Paul, Larry, Secular Stagnation, and the Impact of Negative Real Rates

November 17th, 2013 at 12:10 pm

Paul K was as impressed with the recent words of Larry S as I was, and he (Paul) elaborated in interesting detail.

I’d like to further elaborate and pose a question to Paul and Larry (really, Larries—Summers and Ball) and, of course, anyone else who’d like to weigh in.

One reason Larry’s analysis is so compelling is that it’s framed quite cozily in neoclassical thinking (at least, of the Keynesian sort) and simple empirics.  This is not the stuff of “bloody five-year planners” as Woodhouse labeled the Rooskies.  Many years post-panic, we still have large output gaps and no evidence of price pressures.  The zero-bound is constraining Fed policy, and thus we must do more with economic policy, not less.

In fact, at the heart of the argument is that even before the crash, a massive housing bubble wasn’t achieving full employment (and its corollary: more equitable growth), suggesting a level of secular stagnation that I and others have been worrying about for a very long time.  It’s behind my conviction—really, my life’s work in this field of late—that left to its own devices, the market can’t be counted on to generate full employment.

So, given that this is the stuff of OTE since its inception, what’s the question?

It is this: embedded in Summers’ rap, and Ball’s, and Krugman’s, and my own in many places, is the conviction that one reason we’re stuck where we are (and where we were in the 2000s) is that the real interest rate has been above its equilibrium level.  The nominal rate is of course bound by zero but the real rate is bound by the negative of the inflation rate, and it’s the real rate that hasn’t been low enough.  If it were to fall to the needed level, we’d have a better chance of closing the gaps we’ve been stuck with for a long time.

I wonder.

To be clear, that is explicitly not where the people listed above have stopped.  Everyone on that list has called for more aggressive fiscal policy as well.  But, in the spirit of recognizing limits of interest rate policy, how certain are those of us who advocate this position—which given today’s ZLB means higher inflation to achieve lower real rates—that it would help much?

At first blush, this is simple IS-LM stuff—history is very clear that the IS curve slopes down and there’s a negative relation between real interest rates and output growth.  Ball is most explicit about the growth benefits of lower real rates, as in this section from his recent paper advocating for a 4% inflation target (link above).

How would a larger interest-rate cut have affected the economy? Let us do a back-of-the-envelope calculation using a dynamic IS curve, as calibrated by Ball (1999):

y_t = -(1.0)r­_t-1 + (0.8)y_t-1 ,

where y is the log of output, r is the real interest rate, and a time period is a year. Based on this equation, if interest rates had been two points lower during 2009, output in 2010 would have been 2% higher. If rates stayed constant after that, the effect would have grown because of the lagged output term. The output gain for 2013 would be 5.9%, and the cumulative gain over 2010-2013 would be 16.4% of annual output. Assuming an Okun’s Law coefficient of one half, the cumulative reduction in unemployment would be 8.2 percentage points.

Strong stuff, and surely the sign is right, if not the magnitudes, but there’s something about “secular stagnation” that has a way of messing with old rules.  And I wonder if the key is “secular,” as in sector, as in sectoral misallocation.  Many observers of the US economy have worried about the impact of financialization—the relative growth of the finance sector—on growth.  Part of the concern is the bubble machine, and part is the devotion of considerable resources to non-productive activities.

And the misallocation is profound.  Who out there thinks financial markets are playing their necessary role of allocating excess savings to their most productive uses?  Anyone?…Bueller?…(do click that link—it’s relevant!)

So, I’m totally with the program re getting the real interest rate down to where it should be—in fact, I recently posted on the importance of measuring the output gap correctly (i.e., correcting for the unemployment rate bias) in this regard.  But I’m nervous that it might not be as effective as historical correlations would suggest.

I’d be interested in Paul and Larries responses.

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13 comments in reply to "Paul, Larry, Secular Stagnation, and the Impact of Negative Real Rates"

  1. Dave says:

    After watching Summers (which I should have done before criticizing him) I can understand why he framed it this way given the audience. This is an audience that is very much in touch with these mathematical rules, and the mathematical explanation is going to be helpful in explaining the problem to them.

    However, I don’t think any of that gets to the heart of the cause. He says, basically, what if? What if doesn’t ask why. Why have we needed these bubbles? Why have we needed these misallocations of savings into asset bubbles? Why has our financial industry become dependent upon reservoirs of unproductive investment?

    The answer is to my thinking because there is actually a desire to save rather than invest. The difference between these activities is the desire. Is a person more concerned with growing their nestegg or just keeping it without loss?

    There is nothing anywhere that can control the desire to save. There’s absolutely no reason why, in the long run, we should ever expect that desire to match that which makes an economy work efficiently. We imagined there was something magical here because we used financial innovation to cover the mismatch, but we cannot do that forever.

  2. Dave says:

    Eventually we have to realize as a society what the purpose of saving actually is. There are 2 major ones to my thinking: 1) retirement and 2) class security for yourself and your offspring.

    There’s not any other meaningful reason to desire savings in the long run, to my thinking. We can fix 1 by regulating the level of savings that we will allow the economy to sustain at any time, and provide mechanisms for enforcing that through automatic corrections to the currency. Ignoring this problem has been a luxury that cannot be sustained.

    There are different ways to regulate this. You can do it by adjusting the working hours down to the aggregate demand or by threatening to take those savings with inflation. To stop short of doing either of these is not a prudent management of the economy. We should realize that economic stability in the past was produced by governing policy. It wasn’t produced by any natural force.

  3. Dave says:

    Also, if you look closely at the student loan problem, it should become clear that this excess savings, and it is savings because the principal cannot be lost, slows the economy and indents students at the same time. Thus the slowed economy due to those savings prevents them from finding employment when the graduate.

    One could argue that those savings are actually an investment in a productive activity, in the production of intellectual capital. However, the feedback loop should become apparent. Investing in education only employs teachers, not students. Most of the people are students, and they are not productive while learning except to produce intellectual capital without a purpose.

    I shall be interested in looking at the timing of an increase in the savings rate and the debt level of students, and correlate that to the falling aggregate demand to see if this is indeed once source of secular stagnation.

  4. smith says:

    Summers and Krugman do not have a clue. Money and power in the hands of labor would fuel demand and create inflation, spur investment and lower unemployment. Summers and Krugman instead worry about ways to increase investment when constrained by the lower bound. Corporations are sitting on record amounts of cash. They and the ruling class are quite content with the situation as is, with records profits. An extra 5% unemployment, and lower gross revenue concern them not. Summers and Krugman are near insane in trying to think of novel ways to raise inflation and thereby investment instead of addressing the real problem. Everyone knows current measures by the Fed are a very poor substitute for 80 year old accepted policy of Keynesian stimulus.

    What Summers and Krugman envision is a bubble economy that never pops. Their program produces normal investment and demand, without anything to address weakness of labor. The government supplies incentives to capital in place of stimulus or demand from unemployed. The incentives and new regulations would allow capital to siphon off all of the gains from full employment, exactly as they did before 2007. If normal inflation with full employment will be used to erode wages of the masses, monopolies and oligopolies will not be affected. They will raise prices at will, using inflation and wage demands as an excuse to gouge customers, just like the 1970s until a spiral produced a recession.

    Why would ending the ‘exempt’ status in labor law to return workers to a 40 hour work week be less radical then the original legislation of 1916, nearly a hundred years ago?
    It wouldn’t. America has changed and become more conservative. Educate them. Start pledging candidates to a 35 hour work week and 4 weeks of vacation.

    • Jared Bernstein says:

      It’s funny you should mention “exempt” status on overtime regs. Ross Eisenbrey and I have a new paper on this I’ll be writing up soon. Stay tuned.

      • smith says:

        A commenter on Krugman pointed to Dean Baker blog discussing Krugman and Summers at length.

        Baker writes:
        “Finally, as an alternative to trying to increase demand to deal with secular stagnation, countries could try to reduce supply. This should not sound too crazy. Western Euroepans work on average 20 percent fewer hours a year than do people in the United States. These countries mandate paid vacation (at least four weeks a year), paid sick days, paid parental leave and other forms of paid time off. France has a 35-hour work week. Remember, the problem is too much supply not too little. Reduced work hours (i.e. more leisure) is an easy way to deal with this “problem.”

        What this omits is how business interests nullified labor law in America by making nearly all office workers ‘exempt’. Computer programmers also earned a special ‘exempt’ status of their own, because their work made especially apparent the obvious reality, the office worker is the new factory worker.

        To copy best features of French labor law, pick up 35 hour work week and 4 week vacations for all. Avoid inhibiting hiring by foregoing the French elimination of at-will employment. Abuse of internships is also a problem.

  5. Tom in MN says:

    I knew you would be interested in these ideas.

    So it appears the Fed is targeting too low an inflation rate that never gets us reliably to full employment and contributes to the low wage growth you have pointed out. Does this combined with too much money flowing to the top because of low tax rates *invite* bubbles? Is there lots of money looking for more risky investments precisely because it’s not being properly put to use by people that need it to live on or by infrastructure investments? We certainly seem to have traded higher inflation for bubbles over the last several decades.

    Car analogy: Driving along in a low gear if you give it to much gas you can easily smoke the tires and spin out. Once you are nearer full speed, this is not a concern as the power is already being put to good use.

  6. DRDarrow says:

    Regarding financialization, could our problems be aggravated by the fact that 68% of wealth held in the US is financial, paper assets as opposed to productive capital, as reported by Credit Suisse?

    This is markedly higher than in all other nations, and most of the new wealth being created worldwide is congealing in the US in this form.

  7. Julio Huato says:

    This “secular stagnation” story is a rationalization of the weakness of this country’s political establishment — and this encompasses Congress, the administration, and the Fed. It is a weak political establishment by comparison to the magnitude of its responsibility: ensuring the economy lives up to its potential.

    It is not as if, in the last few years, this economy got hit by a meteorite that disabled its labor force and destroyed a chunk of its other productive wealth. No. As Bernanke noted in passing during his IMF remarks, this is not a natural disaster, but a human-made one, and the policies required to mend things are of a quite different nature.

    Talking about “secular stagnation” gets the political establishment off the hook. It’s a replay of the “structural unemployment” claptrap: You see, there are anonymous forces in the economy that are leading it — under current conditions — to permanent subpar performance. So live with it.” What a lovely cop out!

  8. kappiti says:

    I wonder how much our patent laws affect stagnation. I once read that part of our leap forward in manufacturing was due to FDR’s use it or license it out. Today we have patents bought just in hopes that some entity will infringe and a law suit will cover the cost of the patent. Also, how much do our trade policies prohibit us from doing what needs to be done?

  9. jeff says:

    When the 10% own 90% of assets, isn’t the ‘market’ just about catering to the rich ?

    That hardly seems to be the type of democracy that Friedman intimated market forces would bring.

    Yacht building and dog nannies may be employment in response to market forces but I don’t see that direction as way to have a very pleasant society.

    As for five year plans, I’m pretty sure Walmart has them.

  10. wade says:

    Diminishing financialization with measures such as a financial transactions tax and taxing the wealthy to fund public-service employment seems essential. In fact, why not steadily increase such funding until living-wage jobs go begging due to lack of applicants? Then we would truly have full employment. Granted, other measures would be needed to curb inflation, but those are possible.