Scott Sumner  

Summers believes we can reduce bubbles with big budget deficits.

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Here's Larry Summers:

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.


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COMMENTS (16 to date)
Alex Godofsky writes:

Something got mucked up in the HTML of this post around "The second strategy", FYI.

[Could you email me, webmaster@econlib.org, with a clearer explanation of the problem for you?--Econlib Ed.]

Jason Sorens writes:

Re the trends in global interest rates... To my knowledge, research on "covered interest rate differentials" has for some time shown that covered interest arbitrage is impossible for U.S. investors, because global real (forward exchange rate-adjusted) interest rates are equal to U.S. real interest rates (just for instance: http://www.wiso.uni-hamburg.de/uploads/media/10_Garrett_1998_01.pdf). The U.S., more than any other economy, is in the Mundell-Fleming world in which macroeconomic policy works through the exchange rate, not the real interest rate.

TallDave writes:

extraordinarily easy monetary policies.

Sigh.

Andy Harless writes:

Let's avoid the word "bubble" and just say (as I've said several times before) that low interest rates (and low equilibrium interest rates) make it difficult to value long-lived assets because low discount rates push a greater portion of the value into the less foreseeable distant future. And again my usual stylized example with a constant growth rate for the flows produced by an asset, and a constant discount rate, so the value of the asset V=d/(r-g), where d ("dividend") is the current flow, r is the discount rate, and g is the growth rate. And if r=g, then DV/dg is infinite, so a tiny change in your estimate of g produces a huge change in V. We might decompose r into a risk-free rate and a risk premium, in which case we can say you run into valuation problems when the risk-free rate is close to the growth rate minus the risk premium -- which I take it is what Larry means by "interest rates significantly below growth rates." So presumably, even leaving aside "bubbles," we can expect asset price volatility under such circumstances, because asset values will be very sensitive to changes in (actual or perceived) information. (They'll also be very sensitive to changes in the risk premium, which is maybe the more important issue: a temporary decline in the risk premium would be hard to distinguish from a genuine bubble.)

So I think Larry has a point. If the equilibrium interest rate is very low, and if government spending raises it (as it does in most models), then there's a case for increasing government spending (or, if one is willing to deny Ricardian equivalence, a case for cutting tax revenues at any given level of government spending).

Scott Sumner writes:

Jason, Yes, I think that sounds plausible.

Andy, I certainly agree about the high asset price values, and can also buy the proposition that asset prices may be more volatile. But I don't see there being any implication for fiscal stimulus.

1. If you cut taxes then eventually the national debt blows up. And Summers is not describing a cyclical problem, but rather a long run problem.

2. As I indicated, the effect of deficits on real interest rates is likely to be very small, so any sort of politically feasible fiscal stimulus would not make a significant dent in the "problem."

3. And finally I'm not convinced that volatile asset prices are a problem. I suppose there's some second best story you could tell involving flaws in financial regulation, but I'd guess the costs of a bloated government would far exceed any costs of volatile asset prices. I recall the stock market crash of 1987 having virtually no macro effects, due to sound monetary policy.

Dan W. writes:

Scott,

It is not just home ownership where debt skews economic outcomes and creates outsized economic risks.

The past 30 years show a huge increase in asset values coincident with a huge increase in debt leverage. But real income growth is not as large. This trend is reflected in the past year where corporate equity valuations increased over 30% but corporate earnings increased less than 10%. You are adamant about bubbles not existing but for how long can asset valuations appreciate faster than earnings?

More important, how can the market determine the proper relationship between asset prices and income if the market trusts a buyer of unlimited resources is poised to rescue holders of assets from having to liquidate them? In such an environment is it not rational to continue bidding up the prices of debt & equity, regardless of the underlying income stream?

Now stocks are relatively liquid, and the '87, '97, '98 and '01 market drops show that plunges in equity prices have minor economic impact. But plunges in debt values present a huge economic risk. Yet low interest rates invite firms to assume large debt positions.

Can NGDPLT allow for a reset of debt to dramatically lower prices? If not how can one claim a market for debt can coexist with a NGDPLT policy?

Andy Harless writes:

Scott:

If you cut taxes then eventually the national debt blows up.
Not necessarily. I mean, yes, there is certainly some level of deficit spending that would cause the national debt to blow up in the long run, because obviously our resources aren't unlimited. But since, historically, long-term government bonds yields have tended to be less than growth rates, the explosion point is likely a long way from where we have been historically. Which is to say, we could probably do fairly large tax cuts without putting the national debt on an unsustainable path.

To put that another way, if your second point is right, then your first point is wrong: if the effect of deficits on real interest rates is very small, then we can afford to run large deficits without blowing up the national debt. The case that the national debt will blow up has to rest on the premise that real interest rates would rise significantly if we ran larger deficits. As to the politics, you're probably right that we can't get sustained deficits big enough to materially reduce the asset price volatility problem. But if that's true, it also means deficits have little cost, so a tiny improvement in the problem would likely still be worth it.

Surely volatile asset prices are a problem if people care about risk. It's a good point that 1987 suggests they aren't a big problem. But I'm not sure 1987 was a very good test. If you look at, say, calendar year returns, the 1987 crash was not even an example of volatility. Also, if we go with the monetary authority we have rather than the one we wish we had, it's pretty obvious that a big decline in housing prices screws up monetary policy.

Of course you don't need bloated government to have big deficits (although, if you believe in Ricardian equivalence, the deficits won't matter if they don't include larger government).

Greg Jaxon writes:
Global long term real interest rates have been trending lower for 30 years. [...] inflation and NGDP growth have also been falling for 30 years. [This] reflects changes in the global economy related to slower growth in mature economies, demographics, high Asian and Nordic saving rates, and many other factors.

The facts you've observed reflect a systemic bias toward the buy-side in the bond market where the Fed is almost always a net buyer, not seller in the Open Market. Because their actions are also predictable, the risk in bond speculation is lower than in commodity speculation, which explains low inflation.

Roger McKinney writes:

It's really funny to read the paleo-Keynesians and monetarists go at each other. They use the same terms but with different definitions and claiming the same data as evidence.

I tend to side slightly with the paleo-Keynesians on this because the monetarists have no criteria for loose monetary policy other than rapid ngdp growth, which the paleo-Keynesians rightly see as circular reasoning.

The truth is probably that neither are right. Macro has little impact. Micro factors do the heavy lifting while the macro twins take the credit. Macro is like politics: politicians take credit for anything good that happens on their watch whether they played any role or not.

Mike Sax writes:

Congratulations on the new position here. Unfortunately I'm going to have to disagree with you here no less than at Money Illusion.

"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."

As you would put it 'all kinds of things wrong here.'

For one, Krugman hasn't been ridiculed by anyone other than the usual suspects-you, Bob Murphy (if anyone suffers from derangement syndrome it's Bob Murphy), Ed Lazaar, et al.

I guess this is how mythology is spun-but no one believes it except the usual Krugman bashers.

As to 'voodoo economics' there really is nothing voodoo about the claim that if the government invests it can bring down the debt to income ratio. You find this outlandish only because like all Auterians you only look at the numerator.

Obviously the debt to income ratio can be brought down in two ways-you can lower the numerator or denominator. You only ever look at the numerator. If you didn't you'd see that assuming a rise in govt spending did lead to higher growth and income this would lower the ration as well-it could also lower the deficit by increasing revenue. In the revenue and spending ratio Austerians are only aware of the spending side.

As to Laffer, at least some of the more extreme claims made at the time-whether by him or some of his fellow Supply Siders-was that you could cut taxes very sharply while also raising spending and yet bring down the deficit.

If you just stick to cutting taxes then in theory it could work but by insisting on also ramping up military spending manifold there was no way the deficit could come down.

This theory-basically of Reaganomics-was a kind of Unholy Trinity-cut taxes sharply, raise spending sharply, and cut the deficit(and reduce public debt). You can't do all three.

For the record it wasn't liberals who first used the term 'Voodoo economics' but H.W. Bush in the 1980 GOP primary against Reagan. He was right but he later of course had to forget that when he ran for President in 1988-then he learned to love voodoo.

Scott Sumner writes:

Dan, Asset prices should be higher when rates are low, like right now.

You said:

"More important, how can the market determine the proper relationship between asset prices and income if the market trusts a buyer of unlimited resources is poised to rescue holders of assets from having to liquidate them? In such an environment is it not rational to continue bidding up the prices of debt & equity, regardless of the underlying income stream?"

Very few asset holders trust anyone to rescue them.

You said;

"But plunges in debt values present a huge economic risk."

Beware of reverse causality. Falling NGDP can cause falling debt prices (for risky debt.) But let's say the reverse is also true? How do we fix that? Partly with NGDPLT, and partly with better regulation. Summers thinks we fix it by running big budget deficits, but I doubt that. It's like a three bumper shoot in billiards, done by government bureaucrats.

Andy, You said;

"Also, if we go with the monetary authority we have rather than the one we wish we had, it's pretty obvious that a big decline in housing prices screws up monetary policy."

Actually that's not at all obvious. The only constant I see in the history of central banking is that the central bankers are like generals fighting the last war. That means that mostly likely the next mistake by central bankers will be to overreact to a bubble, not underreact as in 2008.

I think you missed my point about deficits, although it's possible I am wrong. It's true that the Federal government could do a one time deficit, and raise the debt/GDP ratio to a permanently higher plateau. But this would only work for business cycles, it would not address the secular stagnation problem that Summers discusses. Even a small increase in the annual deficit will eventually cause the debt to blow up if maintained indefinitely. Now if it is the case that all we need to do is raise the debt/GDP ratio one time in order to permanently raise real interest rates, then I am wrong. But is that true?

Scott Sumner writes:

Greg, I don't follow your comment.

Mike, You said;

"For one, Krugman hasn't been ridiculed by anyone other than the usual suspects"

You know that is not true because you've been reading the comment section over at TheMoneyIllusion. I don't know how many professional economists you talk to, but you might be surprised to hear what they say in private about Krugman's objectivity.

I very much doubt that you'd be able to document your claims about supply-siders.

Andy Harless writes:
Even a small increase in the annual deficit will eventually cause the debt to blow up if maintained indefinitely.

This isn't true in general, at least not in the relevant sense. First of all, if you permanently increase the total deficit by a fixed amount and GDP continues growing, this fixed amount becomes vanishingly small relative to GDP in the long run. What happens if you permanently increase the primary deficit by a fixed amount? As long as the interest rate on the government's marginal debt remains below the growth rate, the result is essentially the same, because each additional set of interest payments also becomes vanishingly small relative to GDP in the long run. The basic Samuelson result, as I understand it, says that, as long as g>r, the government has no budget constraint. (This is also essentially the result that Darby used to argue against the fiscal theory of the price level: as long as g>r, the endgame is one in which fiscal policy doesn't constrain monetary policy.)

Now obviously the condition g>r isn't going to persist in the face of an arbitrarily large primary deficit. But when it stops persisting, you've solved the original problem, so you don't need large deficits any more. Somewhere there's a sweet spot where g=r and the deficit is just right.

Mike Sax writes:

Which claims did I make about SSers you'd like me to document, Scott? Note that it was Bush who first used the term 'voodoo economics." I mentioned specifically the Reagan campaign that claimed they could cut the deficit while cutting taxes and raising-military-spending.

[comment elided for irrelevance. The commenter objected, but agreed to the edit in email.--Econlib Ed.]

Roger McKinney writes:

What is voodoo about the Laffer curve? It is nothing but the application of the micro principle of diminishing marginal returns to taxes. If you think the Laffer curve is voodoo econ then you have to explain why diminishing marginal returns does not apply to taxes.

Of course, I understand that macro economists have deliberately forgotten everything they learned in macro. Micro is so inconvenient when it contradicts pet macro theories.

Mike Sax writes:

Roger you like many conservatives I come across don't seem to have even read what I wrote. It was Bush that came up with the 'VE' catchphrase though it was a good one. So don't blame me for the phrase.

If you look at what I said, I mentioned specifically the Reagan campaign of 1980-I didn't specifically even address the Laffer Curve. I mentioned specifically the Reaganite claim that he could cut taxes sharply, raise spending sharply-mostly military spending-and yet cut the deficit. Such a belief was certainly voodoo as the record shows-the deficit exploded.

Liberals got some things wrong as well as I know you probably only like to hear about liberals being wrong. They thought that the deficit would produce wild-eyed inflation which pointedly did not happen. Mondale made coming galloping inflation a centerpiece of his 1984 campaign and was dead wrong. Deficits are not necessarily inflationary we certainly should know by now.

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