ByGreg Ip
- Larry Summers, left, and Ben Bernanke wait for President Barack Obama to speak in 2009. As they spar over “secular stagnation,” Greg Ip’s take is that Mr. Bernanke has theory on his side, while Mr. Summers has the evidence.
- ALEX WONG/GETTY IMAGES
For more than a year, Mr. Summers has advanced the theory that “secular stagnation” is to blame: a chronic shortfall in demand. Mr. Bernanke disagrees, blaming a combination of cyclical and special factors.
They both make persuasive (and entertaining) cases. My read is that Mr. Bernanke has theory on his side, while Mr. Summers has the evidence.
While there’s no single definition of secular stagnation, most economists would agree it includes some combination of low growth, low inflation and low interest rates lasting more than a few years. The real interest rate (the nominal rate minus inflation) is key. It acts as a price that rises and falls as needed to balance the supply of savings with the demand for savings, i.e., investment. If saving is high or investment is low, the “equilibrium” real rate will be depressed.
Indeed, in Mr. Summers’s telling, the real rate needed to balance desired saving and investment may actually be negative. And since, in theory, interest rates can’t go below zero, there’s a limit to how negative real rates can be. Most central banks probably can’t achieve that limit, except at the risk of fueling dangerous financial bubbles.
“As Larry’s uncle Paul Samuelson taught me in graduate school at MIT, if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades. It’s therefore questionable that the economy’s equilibrium real rate can really be negative for an extended period.”
This makes airtight intuitive sense. Think of a stock that pays a dividend of 5% per year. As interest rates fall below 5%, that stream of dividends becomes ever more valuable, so the stock price rises. As the interest rate falls to zero, the value of the stock goes to infinity. When the interest rate turns negative, the equation becomes, well, nonsensical.
Mr. Summers’s response is rather powerful. Paraphrasing Mr. Bernanke’s aphorism that quantitative easing (buying bonds with newly printed money) works in practice but not in theory, he says:
“Negative real rates are phenomenon that we observe in practice if not always in theory. The paper by Hamilton, Harris, Hatzius, and West that he cites demonstrates that during the twentieth century, rates in America have been negative at least 30 percent of the time.”
How could rates be negative in practice if they can’t be negative in theory? As both Mr. Bernanke and Mr. Summers agree, when the fact the central bank’s interest rate, or the “risk-free” rate on government bonds, is negative, private borrowers will still often pay a positive rate. That is certainly the case for most borrowers today, though not for the highest-rated corporations. Moreover, when investors are considering what projects to back, they may demand an even higher hurdle, especially if they expect the project’s profits to grow quite slowly in a stagnant economy.
There’s another reason: Mr. Bernanke agrees real rates can be negative temporarily, but not permanently. But secular need not mean permanent. It could mean 10 to 15 years. And while in Summers’s formulation secular stagnation requires real rates to be quite negative, in practice, the condition seems to describe many situations where real rates are merely quite low.
Both of these conditions describe Japan since the late 1990s. Before long they could describe the U.S. and Europe. For example, if the Fed raises interest rates to 3% and then stops because any higher would tip the economy back into recession, that would suggest there was still something fundamentally wrong with the U.S. economy, even though real rates would be positive.
That brings us to the next argument. Mr. Bernanke faults Mr. Summers for downplaying the international dimension. If there were a dearth of profitable investment opportunities in the U.S., then the surplus of savings should go abroad in search of better opportunities overseas. No single country would face an abnormally low real rate so long as capital could move easily across borders. Mr. Bernanke thinks the weak recovery of 2002-06, which Mr. Summers sees as evidence of secular stagnation, was actually due to a “global saving glut” as China and other countries with large trade surpluses saved more than they invested and exported the rest to the U.S. The shortfall in U.S. growth wasn’t due to a shortage of investment, but the fact that imports were displacing domestic production. China’s current account surplus glut has since shrunk, while Europe’s has grown. But Mr. Bernanke considers that a cyclical, temporary problem.
Paul Krugman weighs in and asks, if Mr. Bernanke is right that open capital markets mean an investment shortfall in one country shouldn’t depress real rates, why didn’t it work for Japan? And his answer is that it sort of did. Interest rates were of course rock-bottom in Japan. But because of deflation, real rates were higher—only a bit below those in the U.S. So like Mr. Summers, he sees Japan’s problem, and that of Europe and the U.S. today, as inadequate demand, largely because the central bank can’t make interest rates negative enough.
I think Mr. Bernanke underplays that fact. Most major developed countries exhibit symptoms of secular stagnation. Growth and real interest rates are weak everywhere. Capital mobility is doing its job, depressing real returns across borders. Besides the savings-investment imbalance, there’s another factor here that Mr. Bernanke and Mr. Summers ignore: monetary policy itself.
Something else I think is missing from Mr. Summers’s and Mr. Krugman’s version is any role for the supply side of the economy. Mr. Bernanke himself says “the secular stagnation story is about inadequate aggregate demand, not aggregate supply.” Yet many of the symptoms of secular stagnation are consistent with not just weak demand, but weak supply—that is, slower growing labor, productivity or both.
There is little dispute that population growth has slowed in both rich and emerging economies. This depresses growth directly by reducing the supply of workers and, indirectly, by depressing investment because a smaller workforce needs less machinery and other equipment. It also depresses demand insofar as retirees consume fewer durable goods, and aging workers save more for retirement. (I suppose one could call this a demand, not supply, side effect.)
Productivity growth has also slowed in most countries. This is partly the dampening effects of the financial crisis on capital spending. Those will eventually fade. But part of it also reflects less innovation. Firms may be investing less because they see fewer payoffs to new technology. These, and other factors such as education attainment no longer increasing, are advanced by Robert Gordon to explain why growth is so slow now, and likely to remain that way.
In the end, all these theories are probably part of the story. Secular stagnation is not so much a disease as a syndrome with no single cause.
Related reading:
Larry Summers to Ben Bernanke: I Hope You’re Right, But…
How Far Below Zero Can Interest Rates Go?
Negative Interest Rates Yield Positive Results—So Far
Hard Decisions on Easy Money
The Fed Turns Gloomier on the Supply Side
A British Lesson on Boosting the Supply Side
