On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation

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...."

Łukasz Rachel and Lawrence Summers, "On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation,"Brookings Papers on Economic Activity, March 6, 2019, https://www.brookings.edu/wp-content/uploads/2019/03/On-Falling-Neutral-Real-Rates-Fiscal-Policy-and-the-Risk-of-Secular-Stagnation.pdf