secular stagnation – J. W. Mason

The Roaring 2020s: Further Reading

Mike Konczal and I have a piece in the New York Times arguing that the next few years could see a historic boom for the US economy, if policy makers recognize that strong demand and rising wages are good things, and don’t get panicked into turning toward austerity.

Mike and I and our colleagues at the Roosevelt Institute are planning a series of papers on “planning for the boom” over the coming year. The first, asking how high employment could plausibly rise under conditions of sustained strong demand, will be coming out later this month. In the meantime, here are some things I’ve written over the past few years, making the case that there is much more space for demand-led growth in the US economy than conventional estimates suggest, and that the benefits from pursuing it are broader than just producing more stuff.

In my recent post on the economics of the Rescue Plan, I highlighted the way in which the expansive public spending of the Biden administration implicitly embraces a bigger role for aggregate demand in the longer term trajectory of the economy and not just in short-run fluctuations:

Overheating may have short-term costs in higher inflation, inflated asset prices and a redistribution of income toward relatively scarce factors (e.g. urban land), but it also is associated with a long-term increase in productive capacity — one that may eventually close the inflationary gap on its own. Shortfalls on the other hand lead to a reduction in potential output, and so may become self-perpetuating as potential GDP declines.

I’ve continued making this argument in an ongoing debate with the University of Chicago’s Harold Uhlig at this new site Pairagraph. I also discussed it with David Beckworth on his excellent macroeconomics podcast.

In many ways, this story starts from debates in the mid 2010s about the need for continued stimulus, which got a big impetus from Bernie Sanders first campaign in 2016. I tried to pull together those arguments in my 2017 Roosevelt paper What Recovery? There, I argued that the failure of per-capita GDP to return to its previous trend after 2009 was a striking departure from previous recessions; that an aging population could not explain the fall in labor fore participation; that slower productivity growth could be explained at least in part by weak demand; and the the balance of macroeconomic risks favored stimulus rather than austerity.

In a more recent post, I noted that the strong growth and low unemployment of the later part of the decade, while good news in themselves, implied an even bigger demand shortfall in the aftermath of the recession:

In 2014, the headline unemployment rate averaged 6.2 percent. At that time, the benchmark for full employment (technically, the non-accelerating inflation rate of unemployment, or NAIRU) used by the federal government was 4.8 percent, suggesting a 1.4 point shortfall, equivalent to 2.2 million excess people out of work. But let’s suppose that today’s unemployment rate of 3.6 percent is sustainable—which it certainly seems to be, given that it is, in fact, being sustained. Then the unemployment rate in 2014 wasn’t 1.4 points too high but 2.6 points too high, nearly twice as big of a gap as policymakers thought at the time.

I made a similar set of arguments for a more academic audience in a chapter for a book on economics in the wake of the global financial crisis, “Macroeconomic Lessons from the Past Decade”. There, I argue that

the effects of demand cannot be limited to “the short run”. The division between a long-run supply-side and a short-run demand-side, while it may be useful analytically, does not work as a description of real world developments. Both the size of the labor force and productivity growth are substantially endogenous to aggregate demand.

This set of arguments is especially relevant in the context of climate change; if there is substantial slack in the economy, then public spending on decarbonization can raise current living standards even in the short run. Anders Fremstad, Mark Paul and I made this argument in a 2019 Roosevelt report, Decarbonizing the US Economy: Pathways toward a Green New Deal. I made the case much more briefly in a roundtable on decarbonization in The International Economy:

The response to climate change is often conceived as a form of austerity—how much consumption must we give up today to avoid the costs of an uninhabitable planet tomorrow? … The economics of climate change look quite different from a Keynesian perspective, in which demand constraints are pervasive and the fundamental economic problem is not scarcity but coordination. In this view, the real resources for decarbonization will not have to be withdrawn from other uses. They can come from an expansion of society’s productive capabilities, thanks to the demand created by clean-energy investment itself.

If you like your economics in brief video form, I’ve made this same argument about aggregate demand and climate change for Now This.

The World War II experience, which Mike and I highlight in the Times piece, is discussed at length in a pair of papers that Andrew Bossie and I wrote for Roosevelt last year. (Most of what I know about the economics of the war mobilization is thanks to Andrew.) In the first paper, The Public Role in Economic Transformation: Lessons from World War II, we look at the specific ways in which the US built a war economy practically overnight; the key takeaway is that while private contractors generally handled production itself, most investment, and almost all the financing of investment, came from the public sector. The second paper, Public Spending as an Engine of Growth and Equality: Lessons from World War II, looks at the macroeconomic side of the war mobilization.

Among the key points we make here are that potential output is much more elastic in response to demand than we usually assume; that both the labor force and productivity respond strongly to the level of spending; that the inflation associated with rapid growth often is a sign of temporary shortfalls or bottlenecks, which can be addressed in better ways than simply reducing aggregate spending; and that strong demand is a powerful force for equalizing the distribution of income. The lessons for the present are clear:

The wartime experience suggests that the chronic weak demand the US has suffered from for at least the past decade is even more costly than we had realized. Not only does inadequate spending lead to slower growth, it leads to lower wage gains particularly for those at the bottom and reinforces hierarchies of race and sex. Conversely, a massive public investment program in decarbonization or public health would not only directly address those crises, but could also be an important step toward reversing the concentration of income and wealth that is one of the great failures of economic policymaking over the past generation.

I also discuss the war experience in this earlier Dissent review of Mark Wilson’s book Destructive Creation, and in a talk I delivered at the University of Massachusetts in early 2020.

Alternative approaches to inflation control isn’t something I’ve written a lot about — until recently, the question hasn’t seemed very urgent. But Mike, me and our Roosevelt colleague Lauren Melodia did write a blog post last month about why it’s a mistake to worry about somewhat higher inflation numbers this year. One aspect of this is the “base effect” which is artificially increasing measured inflation, but it’s also important to stress that genuinely higher inflation is both a predictable result of a rapid recovery from the pandemic and not necessarily a bad thing.

A few years ago, Mike and I wrote a paper arguing for a broader toolkit at the Fed. Our focus at the time was on finding more ways to boost demand. But many of the arguments also apply to a situation — which we are definitely not in today, but may be at some point — where you’d want to rein demand in. Whichever way the Fed is pushing, it would be better to have more than one tool to push with.

Another important background debate for the Times piece is the idea of secular stagnation, which enjoyed a brief vogue in the mid 2010s. Unfortunately, the most visible proponent of this idea was Larry Summers, who … well, let’s not get into that here. But despite its dubious provenance, there’s a lot to be said for the idea that recent decades have seen a persistent tendency for total spending to fall short of the economy’s productive potential. In this (somewhat wonkish) blog post, I discussed this idea in terms of Roy Harrod’s model of economic growth, and suggested a number of factors that might be at work:

for secular, long-term trends tending to raise desired saving relative to desired investment we have: (1) the progressive satiation of consumption demand; (2) slowing population growth; (3) increasing monopoly power; and (4) the end of the industrialization process. Factors that might either raise or lower desired savings relative to investment are: (5) changes in the profit share; (6) changes in the fraction of profits retained in the business sector; (7) changes in the distribution of income; (8) changes in net exports; (9) changes in government deficits; and (10) changes in the physical longevity of capital goods. Finally, there are factors that will tend to raise desired investment relative to desired saving. The include: (11) consumption as status competition (this may offset or even reverse the effect of greater inequality on consumption); (12) social protections (public pensions, etc.) that reduce the need for precautionary and lifecycle saving; (13) easier access to credit, for consumption and/or investment; and (14) major technological changes that render existing capital goods obsolete, increasing the effective depreciation rate. These final four factors will offset any tendency toward secular stagnation.

Hysteresis — the effect of demand conditions on potential output — and secular stagnation are two important considerations that suggest that big boost in spending, as we are looking at now, could permanently raise the economy’s growth path. A third, less discussed consideration is that demand itself may be persistent. I discuss that possibility in a recent blog post.

An important aspect of an economic boom which we unfortunately could not fit into the op-ed is the way that faster growth and moderately higher inflation reduce the burden of debt for both the private and public sector. Historically, growth rates, inflation and interest rates have had a bigger effect on the household debt ratio than household borrowing has. This is a major focus of my scholarly work — see here and here. The same thing goes for public debt, as I’ve discussed in a blog post here. The degree to which both the past year’s stimulus and a possible future boom has/will strengthen balance sheets across the economy is seriously underappreciated, in my view.

The question of public debt has moved away from center stage recently. Criticism of public spending lately seems more focused on inflation and supposed ”labor supply constraints.” But if the anti-boom contingent shifts back toward scare stories about public debt, I’ve got pre-rebuttals written here and here.

For the broader economic perspective I’m coming from, I haven’t done a better job laying it out than this interview with the Current Affairs podcast. The ostensible topic is Modern Monetary Theory, but it’s really a general conversation about how we should think about the economy. You could also look at the teaching materials on this website. On the more concrete debates about economic potential and the limits to public spending, Arjun Jayadev and I have written a couple of stock-taking pieces: Strange Defeat: How Austerity Economics Lost All the Intellectual Battles and Still Won the War, and more recently The Crash of Austerity Economics.

Finally, I want to highlight something I wrote about a year ago: The Coronavirus Recession Is Just Beginning. There, I argued that the exceptional reduction in activity due to the pandemic would probably be followed by a conventional recession. You will note that this is more or less the opposite of the argument in the Times piece. That’s because my post least year was wrong! But I don’t think it was unreasonable to make that prediction at the time. What I didn’t take into account, what almost no one took into account, was the extraordinary scale of the stimulus over the past year. Well ok! Now, let’s build on that.

A Few Followup Links

The previous post got quite a bit of attention — more, I think, than anything I’ve written on this blog in the dozen years I’ve been doing it.

I would like to do a followup post replying to some of the comments and criticisms, but I haven’t had time and realistically may not any time soon, or ever. In the meantime, though, here is some existing content that might be relevant to people who would like to see the arguments in that post drawn out more fully.

Here is a podcast interview I did with some folks from Current Affairs a month or so ago. The ostensible topic is Modern Mone(tar)y Theory, but the conversation gave me space to talk more broadly about how to think about macroeconomic questions.

A pair of Roosevelt reports (cowritten with Andrew Bossie) on economic policy during World War II are an effort to find relevant lessons for the present moment: The Public Role in Economic Transformation: Lessons from World War II, Public Spending as an Engine of Growth and Equality: Lessons from World War II

Here is a piece I wrote a couple years ago on Macroeconomic Lessons from the Past Decade. Bidenomics could be seen as a sort of deferred learning of the lessons from the Great Recession. So even though this was written before the pandemic and the election, there’s a lot of overlap here.

This report from Roosevelt, What Recovery? is an earlier stab at learning those lessons. I hope to be revisiting a lot of the topics here (and doing a better job with them, hopefully) in a new Roosevelt report that should be out in a couple of months.

If you like podcast interviews, here’s one I did with David Beckworth of Macro Musings following the What Recovery report, where we talked quite a bit about hysteresis and the limits of monetary policy, among other topics.

And here are some relevant previous past posts on this blog:

In The American Prospect: The Collapse of Austerity Economics

A Baker’s Dozen of Reasons Not to Worry about Government Debt

Good News on the Economy, Bad News on Economic Policy

A Demystifying Decade for Economics

A Harrodian Perspective on Secular Stagnation

Secular Stagnation, Progress in Economics

The CBO Just Handed Us Two Trillion Dollars

Anyone who follows the DC budget game at all knows that the Congressional Budget Office (CBO) is supposed to be its referee. Any proposal that involves new spending or revenue is scored by the CBO for its impact on the federal debt over the next ten years. That score normally sets the terms on which the proposal will be debated and voted on. This ritual is sufficiently established that most spending proposals are described in terms of their cost over the next ten years – the CBO’s scoring window.

The CBO doesn’t only assess individual bills, it also gives a baseline, producing regular forecasts of major economic variables and the path of the debt under current policy. In a sense, these forecasts are the playing field on which budget proposals compete. So it ought to be a big deal when the CBO changes the shape of the field.

In their most recent 10-year budget and economic forecast, the CBO made a big change, reducing their long-run forecast of the interest rate on government bonds by almost a full percentage point, from 3.7 to 2.9. (See Table 2.6 here.)

Most directly, the new, lower interest rate reduces expected debt payments over the next decade by $2.2 trillion. It also significantly reduces the expected debt-GDP ratio. Under the assumptions the CBO was using at the start of this year, the debt ratio under existing policy would reach 120 percent by 2040. Using the new interest rate assumption, it reaches only 106 percent. With one change of assumptions, a third of the long-run rise in the federal debt just disappeared.

Debt-GDP Ratio with CBO Interest Forecasts of January vs August 2019

While this downward revision is exceptionally large, it’s hardly the first time the CBO has adjusted its interest rate forecasts. In April 2018, they raised their estimate of the long-run rate on 10-year bonds from 3.1 percnet to 3.8 percent. But that upward move is an exception; for most of the past decade, the CBO has been steadily adjusting its interest rate frecasts downward, adapting — like most other macroeconomic forecasters — to the failure of the economy to return to pre-recession trends. As recently as February 2014, they were predicting a long-run rate of 5 percent. And it’s likely the interest-rate forecast will continue to decline; the current 10-year Treasury rate is less than 1.8 percent.

The newest forecast was released in August, and as far as I can tell the change in the interest-rate assumption has gotten almost no attention in the two months since then. But it really should.

At the very least, this means that anyone arguing that federal debt is a climate-change-level threat to humanity needs to update their talking points. The claim that federal debt “will be close to 150% of GDP by 2050” is, as of August, not even close to correct. With the new interest assumptions, the figure is less than 120 percent.

To be fair, an argument that doesn’t go beyond “oooh, big number, scary” isn’t likely to be much affected by this revision. But the new interest estimate has broader implications.

If the term “fiscal space” means anything, lower expected interest rates have to mean that there is more of it. That $2 trillion in interest savings the new CBO estimate has handed us, could presumably be used for something else. As a downpayment on single-payer health coverage, say, or as public investment in decarbonization as part of a Green New Deal. Whatever spending we think most urgent or politically practical, we could borrow an extra percent of GDP or so a year to pay for it, and leave the long-term debt picture looking no worse than before.

Whatever level of federal spending you thought would keep the debt on a reasonable path a year ago, you should think that number is $2 trillion higher today.

To be clear, CBO scoring doesn’t actually work this way. Budget proposals are evaluated relative to the baseline, wherever that happens to be. So the change in the interest assumption will have only a marginal effect on the score for individual bills. But if there is any rational content to the CBO scoring ritual, it has to involve some sort of judgement about what level of debt is reasonable, relative to GDP. If you take CBO debt forecasts seriously – as almost everyone in the policy world at least claims to – then lower interest rates mean more space for new borrowing.

Lower future interest rates also have implications for stabilization policy. They mean that in the next recession, whenever it comes, there will be even less space for the Federal Reserve to lower rates to boost demand, and a correspondingly greater need for fiscal policy – a point that, fortunately, members of the House Budget Committee seem to understand.

There’s one more, even broader, implication of the new forecast. What does it mean that the CBO keeps revising its forecasts of future interest rates downward, even as federal debt itself continues to rise? Obviously there is not the tight relationship between a high debt-GDP ratio and rising interest rates that austerity-promoting economists like to predict. Which should raise a question for anyone interested in macroeconomic policy or public budgets: If high federal debt doesn’t have any reliable effect on interest rates, then what exactly is its economic cost supposed to be?

(Cross-posted from the Roosevelt Institute blog.)

In The American Prospect: The Collapse of Austerity Economics

(This review is coauthored with Arjun Jayadev, and appears in the Fall 2019 issue of the The American Prospect. The version below includes a few passages that were cut from the published version for space reasons.)

Review of Albert Alesina, Carlo Faverro and Francesco Giavazzi, Austerity: When It Works and When It Doesn’t
With Arjun Jayadev

A decade ago, Alberto Alesina was one of the most influential economists in the world. His theory of ‘expansionary austerity’ – the paradoxical notion that reducing public expenditure would lead to an increase in economic activity — was one of the hottest ideas in macroeconomics. He claimed to have shown that government surpluses could actually boost growth, but only if they were achieved via spending cuts rather than tax increases. At a moment when many governments were seeking Keynesian remedies to a global recession, his work (along with fellow Harvard economist Silvia Ardagna) reassured conservatives that there was no conflict between keeping up demand in a crisis, and the longer-term goal of reining in the public sector.

Not surprisingly, his ideas were taken up by right-wing politicians both in Europe and in the US, where he was widely cited by the Republicans who took control of the House in 2010. Along with the work of Reinhart and Rogoff on the supposed dangers of excessive government debt, Alesina’s work provided one of the key intellectual props for the shift among elite policymakers towards fiscal consolidation and austerity.

Right from the outset, other economists pointed to serious flaws in the case for expansionary austerity, and challenged virtually aspect of the statistical exercises underlying it. A partial list of criticisms includes: using inappropriate measures of fiscal balance; misapplying lessons from boom times to periods of crisis; misclassifying episodes of fiscal expansion as austerity; and generalizing from the special conditions of small open economies, where exchange rate moves could cushion the effects of austerity. Even the most cherished result— that expenditure based austerity worked better than tax-based austerity — has been convincingly challenged.

In 2009, Alesina suggested that Europe was likely to see faster growth because it was cutting public spending in response to the crisis, while the US had embraced conventional Keynesian stimulus. He was right about the difference in responses to the crisis; about economic growth, not so much. The US recovery was weak by historical standards, but in Europe there was hardly a recovery at all. In the countries that cut public spending the most, such as Spain, Portugal, and Ireland, GDP remained below its 2008 peak four, five, even six years after the crisis. By 2013 the financial journalist Jim Tankersley could offer an unequivocal verdict: “No advanced economy has proved Alesina correct in the wake of the Great Recession.”

Macroeconomic debates have moved on since then. A large new empirical literature on fiscal policy has emerged over the past decade, the great majority of it confirming the old Keynesian wisdom that in a depressed economy, increased public spending can raise output by perhaps $1.50 for each dollar spent. New questions have been raised about central banks’ ability to stabilize the economy, whether with conventional monetary policy or with new tools like forward guidance and quantitative easing. The seemingly permanent reality of low interest rates has changed the debate over the sustainability of government finances, with prominent mainstream economists suggesting that public debt no longer poses the dangers it was once thought to. The revived idea of secular stagnation has suggested that economic stimulus may not be a problem for occasional downturns, but an ongoing necessity. And the urgency of climate change has created big new tasks for the public sector.

It’s a very different conversation from a decade ago. Can Alesina’s ideas adapt to this new environment?

That’s the challenge for his new book, Austerity: When It Works and When It Doesn’t, which offers a summing-up of work on government budgets that goes back now almost three decades. Through the years, Alesina has had a rotating case of co-authors, often from Bocconi University in Italy; this book is co-authored with Carlo Ferro and Francisco Giavazzi, both professors there. Given the way that the book has been advertised and promoted (“towering”, a “counterblast”), one might expect a thorough response to the new arguments that have developed over the past decade about aggregate demand management and the appropriate size of the public sector.

Disappointingly, this is not the case. There has been no marking of beliefs to market. For the most part, the book restates the same arguments that were made a decade ago: countries with high public debt must adopt austerity, and this will not hurt growth if it takes the form spending cuts rather than tax increases. Alesina and his coauthors do make some effort to respond to specific methodological criticisms of the earlier work. But they don’t engage with – or even acknowledge – the larger shifts in the landscape. Tellingly, all the book’s formal analysis and almost all of its text (as well as the online data appendix) stop in 2014. For what is supposed to be a definitive statement, it’s an odd choice. Why ignore everything we might learn about austerity and government budgets from the experiences of the past five years?

The book also operates at an odd mix of registers, which makes it hard to understand who the audience is. Exoteric chapters seemingly intended for a broad readership are interspersed with math-heavy esoteric chapters that will be read only by professional economists. You get the feeling this is mostly material that sat in a drawer for a long time before being fished out and stapled together into a book.

To be fair, there are some advances from the previous iterations. Alesina’s earlier work had been criticized for ignoring problems of causality – when high growth and government surpluses are found together, how do we know which is causing which? Now, instead of relying on purely statistical measures of association, there is more extensive attention given to what has been called the “narrative” approach, with periods of austerity defined by the stated intentions of policy makers rather than simply by changes in the budget position. This approach– pioneered by Romer and Romer to understand US policy actions and expanded by economists at the IMF — does have advantages over the naive statistical approach. By including only tax increases and spending cuts made for reasons other than current economic conditions, it avoids, in principle at least, the problem of fiscal adjustments resulting from changes in economic activity, rather than causing them. But it is still no substitute for a real historical analysis that considers the whole complex of factors influencing both budget positions and growth. Gesturing towards the need for more substantive narrative, the later chapters include several case studies on various OECD countries which undertook austerity measures. These are rather thin and have a Wikipedia air about them; in any case the great bulk of the argument is still based on statistical exercises.

Those who are not convinced by the econometrics in Alesina’s earlier work will not be convinced here either. Even people who share the authors’ commitment to rolling back the public sector may suspect that they are in the presence of what is politely called motivated reasoning.

To those who don’t share that commitment, it is clear from the opening pages that we are dealing with ideological fiction, not objective analysis. Per Alesina and co, most austerity episodes reflect countries persistently spending beyond their means, with debt rising until a tipping point is reached. But in Europe – surely ground zero in any discussion of contemporary austerity – this story lacks even superficial plausibility. On the eve of their crises, Ireland, Spain and even Portugal had debt-GDP ratios below that of unscathed France; Spain and Ireland were well below Germany. (The fact that Germany consistently ran large deficits in the decade before the crisis is not mentioned here.) Indeed, until 2011 Ireland, now an austerity poster child, had the lowest debt ratio of any major Western European country.

The book asserts that episodes of austerity triggered by outside pressures – as opposed to a government’s own mismanagement of its finances – are rare exceptions. But in Europe they were the rule. The crisis came first, then the turn to austerity; the rising debt ratios came last, driven mainly by falling GDP; budget deficits were an effect, not a cause. Even Greece, perhaps the one country where public finances were a genuine problem before the crisis, is a case in point: From 2010 to 2015, deep cutbacks in public services successfully reduced public debt by about $15 billion euros, or 5 percent — but the debt-GDP ratio still rose by 30 points, thanks to a collapse in GDP.

It would be easy to debate the book point by point. But it’s more useful to take a step back, and think about the larger argument. While the book shifts erratically in tone and subject, underlying all of its arguments – and the larger pro-austerity case – is a rigid logical skeleton. First, a government’s fiscal balance (surplus or deficit) over time determines its debt-GDP ratio. If a country has a high debt to GDP, that is “almost always … the result of overspending relative to tax revenues.” (2) Second, the debt ratio leads markets to be confident in the government’s debt – private investors do not want to buy the debt of a country that has already issued too much. Third, the state of market confidence determines the interest rate the government faces, or whether it can borrow at all. Fourth, there is a clear line where high debt and high interest rates make debt unsustainable; austerity is the unavoidable requirement once that line is passed. And finally, when austerity restores debt sustainability that contributes – via lower interest rates and “confidence” more broadly – to economic growth, especially if the austerity involves spending cuts.

Individually, these claims are in keeping with the conventional wisdom of the business press and the maxims of “sound finance.” Together, they make a causal story that’s a one-way track with no side branches: Any problems that a government encounters with debt are the result of its fiscal choices in the past. And any solution must involve a different set of fiscal choices – higher taxes or, better, less public spending.

If you accept the premises, the conclusions follow logically. Even better, they offer the satisfying spectacle of public-sector hubris meeting its nemesis.

But real-world debt dynamics don’t run along such well-oiled tracks. At every step, there are forks, sidings and roundabouts, that leave the link from fiscal misconduct to well-deserved austerity much less direct than the book suggests.

First of all, as a historical matter, differences in growth, inflation and interest rates are at least as important as the fiscal position in determining the evolution of the debt ratio over time. Where debt is already high, moderately slower growth or higher interest rates can easily raise the debt ratio faster than even very large surpluses can reduce it – as many countries subject to austerity have discovered.

Conversely, rapid economic growth and low interest rates can lead to very large reductions in the debt ratio without the government ever running surpluses, as in the US and UK after World War II. More recently, Ireland reduced its debt-GDP ratio by 20 points in just five years in the mid-1990s while continuing to run substantial deficits, thanks to very fast growth of the “Celtic tiger” period. In situations like the European crisis, extraordinary actions like public assumptions of private debt or writedowns by creditors (as in Cyprus and Greece) can also produce large changes in the stock of debt, without any changes in spending or taxes. Ireland again is an example: The decision to assume the liabilities of private banks catapulted its debt-GDP ratio from 27 percent to over 100 percent practically overnight. Cases like this make a mockery of the book’s central claim that a country’s debt burden reliably reflects its past fiscal choices.

At the second step, market demand for government clearly is not an “objective” assessment of the fiscal position, but reflects crowd psychology, self-confirming conventional expectations, and all the other pathologies of speculative markets. The claim that the interest rates facing a country are directly and reliably linked to the state of its public finances is critical to the book’s argument; rising interest rates are the channel by which high debt creates pressure for austerity, while falling interest rates are the channel by which austerity supports renewed growth. But the claim that interest rates reflect the soundness or otherwise of public budgets runs up against a glaring problem: The financial markets that recoil from a country’s bonds one day were usually buying them eagerly the day before. The same markets that sent interest rates on Spanish, Portuguese and Greek bonds soaring in 2010 were the ones snapping up their public and private debt at rock-bottom rates in the mid-2000s. And they’re the same markets that are setting interest rates for those countries at historical low levels today (Greece now pays less to borrow than the US!), even as their debt ratios, in many cases, remain extremely high.

The authors get hopelessly tangled on this point. They want to insist both that post-crisis interest rates reflect the true state of public finances, and that the low rates before the crisis were the result of a speculative bubble. But they can’t have it both ways: If low rates in 2005 were not a sign that the state of public finances was sound, then high rates in 2010 can’t be a sign that they were unsound.

If the analysis had extended beyond 2014, this problem would only have gotten worse. What’s really striking about interest rates in Europe in recent years is how uniformly they have declined. Ireland, which has managed to reduce its debt ratio by 50 points since 2010, today borrows at less than 1 percent. But so does Spain, whose debt ratio increased by 40 points over the same period. The claim that interest rates are mainly a function of a country’s fiscal position just doesn’t fit the historical experience. It’s hard to exaggerate how critical this is for the whole argument. Rising interest rates are the only cost Alesina and his coauthors ever mention for high debt, and hence the only reason for austerity; and reducing interest costs is the only intelligible mechanism they offer for the supposed growth-boosting effects of austerity – vague invocations of “confidence” don’t count.

And this brings us to the third step. One of the clearest macroeconomic lessons of the past decade is that market confidence doesn’t matter: A determined central bank can set interest rates on public borrowing at whatever level it chooses. In the years before 2007, there were endless warnings that if the US did not get its fiscal house in order, it would be faced with rising interest rates, a flight from the dollar and eventually the prospect of default. (In 2005, Nouriel Roubini and Brad Setser were bold enough to predict that unsustainable deficits would lead to a collapse in the dollar within the next two years.) Today, with the debt much higher than even the pessimistic forecasts of that period, the federal government borrows more cheaply than ever in history. And there hasn’t been even a hint of the Fed losing control of interest rates.

Similar stories apply around the world. Perhaps the clearest illustration of central banks’ power over financial markets came in 2011-2012, when a series of interventions by the European Central bank – culminating in Mario Draghi’s famous “whatever it takes” — stopped the sharp spike in southern European interest rates in its tracks. With an implicit guarantee from their central banks – which other developed countries like the US and UK also enjoy – governments simply don’t need to worry about losing access to credit. To the extent that governments like Greece remained locked out of the markets after Draghi’s announcement, this was a policy choice by the ECB, not a market outcome.

If countries can face financial crises even when their debt ratio is low, and can enjoy ultra-low interest rates even when they are high, then it’s hard to see why the debt ratio should be a major object of policy. Alesina and colleagues’ central question – whether expenditure-based or tax-based austerity is better for growth – is irrelevant, since there’s no good reason for austerity at all.

In a world of chronically low interest rates and active central banks, government debt just isn’t a problem. At one point, this was a fringe position but today it’s been accepted by economists with as impeccable mainstream credentials as Olivier Blanchard, Lawrence Summers and Jason Furman – the former chief economist of the IMF, Treasury Secretary and chair of the Council of Economic Advisors, respectively. But not by Alesina, who just goes on singing the same old songs.

The pro-austerity arguments in this book will therefore face more of a headwind than they did when Alesina made them a decade ago. “Sound finance” is no longer the pillar of elite opinion it once was. As we write this, Christine Lagarde, the new head of the European Central Bank, is calling for European governments to spend more during downturns – something hard to imagine when Alesina’s ideas were in vogue. In the US, meanwhile, concerns about the federal debt seem almost passe.

This is progress, from our point of view. The intellectual case for austerity has collapsed, and this book will do little to rebuild it. But that has not yet led to an expansion of public spending – let alone one large enough to restore genuine full employment and meet the challenge of climate change and other urgent social needs. The austerity machinery of the euro system and IMF still churns away, grinding out misery and unemployment across southern Europe and elsewhere, even if it no longer commands the general assent that it once did. At the level of ideas, Keynesian economists can point to real gains in the decade since the crisis. At the level of concrete policy, the work has barely begun.

Can We Afford a Green New Deal?

[I was at an event the other night bringing together people from the economic-policy and climate activism worlds. I was asked to talk about the macroeconomic case for a Green New Deal, and the question of “how do we pay for it?” Here is a somewhat extended and edited version of my remarks.]

Most of the Democratic candidates now have plans for major public investment programs to deal with the challenge of climate change. These involve spending on the order of 2 percent of GDP on average, ranging from half a percent for Beto O’Rourke up to 4 percent for Bernie Sanders.

A question that will get asked about any of these plans is, how do we pay for it? Can we afford it?

We might simply reject the question, on the grounds that what we cannot afford is to continue dumping carbon into the atmosphere. Any plan to substantially reduce carbon emissions will pass any reasonable cost-benefit test.

But I think we should answer the “pay for it” question. It has a good answer!

The question is really two questions:

– How can federal government finance it? – what new money coming in will match the new money going out?

– Are the real resources available, or will we have to sacrifice production in other areas?

On first question, given that low interest rates now seem to be a permanent feature of our world, it is very hard to make a an argument that additional borrowing on the scale of 2, 3 or even 4 percent of GDP would be economically costly. When interest rates are below GDP growth rates, the debt-to-GDP ratio stabilzies on its own, even if you run deficits forever. Unlike in the 1980s and 1990s, when interest rates were higher, today it is impossible for public debt to snowball out of control.

If it has no effect on growth, additional debt-financed spending of 2 percent of GDP would bring the debt-GDP ratio to about 105 percent in 2030. Debt-financed spending of 4 percent of GDP would bring the ratio to 125 percent. Looking around the world, or at history, there is just no evidence that debt at that level has any economic costs. The US ended World War II with a debt ratio of about 120 percent of GDP, the UK over 200 percent. Japan today has a debt ratio of 250 percent of GDP, while France and Belgium have debt ratios around 100 percent. None of these countries have seen any of the negative consequences – spiking interest rates, rising inflation, a collapsing exchange rate — that are supposed to follow from excessive government debt. Quite the opposite, in fact.

And if there is any boost to growth from additional spending – any role for what economists call called hysteresis — then the debt ratio would be even smaller. If we take a standard estimate of the multiplier — the boost to GDP from an additional dollar of public spending — of 1.5, and assume half of that effect is permanent, then debt-financed public spending can actually leave the debt ratio lower than it would be otherwise. In which case the new spending would fully pay for itself, even without any new revenue. Of course there is a lot of uncertainty around these questions – I wouldn’t promise an effect on growth that large. But it doesn’t seem crazy to think that a program public investment could substantially raise the economy’s productive potential.

If we do want to raise revenue, there is also plenty of space for taxes on very high incomes and wealth, or a carbon tax, or other taxes that are socially desirable for their own sake, to finance some substantial portion of a decarbonization program. A recent very thorough study of the space for high-end income and wealth taxes by a couple of professors at NYU identified taxes that could raise over 2 percent of GDP on a very targeted base of the highest incomes. A wealth tax, again targeted at the very richest households, could raise another 2 percent or so. These are taxes we would like to raise anyway, because great concentrations of income and wealth are bad for our democracy and for our society. (There’s even evidence they are bad for our health.) So if we can finance decarbonization this way, we shouldn’t see it as a cost.

We often hear that it’s a fantasy to say that decarbonization will be economically costless, that it isn’t realistic to talk about spending on this scale without broad-based tax increases, without sacrifices by the middle class households. But this is crackpot realism. Of course there will be costs in particular carbon-intensive sectors of the economy. But the notion that investing in decarbonization necessarily requires sacrifices by working people in general, or painful choices about the federal budget, is just not borne out by the numbers.

On the real resources side, the critical point is that by any measure, the US economy has operated below potential for the large majority of the time in recent decades. Taking official statistics at face value, since 1980 there have been 192 months when the unemployment rate was more than one point above the NAIRU – the unemployment rate targeted by the Fed. There have been only 18 months when it was more than one point below. It took a full seven years after the last downturn for output to return to official estimate of potential. The total shortfall equaled 25 percent of GDP.

Even the most ambitious climate plan would have been barely enough spending to fill that gap.

And there are lots of reasons to think that these official measure understates economic potential. GDP today is more than 10 percent below what was forecast a decade ago. Labor force participation still significantly down from a decade, even among those 25-54 – prime working-age adults. Inflation is still below target. Wage growth is still slow. Almost any alternative measure you can think of suggests that the economy is running well below potential even today, and that there is enough slack for a substantial program of public investment without the need to reduce production of anything else.

Even if we think the economy is operating at normal capacity today, there are major social benefits to letting demand push up against capacity – to running the economy hot. There is strong evidence that the only way you get a rise in the wage share and especially a rise in wages at the lower end, is with sustained very low unemployment – what people call a high-pressure economy. Consistent with that, we’ve begun to see some recovery in wages at the bottom of the distribution in the past couple years. This is welcome, but it’s nowhere enough to make up for losses in previous years. For that, we still need more spending, stronger demand.

And that’s today. In a few years, we are likely to want more spending much more.

Today many people are talking about the possibility of recession within next year or so. Nobody except for a few cranks is talking about a sudden surge of inflation, or sudden takeoff of wages.

If there is a recession, the ability of the Fed and other central banks to offset a fall in demand is gong to be even more limited this time than it was in the last recession. In past recessions, the Fed has typically reduced rates by 5 points, and this has still not been enough to stabilize demand. Now we will be starting from a federal funds rate of only 2 percent, giving room for only 2 points of cuts. And there is good reason to think that the economy is less sensitive to changes in the policy rate than we used to believe. Central bankers themselves are quite clear that we will need more public spending in a recession. When Fed chair Jay Powell testified before Congress earlier this summer, Alexandria Ocasio-Cortez asked him what he would do in the event of another deep recession. He said monetary policy would not be enough, that the Fed would need help from fiscal policy – from the federal government spending more. Christine Lagarde, in her first public comments after being appointed head of the European Central Bank, said the same thing, that governments in the eurozone needed to spend more to boost demand. The central bank can’t be “the only game in town,” she said.

One of the big lessons of the stimulus debates in the last recession is that it is very hard to ramp up public spending in a hurry. There are not a lot of “shovel ready” projects out there waiting for someone to just start writing checks. So if we think we are going to need a big boost to public spending in the near future, we had better begin ramping it up now.

Many discussions of the cost of responding to climate change start from the idea that we are fully using our resources. If this were true, we’d have to ask how much consumption is worth giving up today in order to maintain a habitable planet in the future. Obviously the answer should be: A lot! But we don’t have to ask the question, because it isn’t true. We are living in a world where we are not using all our real resources, because of a lack of demand. Some people call this secular stagnation. We are living in a world where the central macroeconomic problem is that there is too little spending to fully utilize the economy’s productive potential – not just occasionally in recessions, but all the time, or at least on average.

Some people will say to this: Ok, we agree that the economy is running below capacity. We agree there is space to add more federal debt, and to raise taxes on the rich. Still, you could use that space for anything. It’s not a case for Green New Deal specifically.

This sounds superficially reasonable, but I don’t think it’s right. Because the evidence of recent history suggests that we won’t use that space.

Almost everyone today agrees that stimulus in last recession was too small — and that even if it might have been big enough in the abstract, it was offset by massive anti-stimulus at the state-local level. The situation in Europe is even worse, with deep austerity almost everywhere, with the result that countries like Italy have lower GDP than a decade ago. Even when mainstream economists say there is actually a case for deficit spending and not to worry about balanced budgets, it turns out to be very hard to get the political system to listen.

If we don’t use our productive capacity and our financial capacity for a Green New Deal, it’s very likely we won’t use it for anything.

The discussion of public budgets, among economists and much of the media and policy world, has not caught up to reality. We still talk about governments being subject to deficit bias – that’s a term of art in the macroeconomics literature, used to justify all kinds of rules to restrict government spending. We have this idea that without some sort of hard external constraint, elected officials are going to declare it’s Christmas every day and shovel money out the door on anything popular. We assume that you need some sort of disciplining device to force policymakers to make hard choices, or else they will just try to spend without limit. But governments today don’t suffer from deficit bias. On the contrary: The problem is austerity bias. For whatever reason governments refuse to spend even when the economic case for it is overwhelming.

This isn’t just a wasted opportunity for all sorts of valuable public spending. It imposes real costs in slower growth, fewer jobs, lower wages. And slow growth and low employment and wages have political costs too, as we know.

In this environment, it’s wrong to think about tradeoffs and making hard choices. This may sound strange coming from an economists, but it’s wrong to think about opportunity costs. The question is not, why should we do this rather than that? The question is, how do we break through the logjam that stops us from doing anything at all?

One of the unique things about climate change is that it may be a crisis urgent enough to overcome the entrenched austerity bias of governments, and to push public spending up toward the level needed to get true full employment. It may be the only thing urgent enough other than a major war — which we certainly do not want.

So when we look at the cost of the climate proposals out there against today’s macroeconomic background, the question should not be, are they too expensive? The question should be: Are they expensive enough?

A Baker’s Dozen of Reasons Not to Worry about Government Debt

(EDIT: It’s not sufficiently clear in the original post, but I wrote this as a sort of compendium of arguments one might use in response to claims that the federal debt is a binding constraint on new spending. I’m not saying these are the best or only reasons to reject the idea that federal government cannot borrow more. I’m saying that these are arguments that seem to have some traction in the mainstream policy world, such that you could use them in a newspaper op-ed or conversation with a congress member’s staff. Also, a premise here is that there are urgent needs we want the public sector to spend more on. Apart from the last couple, these are not arguments for more public dbet as an end in itself.)

Why might larger budget deficits be ok?

There are a number of reasons why economists, policymakers and advocates believe that increased public borrowing is not something to be afraid of. As I’ll discuss below, the fundamental factor linking most of these reasons is the idea that the US economy is generally operating below capacity.

When we think about the fiscal balance – the difference between government spending and government revenue – we always have to keep in mind that it has two sides: the real side and the financial side. Whenever the government increases spending, it has two kinds of effects. First, all else equal, it increases the amount of government debt in circulation. And second, it increases demand for goods and services, both directly when the government buys them and indirectly as government spending creates incomes for private businesses and households.

To put it another way, for government to successfully raise spending without raising taxes, two things have to be true. First, someone – banks, wealthy families, foreign countries – has to be willing to hold the additional debt that the government issues. And second, someone has to be prepared to sell whatever it is that the government is trying to buy. If we are asking what kinds of limits there might be to deficit spending, we have to think about both sides. A government’s spending may face financial constraints, if people are unwilling to hold more of its debt; or real constraints, if the economy cannot produce the additional goods and services it is trying to buy.

Some people who think higher deficits are not a problem – particularly those associated with Modern Monetary Theory – believe that the US federal government never faces financial constraints, so only the real constraints matter. Others believe that the federal government might in principle face financial constraints, but there are good reasons to think that they are not an issue today. For policy purposes, the difference between these positions may not be very important.

On the real constraint side, the essential question is how close the economy is to potential output, or full employment. (The two terms are used interchanegably.) In an economy operating at potential, government can only increase its spending f the private sector reduces its spending. This “crowding out” is the real cost of increased public spending. In an economy below potential, on the other hand, the goods and services purchased by increased public spending come from mobilizing unused productive capacity, so there is no crowding out. In. fact, if the fiscal multiplier is big enough (greater than one) then increased purchases of goods and services by the public sector will result in more goods and services being purchased by the private sector as well.

Below, I lay out a baker’s dozen of related arguments for why, from a macroeconomic perspective, we should welcome increased debt-financed public spending. Some people who believe in greater public borrowing would accept all of these arguments; some only some of them.

Real-economy arguments for more public borrowing

1. The economy generally operates below potential. Over the past 30 years, there have been three recessions, each followed by a long period of weak growth and high unemployment. By official measures, in 10 of the past 30 years GDP has been at least two points below potential; there have been only six months when it was more than two points above potential. And there has been no periods of high inflation. This suggests that in general, the economy is not running at full capacity; there is additional productive potential that could be mobilized by higher public spending, without crowding out private spending. In that sense, there is no real cost to higher public spending, and no need top offset it with higher taxes. Even better, higher public spending will help close the output gap and raise private spending as well.

2. There are long run forces pushing down demand. Larry Summers famously reintroduced into the economic conversation the idea of secular stagnation – that there is a long-run tendency for private spending to fall short of the economy’s productive potential. There are many reasons we might expect private spending to be lower, relative to national income, in the future than in the past. Among these: increased monopoly power; the shift toward information-based rather than resource-intensive production; increased shareholder power; a more unequal distribution of income; slower population growth; and the satiation of demand for market consumption, in favor of leisure and nonmarket activities. (The first three of these factors tend to reduce investment spending, the last three consumption spending.) If this idea is correct, the demand shortfalls of the past thirty years are not an anomaly, and we should expect them to grow larger in the future.

3. Potential output is mismeasured; we are still well below it. Even by the conventional measures of unemployment and potential output, the US economy has spent far more time in recent decades below target than above it. But if the target is mismeasured, the problem may be even worse. There are good reasons to think that both productivity and laborforce growth over the past decade have been depressed by weak demand. If this is the case, the US economy even at the height of a supposed boom, may in fact be operating well below potential today. The fact that even with measured unemployment below 4 percent wage growth has accelerated only modestly, and inflation has not accelerated at all, is important evidence for this view.

4. Recessions and jobless recoveries have occurred repeatedly in past, will occur again in the future. Whether or not the US economy is at potential today, the current expansion will not continue forever. Recessions have occurred in the past and will occur in the future. Many forecasts believe there is a high risk of recession is likely in the relatively near future; the fact that the Fed is moving toward cutting rates suggests that they share this view. When thinking about what fiscal balance is appropriate, we need to consider not just where the economy is today but where it is likely to be in coming years.

5. Monetary policy is not effective at maintaining full employment. In the past, weak demand and recessions weren’t considered an argument for more public spending because it was assumed that a central bank following the correct policy rule could quickly return the economy to full employment. But it is increasingly clear that central banks do not have the tools (and perhaps the willingness) to precent extended periods of weak demand. It is increasingly recognized that fiscal policy is also required to stabilize demand. In his July testimony before Congress, Fed chair Jerome Powell said explicitly that in the event of another deep recession, the Fed would need help from fiscal policy. One important reason for this is the problem of the zero lower bound – since the policy interest rate cannot be set below zero, there is a limit to how far the Fed can lower it in a recession.

6. It’s hard to ramp up public spending quickly in recession. Orthodox opinion has long been that fiscal policy is not as effective as monetary policy in a recession because it takes much longer to ramp up public spending than to cut interest rates. While the experience of the Great Recession undermined conventional wisdom on many points, it supported it on this one. The ARRA stimulus bill was supposed to direct spending to “shovel-ready” projects, but in fact the majority of the infrastructure spending funded by the bill came several years after it passed. There are many institutional obstacles to increasing public spending rapidly. This means that if we need higher public spending in a recession, the best thing is to have higher spending all the time. If that leads to an overheating economy in the boom, that is an easier problem for the Fed to solve then a deep recession.

7. The costs of getting demand wrong are not symmetrical. Traditionally policymakers have defined their goal as keeping output as close to potential as possible. But it is increasingly clear that the costs of demand falling short are greater than the costs of demand overshooting potential. One reason for this is the previous point – that conventional policy has an easier time reining in excessive demand than stimulating weak demand. (As the old saying has it, “you can’t push on a string.”) A second reason is that demand has effects that go beyond the level of output. In particular, strong demand and low unemployment redistribute income toward workers from owners, and toward lower-wage workers in particular. Periods of weak demand, conversely, reduce the share of income going to workers. If we think the upward redistribution of income over the past generation is a problem, we should prefer to let demand overshoot potential than fall short of it.

8. Weak demand may have permanent effects on potential output. Traditionally, economists saw the economy’s long-term growth as being completely independent of demand conditions. People spending more money might raise production and employment today, but the long-term growth of potential output depended on structural factors – demographics, technological change, and so on. More recently, however, there has been renewed interest in the idea that weak demand can reduce potential output, an effect known as hysteresis. high unemployment may lead more people to drop out of the laborforce, while low unemployment may lead more people to enter the laborforce (or immigrate from abroad.) Strong demand may also lead to faster productivity growth. If hysteresis is real, then demand shortfalls don’t reduce output and employment this year, but potentially many years in the future as well. This is another reason to be more worried about demand falling short than overshooting, hence another reason to prefer a more expansionary fiscal stance, which normally implies more public borrowing.

Financial arguments for more public borrowing

9. With low interest rates, debt does not snowball. Traditionally, concerns about the financing of government spending have focused on whether debt is “sustainable” – whether debt levels will stabilize as a fraction of GDP, or rise without limit. When interest rates are greater than GDP growth rates, this implies a hard limit to government borrowing – to keep the debt-GDP ratio on a stable path, a deficit in one year must be made up for by a larger surplus in a future year. Otherwise, the interest on the existing debt will imply more and more borrowing, with the debt-GDP ratio rising without limit. But when interest rates on government debt are below growth rates, as they have been for the past 25 years, the debt ratio will stabilize on its own – deficits do not have to be offset with surpluses. This makes much of the earlier concern with debt sustainability obsolete.

10. There is good reason to think interest rates will remain low. There are a number of reasons to think that interest rates on public debt are likely to remain low, even if debt ratios rise considerably higher. First, low interest rates reflect the conditions of chronic weak demand discussed above, for two reasons. First, low investment means less demand for borrowed funds. And second, weak demand means that the interest rate set by the central bank is likely to be low. A second reason to expect low interest rates to continue is that the past ten years have repeatedly falsified predictions of bond vigilantes driving up the rates on government debt. Prior to the financial crisis of 2007-2008, many observers expected a catastrophic flight by investors away from US government debt and the dollar, but in fact, the crisis saw a steep fall interest rates on government debt and a rise in the dollar, as investors all over the world rushed to the safety of Treasury debt. Similarly, in Europe, even in the worst crisis-hit countries like Greece, interest rates are at their lowest point in history. Similarly Japan, with one of the highest debt0-GDP ratios ever recorded (about triple that of the US) continues to borrow at very low rats. Third, the experience of the past ten years have made it clear that even if investors were to demand higher interest rates on government debt, modern central banks can easily overcome this. The most dramatic illustration of this came in the summer of 2012, when a public statement by European Central bank chief Mario Draghi “we will do whatever it takes, and believe me, it will be enough”) reversed the spike in interest rates in countries like Italy, Spain and Portugal practically overnight. Finally, the prices of bonds — with hardly any premium for 30 year bonds over 5 and 10 year maturities — show that private investors do not expect a rise in interest rates any time in the foreseeable future.

11. With hysteresis, higher public borrowing can pay for itself. Even if we are concerned about lowering the debt-GDP ratio, the existence of hysteresis (point 8 above) means that cutting public borrowing is necessarily the right way to get there. In a world where the long-term path of GDP depends on aggregate demand, austerity can be self-defeating even in its own narrow financial terms. If lower public spending reduces demand, then it can lead to lower GDP, potentially raising the debt to GDP ratio even if it succeeds in reducing debt. Greece offers a clear example of this – the fiscal surpluses between 2010 and 2015 succeeded in reducing government debt by 5 percent, but the deep austerity contributed to a fall in GDP of 25 percent. So the debt-GDP ratio actually rose. Similarly, if debt-financed public spending leads to faster growth, the debt-GDP ratio may end up lower than otherwise.

12. Federal debt is an important asset for financial markets. The points up to now have been arguments for why higher public debt is acceptable. But there is also an argument that increased public debt would be a positive good. Financial markets depend on Treasury debt as a safe, liquid asset. Federal government debt offers an absolutely safe asset that can always be sold quickly and at a predictable price – something that is extremely valuable for banks and other financial institutions. There is a strong argument that the growth of the mortgage-backed security market in the 2000s was fundamentally driven by a scarcity of government debt – many financial institutions wanted (or were compelled by regulation) to hold a substantial amount of ultrasafe, liquid debt, and there was not enough government debt in circulation to meet this demand. So financial markets came up with mortgage-backed securities as a supposed alternative – with disastrous results. Similarly, after the recession, one argument for why the recovery was so slow was a “safe asset shortage” – financial institutions were unwilling to make risky loans without holdings of ultrasafe assets to balance them. While these concerns have receded today, there is still good reason to expect a “flight to safety” toward Treasury debt in the event of a new crisis, and government debt remains important for settling many financial contracts and pricing other assets. So strange as it may sound, there is a serious argument – made by, among others, Nobel prize winner Jean Tirole in his book on financial liquidity — that increased government borrowing would make the financial system more stable and increase access to credit for other borrowers.

13. Federal debt is an important asset for the rest of the world. Federal debt is an important asset not just for the US financial system, but for the rest of the world. In today’s dollar-based international system, the great majority of international trade and investment is denominated in dollars, and most foreign-exchange transactions involve dollars. As a result, central banks (and private financial institutions) all over the world hold foreign-exchange reserves primarily in the form of dollars. These dollar reserves are mainly held in the form of Treasury debt. Close to half of federal debt is now held abroad, mainly as reserves by foreign governments. These holdings are essential for the stability of the international financial system – without adequate reserves, countries are vulnerable to sudden flows of “hot money” out of their countries. As Barry Eichengreen – perhaps the leading economic historian of the international financial system, — has noted, a deep market for government is an essential requirement for a currency to serve as the global reserve currency. If the US is going to be a responsible partner for the rest of the world — and continue reaping the benefits of being at the center of the global economy — it needs to provide an adequate supply of safe government debt for the rest of the world to hold as reserves.

(I wrote this document for internal use at the Roosevelt Institute. Figured I might as well put it up here as well. Obviously it would benefit from links to supporting material, which I may add at some point.)

A Harrodian Perspective on Secular Stagnation

I’ve mentioned before, I think a useful frame to think about the secular stagnation debate through is what’s become known as Harrod’s growth model. [1] My presentation here is a bit different from his.

Start with the familiar equation:

S – I + T – G = X – M

Private savings minus private investment, plus taxes minus government spending, equal exports minus imports. [2] If the variables refer to the actual, realized values, then this is an accounting identity, always true by definition. Anything that is produced must be purchased by someone, for purposes of consumption, investment, export or provision of public services. (Unsold goods in a warehouse are a form of investment.) If the variables refer to expected or intended values, which is how Harrod used them, then it is not an identity but an equilibrium condition. It describes the condition under which businesses will be “satisfied that they have produced neither more nor less than the right amount.”

The next step is to rearrange the equation as S – (G – T) – (X – M) = I. We will combine the government and external balances into A = (G – T) + (X – M). Now divide through by Y, writing s = S/Y and a = A/Y. This gives us:

s – a = I/Y

Private savings net of government and foreign borrowing, must equal private investment. Next, we decompose investment. Logically, investment must either provide the new capital goods required for a higher level of output, or replace worn-out or obsolete capital goods, or be a shift toward a more capital-intensive production technique. [3] So we write:

s – a = gk + dk + delta-k

where g is the growth rate of the economy, k is the current capital-output ratio, d is the depreciation rate (incorporating obsolescence as well as physical wearing-out) and delta-k is the change in the capital-output ratio.

What happens if this doesn’t hold? Realized net savings and investment are always equal. So if desired savings and desired investment are different, that means that somebody’s expectations were not fulfilled. For a situation to arise in which desired net savings are greater than desired investment, either people must have saved less than they wish they had in retrospect, or businesses must have investment more than they wish they had in retrospect. Either way, expenditure in the next period will fall.

What prevents output from falling to zero, in this case? Remember, some consumption is linked to current income, but some is not. This means that when income falls, consumption falls less than proportionately. Which is equivalent to saying that when income falls, there is also a fall in the fraction of income that is saved. In other words, if the marginal propensity to save out of income is less than one, then s — which, remember, is average saving rate — must be a positive function of the current level of output. So the fall in output resulting from a situation in which s > I/Y will eventually cause s to fall sufficiently to bring desired saving into equality with desired investment. The more sensitive is consumption to current income, the larger the fall in income required; if investment is also sensitive to current income, then a still larger fall in income will be required. (If investment is more sensitive than saving to current income, this adjustment process will not work and the decline in output will continue until investment reaches zero.) This is simply the logic of the Keynesian multiplier.

In addition to current income, saving is also a function of the profit rate. Saving is higher out of profits than out of wages, partly because profit recipients are typically richer than wage-earners, but also because are large fraction of profits remain within the business sector and are not available for consumption. [4] Finally, saving is usually assumed to be a function of the interest rate. The desired capital output ratio may also be a function of the interest rate. All the variables are of course also subject to longer term social, technological and economic influences.

So we write

s(u, i, p) – a = gk + dk + delta-k(i, p)

where u is the utilization rate (i.e. current output relative to some measure of trend or potential), i is some appropriate interest rate, and p is the profit share. s is a positive function of utilization, interest rates and the profit share, and delta-k is a negative function of the interest rate and a positive function of the profit rate. Since the profit share and interest rate are normally positive functions of the current level of output, their effects on savings are stabilizing — they reduce the degree to which output must adjust to maintain equality of desired net savings equal and investment. The effect of interest rates on investment is also stabilizing, while the effect of the profit share on investment (as well as any direct effect of utilization on investment, which we are not considering here) are destabilizing.

How does this help make sense of secular stagnation?

In modern consensus macroeconomics, it is implicitly assumed that savings and/or investment are sufficiently sensitive to interest rates that equilibrium can be normally be maintained entirely by changes in interest rates, with only short-term adjustments of output while interest rates move to the correct level. The secular stagnation idea — in both its current and original 1940s edition, as well as the precursor ideas about underconsumption going back to at least J. A. Hobson — is that at some point interest rate adjustment may no longer be able to play this role. In that case, desired investment will not equal desired saving at full employment, so there will be a persistent output gap.

There are a number of reasons that s – a might rise over time. As countries grow richer, the propensity to consume may fall simply because people’s people’s desires for goods and services are finite. This was what Keynes and Alvin Hansen (who coined the term “secular stagnation”) believed. Desired saving may also rise as a result of an upward redistribution of income, or a shift from wage income to profit income, or an increase in the share of profits retained by firms. [5] Unlike the progressive satiation of consumption demand, these three factors could in principle just as easily evolve in the other direction. Finally, government deficits or net exports might decline — but again, they might also increase.

On the right side of the equation, growth may fall for exogenous reasons, slowing population growth being the most obvious. This factor has been emphasized in recent discussions. Depreciation is hardly mentioned in today’s secular stagnation debate, but it is prominent in the parallel discussion of underconsumption in the Marxist tradition. The important point here is to remember that depreciation refers not only to the physical wearing-out or using-up of capital goods, but also to capital goods displaced by competition or obsolescence. In competitive capitalism, businesses invest not only to increase aggregate capacity, but to win market share from each other. Much of depreciation represents capital that goes out of use not because it has ceased to be physically productive, but because it is attached to businesses that have lost out in the competitive struggle. Under conditions of monopoly, the struggle over market share is suppressed, so effective depreciation rates, and hence desired investment, will be lower. Physical depreciation does also exist, and will change as the production technology changes. If there is a secular tendency toward longer-lived means of production, that will pull down desired investment. As for delta-k, it is clearly the case that the process of industrialization involves a large upward shift in the capital-output ratio. But it’s hard to imagine it continuing to rise indefinitely; there are reasons (like the shift toward services) to think it might reach a peak and then decline.

So for secular, long-term trends tending to raise desired saving relative to desired investment we have: (1) the progressive satiation of consumption demand; (2) slowing population growth; (3) increasing monopoly power; and (4) the end of the industrialization process. Factors that might either raise or lower desired savings relative to investment are: (5) changes in the profit share; (6) changes in the fraction of profits retained in the business sector; (7) changes in the distribution of income; (8) changes in net exports; (9) changes in government deficits; and (10) changes in the physical longevity of capital goods. Finally, there are factors that will tend to raise desired investment relative to desired saving. The include: (11) consumption as status competition (this may offset or even reverse the effect of greater inequality on consumption); (12) social protections (public pensions, etc.) that reduce the need for precautionary and lifecycle saving; (13) easier access to credit, for consumption and/or investment; and (14) major technological changes that render existing capital goods obsolete, increasing the effective depreciation rate. These final four factors will offset any tendency toward secular stagnation.

It’s a long list, but I think it’s close comprehensive. Different versions of the stagnation story emphasize various of these factors, and their relative importance has varied in different times and places. I don’t think there is any a priori basis for saying that any of them are more or less important in general.

One problem with this conversation, from my point of view, is that people have a tendency to pick out a couple items from this list as the story, without considering the whole question systematically. For instance, there’s a very popular story in left Keynesian circles that makes it all about (7), offset for a while by (13) and perhaps (11). I don’t doubt that greater income inequality has increased desired private saving. It may be that this is the main factor at work here. But people should not be confidently asserting it is before clearly posing the question and analyzing the full range of possible answers.

In a future post we will think about how to assess the relative importance of these factors empirically.

[1] While the model itself is simple, the interpretation of it — the question it’s intended to answer — is quite controversial. Harrod himself intended it as a model of economic dynamics — that is, describing the system’s transition from one state to another in historical time. As it entered mainstream economics (via the criticism of Samuelson) and also much of structuralist work, it instead became treated as a model of economic growth — that is, of a long-run equilibrium one of whose variables happens to be the growth rate rather than the level of growth. It seems to me that while Harrod clearly was interested in dynamics, not growth in the current sense, the classic article is in fact ambivalent. In particular, Harrod is simply inconsistent in his definition of g: sometimes it is the change in output from one period to the next, while at other times it is the normal or usual change in output expected by business. Furthermore, as Joan Robinson pointed out, his famous knife-edge results depend on using the average savings rate as a parameter, which only makes sense if we are describing a long-run equilibrium. In the short period, it’s the marginal savings rate that is stable, while the average savings rate varies with output. So while it is true that Harrod thought he was writing about economic dynamics, the model he actually wrote is inconsistent. One way to resolve this inconsistency is to treat it as a model of equilibrium long-run growth, as Samuelson did; the other way, which I take here, is to treat it as a Keynesian short-run model in which the current, usual or expected growth rate appears as a parameter.

[2] Strictly speaking it should be the current account balance rather than the trade balance but there’s no harm in ignoring cross-border income flows here.

[3] I am writing here in terms of a quantifiable capital stock, which I have deep misgivings about. But it makes the exposition much simpler.

[4] This is true even in the “disgorge the cash” era, because much of the higher payouts from corporations go to financial institutions rather to households, and thus stay in the business sector.

[5] On the other hand, in a world where investment is constrained by funding, a higher share of profits retained will raise investment as well as savings, leaving its overall effect ambiguous.

EDIT: I think I’ve been misled by reading too much of the Keynesian classics from the 1930s and 40s. The dynamic I describe in this post is correct for that period, but not quite right for the US economy today. Since 1980, the average private savings rate has moved countercyclically, rather than procyclically as it did formerly and as I suggest here. So the mechanism that prevents booms and downturns from continuing indefinitely is no longer — as Keynes said, and I unthinkingly repeated — the behavior of private savings, but rather of the government and external balances. I can’t remember seeing anything written about this fundamental change in business cycle dynamics, which is a bit surprising, but it’s unambiguous in the data.

Fortunately we are interested here in longer term changes rather than cyclical dynamics, so the main argument of this post and the sequel shouldn’t be too badly undermined.

EDIT 2: Of course this change has been written about, what was I thinking. For example, Andrew Glyn, Capitalism Unleashed:

From Marx to Keynes at least, consumption was viewed as an essentially passive component of the growth process. Capital accumulation, investment spending on machinery and buildings, was the essential driving force on the demand as well as on the supply side. It was the capitalists’ access to finance which allowed capital spending to exceed the previous period’s savings and fuelled the expansion of demand; future profits ensured that such borrowing was repaid with a real return. Deficit spending by the government could, in wartime for example, impart a similar impulse to demand, at least till capital markets took fright at the growing debt interest burden and worries about inflation. However household consumption, some two-thirds of aggregate demand, was seen as playing the role of sustaining the current output level rather than driving it up. Savings ratios often fell during recessions, as consumers attempted to maintain spending in the face of falling incomes. Indeed, Milton Friedman criticized the Keynesians for exaggerating the dependence of consumption on current income and ignoring the extent to which savings could be used to ‘smooth’ out the path of consumption. More recently, rather than acting as a stabilizing influence, sharp falls in the savings ratio have occurred during expansions. By boosting consumption proportionately more than the rise in incomes this has intensified upswings, with the danger of sharp falls in demand if savings rebound sharply when the expansion slackens and pessimism builds up.

Debt and Demand

One interesting issue in the ongoing secular stagnation debate is the relationship between debt and aggregate demand. In particular, there’s been a revival of the claim that there is something like a one to one relationship between changes in the ratio of debt to income, and final demand for goods and services.

I would like to reframe this claim a bit, drawing on my recent work with Arjun Jayadev. [1] In a nutshell: Changes in debt-income ratios reflect a number of macroeconomic variables, and until you have a specific story about which of those variables is driving the debt-income ratio, you can’t say what relationship to expect between that ratio and demand. We show in our paper that the entire post-1980 rise in household debt ratios can be explained, in an accounting sense, by higher real interest rates. Conversely, if the interest rates faced by households are lower in the future, debt-income ratios will decline without any fall in demand for real goods and services.

You might not know it from the current discussion, but there is an existing literature on these questions. The relationship between leverage — especially household debt — and aggregate demand was explored in a number of papers around the time of the last US credit crisis, in the late 1980s. Perhaps I’ll write a proper review of this material at some point; a short list would include Benjamin Friedman (1984 and 1986), Caskey and Fazzari (1991), Alfred Eichner (1991) and Tom Palley (1994 and 1997). It’s unfortunate that these earlier papers don’t get referred to in today’s discussion of debt and demand, by either mainstream or heterodox writers. [2]

For most of these writers, the important point was that the effect of debt on demand is two-faced: new borrowing can finance additional expenditure on real goods and services, but on the other hand debt service payments (in the presence of credit constraints) subtract from the funds available for current expenditure. Eichner, for instance, uses the equation E = F + delta-D – DS, or aggregate expenditure equals cashflow plus debt growth minus debt service payments.

More generally, to think systematically about the relationship between debt and household expenditure, we need to start from a consistent set of accounts. The first principle of financial accounting is that, for any economic unit, total sources of funds must equal total uses of funds. There are many ways of organizing accounts, at the level of the individual household or firm, at the level of the sector, or at the level of the nation, but this equality must always hold. You can slice up sources and uses of funds however you like, but total money coming in must equal total money going out.

The standard financial accounts for the United States are the Flow of Funds, maintained by the Federal Reserve. A number of alternative accounting frameworks are reflected in the social accounting matrixes developed by the late Wynne Godley and Lance Taylor and their students and collaborators.

Here’s one natural way of organizing sources and uses of funds for the household sector:

compensation of employees

capital income

transfer receipts

net borrowing

consumption (including consumer durables)

residential investment

tax payments

interest payments

net acquisition of financial assets

The items before the equal sign are sources of funds; the items after are uses. [3] The first two uses of funds are included in GDP measured as income, while the latter two are not. Similarly, the first two uses of funds are included in GDP measured as expenditure, while the latter three are not.

When we look at the whole balance sheet, it is clear that borrowing cannot change in isolation. An increase in one source of funds must be accompanied by some mix of increase in some use(s) of funds, and decrease in other sources of funds. So if we want to talk about the relationship between borrowing and GDP, we need a story about what other items on the balance sheet are changing along with it. One possible story is that changes in borrowing are normally matched by changes in consumption, or in residential investment. This is the implicit story behind the suggestion that lower household borrowing will reduce final demand dollar for dollar. But there is no reason in principle why that has to be the main margin that household borrowing adjusts on, and as we’ll see, historically it often has not been.

So far we have been talking about the absolute levels of borrowing and other flows. But in general, we are not interested in the absolute level of borrowing, but on the ratio of debt to income. It’s common to speak about changes in borrowing and changes in debt-income ratios as if they were synonyms. [4] But they are not. The debt-income ratio has a denominator as well as a numerator. The denominator is nominal income, so the evolution of the ratio depends not only on household borrowing, but on real income growth and inflation. Faster growth of nominal income — whether due to real income growth or inflation — reduces the debt-income ratio, just as much as lower borrowing does.

In short: For changes in the debt-income ratio to be reflected one for one in aggregate demand, two things must be true. First, changes in the ratio must be due mainly to variation in the numerator, rather than the denominator. And second, changes in the numerator must be due mainly to variation in consumption and residential investment, rather than variation in other balance sheet items. How true are these things with respect to the rise in debt-income ratios over the past 30 years?

To frame the question in a tractable way, we need to simplify the balance sheet, combining some items to focus on the ones we care about. In our paper, Arjun and I were interested in debt ratios, not aggregate demand, so we grouped together all the non-credit flows into a single variable, which we called the household primary deficit. We defined this as all uses of funds except interest payments, minus all sources of funds except borrowing.

Here, I do things slightly differently. I divide changes in debt into those due to nominal income growth, those due to expenditures that contribute to aggregate demand (consumption and residential investment), and those due to non-demand expenditure (interest payments and net acquisition of financial assets.) For 1985 and later years, I also include the change in debt-income ratios attributable to default. (We were unable to find good data on household level defaults for earlier years, but there is good reason to think that household defaults did not occur at a macroeconomically significant level between the Depression and the Great Recession.) This lets us answer the question directly: historically, how closely have changes in household debt-income ratios been linked to changes in aggregate demand?

Figure 1 shows the trajectory of household debt for the US since 1929, along with federal debt and non financial business debt. (All are given as fractions of GDP.) As we can see, there have been three distinct episodes of rising household debt ratios since World War II: one in the decade or so immediately following the war, one in the mid-1980s, and one in the first half of the 2000s.

Figure 1: US debt-GDP ratios, 1929-2011

Figure 2 shows the annual change in the debt ratio, along with the decomposition described above. All variables are expressed as deviations from the 1950-2010 average. The heavy black line is the change in the debt-income ratio. The solid red line is final-demand expenditure, i.e. non-interest consumption plus residential investment. The dashed and dotted blue lines show the contributions of nominal income growth and non-demand expenditure, respectively. And the purple line with diamonds shows the contribution of defaults. (Defaults are measured relative to the 1985-2010 average.)

Figure 2: Decomposition of changes in the household debt-income ratio, 1949-2011

It’s clear from this figure that there is an important element of truth to the Keen-Krugman view that there is a tight link between the debt-incoem ratio and demand. There is evidently a close relationship between household demand and changes in the debt ratio, especially with respect to short-term variation. But that view is also missing something important. In some periods, there are substantial divergences between final demand from household and changes in the debt ratio. In particular, the increase in the household debt ratio in the 1980s (by about 20 points of GDP) took place during a period when consumption and residential investment by households were near their lowest levels since World War II. The increase in household debt after 1980 has often been described as some kind of “consumption binge”; this is the opposite of the truth.

The ambiguous relationship between household debt and aggregate demand can be seen in Table 1, which compares the periods of rising household debt with the intervening periods of stable or falling debt. The numbers are annual averages; to facilitate comparisons between periods, the averages for sub periods are again expressed as deviations from the 1950-2010 mean. (Or from the 1985-2010 mean, in the case of defaults.) The numbers are the contributions to the change i the debt-income ratio, so a positive value for nominal income growth indicates lower inflation and/or growth than the postwar average.

Table 1: Decomposition of changes in the household debt-income ratio, selected periods

	Change in debt-income ratio	Contribution of nominal income growth	Aggregate-demand expenditure	Non-demand expenditure	Defaults
1950-2010 mean	1.5	-4.9	89.1	17.7	-0.9
Difference from mean:
1949-1963	1.3	2.3	2.9	-4.3	N/A
1964-1983	-1.6	-1.4	-1.8	1.1	N/A
1984-1989	1.4	-0.3	-2.1	3.8	0.4
1990-1998	-0.5	0.3	-0.8	0.3	0.2
1999-2006	3.2	-1.2	3.1	1.7	0.1
2007-2010	-3.5	1.7	-1.4	-2.0	-1.3

What we see here is that while the first and third episodes of rising debt are indeed associated with higher than average household expenditure on real goods and services, the 1980s episode is not. The rise in debt in the 1980s is explained by a rise in non-demand expenditures. Specifically, it is entirely due to the rise in interest payments, which doubled from 3-4 percent of household income in the 1950s and 1960s to over 8 percent in the late 1980s. (Interest payments continued around this level up to the Great Recession, falling somewhat only in the past few years. The reason “non-demand expenditures” is lower after 1990 is because the household sector sharply reduced net acquisition of financial assets.) Also, note that while the housing booms of 1949-1963 and 1999-2006 saw almost identical levels of household expenditure on real goods and services, the household debt ratio rose nearly twice as fast in the more recent episode. The reason, again, is because of much higher interest payments in the 2000s compared with the immediate postwar period. Finally, as I’ve pointed out on this blog before, the deleveraging since 2008 would have been impossible without elevated household defaults, which approached 4 percent of outstanding household debt in 2009-2010 — partly offset by the sharp fall in household income in 2009, which raised the debt-income ratio.

Figure 3, from our paper, offers another way of looking at this. The heavy black line is the actual trajectory of the household debt-income ratio. The other lines show counterfactual scenarios in which non-interest household expenditures are at their historical levels, but growth, inflation and/or interest rates are held constant at their 1946-1980 average levels.

Figure 3: Counterfactual scenarios for the evolution of household-debt income ratios, 1946-2010

All these counterfactual scenarios show a spike in the 2000s: People really did borrow to pay for new houses! But the counterfactual scenarios also show lower overall trends of household debt, indicating that slower income growth, lower inflation and higher interest rates all contributed to the rise of household debt post-1980, independent of changes in borrowing behavior. Most interestingly, the red line shows that new borrowing after 1980 was lower than new borrowing in the 1950s, 60s and 70s; if households had engaged in the exact same spending on consumption, residential investment and financial assets as they actually did, but inflation, growth and interest rates had remained at their pre-1980 levels, the household debt-income ratio would have trended gradually downward.

To the extent that rising debt-income ratios after 1980 were the result of higher interest rates and disinflation, they were not contributing to aggregate demand. And if lower interest rates and and, perhaps, higher inflation and/or higher default rates bring down debt ratios in the future, deleveraging will not be a headwind for demand.

It is customary to see rising debt as the result of private choices to finance higher expenditures by issuing new credit-market liabilities. But historically, it is equally correct to see rising debt as the result of political choices that increase the real value of existing liabilities.

[1] I’m pleased to report that a version of this paper has been accepted for publication by American Economic Journal: Macroeconomics. This has caused some adjustment in my view of the permeability of the “mainstream-heterodox” divide.

[2] This neglect of the earlier literature is especially puzzling since several of the protagonists of the 1990-era discussion are active in the sequel today. Steve Fazzari, for instance, in his several superb recent papers (with Barry Cynamon) on household debt, does not refer to his own 1991 paper, tho it is dealing with substantially the same questions.

[3] Only a few minor items are left out. This grouping of sources and uses of funds essentially follows Lance Taylor’s social accounting matrices, as presented in Reconstructing Macroeconomics and elsewhere. Neither the NIPAs nor the Flow of Funds present household accounts in exactly this way. The Flow of Funds groups all three sources of household income together, treats consumer durables as a separate category of household investment, and treats interest payments as consumption. The NIPAs treat residential investment and mortgage interest payments as their own sector, separate from the household sector, and omits borrowing and net acquisition of financial assets. The NIPAs also include a number of noncash items, of which the most important is the imputed flow of housing services from the owner-occupied housing sector to the household sector and the corresponding imputed rental payments from the household sector to the owner-occupied residential sector.

[4] For example, a recent paper on the causes of “The Rise in U.S. Household Indebtedness” begins with the sentence, “During the past several decades in the United States, signi ficant changes have occurred in household saving and borrowing behavior,” with no sign of realizing that this is a different question than the one posed by the title.

The Interest Rate, the Interest Rate, and Secular Stagnation

In the previous post, I argued that the term “interest rate” is used to refer to two basically unrelated prices: The exchange rate between similar goods at different periods, and the yield on a credit-market instrument. Why does this distinction matter for secular stagnation?

Because if you think the “natural rate of interest,” in the sense of the credit-market rate that brings aggregate expenditure to a desired level in some real-world economic situation, should be the time-substitution rate that would exist in a model that somehow corresponds to that situation, when the two are in fact unrelated — well then, you are going to end up with a lot of irrelevant and misleading intuitions about what that rate should be.

In general, I do think the secular stagnation conversation is a real step forward. So it’s a bit frustrating, in this context, to see Krugman speculating about the “natural rate” in terms of a Samuelson-consumption loan model, without realizing that the “interest rate” in that model is the intertemporal substitution rate, and has nothing to do with the Wicksellian natural rate. This was the exact confusion introduced by Hayek, which Sraffa tore to pieces in his review, and which Keynes went to great efforts to avoid in General Theory. It would be one thing if Krugman said, “OK, in this case Hayek was right and Keynes was wrong.” But in fact, I am sure, he has no idea that he is just reinventing the anti-Keynesian position in the debates of 75 years ago.

The Wicksellian natural rate is the credit-market rate that, in current conditions, would bring aggregate expenditure to the level desired by whoever is setting monetary policy. Whether or not there is a level of expenditure that we can reliably associate with “full employment” or “potential output” is a question for another day. The important point for now is “in current conditions.” The level of interest-sensitive expenditure that will bring GDP to the level desired by policymakers depends on everything else that affects desired expenditure — the government fiscal position, the distribution of income, trade propensities — and, importantly, the current level of income itself. Once the positive feedback between income and expenditure has been allowed to take hold, it will take a larger change in the interest rate to return the economy to its former position than it would have taken to keep it there in the first place.

There’s no harm in the term “natural rate of interest” if you understand it to mean “the credit market interest rate that policymakers should target to get the economy to the state they think it should be in, from the state it in now.”And in fact, that is how working central bankers do understand it. But if you understand “natural rate” to refer to some fundamental parameter of the economy, you will end up hopelessly confused. It is nonsense to say that “We need more government spending because the natural rate is low,” or “we have high unemployment because the natural rate is low.” If G were bigger, or if unemployment weren’t high, there would be a different natural rate. But when you don’t distinguish between the credit-market rate and time-substitution rate, this confusion is unavoidable.

Keynes understood clearly that it makes no sense to speak of the “natural rate of interest” as a fundamental characteristic of an economy, independent of the current state of aggregate demand:

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest”, which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level.

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.

I am now no longer of the opinion that the concept of a “natural” rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.

EDIT: In response to Nick Edmonds in comments, I’ve tried to restate the argument of these posts in simpler and hopefully clearer terms:

Step 1 is to recognize that in a model like Samuelson’s, “interest rate” just means any contract that allows you to make a payment today and receive a flow of income in the future. It would be the exact same model, capturing the exact same features of the economy, if we wrote “profit rate” or “house price-to-rent ratio” instead of “interest rate.” Any valid intuition the model gives us, applies to ALL asset yields, not just to the the credit-instrument yields that we call “interest rates” in every day life.

Step 2 is to think about the other factors that enter into real-world asset yields, besides the intertemporal exchange rate Samuelson is interested in — risk, liquidity, carrying costs and depreciation, and expected capital gains. Since all real-world asset yields incorporate at least one of these factors, none correspond exactly to Samuelson’s intertemporal interest rate.

Step 3 is to realize that not only are credit-instrument yields not exactly the Samuelson “interest rate,” they aren’t even approximately it. The great majority of credit market transactions we see in real economies are not exchanges of present income for future income, but exchanges of two different claims on future income. So the intertemporal interest rate enters on both sides and cancels out.

At that point, we have established that the “interest rate” the monetary authority is targeting is not the “interest rate” Samuelson is writing about.

Step 4 is then to ask, what does it mean to say that some particular credit-market interest rate is the “natural” one? That is where the dependence on fiscal policy, income distribution, etc. come in. But those factors are not part of the argument for why the credit-market rate is not even approximately the intertemporal rate.

The Interest Rate and the Interest Rate

We will return to secular stagnation. But we need to clear some ground first. What is an interest rate?

Imagine you are in a position to acquire a claim on a series of payments in the future. Since an asset is just anything that promises a stream of payments in the future, we will say you are thinking of buying of an asset. What will you look at to make your decision?

First is the size of the payments you will receive, as a fraction of what you pay today. We will call that the yield of the asset, or y. Against that we have to set the risk that the payments may be different from expected or not occur at all; we will call the amount you reduce your expected yield to account for this risk r. If you have to make regular payments beyond the purchase of the asset to receive income from it (perhaps taxes, or the costs of operating the asset if it is a capital good) then we also must subtract these carrying costs c. In addition, the asset may lose value over time, in which case we have to subtract the depreciation rate d. (In the case of an asset that only lasts one period — a loan to be paid back in full the next period, say — d will be equal to one.) On the other hand, owning an asset can have benefits beyond the yield. In particular, an asset can be sold or used as collateral. If this is easy to do, ownership of the asset allows you to make payments now, without having to waiting for its yield in the future. We call the value of the asset for making unexpected payments its liquidity premium, l. The market value of long-lasting assets may also change over time; assuming resale is possible, these market value changes will produce a capital gain g (positive or negative), which must be added to the return. Finally, you may place a lower value on the payments from the asset simply because they take place in the future; this might be because your needs now are more urgent than you expect them to be then, or simply because you prefer income in the present to income in the future. Either way, we have to subtract this pure time-substitution rate i.

So the value of an asset costing one unit (of whatever numeraire) will be 1 + y – r – c – d + l + g – i.

(EDIT: On rereading, this could use some clarification:

Of course all the terms can take on different (expected) values in different time periods, so they are vectors, not scalars. But if we assume they are constant, and that the asset lasts forever (i.e. a perpetuity), then we should write its equilibrium value as: V = Y/i, where Y is the total return in units of the numeraire, i.e. Y = V(y – r – c + l + g) and i is the discount rate. Divide through both sides by V and we have i = y – r – c + l + g. We can now proceed as below.)

In equilibrium, you should be just indifferent between purchasing and not purchasing this asset, so we can write:

y – r – c – d + l + g – i = 0, or

(1) y = r + c + d – l – g + i

So far, there is nothing controversial.

In formal economics, from Bohm-Bawerk through Cassel, Fisher and Samuelson to today’s standard models, the practice is to simplify this relationship by assuming that we can safely ignore most of these terms. Risk, carrying costs and depreciation can be netted out of yields, capital gains must be zero on average, and liquidity is assumed not to matter or just ignored. So then we have:

(2) y = i

In these models, it doesn’t matter if we use the term “interest rate” to mean y or to mean i, since they are always the same.

This assumption is appropriate for a world where there is only one kind of asset — a risk-free contract that exchanges one good in the present for 1 + i goods in the future. There’s nothing wrong with exploring what the value of i would be in such a world under various assumptions.

The problem arises when we carry equation (2) over to the real world and apply it to the yield of some particular asset. On the one hand, the yield of every existing asset reflects some or all of the other terms. And on the other hand, every contract that involves payments in more than one period — which is to say, every asset — equally incorporates i. If we are looking for the “interest rate” of economic theory in the economic world we observe around us, we could just as well pick the rent-price ratio for houses, or the profit rate, or the deflation rate, or the ratio of the college wage premium to tuition costs. These are just the yields of a house, of a share of the capital stock, of cash and of a college degree respectively. All of these are a ratio of expected future payments to present cost, and should reflect i to exactly the same extent as the yield of a bond does. Yet in everyday language, it is the yield of the bond that we call “interest”, even though it has no closer connection to the interest rate of theory than any of these other yields do.

This point was first made, as far as I know, by Sraffa in his review of Hayek’s Prices and Production. It was developed by Keynes, and stated clearly in chapters 13 and 17 of the General Theory.

For Keynes, there is an additional problem. The price we observe as an “interest rate” in credit markets is not even the y of the bond, which would be i modified by risk, expected capital gains and liquidity. That is because bonds do not trade against baskets of goods. They trade against money. When we see a bond being sold with a particular yield, we are not observing the exchange rate between a basket of goods equivalent to the bond’s value today and baskets of goods equivalent to its yield in the future. We are observing the exchange rate between the bond today and a quantity of money today. That’s what actually gets exchanged. So in equilibrium the price of the bond is what equates the expected returns on the two assets:

(3) y_B – r_B + l_B + g_B – i = l_M – i

(Neither bonds nor money depreciate or have carrying costs, and money has no risk. If our numeraire is money then money also cannot experience capital gains. If our numeraire was a basket of goods instead, then -g would be expected inflation, which would appear on both sides and cancel out.)

What we see is that i appears on both sides, so it cancels out. The yield of the bond is given by:

(4) y_B = r_B – g_B + (l_M – l_B)

The yield of the bond — the thing that in conventional usage we call the “interest rate” — depends on the risk of the bond, the expected price change of the bond, and the liquidity premium of money compared with the bond. Holding money today, and holding a bond today, are both means to enable you to make purchases in the future. So the intertemporal substitution rate i does not affect the bond yield.

(We might ask whether the arbitrage exists that would allow us to speak of a general rate of time-substitution i in real economies at all. But for present purposes we can ignore that question and focus on the fact that even if there is such a rate, it does not show up in the yields we normally call “interest rates”.)

This is the argument as Keynes makes it. It might seem decisive. But monetarists would reject it on the grounds that nobody in fact holds money as a store of value, so equation (3) does not apply. The bond-money market is not in equilibrium, because there is zero demand for money beyond that needed for current transactions at any price. (The corollary of this is the familiar monetarist claim that any change in the stock of money must result in a proportionate change in the value of transactions, which at full employment means a proportionate rise in the price level.) From the other side, endogenous money theorists might assert that the money supply is infinitely elastic for any credit-market interest rate, so l_M is endogenous and equation (4) is underdetermined.

As criticisms of the specific form of Keynes’ argument, these are valid objections. But if we take a more realistic view of credit markets, we come to the same conclusion: the yield on a credit instrument (call this the “credit interest rate”) has no relationship to the intertemporal substitution rate of theory (call this the “intertemporal interest rate.”)

Suppose you are buying a house, which you will pay for by taking out a mortgage equal to the value of the house. For simplicity we will assume an amortizing mortgage, so you make the same payment each period. We can also assume the value of housing services you receive from the house will also be the same each period. (In reality it might rise or fall, but an expectation that the house will get better over time is obviously not required for the transaction to take place.) So if the purchase is worth making at all, then it will result in a positive income to you in every period. There is no intertemporal substitution on your side. From the bank’s point of view, extending the mortgage means simultaneously creating an asset — their loan to you — and a liability — the newly created deposit you use to pay for the house. If the loan is worth making at all, then the expected payments from the mortgage exceed the expected default losses and other costs in every period. And the deposits are newly created, so no one associated with the bank has to forego any other expenditure in the present. There is no intertemporal substitution on the bank’s side either.

(It is worth noting that there are no net lenders or net borrowers in this scenario. Both sides have added an asset and a liability of equal value. The language of net lenders and net borrowers is carried over from models with consumption loans at the intertemporal interest rate. It is not relevant to the credit interest rate.)

If these transactions are income-positive for all periods for both sides, why aren’t they carried to infinity? One reason is that the yields for the home purchaser fall as more homes are purchased. In general, you will not value the housing services from a second home, or the additional housing services of a home that costs twice as much, as much as you value the housing services of the home you are buying now. But this only tells us that for any given interest rate there is a volume of mortgages at which the market will clear. It doesn’t tell us which of those mortgage volume-interest rate pairs we will actually see.

The answer is on the liquidity side. Buying a house makes you less liquid — it means you have less flexibility if you decide you’d like to move elsewhere, or if you need to reduce your housing costs because of unexpected fall in income or rise in other expenses. You also have a higher debt-income ratio, which may make it harder for you to borrow in the future. The loan also makes the bank less liquid — since its asset-capital ratio is now higher, there are more states of the world in which a fall in income would require it to sell assets or issue new liabilities to meet its scheduled commitments, which might be costly or, in a crisis, impossible. So the volume of mortgages rises until the excess of housing service value over debt service costs make taking out a mortgage just worth the incremental illiquidity for the marginal household, and where the excess of mortgage yield over funding costs makes issuing a new mortgage just worth the incremental illiquidity for the marginal bank. (Incremental illiquidity in the interbank market may — or may not — mean that funding costs rise with the volume of loans, but this is not necessary to the argument.)

Monetary policy affects the volume of these kinds of transactions by operating on the l terms. Normally, it does so by changing the quantity of liquid assets available to the financial system (and perhaps directly to the nonfinancial private sector as well). In this way the central bank makes banks (and perhaps households and businesses) more or less willing to accept the incremental illiquidity of a new loan contract. Monetary policy has nothing to do with substitution between expenditure in the present period and expenditure in some future period. Rather, it affects the terms of substitution between more and less liquid claims on income in the same future period.

Note that changing the quantity of liquid assets is not the only way the central bank can affect the liquidity premium. Banking regulation, lender of last resort operations and bailouts also change the liquidity premium, by chaining the subjective costs of bank balance sheet expansion. An expansion of the reserves available to the banking system makes it cheaper for banks to acquire a cushion to protect themselves against the possibility of an unexpected fall in income. This will make them more willing to hold relatively illiquid assets like mortgages. But a belief that the Fed will take emergency action prevent a bank from failing in the event of an unexpected fall in income also increases its willingness to hold assets like mortgages. And it does so by the same channel — reducing the liquidity premium. In this sense, there is no difference in principle between monetary policy and the central bank’s role as bank supervisor and lender of last resort. This is easy to understand once you think of “the interest rate” as the price of liquidity, but impossible to see when you think of “the interest rate” as the price of time substitution.

It is not only the central bank that changes the liquidity premium. If mortgages become more liquid — for instance through the development of a regular market in securitized mortgages — that reduces the liquidity cost of mortgage lending, exactly as looser monetary policy would.

The irrelevance of the time-substitution rate i to the credit-market interest rate y_B becomes clear when you compare observed interest rates with other prices that also should incorporate i. Courtesy of commenter rsj at Worthwhile Canadian Initiative, here’s one example: the Baa bond rate vs. the land price-rent ratio for residential property.

Both of these series are the ratio of one year’s payment from an asset, to the present value of all future payments. So they have an equal claim to be the “interest rate” of theory. But as we can see, none of the variation in credit-market interest rates (y_B, in my terms) show up in the price-rent ratio. Since variation in the time-substituion rate i should affect both ratios equally, this implies that none of the variation in credit-market interest rates is driven by changes in the time-substitution interest rate. The two “interest rates” have nothing to do with each other.

(Continued here.)

EDIT: Doesn’t it seem strange that I first assert that mortgages do not incorporate the intertemporal interest rate, then use the house price-rent ratio as an example of a price that should incorporate that rate? One reason to do this is to test the counterfactual claim that interest rates do, after all, incorporate Samuelson’s interest rate i. If i were important in both series, they should move together; if they don’t, it might be important in one, or in neither.

But beyond that, I think housing purchases do have an important intertemporal component, in a way that loan contracts do not. That’s because (with certain important exceptions we are all aware of) houses are not normally purchased entirely on credit. A substantial fraction of the price is paid is upfront. In effect, most house purchases are two separate transactions bundled together: A credit transaction (for, say, 80 percent of the house value) in which both parties expect positive income in all periods, at the cost of less liquid balance sheets; and a conceptually separate cash transaction (for, say, 20 percent) in which the buyer foregoes present expenditure in return for a stream of housing services in the future. Because house purchases must clear both of these markets, they incorporate i in way that loans do not. But note, i enters into house prices only to the extent that the credit-market interest rate does not. The more important the credit-market interest rate is in a given housing purchase, the less important the intertemporal interest rate is.

This is true in general, I think. Credit markets are not a means of trading off the present against the future. They are a means of avoiding tradeoffs between the present and the future.