The Most Important Passage From the Secret Larry Summers Memo

The New Yorker website has a great catch this afternoon: a 57-page memo that Larry Summers wrote to Barack Obama to frame the debate over the stimulus. It's a long, detailed, fascinating report, but only one passage is underlined, or bolded, or italicized. In fact, it was so important to Summers, it got all three treatments. It's this one:

But it is important to recognize that we can only generate about $225 billion of actual spending on priority investments over next two years. and this is after making what some might argue are optimistic assumptions about the scale of investments in areas like Health IT that are feasible over this period.

Here's why this passage was critical. The recession was so deep that it might require up to $1 trillion in stimulus, according to economists surveyed by Summers' team. But the federal government could "only generate about $225 billion of actual spending" in Summers' estimation. To fill the gap, the White House would have to rely on less-than-ideal sources of stimulus spending. Those sources were tax cuts and state relief.

Tax cuts are good stimulus, if you want to get money into struggling families' wallets, especially families who are cash-poor and likely to spend their next buck. It's also good politics, because Republicans are more likely to support it than a new spending initiative. But tax breaks are more likely to be saved, especially when families are in debt, which dampens their effect as stimulus (since the point of stimulus is to circulate money, not to increase families' savings).

State relief wasn't Summers' idea of perfect stimulus, either. States would likely use the money to offset tax increases, support old spending programs, or fortify rainy day funds, he wrote. "Although there is less research on this topic, it is not unreasonable to assume that a permanent increase in transfers to the states of 1 percent of GOP increases GOP by about 1 percent after two years," Summers said. Put more simply: State relief, like tax breaks, means filling holes in budgets, not building new things.

The gap between the needs of the economy and Summers' doubts about the capacity of government to spend money effectively is all over this memo, and it's summed up nicely in this paragraph:

Constructing a package of this size, or even in the $500 billion range, is a major challenge. While the most effective stimulus is government investment, it is difficult to identify feasible spending projects on the scale that is needed to stabilize the macroeconomy. Moreover, there is a tension between the need to spend the money quickly and the desire to spend the money wisely. To get the package to the requisite size, and also to address other problems, we recommend combining it with substantial state fiscal relief and tax cuts for individuals and businesses.

There are a few ways to read Summers' observation that a $800 billion stimulus would have to rely on sub-optimal channels. One is that he was totally wrong. They could have hired directly, or they could have authorized a larger road-building program. Another is that Summers was totally right. The stimulus signed in February 2009 should be seen as a hole-filler rather than a real stimulator, since what it really succeeded in doing was to fortify state and family budgets.

The fact that this memo has been out of the public eye for the last three years might suggest to you that the administration would be embarrassed by it. Indeed, the now-famous prediction that the stimulus would hold unemployment closer to 7 percent was proved wildly inaccurate. The White House also clearly underestimated the scale of the housing mess, and failed to come up with a way to address the housing crisis on par with its severity.

But there's quite a lot that Summers and his team got right. He was right to suspect that the tax cuts might be saved by indebted families. He was right to suspect that Republicans would attack state relief as unproductive and rewarding to profligate states. He was right that using the stimulus to fulfill the president's campaign promises wasn't ideal, as far as stimulus goes. He was right that the president would inevitably be on the defensive about deficits caused by lower tax revenues and exacerbated (in the short term, at least) by the stimulus. He was right to predict that deficits would lasso entitlement reform into the big picture. He was right that financial reform was a necessary item on the president's agenda, but that it would prove difficult to build political support for major reform while the banks still seemed sick. And so on.

History might remember this memo as the document that killed any hope for a trilion-dollar stimulus, but it's a rich and complicated report that offers a wonderful look at how Obama's team was grappling with an economic downturn that turned out to be even worse than they imagined.