David R. Henderson  

Bernanke and Poole on Secular Stagnation

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Note: The reason for my dearth of blog posts lately is the troubles I've had with my 6-year-old Mac. I now have a new one and all is well. Fingers crossed.

Does the U.S. economy face secular stagnation? I am skeptical, and the sources of my skepticism go beyond the fact that the U.S. economy looks to be well on the way to full employment today. First, as I pointed out as a participant on the IMF panel at which Larry first raised the secular stagnation argument, at real interest rates persistently as low as minus 2 percent it's hard to imagine that there would be a permanent dearth of profitable investment projects. As Larry's uncle Paul Samuelson taught me in graduate school at MIT, if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades. It's therefore questionable that the economy's equilibrium real rate can really be negative for an extended period. (I concede that there are some counterarguments to this point; for example, because of credit risk or uncertainty, firms and households may have to pay positive interest rates to borrow even if the real return to safe assets is negative. Also, Eggertson and Mehrotra (2014) offers a model for how credit constraints can lead to persistent negative returns. Whether these counterarguments are quantitatively plausible remains to be seen.)

This is my favorite paragraph from Ben Bernanke's blog post "Why are interest rates so low, part 2: Secular stagnation," March 31, 2015. Bernanke is a clear writer, which is refreshing.

I heard my own version of "Uncle Paul's" example from Sam Peltzman, who had heard it from Martin Bailey. Another person who had heard it from Bailey is Bill Poole. Poole writes:

A convincing counterargument [to the secular stagnation argument] was presented in a 1962 textbook by Martin J. Bailey, with whom I studied at the University of Chicago. Bailey argued that investment spending would not reach a limit at a zero rate of interest because there are some investments that have an annual return that continues in perpetuity. If an investment has an infinite life, then the present value of the project can be made as large as you please by making the interest rate as low as you please. Mathematically, as the discount factor on future returns goes to zero the present value becomes indefinitely large. The lower the rate of interest the greater the number of investments there would be with present value above their capital cost and the total size of these investments would be easily large enough to bring the economy to full employment.

Bailey used the example, and had estimates of the cost, of creating new farmland by filling shallow coastal areas in the Gulf of Mexico. The newly created land would have a return in agricultural output that would continue indefinitely.

Another example discussed by Bailey is leveling the Midwest. This argument always yielded a few smiles from the class. However, anyone who lives in the hugely productive farm areas of the Midwest knows that the land is not perfectly flat. Water collects in the lower spots, damaging agricultural productivity. At finite cost, a farmer can strip off topsoil, level the land, and put the topsoil back. The increase in output continues indefinitely. At a low enough interest rate, the value of the investment exceeds its cost. Bailey had other examples of investments that would create a long string of returns and that, at a low enough interest rate, would be worth doing.


I don't quote this just to show that the point was well known. Poole goes on to make a point that Bernanke doesn't mention: insecure property rights. Poole writes:
As I speak, the yield on the inflation-protected Treasury bond is about zero at the 10-year maturity and slightly below 1 percent on the 30-year maturity. Yet, I have not observed a rush to fill in the Gulf of Mexico or level the Midwest. Why?

For Bailey's argument to work, environmental permits have to allow the investment in the first place. And, the relevant return is on an after-tax basis. Will future tax law permit such an investment to earn enough to cover its capital cost?

I am convinced that the issue in the United States today is not that business is shortsighted and unwilling to take risk. Consider the enormous investment, and risk, Boeing assumed when it launched the 787 Dreamliner project. The exact timing does not matter for my argument, but a quick Internet search suggests that Boeing went public with the project in early 2003. Although the plane is currently about 3 years late to market, when Boeing decided to proceed it must have had a planning horizon of at least five years to bring the first model into service. Boeing expected the 787 to yield a stream of extra returns over many years; discounting those returns back to the decision date, Boeing must have thought the project had a present value above its enormous cost.

This sort of long-horizon investment is frequent in U.S. history. We do not see more such investment now because of uncertainty over the tax and regulatory environment. Martin Bailey, writing before establishment of the Environmental Protection Agency, could not have foreseen that creating new agricultural land in the Gulf of Mexico would have been impossible, and that plans to level sections of the Midwest might have been held up for years and years. And given the unsustainable federal budget situation, returns from risky projects might never be realized because they would be taxed away.


Interestingly, Larry Summers, whom Bernanke let guest blog on secular stagnation, and who, with me, was a colleague of Bill Poole at the Council of Economic Advisers, does hint at some of Bill Poole's point, writing:
Ben grudgingly acknowledges that there are many theoretical mechanisms that could give rise to zero rates. To name a few: credit markets do not work perfectly, property rights are not secure over infinite horizons, property taxes that are explicit or implicit, liquidity service yields on debt, and investors with finite horizons.


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COMMENTS (12 to date)
Bostonian writes:

The ratio of average Hispanic to average white income is less than 2/3, and the country is becoming more Hispanic. If the average lower income of Hispanics has an intractable cause such as lower average IQ, demographic trends will exert steady downward pressure on average real income.

Kevin Erdmann writes:

I just published a post on this same issue. I believe this is evidence that the problem in the 2000s was not that we had too much housing. It was that we didn't have enough.

Rolf Andreassen writes:

> The newly created land would have a return in agricultural output that would continue indefinitely.

That seems incorrect. There is a nonzero probability in any given year that a rise in the sea level, a hurricane, an asteroid or nuclear strike, or an earthquake will return the land to being sea-bottom, or otherwise unproductive. An interest rate of exactly zero may not be low enough to be easily distinguishable from this yearly probability-of-total-destruction. And you can't borrow for 500-year terms on any interest whatever; if your project requires rolling over debt in ten years, but relies on "indefinite" returns for profitability, then the rate has to go, not just to zero, but low enough to compensate for the risk of having to borrow at 10% in ten years. That seems like a higher bar to clear.

ThomasH writes:

It is true that lots of projects would have positive NPV's with governments able to borrow at near zero rates, but that implies that governments do NOT behave as they have during the 2008-15 recession/recovery. If governments continue policies of "austerity" (failing to invest because it would require increasing the deficit) then zero real interest rates could persist almost indefinitely. Deteriorating infrastructure would gradually reduce the profitability of private sector projects as well. Now it is true that eventually government might revert to using optimal investment decision rules, but how long before the do is quite speculative.

I do not accept as universally true the time-preference explanation for positive interest rates (being that people prefer to enjoy now rather than later). It is easy to imagine circumstances in which an individual who is wealthy today would gladly pay a fraction of that wealth to be sure that the remainder would be available to him later, one or ten years in the future. If, for example, stock markets are crashing, banks are failing, and real-estate values are dropping, then savings will look for safekeeping — even if safekeeping costs 5% per year.

Rick Hull writes:

An aside: how delicious would it be to show Martin Bailey committing the motte-and-bailey fallacy?

brendan riske writes:

again, I don't disagree with the stagnation argument. We have hit at least a temporary wall in growth on our finite planet. We cannot keep producing and polluting indefinitely with the current system. Gains in this century should come from more efficient use of what we have. There will be growth, but it will be of a much smaller (and more sustainable) magnitude.

But the interest rates are being forced down by central bank actions. The reason more investments aren't being undertaken is twofold, only a small number of people have access to money at 0% (large banks), and they are not stupid enough to undertake huge wasteful projects. They are investing back into financial assets! In the case of bonds, as prices rise, yields fall. This has made its way into the bank lending rates as well. The interbank rate is zero right now.

finally, someone needs to really explain how negative interest rates on government bonds arise naturally. Especially in the case of the periphery euro countries, but the same can be said of Japan and the US. They have massive debts built up which will never be paid back. Why loan money to those governments, and pay for the privilege? I see how in the short run this is possible by central bank asset buying programs, but in the long run shouldn't this cause havoc in the financial system? Rates have to go above zero eventually.

baconbacon writes:

If farmland and knocking down the rockies are the best examples that can be come up with, then the proposition that positive projects can always be found is probably false. For one farmland does not simply produce for eternity. Western Massachusettes was once entirely farmlandand is now almost entirely forest, the opening of the mid west lead to outright abandoning of farms. Take a train through the central valley in California right now and you pass by acres of dead orchards for lack of water. Agricultural output doesn't simply happen- there are costs and marginal land (and filling in low lying areas almost always makes it marginal land) is the first to go during any shock.

The example of leveling the rockies is fanciful, and I note zero mention of externalities there. Leveling any significnat portion of the range would alter weather patterns drastically (killing all those farmers who spent millions filling in low spots only to find they had not enough/to much water thanks to the new weather). Ignoring the insanely complex task of determining if level a range was worth it is like trumpeting Chinese growth rates due to projects like the 3 gorges damn without subtracting a single penny for the farmland and villages that had existed prior to the flooding.

Kevin Erdmann writes:

baconbacon,

Those are excellent points.

On the other hand, the environment he is describing is one where the value of reasonable very long term projects goes to infinity because there is no discount on the very far term cash flows. So, if his basic supposition was correct, we would see nominal prices of very long term assets with predictable cash flows soar. And, in fact, that is what we saw in residential real estate.

So, markets were behaving in pretty much the way he describes. It wasn't a matter of markets not finding assets that would behave in the manner necessary to attract investment. They did. The problem was that everyone saw that happening and freaked out about it. So a consensus developed around public policies, including monetary policy, that eventually hobbled credit markets enough that assets like houses simply can't be bid up to their reasonable nominal prices. There wasn't a concern about externalities or any such problem. There was simply a naïve lack of faith in the nominal valuations that were associated with a market that included very low long term interest rates. We didn't say, "You can't tear down that mountain because it will disrupt weather patterns." We said, "We just can't let you pay that much for a mountain." and we all watched as the Fed sucked cash out of the economy until nobody could afford the mountain any more. Then, we patted ourselves on the back and said, "Told you so. It was a mountain bubble. It was bound to go bust."

Housing is still devastated by mortgage markets that haven't expanded in nearly a decade (!). (Here is a whopper of a graph.) So, now that we have destroyed the nominal value of literally tens of trillions of existing homes and undercut new home building, we're all debating this mysterious surplus of savings. That graph of mortgage levels certainly is a bit of a clue as to where savings might have been invested, but weren't. For 60 years, the log scale trend was in a pretty darn straight line until 2007.

baconbacon writes:

Kevin- our main disagreement is probably in our interpretation of that graph. You view that upward trend as sustainable
(to some degree) and I unsustainble and as evidence/symptomatic of a bubble.

Roger writes:

"....the troubles I've had with my 6-year-old Mac. I now have a new one and all is well."

What a difference a comma makes. I read this and mentally inserted a comma. I thought you were having trouble with your young son, and that you... well, replaced the little guy.

Never mind.

David R. Henderson writes:

@Roger,
LOL. But my 6-year-old, Mac, is a problem too. :-)

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