Summary: Larry Summers speech last week was, IMO, a pivotal moment. It forced economists to look at the US from a new perspective, considering things that had been heretical. The previous post, Are we following Japan into an era of slow growth, even stagnation? sketched out his bold speech. Today we look at the text, with the good news (better definition of our problem) and the bad (no new solutions). This post ends with a bang (or warns of a bang, depending on your point of view).
Contents
- Prelude: the missing “V” recovery
- Summers warns of the great stagnation
- We fight a crisis with the theories we have
- Bubbles to the rescue
- More economists jump into the debate
- For More Information
(1) Prelude: the missing “V” recovery
Despite the great economic events of the past five years, economic policy and theory debates have largely run in circles. Pro and con fiscal stimulus. Pro and con monetary stimulus. Forecasts of the “V’ recovery each year; forecasts of slow growth (include me on that team).
One quiet theme has been a few of us warning that we have fallen into a situation like, in its essentials, that of Japan in the quarter-century since their 1989 bust. That’s been declared daft by mainstream economists. Until now. It’s a shattering idea, because Japan shows the intractable nature of this trap. They might have found a solution in “three arrows” of Abenomics (massive monetary AND fiscal stimulus, drastic structural reforms) — but the solution might prove ruinous. Or ineffective Or both.
The speech changed the debate. It deserves your attention.
(2) Larry Summers warns of the great stagnation
Excerpt (lightly edited for clarity) from the transcript of Larry Summers’ speech at the IMF Economic Forum on 8 November 2013, prepared by Randy Fellmy, posted at his Facebook page. Red emphasis added.
It is a central pillar of both classical models and Keynesian models that it is all about fluctuations: fluctuations around the given mean, and that what you need to do is have less volatility. I wonder if a set of older ideas firmly rejected in {graduate monetary economics courses} — that went under the phrase “secular stagnation” — are not profoundly important in understanding Japan’s experience, and {might be relevant} to America’s experience.
… If you study the economy prior to the crisis, there’s something odd. Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody believes that wealth, as it was experienced by households, was in excess of its reality. Too easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilization wasn’t under any great pressure. Unemployment wasn’t under any remarkably low level. Inflation was entirely quiescent. So somehow, even a great bubble wasn’t enough to produce any excess in aggregate demand.
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… So what’s an explanation that would fit these observations?
Suppose that the short-term real interest rate that was consistent with full employment had fallen to negative 2% or negative 3% sometime in the middle of the last decade. Then what would happen? Then even with artificial stimulus to demand coming from all this financial imprudence, you wouldn’t see any excess demand; and even with a relative resumption of normal credit conditions, you’d have a lot of difficulty getting back to full employment.
Yes, it has been demonstrated that panics are terrible, and that monetary policy can contain them when the interest rate is zero. … It has been demonstrated, less conclusively, but presumptively, that when short-term interest rates are zero, monetary policy can affect a constellation of other asset prices in ways that support demand, even when the short-term interest rate can’t be lowered. Just how large that impact is on demand is less clear, but it is there.
But imagine a situation where natural and equilibrium interest rates have fallen significantly below zero. Then conventional macroeconomic thinking leaves us in a very serious problem, because we all agree that, whereas you can keep the Federal funds rate at a low level forever, it’s much harder to do extraordinary measures beyond that forever — but the underlying problem may be there forever. It’s much more difficult to say we only needed deficits during the short interval of the crisis if aggregate demand, if equilibrium interest rates, can’t be achieved given the prevailing rate of inflation.
If this view is at all correct, most of what would be done under the aegis of preventing a future crisis would be counterproductive, because it would in one way or other raise the cost of financial intermediation, and therefore operate to lower the equilibrium interest rate that was necessary.
Now this may all be madness, and I may not have this right at all; but it does seem to me that 4 years after the successful combating of crisis, with really no evidence of growth that is restoring equilibrium, one has to be concerned about a policy agenda that is doing less with monetary policy than has been done before, doing less with fiscal policy than has been done before, and taking steps whose basic purpose is to cause there to be less lending, borrowing and inflated asset prices than there was before.
So my lesson from this crisis is — and my overarching lesson, which I have to say I think the world has under-internalized — is that it is not over until it is over; and that is surely not right now, and cannot be judged relative to the extent of financial panic; and that we may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back below their potential.
(3) We fight a crisis with the theories we have
Five years of zero-interest rate policy (ZIRP) and three rounds of quantitative easing have stabilized the economy, so that mainstream economists’ debate the timing of the start and acceleration of normalization — with tapering QE3 being the first step.
Summers warns that this might prove misguided. Perhaps the unconventional monetary policies at work in Japan, Britain, and USA are necessary. Perhaps return to normal growth requires these policies, and the asset price and investment bubbles they create.
Summers did not give detailed recommendions. He assured us that there is a monetary solution, and it is more of the what we’re doing — perhaps even accelerated. Perhaps so, but I doubt it.
Must we choose between stagnation or calamitous bubbles? Being between economic versions of Scylla and Charybdis? We have fallen into a crisis in scientific theory as described by Thomas Kuhn: paradigms cannot be disproved, only replaced. Economists, like generals, must work with what they have — no matter how inadequate — not with better tools of the future.
We need new theories. Stat. Otherwise I doubt this will end well. The demographic tide of the aging developed nations (e.g., the boomers in America) will put immense stress on our economies. Time is not our friend.
(4) Bubbles to the rescue
“The commonest error in politics is sticking to the carcass of dead policies.”
— Lord Salisbury, discussing Great Britain’s policy on the Eastern Question (1877)
Look with wonder at this graph of home affordability (and hence valuation) in terms of the median price to median family income ratio, from the Q3 2013 Quarterly Letter by Jeremy Grantham , chief investment officer of GMO (Grantham Mayo van Otterloo).
Prices are only one standard deviation from the 36 year mean. But that includes the 8 bubble years. Excluding those, and even more if so including earlier data (back to 1970 or 1960), would show the current level as quite extreme.
The median home/income ratio was 3.47 in September 2012 vs the 1976-2000 average of aprox 2.9 and the pre-bubble peak of aprox 3.1. It rose to 4.06 in September 2013. That’s 40% above average and 30% above the previous pre-bubble peak for what was once a stable series. (source)
Fitch Ratings, attempting to avoid repeat of their failures during the past two bubbles, has just published “U.S. RMBS Sustainable Home Price and Economic Risk Factor Special Report” November 2013. Free registration required. Much of their analysis has an optimistic bias. For example, when calculating home affordability they use mean instead of median incomes, and ignore changes in credit availability (high requirements for downpayments and credit scores)
Other asset prices show similar patterns, such as art and farmland. Rising asset prices stimulate the economy. But each cycle of bubble-collapse further distorts its normal operation. I fear this will not end well.
(5) More Economists jump into the debate
Summers legitimized questions about secular stagnation. Now other economists speak up.
- “A Permanent Slump?“, Paul Krugman, op-ed in the New York Times, 17 November 2013
- “Secular stagnation: The solution that cannot be named“, Ryan Avent (journalist), The Economist, 17 November 2013 — Spoiler (it’s more inflation)
- The monetary magic alternative: ”Focus on NGDP expectations, not interest rates“, Scott Sumner (Prof Economics, Bentley U), The Money Illusion, 17 November 2013
- A powerful critical review: “Are real rates of return negative? Is the “natural” real rate of return negative?“, Tyler Cowen (Prof Economics, George Mason U), Marginal Revolution, 18 November 2013
- Brad DeLong (Prof Economics, Berkeley) comments at the Washington Center for Equitable Growth, 18 November 2013
(6) For More Information
If you liked this post, like us on Facebook and follow us on Twitter. See all posts about bubbles, especially these…
Posts about Japan:
- We are following Japan’s path of decline. The real test comes later this year., 23 June 2009
- As Japan sails into the shadows, let’s wish them well and wave good-by, 14 July 2009
- Japan can again become the land of the rising sun. We should watch and learn from them., 1 November 2012
(b) Monetary policy as addiction:
- Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine., 19 September 2013
(c) About the greatest monetary experiment, ever:
- Important things to know about QE2 (forewarned is forearmed), 21 October 2010
- Bernanke leads us down the hole to wonderland! (more about QE2), 5 November 2010
- The World of Wonders: Monetary Magic applied to cure America’s economic ills, 20 February 2013
- The World of Wonders: Everybody Goes Nuts Together, 21 February 2013
- The greatest monetary experiment, ever, 20 June 2013
- Different answers to your questions about the momentous Fed decision to delay tapering, 20 Sept 2013
- Do you look at our economy and see a world of wonders? If not, look here for a clearer picture…, 21 September 2013
- Two warnings about quantitative easing, the taper, and what comes next, 27 September 2013
- Dr Hunt explains the great monetary experiment. It will be historic, no matter what the result., 20 October 2013
- The great monetary experiment enters a new phase, with America as the stakes, 27 October 2013
- The key to understanding the future of QE3, and the future of our economy, 12 November 2013
(d) Other posts about monetary policy:
- The Fed is not wildly printing money, as yet no hyperinflation, we’re not becoming Zimbabwe, 2 March 2010
- Why the U.S. cannot inflate its way out of debt, 16 March 2010
- What are the limitations of the Fed’s power? It’s neither impotent nor omnipotent!, 17 September 2012
- Lessons from the failed forecasts of inflation since the crash, 5 October 2013
- Let’s learn about hyperinflation. Who knows what the future holds for us?, 21 October 2013 — esp section 3, about the sudden onset of inflation
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