Last month I argued that the U.S. and global economies may be in a period of secular stagnation; in which sluggish growth and output, and employment levels well below potential, might coincide for some time to come with problematically low real interest rates. Since the start of this century, annual growth in U.S. gross domestic product has averaged less than 1.8 percent. The economy is now operating nearly 10 percent, or more than $1.6 trillion, below what the Congressional Budget Office judged to be its potential path as recently as 2007. And all this is in the face of negative real interest rates for more than five years and extraordinarily easy monetary policies.
Lots of problems here. Monetary policy since 2008 has actually been the tightest since Herbert Hoover was President, if we use the criteria recommended by Ben Bernanke in 2003. Summers seems to believe that low interest rates mean easy money, but by that measure money must have been really tight during the German hyperinflation. (And no, switching over to real interest rates doesn't help much, as Bernanke pointed out. NGDP growth is the best measure of the stance of monetary policy.)
If the United States were to enjoy several years of healthy growth under anything like current credit conditions, there is every reason to expect a return to the kind of problems of bubbles and excess lending seen in 2005 to 2007 long before output and employment returned to normal trend growth or inflation picked up again.
I don't believe in bubbles, but excess lending is certainly possible given all the moral hazard built into our financial system.
The second strategy, which has dominated U.S. policy in recent years, is lowering relevant interest rates and capital costs as much as possible and relying on regulatory policies to ensure financial stability. No doubt the economy is far healthier now than it would have been in the absence of these measures. But a growth strategy that relies on interest rates significantly below growth rates for long periods virtually ensures the emergence of substantial financial bubbles and dangerous buildups in leverage. The idea that regulation can allow the growth benefits of easy credit to come without cost is a chimera. The increases in asset values and increased ability to borrow that stimulate the economy are the proper concern of prudent regulation.
The third approach -- and the one that holds the most promise -- is a commitment to raising the level of demand at any given level of interest rates through policies that restore a situation where reasonable growth and reasonable interest rates can coincide. To start, this means ending the disastrous trends toward ever less government spending and employment each year and taking advantage of the current period of economic slack to renew and build out our infrastructure. If the federal government had invested more over the past five years, the U.S. debt burden relative to income would be lower: allowing slackening in the economy has hurt its long-run potential.
The final sentence is of course what Keynesians used to call "voodoo economics", until they started making the same "something for nothing" claims that used to be associated with Art Laffer. That doesn't make those claims false, although given the dismal record associated with massive infrastructure investment in Japan, I'd say Laffer's theory is more promising. It's also an odd time to make the fiscal multiplier argument, just two days after Krugman's widely ridiculed explanation for why his "test" of monetary offset was a valid test in April when things seemed to be going his way, but was no longer a test today because . . . well apparently because of factors that were plainly visible in April.
Global long term real interest rates have been trending lower for 30 years. This trend does not reflect "easy money," as inflation and NGDP growth have also been falling for 30 years. Rather it reflects changes in the global economy related to slower growth in mature economies, demographics, high Asian and Nordic saving rates, and many other factors. Building a few more bridges in the US won't change that dynamic, just as building bridges to nowhere in Japan failed to raise their real interest rates significantly.
Given the low real interest rates, it is quite appropriate that asset prices be higher than their historical norms, as asset values reflect both future returns and the rate at which those returns are discounted. In other words get used to seemingly "overvalued" asset markets for the next few decades. They won't be overvalued (ex ante), but they will look that way.
Summers is right that it isn't easy to stop excess lending, but a good place to start would be for the government to stop encouraging home ownership, and also stop taxing debt-fueled investment more lightly than equity-fueled investment. More importantly, we need to change our monetary policy regime so that a sharp drop in asset prices doesn't push nominal GDP lower, as in 2008-09. A good alternative would be NGDP targeting, level targeting. And no, NGDP targeting is not any more inflationary than inflation targeting. Rather the inflation would be less procyclical. It would not stop asset prices from fluctuating, but at least it won't feed asset price instability, as inflation targeting does.
PS. "ever less government spending"? I'm pretty sure some of readers will question that claim.
PPS. Matt Yglesias has a good post on the Summers piece that concludes as follows:
On the flip side I think that both market monetarists like Scott Sumner and conventional new Keynesians like Michael Woodford would say that Summers has the interest rate mechanism wrong. It's not that monetary stimulus would push interest rates even lower and thus drive investment activity up. Rather, the idea is that monetary stimulus would raise expectations about the future level of nominal income. Those higher expectations would drive more investment activity, which would push interest rates up over time.
My dream would be to tell you that the Abenomics experiment in Japan can answer this question for us--have interest rates on Japanese Government Bonds gone up or down in response to monetary stimulus? The answer, unfortunately, is that they went up then down then up then down then up again to net out at about no change. Macroeconomics, once again, isn't quite giving us a rich enough data set to conclusively demonstrate who's right.
Is that actually Woodford's view? If so, I'd be pleasantly surprised. And if Matt is insinuating that I don't have a good model for explaining how long term interest rates respond to monetary shocks, he's right.