Macro Roundup

late night for Larry last night. posted on his blog this AM. Summers, Larry, "On Secular Stagnation: A Response to Bernanke," Larry Summers Blog, April 1, 2015. Available at:http://larrysummers.com/2015/04/01/on-secular-stagnation-a-response-to-bernanke/"... I think that it will be hard to escape the conclusion that household debt grew at an unsustainable pace in the decade before the great financial crisis and that this was an important spur to growth. And I am fairly confident that wealth effects associated with a booming stock market were important in the late 1990s. As I discuss below, I agree with Ben that the open economy aspects are very important and that excess saving in substantial part has emanated from abroad. I have always listed reserve accumulation and foreign demand for safe assets among the major factors acting to depress real interest rates.... Particularly in the 2003-2007 period it is appropriate to regard Ben’s savings glut coming from abroad as an important impediment to demand in the United States. Ben and I are, I think, in agreement that it is important to think about the saving-investment balance not just for countries individually, but for the global economy. If there are more countries tending to have excess saving than there are tending towards excess investment, there will be a global shortage of demand. In this case countries able to devalue their currencies will benefit from generating more demand. Global mechanisms that concentrate on causing borrowing countries to adjust without seeking to shrink the surplus of surplus countries will tend to push the global economy towards contraction.....Policies that seek to stimulate demand through exchange rate changes are a zero-sum game, as demand gained in one place will be lost in another. Secular stagnation and excess foreign saving are best seen alternative ways of describing the same phenomenon..."On Secular Stagnation: A Response to Bernanke Ben Bernanke has inaugurated his blog with a set of thoughtful observations on the determinants of real interest rates (see his post here) and the secular stagnation hypothesis that I have invoked in an effort to understand recent macroeconomic developments. I agree with much of what Ben writes and would highlight in particular his recognition that the Fed is in a sense a follower rather than a leader with respect to real interest rates - since they are determined by broad factors bearing on the supply and demand for capital - and his recognition that equilibrium real rates appear to have been trending downward for quite some time. His challenges to the secular stagnation hypothesis have helped me clarify my thinking and provide an opportunity to address a number of points where I think there has been some confusion in the public debate. Is Secular Stagnation all about the Zero Lower Bound on Nominal Interest Rates? The essence of secular stagnation is a chronic excess of saving over investment. The natural question for an economist to ask is how can such a chronic excess exist in flexible markets? In particular, shouldn’t interest rates adjust to equate saving and investment at full employment? The most obvious answer is that short term interest rates can’t fall below zero (or some bound close to zero) and this inhibits full adjustment. Ben is skeptical of the importance of this factor, noting that with a 2 percent inflation target real interest rates can fall to -2 percent. True enough. But, it is at least an open question whether central banks can always be credible in claiming they will hit their inflation targets. Market measures of expected inflation suggest that throughout the industrial world inflation may well fall short of 2 percent for a decade or more. Separately, it is worth noting that there may be other reasons why interest rate adjustment to equate saving and investment at full employment does not operate smoothly. In situations where target saving is important, reductions in rates may increase rather than decrease saving, exacerbating imbalances. Further, there are reasons for concern that protracted very low rates precipitate financial instability by increasing capitalization ratios, raising the duration of assets, encouraging risk taking to chase yield and reducing the financial discipline associated with loan coupon payments. Do Real Rates below Zero Make Economic Sense? Ben suggests not- citing my uncle Paul Samuelson’s famous observation that at a permanently zero or subzero real interest rate it would make sense to invest any amount to level a hill for the resulting saving in transportation costs. Ben grudgingly acknowledges that there are many theoretical mechanisms that could give rise to zero rates. To name a few: credit markets do not work perfectly, property rights are not secure over infinite horizons, property taxes that are explicit or implicit, liquidity service yields on debt, and investors with finite horizons. To use a phrase Ben has popularized in a different context, negative real rates are phenomenon that we observe in practice if not always in theory. The paper by Hamilton, Harris, Hatzius, and West that he cites demonstrates that during the twentieth century, rates in America have been negative at least 30 percent of the time. In Germany right now, the 10-year nominal rate is 18 basis points suggesting a negative real rate, and the rate is around 60 basis points for 30 years! In Britain, yields on 50-year indexed bonds have been negative for long periods of time. Were Bubbles an important Contributor to Previous Recoveries? In support of the idea that the economy suffered from a chronic excess of saving, I have argued that the 2003-2007 recovery and quite possibly the late stages of the 1990s recovery were powered in significant part unsustainable financial conditions. Ben is skeptical, relying on the work of Hamilton et. al (2015) to note that the positive effects of the housing bubble during the previous expansion were offset by an increase in the US trade deficit, and that bubbles were only modestly relevant in the late 1990s. This issue requires much more study. I think that it will be hard to escape the conclusion that household debt grew at an unsustainable pace in the decade before the great financial crisis and that this was an important spur to growth. And I am fairly confident that wealth effects associated with a booming stock market were important in the late 1990s. As I discuss below, I agree with Ben that the open economy aspects are very important and that excess saving in substantial part has emanated from abroad. I have always listed reserve accumulation and foreign demand for safe assets among the major factors acting to depress real interest rates. How good a solution is expansionary fiscal policy? Ben accepts the logic of my argument that if reducing rates to equate saving and investment at full employment is infeasible or likely to lead to financial instability, fiscal policy in general and public investment in particular is a natural instrument to promote growth. But he expresses the concern that permanently expansionary fiscal policy may not be possible, given that the government cannot indefinitely expand its debt. This issue is worth further theoretical exploration, but I think Ben greatly understates the scope for feasible fiscal policy for reasons that Brad Delong and I have considered in our 2012 BPEA paper. Imagine a secular stagnation world with a zero real interest rate. Then, government debt service is very cheap. As long as a public investment project yields any positive return it will generate enough revenue to service the associated debt. This effect will be magnified if there are any Keynesian fiscal stimulus effects of the project or if there are any hysteresis effects. Notice that with sufficiently low real interest rates, even fiscal stimulus, which does not have supply effects, can pay for itself through mulitiplier effects. This is not just a theoretical point. The October 2014 IMF World Economic Outlook suggests that public investments in countries where interest rates are near the zero lower bound are likely to significantly reduce debt-to-gdp ratios. The case for expansionary fiscal policy in economies with very low real interest rates is of course magnified if there are reasons to doubt that the central bank can act on its own to raise inflation expectations. It may well be that in situations where the interest rates are trapped near zero - such as those prevailing in Japan and Germany - expansionary fiscal policy reduces real rates by raising inflationary expectations. What about Global Aspects? With the benefit of hindsight, I wish I had been clearer in seeking to resurrect the secular stagnation hypothesis that one should take a global perspective. Indeed, the lower level of rates, the greater tendency towards deflation, and inferior output performance in Europe and Japan suggests that the spectre of secular stagnation is greater for them than for the United States. Moreover, in a world with integrated capital markets real rates anywhere will depend on conditions everywhere. Particularly in the 2003-2007 period it is appropriate to regard Ben’s savings glut coming from abroad as an important impediment to demand in the United States. Ben and I are, I think, in agreement that it is important to think about the saving-investment balance not just for countries individually, but for the global economy. If there are more countries tending to have excess saving than there are tending towards excess investment, there will be a global shortage of demand. In this case countries able to devalue their currencies will benefit from generating more demand. Global mechanisms that concentrate on causing borrowing countries to adjust without seeking to shrink the surplus of surplus countries will tend to push the global economy towards contraction. Successful policy approaches to a global tendency towards excess saving and stagnation will involve not only stimulating public and private investment but will also involve encouraging countries with excess saving to reduce their saving or increase their investment. Policies that seek to stimulate demand through exchange rate changes are a zero-sum game, as demand gained in one place will be lost in another. Secular stagnation and excess foreign saving are best seen alternative ways of describing the same phenomenon. Final Thoughts I would like nothing better than to be wrong as Alvin Hansen was with respect to secular stagnation. It may be that growth will soon take hold in the industrial world and allow interest rates and financial conditions to normalize. If so, those like Ben who judged slow recovery to be a reflection of temporary headwinds and misguided fiscal contractions will be vindicated and fears of secular stagnation will have been misplaced. But throughout the industrial world the vast majority of the revisions in growth forecasts have been downwards for many years now. So, I continue to urge that it is worth taking seriously the possibility that we face a chronic problem of an excess of desired saving relative to investment. If this is the case, monetary policy will not be able to normalize, there will be a continuing need for expanded public and private investment, and there will be a need for global coordination to assure an adequate level of demand and its appropriate distribution. Macroeconomists can contribute by moving beyond their traditional models of business cycles to contemplate the possibility of secular stagnation.

really good Krugman on the Bernanke/Summers debate "...Bernanke correctly, I’d argue, criticizes Summers for insufficient attention to international capital flows - but then argues that once you do allow for international capital movement it obviates many of the secular stagnation concerns, which I believe is wrong....most persuasive evidence that the US may face secular stagnation comes from the lackluster recovery of 2001-2007...mother of all housing bubbles...unsustainable rise in household debt... a fairly unimpressive expansion by historical standards....seem to point to fundamental weakness in private demand. But one reason for the sluggish growth in demand for U.S.-produced goods and services was a huge trade deficit, the counterpart of huge reserve accumulation in China and other emerging markets. So Bernanke argues that what Summers sees as evidence of secular stagnation actually reflects the global savings glut....moral of the Japanese example is that if other countries are managing to achieve a moderately positive rate of inflation, but you have let yourself slip into deflation or even into “lowflation”, you can indeed manage to find yourself in secular stagnation even if the rest of the world offers positive-return investment opportunities. Which brings me to the future of the global savings glut....the case for secular stagnation in Europe is considerably stronger than it is for the U.S.. Working-age population is declining, Japan-style; the euro system, with a shared currency but no fiscal integration, arguably imparts a strong contractionary bias to fiscal policy; and core inflation is already down to just 0.6 percent.By the logic I’ve already laid out, this should imply a persistently very weak euro and a persistently large European current account surplus, as Europe in effect tries to export its secular stagnation - a process limited only by the way low inflation or deflation interact with the zero lower bound to keep interest rates from falling to their Wicksellian equilibrium rate....implies is that even if you downplay domestic U.S. weakness and focus on the export of capital from other countries, especially Germany, there’s no good reason to believe that this new version of the global savings glut will end any time soon.....Europe’s trade and capital imbalances are the result of fundamental weakness of domestic demand, which is then exported to the rest of us, who aren’t that strong either. If true, this says that we have a problem that must be solved with policies that boost demand. So on the policy debate, I come down firmly on the Summers side...." Krugman, Paul, "Liquidity Traps, Local and Global (Somewhat Wonkish),"Krugman Blog, April 1, 2015. Available at:http://krugman.blogs.nytimes.com/2015/04/01/liquidity-traps-local-and-global-somewhat-wonkish/Liquidity Traps, Local and Global (Somewhat Wonkish) April 1, 2015 Photo

If my analysis of the European problem is right, however, this is pretty much irrelevant: Europe’s trade and capital imbalances are the result of fundamental weakness of domestic demand, which is then exported to the rest of us, who aren’t that strong either. If true, this says that we have a problem that must be solved with policies that boost demand. So on the policy debate, I come down firmly on the Summers side. Mobile908.303.9747Office212.404.4646

he US and the international community should continue to oppose national policies that promote large, persistent current account surpluses and to work toward an international system that delivers better balance in trade and capital flows.

Which brings me to the policy debate. Bernanke seems to be saying that if there is a problem, it can be solved by cracking down on currency manipulation:

What this in turn implies is that even if you downplay domestic U.S. weakness and focus on the export of capital from other countries, especially Germany, there’s no good reason to believe that this new version of the global savings glut will end any time soon.

Sure enough, if we try to figure out the market’s implied prediction for the euro, it seems to imply persistent weakness. The euro/dollar rate is down around 30 percent from its level before Europe began running such large surpluses. Meanwhile, German 10-yearreal interest ratesare around -1, while U.S. real rates are slightly positive; this implies that markets expect the euro to recover only a third or so of its recent decline over the next decade.

By the logic I’ve already laid out, this should imply a persistently very weak euro and a persistently large European current account surplus, as Europe in effect tries to export its secular stagnation - a process limited only by the way low inflation or deflation interact with the zero lower bound to keep interest rates from falling to their Wicksellian equilibrium rate.

And this makes sense: the case for secular stagnation in Europe is considerably stronger than it is for the U.S.. Working-age population is declining, Japan-style; the euro system, with a shared currency but no fiscal integration, arguably imparts a strong contractionary bias to fiscal policy; and core inflation is already down to just 0.6 percent.

But look at what bond markets are saying! German interest rates - presumably an indicator of perceived euro safe rates - are negative out to seven years; the 10-year rate is only 16 basis points. This is telling us that markets expect the euro area economy to be depressed, and ECB rates very low, for many years to come. In effect, European bond markets are flashing a secular stagnation warning.

As Bernanke notes, as far as big current account surpluses go, Germany is the new China. However, he argues that the large current account surplus of the euro area as a whole is a temporary phenomenon driven by cyclical weakness in the euro periphery, and therefore not likely to be a source of persistent trouble.

Which brings me to the future of the global savings glut.

The moral of the Japanese example is that if other countries are managing to achieve a moderately positive rate of inflation, but you have let yourself slip into deflation or even into “lowflation”, you can indeed manage to find yourself in secular stagnation even if the rest of the world offers positive-return investment opportunities.

OK, it’s not full equalization. but not too far off — despite being at the zero lower bound for many years, Japan ended up offering more or less competitive real returns.

The answer is that real returns in Japan weren’t exceptionally low - they were, in fact, more or less equal to those abroad. But this equalization of real rates didn’t occur through an equalization of Wicksellian natural rates. Instead, what happened was that persistent deflation in Japan, combined with the zero lower bound, kept the actual real interest rate well above the Wicksellian rate. Here’s the data from 1996 to 2008, with inflation measured by the GDP deflator and interest rates measured by 6-month Libor:

When I first approached this issue, that’s what I thought. But I immediately ran up against a big real-world counterexample: Japan. Japan has effectively been at the zero lower bound since the 1990s, and it wasn’t until the end of 2008 that the rest of the advanced world joined it there. So why didn’t capital flood out of Japan in search of higher returns, driving the yen down and boosting Japan out of its trap?

Still, secular stagnation - as opposed to liquidity-trap analysis in general - is concerned with excess saving that lasts a very long time, that’s quasi-permanent. So in that case wouldn’t we expect capital mobility to be decisive? Shouldn’t it be impossible to have secular stagnation in just one country?

But this isn’t right if the weakness in European demand is perceived as temporary (where that could mean a number of years). For in that case the weakness of the euro will also be seen as temporary: the further it falls, the faster investors will expect it to rise back to a “normal” level in the future. And this expected appreciation back toward normality will equalize expected returns after a decline in the euro that is well short of being enough to raise the natural rate of interest all the way to its level abroad. International capital mobility makes a liquidity trap in just one country less likely, but it by no means rules that possibility out.

You might think not: as long as there are positive-return investments abroad, capital will flow out. This will drive down the value of the euro, increasing net exports, and raising the Wicksellian natural rate. So you might think that you can’t have a liquidity trap in just one country, as long as capital is mobile.

Let’s first ask whether the possibility of investing abroad obviates the problem of liquidity traps in general (as opposed to secular stagnation.) To do this, consider theanalysis I laid outa couple of months ago when I was trying to think about the dollar and U.S. recovery, but run it in reverse. Suppose that a country or currency area - let’s call it Europe — suffers a decline in aggregate demand. And suppose that this threatens to push the Wicksellian natural rate of interest - the rate of interest at which desired savings and investment would be equal at full employment — below zero. Can this happen if there are positive-return investments outside of Europe?

That’s a good point. But Bernanke then goes on, as I understand him, to argue that international capital flows should solve the problem of secular stagnation unless if affects the world as a whole, because capital can seek higher returns abroad; he also argues that the global savings glut is mainly a thing of the past, and that in any case such problems can be addressed mainly by putting pressure on foreign governments to open their capital accounts and stop pursuing policies that promote excessive current account surpluses. And in these assertions, I’d suggest, he goes somewhat astray.

Start with Bernanke’s critique of Summers. The most persuasive evidence that the US may face secular stagnation comes from the lackluster recovery of 2001-2007. We experienced the mother of all housing bubbles, fueled by a huge, unsustainable rise in household debt - yet all we got was a fairly unimpressive expansion by historical standards, and little if any inflationary overheating. This would seem to point to fundamental weakness in private demand. But one reason for the sluggish growth in demand for U.S.-produced goods and services was a huge trade deficit, the counterpart of huge reserve accumulation in China and other emerging markets. So Bernanke argues that what Summers sees as evidence of secular stagnation actually reflects the global savings glut.

As it happens, the role of capital flows in the logic of liquidity traps is an issue I tackled right at the beginning, back in 1998; and I’ve been trying to work out how it plays into the discussion of secular stagnation, which is basically the claim that countries can face very persistent, quasi-permanent liquidity traps. So I think I may have something useful to add here.

There’s been a really interesting back and forth betweenBen BernankeandLarry Summersover secular stagnation. I agree with most of what both have to say. But there’s a substantive difference in views, in which Bernanke correctly, I’d argue, criticizes Summers for insufficient attention to international capital flows - but then argues that once you do allow for international capital movement it obviates many of the secular stagnation concerns, which I believe is wrong.