Macro Roundup

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.

DeLong, Brad, "Do You Really Want to Know How Ben Bernanke Thinks? Also Larry Summers and Paul Krugman," Washington Center for Equitable Growth, April 5, 2015. Available at:http://equitablegrowth.org/2015/04/05/really-want-know-ben-bernanke-thinks-also-larry-summers-paul-krugman/"....In Bernanke’s mind, when the 10-year Treasury bond rate is at the value it would have when the quantities demanded and supplied of safe-and-liquid store-of-value assets wereequal at full employment, then by logical necessity the interest-rate cannot bedistorted. The equality of the market and the natural rate of interest is, by the metaphysical necessity of the case, the true and undistorted value. The Federal Reserve onlydistortsthe capital markets when it either provides too little in the way of safe-and-liquid-store-of-value assets and allows the interest rates to rise above its natural value or provides too much and pushes the interest-rate below its natural value...."Do You Really Want to Know How Ben Bernanke Thinks? Also Larry Summers and Paul Krugman byBrad DeLongPosted on April 5, 2015 at 3:58 pm

Do you really want to know how Ben Bernanke thinks?

OK. But, remember: you asked for it!

Sub-Basic Macroeconomics

1. buy things to consume,
2. invest-that is, buy things that will boost their income in the future
3. hoard-that is, hold on to some of the cash they were paid, or park more of their wealth in something else they value not because it gives them utility or boosts their future income, but rather simply serves as a safe-and-liquid-store-of-value, so they can boost their spending above their income at some point in the future.

I think the key is that Bernanke is-or should be-claiming not that his policies had no effect, but that they had nodistortionaryeffect. He is, really, I think, claiming that his policies in fact helped un-distort an economy that had already been grossly distorted by the financial crisis.

To follow Bernanke’s thinking, start with the fact that people can do three things with their incomes. They can:

Continue with John Stuart Mill’s 1829 insight when the quantity demanded of safe-and-liquid-store-of-value assets to hoard is greater than the quantity supplied, demand for consumption goods and services and for real produced capital assets will be less than the supply. Businesses will then lose money and people will get fired. When people get fired and you lose full employment, incomes and planned spending both drop economy wide.

Let the situation stew for long enough, and eventually somebody in the private sector will probably figure out some circuitous and way to put the unemployed to work making the safe-and-liquid-store-of-value assets people want to buy to hoard. But that may take a very long time. And it takes an especially long time when nobody sane trusts the promises of anybody in the private sector that this is in fact a safe-and-liquid-store-of-value asset that you can hoard and then sleep easy on.

It is much simpler for the central bank to just expand the supply of safe-and-liquid-store-of-value assets when demand for such goes up. It can then shrink the supply back down when demand goes down. It can and does do this via database entries, instantaneously, costlessly.

But how does the central bank know whether it is feeding the private economy the right amount of safe-and-liquid-store-of-value assets? How can it know whether the supply matches the quantity that would be demanded if the economy were at full employment?

Bernanke’s Vision

Well, the way Bernanke looks at it, the central bank has to calculate what the relative price of consumption goods and services relative to real capital assets-that is, whattheinterest-rate-would be if the economy were at full employment, and the central bank were succeeding at doing its job. Then it looks to see whether the actual 10-year Treasury bond rate out there is equal to thisnaturalrate of interest.

In Bernanke’s mind, when the 10-year Treasury bond rate is at the value it would have when the quantities demanded and supplied of safe-and-liquid store-of-value assets were equal at full employment, then by logical necessity the interest-rate cannot bedistorted. The equality of the market and the natural rate of interest is, by the metaphysical necessity of the case, the true and undistorted value. The Federal Reserve onlydistortsthe capital markets when it either provides too little in the way of safe-and-liquid-store-of-value assets and allows the interest rates to rise above its natural value or provides too much and pushes the interest-rate below its natural value.

You may say that this is all very metaphysical and mystical and weird. And were you to say so, you would be right.

Summers, Bernanke, Krugman This entry was posted inFeaturedand taggedBen Bernanke, Federal Reserve, Finance, Global Imbalances, Lawrence Summers, Macroeconomics, Monetary Policy, Natural Rate of Interest, Paul Krugman, Secular Stagnation. Bookmark thepermalink.

You may say: A 10-year nominal Treasury bond rate no higher than inflation is supposed to be the current value of thenaturalinterest-rate? Good God! That is absurd! Something is wrong with our economy, and wrong at a much deeper level than a simple shortage relative to demand of the supply of safe-and-liquid-store-of-value assets that can be hoarded! It makes no sense that real capital assets must be at such a premium valuation, in order to induce wealthholders not to hoard but rather to invest in the future!

And if you were to say that, you would beLarry Summers.

You may say: In the mid-2000s, it was all because wealthholders in China had this extraordinary and not-entirely-rational demand, and today it is because wealthholders in Germany have an analogous extraordinary and not-entirely-rational demand for the safe-and-liquid-store-of-value assets by the US government.

And if you were to say that, youwouldbeBenBernanke.

And you may say: Those extraordinary foreign demands for dollar assets as safe-and-liquid-stores-of-value are, today, reflections of insane austerity and secular stagnation in Europe, and were, last decade, reflections of the global imbalances caused by China’s rapid development and potential political instability.

And if you were to say that, you would bePaul Krugman.

And, of course, all three are right.

Larry is right in that it looks like there is something deeply wrong with our economies. Ben is right in that, from the U.S. perspective, most of our difficulties are severely aggregated by capital inflows. And Paul is right that those capital inflows are not themselves the primary dysfunction we face.

It makes no sense for Bernanke to: 1. Have pounded his chest about the success of QE; 2. Now be claiming that he never had any effect at all he was just seeking the natural rate; and 3. If this IS in fact the natural rate then it makes NO SENSE to suggest Summers is wrong on secular stagnation.

A correspondent writes: