Reviewing Lawrence Summers’s et al.’s VoxEU Ebook on “Secular Stagnation”: The Honest Broker for the Week of August 23, 2014

The Setup:

Let’s start with Paul Krugman, who made me aware of this ebook by writing:

Paul Krugman: All About Zero: “Way back in 2008 I (and many others) argued…

…that the financial crisis had pushed us into a liquidity trap… in which the Fed and its counterparts elsewhere couldn’t restore full employment even by reducing short-term interest rates all the way to zero…. In practice the zero lower bound has huge adverse effects on policy effectiveness… [and] drastically changes the rules… [as] virtue becomes vice and prudence is folly. We want less saving, higher expected inflation, and more…. Liquidity-trap analysis has been overwhelmingly successful in its predictions: massive deficits didn’t drive up interest rates, enormous increases in the monetary base didn’t cause inflation, and fiscal austerity was associated with large declines in output and employment….

Secular stagnation adds… the strong possibility that this Alice-through-the-looking-glass world is the new normal…. This raises problems even for advocates of unconventional policies, who all too often predicate their ideas on the notion that normality will return in the not-too-distant future. It raises even bigger problems with people and institutions that are eager to “normalize” …. Do we know that secular stagnation is here? No. But the case is strong enough that it should color almost every policy discussion.

Start with the observation that in the entire twentieth century only during the Great Depression was the nominal interest rate the U.S. government paid on its debt less more than the trend rate of nominal GDP growth–and the deflation of the Great Depression is not going to come again:

And note that this is a twentieth-century fact only: in the slower real-growth and (usually) precious-metal commodity-money standard nineteenth century, the interest rate on U.S. government debt was more likely to be above than below the trend rate of nominal GDP growth:

Note that this does not mean that in the twentieth century ex-the Great Depression the U.S. economy was “dynamically inefficient”: it would not have been possible to raise consumption in every (or, indeed, in most) states of the world by investing less at the start and maintaining a lower capital-output ratio throughout. Only if there were a large external price-taking entity willing to (a) accept deposits from the U.S. and pay them the U.S. Treasury rate, and (b) pay the outsized equity premium return to U.S. citizens willing to accept their equity risk would any such transaction have been possible. There never was any such entity. The best way to conceptualize it, I think, is that U.S. wealthholders were (and are) prepared to pay U.S. taxpayers via the intermediary of the U.S. government an extraordinarily outsized fee–vastly more than could be justified by any utility value of risk-bearing derived from a declining marginal utility of consumption–for allowing them to use its financial instruments to transfer their purchasing power into the future in a (relatively) safe and secure way.

But this does mean that the issues that Larry Summers has brought to the forefront of the current economists’ discussion under the rubric of “secular stagnation” have in fact been present since the beginning of large-scale gold-mining in the Witwatersrand in the mid-1890s and the accompanying non-adjustment of nominal interest rates to the acceleration of inflation and nominal GDP growth generated by that shift in monetary regime.

The “Secular Stagnation” Argument:

The voxEU ebook Secular Stagnation begins with a chapter by Lawrence Summers that sets out the playing field:

Lawrence Summers: Reflections on the ‘New Secular Stagnation’ Hypothesis: “The experience of Japan in the 1990s and now that of Europe and the US suggests…

…theories that take the average level of output and employment over a long time period as given are close to useless…. The ‘new secular stagnation hypothesis’ responds to recent experience and the manifest inadequacy of conventional formulations by raising the possibility that it may be impossible for an economy to achieve full employment, satisfactory growth, and financial stability simultaneously simply through the operation of conventional monetary policy. It thus provides a possible explanation for the dismal pace of recovery in the industrial world, and also for the emergence of financial stability problems as an increasingly salient concern….

If a financial crisis represents a kind of power failure, one would expect growth to accelerate after its resolution as those who could not express demand because of a lack of credit were enabled to do so. Unfortunately, it appears that the difficulty that has arisen in recent years in achieving adequate growth has been present for a long time, but has been masked by unsustainable finances. Here it is instructive to consider the performance of the US and Eurozone economies prior to onset of financial crisis in 2007.

Let us begin with the US. It is certainly fair to say that growth was adequate–perhaps even good–during the 2003–2007 period. It would not be right to say either that growth was spectacular or that the economy was overheating during this period. And yet this was the time of vast erosion of credit standards, the biggest housing bubble in a century, the emergence of substantial budget deficits, and what many criticise as lax monetary and regulatory policies.

Imagine that US credit standards had been maintained, that housing had not turned into a bubble, and that fiscal and monetary policy had not been simulative. In all likelihood, output growth would have been manifestly inadequate because of an insufficiency of demand. Prior to 2003, the economy was in the throes of the 2001 downturn, and prior to that it was being driven by the internet and stock market bubbles of the late 1990s. So it has been close to 20 years since the American economy grew at a healthy pace supported by sustainable finance…

In this formulation, “sustainable finance” as a placeholder that needs definition and elaboration. What does Summers mean by “sustainable finance” in this context? One piece of the definition is clear:

• “Sustainable finance” requires an economy-wide willingness to invest enough in the formation of risky capital assets to carry employment up to its NAIRU level without requiring irrational and unsustainable expectations of the ongoing real price appreciation of the capital assets invested in.

The fact that NAIRU-level employment in the U.S. in the later 1990s was achieved only via irrational and unsustainable expectations of the appreciation of high-tech capital assets and in the mid-2000s was achieved only by irrational and unsustainable expectations of house price appreciation tells us that finance then was not “sustainable”. And in the absence of such bubbly expectations and asset price patterns, the U.S. economy to a small extent in the early 1990s, to a significant extent in the early 2000s, and to a complete extent now has been unable to pull itself up to the NAIRU level of employment and up to previous confident expectations of where potential output growth would take us.

What is the next analytic step? Think of an economy with three kinds of financial assets: cash that pays a nominal interest rate of zero, relatively-safe interest-bearing government bonds with nominal interest rates that substitution for cash keeps from dropping below or even to zero, and claims–call them equities–on risky private capital investments that must given their returns–warranted profits plus rational or irrational expected capital-asset price appreciation plus inflation–offer a high enough spread vis-à-vis government bonds to induce new issues. The problem, then, is that without bubbles warranted profits plus inflation do not reach a high enough premium over the zero nominal bound on cash to allow for enough investment to attain the NAIRU employment level. There are then five obvious solutions:

1. Have the government undertake more of the long-term capital formation in the economy, thus spreading the risk-bearing capacity of the private sector over a smaller required number of private investment projects and so reducing the risk premium until the NAIRU level of employment is attainable via “sustainable finance”.

2. Raise the return on private investment.

3. Raise the share of income citizens seek to spend on consumption.

4. Have the government explicitly or implicitly bear some risk either via loan guarantees or lender-of-last-resort backstops, thus reducing the amount of risk-bearing capacity each project needs and so reducing the private risk premium until the NAIRU level of employment is attainable via “sustainable finance”.

5. Have the inflation target rise, so that the wedge between warranted profits plus inflation and zero is large enough for the NAIRU level of employment to be attainable via “sustainable finance”.

Summers expresses doubts about (4) and (5):

Low nominal and real interest rates undermine financial stability in various ways. They increase risk-taking as investors reach for yield, promote irresponsible lending as coupon obligations become very low and easy to meet, and make Ponzi financial structures more attractive as interest rates look low relative to expected growth rates…. Operating with a higher inflation rate target… ways such as quantitative easing that operate to reduce credit or term premiums… are also likely to increase financial stability risks…

And he advocates (1), (2), and (3), calling for:

increased public investment…

so that risk-bearing capacity can be spread over fewer required investment projects, and:

a commitment to maintain basic social protections so as to maintain spending power, and measures to reduce inequality and so redistribute income towards those with a higher propensity to spend…

to similarly reduce the amount of required investment projects, plus:

reductions in structural barriers to private investment and measures to promote business confidence…

to raise warranted profits.

One possible further analytical step–one Summers does not take–would be to note that the industrial market economy seemed to run into significant cyclical and political distress in the years before the 1895 trend break and shift to a more inflationary monetary regime, returned to a time of troubles as governments attempted to enforce deflation on their economies in the 1920s and 1930s, and has endured a renewed time of troubles with the Plaza-driven deflation of the yen and the post-Volcker decision to reduce North Atlantic inflation rates from 4%/year to less than 2%/year. It would then draw the conclusion that what we need now is what we needed in both the late 1920s and the early 1890s: a higher trend inflation target.

Another possible analytical step–one that Summers takes but does not develop–would be to develop more fully his argument that a higher trend inflation rate and a government that takes active steps to reduce risk premiums both risk increasing financial instability through various channels.

Indeed, I believe that a stronger argument against the “all we need is a higher inflation target” solution (5) is made by Paul Krugman:

You can get traction if you can credibly promise higher inflation…. But what does it take to credibly promise inflation? It has to involve a strong element of self-fulfilling prophecy: people have to believe in higher inflation, which produces an economic boom, which yields the promised inflation. A necessary (though not sufficient) condition for this to work is that the promised inflation be high enough that it will indeed produce an economic boom if people believe the promise will be kept. If it is not high enough, then the actual rate of inflation will fall short of the promise even if people do believe in the promise, which means that they will stop believing after a while, and the whole effort will fail…. I have come to think of [this] as the ‘timidity trap’…

And Krugman takes aim at (1) as well:

What about fiscal policy? Here the standard argument is that deficit spending can serve as a bridge across a temporary problem, supporting demand while, for example, households pay down debt and restore the health of their balance sheets, at which point they begin spending normally again….But what if a negative real natural rate isn’t a temporary phenomenon? Is there a fiscally sustainable way to keep supporting demand?

But gives no answers:

In this chapter I’ll leave these questions hanging…

Elaboration:

How is this framework developed by and these themes launched by Summers elaborated by the other contributors to VoxEU’s Secular Stagnation? In various ways. Eggertsson and Mehrota build a formal model and begin the process of exploring exactly what the mechanisms are. Guntram Wolff backs up Summers’s and Krugman’s fears that monetary policy and announcement of a higher inflation target cannot do the job: the Inflation Expectations Imp is no easier to summon than is the Business Confidence Fairy.

Caballero and Farhi and Blanchard, Furceri, and Pescatori develop the issues by worrying the issue of the relative supply and demand of safe and risky assets as something that affects the risk premium and thus the ability of an economy to achieve a NAIRU employment level with sustainable finance. Richard Koo suggests that if only leverage could be reduced and balance sheets righted the problems that Summers identifies would vanish. (I am skeptical, largely because I see the problems as perhaps present since the 1870s.) And Jimeno, Smets, and Yiangou call–yet again–for structural reform and accelerated deleveraging.

Nick Crafts sees Summers as more-or-less a hypochondriac as far as the U.S. is concerned, but on target for western Europe because: “European demographics are less favourable…. Productivity growth in Europe will underperform…. Fiscal consolidation… will bear relatively heavily on Europe…. [And] in a depressed economy, the Fed is more likely to take appropriate policy action than the ECB…” Thus: “Europeans should be much more afraid than Americans…”

Barry Eichengreen dismisses the possibility that a slowed rate of technological progress has reduced the rate of profit. Perhaps the inventions that really matter for our utility have already been made. But the rate of profit depends on the pace of innovation in those sectors on which we spend our money even if progress there has little effect on our utility. And the incentives to innovate in the sectors on which we spend our money remain very high. He dismisses the idea of a permanent global savings glut because he sees China as shifting from foreign asset accumulation for domestic consumption.

However, Eichengreen fears that the right-wing dismissal of the value of government has led the North Atlantic to eat its publicly-provided seed corn. And he also fears the hysteresis consequences for potential output of the failure to stimulate aggregate demand enough via fiscal, banking, housing, and monetary policies. Thus the secular stagnation he fears is a self-inflicted one: much less interesting to an intellectual economist than Summers’s variety, and much easier to cure from a technocrat economist point of view, but, alas!, quite probably harder for us to deal with here on the ground where we live in the Sewer of Romulus, A very different place from the Republic of Plato.

Growth and Distribution:

Somewhat orthogonal to the macro-finance-inflation-demand concerns of the main thrust of the book are Robert Gordon, Joel Mokyr, and Ed Glaeser.

Robert Gordon sees an aging society, the plucking of all the low-hanging fruit from raising education levels, A widening gap between real GDP and societal welfare as income inequality continues its inexorable technology-driven march upwards, and continued failure to either raise taxes to a level that can fund the benefits that citizens demand or to lower benefits to a level consistent with the taxes that the rich who control the loophole-generating mechanisms of government. These four headwinds, he says, Will reduce the pace of American economic growth significantly. And he sees no reason to imagine that total factor productivity growth will offset these headwinds by jumping up from the rate it has exhibited over the past four decades to the higher Second Industrial Revolution rate it exhibited over 1920-1970.

Joel Mokyr, by contrast, sees the future of technology as carrying us to a near-singular state:

Compared to the tools we have today for scientific research, those of Galileo and Pasteur look like stone-age tools…. It is not just ‘IT’ or ‘communications’…. This very human shortfall of imagination is largely responsible for much of today’s pessimism. In many other respects, too, the labour-market outlook is not wholly bleak… if telecommuting and driverless cars can cut the commuting time… at least one major (and uncounted) tax on workers will be eliminated. Such an improvement would not be reflected in the aggregate output and productivity statistics…

And thus sees worries about ‘secular stagnation’ of any form as fundamentally wrongheaded.

Ed Glaeser does not see any form of true secular stagnation–“innovation seems unrelenting, at least to me, and I believe that such innovation is the stuff of longer-term economic growth…. I also believe that the benefits of future innovation will continue to flow to a wide swath of humanity, at least in their capacity… as consumers”. What he does see as a crisis is the decline in prime-aged male employment in the U.S. from 95% in the 1950s to 87% before 2008, and 83% today. Largely agnostic about causes, he calls for a two-bladed scissors approach: supply-side sticks to make being idle less comfortable via reduced disability insurance and other social-welfare programs that cushion being without an income for the long term, and “targeted investments in education and workforce training” and perhaps in employment-heavy economic sectors.

Conclusion:

It is very clear to me that Larry Summers did both well and ill when he chose the phrase “secular stagnation” has the label for his argument. He did well because his argument is clearly the same and its macroeconomic aspects as the argument that Alvin Hansen made in his presidential address, and using a phrase that harkens back to that is apposite and useful. He did ill because Hansen saw the root cause as technological exhaustion. I see no signs of technological exhaustion. Yet that label leads people to look for signs of actual technological exhaustion, and this leads to what I see is barking up the wrong or at least a different tree. There should really be three conversations: a macroeconomic structure for demand management conversation, a demography and inequality conversation, and an information economy conversation. Mashing them together does not do much to enlighten.

Instead, I see the root causes as the confluence of an unreasonably high premium return on equities and other risky assets with a deflation or a very low inflation price trend. And where Summers sees this as operating since the mid-1990s and the start of the dot-com boom, I see it as operating since 1895, if not 1865.

What questions do I have? I have many. What answers am I confident of? I am confident of none. What guesses do I have? I have made many in the pages above, but let me make one more: if he returned up to Paul Volker is 4%/year inflation target and beefed up our financial-sector capital requirements, I would give 3-1 odds that in 15 years “secular stagnation” with no longer make our list of the top 10 big North Atlantic macroeconomic issues. But maybe I am wrong: maybe our bubble worries would then be an order of magnitude more severe…

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