Low Equilibrium Real Rates, Financial Crisis, and Secular Stagnation

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CHAPTER 2

     Low Equilibrium Real Rates,
     Financial Crisis, and Secular
     Stagnation
     Lawrence H. Summers

    T
             he past decade has been a tumultuous one for the US economy,
             characterized by the buildup of huge excesses in financial markets
             during the 2001–2007 period; the Great Recession and its contain-
     ment; and, finally, a recovery that has been very slow by historical stan-
     dards and insufficient to bring the economy back even close to the levels
     of output that were anticipated before the recession. The containment of
     the Recession was no easy feat, since economic conditions initially looked
     worse than in the early months of the Great Depression. However, the
     economy is still struggling five years later, and the correct diagnosis of its
     ailment is requisite for applying the appropriate treatment going forward.
        Hence, in this paper I will therefore discuss what I label the new sec-
     ular stagnation hypothesis. This hypothesis asserts that the economy as
     currently structured is not capable of achieving satisfactory growth and
     stable financial conditions simultaneously. The zero lower bound on
     base nominal interest rates, in conjunction with low inflation, makes the
     achievement of sufficient demand to bring about full employment prob-
     lematic. If and when ways can be found to generate sufficient demand,
     they will likely be associated with unsustainable financial conditions.
     Secular stagnation was first suggested by Alvin Hansen in the late 1930s,1
     but did not prove relevant given the rise in demand due to World War II
     and the massive pent-up demand for consumer and investment goods
     after the war. The difficulty that the US economy has had for many
     years in simultaneously achieving full employment, strong growth, and

        I am indebted to Simon Hilpert for extensive and excellent assistance in turn-
     ing my conference presentation into the current paper.
        1. Alvin H. Hansen, “Economic Progress and Declining Population Growth,”
     American Economic Review 29, no. 1 (1939): 1–15.

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
38                                                           Lawrence H. SummerS

     financial stability suggests that secular stagnation should be considered
     anew. Moreover, the problems of achieving sufficient demand appear to
     be even more serious in Europe and Japan than in the United States. I
     will argue that secular stagnation is a scenario supported by both theory
     and evidence, and therefore is an important contingency to be ensured
     against. I will also discuss the policy approaches that could raise demand
     and thus help avoid stagnation woes.

     Economic facts and a hypothesis
     Any explanation of US economic developments in the years leading up to
     the Great Recession of 2007–2008, and the five years since, has to grap-
     ple with two important facts. First, prior to the crisis, the economy grew
     only at a moderate rate and did not overheat. The unemployment rate
     stayed above 4 percent and did not plummet to historic depths (figure 2.1).
     Similarly, capital utilization did not rise to historically unusual levels
     (figure 2.2) and there were no reports of significant shortages in labor
     markets. This is remarkable, since multiple factors combined to substan-
     tially boost aggregate demand: monetary policy kept interest rates low,
     the absence of effective action by financial regulatory authorities and a
     breakdown of risk controls brought about excessive leverage in the finan-
     cial sector, and the housing markets were characterized by the presence
     of large and manifestly unsustainable asset bubbles.
         Second, even after the financial system was repaired, the real economy
     did not pick up, and growth remained sluggish. The LIBOR OIS spread
     (London Interbank Offered Rate, Overnight Indexed Swap), a proxy
     for financial distress, was reduced to regular pre-crisis levels by 2009
     (figure 2.3); credit default swaps on major financial institutions, which
     measure the costs of insuring against a default, quickly normalized (fig-
     ure 2.4); and taxpayer funds outstanding to major financial institutions
     were largely repaid by the end of 2010 (figure 2.5). All three factors reflect
     the swift and successful containment of the crisis and a substantial nor-
     malization of conditions in the financial sector. Nonetheless, the broader
     economy has not returned to normal—the recovery has only kept up with
     population growth and normal productivity growth, but it has not pro-
     duced the catch-up growth required to reach the economy’s potential.
     Figure 2.6 shows the path of actual GDP (gross domestic product) and
     potential GDP as predicted in 2007. With GDP growth limited since the
     aftermath of the crisis, there has been almost no gain in output relative

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
Low Equilibrium Real Rates, Financial Crisis, and Secular Stagnation                       39

     12.0

     10.0

      8.0

      6.0

      4.0

      2.0

      0.0
         ch 8
         ay 1
          ly 4
         pt 7
         ov 0
        Ja 963

         ch 7
         ay 0
          ly 3
         pt 6
         ov 9

     M n1 2
         ch 6
         ay 9
       Ju 992

         pt 5
         ov 8

     M n2 1
         ch 5

               11
         ay 8
          ly 1
      ar 94
      M 195
       Ju 95
      Se 195
      N 196

      ar 96
      M 197
       Ju 97
      Se 197
      N 197

        Ja 98
      ar 98
      M 198

      Se 199
      N 199

        Ja 00
      ar 00
      M 200
       Ju 201
             20
     M n1

             1

             1
     M n1

             1

             1

             1

             2
          ly
        Ja

     FIGURE 2.1 Civilian unemployment rate
     Source: US Department of Labor, Bureau of Labor Statistics

     95.0

     90.0

     85.0

     80.0

     75.0

     70.0

     65.0
       ril 67
        ly 9
       ct 1
      Ja 973

       ril 6
        ly 8
       ct 0
      Ja 982

       ril 85
        ly 7
       ct 9
      Ja 991

       ril 94
        ly 6
       ct 8
      Ja 000

       ril 03
        ly 5
       ct 7
      Ja 009
       ril 12
             12
     Ju 96
     O 197

    Ap 197

     Ju 197
     O 98

     Ju 98
     O 198

     Ju 99
     O 199

     Ju 00
     O 200
    Ap 19

    Ap 19

    Ap 19

    Ap 20

    Ap 20
           20
           1

           1

           1
           1

           1

           1

           1

           2

           2

           2
         n

         n

         n

         n

         n

         n
      Ja

     FIGURE 2.2 Total capital utilization
     Source: Board of Governors of the Federal Reserve System

     to the previously predicted potential. In the labor market, very limited
     progress in restoring the employment ratio (share of the adult popula-
     tion that is working) to pre-crisis levels has been made (figure 2.7), even
     adjusting for demographic changes (figure 2.8).
         The sluggishness of the recovery is counterintuitive on the theory that
     the root cause of the output downturn was the financial breakdown in the
     fall of 2008. As an analogy, consider episodes characterized by a telephone

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
40                                                                 Lawrence H. SummerS

          4

      3.5                 3m LIBOR-OIS spread

                          1m LIBOR-OIS spread
          3

      2.5

          2

      1.5

          1

      0.5

          0
                                                  6

                                                                      9

                                                                             0

                                                                                   1

                                                                                                3
                 2

                        3

                                 4

                                        5

                                                         7

                                                               8

                                                                                          2
                                                /0

                                                                    /0

                                                                           /1

                                                                                 /1

                                                                                              /1
               /0

                      /0

                               /0

                                      /0

                                                       /0

                                                             /0

                                                                                        /1
                                            /4

                                                                   /4

                                                                          /4

                                                                                 /4

                                                                                              /4
              /4

                     /4

                              /4

                                     /4

                                                      /4

                                                             /4

                                                                                       /4
                                            12

                                                                   12

                                                                          12

                                                                               12

                                                                                            12
              12

                     12

                             12

                                   12

                                                      12

                                                           12

                                                                                       12
     –0.5

     FIGURE 2.3 LIBOR-OIS spread
     Source: Bloomberg

     connection problem, a power failure, or a breakdown of the transporta-
     tion system. While GDP would plummet during such episodes, after tele-
     phone connectivity was restored, power turned back on, or transportation
     restarted, we would expect the path of GDP to return to normal. For a
     time, GDP would be above normal as inventories were replenished and
     people caught up with the spending they were unable to do during the
     period of failure. However, this has not proved the case for the “financial
     power failure” of 2007–2008: now that the central connections have been
     repaired, there has been no sign of catch-up, abnormally rapid growth,
     or a closing of slack.
        The point here may be put starkly. It has been over fifteen years since
     the US economy achieved satisfactory and sustainable growth. The Great
     Recession of 2007–2008 and subsequent slow recovery followed the
     2003–2007 period, which was characterized by bubbles in the financial
     markets. Before that was the 2001 recession, which was preceded by the
     Internet bubble.
        In Japan, it has been a generation since growth approached the 3 per-
     cent level that was thought of as a conservative estimate of its potential
Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
4000

      3500                                                                        JPMorgan Chase
                                                                                  Goldman Sachs
                                                                                  Bank of America
      3000
                                                                                  Morgan Stanley
                                                                                  Citigroup
      2500                                                                        AIG
                                                                                  Wells Fargo
                                                                                  GE Capital
      2000

      1500

      1000

                 500

                                 0
                                                                                                05

                                                                                                                                 10

                                                                                                                                       11
                                         02

                                                         03

                                                                                                       06

                                                                                                                                                   13
                                 01

                                                                                        04

                                                                                                                          09

                                                                                                                                             12
                                                                                                             07

                                                                                                                    08
                                                                                               3/

                                                                                                                               3/

                                                                                                                                      3/
                                        3/

                                              3/

                                                                                                      3/

                                                                                                                                                  3/
                      3/

                                                                                     3/

                                                                                                                         3/

                                                                                                                                            3/
                                                                                                            3/

                                                                                                                  3/
                                                                                              8/

                                                                                                                               8/

                                                                                                                                      8/
                                      8/

                                              8/

                                                                                                     8/

                                                                                                                                                  8/
         8/

                                                                                    8/

                                                                                                                         8/

                                                                                                                                            8/
                                                                                                            8/

                                                                                                                  8/

     FIGURE 2.4 CDS spreads (bp) on major financial institutions
     Source: Bloomberg. Eight largest holding companies as of December 31, 2013
     https://www.ffiec.gov/nicpubweb/nicweb/top50form.aspx.

                                 $300
                                               EESA becomes law on Oct. 3, 2008

                                 $250
     Dollar Amounts (Billions)

                                 $200

                                 $150

                                 $100

                                  $50

                                     $0
                                      2008                                         2009             2010         2011         2012         2013         2014

     FIGURE 2.5 TARP repayment
     Source: US Department of the Treasury, TARP Tracker

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
22000.0

                              Actual GDP
                              Potential GDP, 2007 Estimate
     20000.0                  Potential GDP, 2013 Estimate

     18000.0

     16000.0

     14000.0
                                           Q1

                                                                                Q1

                                                                                      20 1
                                                                                           Q1
            Q1

                                   Q1
                    Q1

                                                          Q1
                           Q1

                                                  Q1

                                                                 Q1

                                                                         Q1

                                                                                           Q
                                         11

                                                                              16

                                                                                        17

                                                                                        18
            07

                                 10
                  08

                                                        13
                         09

                                                12

                                                               14

                                                                       15
                                       20

                                                                             20

                                                                                    20
         20

                               20
                 20

                                                      20
                        20

                                              20

                                                             20

                                                                     20

     FIGURE 2.6 Output gap (billions, 2013 USD)
     Source: Congressional Budget Office

     66.0

     64.0

     62.0

     60.0

     58.0

     56.0

     54.0
        ch 7
        ov 0
        ch 8
        ay 1
         ly 4
        pt 7

    M n1 3

        ay 0
      Ju 973

        pt 6
        ov 9

    M n1 2
        ch 6
        ay 9
      Ju 992

        pt 5
        ov 8
       Ja 001
        ch 5
        ay 8
         ly 1
              11
     ar 96
     N 196
     ar 94
     M 195
      Ju 95
     Se 195

       Ja 96

     M 197

     Se 197
     N 197

       Ja 98
     ar 98
     M 198

     Se 199
     N 199

     ar 00
     M 200
      Ju 201
            20
    M n1

            1

            1

            1

            1

            1

            2
    M n2
         ly

         ly
       Ja

     FIGURE 2.7 Civilian employment ratio
     Source: US Department of Labor, Bureau of Labor Statistics

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
Low Equilibrium Real Rates, Financial Crisis, and Secular Stagnation                       43

      96.0

      94.0

      92.0

      90.0

      88.0

      86.0

      84.0

      82.0

      80.0
               55

       Ja 58
       Ja 6 1
       Ja 6 4
       Ja 67
       Ja 7 0
       Ja 973
       Ja 7 6

       Ja 79
       Ja 982
       Ja 985
       Ja 8 8
       Ja 9 1
       Ja 994
       Ja 9 7
       Ja 00
       Ja 03
       Ja 06
       Ja 009
              12
            19

            19
            19
            19
            19
            19

            19
            19

            19
            19

            19
            20
            20
            20

            20
            1

            1
            1

            1

            2
      n

         n
         n
         n
         n
         n
         n
         n
         n

         n
         n
         n
         n
         n
         n
          n
          n
         n
         n
         n
    Ja

       Ja

     FIGURE 2.8 Employment ratio for men ages 25–54
     Source: Organisation for Economic Co-Operation and Development

     throughout the 1980s. And the European economy, like the American
     economy, had unsustainable finance in the pre-2008 period and has had
     manifestly unsatisfactory growth in output and employment since that
     time (figure 2.9).
         Modern macroeconomics in either its New Keynesian or New Classi-
     cal version cannot provide a satisfactory account of this situation. First,
     it is a premise of standard formulations of both schools of thought that
     fluctuations are cyclical around a path of what is labeled as normal or
     trend or potential GDP, so that shortfalls of output in one period are on
     average matched by excesses of output in another. In New Classical mod-
     els, the fluctuations are frequently seen as optimal responses to changing
     economic conditions. In New Keynesian models, fluctuations are treated
     as undesirable, but policy can only aspire to reduce the variance of output
     over time, not to raise its average level. Clearly, what is required to account
     for the experience of recent years in the industrialized world is a theory of
     why output is continually depressed relative to potential for a protracted
     period. Models that see stabilization policy as an exercise in minimizing
     the amplitude of fluctuations around a given mean have little to contribute
     to explaining a prolonged period of stagnation a fortiori, as do models
     which presume the optimality of outcomes.
         Second, models in the dominant macroeconomic traditions attribute
     adverse outcomes to some form of wage or price rigidity. In recent years,
     the industrial world has been below target inflation despite depressed

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44                                                                                                            Lawrence H. SummerS

      6                                                                                                              6

      4                                                                                                              4

      2                                                                                                              2

      0                                                                                                              0
          1999
                 2000
                        2001
                               2002
                                      2003
                                             2004
                                                    2005
                                                           2006
                                                                  2007
                                                                         2008
                                                                                2009
                                                                                       2010
                                                                                              2011
                                                                                                     2012
                                                                                                            2013
                                                                                                                             Average

     –2
                                                                                                                         United States
     –4                                                                                                                  Euro Area
                                                                                                                         Japan
     –6

     FIGURE 2.9 Economic growth in the US, Euro Area, and Japan
     Note: The Euro Area contains the fifteen OECD countries that are members of the euro area
     (Austria, Belgium, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,
     Netherlands, Portugal, Spain, Slovak Republic, Slovenia).
     Source: OECD Economic Outlook 2013 (projections for 2013).

     levels of output and employment. Greater flexibility of wages and prices
     would have exacerbated the situation both by further reducing inflation
     and by raising real interest rates—thereby depressing output. So, if any-
     thing, in the current context wage and price rigidity are sources of stability
     rather than fluctuation.

     The secular stagnation hypothesis
     The tentative hypothesis of secular stagnation provides an explanation
     for the growth patterns just described. Suppose that structural changes in
     the US and global economy led to a substantial increase in the propen-
     sity to save and a substantial reduction in the propensity to spend and
     invest. Then, the real interest rate as the price on saving is supposed to
     fall until supply and demand equilibrate. However, short-term safe inter-
     est rates cannot fall below zero because people would substitute holding
     currency for holding debt instruments that pay a negative yield. Since
     instruments that carry risk have a spread beyond safe instruments and
     since longer-duration debt has higher yields than shorter-duration debt,
     a zero bound on safe government short-term rates implies a lower bound,
     albeit above zero, on a broad range of other interest rates that are relevant
     for firms’ and households’ decisions.

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
Low Equilibrium Real Rates, Financial Crisis, and Secular Stagnation                       45

        With a lower bound on nominal interest rates, savings and investment
     cannot be equated by the price channel and hence must be equated by
     a reduction in output. This view explains both facts: if equilibrium real
     interest rates were low or negative, then the economy would fail to over-
     heat or contain significant slack prior to the downturn even with artifi-
     cially inflated demand. Also, if equilibrium real interest rates were not
     attainable following the crisis, then full employment would not material-
     ize even after the financial system was repaired.
        Elsewhere I have presented2 a variety of reasons for believing that the
     equilibrium real interest rates have fallen. These include (1) decreasing
     population growth and possibly declining technological change; (2) an
     increase in the tendency to save associated with changes in the income
     distribution, with more income being retained by corporations, going to
     owners of capital, and going to those with higher incomes and presumably
     low propensity to consume; (3) a reduction in the demand for invest-
     ment associated with technological changes that reduce the level of capital
     investment necessary to carry out a given quantum of economic activity;
     and (4) the accumulation of substantial holdings of liquid government
     debt by emerging market central banks.

     Responding to secular stagnation doubts
     Concerns about the possibility of secular stagnation have profound policy
     implications. Before analyzing candidate policy responses, two substantial
     doubts about the accuracy of the secular stagnation diagnosis need to be
     addressed.
         First, is growth about to accelerate in the United States and much of
     the industrialized world? After all, fears of secular stagnation when raised
     in the 1930s were proven wrong. If acceleration is imminent, there is lit-
     tle need for great alarm about secular stagnation. Some recent economic
     indicators—like the strength of the stock markets and the end of the sharp
     fiscal contraction—provide grounds for optimism. However, consensus
     forecasts have predicted that escape velocity would be around the cor-
     ner for several years, but have been belied by lingering stagnation. Addi-

         2. Lawrence H. Summers, “U.S. Economic Prospects: Secular Stagnation, Hys-
     teresis, and the Zero Lower Bound,” keynote address at the National Association
     for Business Economics conference, February 24, 2014; forthcoming in Business
     Economics (2014).

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
46                                                           Lawrence H. SummerS

     tionally, Japan failed to achieve its predicted escape velocity in the 1990s,
     despite implementing a zero interest rates following its financial crisis in
     the late 1980s; now, Japan has a level of output only a little more than half
     of what was forecast twenty years ago. Moreover, even if the economy
     accelerates, this provides no assurance that prolonged growth at regu-
     lar real interest rates is possible. Across the industrial world, inflation is
     below target levels and shows no sign of picking up—a strong suggestion
     of a chronic and substantial shortfall in demand.
         Second, and related, why should we believe that the economy will not
     return to normal levels of output and capacity without additional uncon-
     ventional policy? Have real interest rates really declined so substantially
     that the zero bound is much more relevant than in the past? As just noted,
     there are a range of factors that would suggest substantial declines in equi-
     librium real interest rates.
         Beyond these theoretical factors, empirical evidence also indicates
     a reduction in the real rate of interest. The interest rate on Treasury
     Inflation-Protected Securities (TIPS), which is a measure of the real inter-
     est rate, has been declining since mid-2007, with the exception of a single
     spike in early 2009. Figure 2.10 shows the interest rates on five-, ten-,
     twenty-, and thirty-year TIPS. The five- and ten-year real interest rates
     have been negative for substantial periods between 2011 and 2013, with the
     five-year rate dropping to as low as –1.67 percent in September 2012. Even
     the twenty-year TIPS rate dropped into negative territory for a prolonged
     period in the latter half of 2012.
         A related analysis has been performed by Thomas Laubach and
     John C. Williams,3 who seek to determine the equilibrium real interest
     rate for the US economy by using sophisticated statistical techniques to
     estimate the real interest rate necessary for demand and potential supply
     to be equated. Their calculations (depicted in figure 2.11) suggest that
     equilibrium real rates are now negative and have been trending downward
     for a long time.
         Both the abundance of theoretical reasons for a decrease in demand
     and the available empirical evidence thus indicate that the US economy is
     plausibly incapable of generating demand sufficient to exhaust potential
     output, corroborating secular stagnation concerns.

        3. Thomas Laubach and John C. Williams, “Measuring the Natural Rate of
     Interest,” Review of Economics and Statistics 85, no. 4 (November 2003): 1063–1070.

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
5

                      5-Year
  4                   10-Year
                      20-Year
                      30-Year
  3

  2

  1

  0
 1/2/03             1/2/04   1/2/05   1/2/06   1/2/07   1/2/08   1/2/09   1/2/10   1/2/11   1/2/12   1/2/13   1/2/14

 –1

 –2

      FIGURE 2.10 Real interest rates as measured by returns on
      Treasury Inflation-Protected Securities (TIPS).
      Source: Board of Governors of the Federal Reserve System

                6

                4
      Percent

                2

                0

                1960q1            1970q1           1980q1           1990q1          2000q1           2010q1
                                                                 Date

      FIGURE 2.11 Estimate for the real interest rate by Laubach and
      Williams (2003)
      Source: Updated estimates from John Williams’s home page, http://www.frbsf.org
      /economic-research/economists/john-williams/.

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
48                                                           Lawrence H. SummerS

     Policy prescriptions
     Given the concern that demand is constrained by the lower bound on the
     nominal interest rate, there are three potential policy approaches. The first
     and least satisfactory is passivity. Perhaps the situation will right itself or
     policies that promise an increased emphasis on long-run macroeconomic
     rectitude will improve matters. But there is little evidence anywhere in
     the industrialized world that such policies in the face of liquidity trap
     conditions are availing. Early work suggesting the efficacy of fiscal con-
     solidations in stimulating economic activity has been convincingly dis-
     credited by research at the International Monetary Fund (IMF) and in
     other places.4
         The second alternative is to use monetary policy to engineer lower
     real interest rates consistent with the zero lower bound on the nominal
     interest rate. This involves keeping the federal funds rate near zero and
     taking unconventional monetary policy actions that aim aggressively at
     reducing risk and term premiums, so that the economically important
     risky or longer-term interest rates can be reduced. This strategy is more
     attractive than doing nothing, but has multiple problematic aspects. First,
     it is questionable whether investments that are not attractive at already
     negative real interest rates, but only get implemented when real interest
     rates fall even further, will be productive. Second, these new and uncon-
     ventional policies create uncertainty, as markets puzzle about the strategy
     of winding down quantitative easing and about the effect of forward guid-
     ance on investors’ beliefs. Third, as Jeremy Stein5 and others have pointed
     out, reducing interest rates through unconventional monetary policy

         4. See, for instance, IMF, “Will It Hurt? Macroeconomic Effects of Fiscal Con-
     solidation,” chapter 3 of the IMF’s October 2010 “World Economic Outlook”;
     Jaime Guajardo, Daniel Leigh, and Andrea Pescatori, “Expansionary Austerity:
     New International Evidence,” IMF Working Paper WP/11/158 (2011); Christina
     D. Romer and David H. Romer, “The Macroeconomic Effects of Tax Changes:
     Estimates Based on a New Measure of Fiscal Shocks,” American Economic Review
     100 (2010): 763–801; and Alan J. Auerbach and Yuriy Gorodnichenko, “Measuring
     the Output Responses to Fiscal Policy,” American Economic Journal: Economic
     Policy 4, no. 2 (2012): 1–27.
         5. Jeremy C. Stein, “Overheating in Credit Markets: Origins, Measurement,
     and Policy Responses,” speech at the “Restoring Household Financial Stability
     after the Great Recession: Why Household Balance Sheets Matter” research sym-
     posium sponsored by the Federal Reserve Bank of St. Louis, St. Louis, Missouri,
     February 7, 2013.

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
Low Equilibrium Real Rates, Financial Crisis, and Secular Stagnation                       49

     leads investors to increase risk-taking and leverage, thus raising the like-
     lihood of bubbles. The argument that macroprudential policies can be
     used to contain such financial excesses is a chimera—unconventional
     monetary policy stimulates the economy precisely by increasing asset
     values and the ability to borrow, which prudential regulation aims to
     address. In addition, macroprudential policies rely on the ability of regu-
     latory agencies to spot and curb bubbles—the same regulators who were
     unable to discern that Lehman Brothers, Wachovia, Washington Mutual,
     and Bear Stearns were undercapitalized even a week before they failed.
     Regulatory approaches that do not require regulators to be able to out-
     guess markets are preferable. These include sharp increases in capital and
     liquidity requirements and the provision of swift and forceful resolution
     authority. Finally, there are distributional concerns: policy measures that
     drive down interest rates to inflate asset values benefit those who hold the
     assets, which are disproportionately the wealthy.
         The third and most promising policy option is to spur spending at
     every possible level of the real interest rate. The most direct way to do
     this is through fiscal policy action. Consider infrastructure investments,
     which not only increase productivity and thereby raise GDP, but also
     stimulate demand in an economy that is demand-constrained. As such,
     fixing John F. Kennedy International Airport in an environment with a
     construction unemployment rate in the double digits by issuing long-term
     debt at very low interest rates should be highly attractive.
         When the growth rate exceeds the interest rate, which will likely be
     the case for a long time for short-term debt, the debt-to-GDP ratio will
     decline if the government issues debt and rolls over the debt to cover
     interest payments. Elsewhere, I have demonstrated6 that in the model of
     the US economy used for the forecasting and analysis of monetary policy
     at the Federal Reserve Board, a five-year fiscal impulse in the context
     of a nominal short-term interest rate at the zero lower bound leads to a
     lower debt-to-GDP ratio in twenty-five years. The model (1) assumes that
     government expenses do not contribute to utility or productivity—they
     are simply goods that are produced and contribute to GDP, but then are
     thrown into the ocean; and (2) does not take into account public debt at
     the local and state levels. Both are model simplifications that understate
     the real-world effect of expansionary fiscal policy on GDP growth, so that

         6. Lawrence Summers and David Reifschneider, ongoing analysis for speech
     at National Association for Business Economics, 2014.

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
50                                                           Lawrence H. SummerS

     the future debt-to-GDP ratio would likely be even lower than the model
     predicts.
        But public investment is just one way to boost demand. There are
     ample opportunities to improve the efficiency of regulation in ways that
     would stimulate demand, particularly in the energy sector. One example
     in the United States would be to allow exports of fossil fuels. In general,
     a concerted effort to promote competitiveness to increase net exports
     would raise demand in a single nation without the need to lower interest
     rates. However, such a strategy would not work for the world as a whole.
     Finally, long-run supply-side fundamentals such as policy measures that
     ensure the sustainability of entitlement programs, provide for tax reform,
     and facilitate investments in labor force skills and innovation can contrib-
     ute to confidence and thereby boost demand in the short term.

     Conclusion
     Economic developments over the past decade raise concerns about sec-
     ular stagnation. In a sufficiently low inflation environment, it may be
     impossible to attain real interest rates consistent with full employment.
     Even if it is possible, monetary policy actions that keep short-term nomi-
     nal interest rates near zero by reducing term and risk premiums raise the
     likelihood of financial excesses and future crises. However, secular stagna-
     tion is not inevitable. We can ensure both adequate economic growth and
     financial stability with the right policy choice: a commitment to structural
     increases in demand. Embracing this objective will require a sea change
     in contemporary economic thinking.

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
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