“A full-throated defense of economic dynamism.” - The Wall Street Journal
“Unintended Consequences provides a provocative interpretation of the causes of the global financial crisis and the policies needed to return to rapid growth. Whether you agree or not, this analysis is well worth reading.” - Nouriel Roubini, New York University; Chairman, Roubini Global Economics
“…a must-read for serious students of economic policy.” - Glenn Hubbard, Dean, Columbia Business School, and former Chairman of the Council of Economic Advisers
“…a must-read for serious students of economic policy.” - Glenn Hubbard, Dean, Columbia Business School, and former Chairman of the Council of Economic Advisers
“Unintended Consequences is far smarter and more thought-provoking than most economics written for the general public” - Greg Mankiw, Harvard University, Former Chairman of the Council of Economic Advisors
“Unintended Consequences should be read by anyone who takes for granted the superiority of progressive taxation and has not thought carefully about the trade-offs involved.” - The New Republic
“There are an amazing number of good ideas and interesting points made in Unintended Consequences. The thinking underlying it, and the obvious depth of understanding of the author, are very impressive.” - Steven Levitt, coauthor of Freakonomics; 2004 John Bates Clark Medal
“Unintended Consequences represents the most cogent and persuasive analysis of the Financial Crisis to date.” - Andrei Shleifer, 1999 John Bates Clark Medal Winner
“…serious thinking for serious thinkers. …a thought-provoking blueprint for growing middle- and working-class incomes.” - Mitt Romney, former Governor of Massachusetts
“…reminds us that inequality sends a signal of what society lacks most, in America’s case, entrepreneurship and risk taking.” - Lawrence Lindsey, CEO, The Lindsey Group, former Director of the National Economic Council
“Unintended Consequences is full of substance, it is one of the must-read books of the year, and once I finish it I will be giving it a second read through right away.” - Tyler Cowen, Professor, George Mason University
“…challenges misconceptions that distort our economic debates.” - Arthur Brooks, President of the American Enterprise Institute
AI Summary.The author argues that a surge in money growth beginning in 2020 put upward pressure on inflation to a degree unprecedented in the sample period since 1967, and that subsequent monetary tightening produced strong disinflationary pressures. Had policymakers tracked money growth using a price-target model, they might have tightened sooner and avoided some of the inflation.
Peter Ireland, Stephen Miran and Nouriel RoubiniHudson Bay Capital
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Ireland, Miran, and Roubini compare the actual price level to the predictions of an equilibrium model relating prices to money supply. Predicted inflation hit a 60-year high in 2020–21, months before inflation surged and then crashed once the Fed hiked.
Would tracking money growth have helped policymakers tighten sooner?
Core argument: The money growth surge beginning in 2020 and continuing into 2021 put upward pressure on inflation to a degree unprecedented in the post-1967 sample period, according to the graphs in Figure 3.
The graphs in Figure 3 show quite clearly how the surge in money growth starting in 2020 and continuing in 2021 put enormous upward pressure on inflation, to a degree unprecedented in the post-1967 sample period. And while the large and negative price gaps that followed in 2022 and 2023 are likewise indicative of strong disinflationary pressures applied through subsequent monetary tightening, one can’t see these graphs without asking: Had Federal Open Market Committee members been monitoring measures of money growth with the help of the P-star [price target based on monetary aggregates] model, might they have ended QE and raised interest rates sooner and more quickly, thereby avoiding at least some of the post-2020 inflation? Of course, massive fiscal expansion was another driver of the post-2020 surge in inflation, as suggested by fiscal theories of the price level. The model simply observes that regardless of its originating source, excessive money growth signals that inappropriate macroeconomic policies are fueling higher inflation. Fiscal expansions that expand money supply will be reflected in a P-star model.
Takeaways by Macro Roundup® AI
The money growth surge beginning in 2020 and continuing into 2021 put upward pressure on inflation to a degree unprecedented in the post-1967 sample period, according to the graphs in Figure 3.
The large negative price gaps of 2022 and 2023 indicate strong disinflationary pressures from subsequent monetary tightening, raising the question of whether FOMC members using the P-star model would have ended quantitative easing and raised interest rates sooner and more quickly.
Massive fiscal expansion was another driver of the post-2020 inflation surge, as suggested by fiscal theories of the price level, and fiscal expansions that expand the money supply are reflected in a P-star model.
Related Articles:
Money and Inflation— The M2 money supply has contracted for the first time in sixty years, shrinking at an annual rate of nearly 5%, yet inflation has remained high rather than turning to deflation. The author argues this undercuts the claim that money supply growth drives inflation, since the same logic implies severe deflation should now follow.
State Dependence of Monetary Policy During Global Supply Chain Disruptions— The authors present descriptive evidence that global supply chain disruptions were associated with elevated transportation costs, goods supply-demand imbalances, and a surge in goods prices, steepening the aggregate supply curve. In the disrupted state, a contractionary monetary policy shock produces muted responses in real output and spare capacity but a substantially stronger decline in goods prices.
What Next for r*? A Capital Market Equilibrium Perspective On The Natural Rate of Interest— A capital-market equilibrium model estimates that the steady-state safe natural rate of interest across advanced economies has fallen from about 5% to about 0%, driven by slower growth, demographics, higher mark-ups, and rising risk premia. The author estimates that artificial-intelligence-driven growth and heightened inflation risk could each raise it by about 1 percentage point.
AI Summary.Average US weekly pay has risen 31% over six years, outpacing prices, but inflation erased most of those gains. Grocery prices are up about 30% since early 2020, a young married couple now needs 70% of annual household income for an average down payment versus 58% in 2019.
Mark Niquette, Jennah Haque and Jade KhatibBloomberg
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The US price level has risen 26% since January 2020, leaving Americans’ average weekly real wages up only 3.7% over five years.
Why do Americans feel squeezed when wages outpaced prices?
Core argument: Average American weekly pay has risen 31% over the past six years, outpacing prices in the aggregate, but inflation wiped out most of those income gains, and low earners now lag after leading wage growth following the pandemic.
The average American’s weekly pay has risen 31% over the past six years. That’s faster than prices across that period, so Americans in the aggregate aren’t losing ground — but inflation wiped out most of their income gains. For low earners, who saw the fastest wage growth after the pandemic, the last year or so has been tougher and they’re now lagging behind. [Grocery] prices are up about 30% since January 2020, about in line with average wage growth. But Americans had gotten used to paying roughly the same at the supermarket each week in the pre-pandemic years. Lately, they’ve been forced to stomach a bigger bill with almost every visit. A double-punch has pushed homeownership out of reach for many Americans: First the pandemic-era surge in prices, and then a steep run-up in mortgage rates. A young married couple now needs 70% of their annual household income to afford the average down payment, according to Goldman Sachs economist Elsie Peng, up from 58% in 2019 and 45% in 2000. [Further], the average principal and interest payment has doubled since early 2020, according to the National Association of Realtors. Employee premiums for family health insurance have risen 23% in the past five years to almost $6,900 on average. And more than 20 million people who rely on Affordable Care Act plans face a hike in their premiums after Congress let Covid-era subsidies expire.
Takeaways by Macro Roundup® AI
Average American weekly pay has risen 31% over the past six years, outpacing prices in the aggregate, but inflation wiped out most of those income gains, and low earners now lag after leading wage growth following the pandemic.
A young married couple needs 70% of annual household income to afford the average down payment, up from 58% in 2019 and 45% in 2000, according to Goldman Sachs economist Elsie Peng, while the average principal and interest payment has doubled since early 2020, per the National Association of Realtors.
Employee premiums for family health insurance have risen 23% in the past five years to almost $6,900 on average, and more than 20 million people on Affordable Care Act plans face premium increases after Congress let Covid-era subsidies expire.
Related Articles:
The Cost of Money is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly— Variation in the University of Michigan consumer sentiment index that inflation and unemployment cannot explain is strongly correlated with growth in consumer borrowing costs, such as mortgage and car loan rates. The authors estimate that including interest payments and homeownership costs in the consumer price index would raise measured inflation from 3% to 9%.
Why Do We Dislike Inflation?— Survey evidence finds 80% of respondents believe prices rise faster than wages, though real weekly earnings for the median worker grew 1.7% between 2019 and 2023. About 40% think their nominal income would be higher had inflation been lower, and half expect wages to take over a year to catch up if inflation doubled.
A Mystery in Fixed Income— Long-term interest rates have drifted higher than short-term rates and oil prices would predict, an unusual pattern during Federal Reserve rate-cutting cycles. Proposed explanations include investor concern about growing Treasury debt issuance or an effective increase in the Federal Reserve's 2% inflation target.
AI Summary.The authors argue workers must take costly actions to make nominal wages catch up with inflation, so inflation imposes welfare costs even when real wages do not fall, and observed wage growth understates inflation's costs. In their survey, workers would sacrifice 1.75% of wages to avoid such conflict, more than doubling estimated costs.
Joao Guerreiro, Jonathon Hazell, Chen Lian et al.National Bureau of Economic Research
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.@JADHazell @jptguerreiro @ChenLian92 argue inflation is costlier to workers than the decline in real wages, as countering wage erosion requires costly conflict with employers. Workers would sacrifice 1.75% of their real wages to avoid conflict.
Why do workers dislike inflation even when real wages hold up?
Core argument: In a survey of workers, respondents were willing to sacrifice 1.75% of their wages to avoid the costly actions ("conflict") needed to make nominal wages catch up with inflation.
We argue that workers must take costly actions (“conflict”) to have nominal wages catch up with inflation, meaning there are welfare costs even if real wages do not fall as inflation rises. We show that, following a rise in inflation, wage catchup resulting from more frequent conflict does not raise welfare. Instead, the impact of inflation on worker welfare is determined by what we term “wage erosion”—how inflation would lower real wages if workers' conflict decisions did not respond to inflation. As a result, measuring welfare using observed wage growth understates the costs of inflation. We conduct a survey showing that workers are willing to sacrifice 1.75% of their wages to avoid conflict. Calibrating the model to the survey data, the aggregate costs of inflation incorporating conflict more than double the costs of inflation via falling real wages alone. The right figure[s] in Figure 11 shows the dynamic response of real wages and welfare-relevant wage erosion for the 2021-23 inflation surge. The gap between real wages and wage erosion [right panels] measures the large aggregate costs of inflation due to conflict.
Takeaways by Macro Roundup® AI
In a survey of workers, respondents were willing to sacrifice 1.75% of their wages to avoid the costly actions ("conflict") needed to make nominal wages catch up with inflation.
Calibrating their model to the survey data, the authors find that incorporating conflict costs more than doubles the aggregate costs of inflation relative to costs from falling real wages alone.
The authors argue that worker welfare depends on "wage erosion"—how inflation would lower real wages if conflict decisions did not respond to inflation—so measuring welfare using observed wage growth understates inflation's costs.
Related Articles:
Trends in Real Wage Growth among Union, Nonunion Workers— Wage changes for union and nonunion workers tend to move similarly over time, with union workers' nominal wage changes less volatile, and since 2002 both groups' wages increased at the same rate. When consumer prices grew faster than wages, real wage growth turned negative despite a strong labor market, then turned positive as inflation fell.
The Cost of Money is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly— Variation in the University of Michigan consumer sentiment index that inflation and unemployment cannot explain is strongly correlated with growth in consumer borrowing costs, such as mortgage and car loan rates. The authors estimate that including interest payments and homeownership costs in the consumer price index would raise measured inflation from 3% to 9%.
Are Real Wages Catching Up?— Real wage growth has turned slightly positive, but wage levels remain below where they stood before the inflation surge: consumer prices rose nearly 18% while the Employment Cost Index, a broad wage measure, rose a little under 15%, leaving cumulative real wage growth about 3pp below zero.
AI Summary.Using a high-frequency narrative approach around news about US 2021 deficits, the authors estimate an "inflation multiplier" of 0.18% price-level growth over two years for a deficit shock of 1% of GDP. They estimate this implies the 2021 deficits caused about 30% of the 2021–22 inflation.
Jonathon Hazell and Stephan HoblerWorking Paper
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.@JADHazell and @sj_hobler review inflation swap market reactions to the results of ‘21 Georgia Senate run-offs which allowed Democrats to pass legislation on a party-line vote. They infer that the resultant stimulus caused ~30% of 2021-22 inflation.
How much of recent inflation did deficits cause?
Core argument: The authors estimate an "inflation multiplier" of 0.18% price-level growth over two years for a 1% deficit-to-GDP shock, implying the 2021 U.S. deficits caused around 30% of 2021–22 inflation.
This paper measures the causal effect of deficits on inflation using a “high frequency narrative approach”. We identify an event that released news about the 2021 deficits in the United States—the Georgia Senate election runoff. Figure 4 graphs the results for the single event study. The figure shows a jump in inflation expectations around the election, representing the causal effect of the Georgia shock. The outcome variable is the expected increase in the price level over two years, which is calculated from the two year inflation swap, deducting the first value on January 5th. From January 5th to January 7th—as news about the Georgia election is released—the inflation swap jumps upwards. The green line is the estimate of what would have happened to inflation expectations absent the Georgia election. The difference between the blue and green lines is the causal effect of the election on inflation expectations. Excluding data after 2PM on January 6th leads to a qualitatively similar but smaller estimate of 18 basis points. We estimate an “inflation multiplier” of 0.18% price level growth over two years, for a 1% deficit-to-GDP shock. Our estimate implies that the 2021 deficits caused around 30% of the 2021-22 inflation—meaning deficits were important but not the only cause.
Takeaways by Macro Roundup® AI
The authors estimate an "inflation multiplier" of 0.18% price-level growth over two years for a 1% deficit-to-GDP shock, implying the 2021 U.S. deficits caused around 30% of 2021–22 inflation.
Using the Georgia Senate election runoff as a high-frequency narrative shock releasing news about 2021 U.S. deficits, the authors find two-year inflation expectations derived from inflation swaps jumped between January 5 and January 7.
Excluding data after 2PM on January 6 yields a qualitatively similar but smaller estimate of 18 basis points, and the authors conclude deficits were important but not the only cause of the inflation.
Related Articles:
Fiscal Influences on Inflation in OECD Countries, 2020-2022— Across 21 economies, the authors find that headline and core inflation responded positively to a measure of government spending increases scaled by pre-pandemic debt-to-GDP and average debt duration. Estimated coefficients of 0.4–0.5 suggest 40–50% of the extra spending was financed through inflation, with the rest through conventional public finance.
Fiscal Narratives for US Inflation— Fiscal theory attributes the deflation of the deep recession to a fall in real interest rates that lowered real interest costs on government debt, an effect that outweighed large deficits. The predicted deflation spiral and the hyperinflation forecast from quantitative easing both failed to materialize.
Fiscal Arithmetic and the Global Inflation Outlook— Across advanced economies, core inflation is significantly positively associated with growth in government debt since the start of the pandemic, and the authors expect this decade's fiscal expansions to shift price levels permanently higher. They argue this differs from permanently higher inflation, projecting inflation to diminish as temporary deficits normalize, with medium-term inflation expectations still anchored near central bank targets.
AI Summary.Average home prices rose from $303,600 to $422,600 and mortgage rates from 2.8% to 6.5%, doubling the average new buyer's monthly payment to $2,671 from $1,247. Housing and rental affordability indexes have been pushed to 30-year lows, and lifetime payments on an average home rise to $961,560 from $448,920.
Michael SolonWall Street Journal
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Noting that government deficits have exceeded total home sales by 16% for the 4th time in 5 years, Michael Solon argues chronic deficits, not constraints on building or the Fed, are ultimately responsible for the decline in housing affordability.
How have rising home prices and mortgage rates changed affordability?
Core argument: The average new home buyer's monthly mortgage payment has doubled to $2,671 from $1,247, as home prices rose from $303,600 in January 2021 to $422,600 and mortgage rates went from 2.8% to 6.5%.
A house that cost $303,600 in January 2021 now costs $422,600. Mortgage rates that were 2.8% are now 6.5%. Home prices 40% higher have combined with mortgage financing costs up 125% to double new home buyers’ average monthly mortgage payment, to $2,671 from $1,247. This has pushed the housing and rental affordability indexes to 30-year lows. In 2023, the federal deficit was $1.67 trillion, more than the $1.592 trillion value of all 4.09 million homes purchased at an average price of $389,300. Since 1989, the federal government has never borrowed annually more than the dollar total of sold homes except when housing sales and the economy both plunged in the subprime crisis and in three of the last four years. What does that mean to home buyers? The combined growth in average home prices and 30-year mortgage rates equals lifetime payments of $961,560 versus $448,920. That’s $512,640 more on the average home since the start of the Biden-Harris administration.
Takeaways by Macro Roundup® AI
The average new home buyer's monthly mortgage payment has doubled to $2,671 from $1,247, as home prices rose from $303,600 in January 2021 to $422,600 and mortgage rates went from 2.8% to 6.5%.
Home prices 40% higher combined with mortgage financing costs up 125% have pushed the housing and rental affordability indexes to 30-year lows.
The 2023 federal deficit of $1.67 trillion exceeded the $1.592 trillion value of all 4.09 million homes purchased at an average price of $389,300, a pattern absent since 1989 except during the subprime crisis and in three of the last four years.
Related Articles:
The Cost of Money is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly— Variation in the University of Michigan consumer sentiment index that inflation and unemployment cannot explain is strongly correlated with growth in consumer borrowing costs, such as mortgage and car loan rates. The authors estimate that including interest payments and homeownership costs in the consumer price index would raise measured inflation from 3% to 9%.
The Price of Housing in the United States— Real housing price appreciation in the United States has varied widely across regions, with West Coast cities rising earlier while prices in other regions remained comparable in real terms to decades earlier. The authors find essentially no relationship between real price growth and zoning restrictiveness in the earliest period studied, and progressively steeper gradients in later periods.
Housing and the American Worker— Wages net of housing costs were once substantially higher in high-density areas than low-density areas for workers both with and without college education, but over the past half-century that urban wage premium has persisted only for college-educated workers, not for those with a high school degree or less.
AI Summary.Across 21 economies, the authors find that headline and core inflation responded positively to a measure of government spending increases scaled by pre-pandemic debt-to-GDP and average debt duration. Estimated coefficients of 0.4–0.5 suggest 40–50% of the extra spending was financed through inflation, with the rest through conventional public finance.
Robert Barro and Francesco BianchiNational Bureau of Economic Research
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Robert Barro and @Francesco_Bia find that 40-50% of pandemic-era OECD government financing came from the effect of unexpected inflation on the real value of public debt, consistent with the fiscal theory of the price level.
How much of pandemic spending increases was financed through inflation?
Core argument: Across 21 economies—20 non-Euro-zone OECD countries and an aggregate of 17 Euro-zone countries—estimated coefficients of 0.4–0.5 link inflation to scaled government spending, suggesting 40–50% of extra spending was financed through inflation and 50–60% through conventional intertemporal public finance.
We show for a sample of 21 economies—20 non-Euro-zone OECD countries and an aggregated version of 17 Euro-zone countries—that headline and core inflation rates in 2020-2022 responded positively to a theory-motivated government-spending variable. This variable includes cumulated increases in spending-GDP ratios divided by the pre-pandemic level of the debt-to-GDP ratio and by the average duration of the outstanding debt. In contrast, across 17 Euro-zone countries, differences in the government-spending variable do not generate significant differences in inflation rates. We also find in the sample of 21 economies that, while positive and statistically significant, the coefficient that gauges the response of the inflation rate to the scaled measure of government spending is significantly less than one, the value predicted when all of the extra spending is “paid for” through surprise inflation. The point estimates of coefficients of 0.4-0.5 suggest that 40-50% of the extra spending was financed through inflation, whereas the remaining 50-60% was paid for through the more conventional method of intertemporal public finance that involves increases in current or prospective government revenue or cuts in prospective future spending.
Takeaways by Macro Roundup® AI
Across 21 economies—20 non-Euro-zone OECD countries and an aggregate of 17 Euro-zone countries—estimated coefficients of 0.4–0.5 link inflation to scaled government spending, suggesting 40–50% of extra spending was financed through inflation and 50–60% through conventional intertemporal public finance.
Headline and core inflation rates in 2020-2022 responded positively to a government-spending variable defined as cumulated increases in spending-GDP ratios divided by the pre-pandemic debt-to-GDP ratio and by the average duration of outstanding debt.
Within the 17 Euro-zone countries, differences in the government-spending variable do not generate significant differences in inflation rates, in contrast with the sample of 21 economies.
Related Articles:
What We’ve Learned About Inflation— Fiscal theory holds that a one-time $5tn fiscal expansion produces a one-time rise in the price level sufficient to inflate away $5tn of debt value, after which inflation stops even if the Federal Reserve does nothing. Raising interest rates lowers current inflation at the cost of more-persistent inflation, a beneficial smoothing.
Fiscal Arithmetic and the Global Inflation Outlook— Across advanced economies, core inflation is significantly positively associated with growth in government debt since the start of the pandemic, and the authors expect this decade's fiscal expansions to shift price levels permanently higher. They argue this differs from permanently higher inflation, projecting inflation to diminish as temporary deficits normalize, with medium-term inflation expectations still anchored near central bank targets.
When Will There Be No More Excess Savings Left?— Post-pandemic excess savings and core consumer price inflation one year later track each other closely, with inflation rising, peaking, and declining roughly a year after excess savings did. The author argues fiscal stimulus that boosted disposable income and excess savings contributed to this inflation episode, alongside monetary policy and supply chain problems.
AI Summary.Professional economists' median one-year-ahead consumer price inflation forecast has become less sensitive to actual inflation: a regression slope of 0.71 from 1949 through 1998 fell to 0.18 from 1999 onward, implying forecasts now adjust very little in response to realized inflation.
Kevin Lansing and Federico NuceraFederal Reserve Bank of San Francisco
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Looking at postwar data, researchers at @sffed find that there was a regime shift around 1999 towards well-anchored inflation expectations that were not sensitive to incoming CPI data.
Have professional inflation forecasts become less responsive to actual inflation?
Core argument: Regressions of one-year-ahead expected CPI inflation on contemporaneous four-quarter CPI inflation yield a slope of 0.71 for 1949 through 1998, implying professional forecasters' median inflation forecast adjusted nearly one-for-one with actual inflation.
Figure 1 shows that the median forecast of professional economists for one-year-ahead consumer price index (CPI) inflation has become less sensitive to actual CPI inflation. The figure shows the results of regressions measuring the strength of the relationship between one-year-ahead expected CPI inflation (vertical axis) and the contemporaneous four-quarter CPI inflation rate (horizontal axis). For the period from 1949 through the end of 1998, the blue line indicates a strong relationship with a slope of 0.71, implying that the median inflation forecast adjusts nearly one-for-one with actual inflation. The regression yields a much smaller slope of 0.18 for the period from 1999 through the second quarter of 2023 (red line), implying very little forecast adjustment in response to actual inflation.
Takeaways by Macro Roundup® AI
Regressions of one-year-ahead expected CPI inflation on contemporaneous four-quarter CPI inflation yield a slope of 0.71 for 1949 through 1998, implying professional forecasters' median inflation forecast adjusted nearly one-for-one with actual inflation.
For 1999 through the second quarter of 2023, the same regression slope falls to 0.18, implying very little adjustment in the median professional forecast in response to actual CPI inflation.
The median professional forecast of one-year-ahead CPI inflation has become less sensitive to actual CPI inflation, as shown by the decline in the regression slope between the 1949–1998 and 1999–2023 periods.
Related Articles:
What We’ve Learned About Inflation— Fiscal theory holds that a one-time $5tn fiscal expansion produces a one-time rise in the price level sufficient to inflate away $5tn of debt value, after which inflation stops even if the Federal Reserve does nothing. Raising interest rates lowers current inflation at the cost of more-persistent inflation, a beneficial smoothing.
AI Summary.The neutral real interest rate in advanced economies has fallen by about 3% over four decades to slightly above 0, a decline the authors estimate would have been roughly 1.5pp larger without fiscal policies such as higher government debt. They argue that without offsetting budget deficits, unconventional monetary policy, and structural measures, mature economies risk secular stagnation.
Larry SummersBrookings Papers on Economic Activity
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@LHSummers: The natural real rate for advanced economies has declined by ~3% over the past 40yrs, now slightly above 0 in real terms. Without offsetting policies, mature economies risk secular stagnation, necessitating greater budget deficits & unconventional monetary policies.
Has government debt kept neutral real rates from falling further?
Core argument: The neutral real rate in advanced economies has fallen by roughly 3% over the past 40 years and now sits slightly above 0 in real terms.
Over the past 40 years, the neutral real rate for advanced economies has declined by ~3%, now slightly above 0 in real terms. This decline would have been more pronounced if not for fiscal policies, such as increased government debt, which exerted ~1.5pp upward pressure on rates. The private sector neutral real rate may have dropped by up to 700 basis points since the 1970s, driven by changes in saving and investment propensities. Without offsetting policies, mature economies risk secular stagnation, necessitating greater budget deficits, unconventional monetary policies, and structural measures to maintain full employment and meet inflation targets. The current low interest rates are consistent with historical trends and the Japanese experience, suggesting a potential semi-permanent feature in the economic landscape.
Takeaways by Macro Roundup® AI
The neutral real rate in advanced economies has fallen by roughly 3% over the past 40 years and now sits slightly above 0 in real terms.
Fiscal policies including increased government debt exerted about 1.5 percentage points of upward pressure on neutral rates, and the private sector neutral real rate may have fallen by up to 700 basis points since the 1970s on shifts in saving and investment propensities.
Absent offsetting policies, mature economies risk secular stagnation, requiring larger budget deficits, unconventional monetary policies, and structural measures to sustain full employment and meet inflation targets, with low rates consistent with the Japanese experience and potentially a semi-permanent feature.
Summer is back on the secular stagnation beat his new paper finds that the neutral real rate for the advanced economies has declined by ~3% points over past 40 years, is slightly above 0 in real terms, would be even lower if not for increases in government debt
"....This paper demonstrates that neutral real interest rates would have declined by far more than what has been observed in the industrial world and would in all likelihood be significantly negative but for offsetting fiscal policies over the last generation. We start by arguing that neutral real interest rates are best estimated for the block of all industrial economies given capital mobility between them and relatively limited fluctuations in their collective current account. We show, using standard econometric procedures and looking at direct market indicators of prospective real rates, that neutral real interest rates have declined by at least 300 basis points over the last generation.....Our results suggest that real rate for the advanced economy block - what we call AE R* for brevity - declined by around 3pp over the past 40 years, and is currently only slightly above zero in real terms. This is consistent with the evidence presented above on the evolution of measures of long term real interest rates....We argue that these secular movements are in larger part a reflection of changes in saving and investment propensities rather than the safety and liquidity properties of Treasury instruments. We then point out that the movements in the neutral real rate reflect both developments in the private sector and in public policy. We highlight the levels of government debt, the extent of payas-you-go old age pensions and the insurance value of government health care programs have all ceteris paribus operated to raise neutral real rates..... Overall, then, we find that the rising government debt accounts for around 1.5pp (0.8pp+0.7pp) upwards pressure on the neutral real interest rate, consistent with our calculations based on the empirical elasticities.... Using estimates drawn from the literature, as well as two general equilibrium models emphasizing respectively lifecycle heterogeneity and idiosyncratic risks, we suggest that the “private sector neutral real rate” may have declined by as much as 700 basis points since the 1970s. Our findings support the idea that, absent offsetting policies, mature industrial economies are prone to secular stagnation. This raises profound questions about stabilization policy going forward. Achievement of levels of deficits and government debt generally considered desirable - especially if complemented by reductions in social insurance - would likely mean negative neutral real rates in the industrial world. Policymakers going forward will need to engage in some combination of greater tolerance of budget deficits, unconventional monetary policies and structural measures to promote private investment and absorb private saving if full employment is to be maintained and inflation targets are to be hit..... Our findings suggest that the private sector forces dragging down on interest rates are more powerful than previously anticipated, and that on average across the business cycle, equilibration of private-sector saving and private-sector investment may indeed require very low real rate of interest in advanced economies for years to come. This conclusion is consistent with findings of Oscar Jorda, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick and Alan Taylor (2017), who established that the current low levels of interest rates are not unusual in historical terms.9 It is also consistent with the Japanese experience.10 Our findings raise the possibility that the developed world is at risk of mirroring the experience of Japan, whereby the very low equilibrium rate of interest appears to be a semi-permanent feature of the economic landscape....We draw three main conclusions from the analysis in this paper. First, the neutral real rate for the industrial world has trended downward for the last generation and this is best understood in terms of changes in private sector saving and investment propensities. In the face of neutral real rate estimates, past trends in indexed bond yields, and measures of real swap yields, this conclusion seems inescapable. It is also noteworthy that current real rates appear to be quite well predicted by pre-financial crisis trends. We believe that the these trends are best analyzed in terms of changes in saving and investment propensities or equivalently in terms of trends in desired wealth holdings by consumers and desired capital accumulation by producers. While factors involving liquidity, scarcity and risk no doubt bear on levels of real interest rates we find it highly implausible that they are the main factor accounting for trend movements. The movements are too large and too pervasive across assets and the fluctuations in spreads are too small and lacking in trend for these factors to account for the observed trends in the data.Second, the neutral real rate would have declined substantially more over the last generation but for increases in government debt and expansions in social insurance programs. Both straightforward extrapolations of existing rules of thumb regarding debt and deficit impacts on interest rates and calculations using workhorse general equilibrium models suggest that fiscal policies have operated to raise real interest rates by several hundred basis points over the last generation. While this conclusion is dependent on our rejection of Ricardian equivalence, we see nothing that leads us to believe that increased government debt automatically calls for increased saving or that pay-as-you-go social security programs alter bequests for most families. The specific magnitudes are very uncertain, but open economy aspects and the possibility suggested by our analysis - that budget deficits emerge in response to excesses of private saving over private investment - lead us to think that we are more likely to understate than overstate the extent of fiscal support for real interest rates in recent years. Third, the implication of our analysis that but for major increases in deficits debt and social insurance neutral real rates in the industrial world would be significantly negative by as much as several hundred basis points suggests substantial grounds for concern over secular stagnation. From the perspective of our analysis the private economy is prone to being caught in an underemployment equilibrium if real interest rates cannot fall far below zero. Full employment in recent years has been achieved where it has been achieved either through large budget deficits as in the United States or Japan or large trade surpluses as in Germany. It is worth considering that in the United States during the period prior to the financial crisis, negative real short term interest rates, a huge housing bubble, erosion of credit standards and expansionary fiscal policy were only sufficient to achieve moderate growth. Adequate growth in Europe was only maintained through what in retrospect appears to have been clearly unsustainable lending to the periphery...."
