Larry Summers' blog

Case Still Out on Whether Corporate Short-Termism Is a Problem

02/09/2017

 

McKinsey has a new study out on an important topic—the question of whether corporations systematically take too short a view and do not invest enough for the long term.  If true — as many CEOs believe — this is a serious indictment of current corporate governance arrangements and has important policy implications.  To take one close to my heart, if short termism causes under investment it will be a cause of secular stagnation.

I am not sure what to believe in this area.  On the one hand, there are many anecdotes suggesting that pressures to manage earnings hold back investment.  And the short termism view is very widely believed.

On the other hand, some of what is done in the name of long term may be unmonitored waste.  The observation that many “unicorn” companies with no profits, and sometimes no revenues or even fully developed products, get valued so highly makes me skeptical of the idea that the capital market is systematically myopic.  It is also the case that the companies generating the highest immediate cash flows — which should be overvalued on the myopia theory — historically have had the highest stock market returns, implying undervaluation rather than overvaluation.

I was therefore excited to see that McKinsey had a new empirical study out that provides evidence in favor of the view that corporations should take longer views.  They have a reasonable methodology.  They divide their sample between companies that take a long-term view and those that do not and then compare their performance.  They find that companies that take a long-term view perform better on many metrics like employment growth and shareholder return.

Their findings deserve much discussion, debate and attempts at replication.  At this point though I would give a Scottish verdict of “not proven” to their case.  They may be right but I do not think they have provided evidence that would convince anyone other than a prior believer.

Consider an analogy. It is doubtless the case that golfers with long swings like Phil Mickelson hit the ball further and more accurately than golfers with short swings like myself.  An index of swing length would be highly correlated with almost any measure of golf performance.  Does this mean I should lengthen my swing?  I doubt it.  Those with more flexibility and coordination are able to take and control longer swings and play golf better.  If I were to try to swing like Phil, I would mishit the ball and maybe break my back.

Some companies have great ideas, great management teams, and compelling strategies.  They invest heavily, seek to grow revenue, ignore the management of earnings, and do limited stock buybacks.  These are the criteria McKinsey uses to measure long termism.  Others lack vision and have mediocre management.  They invest less, cut costs more, manage earnings and buy back stock.  McKinsey deems them short term focused.

No surprise the long-term companies outperform the short-term companies.  But this may be due to their vision and execution capacity not their long-term focus.  Mediocre companies seeking to imitate them will be like me trying to imitate Phil—painful failures.  I do not see any basis in the McKinsey results for saying that companies should extend their horizons.

McKinsey tries to address this issue by doing comparisons within industries.  But everything we know suggests that there are substantial differences in company quality within industries as well as across industries.

Again, it may be that the long-termism hypothesis is right and there may be ways of teasing causality out of the very interesting data set that McKinsey has created.  But at this point I think the issue is still unresolved.

US adoption of a carbon tax would encourage others to follow

02/09/2017

Ideas should be judged by their quality not their pedigree.  I am not usually a fan of Republican tax policy proposals or environmental initiatives. But I strongly support the proposal put forward yesterday by Republicans George Shultz, James Baker, Martin Feldstein, Hank Paulson, Greg Mankiw and others for a substantial carbon tax in the USA to address global climate change.  Their proposal that the carbon tax be coupled with a mechanism for rebates to consumers, a rollback of command and control regulation, and a border adjustment mechanism is also sound.

The United States has a moral and a prudential obligation to lead on global climate change. There would be no clearer sign of our commitment than the introduction of a substantial carbon tax.  Our adoption of a carbon tax would encourage others to follow.  The border adjustment mechanism would be a further inducement since foreign countries would presumably prefer their carbon emitters pay them than pay us.  And because a carbon tax is easy to change it would enable us to be responsive to new developments in the science of global climate change.

Some of my friends may not completely agree, but I think the replacement of command and control regulation with a carbon tax is a positive step.  It will reduce uncertainty and thereby encourage investment.  Raising carbon prices has the virtue of discouraging all types of carbon use, be it from power production or transportation, from changing fuels or reducing energy use.  It is therefore likely an efficient way to reduce emissions.  Of course the devil is in the details and, as the authors point out, the tax has to be set high enough to reduce emissions at least as much as any repealed regulations.

I also think that the proposal for a lump sum rebate that gives an equal amount to all citizens is a very sound one.  Since a person with a $2 million income gets no more than a person with a $20,000 income, it is highly progressive.  It reminds me of Alaska’s approach of sharing oil revenues equally with all citizens.  I think that the approach of not adjusting the income tax but instead declaring a social dividend also will operate to give people a stake in environmental protection because whenever the carbon tax is raised, people will get a larger and highly visible rebate.

It is hard to know how the Trump administration, which has flirted with climate denialism and has been less than embracing of traditional Republicans, will react to today’s proposal.  I do know that they could change the way they are perceived in many parts of the world and by many well-intentioned Americans if they tried to run with it.  It is also hard to know how Democrats will react.  I hope they will seize on prominent Republican endorsement to take the largest steps on global climate change in our history and at the same time to achieve the most universal social benefit.

Big risks in the hasty rollback of financial regulation

02/07/2017

Many business people think it is wonderful that we now have an Administration filled with people from business backgrounds. To a point, I relate. People who have worked primarily in the private sector bring an awareness that others sometimes lack of maintaining business confidence, which as I have often said is the cheapest form of stimulus. And for some government tasks, management experience is much more important than policy experience. That is why Bob Rubin and I worked to install a (Republican) business leader as commissioner of the IRS given its vast IT problems.

Unfortunately, just as being able in government does not equip you to step in and run a company—at least not without much help—so also business experience does not equip you to run on your own public policy and political processes.

The concerns of those who worry about business dominated government have been demonstrated all too clearly by the Trump administration’s roll-out of plans to scale back financial regulation. There are surely areas where regulation is too burdensome, particularly involving bureaucratization and small banks. But much of what was said by the President and his advisors sounds more like grousing at an East Hampton cocktail party than a serious basis for public policy reform.

The President suggested that it was a problem that many of his good friends could not get as much credit as they wanted. We do not travel in the same social circles, so I am not sure who he means. But if he is saying that real estate developers cannot get all the credit they want, that would seem a good thing. Indeed, I would submit that the financial history of the last 40 years demonstrates that often when real estate operators are thrilled about credit availability, financial crisis is only a few years away.

Gary Cohn, the former number two at Goldman Sachs now heading the NEC, asserts that “ we are not going to burden the banks with literally hundreds of billions of dollars of regulatory costs every year”. I would challenge him to document that such costs exist today, which feels to me like an “alternative fact”. Note that total bank profits last year were about 170 billion so the claim is that without excessive regulation profits would more than double.

There is room for reasonable argument about the fiduciary rule requiring that financial advisors act in the best interest of their clients. I think the case made in the Obama CEA report is very strong but I can see counter arguments. Cohn’s analogy that “this is like putting only healthy food on the menu, because unhealthy food tastes good but you still shouldn’t eat it because you might die younger” is bizarre. We do after all require food labeling, inspect food processing, and no one is suggesting that financial products be banned, only that the economic interests of advisors be disclosed.

It does not get better. Leaving aside Cohn’s statement thatwe have all submitted living wills” referring to Goldman Sachs, which was a slip for a policy official, I wonder why an Administration that professes to hate “too-big-to-fail” wants to scale living wills for banks and plans for resolution way back.

And Cohn’s argument that since banks are so well capitalized now we do not have to worry much about other aspects needs to reckon with the experience of 2008. Some of the institutions that failed, like Bear Stearns and Lehman Brothers, had capital cushions well above what both the Federal Reserve and Basel required to be labeled as “well-capitalized” in the week before their failures.  Others like Goldman would likely have failed but for the bailout of their counterparties. Evidence on ratios of the market value of equity to assets suggests that even after the recent run-up, banks are operating with historically high levels of operating leverage.

Blog Graph Feb 7

 

 

 

 

 

 

I would rather live with even a very bad knee than let a carpenter operate on me. On the evidence of statements so far by those in the executive branch, the safest posture is to resist changes in the financial regulatory framework until there is proof that they have been thought through carefully. If and when this happens, there will be room to promote the flow of credit, reduce bureaucratic burdens, and make the financial system safer.

 

Markets enjoying a sugar high that will not last

01/29/2017

This week the Trump rally continued as the Dow crossed 20,000 and our President issued a celebratory tweet. How much does this mean? To what extent is it a vindication of the economic policy approaches pursued by the new Administration? Will the post election rally continue? No one knows these answer and market timing is a fool’s game but I remain persuaded that markets and the economy are most likely enjoying a sugar high that will not last a year.

First Dow 20,000 is a meaningless benchmark and crossing it means little. Its numerology not analysis to focus on round numbers. The Dow is an odd and arbitrary index which weights companies by their share price not their market value. It is highly limited in who is included with Goldman Sachs accounting for over 20 percent of the gain in the 30 stock index since election day.

Second, as Bob Rubin constantly reminded his colleagues in the Clinton administration “markets go up, markets go down” and it is a mistake to judge policy on immediate market reactions rather than concentrating on fundamentals. The observation that the best post-election pre-inauguration performance of the stock market in the last 100 years occurred during Herbert Hoover’s transition underscores this point as does the market’s poor performance during the Roosevelt and Obama transitions.

Third, there are indicators in markets of possible trouble ahead. While financial stocks have been very strong over the last several months, insider sales have soared.

Despite what most observers see as highly uncertain environment, market expectations of near term volatility are near record lows suggesting scope for sudden disillusionment. Rapid inflows into mutual funds could easily go into reverse.

Fourth, the fundamental basis for a big market rally is very unclear. If “pro business policies” were key over time it would not be the case that Democrat administrations have consistently seen stronger markets than Republican ones over the last 70 years. Recall also that nearly half of S&P 500 revenue is earned abroad and will not be enhanced by new US domestic policies but may be hurt by new nationalist measures. It is far from clear that corporate tax reform on the scale envisioned by the new administration will pass this year and even the hallmark 1986 Act had only modest stock market impacts. The impact of regulatory changes will be felt only in some sectors and may be offset by new populist measures such as restrictions on pharmaceutical pricing.

Fifth, and most important new governments with authoritarian tendencies have historically brought about bull markets even before they led to disaster. Governments with much stronger authoritarian tendencies than anything plausible in the USA like those of Hitler or Mussolini nonetheless saw strong markets in their early years.

I am not sure which is more difficult: predicting what President Trump will do next or timing the market. Either way after the events of the last week it is much easier to imagine downside than upside scenarios.

 

Time for Business Leaders To Wake Up

01/24/2017

I wonder what the business leaders who have been waxing enthusiastic about our new pro-business Administration are thinking right now.

Confidence and prosperity depend on a perception of government credibility and confidence. Is that present when an administration lies about readily observable facts like crowd sizes and then defends the lie with the Orwellian concept of alternative facts?

Does the business community really want NAFTA to be abrogated, Asian trade architecture turned over to the Chinese or a trade war launched with China?

Secretary of commerce Designate Wilbur Ross vows to self-initiate dumping cases rather than waiting for industry to file. During the two administrations I served in industry discouraged such efforts because of retaliation fears. Have matters really changed or is the new Secretary ahead of his constituency?

Do the financial cheerleaders for a business-leader dominated Administration approve of the emerging combination of weak dollar rhetoric from both the President and Treasury Secretary nominee along with strong dollar policy.

If as Secretary designate Mnuchin has just written to Congress and the President has asserted the administration believes the dollar is too strong why are all its policies calculated to raise the dollar: (i) very expansionary fiscal policy (ii) complaints about easy money (iii) measures like the border tax adjustment that discourage imports and encourage exports (iv) measures to reduce capital outflows as American companies outsource? This is the least coherent dollar policy since the Carter Administration.

I guess as someone put it to me in Davos business people are more comfortable with fellow business people than with policy people.  Perhaps in forming views they should get modern and look at data. Almost 30 years ago in 1988 Roger Altman and I had a piece in the WSJ showing that in the then preceding 35 years the economy and corporate profits did much better with Democrats in power. At the time I thought the point was a valid counter to Republican rhetoric but not necessarily a strong regularity. But the best test of any statistical finding is looking at data subsequent to its publication. The recent much more thorough study by Alan Blinder and Mark Watson shows that Democrats are much better for business than Republicans.

Little is going right or giving confidence. Increasingly I think the sugar high may be short lived. For the sake of their shareholders corporate leaders need to stop cheerleading and start insisting that policy have a modicum of logical coherence and factual support.

Disillusioned in Davos

01/20/2017

Edmund Burke famously cautioned that “the only thing necessary for the triumph of evil is for good men to do nothing.”  I have been reminded of Burke’s words as I have observed the behavior of US business leaders in Davos over the last few days.  They know better but in their public rhetoric they have embraced and enabled our new President and his policies.

I understand and sympathize with the pressures they feel.  I used to remind my colleagues in the Obama White House that “confidence is the cheapest form of stimulus.”  There is a clear case for corporate tax reform, for some targeted regulatory relief and a more positive government attitude towards business.  Businesses who get on the wrong side of the new President have lost billions of dollars of value in sixty seconds because of a tweet.  And you cannot hope to have influence on an Administration you go out of the way to condemn.

Yet I am disturbed by (i) the spectacle of financiers who three months ago were telling anyone who would listen that they would never do business with a Trump company rushing to praise the new Administration (ii) the unwillingness of business leaders who rightly take pride in their corporate efforts to promote women and minorities to say anything about Presidentially sanctioned intolerance (iii) the failure of the leaders of global companies to say a critical word about US efforts to encourage the breakup of European unity and more generally to step away from underwriting an open global system (iv) the reluctance of business leaders who have a huge stake in the current global order to criticize provocative rhetoric with regard to China, Mexico or the Middle East (v) the willingness of too many to praise Trump nominees who advocate blatant protection merely because they have a business background.

I have my differences with the new Administration’s economic policies and suspect the recent market rally and run of economic statistics is a sugar high.  Reasonable people who I respect differ and time will tell.  My objection is not to disagreements over economic policy.  It is to enabling if not encouraging immoral and reckless policies in other spheres that ultimately bear on our prosperity.  Burke was right.  It is a lesson of human experience whether the issue is playground bullying, Enron or Europe in the 1930s that the worst outcomes occur when good people find reasons to accommodate themselves to what they know is wrong.  That is what I think happened much too often in Davos this week.

 

Congress is considering an extremely dangerous idea almost nobody has heard of

01/18/2017

Inevitably, Congress has more attractive uses for new funds than it has sources of new funds, so there is always is a desperate search for “pay-fors” — measures that are scored by the Congressional Budget Office as raising revenue or reducing outlays and so can be used to finance new initiatives. The pressure is particularly acute this year with the ambitious plans of the new administration. There is also the likelihood that the use of the budget reconciliation procedure will preclude careful deliberation of proposed pay-fors.

I recently learned of a particularly dangerous pay-for that may have superficial appeal —the repeal of Orderly Liquidation Authority (OLA).  This repeal, if enacted, will exacerbate moral hazard, impair financial stability, increase economic vulnerability and in all likelihood increase the national debt. It would be a major unforced error.

OLA is a new bankruptcy-type provision included in Dodd-Frank financial reform legislation that gives the Federal Deposit Insurance Corp. the authority to resolve insolvent systemic financial institutions (think future Lehman-like episodes). It allows the FDIC to borrow funds from the Treasury to support the liquidation of such firms with the proviso that in the event of any losses, fees will be levied on bank holding companies and other financial institutions to fully reimburse the Treasury. This authority is a wholly rational response to the gaping hole in our financial architecture evinced by the catastrophic Lehman failure, where policymakers’ only alternatives were uncontrolled bankruptcy or taxpayer-financed bailout. Had it been in place in 2008, much carnage could have been avoided.

So, much is wrong with eliminating OLA in order to get about $20 billion in CBO-blessed revenue.

The case for a proper program of infrastructure spending

01/17/2017

On Monday, I gave a speech at Brookings and then had a discussion with my Harvard colleague Ed Glaeser on aspects of infrastructure investment. Here are the links to the video and transcript. While for reasons described below I believe the Trump campaign proposals are wholly ill-conceived, I remain convinced that an increased and improved programme of public infrastructure investment would be very much in the American national interest. The case for public investment today rests largely on grounds of long-run policy and microeconomic efficiency given the sub-5 per cent unemployment rate.

My remarks and conversation with Ed focused on five main issues.

First, improved infrastructure has benefits that go well beyond what is picked up in standard rate of return on investment calculations. Because infrastructure is integrative, we often fail fully to understand the benefits of investment.

Nonquantitative historians are convinced that the Transcontinental railway played a crucial role in American history. They believe it permitted the integration of the west and more broadly drew our nation together. This idea was famously challenged by Nobel Prize economist Robert Fogel in his doctoral dissertation. Fogel pointed out that transport made up only a small per cent of GDP and that the railroad was only a certain per cent cheaper than canals so the contribution to economic growth had to be small. I suspect this calculation, which mirrors those usually done in evaluating infrastructure projects such as high-speed rail, misses the benefits of integrative infrastructure in spurring investment and promoting agglomeration by increasing the range over which the best companies can expand and compete. My bet is that the railway project was in fact very important for the US economy. I suspect something similar can be said on a global basis about the Suez or Panama Canal projects.

There is a broader point as well. Investments in a location can be divided between those that have “spill-out consequences” and those that have “pull-in” effects. Investments in new science, for example, have benefits that spread out widely, as do investments in educating children some of whom inevitably migrate. Investments in infrastructure on the other hand have benefits that are local to where they take place and are likely to attract other investments. For example, Dulles airport and its successive expansion has been a huge spur to the economic development of Northern Virginia. At a time of resurgent interest in the national dimension of economic success, infrastructure projects have the virtue that their benefits are very much concentrated where the investments take place.

Second, there is a particularly compelling case for maintenance investment. Ed and I agreed that there was a presumption that this should be the case since all the incentives facing political decision makers work against adequate maintenance. Deferred maintenance liabilities are largely unmeasured, unnoticed and passed on to subsequent generations of elected officials. No one can name a maintenance project. The desire to come in on budget discourages what might be called “pre-maintenance”, such as when the high-return insulation investments got stripped out at the last moment of Harvard building projects.

The examples are pretty stark. The American Society of Civil Engineers, which is admittedly an interested party, estimates that extra repairs for American automobiles each year have a cost that is the equivalent of a 75 cent a gallon gasoline tax. As I have said many times, look at La Guardia or Kennedy airport. I was struck many years ago by the young teacher who approached me in Oakland after, as secretary of the Treasury, I gave a speech about the importance of education. She said “Secretary Summers — that was a great speech. But the paint is chipping off the walls of this school, not off the walls at McDonald’s or the movie theatre. So why should the kids believe this society thinks their education is the most important thing?” I had no good answer.

As with potentially collapsing bridges, prevention is cheaper than cure and in many cases the return on “un-derferring” maintenance far exceeds government borrowing rates. Borrowing to finance maintenance should not be viewed as incurring a new cost but as shifting from the fast-compounding liability of maintenance to the slowly compounding liability of explicit debt. It should also be noted that inevitably one maintains what has been used, so maintenance investment is much less likely to turn out a white elephant than new infrastructure investment.

My guess is that the US could profitably spend an additional 0.5 per cent of GDP, or about $1.25tn over the next decade, on maintenance of its infrastructure.

Third, there are important new infrastructure investment projects that almost certainly have high rates of return. I have previously used as an example the renewal of the US air traffic control system. While vacuum tubes are no longer in use in our system, radar technology of the kind used during the second world war is pervasive, and there is essentially no role for GPS in our current architecture. The result is greater than necessary threats to safety, substantial unnecessary emission of greenhouse gases as planes circle to maintain greater than necessary distances from each other, pervasive delays during peak travel times, and inefficient usage of airport capacity. Current plans do not involve a satisfactory system being fully implemented until the mid-2030s.

The Treasury department recently released a study identifying 40 projects with a combined cost in the range of $200bn and cost-benefit ratios in the range of 2 to 10. This does not take account of technological progress. For example, autonomous vehicle technology will create new possibilities for very high speed travel lanes. And new developments in energy storage and transmission create potential for infrastructure technologies that will yield large social benefits by facilitating the adoption of renewable energy technologies like solar and wind, where intermittency is an important issue. I suspect also that pervasive fast wireless will create benefits that are currently unimaginable in the same way that the Transcontinental Railroad did.

I would be very surprised if another 0.5 per cent of GDP could not be profitably invested in new infrastructure over the next decade. A $2.5tn programme would still leave public investment at levels that are low by the standards of the post-war period in the US or other countries. Given how much less we are now spending — of the order of 3 per cent of GDP — on national defence compared to the more than 5 per cent we spent for much of the post-war period, it is not plausible to assert that we cannot afford these investments as a nation. Indeed, if over time infrastructure investments yield a return of even 6 per cent and if government can capture even 1/6 of that return in increased tax collection, they will pay for themselves at current low levels of real interest rates.

Fourth, better infrastructure investment is as important as more infrastructure investment. Quality is as important as quantity. Progressives are right to decry the inadequate level of public investment in the US. Conservative complaints about regulatory obstacles, problems in project selection, inefficient procurement and inattention to the use of pricing in assuring the efficient use of infrastructure are equally valid. The short 300-foot bridge outside my office connecting Cambridge and Boston has been under repair with substantial traffic delays for nearly five years. Julius Caesar built from scratch a bridge seven times as long spanning the Rhine in nine days! Famously, it has taken longer to repair the eastern span of the Bay Bridge in San Francisco than took to build the original. Yes, Robert Moses and his contemporaries were too heedless of the environment and the interests of local communities. But we can surely find ways of coming to far more rapid decisions with far less promiscuously distributed veto power than is the case in much of the country today.

There is too much pork barrel and too little cost-benefit analysis in infrastructure decision-making. Projects should be required to pass cost-benefit tests and proposals like a national infrastructure bank that would insulate a larger portion of decision-making from politics should be seriously considered. Ed Glaeser is right that new infrastructure investment in declining areas is often a terrible idea as shrinking populations means that these areas have if anything too much infrastructure. And Field of Dreams — “build it and they will come” approaches do not have a very good track record. Ways should be found to make the costs of procrastination on maintenance more salient and to institutionalise resistance to low-ball cost estimates from advocates of more visionary projects.

The goal of building rapidly at minimum cost should be the primary objective in infrastructure procurement. Deviations from this principle should take place only with compelling justification.

Crucially, modern technology makes possible much more pricing of infrastructure usage than was once the case. In particular, transponder technology means that usage of roads can be priced with sensitivity to exact location and time much as power is priced today. To date, congestion pricing has been very difficult politically. My hope is that in the same way that pricing in the environmental area was once decried as “purchased licences to pollute” but is today quite widely accepted, formulas can be found to introduce congestion pricing. The benefits are potentially very large. And it should be possible to find formulas to compensate losers.

To assert that current public investment decision-making is highly flawed should not be taken as a blanket endorsement of private sector reliance. While there are areas where public-private partnerships are desirable, these should be approached with great caution. The private sector often demands rates of return far greater than public sector borrowing costs, especially in the current low interest rate environment. Insisting on private participation could well substantially raise costs without addressing major problems.

The proposals of Trump advisors Peter Navarro and Wilbur Ross to rely on tax credits to augment infrastructure investment are a textbook case of the dangers of knee-jerk private sector reliance. These benefits would (i) largely go to developers and contractors for infrastructure projects like new pipelines that would happen even without new incentives and so be highly regressive; (ii) raise costs by failing to reach the tax-free pension funds, sovereign wealth funds and international investors that are the most plausible sources of incremental infrastructure finance; (iii) not encourage at all the highest return maintenance projects like fixing potholes that do not yield a pecuniary return for investors; and (iv) by offering credits at an unprecedented 82 per cent rate, invite all kinds of tax-shelter abuse.

Fifth, while the case for expanded infrastructure investment does not depend on Keynesian stimulus or aggregate demand considerations, secular stagnation risks reinforce the argument for increased public investment. As the previous points illustrate, there is a compelling case (wholly apart from any ideas about aggregate demand) for increased infrastructure investment. To the extent that, as I have argued elsewhere, the industrial world is likely to be prone to a chronic excess of saving over private investment in the years ahead, this case is reinforced. Excess saving means that very low real interest costs are likely to persist, reducing the capital cost of infrastructure investment.

While the evidence is far from conclusive, my guess is that low real borrowing costs raise the risk of bubbles and financial instability. This argues for a shift in the policy mix, from monetary policy towards fiscal policy. And to the extent that, because of constraints on how low interest rates can go, recessions become more frequent and protracted in the years ahead, the case for expansionary fiscal policy is reinforced. To be clear, I do not believe that infrastructure investment can be turned on and off in response to cyclical fluctuations without big efficiency losses. And I do not believe there is a case for make-work projects that cannot be justified on microeconomic grounds. There is, however, a case for expanded public investment on a sustained basis with financing from borrowing or taxes that varies with cyclical conditions.

There is also the consideration that infrastructure investment is likely to disproportionately benefit groups such as middle-aged men with limited education who face a major structural employment problem. One way of thinking about this is that it means the real cost of investment is lower because those working on infrastructure would otherwise have been jobless and perhaps collecting unemployment or disability benefits. Another is to simply note that even if the economy does not face a chronic shortage of demand overall, it does face a shortage of demand for certain types of labour and policies that address this shortfall are, other things being equal, desirable.

While President-elect Trump’s plans for infrastructure stimulus are, I think, misguided and probablyharmful, I agree with the incoming administration on one thing: the case for a substantially increased programme of public infrastructure is undeniable.

Public Infrastructure Investment in the National Interest

01/16/2017

On Monday, I gave a speech at Brookings and then had a discussion with my Harvard colleague Ed Glaeser on aspects of infrastructure investment.  Here are the links to the video and transcript.  While for reasons described below I believe the Trump campaign proposals are wholly ill conceived, I remain convinced that an increased and improved program of public infrastructure investment would be very much in the American national interest.  The case for public investment today rests largely on grounds of long run policy and microeconomic efficiency given the sub-5 percent unemployment rate.

My remarks and conversation with Ed focused on five main issues.

First, improved infrastructure has benefits that go well beyond what is picked up in standard rate of return on investment calculations.  Because infrastructure is integrative, we often fail to fully understand the benefits of investment.

Nonquantitative historians are convinced that the Transcontinental railroad played a crucial role in American history.  They believe it permitted the integration of the West and more broadly drew our nation together. This idea was famously challenged by Nobel Prize economist Robert Fogel in his doctoral dissertation.  Fogel pointed out that transport was only a small percent of GDP and that the railroad was only a certain percent cheaper than canals so the contribution to economic growth had to be small.  I suspect this calculation, which mirrors the ones usually done in evaluating infrastructure projects like high-speed rail, misses the benefits of integrative infrastructure in spurring investment and promoting agglomeration by increasing the range over which the best firms can expand and compete.  My bet is that the railroad project in fact was very important for the American economy.  I suspect something similar can be said on a global basis about the Suez or Panama Canal projects.

There is a broader point as well.  Investments in a location can be divided between those that have “spill-out consequences” and those that have “pull-in” effects.  Investments in new science for example has benefits that spread out widely, as do investments in educating children some of whom inevitably migrate.  Investments in infrastructure on the other hand have benefits that are local to where the investment takes place and are likely to attract other investments. For example Dulles airport and its successive expansions has been a huge spur to the economic development of Northern Virginia.  At a time of resurgent interest in the national dimension of economic success, infrastructure projects have the virtue that their benefits are very much concentrated where the investments take place.

Second, there is a particularly compelling case for maintenance investment.  Ed and I agreed that there was a presumption that this should be the case since all of the incentives facing political decision makers work against adequate maintenance.  Deferred maintenance liabilities are largely unmeasured, unnoticed and passed on to subsequent generations of elected officials.  No one can name a maintenance project.  The desire to come in on budget discourages what might be called “pre-maintenance,” such as when the high return insulation investments got stripped out at the last moment of Harvard building projects.

The examples are pretty stark.  The American Society of Civil Engineers, who are admittedly an interested party, estimate that extra repairs costs for American automobiles each year have a cost that is the equivalent of a 75 cent a gallon gasoline tax.  As I have said many times, look at La Guardia or Kennedy airport.  I was struck many years ago by the young teacher who approached me in Oakland after as Secretary of the Treasury I gave a speech about the importance of education. She said “Secretary Summers—that was a great speech.  But the paint is chipping off the walls of this school, not off the walls at McDonald’s or the movie theatre. So why should the kids believe this society thinks their education is the most important thing”  I had no good answer.

As with potentially collapsing bridges, prevention is cheaper than cure and in many cases the return on “un-derferring” maintenance far exceeds government borrowing rates.  Borrowing to finance maintenance should not be viewed as incurring a new cost but as shifting from the fast compounding liability of maintenance to the slowly compounding liability of explicit debt.  It should also be noted that inevitably one maintains what has been used, so maintenance investment is much less likely to turn out a white elephant than new infrastructure investment.

My guess is that the United States could profitably spend an additional 0.5 percent of GDP or about $1.25 trillion over the next decade on maintenance of its infrastructure.

Third, there are important new infrastructure investment projects that almost certainly have high rates of return.  I have previously used as an example the renewal of the US air traffic control system.  While vacuum tubes are no longer in use in our system, radar technology of the kind used during World War II is pervasive, and there is essentially no role for GPS in our current architecture.  The result is greater than necessary threats to safety, substantial unnecessary emission of greenhouse gases as planes circle to maintain greater than necessary distances between themselves, pervasive delays during peak travel times, and inefficient usage of airport capacity.  Current plans do not involve a satisfactory system being fully implemented until the mid 2030s.  The Treasury Department recently released a study identifying 40 projects with a combined cost in the range of $200 billion and cost-benefit ratios in the range of 2 to 10.  This does not take account for projects that take account of new technological progress.  For example, autonomous vehicle technology will create new possibilities for very high speed travel lanes.  And new developments in energy storage and transmission create potential for infrastructure technologies that will yield large social benefits by facilitating the adoption of renewable energy technologies like solar and wind, where intermittency is an important issue.  I suspect also that pervasive fast wireless will create benefits that are currently unimaginable in the same way that the Transcontinental Railroad did.

I would be very surprised if another 0.5 percent of GDP could not be profitably invested in new infrastructure over the next decade.  A $2.5 trillion program would still leave public investment at levels that are low by the standards of the post-World War II period in the United States or other countries.  Given how much less we are now spending–on the order of 3 percent of GDP — on national defense compared to the above 5 percent we spent for much of the post-War period, it is not plausible to assert that we cannot afford these investments as a nation.  Indeed, if over time infrastructure investments yield a return of even 6 percent and if government can capture even 1/6 of that return in increased tax collections, they will pay for themselves at current low levels of real interest rates.

Fourth, better infrastructure investment is as important as more infrastructure investment.  Quality is as important as Quantity.  Progressives are right to decry the inadequate level of public investment in the United States.  Conservative complaints about regulatory obstacles, problems in project selection, inefficient procurement, and inattention to the use of pricing in assuring the efficient use of infrastructure are equally valid.  The short 300 foot bridge outside my office connecting Cambridge and Boston has been under repair with substantial traffic delays for nearly 5 years. Julius Caesar built from scratch a bridge 7x as long spanning the Rhine in 9 days! Famously, it has taken longer to repair the eastern span of the Bay Bridge in San Francisco than took to build the original.  Yes, Robert Moses and his contemporaries were too heedless of the environment and the interests of local communities.  But we can surely find ways of coming to far more rapid decisions with far less promiscuously distributed veto power than is the case in much of the United States today.

There is too much pork barrel and too little cost-benefit analysis in infrastructure decision making.  Projects should be required to pass cost-benefit tests and proposals like a national infrastructure bank that would insulate a larger portion of decision-making from politics should be seriously considered.  Ed Glaeser is right that new infrastructure investment in declining areas is often a terrible idea as declining population means that these areas have if anything too much infrastructure.  And Field of Dreams— “build it and they will come” approaches do not have a very good track record.  Ways should be found to make the costs of procrastination on maintenance more salient and to institutionalize resistance to low-ball cost estimates from advocates of more visionary projects.

The goal of building rapidly at minimum cost should be the primary objective in infrastructure procurement.  Deviations from this principle should take place only with compelling justification.

Crucially, modern technology makes possible much more pricing of infrastructure usage than was once the case.  In particular, transponder technology means that usage of roads can be priced with sensitivity to exact location and time much as power is priced today.  To date, congestion pricing has been very difficult politically.  My hope is that in the same way that pricing in the environmental area was once decried as “purchased licenses to pollute” and is today quite widely accepted,  formulas can be found to introduce congestion pricing.  The benefits are potentially very large.  And it should be possible to find formulas that assure that losers are compensated.

To assert that current public investment decision-making is highly flawed should not be taken as a blanket endorsement of private sector reliance.  While there are areas where public-private partnerships are desirable, these should be approached with great caution.  The private sector often demands rates of return far greater than public sector borrowing costs, especially in the current low interest rate environment.  Insisting on private participation could well substantially raise costs without addressing major problems.

The proposals of Trump advisors Peter Navarro and Wilbur Ross to rely on tax credits to augment infrastructure investment are a textbook case of the dangers of knee-jerk private sector reliance.  These benefits would (i) largely go to developers and contractors for infrastructure projects like new pipelines that would  happen even without new incentives and so be highly regressive; (ii) raise costs by failing to reach the tax-free pension funds, sovereign wealth funds and international investors who are the most plausible sources of incremental infrastructure finance; (iii) not encourage at all the highest return maintenance projects like fixing potholes that do not yield a pecuniary return for investors; and (iv) by offering credits at an unprecedented 82 percent rate, invite all kinds of tax shelter abuse.

Fifth, while the case for expanded infrastructure investment does not depend on Keynesian stimulus or aggregate demand considerations, secular stagnation risks reinforce the argument for increased public investment.  As the previous points illustrate, there is a compelling case (wholly apart from any ideas about aggregate demand) for increased infrastructure investment.  To the extent that, as I have argued elsewhere, the industrial world is likely to be prone to a chronic excess of saving over private investment in the years ahead, this case is reinforced.  Excess saving means that very low real interest costs are likely to persist, reducing the capital cost of infrastructure investment.  While the evidence is far from conclusive, my guess is that low real borrowing costs raise the risk of bubbles and financial instability.  This argues for a shift in the policy mix, from monetary policy towards fiscal policy.  And to the extent that, because of constraints on how low interest rates can go, recessions are more frequent and protracted in the years ahead, the case for expansionary fiscal policy is reinforced.  To be clear, I do not believe that infrastructure investment can be turned on and off in response to cyclical fluctuations without big efficiency losses.  And I do not believe that there is a case for make-work projects that cannot be justified on microeconomic grounds.  There is however a case for expanded public investment on a sustained basis with financing from borrowing or taxes that varies with cyclical conditions.

There is also the consideration that infrastructure investment is likely to disproportionately benefit groups like middle-aged men with limited education who face a major structural employment problem.  One way of thinking about this is that it means the real cost of investment is lower because those working on infrastructure would otherwise have been unemployed and perhaps collecting unemployment or disability benefits. Another is to simply note that even if the economy does not face a chronic shortage of demand overall, it does face a shortage of demand for certain types of labor and policies that address this shortfall are other things equal desirable.

While President-Elect Trump’s plans for infrastructure stimulus are I think misguided and likely harmful, I agree with the incoming Administration on one thing: the case for a substantially increased program of public infrastructure is undeniable.

Trump’s Carrier Deal – Ad Hoc Deal Capitalism

12/02/2016

There are many aspects of the economic policy of the new Administration that I find misguided.  But I am most troubled by what the President-elect did with Carrier to hold on to an extra 700 jobs in Indiana. Ronald Reagan’s response to the air traffic controllers’ strike was a small act that had profound consequences.  I fear in a similar way that the negotiation with Carrier is a small thing that is actually a very big thing—a change very much for the worse with regards to the operating assumptions of American capitalism.

Market economies can operate anywhere along a continuum between two poles.

I have always thought of American capitalism as dominantly rule and law based.  Courts enforce contracts and property rights in ways that are largely independent of just who it is who is before them.  Taxes are calculable on the basis of an arithmetic algorithm.  Companies and governments buy from the cheapest bidder.   Regulation follows previously promulgated rules. In the economic arena, the state’s monopoly on the use of force is used to enforce contract and property rights and to enforce previously promulgated laws.

Even though we know of instances of corruption, abuse of power, favoritism and selective enforcement, we take this rules-based system for granted.  But looking around the world today or back through American history, this model is hardly a norm.  Many market economies operate what might be called ad hoc or deals-based capitalism:  Economic actors assume that they have to protect their property and do their own contract enforcement.  Tax collectors use discretion in assessing taxes.  Companies and governments buy from their friends rather than seek low cost bids.  Regulators abuse their power. The state’s monopoly on the use of force is used to enrich and satisfy the desires of those who control the apparatus of the state.

This is the world of New York City under Tammany Hall, of Suharto’s Indonesia, and of Putin’s Russia.

Reliance on rules and law has enormous advantages.  It greatly increases predictability and reduces uncertainty.  It reduces expenditures on both guarding property and seeking to appropriate property.  It promotes freedom because most of the people most of the time do not take political positions with a view to gaining commercial advantage.  The advantages of the rule of law are so great that I would claim that there is no country more than 2/3 as rich as the United States that does not have a strong tradition of the rule of law based capitalism.  And I know of no country where the people are free where the rule of law does not largely govern market interactions.

What about Carrier?  The President-elect of the United States decided in a purely ad hoc basis that he wanted Carrier to remain in Indiana.  He deployed some combination of carrots and sticks at his disposal to lever Carrier into doing what he wanted.  Implicitly or explicitly, there must have been sticks, as press accounts suggest that the tax benefits provided offset only a small part of the savings foregone by staying in Indiana.   It is not hard to see from the point of view of United Technologies, the parent of Carrier, that for a company with more than $50 billion in revenue its surely worthy $60 million dollars to not be on the wrong side of a possibly vindictive President of the United States.

It seems to me what we have just witnessed is an act of ad hoc deal capitalism and worse yet its celebration as a model.  As with the air traffic controllers only a negligible sliver of the economy is involved but there is huge symbolic value.  A principle is being established: it is good for the President to try to figure out what people want and lean on companies to give it to them.  Predictability and procedure are less important than getting the right result at the right time.  Like Hong Kong as the mainland increasingly imposes its will, we may have taken a first step towards a kind of reverse transition from rule of law capitalism to ad hoc deal-based capitalism.

The commentary on the President-elect’s actions has emphasized its novelty, has emphasized the difficulties of scaling, and in the case of Bernie Sanders has argued that the actions taken were insufficiently forceful because some workers will still be relocated to Mexico.  All of this misses the point.  Presidents have enormous latent power and it is the custom of restraint in its use that is one of the important differences between us and banana republics.  If its ad hoc use is licensed, the possibilities are endless.  Most companies will prefer the good to the bad will of the US President and his leadership team.  Should that reality be levered to get them to locate where the President wants, to make contributions to the President’s re-election campaign , to hire people the President wants to see hired, to do the kinds of research the President wants carried out, or to lend money to those that the President wants to see assisted?

Some of the worst abuses of power are not those that leaders inflict on their people.   They are the acts that the people demand from their leaders.  I fear in a way that is more fundamental than a bad tax policy or tariff we have started down the road of changing the operating assumptions of our capitalism.  I hope I am wrong but I expect that as a consequence we are going to be not only poorer but less free.

 

The Future of Aid for Health

12/01/2016

Yesterday, I gave a keynote speech at the World Innovation Summit for Health on “The Future of Aid for Health”.  When I agreed to give the speech, which built on the work of a Commission I chaired several years ago on Global Health 2035, I did not imagine the degree of uncertainty that the US election would bring to the global health area and indeed to the global community.

We are in uncharted territory.  No one can know what the attitude of the new US administration will be to funding foreign assistance of any kind or to global cooperation in the health area.  Certainly an “America first” strategy is not highly propitious.  Global health has been an area of bipartisan cooperation with major initiatives launched during  both Democratic and Republican administrations and has some Congressional champions in both parties so perhaps things will work out.

Rather than dwelling on political uncertainties I could not dispel, I chose to concentrate on something that should be a priority for those concerned with reducing premature death around the world, for those looking to foreign assistance as forward defense of US interests, and to those primarily interested in reducing budgets—assuring the optimal allocation of aid resources.

My argument was simple.  The world needs to move decisively away from the current regime where 80 percent of health assistance is devoted to supporting national health care delivery and only 20 percent is devoted to global service delivery towards a model where half of assistance is devoted to global goods.

In part this is because of the problematic aspects of continuing foreign assistance to national governments for health which raises issues of fungibility, sustainability and of distortion of countries’ exchange rates.  Mostly though it is because of the overwhelming return on investments in global goods that bear on health.

I noted that:

–investments in the development of the polio vaccine had returns orders of magnitude greater than investments in more iron lungs.

Dean Jamison, Victoria Fan and I demonstrated that the expected costs of global pandemics like the Spanish flu after World War I are in the same general range of those associated with climate change even though they receive almost no policy attention.

–research on tobacco and its health impacts, if fully acted on, could avert 200 million tobacco related deaths over this century.  And the set of issues around sugar and obesity are today in a place similar to where tobacco issues were 50 years ago.

–Many believe that the anti-microbial resistance—the development of bacteria that are resistant to antibiotics is the largest health risk facing humanity in coming decades and that much too little is being done to address it.

I am reasonably confident about my judgement regarding health assistance priorities though aspects of my argument are certainly open to debate. I am certain though that foreign assistance priorities should be based on analysis, evidence and argument.  The more morally important the issue, the more important is rigorous analysis and debate.

While I have often disagreed with particular judgments or been distressed that political considerations sometime carried the day my experience in policymaking in the United States and at the international level is that reason has always had its day in court and usually carried the day.

I desperately hope this tradition continues.  But when the President of the United States is someone who believes that vaccines cause autism, that Barack Obama was born in Kenya, and that global climate change is a hoax, I am far from certain how decisions will be made going forward.

 

Castro is Dead

11/29/2016

As I read the obituaries and saw reactions to Fidel Castro’s death I was struck by two things.

First, history will judge the US embargo policy a total failure. Suppose it’s authors had been told nearly 60 years ago that The Berlin Wall will fall. The Iron Curtain will fall. The USSR will break into 15 separate nations. Central Europe will join NATO. Russia and China will renounce Marxist Leninism. McDonald’s will come en masse to Moscow and Beijing.  US Presidents will routinely summit with China which will become one of our largest trading partners.

And a Castro will still rule Cuba for another quarter century.

There is a huge lesson here in the dangers of isolating a nation rather than engaging with it. Yitzhak Rabin was right when he noted that “you don’t make peace with your friends”. We could have done much better.

Second, President-elect Trump’s response has been highly problematic. I share his loathing of Castro, his record, his ideology and all he stood for. And I was disturbed by the statements like those of Canadian PM Justin Trudeau that seemed to celebrate Castro as a heroic leader.

But it’s instructive to contrast the President-elect’s celebration of Castro’s death, condemnation of Cuba’s governance, and bragging about his campaign with America’s response at other epochal moments. After Stalin died at the height of the Cold War, President Eisenhower’s reached out to the Russian people emphasizing our common humanity under God.  Or one can consider President George H.W. Bush’s carefully modest and non-gloating response  to the fall of the Berlin Wall.

The goal of Presidential statements should be to advance US interests not to settle scores or score points. I hope the that President-elect Trump will adopt a different tone once in office.

 

 

Most sweeping change in currency policy in the world in decades 

11/21/2016

By Natasha Sarin and Lawrence H. Summers

One of us (Larry) has long advocated the abolition of the $100 note in the US context and the 500 euro note (aka the Bin Laden) in the European context.  We assumed the next step after the ECB’s announcement that the 500 euro note would be phased out would be discussion of the $100 bill and of the particularly pernicious 1000 Swiss franc note.

Like everyone else, we were surprised by the dramatic action taken by Indian Prime Minister Narendra Modi to demonetize the existing 500 and 1000 rupee notes.  This is by far the most sweeping change in currency policy that has occurred anywhere in the world in decades.

First, it impacts notes that are in widespread use, being valued at 7.34 and 14.68 dollars respectively.  While it might be argued that since India is much poorer than the United States $15 in India is equivalent to $100 in the United States, the reality is that most Americans in the top 1 percent of the income distribution do not handle $100 bills on even a weekly basis whereas 500 rupee notes are very widely used in India.

Second, and more fundamental, actions like those taken by the ECB or those proposed for the US end the creation of new high denomination notes.  They do not contemplate declaring what has been legal tender to no longer be legal tender essentially overnight  It is the imminent prospect of notes currently held becoming worthless that has created such alarm and disruption in India.  Small and medium-sized merchants have seen their shops (which transact mostly in cash) deserted and ordinary Indian citizens have spent the last week in line outside banks hoping to be able to exchange their cash holdings for legal tender.

We recognize that many of those who hold large quantities of cash in India have come by their wealth in corrupt or illegal ways.  So, the temptation to expropriate is understandable.  After all, as the argument goes, anyone who came by their wealth legally has nothing to fear from coming forward and exchanging old notes for new ones.

Most free societies would rather let several criminals go free than convict an innocent man.  In the same way, for the government to expropriate from even a few innocent victims who, for one reason or another, do not manage to convert their money is highly problematic.  Moreover, the definition of what is illegal or corrupt is open to debate given commercial practices that have prevailed in India for a long time.

There are also questions of equity and efficacy.  We strongly suspect that those with the largest amount of ill-gotten gain do not hold their wealth in cash but instead have long since converted it into foreign exchange, gold, bitcoin or some other store of value.  So it is petty fortunes, not the hugest and most problematic ones, that are being targeted.

Without new measures to combat corruption, we doubt that this currency reform will have lasting benefits.  Corruption will continue albeit with slightly different arrangements.

On balance, nothing in the Indian experience gives us pause in recommending that no more large notes be created in the United States, Europe, and around the world.  We were not enthusiastic previously about the idea of withdrawing existing notes from circulation because we judged the costs to exceed the benefits. The ongoing chaos in India and the resulting loss of trust in government fortify us in this judgement.

Winning an election does not entitle one to upend basic values

11/17/2016

I will never again use the term “political correctness.” Whatever rhetorical value the term may have once had is far more than offset by what has been unleashed in the name of resistance to it since the presidential election.

I have made no secret over the years of my conviction that the sensitivities of individuals or members of various group should not be permitted to chill free speech on college campuses. I have the scars to show for speaking out against overdoing the idea of microaggression, the regulation of Halloween costumes and the prosecution of students for taking part in sombrero parties – all of which have struck me as “political correctness” run amok.

But the events of the last week are giving me pause about that term and its usage and the complex issues underlying it. It’s not that I now think speech codes are wise or that we should stamp out microaggressions wherever they are perceived.    Rather, my reaction is to the way the President-elect has been heard during the campaign and the terrifying events his election has set off.

The widespread perception is something like this.  Mr. Trump has vowed to ban Muslims from entering the country and to force deportation of Mexicans. He has ridiculed the disabled. He has accepted without criticism the enthusiastic support of the Ku Klux Klan and other hate groups that were previously on the fringes of society. He has invoked standard anti-Semitic tropes in his political advertising. And he has made clear that he believes grabbing and groping women is appropriate behavior.

Black students, gay students, Hispanic students, Muslim students, disabled students, female students – all of them now fear that the basic security and acceptance on which they relied is at risk. Help lines are flooded with calls.  Those who seek to count hateful incidents report an upsurge.  I cannot convince myself that that fear is irrational.  Personal experience has brought home to me the pervasive change since the election.    Painted swastikas have defaced the middle school that my twin daughters attended and the college another daughter now attends. At a different university where my daughter studies all the black freshman were sent emails with pictures depicting lynchings.

In the face of all this, the President-elect and his staff condemn those who march in protest over his election but as of yet have not forcefully condemned those overt acts of racism, sexism and bigotry the election has stimulated.  They have allowed, without adequate response and rejection, the celebration of victory to metastasize into something dark and evil.  It is surely wrong to hold the President-elect personally responsible for all the words and deeds of all who support him.  Equally, the President-elect has a moral obligation to stand up for tolerance and against intolerance whatever its source.

The fight for academic freedom and for ideological diversity on college campuses should and will go on.  But given what opposition to “political correctness” has licensed, it time to retire the term.

More importantly, democracy does not mean electocracy. Winning an election does not entitle one to upend our basic values. The refusal to tolerate blatant racism, bigotry and misogyny are beyond compromise.  The first obligation of anyone currently in a leadership position is not to find common ground with our new President-elect now that the ballots have been counted and the election is over. It is instead to once again make it possible for all who live in our country to feel safe.

 

Four things the Fed should do now to help the economy

09/30/2016

On Tuesday, I spoke in Houston at a forum sponsored by the Dallas Federal Reserve. Inevitably given that I was at the Fed, the topic turned to monetary policy.  On monetary policy, President Kaplan asked what I thought the Fed should be doing and saying.  I suggested four modifications to its current posture.

First, it should acknowledge that the neutral rate is now close to zero and it may well remain under 2 percent for the foreseeable future.  With the economy growing at below 2 percent over the last year, total hours of work essentially flat for the last 6 months, and with long term inflation expectations declining there is no reason to think we are currently much below the neutral rate.  And given that the neutral rate has been trending downwards since well before the financial crisis we have no basis for being confident that it will not continue declining, and certainly no basis for supposing it will increase.

Second, it should acknowledge at least to itself that it has damaged its credibility by repeatedly  holding out the prospects of much more tightening than the market anticipated, being ignored by the market, and then having the market turn out to be right.  It should recognize output and inflation and unemployment would all be closer to their target levels today and in their forecasts if rates had not been increased last December.  It should move to bring its stated plans more in line with external expectations regarding how much tightening the economy can tolerate.

fed-vs-market-interest-rate-projections

 

 

 

 

 

 

 

 

 

 

 

 

Third, the Fed should make real the idea that its inflation target is symmetric by being clear that in the late stage of prolonged expansion with low unemployment it is comfortable with inflation rising a little bit above 2 percent with the confidence that it will decline when the next recession comes.  The Fed does not expect inflation to reach 2 percent until 2018 and the gradient is not steep.  So it should be clear that until inflation expectations look to be rising above 2 percent there is no need to restrain the economy.

Fourth, the Fed should make clear that it sees risk as asymmetric right now.  If the economy falls into recession there is a real risk of a Japan scenario in which it will be very difficult to combat deflation.  On the other hand, there is no great risk if inflation drifts above two percent.  It might as I have noted actually be desirable.  And if not, policy can be tightened to prevent the economy from overheating as has occurred many times in the past.

Eric Rosengren, in explaining his dissent on the decision not to raise rates in September, argues that the Fed has historically had a hard time tapping the brakes and that if the Fed has to cool off an overheated economy a recession is likely to result.  I am not sure what aspect of history he has in mind here.  It certainly is true that the Fed has on occasion reacted strongly to inflation in ways that caused a recession.  But on each of those occasions inflation was far beyond desired levels and the recession was the price of bringing it back to desired levels.  Rosengren’s case would be made by examples where so much extra slack was induced that the economy undershot on inflation.  I am not aware of such instances.

Governor Brainard did an excellent job in her recent speech of making the asymmetric risks argument.  It is actually a very broad one.  A recession would push millions out of work, stunt economic growth, increase inequality, balloon Federal debt and in all likelihood cause our politics to become ever more bitter and toxic.  Every prudent precaution to prevent one should be taken.

It takes a tortured argument to believe that you can prevent a car from stopping by hitting the brakes.  Much better if you want the car to keep going to keep your foot off the brake until and unless you see imminent danger.  This is no time for the Fed to be creating uncertainty by raising the specter of interest rate increases at a time when markets do not expect 2 percent inflation in this decade.

A Tribute to Shimon Peres

09/29/2016

I have been thinking all day about Shimon Peres and how much I will miss him.  I first got to know Shimon in the mid 1990s when I was working in the International Affairs section of the Treasury.  It was a time of more optimism than we have today about the efficacy of economic assistance in supporting harmony among nations.  We were intensely engaged in supporting economic development in reform in the nations of the Former Soviet Union.

Shimon was pushing very hard for various Marshall Plan like schemes for the Middle East referencing the European Community experience in making war within Europe inconceivable after a thousand years of intermittent strife.  The White House and the State Department very much wanted to support him in any responsible way.

Treasury staff rightly saw a million problems with Shimon’s proposals.  There were corruption risks, duplication of already fragmented efforts of the existing development banks, shortages of trained personnel, and real security issues to mention just a few.  I have never seen anything like the response of Shimon and his close aide Uri Savir to these problems.   They would listen sympathetically and then explain how one could not let obstacles stand in the way of grand vision.  I called their interventions “dare to be great speeches”.  They were unlike anything I have ever heard in a diplomatic meeting.  Little wonder that they persuaded me and many others.

Tragically, politics got in the way and much of what Shimon was trying to do did not get done.  A lesser man would have been discouraged.  Shimon simply persevered looking for any daylight where hope could replace fear.  To be sure, there was nothing soft about him.  Indeed early in his career he had driven the Israeli nuclear program.  But he never stopped standing for hope.

Most people who have spent a decade in government let alone a half century become consumed with process, with prerogative, with the next task.  Not Shimon.  He was always thinking about the value of scientific truth and of beauty.  The last time I saw him maybe 9 months ago he shared with me a manuscript addressing the transcendent values that needed to guide civilization going forward.

Shimon was an immense presence on the global stage.  Most large men make others feel small.  Whenever I saw him, I always left elevated feeling there was more I could do to make the world a better place.  I am diminished by the knowledge that I will never see him again.  The world is now a harsher place.

Men Without Work

09/26/2016

Over the weekend, the FT published my review of Nicholas Eberstadt’s important new book Men Without Work.  The core message is captured in the graph below.

men-without-work

 

 

 

 

 

 

 

 

 

Job destruction caused by technology is not a futuristic concern.  It is something we have been living with for two generations.  A simple linear trend suggests that by mid-century about a quarter of men between 25 and 54 will not be working at any moment.

I think this is likely a substantial underestimate unless something is done for a number of reasons.  First everything we hear and see regarding technology suggests the rate of job destruction will pick up.  Think of the elimination of drivers, and of those who work behind cash registers.  Second, the gains in average education and health of the workforce over the last 50 years are unlikely to be repeated.  Third, to the extent that non-work is contagious, it is likely to grow exponentially rather than at a linear rate.  Fourth, declining marriage rates are likely to raise rates of labor force withdrawal given that non-work is much more common for unmarried than married men.

On the basis of these factors, I expect that more than one-third of all men between 25 and 54 will be out work at mid-century.  Very likely more than half of men will experience a year of non-work at least one year out of every five.  This would be in the range of the rate of non-work for high school drop-outs and exceeds the rate of non-work for African Americans today.

Will we be able to support these people and a growing retired share of the population?  What will this mean for the American family?  For prevailing ethics of self-reliance?  For alienation and support for toxic populism? These are vital questions.  Even more vital is the question of what is to be done. These questions should preoccupy social science researchers.  They are vital to our future.

 

The Fed’s complacency about its current toolbox is unwarranted

09/06/2016

As I argued in the first blog in this series last week, I was disappointed in what came out of Jackson Hole for three reasons.   The first reason, developed in that blog, was that the Fed should have signaled a desire to exceed its two percent inflation target during periods of protracted recovery and low unemployment and in this context to signal that a rate increase was off the table for September and quite likely the rest of the year.  Friday’s employment report further strengthens the case for delay both by adding to the evidence on the absence of inflation pressures and by suggesting a less robust economy than most expected.

Even apart from the desirability of allowing inflation to rise above two percent in a happy economic scenario GDP, labor market and inflation expectations data all make a compelling case against a rate increase.  Private sector GDP growth for the last year has averaged 1.3 percent a level that has since the 1960s always presaged recession.  Total work hours have over the last 6 months grown at nearly their slowest rate since early 2010.   And both market and survey measures of inflation expectations continue to decline.

Figure 1 Aggregate Hours Worked 090616

 

 

 

 

 

 

 

 

Figure 2 Inflation Expectation CPI

 

 

 

 

 

 

 

 

My second reason for disappointment in Jackson Hole was that Chair Yellen, while very thoughtful and analytic, was too complacent to conclude that “even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively”.   This statement may rank with Ben Bernanke’s unfortunate observation that subprime problems would be easily contained.

Rather I believe that countering the next recession is the major monetary policy challenge before the Fed.   I have argued repeatedly that (i) it is more than 50 percent likely that we will have a recession in the next 3 years.  (ii) countering recessions requires 400 or 500 basis points of monetary easing.  (iii) we are very unlikely to have anything like that much room for easing when the next recession comes.

Chair Yellen, relying heavily on research by David Reifschneider using the FRBUS model, comes to the relatively serene conclusion that by using forward guidance and QE policies—or LSAP (Large Scale Asset Purchases) in Fed parlance, the Fed will likely able to respond adequately to the next recession with its existing tool kit.  I think this conclusion is unlikely to be right.

As Paul Krugman points out Reifschneider, working with John Williams and using the same FRBUS model, concluded that the ZLB was only a very small issue less than a decade before the financial crisis led to an 8 year stretch of zero rates.  The market has been consistently wrong for most of the last decade on the ease with which interest rates could be raised by the Fed.  And estimates of the neutral rate have been far lower for far longer than anyone would have predicted a decade ago.  All of this suggests the need for substantial humility about what the Fed’s capacities will be the next time the economy encounters difficult times.

There is an important methodological point here—distrust conclusions reached primarily on the basis of model results.  Models are estimated or parameterized on the basis of historical data.  They can be expected to go wrong whenever the world changes in important ways.  Alan Greenspan was importantly right when he ignored models and maintained easy policy in the mid 1990s because of other more anecdotal evidence that convinced him that productivity growth had accelerated.  I believe a similar skeptical attitude towards model results is appropriate today in the face of the clear evidence that the neutral real rate has fallen.  I pay attention to model results only when the essential conclusion can be justified with some calculation where I can see and follow each step.

Four more specific points deserve emphasis.  First, Reifschneider assumes in is base case that the Fed funds rate reaches 3 percent before the next recession and treats as an extreme case the possibility that rates will reach only 2 percent before the next recession.  As Jared Bernstein points out market expectations are much more pessimistic than this.  According to the OIS market (basically long term fed fund futures) fed funds are expected even in the long run to rise only to 1.5 percent. This may be a bit misleading because the expected fed funds rate in 2020 of 1 percent includes some probability that it is zero because of a recession.  Even so markets, which have been much more right than the Fed so far, are clearly signaling the likelihood that rates will be under 2 percent when the next recession comes.

I appreciate that Reifschneider takes seriously the possibility of secular stagnation by including a section on it.  However, I fear he is overly sanguine in assuming that even under secular stagnation the Fed will start the next recession with an interest rate of 2 percent, as well as a ten year rate of 3 percent.  This seems optimistic given both the market expectations discussed above and the fact that current interest rates are 0.50 percent nearly eight years after the last recession.

Second, though he downplays the significance, Reifschneider finds that the Fed will likely not have as much room to cut rates as it would like under the so-called “optimal control” method that Yellen has extolled in the past.  Under this method the Fed is attempting to minimize the amount which inflation and unemployment differ from target over a series of years.  In his simulations, the Fed is not able to use unconventional policies to fully achieve the equivalent of the nearly 12 percent rate cut it would otherwise desire.  This shortfall is in response to a recession less severe than the recent one and with the questionable assumption that the Fed should view unemployment being too low as being as harmful as being too high.

Third, I suspect that prevailing views at the Fed about the efficacy of QE and forward guidance substantially exaggerate their likely impact.  I don’t think the Fed has taken on board the lesson of the three year period since QE ended.  If longer term rates had risen after QE and forward guidance ended, this would surely have been taken as further evidence of their potency.  It follows that the fact that term spreads have fallen substantially since the end of unconventional policy as shown in Figure 3 should lead to more skepticism about their efficacy.

Figure 3 10 Year 3 Month Spread and QE

 

 

 

 

 

 

 

 

 

On the issue of QE Greenwood, Hanson, Rudolph and I show that the contrary to much of the discussion during the QE period the stock of longer term public debt that the market has to absorb went up not down.  The amount of longer term Federal debt that markets have to absorb is now as high as it has been in the last 50 years and long rates are extraordinarily low, as are term spreads.  This calls into question the idea that price pressures caused by changing relative supplies are likely to have large impacts at times like the present when markets are functioning.

I wonder what credibility Fed forward guidance is likely to have given the utter disconnect over many years between Fed and market views regarding future rate and the track record so far of the Fed being wrong and the market being right.

Fourth, even if unconventional policy could be highly efficacious in moving long term rates and even if QE induced moves in long rates were potent, there is the question of how much room there is to bring down long rates.   Reifschneider in his very careful paper shows that with a big recession rates would likely approach -6 percent, or even -9 percent, but for the zero lower bound.  I find the idea that forward guidance and QE could do the anything like the work of 600, let alone 900, basis points of rate cutting close to absurd.  Both QE and forward guidance are said to work by bringing down longer term rates.  The 10 year Treasury is now in the 1.6 percent range.  If the Fed returned Fed Funds to its lower bound level in the context of a recession, I would expect to see 10 year rates fall substantially perhaps to 1 percent without any QE or forward guidance.   How much room is there for unconventional policy to bring them down further?  Reifschneider ‘s assumption that there will be room for unconventional policy to bring down 10 year rates by hundreds of basis points seems to me very doubtful.

To put the point differently, typically in recessions the 10 year Treasury has declined from peak to trough by around 1.8 percentage points.  Even if the rate got to European or Japanese levels, surely an unappealing prospect, there may not be enough room to bring down long rates to assure prompt recovery.

On balance, I think the Fed’s complacency about its current toolbox is unwarranted.  If I am wrong in either exaggerating the risks of recession or understating the efficacy of policy, the costs of taking out insurance against a recession that cannot be met with monetary policy are relatively low.  If I my fears are justified, the costs of complacency could be very high.  The right policy in the near term should be tilting as hard as possible against recession as argued in the first blog in this series. For the longer term the Fed will have to reconsider its broad policy approach.  This will be subject of my next entry.

Disappointed by what came out of Jackson Hole

08/29/2016

I had high hopes for the Federal Reserve’s annual Jackson Hole conference.  The conference was billed as a forum that would look at new approaches to the conduct of monetary policy—something that I have been urging as necessary given secular stagnation risks and the sharp decline in the apparent neutral rate of interest.  And Chair Yellen’s speech in a relatively academic setting provided an opportunity to signal that the Fed recognized that new realities required new approaches.

The Federal Reserve system and its Chair are to be applauded for welcoming challengers and critics into their midst.  The willingness of many senior officials to meet with the Fed Up group is also encouraging.  And its important for critics like me to remember that the policy explorations of today often become the conventional wisdom of tomorrow.   In this regard the fact that the Fed has now recognized that the decline in the neutral rate is something that is much more than a temporary reflection of the financial crisis is a very positive sign.

On balance though, I am disappointed by what came out of Jackson Hole judging by press reports since I was not there.  First, the near term policy signals were on the tightening side which I think will end up hurting both the Fed’s credibility and the economy.  Second, the longer term discussion revealed what I regard as dangerous complacency about the efficacy of the existing tool box.  Third, there was failure to seriously consider major changes in the current monetary policy framework.

I shall argue each of these points in a blog series this week.  At the outset however, it is important to recognize that the Fed has not earned the right to be intellectually complacent or to expect that others will have faith in its current policy framework.  Given the Great Recession and its forecasting record, it is not surprising that Gallup has found that public confidence in the Fed has sharply declined in recent years, though it has increased recently.

For nearly a decade, since the mid 2008 FOMC meetings where many believed that the worst had past, the Fed been too serene about the economic outlook and a return to past regularities.  When the Fed predicted last December that it would raise rates four times in 2016, market participants saw a disconnect from reality.  It has been that way for a long time.  Figure 1 shows the Fed’s forecasts of its future monetary policies since they began releasing them.  The Fed has always believed that rate increases and normalization were around the corner but never been able to deliver.  Figure 2 looks at the current situation showing the “dots” reflecting Fed forecasts and the market’s prediction of future interest rates.  The divergence between the market and even the dovish end of Fed forecasts is clear.

Figure 1 Fed Interest Rate Projections

 

 

 

 

 

 

 

 

 

 

Fig 2 FOMC vs Mkt Expectations

 

 

 

 

 

 

 

 

 

 

Near Term Policy

Chair Yellen in Jackson Hole basically repeated the existing Fed position that rates would be raised at some point when the data were clear that the economy was strong and inflation reaching two percent.  Markets took the remarks as mildly dovish until Vice Chair Fischer was seen on CNBC as interpreting the Chair as implying that two rates increases by the end of the year were possible at which point interest rates across the spectrum rose fairly sharply and stock prices fell.

The right signal to have sent in my view was very dovish.  The Fed has emphasized that its two percent inflation target is a symmetric one.  Its current forecast is for a strong economy  that will next Spring enter its 9th year of recovery.  If inflation should not be allowed to rise a bit above two percent in such circumstances, how can it be expected to average two percent over time given that recessions and downturns at some point are inevitable? I hoped that the Fed would make clear that it would tighten only when there appeared a real risk of inflation expectations rising above two percent.  At a time when market forecasts of inflation on Fed’s preferred price index are in the range of 1.2 percent, this is very likely some time off.   Some are skeptical of market measures of inflation expectations.  Note that survey measures of long term inflation expectations for both professionals and consumers are near historical lows and if anything have declined over the last year.

Additional points that I would have thought appropriate in commenting on near term policy include: (i) With current estimates of the real neutral rate running near zero and there being a downward trend it is far from clear that current policy is highly expansionary.  (ii) It is plausible that hysteresis effects account for some of the decline in productivity growth and that if so allowing for rapid demand growth might have lasting supply side benefits.  (iii) If a two percent inflation target was appropriate when the neutral real rate was thought to be two percent and stable, surely a higher target is appropriate when the neutral real rate is zero and unstable.  (iv) In contrast to the risks of inflation exceeding two percent ,which are likely very small, the risks of a downturn are very serious. (v) The apparent rigidity of inflation expectations and insensitivity of inflation to measures of slack create extra uncertainties about the conventional idea that unemployment rates in the 4.5 percent range risk accelerating inflation.

I agree with Chair Yellen’s observation that the case for a rate increase now is stronger than it was a few months ago.  The economy certainly does appear to be gaining strength in the second half of the year,  the Brexit shock has been easily absorbed, and markets are unusually calm.  But to say that the case for a rate increase has strengthened is not to say that it has reached the point of being persuasive.

Even if the September employment report is strong, I do not see a case for a September rate increase.  There is no imminent danger of repeating the 1970s experience where inflation expectations ratcheted up leading to stagflation.  If a greater than 1/3 chance of a rate increase in September was not in markets, the cost of credit for small business would be lower and mortgage rates would decline.  Employers would be more confident about hiring.  And pressures would be removed from emerging markets.  The world economy would be more robust.

 

A Thought Provoking Essay from Fed President William

08/18/2016

John Williams has written the most thoughtful piece on monetary policy that has come out of the Fed in a long time.  He recognizes more explicitly than others that r* (r-star), the neutral interest rate, is now very low and quite likely will remain very low for a long time to come.  As he recognizes, this the essence of the secular stagnation concern that I and others have been expressing for the last 3 years.

I now believe that it just as reasonable to suppose that neutral rates will fall further as it is to suppose they will revert towards historically normal levels.  First, there is a kind of hysteresis in rates in which a lower interest rate today tends to lower the neutral rate in the future.  To the extent that low rates stimulate spending by pulling forward investment, low rates today reduce neutral rates tomorrow by moving investment forward.  Second, major structural factors like rising inequality, slowing labor force  growth, lower capital goods prices, slowing productivity growth  and more capital outflows from developing countries appear to represent continuing trends.  Third, there is the prospect that the growing expectation that rates will be low for a long time decreases the spending of target savers and interferes with financial intermediation.

Wlliams rightly if rather tentatively draws the conclusions that a chronically very low neutral rate has important policy implications.  He stresses the desirability of raising r* by pursuing structural policies to raise growth and affirms the importance of fiscal policy.  I yield to no one in my enthusiasm for improved education and educational opportunity but I do not think it is plausible that it will change the neutral rate appreciably in the next decade given that the vast majority of the 2030 labor force will be unaffected.

If Williams is overenthusiastic on education, he is under enthusiastic on fiscal stimulus.  He fails to emphasize the supply side benefits of infrastructure investment that likely enable debt financed infrastructure investments to pay for themselves as suggested by DeLong and Summers and the IMF.  Nor does he note at current interest rates an increase in pay as you go social security could provide households with higher safe returns than private investments.  More generous Social Security would likely reduce the saving rate, thereby raising the neutral interest rate with no change in budget deficits.  Nor does Williams address the possibility of tax measures such as incremental investment credits or expansions in the EITC financed by tax increases on those with a high propensity to save.  The case for fiscal policy changes in the current low r*’environment seems to me overwhelming and much can be accomplished without any increase in deficits.

Williams comments on monetary policy have generated more interest.  He makes the now familiar point that if negative real rates are sometimes desirable on counter cyclical grounds there is a strong argument for an inflation target high enough that the ZLB does not bind or binds only very infrequently.  If the Fed believed that a 2 percent inflation target was appropriate at the beginning of 2012 when it believed the neutral real rate was above 2 percent, I cannot see any argument for not adjusting the target or altering the framework when the neutral real rate is very plausibly close to zero.  The benefits of a higher target have increased and so far as I can see nothing has happened to change the cost of a higher target,

I am disappointed therefore that Williams is so tentative in his recommendations on monetary policy.  I do understand the pressures on those in office to adhere to norms of prudence in what they say.  But it has been years since the Fed and the markets have been aligned on the future path of rates or since the Fed’s forecasts of future rates have been even close to right. I cannot see how policy could go badly wrong by setting a level target of 4 to 5 percent growth in nominal GDP and think that there could be substantial benefits. (I expect to return to this topic in the not too distant future)

Moreover even accepting the current framework, I find the current policy framework hard to comprehend.  If as it asserts, the Fed is serious about the 2 percent inflation target being symmetric there is an anomaly in its forecasts.   Surely if, as the Fed forecasts, the economy enters a 10th year of recovery with unemployment below five percent inflation should be expected to be above 2 percent at that point.  How else could inflation average 2 percent over time given the likelihood of downturns and recessions?

Finally there is this:  Everything we know about business cycle history suggests an overwhelming likelihood that there will be downturns in the industrial world sometime in the next several years.  Nowhere is there room to cut rates by anything like the normal 400 basis points in response to potential recession.  This is the primary monetary and indeed macroeconomic policy challenge of our generation.  I hope it will be very much in focus at Jackson Hole.