In November, former Treasury secretary Larry Summers took the podium at the International Monetary Fund's annual conference and delivered a speech that shook the economics world. The weak recovery, he hypothesized, isn't just the hangover from the financial crisis. It's evidence of a sickness that predated the crisis. Looking back over the last decade, he argued that the economy, even in the seemingly good times, has been incapable of creating enough demand absent bubbles or extraordinary stimulus. And that problem is getting worse by the day.
In this interview, Summers lays out his concerns in more detail -- and suggests three paths we might take to restoring economic balance. The transcript has been edited for length and clarity.
Ezra Klein: Let’s start at the beginning. What does “secular stagnation” mean?
Larry Summers: Secular stagnation refers to the idea that the normal, self-restorative properties of the economy might not be sufficient to allow sustained full employment along with financial stability without extraordinary expansionary policies. The idea was put forth first by Alvin Hansen in the late 1930s. Given the Second World War and the tremendous pent-up demand for consumer and investment goods after the war, it did not prove relevant. But the difficulty our economy has had for many years now in maintaining simultaneously full employment, strong growth and financial stability makes me wonder about its current relevance. So does the rather dismal growth performance in recent years of the remainder of the industrial world.
EK: How do you measure that? That is to say, how do you distinguish an economy that can’t generate enough demand from one that simply hasn’t generated enough demand quite yet?
LS: No one can be sure. I've spoken of secular stagnation as a contingency that has to be planned for rather than a certainty that has to be assumed. No one would be more pleased than I if the economy suddenly hit escape velocity and grew at four percent for the next several years while remaining stable financially. We are now 10 percent below where we thought the economy would be now in 2007, as the economy has performed surprisingly poorly in the past four years. There's been close to no progress in regaining potential measured relative to the judgments made at the time in 2007. There's been only very, very limited progress -- even adjusting for demography -- in restoring the fraction of the adult population that is working (the employment ratio to previous levels).
One of the reasons for my concern was that before the financial crisis, when we had the mother of all bubbles in the housing market, that was enough to propel growth to perhaps adequate levels, but not enough to produce any kind of overheating as measured by wage and price inflation or as measured by unemployment relative to traditional low points. Imagine the economy between 2003 and 2007 without the consequences of housing bubbles and overly easy credit. Housing investment would have been two to three percent of GDP lower, and consumption expenditure would have been considerably lower, as well, resulting in very inadequate performance.
EK: Do you see this as an American problem or a global one?
LS: The question of secular stagnation is probably best thought in a global context as a problem of the industrial world. There is very little evidence of latent economic energy in either Europe or in Japan. So there's almost no chance that the industrial world is, over the next five to 10 years, likely to get back to the levels of output relative to potential and employment that one would've assumed and forecast five years ago. It's interesting to note that the United States is probably further below its economic potential as projected five or six years ago than Japan was five or six years into its period of malaise. Part of the reason for secular stagnation on a global basis is the emergence of countries that engage in large-scale reserve accumulation in order to maintain exchange rates that are consistent with large trade surpluses that reduce demand in the rest of the global economy.
EK: If this is a problem that reaches back into the pre-crisis period, when do you see it as starting?
LS: I don't think it's easy to know. I’m fairly confident that it was present in the middle of the last decade because I don’t see how growth would have been adequate if either tighter monetary policy or much stronger regulatory policy had cut off the housing boom and reduction in credit standards. The problem likely goes back further. We had a fairly slow recovery from the 2001 recession. And, certainly, unsustainable stock market valuations, especially in technology, contributed to the strong recovery in the late 1990s. A number of scholars have estimated what they think of as neutral real interest rates. There are many methodological issues, but the general finding is that they have been declining for the last two decades.
In addition to the empirical observation that real interest rates over both the short and long term have declined substantially and the calculations suggesting that neutral real rates have declined, there are good reasons to expect that equilibrium real rates should have declined and stay low enough to be a cause for concern.
First, slower population growth and possibly slower growth in underlying productivity should reduce real interest rates.
Second, as I mentioned, an increase in demand for safe liquid assets coming from massive reserve accumulation in the developing world should reduce real rates and suck demand out of the industrial world.
Third, increases in inequality and in the share of income coming in the form of profits and retained earnings should operate to raise global saving and reduce real rates. As a rough estimate, the share of U.S. GDP going as wages to the bottom 99 percent of the population has fallen by about 10 points over the last 15 years. If one assumes that this group saves only 2 or 3 percent of their income and that the top 1 percent and the recipients of profit income (often pension funds with automatic reinvestment) save at a 20 percent rate, this alone would raise the over all saving rate by perhaps 2 percent GDP at a given interest rate.
Fourth, the nature of technology and production has changed. It used to take large sums to start a company. Now many are started with less than $1 million. It used to be that cutting-edge technology companies like the automobile companies 75 years ago were large absorbers of cash. Now our most dynamic technology companies like Apple and Google have more cash than they are able to deploy. Or to take a final example, considerable success in energy efficiency means that as a country we need far less utility investment than we once did. All of this is relevant to why companies have so much cash on their balance sheets and, so, interest rates are so low.
Fifth, reductions in inflation means that real rates have to be lower to achieve any given after-tax real rate. So, for example, if the inflation rate was 3 percent and the nominal interest rate was 5 percent, an individual in the 40 percent bracket would have a 0 percent real after tax borrowing cost and the pre-tax real rate would 2 percent. Now imagine a 1 percent inflation world. The same zero after-tax real rate would require a 1.67 percent real rate implying a pre-tax real rate of -.33 percent.
Sixth, to the extent that in the aftermath of the financial crisis there is more burden placed on financial intermediation, more uncertainty and fear for a sustained period, this will operate to reduce demand and neutral real rates.
EK: So one interpretation of this is that the economy can’t generate even sufficient demand without bubbles. The interpretation you take, though, is that it requires an extended period of expansionary policy that, in a more normal kind of economy, would be unwise. What makes you confident that policy can correct the problem?
LS: First, I never intended to suggest, and I don't think I did suggest, that it should be the objective of policy to create bubbles. It does stand to reason that in a world where natural interest rates are lower there will be a greater tendency towards bubbles. Whenever you have interest rates lower than growth rates it’s easy to make ponzi schemes of various kinds work. When investors can make only very low returns being prudent they become less prudent. So an environment of secular stagnation is likely to be bubble-prone, but that isn’t the something to be welcomed or sought after.
But if you believe that demand is constrained by the lower bound on interest rates, there is, as a matter of logic, three ways of proceeding. One is to do nothing and wait for supply to fall back to demand through hysteresis effects. We have tragically done this in the United States. Already the potential of the economy has been marked down by about $800 billion a year, or nearly $10,000 per family of four, as a consequence of the Great Recession. That seems the worst strategy.
The second strategy is to try to relax constraints on interest rates either by finding ways of literally reducing the zero lower bound or by reducing risk premiums so that even if the short-term Treasury rate is constrained from falling by the zero lower bound, other interest rates and capital costs are enabled to fall.
That strategy must be better than doing nothing, but it's not so attractive. First, there are the questions of just how productive will be the investments that are not attractive at a negative real rate but only become attractive at a more negative real rate, and how much incremental investment will be stimulated. Most observers think quantitative easing has run into diminishing returns.
Second, there is the question of financial stability. As Fed governor Jeremy Stein, among many others, has pointed out, lower real and nominal rates achieved either through quantitative easing or forward guidance raise the risk of bubbles as investors increase their risk-taking and the attractiveness of leverage is increased. I have been disturbed in recent months by anecdotal evidence of a return to covenant lite lending. Some hold out the prospect that macroprudential policies can contain all this. I’m skeptical. To an important extent, macroprudential policies, if they work, undo the stimulus that comes from easier money. Moreover, I am much more comfortable with regulatory approaches like sharp increases in capital and liquidity requirements and resolution authority that do not presume the ability to outguess markets than I am with the ability of regulators who could not discern that Bear or Lehman or Wachovia or Washington Mutual were undercapitalized even a week before they failed to spot and curb bubbles.
Third, there are fairness issues. A strategy of driving down discount rates to inflate asset values benefits those who hold assets — very disproportionately the wealthy.
EK: That second strategy is pretty much what the Fed has been doing, correct?
LS: Exactly, yes. I am not being critical of the Fed here. There orientation to doing what they can to increase demand has in my view been entirely appropriate, and the economy would be in much worse shape without their efforts. But I am convinced it would be still better to raise demand in the economy in ways that do not work through reduced interest rates but operate at any given level of rates.
This is the third and, in my view, best way of responding to stagnation concerns. Consider my favorite example: debt-financed infrastructure spending. Notice several things: First, when your growth rate exceeds your interest rate -- which is surely going to be true for a long time for short-term debt -- then you can issue debt, roll over the debt to cover interest and still have a declining debt-to-GDP ratio. Further, debt-financed infrastructure increases GDP by increasing productivity, which makes us wealthier and stimulates demand in an economy that is demand-constrained. Finally, if we fix Kennedy airport today, we don’t need to fix it tomorrow. If the concern is the obligation placed on future generations, then our accounting leads us seriously astray if it teaches us to fret over the Treasury debt that will be left behind but not the deferred maintenance liability that will be left behind.
To put the point a different way. If government is going to issue more short-term debt, what it should do with the proceeds? Is it best to buy back long-term bonds where the government is borrowing on behalf of the public at record low interest rates? This is what quantitative easing does. Or is it better to invest the proceeds in real assets that will increase the economy’s capacity and diminish the need for future government investments.
I’ve emphasized infrastructure because that is probably where the most can be invested. But there are other areas, as well. I am confident that reversing the cutbacks we have made in biomedical research in recent years would pay for itself through the demand stimulus effects and through the savings in health care costs that would ultimately result.
More generally, public investment is not the only way to increase demand. There are ample opportunities, particularly in the energy sector, to improve the efficiency of regulation in ways that would stimulate demand. Allowing the export of fossil fuels is one example. And a concerted effort to promote net exports would also raise demand in the United States without the need to reduce interest rates.
EK: What would convince you that you’re wrong here and there is no secular stagnation -- just an extended hangover from a financial crisis and a period of bad economic luck mixed with bad economic policy?
LS: It’s a very fair question. I think we would have more intelligent economic debates if all participants were asked to state what could happen that would cause them to modify their views.
I think there are at least three ways these views could prove wrong. One, we could be much less demand-constrained than I supposed. If that were the case, we'd start to see evidence of bottlenecks and inflation increasing. Then the Fed would come under pressure to raise interest rates, and the zero lower bound, which is important for secular stagnation arguments, would go back to being a theoretical curiousity.
Second, if there were to be evidence that expansionary policies produced adverse confidence affects that diminished or reversed their impact on demand either because people worried about future burdens or because of their impacts on markets. If we started to see persistent sequences where the pattern was long-term interest rate up, stock market down, dollar down, then I’d become more anxious that policy uncertainty was undermining market confidence in ways that might hurt demand. This is the kind of concern that Bob Rubin has long had. It is a matter of judgment. Paul Krugman has argued that countries with floating exchange rates and debt denominated in domestic currency are essentially immune from confidence crises as a matter of economic logic. I would not go nearly that far, but I do not see any evidence of confidence effects from our current or foreseeable fiscal policies holding the U.S. economy back.
Third, if over the next few years as fiscal contraction ends, the economy grows rapidly stably and sustainably and returns to previous output and employment trends without the emergence of bubbles, my current alarm will in retrospect have been excessive. This is the outcome I would like best.
How many Obama administration officials can you find in this picture? (AP Photo/Doug Mills)
EK: Some of these arguments seem to be in tension with your support for Rubinomics in the Clinton era and for a smaller-than-needed stimulus in 2009. These days you seem a lot less worried about the deficit.
LS: It’s a question I am often asked. Conditions in 1993 were very different than they are now. Real interest rates and capital costs were quite high, and the global economy was strong, and U.S. debt ratios were expected to grow rapidly over the ensuing decade. So there was every reason to think it was a time to reload the fiscal cannon and rely on monetary policy to offset any possible contractionary effects. This is what happened, and the country enjoyed a period of investment-led growth. At the time, Japan’s situation was in many ways like ours is now, and we urged that they make aggressive use of fiscal policy.
My consistent advice in 2009 and 2010 when I advised President Obama was that there was essentially no risk of overdoing fiscal expansion given the magnitude of the downturn. I joked often that the question of how much fiscal expansion would be too much was like the question of how much weight loss would be too much for me, highly hypothetical given what was likely to happen. There were political constraints that limited the Administration’s proposals relative to what most of us on the economic team preferred, and even what was proposed was significantly cutback in the legislative process.
Certainly, though, the experience and the economic analysis of the last few years has led me to a much greater appreciation of how the zero lower bound on interest rates strengthens the case for expansionary fiscal policy than I had in 2008. As Keynes famously said when accused of inconsistency: “When I get new information, I change my mind — and you?”
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