By Mario Seccareccia, Professor of Economics, University of Ottawa
Over a week ago Lawrence Summers stunned the world of economics by the remarks he made at the IMF‘s 14th Annual Research Conference on the Economic Crisis, where he pronounced the dreaded “SS” words: “secular stagnation”. His comments seem to have shocked much of the mainstream that still believes that the economy will return to the pre-2008 potential growth. Indeed, he surprised many by stating that, after effectively preventing the complete collapse of the financial system in 2008 through the government bailout and liquidity measures undertaken by the US Fed, there is still no real evidence that there will be a restoration of “normal” growth and that the “new normal” may well be secular stagnation. According to Summers, the principal culprit is the simple fact that nominal interest rates cannot fall below zero and that this zero lower bound will remain “a chronic and systemic inhibitor” of growth. While agreeing that Western economies are headed towards long-term stagnation, in this commentary I would like to question the analysis of the cause of this problem, as well as the solution being offered to address it.
In listening to his speech, it is obvious how many economists, including not only Summers but also Paul Krugman, are still wedded to variants of the now not-so-new “New Consensus” framework that was so popular among economists before the financial crisis. Being in some ways a natural extension of the original Hicksian IS-LM model along the lines, for instance that David Romer reformulated over a decade ago, the New Consensus macro model of the economy suggested that the economy can get temporarily stuck in some sort of “liquidity trap”, a concept that Keynes never really made much of. One must say that the notion that the economy can remain trapped in a stagnant state because interest rates cannot fall below zero is hardly a new idea. Readers well versed in the history of economic thought would know that there had been much debate over this issue, especially during the 1940s, after the publication of Keynes’s General Theory.
The problem raised by Summers is perhaps best described in a famous article published in the American Economic Review by Don Patinkin in 1948 in which he adopted the old Wicksellian loanable funds model with the usual depiction of the neoclassical Investment/Saving relations. In this account, the investment relation is presumed downward sloping and the saving relation is upward sloping vis-à-vis the rate of interest. Patinkin pointed out that, in times of crisis, these investment/saving curves could cross only at negative interest rates. However, because of the zero lower bound in the nominal interest rate, the economy would find itself stuck in a non-market-clearing disequilibrium state, dubbed a liquidity trap. However, unlike Patinkin who sought a solution in terms of the workings of the real balance (or “Pigou”) effect, in which flexible wages and prices eventually generate deflation, which then shifts the saving function in such a way that eliminates the disequilibrium gap (as real balances rise), no one nowadays believes in the significance of the real balance effect in a world of an essentially endogenous “inside” money to which the New Consensus model formally subscribes. In terms of Patinkin’s vocabulary, “inside” money is simply private money that is created within the commercial banking system and appears in the economy in the form of bank (deposit) liability, while “outside” money was government money, that is to say, central bank-issued money, constituting the country’s monetary base. As Michal Kalecki had noted also in the 1940s, without the assumption of significant “outside” money, the real balance effect cannot work, leaving supporters of the New Consensus nothing to resort to that could bring the system back to “normal” growth.
Hence, the explanation offered by Summers, Krugman et al., is nothing more than what neoclassical economists were saying over half a century ago: because of the crisis, the expectations-determined Wicksellian “natural” rate remains persistently negative, but the money rate has a zero lower bound, which implies that the economy remains stuck in a Patinkinesque disequilibrium state. Indeed, one wonders what the controversy is really all about since, except for the use of the “secular stagnation” words, which, by the way, had been used by Great Depression economists, such as Alvin Hansen during the late 1930s, there is nothing new that Summers is saying. This is all déjà vu not only from before the financial crisis, but actually ever since the 1940s! Our economics profession appears to be stuck in a time warp or has succumbed to some sort of collective amnesia by continuing to repeat the same old controversies!
Within this neoclassical theoretical box, there is only one solution offered to move the economy out of secular stagnation. One must boost the Wicksellian “natural rate” by strengthening expectations of return. More precisely, the solution offered by both Summers and Krugman is to promote asset bubbles. Hence, instead of aborting the bubble that will ineluctably end in a crisis, we are told that we should be sustaining these bubbles and keeping them aloft. It is truly ironic that, while these economists would probably never recommend wage inflation (because it would supposedly cause unemployment), they have no problem in promoting sustained asset price inflation that would redistribute wealth towards those who already own too much of it! But even if one wanted seriously to contemplate this proposal, regardless of its equity considerations, how would you do it? Monetary policy has already been doing all that it can to sustain asset inflation via reducing interest rates and keeping them extremely low, and, as Summers and his allies recognize, the monetary authorities are constrained by the zero lower bound.
If this liquidity trap is really a problem and if they wish to be consistent with their loanable funds theory and remove the disequilibrium gap, why does the central bank not pay a premium to any bona fide borrower at banking institutions so that the effective real borrowing rates become negative even with a positive inflation rate? Instead of charging positive interest rates, borrowers would be receiving an interest transfer for borrowing until the bank rate reaches or falls even below the negative real natural rate. Such a policy of negative real interest rates would certainly be consistent with their hybrid Wicksellian framework and this type of policy could well trigger an asset bubble. However, in reality, instead of being a monetary policy, this would actually turn out to be a very peculiar, and rather perverse, type of fiscal policy measure. Surely one could think of much better measures than subsidizing across-the-board bank borrowing just because it would be consistent with their theory.
As I have argued elsewhere, if Summers et al., are really worried about secular stagnation and truly want to kick-start the economy, what is needed is an expansionary Keynesian fiscal policy of massive public investment, not as a temporary measure (as partly happened during the financial crisis with the disjointed implementation of fiscal stimulus packages internationally), but as a long-term measure that would sustain aggregate demand in the long term. This measure will support not only employment growth in more well-paying and highly skilled jobs, but also long-term productivity growth, thereby encouraging private investment as well. To a large extent, this is what happened during the early postwar period that produced a virtuous cycle of growth, now remembered as the “Golden Age” of western capitalism. Instead of secular stagnation, with the precise political commitment and policy mix in favor of activist fiscal policy cum public investment, we could actually be looking forward to a world of strong expansion and a truly full employment environment that had largely characterized much of the early postwar era.
It is time to abandon that outmoded New Consensus model that seems to be keeping even some of the brightest in the profession stuck in an intellectual cul-de-sac. The real inhibitor of growth is not the zero lower bound, but the lack of desire to venture outside the neoclassical box. This lack of desire to pursue new fiscal policy measures that would commit government to long-term spending and full employment is not because the latter is not a viable alternative, but perhaps because, as Kalecki had long surmised also in the 1940s, it is the political fears of the wealthy who would benefit from asset booms that overrides good common sense and prevents the enhancement of the welfare of the majority who, under the existing policies, are faced with the continued spectre of long-term austerity and secular stagnation.
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Hansen, A. (1939), “Economic Progress and Declining Population Growth.” American Economic Review, 29, no. 1(March), pp. 1- 15.
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Krugman, P. (2013), “Secular Stagnation, Coalmines, Bubbles, and Larry Summers.” New York Times, (Novemeber 16); http://krugman.blogs.nytimes.com/2013/11/16/secular-stagnation-coalmines-bubbles-and-larry-summers/?_r=0
Patinkin, D. (1948), “Price Flexibility and Full Employment.” American Economic Review, 38, no. 3 (September), pp. 543-64.
Romer, D. (2000), “Keynesian Macroeconomics without the LM Curve.” Journal of Economic Perspectives, 14, no. 2 (Spring), pp. 149-69.
Seccareccia, M. (2011-12), “The Role of Public Investment as Principal Macroeconomic Tool to Promote Long-Term Growth: Keynes’s Legacy.” International Journal of Political Economy, 40, no. 4 (Winter), pp. 62-82.
Summers, L. (2013), Speech delivered at the 14th Annual IMF Research Conference: “Crises Yesterday and Today.” International Monetary Fund, (November 8); http://www.youtube.com/watch?v=KYpVzBbQIX0&feature=youtu.be