Must-Re-Read: Paul Krugman: Secular Stagnation, Coalmines, Bubbles, and Larry Summers

Must-Re-Read: Yes, you do need to reread this. And I do still find myself disturbed by a division in the ranks of those of us economists who I think have some idea of what the elephant in the room us. Some of us–Rogoff, Krugman, Blanchard, me–think our deep macro economic problems could be largely solved by the adoption and successful maintenance of a 4%/year inflation target in the North Atlantic. Others–Summers, Bernanke–do not. They appear to think that a strongly negative natural real safe rate of interest (there’s at mouthful!) will cause sigificant problems even if 4%/year inflation allows a demand-stabilizing central to successfully do its job without hitting the zero lower bound.

My failure to comprehend why they think this disturbs me, for I would have said that my mental model of Bernanke thought is very good. And I would have said that the sub-Turing evocation of Summers that I am currently running on my wetware is world-class:

Paul Krugman (2013): Secular Stagnation, Coalmines, Bubbles, and Larry Summers: “I’m pretty annoyed with Larry Summers right now…

…His presentation at the IMF Research Conference is, justifiably, getting a lot of attention. And here’s the thing…. Larry’s formulation is much clearer and more forceful, and altogether better, than anything I’ve done. Curse you, Red Baron Larry Summers! OK, with professional jealousy out of the way, let me try to enlarge on Larry’s theme….

Larry’s formulation… is the same as my own… works from the understanding that… monetary policy is de facto constrained by the zero lower bound… [and] in this situation the normal rules of economic policy don’t apply…. This is the kind of environment in which Keynes’s hypothetical policy of burying currency in coalmines and letting the private sector dig it up… becomes a good thing…. Larry also indirectly states an important corollary: this isn’t just true of public spending. Private spending that is wholly or partially wasteful is also a good thing…. This is… standard, although a lot of people hate, just hate, this kind of logic–they want economics to be a morality play, and they don’t care how many people have to suffer in the process. But now comes the radical part of Larry’s presentation: his suggestion that this may not be a temporary state of affairs…. The point is that it’s not hard to think of reasons why the liquidity trap could be a lot more persistent than anyone currently wants to admit….

The underlying problem in all of this is simply that real interest rates are too high…. The market wants a strongly negative real interest rate, [and so] we’ll have persistent problems until we find a way to deliver such a rate. One way to get there would be to reconstruct our whole monetary system–say, eliminate paper money and pay negative interest rates on deposits. Another way would be to take advantage of the next boom–whether it’s a bubble or driven by expansionary fiscal policy–to push inflation substantially higher, and keep it there. Or maybe, possibly, we could go the Krugman 1998/Abe 2013 route of pushing up inflation through the sheer power of self-fulfilling expectations….

Oh, and one last point. If we’re going to have persistently negative real interest rates along with at least somewhat positive overall economic growth, the panic over public debt looks even more foolish than people like me have been saying: servicing the debt in the sense of stabilizing the ratio of debt to GDP has no cost, in fact negative cost…. What Larry did at the IMF wasn’t just give an interesting speech. He laid down what amounts to a very radical manifesto. And I very much fear that he may be right.

Gavyn Davies (2013): The implications of secular stagnation: “The alleged consequence of the fact that the actual real rate is above the equilibrium…

…is that there has been a prolonged period of under-investment in the developed economies, with GDP falling further and further behind its underlying long run potential. In a largely unsuccessful effort to close the gap, the central banks have created asset price bubbles (technology stocks in the late 1990s, housing in the mid 2000s and possibly credit today), since this has been the only means available to boost demand…. If they are right, is that the problem of under-performance of GDP will last for a very long time, and will not solve itself through flexibility in prices and interest rates…. The normal route through which monetary policy works, by bringing forward consumption from the future into the present, is unlikely to be successful…. There will still be a shortage of demand when the future comes around…. Calls for fiscal action are bound to intensify…. The conclusion about public investment now seems to be supported by most shades of professional economic opinion, including Ken Rogoff at the IMF conference. Yet there is little sign of it happening on any significant scale.

Paul Krugman (2013): Bubbles, Regulation, and Secular Stagnation: “Looking at current macroeconomic policy…

…the obvious question is, stupid or evil? And the obvious answer is, why do we have to choose? But it is… at any rate soothing… to think about the longer-term future…. I recently talked about some of these issues with Adair Turner… (just to be clear, Adair bears no responsibility for any errors or confusion in what follows). In brief, there is a case for believing that the problem of maintaining adequate aggregate demand is going to be very persistent–that we may face something like the “secular stagnation” many economists feared after World War II….

When the Minsky moment came, there was a rush to deleverage; this drove down overall demand for any given interest rate, and made the Wicksellian natural rate substantially negative, pushing us into a liquidity trap…. How should pre-2008 policy have been different? And what should policy look like looking forward? There are many economic commentators who take rising leverage, asset bubbles and all that as prima facie evidence that monetary policy was too loose…. The trouble with this line of argument is that if monetary policy is assigned the task of discouraging people from excessive borrowing, it can’t pursue full employment and price stability, which are also worthy goals (as well as being the Fed’s legally binding mandate)…. Since the US economy shows no signs of having been overheated on average from 1985 to 2007, the argument that the Fed should nonetheless have set higher rates is an argument that the Fed should have kept the real economy persistently depressed, and unemployment persistently high…. That’s quite a demand. Many of us would therefore argue that the right answer isn’t tighter money but tighter regulation….

Our current episode of deleveraging will eventually end, which will shift the IS curve back to the right. But if we have effective financial regulation, as we should, it won’t shift all the way back to where it was before the crisis…. And here’s the worrisome thing: what if it turns out that we need ever-growing debt to stay out of a liquidity trap?… Bear in mind that interest rates were actually pretty low even during the era of rising leverage, and got worryingly close to zero after the 2001 recession and even, you might say, after the 90-91 recession (there was talk of a liquidity trap even then)….

One answer could be a higher inflation target, so that the real interest rate can go more negative. I’m for it! But you do have to wonder how effective that low real interest rate can be if we’re simultaneously limiting leverage. Another answer could be sustained, deficit-financed fiscal stimulus. But, you say, this would lead to exploding public debt! Actually, no–not if the real interest rate is persistently below the economy’s growth rate….

OK, I’m shooting from the hip here. The main point is simply that the weirdness of our current situation may well go on much longer than anyone currently imagines.

Jared Bernstein (2013): Paul, Larry, Secular Stagnation, and the Impact of Negative Real Rates: “Paul K was as impressed with the recent words of Larry S as I was…

…I’d like to further elaborate and pose a question to Paul and Larry (really, Larries—Summers and Ball) and, of course, anyone else who’d like to weigh in…. Larry’s analysis is… compelling… [because] it’s framed quite cozily in neoclassical thinking… and simple empirics…. Many years post-panic, we still have large output gaps and no evidence of price pressures.  The zero-bound is constraining Fed policy, and thus we must do more with economic policy, not less…. [This] suggests a level of secular stagnation that I and others have been worrying about for a very long time… [is] behind my conviction… my life’s work… that left to its own devices, the market can’t be counted on to generate full employment….

In the spirit of recognizing limits of interest rate policy, how certain are those of us who advocate this position—which given today’s ZLB means higher inflation to achieve lower real rates—that it would help much? At first blush, this is simple IS-LM stuff—history is very clear that the IS curve slopes down…. But there’s something about “secular stagnation” that has a way of messing with old rules…. Many observers of the US economy have worried about the impact of financialization… the bubble machine… the devotion of considerable resources to non-productive activities…. Who out there thinks financial markets are playing their necessary role of allocating excess savings to their most productive uses?…

So, I’m totally with the program re getting the real interest rate down… But I’m nervous that it might not be as effective as historical correlations would suggest. I’d be interested in Paul and Larries responses.

August 25, 2015

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