How to Pull the World Economy Out of Its Rut
Crazy things are happening in the world economy. In Europe and Japan, interest rates have turned negative, something long thought impossible. In the U.S., workers’ productivity is improving at the feeblest five-year rate since 1982. China is a confusing welter of slumping growth and asset bubbles.
Through it all, Federal Reserve Chair Janet Yellen practices the central banker’s art of draining the drama from any situation. She insists that conditions are returning to normal, albeit slowly. Her favored approach, “data dependence,” is nonpredictive and noncommittal, like finding your way in the dark by pointing a flashlight at your toes.
Lawrence Summers, the Harvard economist who almost got Yellen’s job, has no patience for such patience. Since losing out to Yellen in 2013, he’s been jetting around the world—from Santiago to St. Louis to Florence, Italy—to argue that the world economy is in much worse shape than central bankers understand. Focusing on monetary policy alone, he says, they’re doomed to fall short of reviving growth. They need to reach out to the governments they work for, he argues, and insist on strong fiscal stimulus in the form of infrastructure spending and the like. As an intellectual brawler from way back, he’s in his element.
The jury’s still out on Yellen vs. Summers. Boring does not equal wrong, and provocative does not equal right. If the U.S. economy heals nicely over the next few years under business as usual, Yellen’s incrementalism will look smart. But the longer things stay weird, the more Summers appears to be onto something.
“My sense is that if Larry’s hypothesis is true, it’s a total game changer. It will affect how we think about macroeconomic policy for the next several decades,” says Gauti Eggertsson, an Iceland native who worked in the Federal Reserve System for eight years and is now a macroeconomic theorist at Brown University. In November, after Summers presented his ideas at the Peterson Institute for International Economics, its president, Adam Posen, himself a former policymaker at the Bank of England, blogged that “all of us in the profession have a lot of work to do” to respond to the “disturbing questions” Summers raised.
For economic policymakers, the most disturbing question is why global growth remains paltry and uneven. The annual growth rate of gross domestic product in the U.S. in the January-March quarter was just 0.5 percent. The euro zone was stronger than the U.S., at 2.2 percent; Japan, which has been flipping in and out of recessions for a quarter century, shrank 1.1 percent. Deflation once seemed to be a strictly Japanese problem—now it’s a worldwide threat. Pessimism about growth prospects is reflected in low forecasts for long-term interest rates. The annual yield on German 10-year notes is only 0.13 percent.
It wasn’t obvious in the summer of 2013, when President Obama was choosing between Yellen and Summers, that Summers would turn out to have such out-of-the-box ideas. Obama said that “when it comes down to their basic philosophy on the future of the Fed,” the differences between the candidates were so small “you couldn’t slide a paper between them,” according to Democratic Senator Dick Durbin of Illinois, who attended a meeting with the president. Both were highly credentialed—she as a longtime Fed official who was a labor economist at the University of California at Berkeley’s Haas School of Business; he as Treasury secretary under Bill Clinton, former Harvard University president, and former head of Obama’s National Economic Council. If anything, Yellen seemed more likely to be an activist Fed chair and “would probably be more committed to keeping stimulus in place until the economy was definitely recovered,” Michael Feroli, chief U.S. economist at JPMorgan Chase, said at the time.
But in November 2013, after Yellen was chosen but before she replaced Ben Bernanke as chair, Summers went to the International Monetary Fund in Washington and raised the specter of “secular stagnation,” a term coined in the Great Depression by Harvard economist Alvin Hansen, who lamented “sick recoveries which die in their infancy, and depressions which feed on themselves and leave a hard and seemingly immovable form of unemployment.” “Secular” is econospeak for long-lasting, as opposed to cyclical. Hansen’s warnings about secular stagnation seemed to be disproved when U.S. growth accelerated in World War II and then remained strong after the war stimulus ended.
For Summers, bringing the idea of secular stagnation back into the academic debate was like putting on a moldy old coat from Grandpa’s attic. But revive it he did. “Now, this may all be madness, and I may not have this right at all,” he told the IMF audience, before coming around to saying, “we may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back below their potential.”
In other words, Summers claimed world economies could be so imbalanced that even zero interest rates would be too high—and for many years, not just briefly as economists had believed. The speech lit up the Twitterverse and drew heavy news coverage. Journalists’ attention has waned a bit, but Summers has kept developing the concept on his blog, in his Financial Times columns, in speeches, and in papers written with other economists, including Brown’s Eggertsson, who’s translated Summers’s thinking into the formal language of general-equilibrium economics. The real world is helping Summers’s case. The longer stagnation lasts, the more it looks secular rather than just cyclical. “I’ve come to a growing conviction” that the theory is right, he says.
To be clear, Summers is challenging much more than when and how much the Fed should raise interest rates. True, he criticized it for voting in December to lift the federal funds rate by a quarter of a percentage point after seven years at just more than zero. But that’s an ordinary argument over how high to set the monetary thermostat.
Summers’s deeper argument is that world growth is stuck in a rut because there’s a chronic shortage of demand for goods and services and a concomitant excess of desired savings. The U.S. and other industrialized nations tend to save more as their populations age, he says. Meanwhile, growing inequality puts a bigger share of the world’s income in the pockets of rich people; they can’t spend everything they make, so they save it. The investment that would ordinarily soak up those savings is falling short. That’s partly because the new economy is asset-lite: Companies such as Uber and Airbnb prosper by exploiting assets (cars and houses) that already exist. Software, which is pure information and doesn’t require the construction of factories, accounts for a bigger share of the economy. Slow growth in output and productivity reduces investment as executives lose faith in the payoff from capital spending.
Exhibit No. 1 in Summers’s case: Interest rates have been trending down for 30 years, even after taking into account the decline in inflation. The interest rate, like any price, reflects supply and demand. It’s fallen because the demand for loans is weak and the supply of loans from savers, who have extra cash to deploy, is strong. It used to be thought that interest rates couldn’t go below zero, but the Bank of Japan and the European Central Bank, among others, are so desperate to kindle growth that they’ve pushed some rates below what used to be called the “zero lower bound” into negative territory.
Despite opposing the Fed’s December hike, Summers continues to worry that an extended period of ultralow and even negative rates will cause bubbles in assets like stocks and housing, as desperate investors chase after higher returns. He says fiscal policy needs to play a much bigger role than it has. How? On the investment side, he favors government spending to fix America’s dilapidated roads and bridges, combat global warming, and improve education—big, expensive projects that would provide value while soaking up excess savings. A favorite line: “The United States right now has the lowest infrastructure investment rate that it has had since the second world war.” On the savings side, he favors, among other things, changing the tax code to get more money into the hands of lower-income and middle-class families who’d spend rather than hoard it.
This, of course, sounds a lot like the agenda Obama has been pushing unsuccessfully for the past eight years. “To me, it looks like an opinion masquerading as a theory,” Arnold Kling, a former Fed economist, wrote on his blog in 2014. Congress shows no interest in any measure that smells like fiscal stimulus—especially now, with lawmakers hiding under their desks until after the election. Summers responds that his prescription is separable from his diagnosis; conservatives might prefer to fix the problem with, say, export promotion, the elimination of wasteful regulations, and big tax cuts to induce companies to build factories.
Summers has been getting more of a hearing from central bankers around the world. His message to them: Think bigger. The Fed traditionally restricts itself to managing the “business cycle”—fluctuations of output around a supposed long-term upward trend. Summers questions the very existence of a business cycle, an inherently optimistic concept implying that what goes down must come up. When output declines, his research shows, it never quite gets back to its original trajectory. Productive capacity suffers lasting damage, in part because laid-off workers lose skills. That makes it imperative to avoid a recession whenever possible. Yet Summers says the odds of a U.S. recession in the next three years are “significantly better than 50-50.”
Lately, he’s added the idea that secular stagnation is infectious, spreading between countries by trade and investment flows. A stagnant country can try to cure its unemployment problem by pushing down the value of its currency and running a big trade surplus; that worsens unemployment in its trading partners, which suffer trade deficits, according to recent work by Eggertsson, Summers, and others. Beggar-thy-neighbor trade theory, in other words, is alive and well.
Summers argues that central bankers should stop focusing on the business cycle, stop jealously guarding their independence, and work with other institutions to solve the deep problems that have gotten the economy into this condition. “Central banks like to say … ‘Well, yeah, productivity growth’s a problem. That’s not our problem, though.’ ‘Inequality’s a problem. That’s not our problem, though,’ ” Summers said in a question-and-answer session after his Peterson talk. “I would suggest that no major central banker in the world is seriously engaged with this as an issue.”
The Federal Reserve System employs more Ph.D. economists than any other organization in the world, so it would seem to be an ideal place to bang out big ideas about secular stagnation. But Fed economists tend to focus on short-term forecasting and the mechanics of monetary policy, says Peterson’s Posen. Yellen can’t afford to indulge in blue-skying. Her most important job is to move the rate-setting Federal Open Market Committee along by baby steps, maintaining as much of a consensus as possible among hawks and doves and being careful not to surprise the financial markets. “If you’re a member of a central bank committee, let alone the chair, every word gets scrutinized,” Posen says.
On the narrow question of where rates are headed, the Fed is gradually drifting in Summers’s direction. The median projection by rate setters of where the federal funds rate will eventually settle has come down a full percentage point, to 3.25 percent, since the Fed began releasing projections in 2012. But Yellen, unlike Summers, isn’t calling on Congress to amp up stimulus. In a speech in November at the Banque de France, she said contractionary tax-and-spending policy was “hardly ideal,” but gave fiscal authorities an out by saying they had to take long-term sustainability into account.
Yellen has tiptoed around secular stagnation, referring to the theory but not endorsing it. Her right-hand man, Vice Chair Stanley Fischer, who taught Summers, Bernanke, and European Central Bank President Mario Draghi at MIT and once ran Israel’s central bank, seems more open to the idea that something fundamental has changed. Speaking to academic economists in San Francisco in January, he referred to “the secular stagnation hypothesis, forcefully put forward by Larry Summers in a number of papers.” He agreed that interest rates will likely “remain low for the policy-relevant future.” He even entertained one of Summers’s solutions for the savings/investment imbalance: government spending on long-term projects. Says Summers: “Even people who don’t like to use the term ‘secular stagnation’ are accepting new realities of excess saving relative to investment, very low rates, and chronic demand shortfall.”
One big fact is hard to square with Summers’s idea that the economy suffers from a shortfall in demand—namely, the 5 percent U.S. unemployment rate. If Americans spend a lot more, as he desires, there might not be enough workers available to handle the demand. The result could be a bidding war for talent, climbing wages, and unacceptably high inflation.
Princeton’s Alan Blinder, a former Fed vice chairman, is one of a group of economists who argue that economic stagnation emanates from weak supply, not weak demand. “When I go to sleep at night worrying about the economy, I’m never worrying that Americans won’t spend enough,” he says. Robert Gordon of Northwestern University similarly says growth is impeded by a lack of innovation—a supply-side explanation.
Summers, no surprise, has an answer to those objections. He says there may be more slack in the labor market than is sometimes recognized. And he says the demand-side and supply-side explanations for stagnation aren’t mutually exclusive: Weak demand growth can itself damage the supply side of the economy—i.e., the people and machines who make stuff. Unemployment causes workers’ skills to atrophy; companies stop investing in equipment and software.
Strengthening demand can turn that vicious circle around and gradually raise the economy’s productive potential, Summers says. Far from crowding out private investment, government spending could induce more of it.
When interest rates can go negative, all of the verities in economics are up for grabs. Economists joke that the questions on their doctoral exams haven’t changed in 50 years, but the answers have. The joke “captures a truth,” Summers says.
He seems to relish being in the midst of the upheaval. “That’s the effect of living backwards,” the White Queen told Alice in Wonderland. “It always makes one a little giddy at first.”