Larry Summers is out today with a new op-ed (Washington Post version | Financial Times version) following up on his earlier musings on “secular stagnation.” What’s more, he presented on this at the American Economic Association annual meeting this past weekend, and watching that presentation, I think I see what he’s getting at.
To understand it, I think you have to break things down further than he does.
But start with the idea that there’s a “natural rate of unemployment” such that when the actual unemployment rate is below this rate, you get fast-rising inflation, but when it’s higher, you don’t.We want to achieve full employment, which is to say an unemployment rate that’s right around the natural rate. During the pre-crisis years we left achieving that primarily in the hands of the Federal Reserve, which manipulated interest rates to keep joblessness in check. The “equilibrium interest rate” is the interest rate the Fed needs to achieve to push unemployment down to its natural rate.
That equilibrium rate is currently very low. Some interest rates are currently negative in inflation-adjusted terms and have been for some time. And yet apparently we would need even lower rates to achieve full employment. Summers’ contention is that if you keep interest rates that low for a long time—he specifically mentions the idea of interest rates that are lower than the growth rate of the economy—you generate unsustainable credit booms and asset price bubbles. Some people use that kind of worry that monetary stimulus generates financial instability to argue for tighter money and learning to live with mass unemployment. Summers’ view is that we shouldn’t do that, that we should instead use massive deficit-financed government spending programs to reduce the unemployment rate and increase the equilibrium interest rate to a sustainable level.
Now an interesting wrinkle in this is that Summers, coming very much from the political center, seems to have rederived the left-wing “post-Keynesian” view of how the economy works. Summers’ new position has traditionally appealed to left-wing people since it implies that the state rather than the market needs to direct the bulk of investment activity in the economy (indeed, this is where Keynes ends Chapter 12 of his General Theory). Post-Keynesians also often deploy this logic to argue that the kind of budget policies Summers pursued during the Clinton administration destroyed the economy—balanced budgets and surpluses could only be managed by creating an unsustainable debt boom. It would be fascinating to see Summers engage more with the longstanding heterodox literature on these themes now that his thinking has evolved.
On the flip side I think that both market monetarists like Scott Sumner and conventional new Keynesians like Michael Woodford would say that Summers has the interest rate mechanism wrong. It’s not that monetary stimulus would push interest rates even lower and thus drive investment activity up. Rather, the idea is that monetary stimulus would raise expectations about the future level of nominal income. Those higher expectations would drive more investment activity, which would push interest rates up over time.
My dream would be to tell you that the Abenomics experiment in Japan can answer this question for us—have interest rates on Japanese Government Bonds gone up or down in response to monetary stimulus? The answer, unfortunately, is that they went up then down then up then down then up again to net out at about no change. Macroeconomics, once again, isn’t quite giving us a rich enough data set to conclusively demonstrate who’s right.