As I read Lawrence Summers’s observations on the prudent steps for bringing the credit crisis under control in the Financial Times, this statement jumped out at me:
While spreads have come in somewhat, markets continue to price in significant probabilities of default for even the most apparently strong financial institution, reflecting in part concerns about their solvency. At the same time it needs to be recognised that the federal government is bearing credit risk in extraordinary ways through its implicit guarantee to the GSEs, the lending activities of the Fed and the general backstop it is providing to the financial system.
All of this implies that a priority for financial policy has to be increases in the level of capital held by financial institutions. Capital infusions to date fall far short of prospective losses. Without new capital, the financial sector will operate with too much risk and leverage or will put the economy at risk by restricting the flow of credit.
On a favourable economic scenario, increases in capital will accelerate the return to normality in sectors such as municipal finance and student loans where credit has dried up, and will offset the moral hazard created by lending to financial institutions.
The emphasis is mine.
The reason that I found this of note was that it seems to me that the revolution in American big business over the last 15 years or so has been the high profits at dramatically reduced levels of capitalization or, said another way, that capital has been substantially more productive recently than it used to be. I’ve been working for some time on a post explaining the ways in which this has been happening and found Dr. Summers’s comments fortuitous. I can’t help but wonder if we aren’t turning a corner in which tomorrow’s economy will look more like that of 20 years ago in some ways than it does like that of the last 15.
