When distinguished economists come close to defending asset price bubbles, something has gone badly wrong. Larry Summers, for example, overestimates the power of monetary policy and underestimates the importance of economic trends.
In a November talk, the former U.S. Treasury secretary discussed the possibility that the United States had entered into a period of secular stagnation. In doing so, he revived a phrase first coined in the 1930s by the American economist Alvin Hansen, who thought massive government spending was the only way to end years of low output and high unemployment.
Summers’ suggested cure is aggressive monetary policy designed to keep real interest rates negative for many years. While he recognised that sub-zero real borrowing costs encourage financial booms, he did not sound worried about them, or about the subsequent busts. Rather, he criticised post-crisis policies which have led to “less lending, borrowing and inflated asset prices than there was before”.
Summers’ recommendations have inspired enthusiastic commentary from experts who think of themselves as heirs to John Maynard Keynes. They are being hasty.
There’s no doubt that Hansen was wrong: stagnation ended shortly after he wrote. The reversal started with the most destructive war in world history and was followed by decades of steady and rapid increases in prosperity in the United States, Europe and Japan. But it is not clear what ended the malaise. Possible answers include war-related demand in the United States, post-war reconstruction elsewhere, new technologies, a baby boom, renewed animal spirits, sage monetary policy and appropriate government spending.
The secular stagnation thesis made a small and brief comeback in the 1970s, when inflation and unemployment rates were high and growth rates slowing. The economy then improved, but there is no agreement on what went right. While financial types credit central banks for cracking down on inflation, there are other plausible catalysts: the recovery from the first energy price shock, a big crop of male and female baby boomers entering the workforce and the first stirrings of the computer productivity revolution.
Now, after five years of tepid recovery it is once again time to talk about stagnation. But what exactly is going wrong?
For Summers, as for Hansen, the problem is fundamentally financial: spending is inadequate. Summers mentioned only financial cures: bigger fiscal deficits and more aggressive central banks. In effect, he is calling for more of policies which have been tried for the past five years, with little obvious good effect. He could be right, but probably isn’t. To start, Summers underestimates the evils wrought by financial booms and busts. They distort investment, drain confidence and spawn destabilising debts. Though the financial system needs help, Summers’ aid could do more harm than good.
But the bigger problem with Summers’ prescription is that this stagnation could be genuinely secular. In that case, loose monetary policy and financial excesses only delayed the inevitable arrival of slow GDP growth and high unemployment. The financial crisis was a match lit in a field of gunpowder.
The most notable secular force is demographic. GDP growth inevitably slows as the post-War baby boomers leave the workforce and are replaced by a much smaller crop. Also, the big gains may well have been harvested from the post-Communist recoveries, the unification of Europe and the rise of low cost Asian manufacturing.
Governments haven’t helped. They often skimped on investment while splurging on pension promises and healthcare. Protective labour laws tended to prevent job creation. And deregulation encouraged a productivity-sapping boom-bust cycle.
Summers has done the world a service by introducing the old and relevant idea of secular stagnation into the debate. He would have been even more helpful if he had set the debate off in a more helpful direction.
If stagnation really is secular, the first priorities should be to squeeze more jobs out of slower-growing GDP. That probably requires greater government subsidies for hiring. There is also a financial need to align government budgets, national balance sheets and financial systems with the reality of a duller future. That probably requires politicians to break some big promises, and debts to be written down.
It might also be possible to increase the GDP growth rate by investing more sensibly in infrastructure and new technology. But Summers’ proposed solution of just throwing more money around looks like a move in the wrong direction.