By Servaas Storm, Professor, Department of Economics, Faculty TPM, Delft University of Technology and co-author, with C.W. M. Naastepad, of Macroeconomics Beyond the NAIRU (Cambridge, MA: Harvard University Press), which has just won the Myrdal Prize of the European Association for Evolutionary Political Economy
The Obama administration and the mainstream media are now talking up an imminent recovery, perhaps even a modest boom. Certainly, President Obama thinks so: “We head into next year with an economy that’s stronger than it was at the start of the year,” he said during his year-end news conference. “I firmly believe that 2014 can be a breakthrough year for America.”
We’ve of course heard this many times before during the past five years — and there is no reason why we should be optimistic now. For one, Obama’s optimism stands in sharp contrast to the gloomy spectre raised by former Treasury secretary and key White House adviser Lawrence Summers in speeches made at a Brookings-Hoover conference in October, and then again at an International Monetary Fund conference in November 2013.
Mr Summers fears the U.S. has entered a period of “secular stagnation” — a notion proposed by Keynesian economist Alvin Hansen back in the 1930s to explain America’s dismal economic performance—in which sluggish growth and output, and employment levels well below potential, coincide with a problematically low (even negative) equilibrium real interest rates even in the face of extraordinarily easy monetary policy.
Summers believes that the negative equilibrium interest rate is caused by the so-called Global Savings Glut—U.S. banks are said to be flooded by the inflow of Asian capital which supposedly depresses the equilibrium interest rate.
Initially Summers left the impression that not much could be done to get the economy out of this conundrum, even — somewhat guardedly — hinting at the need for another asset price bubble to restore growth. But in a Financial Times article of January 5, he has clarified his position, arguing that secular stagnation is not inevitable and can be undone by the right policies, essentially fiscal stimulus (in the form of public investment in “green” energy and infrastructure). It is encouraging that Mr. Summers is finally coming around to the realistic view, held by many Keynesians for long, that economic recovery will not come about spontaneously, and that the greatest threat to the recovery process now is Washington’s optimism which is lulling the administration into a false sense of security and fiscal inaction.
It is no surprise that Mr Summers’ analysis has stirred up strong responses on the political right. It is easy to predict that these reactions will become even more antagonistic after his recent “coming out” on fiscal stimulus. The tenor of these responses is quite predictable: the pitiful recovery must be blamed on government failure.
One prominent supporter of this view is Stanford economist John B. Taylor, a known partisan of efficient (financial) markets who had earlier argued that the Great Financial Crisis was triggered not by the bankruptcy of Lehman Brothers, but by the Bush-Paulson-Bernanke financial sector bailout. Hence, after blaming government for the crisis, the time has now come to blame it for the poor recovery as well. In a recent Wall Street Journal article, Mr Taylor acknowledges that the recovery of the U.S. economy from the Great Financial Crisis has been very slow and protracted, when compared to earlier episodes of recovery from (financial) crises. He agrees with Mr Summers that the cause(-s) of the stagnation need to be explained, but he rejects Summers’ “Global Savings Glut” explanation.
While Mr Taylor is right in rejecting the savings glut argument, it is rather unfortunate that he does it for the wrong reasons.
Mr Taylor actually misinterprets the “Global Savings Glut” hypothesis by arguing that the view implies that there should have been slack economic conditions (stagnation) and high unemployment already in the five years before the crisis, because excess foreign savings had been flowing into the U.S. economy and its banking system on a massive scale already then.
But his claim that the boom before the crisis cannot be squared with the savings glut argument is wrong. What he fails to understand is that in the years before 2007-8, the massive inflow of foreign capital — following the logic of Wicksell’s market for loanable funds — should have shifted the upward-sloping supply schedule of loanable funds downwards, while the downward-sloping loanable funds demand schedule (reflecting investment demand) remained unchanged. The result should have been a reduction in the equilibrium real interest rate, leading to higher investment.
However, once the crisis erupted full force, the loanable fund demand schedule must have shifted downwards (as profit expectations became depressed), and this created the situation, alluded to by Mr Taylor, in which “firms need an extra-low interest rate—even a negative interest rate—to be induced to invest. With interest rates at or near zero and inflation low, it is hard to get real interest rates down enough to provide these incentives.” This is the negative equilibrium real interest rate—the culprit identified by Mr Summers.
The second line of attack of the secular-stagnation thesis is Mr Taylor’s claim, perhaps surprisingly, that there has been no global savings glut at all. “In the past decade”, writes Mr Taylor, “global savings rates fell below what they were in the 1980s and 1990s. The U.S. has been running a current account deficit, which means national saving is below investment.” Well, Mr Taylor may be right (or wrong), but he is providing no evidence at all on this point. What he seems to be saying is that there has been no savings glut in the US economy. But he seems oblivious or unaware of the fact that the US current account deficit does imply — in a national accounting sense — an inflow of (excess) foreign or global savings.
But let us be clear. All this talk about the savings glut is a mere side-show. This is not at all Mr Taylor’s main point. What he seems to dislike most about the “negative equilibrium real interest rate” argument of Mr Summers is that it is lets “government get off the hook”. Mr Taylor begs to disagree. In his view, the poor recovery is due to weak business investment which is in turn “most likely explained by policy uncertainty, increased regulation, including through the Dodd Frank and Affordable Care Act, about which there is plenty of evidence”. Mr Taylor does not feel obliged to provide his readers with any evidence. He also does not feel any need to explain how “policy uncertainty” and “increased regulation” hang together and work out separately or in tandem. More regulation would appear to suggest that there is little uncertainty about policies, or put differently: how exactly do new regulations create policy uncertainty? “Policy uncertainty” falls into the same catch-all category as “business or investor confidence”: it is fundamentally un-measurable, it sounds very serious (notwithstanding or perhaps due to its vagueness), and it is always there. It is “an explanation of last resort”: if we can’t think of any good causes and don’t want to blame it on markets, then in that case we can always blame it on government creating “policy uncertainty” which in turn is undermining business confidence. This is, clearly, “Very Serious Talk”.
What is saddening about all this, however, is not just the narrowness of the debate between Messrs’ Summers and Taylor. Both are trying to come to terms (and unsuccessfully so) with the present weak recovery from mainstream economics’ positions — and in doing so, invoke 19th century theoretical constructs, such as Wicksell’s model of a loanable funds market, which were shown to be irrelevant for contemporary monetary economies long ago. But while Mr Summers is beginning to cautiously argue in favour of (actually: much-needed) fiscal stimulus, Mr Taylor continues to claim the economist’s privilege of social irresponsibility, rejecting stimulus and at the same time pinning the failure of (financial) markets on public policy.
What remains unstated in mainstream discussions is that the slow recovery and the looming secular stagnation is characteristic of economies suffering from a balance-sheet recession, as forcefully argued by Nomura’s Richard Koo as well as by many Keynesian economists. The key point indeed is that private investment is down (as both Messrs’ Summers and Taylor acknowledge), not because of “policy uncertainty” or “increased regulation”, but because business-sector expectations about future profitability have become dramatically depressed — and rationally so — in a context characterized by heavy indebtedness (of both households and corporations) and austerity.
Let the 1930s—a period of balance-sheet recession as well—provide some perspective. Roosevelt was no socialist, but his New Deal did frighten many businesses. That effect has to have been much bigger then than anything Obama ever did. But when public investment and hence aggregate demand expanded, the economy grew anyway. Roosevelt did have a vision and he did convince the electorate about the way to go. Cheap optimism or even audacity of hope will not be enough. After all, as Francis Bacon may remind us: “Hope is a good breakfast, but it is a bad supper” (Apophthegms, 1624).