There are two ways to understand “secular stagnation.” One is that the growth rate of income and output will be slower in the future. The other is that there will be a systematic tendency for aggregate demand to fall short of the economy’s potential output. It’s the second claim that we are interested in.
For Krugman, the decisive fact about secular stagnation is that it implies a need for persistently negative interest rates. That achieved, there is no implication that growth rates or employment need to be lower in the future than in the past. He is imagining a situation where current levels of employment and growth rates are maintained, but with permanently lower interest rates.
We could also imagine a situation where full employment was maintained by permanently higher public spending, rather than lower interest rates. Or we could imagine a situation where nothing closed the gap and output fell consistently short of potential. What matters is that aggregate expenditure by the private sector tends to fall short of the economy’s potential output, by a growing margin. For reasons I will explain down the road, I think this is a better way of stating the position than a negative “natural rate” of interest.
I think this conversation is a step forward for mainstream macroeconomic thought. There are further steps still to take. In this post I describe what, for me, are the positive elements of this new conversation. In subsequent posts, I will talk about the right way of analyzing these questions more systematically — in terms of a Harrod-type growth model — and about the wrong way — in terms of the natural rate of interest.
The positive content of “secular stagnation”
1. Output is determined by demand.
The determination of total output by total expenditure is such a familiar part of the macroeconomics curriculum that we forget how subversive it is. It denies the logic of scarcity that is the basis of economic analysis and economic morality. Since Mandeville’s Fable of the Bees, it’s been recognized that if aggregate expenditure determines aggregate income, then, as Krugman says, “vice is virtue and virtue is vice.”
A great deal of the history of macroeconomics over the past 75 years can be thought of as various efforts to expunge, exorcize or neutralize the idea of demand-determined income, or at least to safely quarantine it form the rest of economic theory. One of the most successful quarantine strategies was to recast demand constraints on aggregate output as excess demand for money, or equivalently as the wrong interest rate. What distinguished real economies from the competitive equilibrium of Jevons or Walras was the lack of a reliable aggregate demand “thermostat”. But if a central bank or other authority set that one price or that one quantity correctly, economic questions could again be reduced to allocation of scarce means to alternative ends, via markets. Both Hayek and Friedman explicitly defined the “natural rate” of interest, which monetary policy should maintain, as the rate that would exist in a Walrasian barter economy. In postwar and modern New Keynesian mainstream economics, the natural rate is defined as the market interest rate that produces full employment and stable prices, without (I think) explicit reference to the intertemporal exchange rate that is called the interest rate in models of barter economies. But he equivalence is still there implicitly, and is the source of a great deal of confusion.
I will return to the question of what connection there is, if any, between the interest rates we observe in the world around us, and what a paper like Samuelson 1958 refers to as the “interest rate.” The important thing for present purposes is:
Mainstream economic theory deals with the problems raised when expenditure determines output, by assuming that the monetary authority sets an interest rate such that expenditure just equals potential output. If such a policy is followed successfully, the economy behaves as if it were productive capacity that determined output. Then, specifically Keynesian problems can be ignored by everyone except the monetary-policy technicians. One of the positive things about the secular stagnation conversation, from my point of view, is that it lets Keynes back out of this box.
That said, he is only partway out. Even if it’s acknowledged that setting the right interest rate does not solve the problem of aggregate demand as easily as previously believed, the problem is still framed in terms of the interest rate.
2. Demand normally falls short of potential
Another strategy to limit the subversive impact of Keynes has been to consign him to the sublunary domain of the short run, with the eternal world of long run growth still classical. (It’s a notable — and to me irritating — feature of macroeconomics textbooks that the sections on growth seem to get longer over time, and to move to the front of the book.) But if deviations from full employment are persistent, we can’t assume they cancel out and ignore them when evaluating an economy’s long-run trajectory.
One of the most interesting parts of the Summers talk came when he said, “It is a central pillar of both classical models and Keynesian models, that it is all about fluctuations, fluctuations around a given mean.” (He means New Keynesian models here, not what I would consider the authentic Keynes.) “So what you need to do is have less volatility.” He introduces the idea of secular stagnation explicitly as an alternative to this view that demand matters only for the short run. (And he forthrightly acknowledges that Stanley Fischer, his MIT professor who he is there to praise, taught that demand is strictly a short-run phenomenon.) The real content of secular stagnation, for Summers, is not slower growth itself, but the possibility that the same factors that can cause aggregate expenditure to fall short of the economy’s potential output can matter in the long run as well as in the short run.
Now for Summers and Krugman, there still exists a fundamentals-determined potential growth rate, and historically the level of activity did fluctuate around it in the past. Only in this new era of secular stagnation, do we have to consider the dynamics of an economy where aggregate demand plays a role in long-term growth. From my point of view, it’s less clear that anything has changed in the behavior of the economy. “Secular stagnation” is only acknowledging what has always been true. The notion of potential output was never well defined. Labor supply and technology, the supposed fundamentals, are strongly influenced by the level of capacity utilization. As I’ve discussed before, once you allow for Verdoorn’s Law and hysteresis, it makes no sense to talk about the economy’s “potential growth rate,” even in principle. I hope the conversation may be moving in that direction. Once you’ve acknowledged that the classical allocation-of-scarce-means-to-alternative-ends model of growth doesn’t apply in present circumstances, it’s easier to take the next step and abandon it entirely.
3. Bubbles are functional
One widely-noted claim in the Summers talk is that asset bubbles have been a necessary concomitant of full employment in the US since the 1980s. Before the real estate bubble there was the tech bubble, and before that there was the commercial real estate bubble we remember as the S&L crisis. Without them, the problem of secular stagnation might have posed itself much earlier.
This claim can be understood in several different, but not mutually exclusive, senses. It may be (1) interest rates sufficiently low to produce full employment, are also low enough to provoke a bubble. It may be (2) asset bubbles are an important channel by which monetary policy affects real activity. Or it may be (3) bubbles are a substitute for the required negative interest rates. I am not sure which of these claims Summers intends. All three are plausible, but it is still important to distinguish them. In particular, the first two imply that if interest rates could fall enough to restore full employment, we would have even more bubbles — in the first case, as an unintended side effect of the low rates, in the second, as the channel through which they would work. The third claim implies that if interest rates could fall enough to restore full employment, it would be possible to do more to restrain bubbles.
An important subcase of (1) comes when there is a minimum return that owners of money capital can accept. As Keynes said (in a passage I’m fond of quoting),
The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money. Cf. the nineteenth-century saying, quoted by Bagehot, that “John Bull can stand many things, but he cannot stand 2 per cent.”
If this is true, then asking owners of money wealth to accept rates of 2 percent, or perhaps much less, will face political resistance. More important for our purposes, it will create an inclination to believe the sales pitch for any asset that offers an acceptable return.
Randy Wray says that Summers is carrying water here for his own reputation and his masters in Finance. The case for bubbles as necessary for full employment justifies his past support for financial deregulation, and helps make the case against any new regulation in the future. That may be true. But I still think he is onto something important. There’s a long-standing criticism of market-based finance that it puts an excessive premium on liquidity and discourages investment in long-lived assets. A systematic overestimate of the returns from fixed assets might be needed to offset the systematic overestimate of the costs of illiquidity.
Another reason I like this part of Summers’ talk is that it moves us toward recognizing the fundamental symmetry between between monetary policy conventionally defined, lender of last resort operations and bank regulations. These are different ways of making the balance sheets of the financial sector more or less liquid. The recent shift from talking about monetary policy setting the money stock to talking about setting interest interest rates was in a certain sense a step toward realism, since there is nothing in modern economies that corresponds to a quantity of money. But it was also a step toward greater abstraction, since it leaves it unclear what is the relationship between the central bank and the banking system that allows the central bank to set the terms of private credit transactions. Self-interested as it may be, Summers call for regulatory forbearance here is an intellectual step forward. It moves us toward thinking of what central banks do neither in terms of money, nor in terms of interest rates, but in terms of liquidity.
Finally, note that in Ben Bernanke’s analysis of how monetary policy affects output, asset prices are an important channel. That is an argument for version (2) of the bubbles claim.
4. High interest rates are not coming back
For Summers and Krugman, the problem is still defined in terms of a negative “natural rate” of interest. (To my mind, this is the biggest flaw in their analysis.) So much of the practical discussion comes down to how you convince or compel wealth owners to hold assets with negative yields. One solution is to move to permanently higher inflation rates. (Krugman, to his credit, recognizes that this option will only be available when or if something else raises aggregate demand enough to push against supply constraints.) I am somewhat skeptical that capitalist enterprises in their current form can function well with significantly higher inflation. The entire complex of budget and invoicing practices assumes that over some short period — a month, a quarter, even a year — prices can be treated as constant. Maybe this is an easy problem to solve, but maybe not. Anyway, it would be an interesting experiment to find out!
More directly relevant is the acknowledgement that interest rates below growth rates may be a permanent feature of the economic environment for the foreseeable future. This has important implications for debt dynamics (both public and private), as we’ve discussed extensively on this blog. I give Krugman credit for saying that with i < g, it is impossible for debt to spiral out of control; a deficit of any level, maintained forever, will only ever cause the debt-GDP ratio to converge to some finite level. (I also give him credit for acknowledging that this is a change in his views.) This has the important practical effect of knocking another leg out from the case for austerity. It’s been a source of great frustration for me to see so many liberal, “Keynesian” economists follow every argument for stimulus with a pious invocation of the need for long-term deficit reduction. If people no longer feel compelled to bow before that shrine, that is progress.
On a more abstract level, the possibility of sub-g or sub-zero interest rates helps break down the quarantining of Keynes discussed above. Mainstream economists engage in a kind of doublethink about the interest rate. In the context of short-run stabilization, it is set by the central bank. But in other contexts, it is set by time preferences and technological tradeoff between current and future goods. I don’t think there was ever any coherent way to reconcile these positions. As I will explain in a following post, the term “interest rate” in these two contexts is being used to refer to two distinct and basically unrelated prices. (This was the upshot of the Sraffa-Hayek debate.) But as long as the interest rate observed in the world (call it the “finance” interest rate) behaved similarly enough to the interest rate in the models (the “time-substitution” interest rate), it was possible to ignore this contradiction without too much embarrassment.
There is no plausible way that the “time substitution” interest rate can be negative. So the secular stagnation conversation is helping reestablish the point — made by Keynes in chapter 17 of the General Theory, but largely forgotten — that the interest rates we observe in the world are something different. And in particular, it is no longer defensible to treat the interest rate as somehow exogenous to discussions about aggregate demand and fiscal policy. When I was debating fiscal policy with John Quiggin, he made the case for treating debt sustainability as a binding constraint by noting that there are long periods historically when interest rates were higher than growth rates. It never occurred to him that it makes no sense to talk about the level of interest rates as an objective fact, independent of the demand conditions that make expansionary fiscal policy desirable. I don’t mean to pick on John — at the time it wasn’t clear to me either.
Finally, on the topic of low interest forever, I liked Krugman’s scorn for the rights of interest-recipients:
How dare anyone suggest that virtuous individuals, people who are prudent and save for the future, face expropriation? How can you suggest steadily eroding their savings either through inflation or through negative interest rates? It’s tyranny!
But in a liquidity trap saving may be a personal virtue, but it’s a social vice. And in an economy facing secular stagnation, this isn’t just a temporary state of affairs, it’s the norm. Assuring people that they can get a positive rate of return on safe assets means promising them something the market doesn’t want to deliver – it’s like farm price supports, except for rentiers.
It’s a nice line, only slightly spoiled by the part about “what the market wants to deliver.” The idea that it is immoral to deprive the owners of money wealth of their accustomed returns is widespread and deeply rooted. I think it lies behind many seemingly positive economic claims. If this conversation develops, I expect we will see more open assertions of the moral entitlement of the rentiers.