Larry Summers, the man who was almost chairman of the Federal Reserve, is awfully gloomy about U.S. growth prospects. In a Nov. 8 speech at the International Monetary Fund, he suggested the U.S. might be stuck in “secular stagnation”—a slump that is not a product of the business cycle but a more-or-less permanent condition. Summers’s conclusion is deeply pessimistic. If he’s right, the economy is incapable of producing full employment without financial bubbles or massive stimulus, both of which tend to end badly. The collapse of the debt-fueled housing bubble led to the crisis of 2007-09, and some policymakers worry that the Fed’s easy-money approach is setting the economy up for another fall. Witness the Dow Jones industrial average surpassing the 16,000 mark on Nov. 18.
The problem, as Summers sees it, is that the economy is being held back by what economists call the “zero lower bound”—interest rates, once cut to zero, can’t be reduced further to stimulate the economy. In a typical slump, the Federal Reserve encourages borrowing by reducing the interest rate to substantially below the rate of inflation, so people are effectively being paid to take out loans. (In econ jargon, that’s a “negative real interest rate.”) But interest rates can’t be much below inflation when the inflation rate itself is close to zero, as it is now. Summers speculates that the interest rate would need to be 2 or 3 percentage points lower than the inflation rate to get the economy going. Right now that’s impossible: The Fed’s favored short-term measure of inflation is just 1.2 percent, and the federal funds rate can’t go any lower than its current range of zero to 0.25 percent.
That, says Summers, is why the economy is stuck in a rut. “We may need to deal with a world where the zero lower bound is a chronic and systemic inhibitor.” He didn’t offer a solution in his speech, and could not be reached for an interview.
Summers, favored by many in the White House to run the Federal Reserve, withdrew from consideration in September, and now Fed Vice Chairman Janet Yellen is the nominee. While critics argued that Summers lacked the proper temperament to lead the Fed, no one has questioned his credentials as an economist. At age 28, he became one of the youngest tenured professors in Harvard University’s history on the strength of his economic research. He’s also been Treasury secretary to President Bill Clinton, president of Harvard, and director of President Obama’s National Economic Council.
Plenty of economists aren’t persuaded by Summers’s diagnosis of what ails the U.S. economy. “Instead of having more experiments with free money, let’s try the experiment of actually passing a budget. Wouldn’t that be novel?” says David Rosenberg, chief economist at Canadian investment firm Gluskin Sheff. “I fail to see how negative real interest rates are the correct prescription,” he says. “How would you ever encourage the private sector to lend money at negative interest rates?” Adds Douglas Holtz-Eakin, a former director of the Congressional Budget Office who served as John McCain’s chief economic adviser during the 2008 presidential campaign: “We’ve had four years of extraordinarily loose monetary policy without satisfactory results, and the only thing they come up with is that we need more?”
Joseph LaVorgna, chief U.S. economist for Deutsche Bank, says the economy doesn’t need extreme measures, because it’s starting to recover on its own. Pushing rates sharply negative—presumably by raising the rate of expected inflation—could rattle investors, LaVorgna says. “It could affect confidence and be a challenge to the animal spirits.” Even some liberals sympathetic to Summers’s arguments aren’t fully on board. “How sure are we that negative real rates would give us the pop we need?” asks Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities. “It’s not obvious.”
Summers has heard these arguments before. His point is that the conventional wisdom has failed—the medicine that once worked isn’t working anymore. If the economy’s “natural” interest rate is now substantially below zero, he said in the speech, “conventional macroeconomic thinking leaves us in a very serious problem.”
What are the options if Summers is right? One is to continue monetary and fiscal stimulus. But that inflates the national debt and, possibly, asset bubbles. University of Michigan economist Miles Kimball has another approach: Break the zero lower bound by placing sharply negative interest rates on deposits—i.e., charging customers for keeping money in the bank. Depositors would normally defeat this tactic by pulling their money out and keeping it in cash. So Kimball proposes devaluing cash itself by tying its value to that of money deposited in the bank. “Paper currency could still continue to exist,” Kimball writes, “but prices would be set in terms of electronic dollars (or abroad, electronic euros or yen), with paper dollars potentially being exchanged at a discount compared to electronic dollars.” In practical terms, shoppers who paid cash would be assessed a surcharge that would grow over time. The pressure on consumers to buy before their money lost value would be intense.
Money that automatically loses value might seem like an overly risky tactic—unless Summers is right that the U.S. is sinking into a Japanese-style deflationary rut. In that case, bring on those negative rates.