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.