What Is the Eccles Building Thinking Today? I: The Failure to Think Through the Consequences of “Secular Stagnation”

Olivier Blanchard, at least, has said that the secular decline in global real interest rates and increased macro instability means that the 2%/year inflation target was greatly ill-advised and needs to be raised to 4%/year. But, among the great and good who staff the finance ministries, central banks, and international organizations these days, he is nearly alone. And the other pieces of the policy puzzle that might get us out of our zero-lower-bound-secular-stagnation pickle–aggressive redistribution via taxes and transfers, higher debt levels for reserve currency-issuing sovereigns with exorbitant privilege to boost the supply of safe assets, reducing risk premia by governments’ assumption of the role of entrepreneurial risk-bearer of last resort, international organizations that emerging markets regard as friends rather than enemies–are nowheresville.

The prevailing view among the great and good who staff governments and organizations is that the interest rate-capacity utilization configuration is going to normalize “soon”. As Larry writes: “the ‘headwinds’ orthodoxy prevailing in the official community… has been consistently far behind the curve…. The ‘temporary headwinds’ interpretation of low neutral real rates has been wrong for the last few years and is not hugely plausible as a basis for predicting the next few…”

And with U.S. 30-year Treasury bonds at 3.0%/year nominal and German at 1.4%/year nominal, financial markets provide no warrant for believing what are now called “headwinds” will ease any time over the next generation.

Since World War II, central bankers and governments have at least believed that they had the tools to successfully manage the macroeconomy. Now I do not believe that they think they do have tools adequate to the likely macroeconomic environment over the next generation. Yet this lack of tools does not seem to bother the great and good very much today…

Must-Read: Larry Summers: Breaking New Ground on Neutral Rates: “Lukasz Rachel and Thomas Smith have a terrific new paper…

…document[ing]… the length and breadth of the decline… in real rates… over 25 years… shows the inadequacy of shorter-term explanations of low neutral real rates such as those of Ken Rogoff that focus on the financial crisis and its aftermath…. They present thoughtful calculations assigning roles to rising inequality and growing reserve accumulation on the saving side and lower priced capital goods and slower labor force growth on the investment side. They also note the importance of rising risk premia… [an] first important word on decomposing the causal factors behind declining real rates….

They reach the important conclusion that there is little basis for assuming a significant increase in neutral real rates going forward. This conclusion differs sharply from the ‘headwinds’ orthodoxy prevailing in the official community…. There will be much less scope to raise rates in the industrial world over the next few years than the world’s central banks suppose…. The zero lower bound is likely to be a major issue….

Rachel and Smith also share my concern that a world of chronic very low real rates is going to be a world of high volatility, imprudent risk taking, excessive leverage and frequent financial accident…. It is fashionable to invoke the brave new world of macro-prudential policy…. As best I can tell, US macroprudential policy as currently practiced has meaningfully impaired liquidity in some key markets and damaged the credit availability for small and medium sized businesses while not touching excessive flows to emerging markets and high yield corporate issuance…. I doubt that actual regulators who, after all, were proclaiming the health of the banking system in mid 2008 are capable of pulling it off consistently given the pressures they face.

December 16, 2015


Brad DeLong
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