Larry Summers expects a long winter
After having been considered to head both the Federal Reserve and the Bank of Israel earlier this year, Lawrence Summers has been propelled back into the center of the broader economic dialogue with a speech at a recent IMF Economic Forum.
Essentially his argument is deceivingly simple and straight forward. The natural or neutral interest rate, which is needed to achieve full employment is below zero. Given the relationship between labor force growth and the natural rate of interest, the demographic outlook suggests that negative interest rates may be necessary for a prolonged period. Moreover, for the past 30-years, it has been arguably debt-fueled bubbles that allowed the economy to reach full employment and bolster the natural interest rate.
There is little that is new in Summers’ argument, but it has captured much territory in traditional media and the blogosphere. Economists have been fretting of a New Normal; of a new era of low growth and low interest rates since at least 2009. Many have also highlighted the economic knock-on effect of the dramatic slowing of population growth. In many ways then Summers retold an oft told narrative. However, the way he recapitulated the argument and the timing appears to have struck a responsive chord for many.
He does seem to be among the most serious economists to embrace the possibility that the advanced high income economies may need bubbles to achieve full employment. In the absence of bubbles, the natural interest rate may be negative. Arguably, after the initial recovery from the double dip recession in the early 1980s, the expansion in the latter part of Reagan’s expansion was fueled by excessive lending (and risk taking) by savings and loan banks to commercial real estate. In the late part of the 1990s, there was the so-called “tech bubble”. The 2003-2007 expansion was another bubble, with residential mortgages being the epicenter.
The rise in debt during the Great Moderation (1985-2007) did not fuel over-heated economies or inflation. Summers considers this a prima facie argument against those who maintain that monetary policy was habitually too loose. Bubblse square the circle in Summers’ narrative. With the increase in debt, interest rates would have been even lower.
His pessimism going forward draws on the work of his uncle the Nobel-prize winning economist Paul Samuelson. Summers recognizes that the natural rate of interest is roughly equal to population growth. The US labor market grew on average by about 2% annually between 1960 and 1985. It is expected to slow to 0.2% over the next decade.
A few months ago, many observers argued that Yellen was more dovish than Summers. However, Summers’ argument here that the US (and other high income economies) may need negative interest rates for much longer catapults him into a super dovish position. He says, “We may well need in the years ahead to think about how to manage an economy where the zero nominal interest rate is a chronic and systemic inhibitor of economic activity…”
Summers suggests that the normal condition of the high income countries is one of inadequate demand, from which it can only achieve some semblance of full employment when being goosed by bubbles. This is among the best that neo-liberalism has to offer. However, it stops just where it needs to begin, but that requires an ideologically difficult question: what is the source of chronic shortage of aggregate demand.
We have suggested (here and here, for example) that the heart of the problem is one of surplus capital (a 19th-century concept has fallen out of favor), which is partly expressed as redundant investment and excess capacity. The problem grows out of the success not the failure market economies. In aggregate, savings or accumulation outstrip profitable investment opportunities. At the same time, ideological constraints prevent much re-distribution and this is reflected in the record corporate profits and wages that are not keeping up with inflation.
What the financial crisis marks the end of is the Reagan-Thatcher strategy of dealing with the surplus capital. The solution that construct allowed for was the deepening and broadening of the capital markets in the Anglo-American economies to absorb the world’s excess savings. Through economic identities, this was reflected, for example, in large and persistent current account deficits in the US, UK and Australia. Yet the crisis showed the limitations on this strategy as the surplus savings overwhelmed countries ability to recycle them.
Summers’ narrative does not prelude this extension into the surplus capital direction. The return to capital, such as interest rates, is low because, as in other commodities, there is too much relative to demand. Bubbles can only arise in conditions in which capital is in surfeit.
The problem is one characterized by the congestion of capital. The main obstacle of truly addressing it is ideological. Contemporary orthodox economists cannot envisage a situation in which capital is in surplus. The dictates of market disciple deters more redistribution efforts. Wars, traditionally, get rid of capital (people too), but the destructive power that is capable of being unleashed when science is applied to warfare provides powerful disincentives to large-scale use.
This has produced a fissure between the philosophic conservatives and market fundamentalists. Conservatives, like Edmund Phelps, the Nobel Prize winning economist, are not as antithetical to a more activist state. The conditions we associate with surplus savings, and Summers with the bubbles needed to achieve full employment, has threatened to undermine what conservatives like Phelps sees as our way of life: the market and its mechanisms are means to the end, but the end is important.
Phelps explains in the speech he delivered upon receiving the Nobel Prize in economics (2006): “I have argued that…suitably designed employment subsidies would restore the bourgeois culture, revive the ethic of self-support and increase prosperity in low wage communities.”
There is similar divide that appears to be taking shape in Europe. We referred to this in yesterday’s note as aThermidor. This is a reference to the bourgeois pushing back against the extremists during the French Revolution, but also used by some historians to refer to the restoration of the southern landed elite in the US after the reconstruction that followed the Civil War.
Germany’s ordo-liberalism is threatening the bourgeois social order, as exemplified by insufferably high unemployment and the rise of extreme nationalist movements. While there may not be a coherent leftist response to the financial crisis, the split between the defenders of the bourgeois way of life and market fundamentalists, may be an under-appreciated key to policy developments in the period ahead.