Government has no higher responsibility than insuring that economies have an adequate level of demand. Without growing demand, there is no prospect of sustained growth, let alone significant reduction in joblessness. And without growth and reduced unemployment, there is no chance of engineering reductions in government debt-to-income ratios. Of course risks of inflation, of promoting excessive risk-taking in the future, and of spending that is not ideally efficient need to be balanced. But the simple fact is that markets in the large concur with the judgment of individual business managers that increasing demand is the sine qua non of a return to economic health.

At the same time, businesses are understandably uncertain about their prospects after the events of recent years. This is not the right time to add unnecessarily to their worries. Except where the rationale is both urgent and compelling, new regulations that burden investment should be avoided. Inequality is a growing problem that will have to be addressed in the United States and beyond — it cannot be ignored. But there is the risk that policies introduced in the name of fairness that excessively burden job-creating investment could actually exacerbate the challenges facing the middle class. At a moment of substantial doubt about the functionality of government, government could do much to increase confidence in its functioning by devising a clear plan to better align spending and taxing once recovery is established.

By working both to directly increase demand and augment business confidence, governments have the best chance of creating economic recovery. At Davos and beyond that should be the near-term focus of economic debates.

PHOTO: People walk past the logo of the World Economic Forum (WEF) in front of the congress center in the Swiss mountain resort of Davos, January 22, 2012.  REUTERS/Arnd Wiegmann

Americans have traditionally been the most enthusiastic champions of capitalism.  Yet a recent American public opinion survey found that just 50 per cent of people had a positive opinion of capitalism while 40 per cent did not.  The disillusionment was particularly marked among young people 18-29, African Americans and Hispanics, those with incomes under $30,000 and self-described Democrats.

Three elections in a row in the U.S. have been bloodbaths by recent standards for incumbents, with the left side doing well in 2006 and 2008 and the right winning comprehensively in 2010.  With the rise of the Tea Party on the right, and the Occupy movement on the left, this suggests far more is up for grabs than usual in this election year.

So how justified is disillusionment with market capitalism?  This depends on the answer to two critical questions. Do today’s problems inhere in today’s form of market capitalism or are they subject to more direct solution? Are there imaginable better alternatives?

The spread of stagnation and abnormal unemployment from Japan to the rest of the industrialized world does raise doubts about capitalism’s efficacy as a promoter of employment and rising living standards for a broad middle class.  This problem is genuine. Few would confidently bet that the U.S. or Europe will see a return to full employment as previously defined within the next 5 years. The economies of both are likely to be constrained by demand for a long time.

But does this reflect an inherent flaw in capitalism or, as Keynes suggested, a “magneto” problem (like the failure of a car alternator) that can be addressed with proper fiscal and monetary policies, and which will not benefit from large scale structural measures? I believe the evidence overwhelmingly supports the latter. Efforts to reform capitalism are more likely to divert from the steps needed to promote demand than to contribute to putting people back to work. I suspect that if and when macroeconomic policies are appropriately adjusted, much of the contemporary concern will fade away.

That said, sharp increases in unemployment beyond the business cycle—one in six American men between 25 and 54 are likely to be out of work even after the U.S. economy recovers—along with dramatic rises in the share of income going to the top 1 and even the top .01 per cent of the population and  declining social mobility do raise serious questions about the fairness of capitalism. The problem is real and profound and seems very unlikely to correct itself untended. Unlike cyclical concerns there is no obvious solution at hand. Indeed the observation that even Chinese manufacturing employment appears well below the level of 15 years ago suggests that the problem’s roots lie deep with the evolution of technology.

The agricultural economy gave way to the industrial economy because progress enabled demands for food to be met by only a small fraction of the population, freeing large numbers of people to work outside agriculture. The same process is underway today with respect to manufacturing and a substantial range of services reducing employment prospects for most citizens.  At the same time, just as in the early days of the industrial era, the combination of substantial dislocations and greater ability to produce at scale is enabling a lucky few to acquire great fortunes.

The nature of the transformation is highlighted by the 50-fold change in the relative price of a television set of a constant quality and a day in a hospital over the last generation.  While it is often observed that wages for median workers have stagnated, this obscures an important aspect of what is occurring. Measured via items  such as appliances or clothing or telephone service where productivity growth has been rapid, wages have actually risen rapidly over the last generation.  The problem is that they have stagnated or fallen measured relative to the price of housing, health care, food and energy or education. As fewer and fewer people are needed to meet the population’s demand for goods like appliances and clothing, it is natural that more and more people work in producing goods like health care and education where outcomes are manifestly unsatisfactory.  Indeed as the economist Michael Spence has documented, a process of this kind is underway; essentially all employment growth in the U.S. over the last generation has come in non-traded goods.

The difficulty is that in many of these areas the traditional case for market capitalism is weaker. It is surely not an accident that in almost every society the production of health care and education is much more involved with the public sector than the production of manufactured goods.  There is an imperative to move workers from activities like producing steel to activities like taking care of the aged.  At the same time there is the imperative of shrinking or least slowing the growth of the public sector.

This brings us to the charge that the governments of industrial market capitalist societies are bankrupt. Even as market outcomes seem increasingly unsatisfactory, budget  pressures have constrained the ability of the public sector to respond.  How and when–and not whether–basic programs of social protection will be cut back, is now back on the table.  The basic solvency of too many capitalist states seems in question.

Again the problems are very real.  While I believe more than most that the U.S. government will be able to borrow on very attractive terms for a long time, if as I fear private borrowing remains depressed, there is no denying that the current path of planned spending and planned revenue collection are inconsistent.  And Europe is teaching us that markets can take significant fiscal problems and make them catastrophic  by becoming too alarmed too rapidly.

At one level the answer here is simply to insist on more political will and courage.  But at a deeper level, citizens of the industrial world who believe that they live in progressive societies are right to wonder why increasingly affluent societies need to roll back levels of social protection. Paradoxically, the answer lies in the very success of capitalism which has made the opportunity-cost of an individual teaching or nursing or administering that much more expensive.

When outcomes are unsatisfactory, as they surely are at present, there is always a debate between those who believe that the current course needs to be pursued with increased vigor and those who argue for a radical change in direction. That debate  is somewhat beside the point in the case of market capitalism. Where it has been applied it has been an enormous success.  The challenge for the next generation is that while that success will increasingly be taken for granted and indeed will become an increasing source of frustration in these pinched times, its success cannot be matched outside the market’s natural domain.  It is not so much the most capitalist parts of the contemporary economy but the least—those concerned with health, education and social protection–that are in most need of reinvention.

By Lawrence Summers
The opinions expressed are his own.

European leaders will meet today for yet another “historic” summit at which the fate of Europe is said to hang in the balance. Yet it is clear that this will not be the last convened to deal with the financial crisis.

If public previews from France and Germany are a guide, there will be commitments to assuring fiscal discipline in Europe and establishing common crisis resolution mechanisms. There will also be much celebration of commitments made by Italy, and a strong political reaffirmation of the permanence of the monetary union. All of this is necessary and desirable, but the world economy will remain on edge.

Given that Europe is the largest single component of the global economy, the rest of the world has a stake in helping to avoid major financial accidents. It also has a stake in aiding continued growth in Europe and ensuring that the European financial system supports investment around the world – particularly as cross-border European bank lending dwarfs that of banks from any other region.

Now is also a historic juncture for the International Monetary Fund. The focus of the policy response to the crisis must now shift from Brussels and Frankfurt to the IMF’s boardroom.

From the problems of the UK and Italy in the 1970s, through the Latin American debt crisis of the 1980s, the Mexican, Asian and Russian financial crises of the 1990s, the IMF has operated by twinning the provision of liquidity with strong requirements that those involved do what is necessary to restore their financial positions to sustainability. There is ample room for debate about the precise policy choices the fund has made in the past. But, the IMF has consistently stood for the proposition that the laws of economics do not and will not give way to political considerations. At key points the IMF has offered prescriptions, not just for countries in need of borrowed funds, but also for those whose success is systemically important for the global economy.

Christine Lagarde, the head of the IMF, highlighted the seriousness of problems in Europe to members of the international financial community assembled in Jackson Hole in August. She pointed to capital shortfalls in the European banking system and the need for adjustment to be carried on in ways that were consistent with continuing growth. Now, the IMF needs to speak and act on several fronts.

First, it is essential that Italy’s adjustment be carried out within the context of an IMF program. After European authorities emphasized that Greece was fully solvent and able to service all debts in full, it is unlikely that they, acting alone, have the capacity to reassure markets. Moreover, there are profound intra-European political problems if northern Europe either does or does not impose conditions on Italy. It would be much better to outsource those traumas to the IMF.

Second, as the IMF deals with individual European countries, it needs to recognize more than it did in the past that they are embedded within a monetary system and community of nations with an increasing number of common institutions. It would be inconceivable that the IMF would lend money to a country whose central bank was not committed to an appropriate monetary policy, or that was ignoring contingent liabilities in the banking system. IMF support for any European country should be premised on understandings with the European Central Bank that controls that country’s monetary policy.

Third, when engaging with individual members of a monetary union, the IMF cannot assess the prospects of one member of the monetary union in isolation. If some countries are to enjoy reduced trade deficits, others must face reduced surpluses. If there is no clear path to reduced surpluses there is no clear path to reduced deficits and hence to solvency. More generally, the sustainability of any program must be assessed in the context of realistic projections of the economic environment. The IMF must be careful not to approve adjustment programs that are not realistic.

Fourth, the IMF has a responsibility to speak clearly about threats to the global economy. Even if debt spreads in Europe fall and modest growth is reattained, the global economy is threatened by the large-scale deleveraging of European banks. An improvement in the fiscal position of sovereigns will help but this is insufficient. If banks are not recapped on a substantial scale soon, there will be a large contraction of credit in the global economy.

After Friday’s summit, attention will and should shift to the IMF.  It must act boldly but no one should ever forget a fundamental lesson of all past crises.  The international community can provide support but a nation or a region’s prospect for prosperity depends ultimately on its own efforts.

Photo: IMF Managing Director Christine Lagarde attends at a news conference in Tokyo.

By Lawrence Summers
The opinions expressed are his own.

The principal problem facing the United States and Europe for the next few years is an output shortfall caused by lack of demand. Nothing would do more to increase the incomes of all citizens—poor, middle class and rich—than an increase in demand, which would bring with it increases in incomes, living standards, and confidence. A more rapid recovery than now appears likely would reverse, at least partially, a growing disillusionment with almost all institutions and doubts about the future.

It would be, however, a serious mistake to suppose that our only problems are cyclical or amenable to macroeconomic solutions. Just as evolution from an agricultural to an industrial economy had far reaching implications for society, so too will the evolution from an industrial to a knowledge economy. Witness structural trends that predate the Great Recession and will be with us long after recovery is achieved: The most important of these is the strong shift in the market reward for a small minority of persons, relative to the rewards available to everyone else. In the United States, according to a recent CBO study, the incomes of the top 1 percent of the population have, after adjusting for inflation, risen by 275 percent from 1979 to 2007. At the same time, incomes for the middle class (in the study, the middle 60 percent of the income scale) grew by only 40 percent. Even this dismal figure overstates the fortunes of typical Americans; the number unable to find work or who have abandoned the job search has risen. In 1965, only 1 in 20 men between ages 25 and 54 was not working. By the end of this decade it will likely be 1 in 6—even if a full cyclical recovery is achieved.

To highlight the disturbing trends in a different way, one calculation suggests that if income distribution had remained constant in the U.S. over the 1979-2007 period, incomes of the top 1 percent would be 59 percent or $780,000 lower and the incomes of the average member of the bottom 80 percent of the population would be 21 percent or over $10,000 dollars higher.

Those looking to remain serene in the face of these trends, or who favor policies that would disproportionately cut taxes at the high end and so exacerbate inequality, assert, for example, that what could be called “snapshot inequality” is not a problem, as long as there is mobility within people’s lifetimes and across generations. The reality is that there is too little of both. Inequality in lifetime incomes is already only marginally smaller than inequality in a single year. And tragically, according to the best available information, intergenerational mobility in the United States is now poor by international standards, and, probably for the first time in U.S. history, is no longer improving. To take just one statistic, the share of students in college coming from families in the lowest quarter of the income distribution has fallen over the last generation, while the share from the richest has actually increased. Given the pressures associated with recession, it appears that more elite American colleges and universities have dropped need-blind admissions than have adopted it in recent years.

Why has the top 1 percent of the population done so well relative to the rest of the population? Probably the answer lies substantially in changes in technology and in globalization. When George Eastman revolutionized photography he did very well, and because he needed a large number of Americans to carry out his vision, the city of Rochester had a thriving middle class for two generations. When Steve Jobs revolutionized personal computing, he and the shareholders in Apple (who are spread all over the world) did very well, but a much smaller benefit flowed to middle class American workers, both because production was outsourced and because the production of computers and software was not terribly labor intensive. In the same way, the moves from small independent bookstores to megastores like Barnes and Noble, and now to Amazon and e-books, have meant that more books at less cost are available to consumers, but also mean fewer jobs for middle class workers in retail, publishing and distribution, and greater rewards for superstar authors and entrepreneurs who are transforming the way content is delivered. One other manifestation of progress is that increasingly sophisticated financial markets have provided ever-greater opportunities for those like Warren Buffett, with the ability to detect errors in prevailing valuations, to profit handsomely.

There is no issue that will be more important to the politics of the industrialized world over the next generation than its response to a market system that distributes rewards increasingly inequitably and generates growing disaffection in the middle class. To date, the dialogue has been distressingly polarized. On one side, the debate is framed in zero-sum terms and the disappointing lack of income growth for middle class workers is blamed on the success of the wealthy. Those with this view should ask themselves whether it would be better if the U.S. had more entrepreneurs like those who founded Apple, Google, Microsoft and Facebook, or fewer. Each did contribute significantly to rising inequality.  It is easy to resent the level and the extent of the increase in CEO salaries in the United States, but it bears emphasis that firms that have a single owner, such as private equity firms, often pay successful CEOs more than public companies do. And for all their problems, American global companies over the last two decades have done very well compared to those headquartered in more egalitarian societies. When great fortunes are earned by providing great products or services that benefit large numbers of people, they should not be denigrated.

At the same time, those who are quick to label any expression of concern about rising inequality as either misplaced or a product of class warfare are even further off base. The extent of the change in the income distribution is such that it is no longer true that the overall growth rate of the economy is the principal determinant of middle class income growth—how the growth pie is sliced is at least equally important. The observation that most of the increase in inequality reflects gains for those at the very top—at the expense of everyone else—further belies the idea that simply strengthening the economy will reduce inequality. Indeed, focusing on American competitiveness, as many urge, could easily exacerbate inequality while doing little for most Americans, if that focus is placed on measures like corporate tax cuts or the protection of intellectual property for companies who are not primarily producing in the United States.

What then, is the right response to rising inequality? There are today too few good ideas in the political discourse, and the development of better ones is crucial to our democracy. But here are several:

First, government must be careful to insure that it does not facilitate increases in inequality by rewarding the wealthy with special concessions. Where governments dispose of assets or allocate licenses, there is a compelling case for more use of auctions to which all have access. Where government provides insurance—implicit or explicit—it is important that premiums be set as much as possible on a market basis rather than in consultation with the affected industry. A general posture for government of standing up for capitalism rather than particular well-connected capitalists would also help.

Second, there is scope for pro-fairness, pro-growth tax reform. A time when more and more great fortunes being created and government has larger and larger deficits is hardly a time for the estate tax to be eviscerated. With smaller families and ever more bifurcation in the investment opportunities open to the wealthy, there is a real risk that the old idea of “shirt sleeves to shirt sleeves in three generations” will be obsolete, and those with wealth will be able to endow dynasties. There is no reason why tax changes in a period of sharply rising inequality should reinforce the trends in pretax incomes produced by the marketplace.

Third, the public sector must insure that there is greater equity in areas of the most fundamental importance. It will always be the case in a market economy that some will have mansions, art, and the ability to travel in lavish fashion. What is far more troubling is that the ability of children of middle class families to attend college has been seriously compromised by increasing tuitions and sharp cutbacks at public universities and colleges. At the same time, in many parts of the country, a gap has opened between the quality of the private school education offered to the children of the rich and the public school educations enjoyed by everyone else. Most alarming is the near doubling, over the last generation, in the gap between the life expectancy of the affluent and the ordinary.

Neither the politics of polarization nor those of noblesse oblige on the part of the fortunate will serve to protect the interests of the middle class in the post-industrial economy. We will have to find ways to do better.

Photo: An Occupy Wall Street demonstrator projects a message on the side of the Verizon Building during what protest organizers called a “Day of Action” in New York. REUTERS/Jessica Rinaldi